The hotbed of risk transfer innovation today lies in the insurance-linked securities marketplace, and the growth is accelerating despite the recent meltdown of the subprime mortgage-backed securities markets.
Today, the participation of the capital markets in the insurance marketplace is still relatively small but becoming more common. "Insurance risk is now seen as an accepted class of risk by the capital markets," says David Priebe, president of reinsurance broker Guy Carpenter Europe.
The participation of the capital markets in the insurance-related risk transfer business now comes in various forms, ranging from the reinsurance sidecar, to collateralized debt obligations, to catastrophe bonds and others yet to be imagined.
But the catastrophe bond is where the capital markets really gained traction. They first appeared about a decade ago after the huge losses from Hurricane Andrew when there was a hard market and it was difficult to obtain the needed reinsurance cover.
A CAT bond is usually issued by insurance companies to transfer the risk of specific exposures to natural catastrophes like hurricanes and earthquakes in their portfolio of risk.
Such a bond, for example, might cover losses in South Florida from a Category-5 hurricane, or it might cover an earthquake in Japan. If the event occurs, the proceeds from the bond offering, including principal, would be used to pay off the losses incurred by the issuer.
A big advantage of a CAT bond is that there is no credit risk--losses are fully collateralized by the bond itself. The other advantage is the payment-on-demand feature, Philip V. Moyles Jr., executive vice president of Marsh, points out. In other words, if the terms of a bond are met, the issue gets paid.
The size of the CAT bond marketplace will probably grow to close to $6 billion by the end of 2007, according to A.M. Best & Co. Inc. Emmanuel Modu, managing director for structured finance at A.M. Best, points out that there were $2.1 billion of new CAT bonds put out through July of 2007 by issuers new to the market.
"This is just the beginning compared with what is going to come," Modu says. The size of the market remains comparatively small compared with the overall securities marketplace, which is measured in the hundreds of trillions, rather than the handful of billions.
"The capital markets thrive on volume and innovation," says Quentin Hills, managing director of financial risk products at Marsh, who anticipates further development of capital market risk alternatives.
But, as Marsh's Moyles points out, the capital markets also thrive on standardization, hence the growth of the syndicated mortgage-backed securities markets. That's a big challenge for insurance-linked securities, Moyles explains, especially for long-tail risks that can be difficult to model, quantify and standardize.
The critical factor is the trigger--the event that determines whether a particular natural catastrophe qualifies for coverage under the bond. Growth of the CAT bond market has been dependent upon the development of triggers by the major modeling companies.
PULLING THE TRIGGERS
Basically, there are two kinds of triggers, parametric and indemnity, although there are also industry loss and modeled loss triggers.
Parametric triggers are fairly straightforward and transparent to investors, making them more attractive as the market for insurance-linked securities grows. Typically, the trigger involves a particular event, a Category-5 hurricane for example, at a specific location, say South Florida.
Karen Clark, founder of AIR Worldwide Corp., one of the largest catastrophe modeling companies, says "There has been lots of creativity in developing different options for issuing companies to choose from. Today, there are more tailored triggers to the exposures of individual insurance company customers."
To develop the trigger, the modeler needs information about the exposure and the kind of damage expected in a particular situation. "Every time there is a new message from Mother Nature that losses are going to be higher than anticipated, there is more and more demand from insurance companies for new variations on the old themes," Clark says.
An indemnity trigger involves payment if losses in a specific area exceed a certain dollar amount. For example, an indemnity CAT bond might trigger payment if an insurer's losses from catastrophes in South Florida exceeded $2 billion.
Moyles says the capital markets find parametric triggers easier to understand and transparent but that insurance companies prefer CAT bonds with indemnity triggers because indemnity triggers don't have what's called "basis risk."
Edward Torres, senior vice president of reinsurance broker The Benfield Group, likes to look at "basis risk" as a kind of meteor risk.
"Let's say, South Florida is hit by a meteor from space," Torres explains. "That's a natural catastrophe. The losses might be the same or more as a Category-5 hurricane, but if the CAT bond is triggered by a parametric for a hurricane, it won't pay off on the meteor." Insurers want bonds that cover all losses--hence the popularity of the indemnity trigger.
The market's attitude is changing, however. Torres says, "Investors are getting more open to indemnity triggers while insurers are getting more comfortable with parametric triggers."
The first CAT bonds were issued in the wake of Hurricane Andrew, at a time of a hard market and at a time when the market was having difficulty providing enough capacity in the reinsurance markets.
CAT bonds are usually issued for two to three years of coverage. The bonds are typically bought by large, global investors like hedge funds, pension funds and other fixed-income investors because CAT bonds exhibit risks that are uncorrelated with most other securities.
Thus, adding CAT bonds to an investment portfolio tends to reduce the portfolio's overall risk.
Most CAT bonds are issued through a "special purpose vehicle," an entity that accepts the proceeds of the bond offering and then insures an issuer against a particular catastrophic loss.
The insurer pays the SPV a premium for this coverage. The SPV generates income by investing the proceeds of the bond offering and from the premiums paid by the insurer (the ceding company).
During the term of the bond, investors receive interest, and when the term expires the principal or the original investment is returned to the investors, if there has been no catastrophe. If there is a covered catastrophe, the investor may lose the entire principal plus future interest payments.
Bryon Ehrhart, president and CEO of Aon Re Services, remarks, "If you think about how the world has innovated, we've innovated the most difficult problems first. There is no reason that securitization of more predictable items should have occurred first."
Indeed, the insurance-linked securities market is entering a new phase as investment bankers, modelers, insurers and brokers are now developing and issuing securities well beyond the traditional CAT bond that covers losses from a natural catastrophe.
There is work under way looking for triggers and correlations that could result in the development of insurance securities for directors' and officers' liability coverage, for example. Already this year, Hanover Re issued a bond to cover the credit risk involved in reinsurance recoverables.
Priebe predicts ongoing healthy markets for reinsurance, but "in the high severity, low occurrence market, there is a need for a very large pool of capital. That's where the CAT bond market will continue to grow."
This market, he says, isn't as generic and commoditized as other parts of the securities market. In addition, the underwriting scenario is more challenging and complex.
Although the insurance-linked securities market may be the current hotbed of innovation, don't expect it to supplant more traditional reinsurance, experts also say.
Norman Brown, global head of product development for Marsh Inc., points out that "insurance, from a pricing point of view, is very efficient."
Insurance will take long-tail risk because they understand it and can underwrite it far better than the capital markets, he says.
And insurance-linked securities can be expensive to develop, depending upon investment grade ratings from the markets, and not yet very adaptable to the changes in risks.
"One risk is not the same as another," notes Priebe. Reinsurers specialize in the understanding of risk, and that is often the critical factor.
But, as Aon's Ehrhart says, "Reinsurers will need to compete with whatever cheaper sources of capital that we can find and bring to our clients along with traditional reinsurance."
"Traditional reinsurance as a tool is very productive and very effective and that's why it's called traditional reinsurance," Ehrhart adds. "But there are moments like post-Katrina and other things when it's not. And that's when these alternatives come into play."
JACK ROBERTS is editor-in-chief of Risk & Insurance®.
ALSO: READ THE OTHER PARTS TO THE INNOVATION SHOWCASE ISSUE.
September 15, 2007
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