When to Sponsor a Cat Bond

Catastrophe bonds offer a compelling supplement to traditional reinsurance catastrophe programs when capacity is difficult to obtain and multi-year solutions or hard collateral are needed, given a company’s own strategic risk management plan. However, despite a closing price gap, traditional reinsurance remains the more cost-effective option for Canadian insurers in the current environment.

Although reinsurers faced challenges in 2011, underwriters have demonstrated resiliency and remain well-capitalized. Most balance sheets are markedly stronger now than this time a year ago, following a very quiet first two quarters of 2012 in terms of global natural catastrophes.

The gap in the perspective of risk is growing. Reinsurers are becoming increasingly sophisticated with respect to deconstructing models, making adjustments and even creating their own models so as not to be dependent on a third party’s changing view of risk. A thorough understanding of a company’s risk profile from many perspectives and analyses, accompanied by candid dialogue with reinsurers on understanding the risk and its drivers, is essential to creating a valuable bespoke reinsurance program.

This type of “customized” risk solution offers reinsurance that responds to management’s specific goals and the company’s unique risk profile rather than to an industry loss event.

THE CURRENT LANDSCAPE

The (re)insurance sector experienced historic catastrophe losses in 2011, many in areas not previously considered “peak” risks. Devastating earthquakes in Japan and New Zealand, floods in Thailand and Australia and a record-breaking tornado season in the United States contributed to insured losses in excess of $100 billion.

Many reinsurers undertook a comprehensive review of modelling methodology and implementation to assess analytical adequacy after the loss activity of 2011. Most reinsurers are now making customized adjustments to model outputs, blending results from multiple models and, in some cases, building their own model view.

Given loss experience and significant model version changes affecting the property catastrophe space, balanced by a healthy capital environment, reinsurers were in a position to undertake a major review of pricing and underwriting going into the renewals. This approach led to significant market fragmentation in the market’s assessment and pricing of risk at Jan. 1, 2012.

While the market historically has tended to respond to loss activity or model change in a relatively uniform fashion, there was far more customization in reinsurers’ responses at this renewal. As the level of sophistication increases, reinsurers are tailoring pricing and capacity decisions to adhere to their own unique perspectives. This can lead to idiosyncratic capacity shifts, with some reinsurers increasing capacity in certain regions while others are pulling back.

ALTERNATIVE CAPACITY SOURCES

The outcome of the Jan. 1, 2012 reinsurance renewal was a 9.5% increase in global catastrophe rates. However, there were wide-ranging rate movements at national and provincial levels that depended on both loss experience and exposure perceptions. Reinsurance rate increases and dislocation of capacity naturally encourage the sector to assess non-traditional reinsurance products with growing interest in capital markets solutions. This trend is expected to continue in 2012, with significant growth anticipated from alternative capacity sources, including the catastrophe (cat) bond, the industry loss warranty (ILW) and the collateralized reinsurance markets.

So, when are these nontraditional solutions right for a Canadian client?

CATASTROPHE BONDS

A stand-alone Canadian-peril catastrophe bond has never been placed, although Canadian earthquake risk has entered the catastrophe bond market on a combined basis with other perils. (Blue Danube Ltd., a $240-million transaction that closed in April 2012, included all Canadian provinces in its covered area.) To explore the reasons why Canadian perils have not been securitized more frequently, we examine the four critical factors to the purchase of a cat bond: risk transfer cost, risk period (single year versus multi-year), basis risk and industry impact.

RISK TRANSFER COST

The easiest explanation for the lack of Canadian perils-only catastrophe bond activity is the discrepancy in minimum rates on line between the traditional reinsurance market and the catastrophe bond market. Canadian insurers historically have been successful in achieving top-layer traditional catastrophe rates on line (premium/coverage purchased) below 2%.

On the other hand, cat bond investors – particularly in recent years, with inexpensive financial leverage being less available – traditionally required minimum returns of 3% to 3.5%, resulting in 50% to 75% premiums for the cat bond market relative to traditional reinsurance catastrophe capacity. In the aftermath of significant “cold spot” area losses in 2011, reinsurers applied a hard 2% minimum rate on line to most Canadian cedents at Jan. 1 renewals. In the catastrophic bond market, however, capacity providers continue to reduce minimum return thresholds for perils that allow them to diversify away from U.S. wind, which is the market’s peak exposure.

Accordingly, as minimum rates on line increase for Canadian risk in the traditional market while decreasing in the capital markets, the capital markets are becoming comparatively more attractive from a price perspective.

RISK PERIOD

While both traditional reinsurance and catastrophe bonds offer multi-year fixed

price protection options, the cat bond market typically offers better rates and larger capacity for multi-year options. Catastrophe bonds predominantly carry a three-year risk period, though transactions with a risk period of four or even five years also have been completed – often with little or no increase in the required rate on line. Increasing a transaction’s risk period (all else equal) reduces annualized burden of issuance expenses, as the bulk of these expenses are fixed and one-time expenses are incurred at the inception date of each transaction.

Related to both price and limit are the frictional costs involved in catastrophe bond issuance. As mentioned, the impact of issuance expenses on the annualized “all in” cost of catastrophe bond is highly dependent on transaction size. However, as the technology of the cat bond market has become more standardized, these costs are continuing to decline. In addition, repeat sponsors often can achieve reduced issuance expenses on second and subsequent issuances relative to initial offerings.

In general, the minimum reasonable size for a catastrophe bond transaction is US$50 million to US$75 million, with more typical transactions in the region of US$150 million to US$200 million.

Significantly larger limits are also possible. For example, Everglades Re Ltd., a US$750-million transaction, was completed in May 2012 for Citizens Property Insurance Corporation.

BASIS RISK

Basis risk is the risk inherent to the cat bond’s triggering when funds are not required, or not triggering when funds are needed. There is nothing worse than paying millions of dollars for a risk management solution that doesn’t recover when surplus is needed.

New developments in catastrophe bond sophistication are doing an excellent job of reducing or eliminating the basis risk from catastrophe bonds. Traditional reinsurance layers that are stripped of the main catastrophe peril covered by the bond can be “wrapped around” the bond to eliminate basis risk and provide an effective overall risk management solution. These solutions are particularly effective when traditional reinsurance capacity cannot be found at any price.

Indemnity-based triggers are also on the rise (accounting for more than 60% issuance during 2012 year to date) and would no doubt be worth careful cons ideration for the Canadian stand-alone market as well.

INDUSTRY IMPACT

The final major consideration for the catastrophe bond market over traditional reinsurance is an assessment of industry impact on the peril and return period being managed. If a company wants to cover its 1-in-1,000-year B.C. earthquake event, it is prudent to consider the overall industry impact. When managing against remote events, it is comforting to have access to the hard collateral of a catastrophe bond.

The ability to provide access to high-quality collateral in trust is one of the most important – and appealing – features of the catastrophe bond product to protect buyers seeking to effectively address particularly remote scenarios at manageable cost levels.