Insurance-Linked Securities: Here to Stay?

The convergence of the capital markets and reinsurance is currently a hot topic in Europe and the United States. Driven by investors attracted to high spreads and the opportunity to diversify their portfolios, the insurance-linked securities (ILS) market has taken off in recent years. It has shown significant growth across the spectrum of ILS products, including industry loss warranties, catastrophe futures and derivatives. Cat bonds in particular have experienced a surge in popularity, as have life bonds.

ILS products that transfer risk to the capital markets as an alternative to reinsurance for low-probability, high-severity events have existed for some time. Growth of the ILS market accelerated after the 2004 and 2005 hurricane seasons, when rating agencies increased capital requirements for catastrophe-exposed underwriters, creating a demand for and a contraction of the supply of reinsurance capacity. Insurers increasingly turned to the capital markets as a supplement to reinsurance for their risk transfer solutions for peak U. S. exposures.

But the recent enthusiasm for ILS products manifested in the European, United States and Japanese markets has not to date been reflected in the Canadian market. This may be due in part to the current lack of clarity around the regulatory guidance for ILS. The Office of the Superintendent of Financial Institutions (OSFI) has released a number of guidelines with respect to securitization, but currently there is no specific regulatory guidance for ILS in Canada. ILS may not currently be taken into account for statutory solvency considerations for insurers such as MCT (Minimum Capital Test) and BAAT (Branch Adequacy of Assets Test). However, for DCAT (Dynamic Capital Adequacy Test), a risk management tool that tests a company’s capital adequacy, it may be that a well-structured ILS can help reduce the total capital requirement.

THE FUTURE OF ILS

How successful this trend will prove to be in Canada or elsewhere over the long term is yet to be seen. In the short term, the convergence of reinsurance and the capital markets is already significantly changing the risk transfer landscape in markets in which ILS is well established. Some capital markets institutions are starting to build or acquire their own internal insurance underwriting expertise. On the reinsurance side, some reinsurers are going the route of full convergence and implementing investment banking business models.

Over the past two years, there has been significant innovation with new products. As a result, there is currently a wide spectrum of products available to cedants, from “pure” reinsurance — which is generally customized, indemnity-based and uncollateralized — to catastrophe bonds, which tend to be based on market losses, modelled losses or a parametric index, and fully collateralized. Indemnity bonds represent yet another option.

Cat bonds once covered single perils and single territories. Now, however, they can include various natural perils such as earthquake, tornado, hail, wildfire, flood and winter storm in multiple territories. At one time, rating agencies considered catastrophe bonds “less than investment grade.” More recent catastrophe bond issues provide coverage at high attachment levels and have received investment-grade ratings, opening up the asset class to new investors.

Interest is also growing on the life side, particularly around the securitization of extreme mortality risk — such as pandemics and regulatory capital relief — as well as for the securitization of longevity risk as life expectancy continues to extend.

With such an enormous choice of risk transfer solutions currently available on the market, both through the capital markets and traditional reinsurance, cedants need to be clear about their objectives and carefully consider the pros and cons of each. For example, ILS products can be expensive to set up: fixed up-front costs include legal, rating and bank fees. They are fully collateralized and so bear minimal credit risk. However, basis risk — the risk that index calculations will not equal the actual loss — can be significant. Reinsurers offer technical expertise particularly valuable to small-to mid-sized cedants, no fixed up-front costs and customized coverage. But credit risk may be an issue for lower-rated reinsurers.

Reinsurance and the capital markets present two very different approaches to risk transfer, both with advantages. The attraction of ILS as an alternative source of capacity is undeniable; its long-term success will depend on the care with which capital markets solutions are chosen and applied.

Seven Questions to Ask About ILS

Choosing between ILS and reinsurance requires careful deliberation. Here are some issues you might wish to consider:

1 What are your objectives in considering ILS products? Finding the right balance between traditional reinsurance products and ILS depends on an insurer’s size, risk appetite and many other factors. There is no one-size- fits-all solution; the factors for and against should be carefully considered.

2 Does your company have a tolerance for basis risk within your reinsurance program?

Bonds are generally issued on a named-perils basis and introduce basis risk. Traditional reinsurance coverage, on the other hand, is indemnity-based; as a result, it is much broader and less restrictive with no basis risk. Although ILS might make sense for large, geographically diverse primary insurers, this may not be the case for mid-sized or smaller insurers that are less able to absorb basis risk.

3 How important is full collateralization to your reinsurance program?

The need for collateralization depends on the insurer’s appetite for credit risk. Some insurers elect to supplement their program of strongly rated reinsurers with fully collateralized bonds.

4 How do the costs and resource requirements of risk transfer compare between reinsurance and capital markets issuance? The average first-time issuance of a bond takes three months or more to complete, and may require significant legal and other specialist resources. These expenses can be efficiently amortized through a large, multi-year program. Companies considering this route should consult with a broker or banker about expected fees.

5 If your company has decided to pursue a capital markets solution, would a derivatives strategy provide lower costs and more flexibility in risk transfer than a catastrophe bond issuance? Given the up-front issuance costs, it may be more cost-effective to pursue a derivative strategy for mid-sized cedants. Anyone considering this strategy should first talk with a broker or trusted reinsurer that can offer a considered view of the various options.

6 How will the rating agencies credit this form of risk transfer versus reinsurance?

Rating agencies do not give full capital credit for many ILS products because of the basis risk, but they do publish guidance. A. M. Best Company, which specializes in insurance company ratings, has provided guidance for evaluating basis risk.

7 What are the legal, regulatory and accounting implications of placing risk in the capital markets? The legal, regulatory and accounting implications around capital markets transactions may be significant and should be checked first with both a legal counsel and auditor.

This Q&A is an excerpt from PartnerRe’s recent publication, A Balanced Discussion on Insurance-linked Securities. The publication in full is available at www.partnerre.com