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By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®

One investor, who shall remain nameless, grumbled incessantly during the afternoon session on collateralized reinsurance at last week's catastrophe bond conference in New York City. Luckily, the words under his breath were in a foreign tongue, otherwise we here at Risk & Insurance® might have recorded them in our notebook.

It is a matter of debate whether the speakers denied that or not, but what they did say definitely is that collateralized reinsurance has its own special place in the world of insurance-linked securities (ILS), separate from CAT bonds. It's not that one product covers better property-catastrophe risks than the other.

It's that collateralized reinsurance has found itself a niche at the bottom of the reinsurance program. Collateralized reinsurance usually comes into play at the lowest layers of a primary carrier's reinsurance program. We're talking even below the traditional "working layers" where the big-name reinsurers play.

"It really doesn't overlap," as Chi Hum, managing director at GC Securities, explained collateralized reinsurance and CAT bonds to Risk & Insurance®.

Bonds usually cover something like a one-in-100-year event. Bad things that aren't supposed to happen. Collateralized reinsurance is for bad events that could, and do, happen.

That's the beauty of the "collateralized" part of this product. You can rest assured that money will be there when you file a claim. Instead of traditional reinsurance, where you're banking on the reinsurer's rating.

"I promise to pay you when something bad happens and, by the way, here is the money in a trust," was the way Barney Schauble, principal and co-owner of investment manager Nephilia Capital Ltd., put it.

The collateral in these arrangements is frequently held in cash or treasuries. Not $1 has been lost over the last couple years in any of the collateralized reinsurance trusts at insurance-focused investment firm Juniperus Capital, according to its chief underwriting officer, Stephen Velotti.

Most amazingly, investors can see returns upward of 20 percent to 30 percent for putting up that collateral in a great year when no event happens. On average, though, expected returns can be 8 percent to 15 percent, depending on someone's risk appetite. (If an event occurs, returns obviously would be less.)

Another benefit, as explained by Lixin Zeng, portfolio manager at Validus and also a speaker during the session, is that collateralized reinsurance can be an integral part of a reinsurance program.

While some at the CAT bond conference put on by IQPC called collateralized reinsurance "pioneering" and an "integral part" of a hedging program, Velotti admitted that "the market has a ways to go."

As Zeng pointed out, it can still be tricky for investors to enter into because, for one, no centralized market exists. And analytics can also be a hurdle, as licensing expensive catastrophe modeling software is but one part of understanding the underlying exposures.

Still, Velotti predicted, should another active hurricane season occur, the capital markets will not launch another "Class of 2005" of fledgling reinsurance companies Chances are, investors will funnel their cash through vehicles like Bermuda-based Juniperus and Nephilia, which can set up these ILS deals.

For the time being, though, our grumbling investor still considered collateralized reinsurance "the hidden market," one whose current size no one can be certain of.

He also didn't like it when the speakers suggested that a big benefit for investors of this ILS product was that they could get much more detailed data about the underlying exposures.

February 2, 2010

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