The convergence market: two decades in the making
The alternative market continues to evolve from insurance-linked securities (ILS), such as catastrophe bonds, longevity bonds, sidecar debt, and industry-loss warranties (ILWs) to insurance-linked structures, including sidecars, reinsurance transformers, ILS funds engaged in collateralised reinsurance programmes and warehousing insurance-related exposures and ILS, and hedge fund reinsurers.
Current estimates place the total value of these alternative market products—catastrophe bonds, sidecars, collateralised reinsurance programs, and ILWs—at approximately $71 billion, roughly 20 percent of the nearly $400 billion global reinsurance market. This is about 20 percent of the total limit for catastrophe risk being ceded to capital market participants. Some industry participants boldly forecast that this alternative market segment may balloon to $150 billion within the next five years.
Here is the estimated property & casualty (P/C) related risk capacity provided by the ILS segment in 2015:
Catastrophe bond risk capacity—$23 billion;
Collateralised reinsurance—$40 billion;
Sidecar capacity—$5 billion;
ILWs—$3 billion.
Catastrophe bonds–P/C-related risks
Approximately $69 billion in catastrophe bonds have been issued since 1997, with average annual growth of about 22 percent through 2015. An estimated $6.8 billion in P/C-related catastrophe bonds were issued in 2015, marking the fourth highest year in the past two decades. This was a decrease from $8.3 billion and $7.3 billion issuances in 2014 and 2013, respectively.
Catastrophe bond risk capital reached $22.8 billion in 2014 and approximately $23.5 billion at year-end 2015. Issuance during the first six months of 2016 was around $3.3 billion with risk capital at approximately $21.3 billion as of June 30, 2016. Indemnity triggers continue to outpace non-indemnity triggers, both in dollar amount and number of issuances during the past three years. The majority of catastrophe bonds were not rated during 2015 and the first half of 2016.
Cat bond lite
The cat bond lite segment, a private transaction separate from traditional 144A cat bond offerings, continued to grow in 2015 with the issuance of approximately $903.9 million from 20 transactions. There were seven transactions alone through insurance broker-sponsored platforms in the first half of 2016, which totalled $276 million. This segment of the cat bond market growth reflects the desire of small-to-medium-size insurers/sponsors to reduce transaction and structuring costs.
New perils and geographic regions
Peak exposures such as US wind, US earthquake, European wind, Japanese earthquake, and Japanese typhoon continue to dominate the cat bond market. There have been just a few transactions involving a non-peak peril that use cat bonds to transfer insurance risk to the capital market. Chinese earthquake; non-modelled perils including wildfires, meteor impact, volcanic eruption, operational risks, and US private mortgage guaranty insurance were added to the mix between 2014 and 2016. This may open the door for other perils such as marine, aviation, terrorism risk, flood insurance exposure, and cyber risk to become part of the convergence market phenomenon.
Two insurance-linked notes related to operational risks and mortgage insurance were issued in the first half of 2016. The operational risk-linked notes were issued by Operational Re (CHF 220 million [$224.5 million]) and sponsored by Credit Suisse/Zurich Insurance Company. The private mortgage guaranty insurance risk linked notes were issued by Bellemeade Re II ($298.6 million) and sponsored by AIG subsidiary United Guaranty Corporation, the second such note sponsored by this company. The first issuance was in July 2015 ($298.9 million).
Insurers of last resort and public entities
The convergence market has provided an opportunity for insurers of last resort, insurance pools, and non-insurance public entities with huge peak exposures to continue tapping into the ILS market. Just like other primary insurance companies seeking to transfer peak risk exposures, these entities can compare the cost of traditional reinsurance coverage with the use of insurance-linked instruments. This added benefit may reduce reinsurance costs. In 2015, approximately $2.3 billion out of the $6.8 billion cat bonds was issued by these entities. Approximately $7.9 billion of cat bonds have been issued by these entities between 2009 and 2015.
Defaulted catastrophe bonds
Hurricane Patricia, the strongest hurricane ever measured in the Western hemisphere, wreaked havoc off Mexico’s Pacific coast on October 23, 2015, and triggered the Class C notes ($100 million) of MultiCat Mexico Series 2012-1 cat bond. This resulted in a $50 million loss (50 percent payout of the notes’ principal). Despite the trigger events that caused varying degrees of principal loss on 14 transactions from the hundreds of cat bonds issued, market participants have not abandoned this asset class and have sought solutions.
Overall, the average recovery rate is approximately 48 percent, associated with a loss given default of 52 percent based on the historical defaulted cat bonds. The potential for legal disputes remains a problem as ILS investors move further down the risk chain into more working layers of catastrophic coverage and the use of models for perils, which has not gained full industry acceptance. Also, the potential for major catastrophic events still exists and may exacerbate the legal risk.
Risk/return dynamics
Benchmarks for estimating the actual risk transferred by ILS market participants include the attachment probability, expected loss percentage, and exhaustion probability. The attachment probability (the frequency at the point of attachment) details the likelihood that noteholders will lose money; the expected loss percentage details the amount noteholders will lose on average; and the exhaustion probability quantifies the prospect that noteholders will lose everything.
Two simple metrics used by ILS investors to gauge the perceived risk/reward scenario include: ratio of spread to expected loss (loss multiplier) and expected excess return. The spread, expressed in basis points, in addition to coupon interest, is the compensation to noteholders of a potential cat bond loss. In effect, this is the premium paid to noteholders in addition to interest payments on the note’s proceeds, which are invested in permitted investments. The expected excess return is the difference between the spread and the expected loss percentage.
The loss multiplier has been declining for the past four years, underscoring catastrophe bond investors’ willingness to accept reduced compensation for taking on the same level of risk. Based on the 23 tranches for which spread and expected loss information was available (as of June 30, 2016), the loss multiplier on a dollar-weighted basis was 2.12x, compared with 2.43x based on 31 tranches in 2015. This loss multiplier was 3.00x based on 35 tranches in 2014, and 3.47x based on 41 tranches in 2013.
This demonstrated that investors have been compensated less and less for taking on the same level of risk. These results are also reflected in the overall traditional reinsurance market, where the rate-on-line (premium:limit ratio) for property catastrophe reinsurance has been in the doldrums for quite some time.
Collateralised reinsurance structures
Collateralised reinsurance structures are the fastest-growing sector of the ILS market. Estimates place collateralised reinsurance capacity at approximately $40 billion and growing. The growth of this market has been propelled by ILS funds seeking to increase leverage through the use of fronting carriers; coverage tailored for the ceding insurers; and providing coverage for risks that may not be suited for or available from other ILS instruments.
Generally, collateral reinsurance structures use trust accounts to collateralise their exposures. The intent is to provide the ceding insurer with an easily available mechanism from which to tap the funds in the event of a covered loss. The assets in the trust account are segregated from other assets in case of insolvency and there are collateral release provisions that determine the release of funds or assets.
Collateral/counterparty risks
The proliferation in the volume and value of collateralised reinsurance transactions will undoubtedly create collateral and counterparty risks. The use of fronting arrangements and guarantees by re/insurers further exposes the ceding insurer to the credit risk of the fronting carrier. The issue of collateral and counterparty risks is a paramount concern and may create systematic risk during major catastrophic loss events or stressed financial market conditions.
When collateral has been posted to minimise counterparty risks, the transaction’s collateral agreement is expected to address issues related to maintaining the specified amount of agreed-upon liquid collateral during the term of a transaction. The collateral agreement is expected to cover the liability amount (which in most cases is the maximum liability amount or limit); the nature of the eligible collateral; any draw-down mechanism; the timing of delivery of the replenishment of the collateral; the mechanism for determining the collateral value, including any assumed haircuts; the frequency of the collateral’s market valuation; and other significant aspects of collateral management.
ILS funds
Assets under management (AuM) for specialist ILS funds and reinsurer-backed ILS fund managers stood at approximately $54 billion and $14 billion, respectively, as of June 30, 2016. The top 10 specialist ILS funds increased 7.7 percent in the first half of 2016 to $48 billion, compared with the same prior-year period.
Specialist ILS funds are finding ways to increase leverage on collateral transactions by entering into fronting arrangements, forming reinsurance transformers, and creating business models similar to traditional reinsurance/insurance entities in order to access the primary markets via Lloyds’s syndicates, managing general agents/underwriters, and special purpose insurers.
Counterparties are becoming more concerned about the credit exposure of specialist ILS funds as their reinsurance and investment activities expand, and they enter into other long duration contracts risks, and risks with longer payout patterns apart from property catastrophe risk.
Sidecars
Sidecar structures continue to flourish despite softening property catastrophe reinsurance market conditions and the benign insured loss environment. The majority of existing quota share sidecars were renewed in 2015; some have morphed into unrated/rated reinsurance entities without any fixed duration.
Actively managed sidecars also underwent significant capital growth in 2015. These structures that are more permanent in nature have become valuable revenue sources for some sponsors as they performed both underwriting and investment management services in return for a fee. The sidecar market segment creates an additional product offering for the sponsor/reinsurer and also allows leveraging of support staff and infrastructure without capital constraints.
Tail risk
In the context of sidecar transactions, tail risk is the risk borne by the insurer or reinsurer, the original sponsor of the transaction, if the sidecar is insufficiently capitalised to absorb losses and the risk assumed to be fully hedged by the sidecar. From AM Best’s perspective, tail risk is determined by the capital amount needed such that the probability of exhausting that capital level is within a given rating tolerance.
ILWs
Given the private nature of most of the ILW deals, industry estimates range from as low as $2 billion to as high as $7 billion. A more realistic range is $3 to $4 billion of market capacity. In its basic structure, an ILW provides payment if a specific natural catastrophe event reaches a pre-specified trigger level. An ILW can be structured as a reinsurance contract or a derivative contract.
As a reinsurance contract, two conditions must be satisfied for payment to occur: (1) actual industry-wide losses must exceed the pre-specified industry loss level; and (2) the protection buyer’s losses, ie, indemnity, must also exceed a selected attachment level. In most cases, the attachment level for the protection buyer is set so low that once the pre-specified industry losses level are exceeded, the protection buyer’s attachment level is also breached. As a derivative contract, payment is made if actual industry loss amount due to a covered event exceeds the pre-specified industry loss amount.
Basis risk
Basis risk refers to what an insurer or reinsurer would recover from an actual event loss, less any proceeds from hedging. This is a key regulatory and rating concern as the volume and value of ILS transactions continue to increase. AM Best is concerned that an ILW transaction or ILS instrument transaction may not trigger for a covered event, even if 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 in the Best’s Capital Adequacy Ratio (BCAR) analysis, which is an integral element in assigning reinsurance and insurance company ratings.
Life/health-related risks
The life/health-related risk transfers to the capital market continue to trail the P/C segment, despite the growing interest in this segment and the gigantic volume of longevity risks on life reinsurers’ balance sheets. AM Best expects to see more capital market transfers of life/health-related-risks as specialist ILS funds take on mortality, lapse, and longevity risks; and risk mitigation provided by Solvency II under the Solvency Capital Requirement for both the standard formula and the use of internal models.
Conclusion
Alternative capital will continue to flow to the reinsurance sector for the foreseeable future. ILS fund managers will be major players in the reinsurance sector as more collateralised reinsurance programmes covering nonpeak exposures are ceded to the capital market; catastrophe bond risk capital continues to grow; and the potential for longevity risk transfers becomes part of the ILS transaction mix.
Over the years, AM Best has consistently seen new capital enter the insurance market after a catastrophic underwriting event, albeit following the initial post-event market disruption. This new capital helps stabilise the market and address capacity issues. However, the question remains, in what form will that new capital arrive? Will it be the ILS market or the emergence of another reinsurance class as witnessed in 1993 following Hurricane Andrew, in 2001 after the 9/11 terrorism events, or in 2005 following Hurricanes Katrina, Rita, and Wilma.
The next major catastrophe will be the first for most ILS fund managers. How they might react is uncertain, but if capacity issues arise, history has shown that new capital will enter the market. AM Best expects that this additional capacity is more likely to come from capital market solutions than the more traditional creation of ‘bricks and mortar’ re/insurance companies.
This article was excerpted from AM Best’s annual special report on the global reinsurance industry: Innovation: The Race to Remain Relevant.
Asha Attoh-Okine is a managing senior financial analyst at AM Best. He can be contacted at: asha.attoh-okine@ambest.com
