Choose your weapon carefully

Indemnity trigger transactions have become something of a norm within the insurance-linked securities (ILS) market in recent months, with more cedants opting for these structures.

While the total volume of catastrophe bonds soared to an impressive $6 billion in the first half of 2014, only four out of 23 cat bond offerings used a different type of trigger, with nearly all first-time sponsors deciding to use an indemnity trigger.

This figure points to a significant trend within the market. Going back only a couple of years, less than 50 percent of bonds were issued with indemnity triggers; the rest were non-indemnity deals with triggers tied to indexes or parametric payment triggers.

Historically, although perhaps slightly simplifying the matter, indemnity triggers were regarded as better for cedants because the payout from any ILS deal would more likely match the actual losses in their portfolio.

The downside was that these losses could take longer to calculate. From an investor’s point of view, parametric or index-linked triggers were generally preferred because of the quick certainty they provided in terms of what losses would be incurred.

A closer match

Indeed, it appears that much of this trend can be attributed to cedants having greater leverage in the market at the moment. With investors competing for deals and prices at an all-time low, cedants are more able to set their own terms and conditions on the structure of deals.

Michael Madigan, a partner in the insurance practice, and head of the property and casualty alternative risk transfer practice in New York, at law firm Sidley Austin, agrees that the driving force behind the rise in the use of this trigger—something which has also helped to encourage growth in non-peak ILS issuance—is the similarity in the coverage cedants receive to that offered by traditional reinsurance.

“When seeking to obtain reinsurance coverage through a cat bond, a cedant naturally focuses on obtaining coverage on terms similar to its traditional reinsurance treaty. An indemnity trigger would therefore seem to be the natural fit for obtaining such coverage,” explains Madigan.

“However, as ceding companies quickly discover, because cat bond offerings are broadly distributed securities offerings, obtaining coverage through a cat bond involves a very different process than procuring traditional reinsurance.

“Unlike traditional reinsurance arrangements, a securities offering is marketed towards sophisticated investors that do not necessarily have the same level of insurance expertise as a traditional reinsurer, and the relevant insurance risks must be described in an offering circular.

"Obtaining coverage through a cat bond involves a very different process than procuring traditional reinsurance."

Modelling plays an important role in any risk transfer. In previous years, this has caused some risks to be excluded from catastrophe bonds, Madigan explains.

“An essential component of this description is a risk analysis assessment produced by a third party insurance risk modelling company. Due to model limitations, not all risks can be properly modelled, and there is typically much focus on what the modelling firm can and cannot model,” he says.

“In prior years, this usually led to excluding from catastrophe bond cover certain risks that would normally be covered by traditional reinsurance. However, as investors have become more receptive to covering these risks, unmodelled risks that were traditionally excluded from the cover have now been included in more transactions.”

The market’s rapid growth in recent months has resulted in a gradual expansion of the risks covered. Madigan says the logical conclusion of this process is an even closer match to the coverage offered by traditional reinsurance.

“In the 144A cat bond market, the focus is to expand the use of indemnity transactions even further with the ultimate goal being to match the cedant’s traditional reinsurance treaty as closely as possible. Although the indemnity cat bonds have this goal, they nonetheless remain securities and not insurance/reinsurance from a legal perspective,” he says.

Pricing push

While similarity in coverages may have been the driving force behind these transactions, there are other factors such as price which have contributed to the trend.

Previously, indemnity bonds would have allowed for a larger premium due to modelling uncertainty and the execution of risks inherent with these triggers. However, as the alternative capital has continued to soften the market, investors are more willing to forgo the premium.

But as Madigan warns, cedants must be aware of all the factors when making this decision.

“Although indemnity triggers have increased in popularity, cedants must still be mindful of other considerations when choosing between an indemnity and a non-indemnity trigger,” he says.

“The threshold question to using a non-indemnity trigger is whether such a trigger can be created without creating too much basis risk (ie, a mismatch between the cedant’s actual losses and what payout the trigger will generate). Only a non-indemnity trigger that closely aligns with actual expected losses will be considered.

The legalities

Madigan explains that given the additional considerations, disclosure documents for indemnity transactions require more time and resources from the cedant.

“One of the most time-consuming portions of an indemnity transaction is the development of the ceding company’s subject business disclosure to be included in the offering document,” he says.

“This section of the offering document, which describes the cedant’s business that is being reinsured, usually requires the extensive involvement of a number of the cedant’s employees.

“Additionally, this section is subject to extensive due diligence, both in the form of management due diligence and review by lawyers of documents such as policy forms, underwriting manuals, claims manuals and other documents. In contrast, a non-indemnity transaction typically requires only a one-paragraph description of the cedant in the offering document.”

The challenges

While the closer alignment of an indemnity transaction with the reinsurer’s own needs is viewed as a positive, cedants must be prepared for the challenges that may follow as a result.

Often, the payout amount following an event in a non-indemnity transaction is determined by a third party—making payment quick and usually received within a few months. In an indemnity transaction, the cedant must submit a proof of loss claims to the cat bond issuer for paid claims only.

Subsequently, the third party must review the claims submitted and decide whether these are covered under the event definition, which can be a lengthy process.

Additionally, there is room for dispute, as Madigan explains.

“Investors could challenge whether the insurance risks were properly disclosed in the offering circular, or whether the cedant’s claims handling has been conducted in accordance with its established claims procedures as described in the offering document,” he says.

“Additionally, in an indemnity transaction, the cedant must be comfortable with disclosing its book of business in an offering document and providing exposure data to investors. Since a 144A cat bond offering is normally listed on a stock exchange, the document is a public document regardless of the fact that the offering document claims to be confidential.”

As the market continues to grow and evolve, Madigan says that the trend towards indemnity cat bonds is most likely here to stay.

“As investors become more willing to cover insurance risks that are not fully modelled and indemnity cat bond coverage more closely aligns with coverage provided by traditional reinsurance, I think we will see a continuation of this trend. However, before making a decision to go with an indemnity transaction, the advantages and disadvantages of indemnity versus non-indemnity should be thoroughly evaluated,” he warns.