The Bonds That Tie

Catastrophe bond issuance has increased since 2008, despite sufficient capacity and favourable terms from the traditional property reinsurance market, upheaval in the world financial markets, increased catastrophic activity and concerns over credit risk associated with catastrophe bond collateral accounts. The uptick in the insurance-linked securities (ILS) market demonstrates that insurance-linked products (cat bonds, industry loss warranties, sidecars and peak exposure exchange-traded contracts) remain a viable risk and capital management arsenal available to reinsurers/insurers.

INCREASED ILS ACTIVITY

Cat bond issuance totalled $4.7 billion in 2006 — a record at that time — representing a 136% increase over 2005’s activity. Cat bond issuance in 2007 was approximately $7 billion, surpassing 2006’s issuance by 49%. Cat bond issuance dropped in 2008 to approximately $2.7 billion because of the global financial markets crisis; favourable reinsurance prices, as measured by average drop in property rate on line (ROL); and uncertainty among both issuers and ILS investors about the future direction of the cat bond market. Cat bond issuance is expected to be almost $3.4 billion in 2009, a 24.5% increase from 2008. Cat bond capital at risk, which peaked at about $14 billion at year-end 2007, stood at approximately $12 billion in 2008. It is expected to increase modestly to approximately $12.2 billion at year-end 2009.

Activity in the sidecar arena was negligible in 2008 and 2009. Sidecars are playing the role expected — providing capital when markets are hard and returning capital to investors when prices decline. The Industry Loss Warranties (ILW) market has been very light, given that sellers of capacity have been outnumbering buyers recently.

COLLATERAL ACCOUNT DEVELOPMENTS

Notable changes to collateral accounts during 2009 include the use of various types of collateral structures:

• tri-party repurchase agreements;

• total return swaps with Federal Deposit Insurance Corporation (FDIC)-guaranteed bank debt;

• customized puttable floating rate notes [According to Wikipedia, the holder of a puttable bond has the right, but not the obligation, to demand early repayment of the principal. A floating rate bond has both a variable interest rate that is equal to a money market reference rate, like London Interbank Offered Rate (LIBOR), or federal funds rate, as well as a rate that remains constant.]; and

• investment restrictions to highly rated U.S. Treasury money market funds.

The diversity of collateral structures is an added measure to limit the impact on the market of credit risk due to a single collateral approach.

The collateral account is one of the key parameters in cat bond transactions and thus does impact the ratings of catastrophe bonds. The demise of Lehman Brothers Holdings Inc., one of the total return swap counterparties in 2008, has heightened awareness of asset quality and duration of securities in the collateral account. Recent improvements in the quality of assets in the collateral account have provided a measure of assurance for market participants.

PRIMARY INSURERS ISSUE LARGE PERCENTAGE OF CAT BONDS

The majority of the 2009 issues were sponsored by experienced reinsurers/insurers that accounted for approximately 96% of risk capital issued. There was only one first-time issuer, Re Ltd., sponsored by Assurant Inc. Primary insurance companies were fairly represented, with seven such sponsors making up 49.4% of risk capital issued. Ten reinsurers accounted for a 42% share of the risk capital issued. The dominance by experienced sponsors is is explained in part by the learning curve and initial high cost confronting newcomers to this market space.

Cat bonds with an industry loss trigger accounted for the lion’s share of the risk capital issued; these represented approximately $1.5 billion, or 44.1%, of the total. All of the industry loss trigger transactions were associated with U.S. hurricane and earthquake perils, using loss information from Property Claim Services. Indemnity and parametric triggers accounted for roughly 24.3% and 18% of the risk capital, respectively. Three cat bond transactions, Successor II Ltd. and Successor X Ltd. by Swiss Re, and Ianus Capital by Munich Re, were based on multiple triggers.

ASSESSING THE RISKS

The assessment of risk associated with cat bonds usually is based on risk analysis output from catastrophe models by the leading peril modellers (AIR Worldwide Corp., EQECAT Inc. and Risk Management Solutions Inc.). Generally, ratings are assigned based on attachment probability and/or expected loss. Industry losses generated by Hurricane Katrina in 2005 and Hurricane Ike in 2008 far exceeded model estimates by peril modellers. This brought unwelcome attention to the peril modellers. Some experts began to question whether the rare, improbable “black swan” event is applicable to managing losses associated with peak exposures.

More than 75%, or $2.6 billion, of cat bond issuance in 2009 was based on non-indemnity triggers, which exacerbate the issue of basis risk for the ceding companies. Basis risk is the risk of an imperfect hedge. In the context of catastrophe-related insurance-linked securities, it generally is the risk that a cat bond will not trigger even though the sponsor of the bond has suffered a loss for which coverage is being sought.

Whatever instruments are used to manage assets in the collateral account — total return swap agreements, bank deposit agreements or tri-party repurchase agreements — A.M. Best expects a prudent risk management process to be the norm and to include proper reporting and replacement procedures, timely valuation mechanisms by third parties and increased transparency.

Historically, Canadian property and casualty insurers historically have not used catastrophe bonds as part of their overall catastrophe risk management programs. This is likely attributed to both adequate reinsurance capacity and lower weather-related risk when compared to other regions. Should reinsurance market capacity change considerably, companies in the Canadian market may be more inclined to consider catastrophe bonds.

A.M. Best determines how much reinsurance credit should be given in the Best’s Capital Adequacy Ratio analysis based on its evaluation of basis risk associated with non-indemnity cat bonds. This is an important element in assigning financial strength ratings. Before giving reinsurance credit, A.M. Best requires a review of all the executed documents associated with the non-indemnity cat bond transaction. Given the fact that basis risk can change significantly from year to year, a sponsor of non-indemnity cat bonds should monitor the underlying book of business on an annual basis.

At a minimum, A.M. Best expects monitoring to include growth of exposure, demographic trends and property values. A yearly calculation of basis risk for a multi-year, non-indemnity cat bond is prudent, given that changes in the book of business occur over time. For transactions employing indemnity triggers, A.M. Best also reviews related documentation to gain a complete understanding of the transaction structure and to become comfortable with the reinsurance credit taken by the sponsor.

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Historically, Canadian property and casualty insurers have not used catastrophe bonds. This is likely attributed to both adequate reinsurance capacity and lower weather-related risk when compared to other regions.