Basis Risk Remains Key Problem for Cat Bond Market

The catastrophe bond market could triple in size over the next decade, but that means sponsors and investors will only need to manage the problem of basis risk at even greater levels, according to industry professionals.

“The basis risk issue is a serious one and one that investors need to be aware of,” said John Seo, managing partner with Fermat Capital in Westport, Conn. “Early days, investors blew it off. We just can’t put on the blinders and say it’s not my problem.”

Broadly, basis risk in the catastrophe bond market refers to the possibility that the index or model used to trigger a bond payout will not correlate with the sponsor’s actual losses.

The result is that although an insurer suffers a loss it feels should be covered by the bond, it cannot collect.

During the initial development of the catastrophe bond market, sponsors managed their basis risk concerns by focusing on issuing bonds for “clean risks.” These include exposures like U.S. windstorm and U.S. earthquake, where sponsors have decades of information that could reliably depended on to match possible modeled losses.

But as the market expands into new regions, the threat of basis risk will only become larger, said Andreas Muller, Ph.D., head of origination/distribution of ILS investment at Munich Re.

“I strongly believe that we would have had much more transactions in the past if we had stronger tools in place,” Muller said. “We would have many more deals, especially in Asia or Europe.”

Muller added that European investors are already becoming focused on development of basis risk. Their concerns are particularly acute when it comes to structuring catastrophe bonds for European perils, where modeling information is significantly limited when compared to the U.S.

“When we discuss cat bonds with European investors, basis risk is at the top of the agenda,” he said.

New efforts to develop and expand catastrophe models will assist in alleviating some of the basis risk concerns going forward, said Fermat’s Seo.

He pointed to the development of PERILS, a newly created industry loss index being developed by a consortium of insurers and reinsurers as a step in the right direction.

“PERILS indices is an absolute right direction,” Seo said. “It’s part of a virtuous cycle that improves the risks,” he explained. “Sponsors self-selected for a very small part of the market risks that are very clean for investors. But if the market is going to grow we are going to start penetrating into risks that are less clean.”

Munich Re’s Muller added that once basis risk can be controlled or just more accurately quantified, pricing for catastrophe bonds should also fall in line with traditional reinsurance, and more sponsors and investors will follow.

“A little bit more movement [on pricing] will see a lot more sponsors in the marketplace” he said. “As far as investors, an investment committee will want to know is what the deepness of the market is. If they hear $50 billion, they will say no.”

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