Standardised reporting could popularise cat bonds further
Improved standardisation regarding risk reporting can consolidate cat bonds as an asset class. Even waiting for a comprehensive standard, the industry could take several steps to increase the transparency of risk assessment.
These days, we see a keen interest in ILS investments, as investors seek uncorrelated returns in a low interest environment. The increased interest should give incentives to consolidate the asset class even more. One important part of this should be new steps towards standardised reporting.
Yesterday, this was highlighted in an article concerning the need for standardised reporting at the news site Artemis.bm. We also know that some institutional clients have started to ask for increased standardisation and comparability of risk figures. The industry should see this as an opportunity to address investor concerns before they become real concerns.
Many of the people in the ILS industry I talk to seem to agree that a standardised method for assessing and reporting risks is highly desirable. While this is eventually a very likely outcome, it is obvious that it will take considerable time to achieve. It is thus important that we find substantial intermediate steps.
For a substantial share of the ILS sphere, that is cat bonds, risk reporting is fairly straightforward as the risks are modelled using products from one of the three industry leading catastrophe modelling software firms. Differences in reporting can basically be explained by the use of different modifiers within the software solutions themselves. Within the industry, this is hardly controversial, but to outsiders it may easily be perceived as arbitrariness. However, it is a problem that could handily be addressed, for example by reporting risks metrics provided by this software using unmodified settings, independent of the settings used for internal risk assessment. Another step could be disclosing which modifications are used in producing the reports. While this would not produce comparable figures, it would provide investors with an intelligible explanation of differences between different reporting formats.
A more difficult task to tackle is probably how to report risks that are predominantly calculated using proprietary methods, such as a large number of collateralized reinsurance deals. Developing a common standard will certainly require a lot of time and a substantial effort. But there are things that could be done before having a comprehensive risk reporting standard in place. One such thing could be to separate the reporting for portfolio risks that are calculated using independent software from the risks that are calculated using proprietary methods. At Entropics, we have chosen not to mix risks that are derived from different settings and software in the same reporting. But a portfolio can certainly hold and report both types of instruments, provided that not only an aggregate risk is reported, but also enough information on how this aggregate is calculated based on underlying otherwise incommensurable risks.
For alternative investments, including hedge funds and managed futures, the establishment of the European Managed Futures Association (EFMA), which soon developed into AIMA (the Alternative Investment Management Association), was a crucial step in broadening the appeal of these asset classes. The work on, for example, standardised DDQs provided investors with a comprehensible tool to evaluate managers and strategies, which hugely contributed to the ensuing success of alternative investments. Perhaps this is something that could also inspire the ILS industry?