TECHNOLOGY 11
T
he insurance-linked securities (ILS) space has attracted a lot of attention in the past few years. It has seen large
influxes of capital, the entrance of a number of niche players and the increasing recognition by traditional reinsurers that they need to join the party or continue to see their market share erode.
Early ILS entrants have established a firm foothold, but those just
starting now face a
competitive landscape of new and established balance
sheets vying for capital investment
dollars and attractively priced risk. Success for startups now, as always, is driven by their ability to come to market at the right time with products investors want.
Meanwhile the flood of new capital, combined with several years of relatively benign catastrophe losses, is having a negative impact on pricing as reinsurance rates continue their steady downward march. Many traditional reinsurers have yet
to commit fully to their own ILS
strategies for fear of cannibalising their existing books of business, but few in the industry expect this reticence to last.
The tough choice facing established reinsurers is similar to that faced by another industry, described by Clayton M Christensen in his best- seller, The Innovator’s Dilemma. In this book he studied how computer hard drive manufacturers in the late 20th century went through rapid cycles of innovation, market dominance, and a reluctance to innovate, resulting in less profitable devices and their eventual bankruptcy.
The most startling aspect of his research was
how few market leaders of the day were able to transition to the next generation of product before being made irrelevant by new entrants.
THE PACE OF CHANGE Part of the problem facing the companies in The Innovator’s Dilemma was the speed with which hard drive technology evolved. The ILS space is not evolving quite this quickly but it’s not far behind. New products, new structures and new entrants are competing with each other for a limited amount of risk and capital. The ability to create a new vehicle that addresses a specific need and operates with thin margins, and to be first to market, will be essential for long-term profitability in a crowded space.
One important enabler of innovation and
speed to market is the ability of the company to quantify its risk and plug the new structure into its existing back office. Quantifying risk across
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an entire portfolio, identifying diversification opportunities, building optimised hypothetical portfolios, mirroring complex contract terms in the system, accounting for various commissions and measuring impact to profit and loss are all features that support product innovation and construction of optimal books of business.
Unfortunately simply understanding your risk exposure and being able to represent an arbitrarily complex product in your risk portfolio management system is not sufficient by itself. The business will come in but accounting for it can quickly become a drain on resources, which is why a strong tie to the back office accounting systems is vital. This is a problem that can’t be ignored when the pressure to drop prices and keep headcount low is unrelenting.
There are a number of existing packages on
the market that can help with many of these requirements. Some are particularly good at analysing aggregate exposure, some are great at portfolio optimisation and some can blend many vendor models together into composite views on risk. However a system that combines all this functionality as well as close ties to common back office products remains elusive.
When it comes to such systems, one size
definitely does not fit all. A special purpose vehicle
that supports a single structure may
require very simple tools to maintain itself, while a multi-line fund or reinsurer greatly benefits from implementation of a full underwriting platform.
What we have observed is that most of our
clients share a common desire to do things their own way, avoid vendor lock-in and build right- size tools for themselves that their competitors do not possess. They believe such customisation provides a market edge and a demonstration of superior risk management that justifies premium pricing for their products.
Dmitry Mnushkin is president of Treefrog Consulting, a Bermuda-based consultancy specialising in custom risk portfolio management
systems and tools for the reinsurance, cat bond and ILS sectors.
“New products, new structures and new entrants are competing with each other for a limited amount of risk and capital.”
The right ILS or reinsurance system must possess several
key characteristics. It must
be flexible enough to allow the business to bring new products to market without lengthy system modification. It must allow for a full understanding of
risk and aggregate exposure
to multiple loss scenarios. For underwriting platforms it is vital that the system speaks the common language of loss curves, allowing for arbitrarily complex structures to be built without involving IT.
The system must also support comprehensive integration into the
business ecosystem.
Accounting packages, trading desks, and enterprise risk management systems should all be interlinked to ensure the seamless flow of business transactions. In our experience this typically means a custom software build.
Innovation will be the key to survival and
prosperity in the ILS space. A company with creative business minds empowered by the right tools can consistently beat
its competition to
market with products the back office and pricing system can support. n
MEET THE AUTHOR Dmitry Mnushkin
INTELLIGENT ILS JUNE 2014
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