2 July 2013ILS

Risk pools and convergence capital: getting comfortable

Convergence capital is becoming an increasingly attractive option for state risk pools considering their reinsurance coverage. While appetite for the various forms of convergence capital varies by state—driven by diversification of sources of coverage, existing relationships with traditional reinsurers and associated coverage, levels of comfort with convergence capital, political pressures and price competition—it is clear from a number of major deals that state risk pools are increasing their involvement in the convergence space.

Cat bonds this year, such as the $140 million Pelican Re transaction issued by Louisiana Citizens, the $500 million Tar Heel Re transaction issued by the North Carolina Joint Underwriters Association and the North Carolina Insurance Underwriters Association and the $250 million Everglades Re transaction issued by Florida Citizens, provide some indication of the levels of reinsurance buying in the convergence space. And such deals are only the publicised cat bond deals. State risk pools are also entering into collateralised deals and exploring the potential of the wider capital markets.

As David Gibbons, director of assurance at PwC explained: “Significant deals such as Tar Heel Re are likely to pique the interest of other state risk pools. Markets will undoubtedly be watching their peers with interest.”

The Mississippi Windstorm Underwriting Association (MWUA) and the Texas Windstorm Insurance Association (TWIA) are two such state risk pools that are paying increasingly close attention to the potential of convergence capital. Currently neither the MWUA nor the TWIA is involved in cat bonds, but the MWUA is active in the convergence space through a private placement using a non-traditional trigger, and TWIA through collateralised deals with a number of capital market players. John Polak, general manager at the TWIA, said that his organisation would consider cat bonds if they proved a good fit for its reinsurance programme, with the competitive pricing environment likely to encourage a closer look.

Polak said that in recent months there has “clearly been greater utilisation of convergence capital in all the residual markets”, with the trend likely to continue. “Wind pools have significant need for capacity due to the cat nature of our perils and aggregated values, making it an attractive alternative to traditional reinsurance. It certainly won’t replace traditional reinsurers, but it does increase the options,” he added.

Risk pools are also attractive prospects for investors. The low frequency-high severity nature of such risks, the relative simplicity of residual markets and the wealth of loss data make them an easily commoditised and understood peril, said Polak. “This contrasts significantly with a multi-line insurer where the portfolios are considerably more complex.” Gibbons agreed that “investor interest is high”, with the capital markets seeking out investment alternatives in the current climate. As he explained: “At present any sort of underlying risk is proving attractive to investors.”

Joe Shumaker, manager at the MWUA, said that the risk pool had utilised the participation of convergence capital for the past four years as a part of its reinsurance strategy, in order to have a feel for the space and build up relationships, as well as to help balance out market conditions and cycles, and had built up a good level of comfort around using convergence capital. Nevertheless, Shumaker said he doubted the board would “feel comfortable placing large portions of our cover within the capital markets”, with traditional reinsurers continuing to play a valuable role in the risk pool’s reinsurance programme.

Holding back a wholesale push into the convergence market is continued uncertainty regarding the durability of such capital in the event of a significant loss, regardless of the type of arrangement that risk pools have entered into with convergence capital participants. Nevertheless, the number of new entrants into the convergence space—particularly over the past 12 months—does raise questions about the longevity of capital market-backed reinsurance. That said the pricing environment is such that risk pools cannot but consider the prospects of convergence capacity.

Backyard pricing

As Polak indicated, there is now more capital markets money out there and more traditional reinsurers are developing their capabilities in the convergence space. “Convergence capital has been responsible for an increasingly competitive reinsurance market this year,” he said, with the pricing environment making an exploration of alternatives all the more attractive.

Pricing appears to be a significant factor in encouraging state risk pools to consider the convergence space—although it is by no means the primary driver. As John Rollins, vice president of public risk services at AIR Worldwide outlined, risk pools are by their nature rather more price-sensitive than commercial insurers. “Public pools have been sensitive to pricing, largely because their buying decisions are dictated differently from those of private insurers, and investors have also been sensitive, because the pools have not always demonstrated long-term commitment to risk transfer. So, it’s logical to expect more pools to ‘make the leap’ into insurance-linked securities (ILS) as net costs decline on a risk-adjusted basis.”

Polak said that he had seen the price of convergence capacity decline, particularly in recent months. The simple reason is the increased level of capacity being extended by capital market investors, he said. At the same time this was prompting a pricing and strategic response from traditional reinsurers. “Traditional reinsurance markets are recognising that the capital markets are walking into their backyard—their choice is either to compete or to withdraw some of their capacity.” Many appear to be exploring the convergence option—and this is particularly the case among Bermuda players—all of which bodes well for risk pools looking to acquire competitively priced reinsurance capacity.

Cat bonds and long-term structures also offer the possibility of locking in pricing over the longer term. For many risk pools this is an attractive prospect and Polak agreed, but warned that “you always run the risk of locking pricing in while rates continue to go down as you look to insulate yourself from rates going up”. Nevertheless, he said that irrespective of trying to control price there is a “value in predictability. It enables you to plan your own financial projections with a lot less variability”.

Rollins added that risk pools have traditionally been opportunistic in their employment of convergence capacity, with such deals presenting them with the opportunity to “lock in a longer-term transfer of risk”. With pricing proving particularly attractive of late thanks to the influx of capital markets interest; a convergence play is likely to prove an attractive prospect.

Adaptable capital

Pricing isn’t the only factor encouraging risk pools to consider the convergence option. Optionality is also playing a major part. “It clearly allows us to access a broader amount of reinsurance capital through the capital markets than we might otherwise do through traditional reinsurance,” said Polak. “For investors we provide a diversifying alternative asset class. Reinsurers have a finite level of risk tolerance—the capital markets allow us to access greater levels of risk capacity and often at more attractive rates.”

It also provides risk pools with “an adaptable form of coverage that can be tailored to their specific needs”, said Gibbons. “Since it is easily collateralised and accessed if an event occurs, such products are attractive from an event funding perspective.” Further strengthening the attractions of such options is increased understanding around the structuring of such risks in bond form.

As Rollins explained: “The risk for many perils, especially on the indemnity triggered deals that are preferred by the governors of public risk pools, is now viewed as ‘modellable’ and therefore price-able for investors. All parties seem sufficiently comfortable with the quality of the models and structure of the transactions to reach common ground and make cat bond deals happen in the public sector.” The capital markets have increasingly got their arms around reinsurance risk, with the additional capacity enabling risk pools to create an increasingly diverse reinsurance programme.

A fight of sorts

Despite suggestions from some quarters that convergence capital would erode the value proposition of traditional reinsurance, Shumaker is convinced that they will continue to prove their worth. Addressing the MWUA’s bench of reinsurers, Shumaker said that the risk pool has been balanced in its use of convergence capital as it continues to utilise traditional treaty coverage intensively, as well as direct and facultative reinsurance. “It is a matter of placement, not capacity,” said Shumaker, adding that while pricing plays its part in the MWUA’s decisions “some markets provide us with specialised protection”.

“Our board is seeking not only to protect our pool from the next large storm, which means seeking out top-end cover; but also from the threat from repetitive smaller storms,” he explained. “There is significance placed on reinstatements and aggregates either per occurrence or annually. Diversification of our cover portfolio is an important part of our reinsurance consideration.”

Some forms of reinsurance are a strong fit for the low end of MWUA’s risk tower while others are best placed on the top end. Citing years such Florida in 2004, he said that traditional reinsurance continues to offer a valuable proposition to those risk pools looking to mitigate the effects of smaller, repetitive storms.

Gibbons is of a similar opinion, and argued that there is space for both traditional and convergence capacity. “I don’t see there being a cannibalisation of the traditional market by convergence capital—in fact in many instances traditional reinsurers are accessing or participating in the provision of that capacity themselves.” Involvement in the convergence space will very much depend upon the strategic approach pursued by reinsurers, said Polak. “Some players want strategically to remain a pure reinsurer. Others have opted to pursue involvement in the collateralised and ILS space. Reinsurers are pragmatic about the implications of convergence capital.”

Polak added that wind pools and reinsurers alike question the longevity of capital market interest. While opportunities in the cat space are pursued aggressively today, capacity “might not be there tomorrow”. He explained that wind pools are “unlikely to abandon traditional reinsurers simply because the capital markets are attractive today. We appreciate that this is a long-term partnership, and as such we would strive for a balance”.

He said that wind pools have a “fiscal responsibility to our board and policyholders to purchase the best portfolio of coverage we can afford”, but cautioned against a wholehearted adoption of convergence capital. Polak added that he does not view reinsurance as a commodity—“it is more than simply who can bring the capacity at the lowest dollar amount”—rather it is about the capabilities of the reinsurer and the partnership it can bring to the table, he said.

Nevertheless, risk pools are increasingly considering their alternatives, exploring the most economic means to provide state-wide coverage. As Shumaker explained “they are often under a spotlight, which can mean balancing two things: exercising more caution in their reinsurance buying behaviour, and pursuing cover more aggressively, with convergence capital inevitably forming a part of that picture if it provides a stable alternative”.

Further involvement in the convergence space by residual markets seems inevitable, but Polak did conclude with a note of caution: “We shouldn’t be naive and think that the way it is today, is the way it will be forever.” Risk pools will need to consider their alternatives carefully. But more options are unlikely to be viewed as anything other than a positive development for the sector.