14 October 2013

Convergence capital sets its sights on casualty

It could be a turning point for insurance-linked securities (ILS). As Aon Benfield’s annual report on ILS declared in the summer, annual catastrophe bond issuance reached $6.7 billion for the first half of 2013, while the value of the market reached a record $17.5 billion.“We believe that the 2013 calendar year could prove to be an inflexion point for the sector,” the report noted.

Aon Benfield is not alone. Willis Capital Markets & Advisory (WCMA) was equally upbeat a couple of months before, noting that catastrophe bond, sidecar, and collateralised reinsurance activity were “roaring forward” in 2013. All bar one of the major Bermuda reinsurers, now had third party capital initiatives in place, it noted. “We may be witnessing the moment when the capital markets have moved from the sideshow to the main tent,” its release stated.

That tent may also be increasingly broad. Aon Benfield and WCMA, as well as analysts at ratings agencies such as Moody’s and AM Best, have raised the prospect of capital markets spreading beyond catastrophe risk—and perhaps even to casualty.

For some, the move is well overdue. Bryon Ehrhart, chief strategy officer for Aon Benfield and chairman of its analytics and investment banking arms, recalls discussions when the risk securitisation industry was founded more than two decades ago. “We never really imagined we would be doing cat and only cat for this long,” he said.

Trouble with the tail

Of course, there have already been deals outside the property catastrophe arena. Aon Benfield’s report total of 27 transactions included three from the life and health sectors. Elements of casualty cover have been included in capital markets transactions: in 2011, the Golden State Re catastrophe bond covered workers’ compensation claims from earthquakes, with the trigger based on ground motion data from the US Geological Survey.

For investors, casualty and other risks offer the potential for more diverse exposure as their interest grows in ILS, which to date has been heavily focused on natural catastrophe risks. US hurricane risk alone accounted for more than 70 percent of catastrophe bonds placed in the first quarter of 2013, according to figures from Willis. At some point, investors are likely to broaden their horizons, according to Arthur Wightman, partner at PwC Bermuda. “Investors will have to accept new types of risks or more extreme risks to maintain their target yields.”

Alex Korb, manager of corporate development and strategy at Verisk Analytics, whose Property Claim Services (PCS) Catastrophe Loss Index is used for cat bonds, industry loss warranties, agrees. “Even the largest funds that invest in this space I am sure have their constraints, and there is only so much UK flood risk or Japanese typhoon risk they will want to take. Casualty is the next frontier.”

Nevertheless, progress so far has been slight. A number of attempts to transfer casualty insurance risk directly to the capital markets have been made—with none so far that can be replicated, according to Alex Krutov, president of Navigation Advisors and member of the Casualty Actuarial Society. He said: “Prophesies of the coming explosion of casualty insurance risk securitisation remain unfulfilled.”

There are a number of obstacles. For a start, its allure for investors may be overstated. Much of the attraction of natural catastrophe risk for capital markets has been its power as a diversifier, with little similarity in its return profile to other assets. That’s not likely to be the case for deals where collateral might be tied up for years, exposed to interest rate and inflation risks that investors such as pension funds have elsewhere in their portfolios.

“On the property side it is perceived that there was little to no correlation with other assets. On the casualty side there is more correlation with investors’ portfolios,” explained Michelle Harnick, structured risk specialty leader and managing director at Guy Carpenter. Nor is that the only issue. The long tail of many casualty risks presents difficulties, with potential for disputes over liability and time working against quick settlement.

"Reinsurance companies presently price casualty contracts using actuaries. Hiring actuaries would increase the historically low cost base of ILS managers, but is unlikely to prove prohibitive."

“It is not like catastrophe risk, where the storm has blown and house has disappeared,” said Alastair Speare-Cole, chief executive of JLT Re. “The trouble with casualty is that even if you know what the claims are you don’t know exactly how long it is going to be until it is settled.”

With perhaps five or 10 years to settlement, there are challenges when it comes to collateral. Do investors put up another lot of collateral for the second year, while they still don’t know the results from the first year, for example? They would also have to do so without the benefit of independent third party vendor models that enable cat bond investors to assess risk and enjoy transparent pricing. “There are definitely some structural issues,” said Speare-Cole.

Finally, convergence capital on the catastrophe side has grown on the back of demand from insurers to transfer the risk to the capital markets. Yet it’s not clear that the same demand is there for casualty lines. For businesses that are still often assessed in part by the growth in net premium, there’s little incentive to transfer the risk. According to Ehrhart, this is a key reason it hasn’t taken off. “Frankly, insurers have adequate capital basis to write most of these risks,” he said. “The auto business isn’t losing money; it’s actually making money. It’s generating capital.”

Casualty reinsurance purchases are pretty flat recently, agrees James Eck, vice president and senior credit officer in the financial institutions group at Moody’s Investors Services. According to him, companies are retaining significant risk on their balance sheets without much difficulty. “There might be a lot of appetite from investors but some reluctance from the insurers.”

Making it work

That might change, however. For a start, the weight of ILS money in catastrophe risk has forced down returns, without seeming to affect investors’ appetite. Insurers might be tempted to use capital seeking just 500 to 800 basis points to improve their return on equity. Some also argue that development of products has been stymied in part by regulatory uncertainty—whether over Dodd Frank, Solvency II or the reconciliation between IFRS and US GAAP on reinsurance accounting.

“If someone is going to invest a huge amount of resources innovating and creating new structures for the casualty area, the last thing they want is to have the whole thing upset by changes in rules,” said Bill Dubinsky, head of ILS at WCMA. “Once all those uncertainties are resolved, however, I think that will jumpstart the development of the products.”

Nor are the structural problems insurmountable. A casualty convergence market might not necessarily need third party models, for example. Reinsurance companies presently price casualty contracts using actuaries. Hiring actuaries would increase the historically low cost base of ILS managers, but is unlikely to prove prohibitive. “There are no widely distributed vendor models but there are certainly ways around that,” said Pete Cangany, partner and insurance leader at Ernst & Young, Bermuda.

Furthermore, not all the risks have particularly long tails, while others see possibilities for hedging long-tail systemic risks in the casualty market through indices. A number in the industry exist, such as Guy Carpenter’s CasReDex index and the ISO Casualty Index,launched in conjunction with JLT Re. The latter covers 10 segments of general liability and commercial motor insurance, updated quarterly for the rolling 10-year experience of more than 700 US insurer groups. This could be used in casualty deals by relying on the industry average to provide a proxy for an individual company’s experience.

According to Korb the index also shows fairly strong correlations of loss ratios between early and subsequent evaluation points for any given accidents year, enabling it to forecast how these will develop. Consequently, the loss ratio after two or three years provides an indication of the final results after settlement. “One approach could be simply to use the earlier evaluations as a fairly good proxy for the ultimate evaluation.” The trigger point could be set at 36 months of development, he suggests. “That would put it squarely into a typical cat bond duration.”

There remain significant barriers. According to Krutov, while there’s significant value in hedging systemic risk, using such a hedge shouldn’t create the illusion that casualty risk has been completely eliminated. The non-systemic risk component still remains and individual insurers continue to be exposed to potentially sizable casualty losses unique to their businesses.

Dubinsky is also cautious on indices. “It needs to start with some trades among reinsurers and insurers to prove the concept. It is unlikely investors will be enticed without the reinsurers having validated the structures.” There is nonetheless more scope for deals on the quota share side, said Dubinsky, perhaps using sidecars—and particularly for certain specialist risks.

“If you have companies that are superbly good at writing terrorism liability coverage outside workers’ comp, I don’t think investors are going to want to be on the other side of them; they will want to be partnering with them in a quota share.”

Nevertheless, few doubt that growing investor interest means convergence capital will seep into the casualty space at some point. It has to, said Cangany. Earlier this year, Towers Watson estimated global pension fund assets in 13 major markets to be $30 trillion. Even a small increase in allocations from pensions would flood the current market. “You cannot fit all that into peak peril risks,” said Cangany. “Ultimately, if you want ILS to grow in a meaningful way, you have to diversify into other lines of business.”