ALTERNATIVE RISK TRANSFER MARKET UPDATE [Rough Notes]

Insurance-linked securities market matures and gathers momentum

For the better part of the past 10 years, the financial service industry has been trying to find ways to combine the advantages of an unlimited supply of funds via the capital markets with methods to help finance the risk transfer industry. This process, commonly known as convergence, has been slow to develop; however, the process intensified after Hurricanes Katrina, Rita and Wilma. The insurance industry became very interested in locating an established source of funds, and the capital markets were interested in finding better ways to deploy their capital.

As a result, a number of innovative financial products soon began to appear in the investment community. Initially, these products-catastrophic bonds (CAT bonds) and other insurance-linked securities (ILS) products)-were costly to establish, difficult to understand and generally lacking in standardized methodology; but, today, many of these impediments have been resolved. As a result, the world capital markets, primarily hedge funds, have become a major player in the insurance industry.

Just to set the stage, it should be noted that 2011 was a very active year for catastrophic losses. In fact, 2011 may ultimately go into the record books as one of the worst in recorded history. What made this so remarkable was that the record was set while the United States did not experience a single cat event. This of, course, fueled interest in bonds and other securities in other areas of the world. Presented below is an overview of 2011 and a preview of 2012.

Early activities

It is important to remember that the ILS market did not get its start until 1996. And, it was not until the aftermath of the three sisters in 2005 that any real advancement was noted. From its humble beginnings, the ILS market has matured, and adjusted to concerns of both buyers (investors) and sellers (sponsors) over the intervening years. Despite numerous impediments, the ILS market has experienced robust growth worldwide over the last few years.

Many early proponents of the ILS concept were able to see the long-standing shortcomings associated with the insurance industry which typically follow extreme catastrophic events. This situation arises immediately since large losses tend to tax the entire insurance marketplace. Initially capital is stressed which, in turn, puts pressure on insurers/ reinsurers to increase rates to rebuild surplus and provide financial support for higher premiums. This cyclical pattern has played out time and time again, and leftthe future of the insurance industry in the hands of fate.

Most experts agreed that some more stable source of funds was needed to weather the effects of these catastrophic losses. One source that was quickly identified was the capital markets, which had an unlimited supply of funds, but no good way to provide support to the insurance industry. However, a number of innovative ideas began to emerge, including one of the first ILS products: the catastrophic bond or CAT bond for short.

From the start, some insurance industry experts voiced a major concern that once funds started to flow from the capital markets, they would want to control the market. Additionally, initial deals that were completed took an inordinate amount of time, which usually meant higher fees that would be associated with the ILS products. Because these programs were so complex, it generally meant that legal advice and counsel was involved with every step of the process, ultimately adding to the transactional cost associated with the product.

However, both sides to the transactions received a number of major advantages that for the most part were not available elsewhere in the marketplace. For the buyers (investors) of these products, ILS were zero beta investments, which means that price changes were not tied to the results of the general stock market, thus providing a diversification that was welcomed by the investment community. Additionally, when compared with other investment vehicles, returns from ILS products were typically higher, and in some cases, significantly higher, than other investment vehicles.

For the sellers (sponsors) of the ILS products, it meant that they had a source of capital that was already funding, and payment of claims could be made in a timely manner. From the start, most of the CAT bonds did not even require a proof of loss, since payment was pegged to some predetermined loss level (i.e., intensity of a storm or earthquake, amount of rain fall, etc.). Further, since the ILS product was written on a three- to five-year policy period, both parties avoided the time-consuming annual renewal process.

2012 and beyond

Following a recording-setting year for catastrophic losses, most industry observers are looking for big things in the ILS market. However, it is not just the follow-up to an active 2011 that is signaling a banner year. The entire ILS market and particularly CAT bonds have matured significantly over the past few years and, as a result, acceptance is much higher with the financial services community.

Initially the ILS market grew out of a need for additional capacity for hurricane risks in the United States, more specifically in the Gulf Coast. As a result, there was little diversity in the risks to be covered, and investors had no chance to spread this risk to other areas. However, since that time, there have been meaningful changes in the risks covered, as well the locations of the risk. Today, many of the current crop of CAT bonds will cover a multitude of perils. Coverage is not only provided for wind and storm damage, but also for earthquake, snow and rainfall; but even more important to investors, the locations are being spread worldwide. With the wide range of losses experienced last year, including earthquakes in Japan and New Zealand, and severe winter storm damage in many of the EU countries, ILS products are being adopted to exposures and risks around the world. Additionally, ILS products have begun appearing that include such unique risks as life and health perils.

Another trouble spot for early adopters was arriving at policy wording, policy period and a claims triggering mechanism that were acceptable to both sides. For the most part, these early deals started with a blank sheet of paper; however, over the years there has been progress of the ILS industry to standardize the policy wording and policy conditions of the ILS contracts. This work has greatly assisted in the transparency of the transactions. It was also a key consideration in being able to establish a secondary market where ILS can be actively traded.

The standardization of the contracts has also greatly reduced the transactional cost of each deal, thus helping to encourage more participation by both investors and sponsors. Standardization has also made it easier for some sponsors to elect to go directly to the capital markets. This is a new approach that started recently when the California Earthquake Authority established its own reinsurance company, Embarcadero Re Ltd., to deal directly with investors. More recently, this trend has included a Japanese earthquake deal via Zenkyoren and the start of Pelican Re Ltd. Louisiana Citizens Property Insurance Corporation, a nonprofit insurer of last resort for the residential and commercial property owners in the state, decided to sponsor its own CAT bond known as Pelican Re Ltd. More of these direct relationships should be anticipated.

Conclusion

It is difficult to see how rapid growth of the ILS market will not occur. Following on the heels of a recordbreaking CAT loss year of 2011, interest is high in identifying a sustainable source of funds for the insurance industry in the event of further adverse loss experience. As early adopters begin to better integrate ILS into their risk transfer programs, they have become an important part of an overall transfer strategy. Many of these early proponents have now begun the renewal process on their multi-year policies, and additional insurers/reinsurers have also added to the total of ILS participation.

Bottom line, while some in the insurance industry have tried to postpone this eventuality, most industry observers can now readily see the advantages that the capital markets can bring to the table. Growth of the ILS market has occurred for a variety of reasons; however, the underlying rationale remains the same. For the most part, sponsors continue to value the fully collateralized, multi-year capacity provided from the capital markets. Investors, on the other hand, continue to prize a diversified zero-beta asset class that can attain superior returns. Long-term this should prove to be a win/win situation for both the capital markets and the insurance industry.

The standardization of the contracts has greatly reduced the transactional cost of each deal, thus helping to encourage more participation by both investors and sponsors.

By Michael J. Moody, MBA, ARM