The convergence market’s growing proposition

The evolution of the convergence market continues unabated as evidenced by the increased amount of peak exposures ceded to the insurance-linked securities (ILS) space, the record-breaking amount of cat bonds issued, the increase in assets under management of dedicated ILS investors and last but not least, the benign insured loss environment over the past years.

Estimates for the convergence market’s overall value in 2014 ranged from $45 billion to $60 billion. The growth in the ILS property catastrophe exposure market has been phenomenal given it was non-existent 20 years ago.

Catastrophe bonds issued for property/casualty exposures have averaged annual growth of about 24.4 percent since 1997, compared with 16 percent annual growth related for both property/casualty and life/health exposures.

The emergence of this market, which blends traditional re/insurance contracts with financial instruments, has generally been caused by perceived inefficiencies in the traditional reinsurance market, the weakness of the insurance underwriting cycle due to pricing and major catastrophe events, the desire by holders of peak insurance exposures to diversify reinsurance coverage (ie, credit risk reduction) and the emergence of enterprise risk management.

Most of the financial instruments underlying this market have been patterned on asset-backed securities, futures and options, and other derivative instruments that provide direct access to the capital markets, which has greater capacity than the traditional reinsurance market.

Last year’s record cat bond issuance of about $8.8 billion (combined perils) was the highest amount since 1997 (see Chart 1). Issuance has increased despite an overall decline in spread and the spread-to-expected loss multiplier of cat bonds compared with previous years.

The cat bond market continues to be dominated by the following perils: US wind, US earthquake, European wind, Japanese earthquake and Japanese typhoon. Non-modelled perils including US wild fires, meteorite impact and volcanic eruption were added to the mix in 2014 and the first half of 2015. Potential still exists for adding other insurance lines, such as the casualty arena, to the property cat business.

Key trends

Cat bond lite: These transactions are gaining traction due to the efforts of the major insurance brokers, overseas insurance managers and the Florida take-out companies accessing the Citizens Property Insurance Corporation’s depopulation programme. An alternative to the traditional 144A cat bond offerings, cat bond lite programmes are private catastrophe bond platforms designed to help capital market participants efficiently fund smaller catastrophe reinsurance programmes.

These offerings are generally below $50 million and have increased in dollar amount and volume since 2013 (see Charts 2 and 3). Cat bond lite provides the following advantages: lower transaction and structuring costs; reduced and streamlined documentation; easy entry for small- to medium-size insurers; and accessibility for small investors.

Indemnity triggers: Over the past three years, cat bonds with indemnity triggers have outpaced non-indemnity triggers both in amount and the number of issues. In the 18 months prior to June 30, 2015, more than 70 percent of the cat bonds issued had indemnity triggers (see Chart 4). This recent proliferation is partly due to investors becoming more comfortable with indemnity triggers and sponsors’ willingness to make available detailed company data for modelling purposes. This increase has occurred despite the potential for modelling errors and moral hazard.

Transaction costs, platform and clearing: Compass Re II’s $300 million cat bond issued June 1, 2015 (sponsored by AIG) had some notable features that may have broader implications, including structural and transaction costs, delivery and clearing mechanisms. A parametric cover, Compass Re II has a six-month risk period, which is a far cry from most cat bond transactions with an average three-year risk period and was also cleared on a new online platform.

There was no risk analysis report included in the offering circular as the sponsor did not hire a modelling agent. Instead, investors assessed their own view of risk by performing or retaining the services of their own modelling agent.

The sponsor’s ultimate goal was to reduce structuring and transaction costs. Going forward, expect more platform-based transactions that involve exchange-clearing trading, which will bring greater simplicity and efficiency to the cat bond market.

Other ILS instruments: Collateralised reinsurance, sidecars and insurance-linked warranties (ILW) continue to play a part in convergence market capacity, with the collateralised reinsurance segment being the major driver. This segment’s growth has been driven by specialised ILS funds managers. Recent estimates put the assets under management for specialised ILS funds at around $45 billion and approximately $10 billion for reinsurer-backed fund managers. AM Best expects capacity from the collateralised reinsurance sector to increase, with sidecars and ILW sectors providing a small fraction of convergence market capacity in the near future.

Shared appetite: The barrier between traditional reinsurers and ILS fund managers continues to dissipate. ILS fund managers are finding ways to increase leverage and improve profitability on collateral reinsurance transactions by entering into fronting arrangements with rated reinsurers. Reinsurance transformers being formed by ILS funds and reinsurers have created business models similar to traditional re/insurance in order to access the primary market. This includes the formation of hedge fund reinsurers and insurance entities (eg, Lloyd’s syndicates). These actions in the long run will blend the capacity provided from both capital market participants and traditional reinsurers.

Regulatory framework develops, as does risk profile

The regulatory environment has been very positive and friendly

for the ILS market with various regulatory regimes positioning through legislation to woo market participants. Bermuda took the lead in 2009 with the creation of the special purpose insurer (SPI) class associated with insurance sidecars, cat bonds and other insurance-linked transactions. Despite a drop in the number of Bermuda-registered SPI registrations to 28 in 2014 from 51 in 2013, Bermuda’s SPI class has experienced significant business activity.

Regulators in the Cayman Islands, Guernsey, Isle of Man, Gibraltar and Malta have enacted regulations with the goal of providing risk-bearing entities with protection other than the traditional insurance and reinsurance, and mostly through capital market participants. These new laws and regulations have created a surge in the ILS market.

In the US, the National Association of Insurance Commissioners is debating the risk-based capital treatment of cat bonds held by US life insurers while the UK is considering ways to attract ILS through developing a regulatory and tax framework. These developments are still in the embryonic stage.

A whole host of concerns and emerging risks may manifest and impact the convergence market as it grows. Basis risk remains a key regulatory and rating agency concern as the volume and amounts of ILS transactions increase. This is the risk that a re/insurer would recover less from a hedging product than its actual event loss. The concern is that a catastrophe bond or ILS instrument may not trigger for a covered event when the sponsor has suffered a loss. This ‘negative’ basis risk is especially a concern for ILS instruments with non-indemnity triggers.

From AM Best’s viewpoint, the objective in estimating basis risk is to determine how much reinsurance credit should be given to non-indemnity ILS instruments under Best’s Capital Adequacy Ratio (BCAR) analysis, which is an integral element in assigning reinsurance and insurance company ratings.

Tail risk is borne by the insurer or reinsurer. If the ILS instrument is insufficiently capitalised to absorb losses and the risk assumed to be fully hedged, this exposure may ultimately be borne by the original sponsor. Sidecar sponsors generally take reinsurance credit for transferring risks. While some sidecars may be capitalised to full aggregate limits, others may not be adequately capitalised to absorb losses that deviate from expectations.

In the context of sidecar transactions, tail risk refers to the risk that will have to be borne by the sidecar’s sponsor if it’s not sufficiently capitalised to support the reinsurance transaction. From a rating agency perspective, the appropriate question needed to determine tail risk follows: what capital level is needed such that the probability of exhausting it is within a given rating tolerance?

Collateral and counterparty risks are not solely confined to the convergence market. Yet in 2008, four cat bonds defaulted due to missed interest/full repayment of principle. This resulted from the demise of the transactions’ swap counterparty and brought to light the risk posed by the type of collateral instrument/counterparty used in these transactions. Unless there is full collateralisation of ceded exposures and any changes in market value of the collateral instrument is not borne by the transaction sponsor, collateral and counterparty risks cannot be discounted.

A hallmark of the convergence market is the proliferation and use of special purpose vehicle, protected cell and trust account structures to achieve securitisation/monetisation of insurance risk. Despite the industry’s acceptance of these structures, the preponderance of legal opinions and specific regulations in some jurisdictions that provide statutory segregation of assets and liabilities, to date, have not been subject to judicial scrutiny in any jurisdiction. This includes the walled-off feature between two or more cells, segregation of asset/liabilities and limited liability features. Although remote, legal risks relating to the formation and legitimacy of these structures remains a concern.

Future landscape

The convergence market is here to stay and will continue to play an important role in the risk transfer and risk mitigation process for both property/casualty and life/health catastrophe exposures. This could help dampen the pricing volatility observed in the reinsurance and retro markets, which has been a recurring phenomenon during capacity contraction and expansion.

The growth of this market will depend on the continued decline in the structuring and transaction costs; the comfort level investors and rating agencies have with the risk modelling; development of the secondary market for trading of the various ILS instruments and other innovations; and capacity and pricing constraints in the traditional reinsurance market.

The attraction for cedants to use programmes such as cat bonds or collateralised reinsurance, which are totally collateralised, versus unsecured promises-to-pay from a rated entity, the hallmark of traditional reinsurance, will continue to be the leading catalyst for growth of the convergence market.