1 October 2012ILS

Innovation in triggers helps drive ILS market

The insurance-linked securities (ILS) marketplace is in robust health, with 2012 looking set to be the best year since the record issuance of 2007. Issued volume should be in the region of between $6 and 7 billion, up from $4.2 billion last year. Appetite for cat bond investment remains strong amid continuing volatility in other asset classes, while sponsors seek access to the capital markets as a source of alternative capacity for their peak natural catastrophe risks. Recent innovations in indices and triggers have helped to grow issuance of diversifying secondary risks, such as European windstorm, as well as increase transparency for investors.

Strong demand for cat bonds is being driven by keen interest from investors who are looking for an attractive return amid the significant volatility we see in today’s financial markets. ILS investors are institutional investors who are able to incorporate this specialised asset class into their broader asset management strategies. Traditionally, specialised cat bond funds have tended to be the main buying force. Given record low interest rates, however, more institutions such as pension funds, life insurers and even some sovereign wealth funds, are seeking out these alternative investments.Such investments are also appealing because they help institutional investors to diversify their portfolios. Since triggering events like a hurricane or an earthquake occur independently of the gyrations in financial markets, cat bonds offer the opportunity to introduce non- correlated risks into the investment mix. This is particularly attractive at times such as now, when the volatility caused by uncertainties over the eurozone are creating severe headaches for investors.

Over the past 10 years, there has been no significant period during which cat bonds posted negative returns. Cat bonds have consistently outperformed corporate bonds and equities, despite the financial crisis and last year’s record natural catastrophe losses from events such as the Tohoku earthquake and tsunami.

Since 2002, cat bonds have offered an average annual result of over 8 percent, while BB-rated corporate bonds offered a return of 7.3 percent on average. Cat bonds do carry the risk of a partial or total loss for the investor, however, with capital flowing to the insured party in the case of a triggering event. For instance, Tohoku resulted in a payment to the insured of $300 million, while the 2011 US hurricane season resulted in a $200 million payment.

What is perhaps even more significant for investors, however, is the fact that ILS enjoy a high degree of liquidity through the active secondary market that has grown around this asset class. Risk-averse investors tend to reduce their exposure to natural catastrophes during times of high hurricane or natural catastrophe activity. Demand from risk-seeking investors has tended to ensure that market liquidity is maintained even at times of high natural catastrophe activity.The insurance companies that issue cat bonds, the so-called sponsors, continue to view ILS as an alternative source of capital which allows them to efficiently and effectively manage their peak natural catastrophe risk scenarios as well as the risk of exposure concentration. These sponsors also value the collateralisation that is offered by cat bond structures as well as the possibility of securing multi-year coverage for their risks, which helps them to increase their planning.

Developing triggers

A major development in the approximately 15 years since cat bonds were first issued has been in the kinds of triggers used in the various bonds. Swiss Re’s first cat bond, issued in 1997, was the second such bond to be issued and the first to be based on the Property Claim Services industry loss trigger. Over time, ceding companies began increasingly to use other kinds of triggers— parametric or modelled loss triggers, for instance—that have different qualities and represent a different degree of transparency or basis risk (Figure 1).

"Swiss Re's first cat bond, issued in 1997, was the second such bond to be issued and the first to be based on the property claim service industry loss trigger."

Different kinds of triggers and structures are able to co-exist in this particular market, reflecting the various needs of ceding companies and the preferences of investors. Since 2011, the number of bonds issued that use indemnity triggers has seen a large increase. This is, of course, a great advantage to sponsors since it reduces their basis risk and allows them to issue risks to the capital market in a way that closely matches their traditional reinsurance portfolios. At present, more than a third of the cat bonds outstanding are based on an indemnity trigger.In indemnity deals, triggers are based on the ceding company’s own book of business and resemble traditional re/insurance solutions. The cover provided by the cat bond ‘attaches’ (or becomes effective) only if the ceding company incurs a predetermined level of losses. Above the predetermined level, or attachment point, the ceding company is reimbursed for its actual losses from the covered event(s).

Investors may demand an increased spread for indemnity trigger transactions. They are exposed not only to the natural catastrophe risk, but also to unexpected secondary loss effects. Furthermore, they are subject to the operational risk of the ceding company’s underwriting and claims functions. And, rating agencies tend to require additional stress testing due to the operational risk exposure, which may result in a lower rating.

Indemnity triggers have been proven. Swiss Re issued the first ever transaction with an indemnity trigger on a commercial portfolio in 2005 for Zurich American Insurance Corporation. The cat bond— called Kamp Re—protected against US hurricanes and earthquakes in the New Madrid fault. Kamp Re was triggered by the 2005 hurricane season—the year Katrina, Rita and Wilma swept through the country. Actually, it was the first cat bond ever triggered. When the bond matured three years later approximately 24 percent of the principal was returned to investors.

Index-based triggers can also bring great benefits to the market. They help to broaden the market for natural catastrophe risks by creatingan additional way for risks to be shared. Index-linked contracts can be more easily standardised than indemnity-based transactions, they lessen moral hazard and adverse selection problems, and facilitate market liquidity and transparency. For investors, indices are often easier to understand than individual insurance risks, but they do carry more basis risk for the sponsor.

Different triggers, such as parametric triggers and industry loss triggers, may encourage further diversifying secondary perils to come to the market. At the moment, approximately 70 percent of outstanding cat bonds are for peak US wind risks but other secondary perils such as European windstorm or Japanese earthquake are increasingly sought by investors looking to further diversify their catastrophe bond exposure. New indices such as PERILS AG are enabling these issuances by making transparent triggers available for secondary risks such as European windstorm.

Wells Fargo Insurance Trust team named ‘Global Best Bank for Insurance Trusts’

Over the past 13 years, the Wells Fargo ILS and Reinsurance Trust group has established billions of dollars of trusts used to collateralised ILS, reinsurance, and captive programmes worldwide. The cost savings realised by our clients using the WF Trust in lieu of letters of credit (LOCs) is staggering.

There are many benefits to using the Wells Fargo Trust in lieu of LOCs to collateralise such programmes. They include:

•Saving between 80 percent and 98 percent of LOC fees •Keeping corporate credit lines available •Retention of the interest income of assets held in trust •Retention of ownership of the assets in trust

•Ease of set-up and renewal

The trust concept is simple. Rather than posting a letter of credit as collateral, our clients deposit cash or cash equivalents (the same cash that they would likely use to collateralise an

LOC) into a legal trust account where the depositor “owns” the money and the transformer (for ILS deals) or cedent (for reinsurance) is the beneficiary of the trust. From a regulatory and carrier perspective, this satisfies the collateral requirement.

The Wells Fargo ILS and Reinsurance Trust team has the well deserved reputation as the most knowledgeable and responsive trust group in the industry. So if you are posting LOCs for ILS, Reinsurance, or Captive programmes, or if you are finding your current trustee less than ideal, consider using the ILS or Reinsurance Trust, and please consider Wells Fargo as trustee.

For more information please contact Robert Quinn on: Tel: +1 203-293-4394 Website: