Resurgence of ILS market
The insurance-linked securities (ILS) market has enjoyed a prosperous year to date, marking a full recovery from the market shut-down brought about by the bankruptcy of Lehman Brothers and its resulting implications for collateral and transparency. Forecasted full-year 2010 issuance estimates exceed all prior year issuance levels, except those associated with the market dislocation caused by hurricanes Katrina, Rita and Wilma.
Both issuers and investors have returned to the capital markets, refl ecting shared optimism that the foundations underpinning the global recovery are intact.
The same holds true in the ILS market, where the statistics tell a story of steady recovery.
Analysing the market rebound
This new momentum can be quantifi ed by looking at the six-month ILS issuance volumes over the past three periods: $1.4 billion of issuance in the six-month period ending June 30, 2009, followed by $2 billion and $2.6 billion in the subsequent six-month periods.
While these figures do not quite reach the volumes generated in 2007 prior to the financial crisis and subsequent market disruption, the recent progress is highly encouraging and is set to continue.
As the ILS market continues to rebound, investor appetite remains robust. Catastrophe bonds experienced significant yield increases (and price declines) in the wake of the financial dislocation of 2008, as investors withdrew from the capital markets generally and sponsors sought new structures to appease investor concerns over collateral management.
However, with more transparency in deal structures—and maturities exceeding new issuance—investor demand returned in the fourth quarter of 2009. Demand was further bolstered by dedicated ILS investment funds successfully raising new capital. Combined, these effects lifted bond prices and drove down the cost of capital into the beginning of 2010, enticing sponsors to consider and ultimately tap the ILS market.
The ability to deploy capital is somewhat tempered by the peak peril allocation limits of certain investors, in particular with regard to US hurricane risk.
A further driver of the ILS sector has been changes to the bonds’ collateral structure. In the second quarter of 2009, transactions including Residential Reinsurance 2009 Limited Series 2010-1 were among the first to use money market funds as collateral.
These conservative collateral management options were developed to address investor unease regarding total return swaps. While total return swaps had become a common solution in earlier years, swaps lost favour when Lehman Brothers—a swap counterparty on four notes—collapsed in the 2008 financial crisis. Since that time, money market funds have proved to be the most popular method of collateral management.
As they tend to be invested in liquid, observable and highquality government securities, money market funds fulfil investors’ and sponsors’ desire for collateral that is far less dependent on the creditworthiness of the counterparties.
In the fourth quarter of calendar year 2009, several transactions— including MultiCat Mexico 2009 Limited Series 2009-1, Successor X Ltd. Series 2009-1, Longpoint Re II Ltd. Series 2009-1, Lakeside Re II Ltd., and Redwood Capital XI Ltd.—used this collateral management approach.
The sidecar situation
Over the past three years, specialty insurance and reinsurance stock prices have declined steadily and now trade at well below book value, despite the sector’s resilience during the credit crisis.
While these companies remain well capitalised, the outlook for valuations is not encouraging, despite share buy-backs and other capital management strategies.
After the experience of the summer of 2009, in which few of the attempted sidecars were consummated, the market has been largely dormant. Business planning has focused on mergers and acquisitions.
However, current stock valuations cast doubt on the sector’s ability to replenish equity capital in the wake of the next major catastrophe, since companies will be reluctant to issue equity or undertake a rights issue at a discount to book value.
Given these conditions, we expect insurers and reinsurers will take a new look at reinsurance sidecars or similar structures that rapidly assimilate and deploy capital following a catastrophe event.
Companies with pre-positioned capital resources and a strong postevent business plan will be in the best position to take advantage of the market opportunity.
Currently, collateralised reinsurance and hedge funds would seem to be the likeliest beneficiaries of such a capital influx, as they generally allow investors to enter and exit the insurance and reinsurance market at book value.
Previous market cycles have seen the creation of several similar sidecar vehicles at moments of market distress. These sidecars have either operated as providers of specific retrocession for reinsurers, or have faced the market as reinsurance or retrocessional writers.
However, such structures are generally unable to provide the kind of product and capacity needed by the insurance buyers or cedants (for example, often requiring single-limit or non-reinstatable coverage) and are often seen by cedants as opportunistic ventures.
The challenge faced by companies in the current trading environment— considering both the underwriting cycle and the condition of the capital markets—is to create a platform that allows for the flexible entry and exit of capital at par with valuation or better. Such a platform would support business opportunities, while also giving customers a stable and long-term source of value and capacity.
The end of 2010’s second quarter saw rising interest in ‘contingent sidecars’, in which the documents and other financial structuring are completed to the best extent possible prior to an event occurring. In an ideal case, investors are prepared to commit capital to the vehicle contingent upon an event, but in many cases, a soft circling of capital may be all that is practical given the uncertainties of characterising a post-event world from a pre-event vantage point.
Following a major catastrophe, the entire industry may seek to raise new capital. Companies with pre-established procedures and systems, and a clear contractual framework for providing capital with an entry point, will likely emerge as victors in the competition for new funds.
Diversification strategies in force
US perils continued to dominate catastrophe bond issuance through the 12 months that ended on June 30, 2010. Indeed, over the preceding two years, expected loss from US perils grew from 66 to 86 percent of total catastrophe bond issuance.
This is to be expected given that the reinsurance market has significant exposure to US perils. Nonetheless, the low volume of non-US peril issuance has left many ILS investors overweight in their allocations to US perils.
There are several reasons for this trend. In some instances, there was a large pricing differential between the capital and traditional reinsurance markets. When combined with discomfort with the level of basis risk inherent in any non-indemnity based structure, this differential made it difficult for some sponsors to choose the capital markets for risk transfer.
In the 12 months ending June 30, 2010, only three transactions came to market offering exclusive diversification from US perils: Eurus II Ltd. Series 2009-1 covered Europe windstorm, MultiCat Mexico 2009 Limited covered Mexico hurricane and earthquake, and Atlas VI Capital Limited Series 2009-1 covered Europe windstorm and Japan earthquake.
Reinsurance companies sponsored two of these transactions, as capital market spreads on retrocession business have been more competitive than those on traditional reinsurance business.
Although the supply and demand dynamics of the global reinsurance market suggest continued softening in traditional reinsurance pricing, insurers remain concerned about counterparty credit risk at the more remote levels of their reinsurance programmes and continue to be receptive to capital market solutions.
Meanwhile, investor demand for diversifying non-US perils has strengthened, leading to material tightening in price expectations and investors’ willingness to accept alternative structures, including indemnity-based coverage.
The long-term resolution of global financial concerns and increasing investor demand will continue to drive minimum pricing downwards, creating a more favourable environment in which sponsors of non- US peril transactions can access the multi-year collateralised capacity offered by the capital markets.
Historically, most non-US peril transactions have been structured on a parametric or modelled loss basis, due to the lack of credible industry loss reporting agencies. Indemnity transactions have been limited as the data disclosure requirements have proven challenging for sponsors to satisfy. The December 2009 launch of PERILS AG (an insurance industry initiative offering Europe windstorm industry exposure and event loss data, and an associated industry loss index service) created a new industry loss reporting agency for Europe windstorm.
Structuring a transaction using an industry loss index calibrated to CRESTA zone level will greatly assist sponsors in mitigating potential basis risk.
The credibility and independence of the industry loss information produced by PERILS will be critical to gaining the acceptance of both sponsors and investors.
Loss reports have already been produced for Europe Windstorms Klaus and Xynthia, both of which appear to have been well received by the market. Successor X Ltd. Series 2010-1 Class II was the first catastrophe bond to use PERILS’ industry loss information as the trigger for its Europe windstorm component. To reinforce PERILS’ independence going forward, it is important that sponsors that are not founding investors in the PERILS organisation also select PERILS as their loss-reporting agency.
Aside from the ability to structure transactions with an industry loss index trigger, primary insurers will likely be looking to evaluate the opportunity to structure an indemnity-based transaction.
Improvements in both exposure data quality and models in Europe make a Europe windstorm indemnity transaction from a primary insurer more attractive for both sponsors and investors, and long overdue.
For a successful indemnity transaction, investors will require a complete database of detailed property exposures listing total insured values by line of business at postal code resolution. In addition, investors will seek profiles of primary building characteristics such as type of building, construction class, occupancy type and year of construction.
Paul Schultz is president of Aon Benfield Securities, the investment banking division of Aon Benfield. He can be contacted at: paul.schultz@ aonbenfield.com