Intuitively, when reinsurers are strong and reinsurance is cheap, alternative sources of capital such as catastrophe bonds and other ILS structures may not seem necessary. However, although ILS issuance is expected to decline in the fourth quarter of 2008 compared to 2007, it remains at all-time-high levels. The up-front transaction costs and time spent bringing bonds to market require a commitment to longer-term strategic solutions as opposed to tactical responses to managing risk. Cedents should take advantage of the lower risk-transfer costs and other benefits of this alternative source of capacity.
INSURANCE-LINKED SECURITIES OFFER INNOVATIVE STRUCTURES
In a typical catastrophe bond transaction, the special-purpose vehicle (SPV) issues a reinsurance contract to the sponsor while simultaneously issuing limited recourse notes to investors (see Exhibit 1). Proceeds from the notes are invested in high-quality, short-term securities and deposited in a reinsurance trust, collateralizing the transaction. Through a swap mechanism, fixed-return bonds are transformed into floating-rate notes, from which the interest-rate risk is largely removed. Over the term of the bonds, the periodic interest paid by the SPV to investors consists of the "risk premium" paid by the sponsor and the floating-rate returns earned by the bond principal. The risk premium is linked to the default probability of a bond, with higher default probabilities yielding higher premiums. In addition, some catastrophe bonds are subject to seasonal price fluctuations in the form of mark-to-market price adjustments due to the seasonality of covered events. At the conclusion of the bond term, assuming covered events have not occurred, the principal is returned to investors, just as with other fixed-income investments.
Over the past year, the industry witnessed many first-time issuers and the creation of new and innovative structures covering new perils and regions while accessing entirely new classes of investors.
What's Driving ILS?
From the cedent's perspective, there are several incentives to pursuing an ILS strategy along with elements of traditional reinsurance strategy:
- access to long-term, stable capital market capacity
- the ability to lock in terms and conditions for multiple periods
- diversifying reinsurance recoverables out of the reinsurance market and into the broader fixed-income market, which is not susceptible to traditional market cyclicality.
In addition, catastrophe bonds are structured so that principal and periodic interest payments owed to investors are fully secured by high-quality investments placed in a reinsurance trust (e.g., a trust created under New York Regulation 114). The trust is structured such that the SPV makes periodic payments into the trust account of required "assets" (typically A-rated U.S. government obligations), which are held by a trustee (usually a bank) to guarantee payment of the obligation, thereby minimizing credit risk vis-à-vis traditional reinsurance.
From the investor's perspective, ILS provide an opportunity to diversify portfolio holdings with a noncorrelated asset class. Since these securities are not influenced by mortgage defaults, the stock market or commodity values, they present an attractive alternative to traditional asset- and mortgage-backed fixed-income securities. While spreads for BB-rated corporate debt widened tremendously over the past year, ILS spreads tightened, on average. Additionally, interest-rate risk is mitigated, since all catastrophe bonds are structured as floating-rate securities based on LIBOR or EUROBOR.
What's Hampering ILS Development?
As with any investment or reinsurance strategy, potential limitations and risks need to be addressed. From an investor's perspective, the market for ILS is still in its infancy and can be characterized as "illiquid," as the secondary market for this asset class is much smaller than the $30 trillion fixed-income securities market. Investors are also wary of the moral hazard associated with indemnity triggers, since the lack of transparency (within the SPV structure) can inhibit their ability to price the risk appropriately.
Amid the collapse of the collateralized debt obligation market, there is a certain negative connotation associated with off-balance-sheet, offshore SPVs, which worries investors not entirely familiar with this relatively new asset class. Another concern is model risk, or the perceived risk associated with imperfections in the catastrophe models used to determine the probability of expected loss. The ultimate concern is that investors may miscalculate the risk of losing their entire principal if a covered event takes place. And even if no covered events take place, changes to catastrophe models could result in rating agency downgrades and subsequent mark-to-market losses.
Most important for sponsors is basis risk — the risk of an imperfect hedge — in the event an indemnity cover is cost prohibitive. Unlike indemnity or ultimate net loss covers, catastrophe bonds based on third-party reporting agencies (i.e., parametric, index or modeled loss triggers), as opposed to the sponsor's incurred losses, result in a coverage gap if not aligned properly. Sponsors are increasingly structuring ILS to cover multiple perils over multiple regions, using trigger-specific strategies to minimize this risk. Additionally, the substantial up-front transaction costs and complex structures deter cedents looking for short-term solutions or coverage in smaller amounts.
Now many cedents are making a long-term commitment to ILS, using shelf (deferred issue) programs that help spread these costs over multiple periods. As the market matures, many of the concerns will become easier to address. ILS will then more clearly benefit both cedents and investors.
The ILS issuance landscape in 2008 can be characterized as steady, though not at the same level as 2007 (see Exhibit 2).
Continued innovation in the capital markets has surprised investors and sponsors, as ILS have become a mainstream product embedded in many risk management programs. Although a direct relationship between catastrophe activity and ILS issuance still exists, sponsors are now considering this alternative means of risk transfer for reasons other than year-to-year price variation. Since 2007, we have witnessed a flurry of both new sponsors and new products (see Exhibit 3).
Additionally, several new investors have come onto the scene recently, suggesting further adoption of this once exotic and elusive product:
- specialized catastrophe-oriented reinsurance funds including Juniperus Re, Pentelia Capital Management, Nephila Capital, DE Shaw and Citadel
- asset managers such as Credit Suisse Asset Management, Fermat Capital Management and Goldman Sachs Asset Management
- closed-end mutual funds such as Pioneer Diversified High Income Trust and Oppenheimer Master Event-Linked Bond Fund, following similar strategies previously implemented by PIMCO and others
- money managers, pension funds and private bankers.
PERFORMANCE AND PRICING
Since the market's inception in 1997, only three defaults have been reported (less than 2% of principal issuance to date): Atlantic & Western Re (PXRE), Kamp Re (Zurich) and Avalon Re (OCIL). This suggests that, while defaults have been triggered (relatively infrequently), ILS do effectively transfer risk. The total return demanded by investors can be broken into three components: floating interest earned on the principal, compensation for the expected underlying loss cost (pure premium) and the investor's risk premium. Given the low default rates, ILS yielded a return to investors of approximately 500 basis points (i.e., 5%) over and above the underlying floating interest rate — over the last six years.
Today, insurers have strong balance sheets and an ability to accept higher retentions. Reinsurers also have strong balance sheets and are competing to put their capital to use. The result is a softening rate environment for traditional reinsurance coverage, which puts downward pressure on the risk premiums incorporated into ILS pricing. Between 2003 and 2007, ILS pricing levels followed a pattern similar to traditional catastrophe reinsurance. We can expect continued activity, despite current market conditions, as cedents begin to use ILS for long-term benefits in addition to short-term problem solving.
Developments in the ILS market are helping participants better capture the potential value of this alternative coverage option.
Increased Use of Shelf Offerings
Shelf offerings allow sponsors to create a single set of offering documents summarizing general characteristics and then issue additional bonds (takedowns) up to a maximum limit over the course of a stated period. The increased use of shelf offerings is a positive sign for the catastrophe bond market, as it indicates a more broad-based intention on the part of sponsors to systematically incorporate catastrophe bonds into their risk-transfer programs (as opposed to only turning to them for one-off solutions in times of crisis).
The softening rate environment is flowing upstream to the ILS market as sponsors are creating combinations of structural elements, specifically multiperil/multi-location deals. This could be viewed as analogous to a loosening of terms and conditions in traditional reinsurance, as buyers add in as many features as possible for the same premium. In hard markets, providers of capital are likely to be more selective in the coverages they provide.
More Investment-Grade ILS
To attract a wider spectrum of potential investors, sponsors are floating more investment-grade securities. A new innovation for achieving this, first sponsored by Bermuda-based Nephila Capital, is the actively managed, model-driven CDO structure, which creates different buckets of perils (tranches). By customizing securities via the CDO structure, decisions can be made on the alpha — measuring the absolute performance of an asset, in excess of the expected yield — and beta of a single contract, allowing investors to assess the impact of an inherently diversified portfolio. ILS provide a new source of collateralized capacity to reinsurance buyers while also offering a range of securities to investors with specific risk/return appetites seeking truly noncorrelated assets. Other recent catastrophe bonds that achieved investment-grade ratings include Brit's Freemantle, Arrow's Javelin Re, State Farm's Merna Re and Swiss Re's Vega Capital.
U.S. Primary Issuances
Historically, issuance has been driven by reinsurers. Recently, however, several large U.S. primary insurers have implemented an ILS strategy in their risk management program. Over the past 12 months, U.S. primaries have issued over $2.4 billion, or 30%, of the market's bonds. State Farm recently launched Merna Re, the largest single issuance in the market's history, all of which is investment grade. The transaction uses an indemnity trigger and provides protection for U.S. and Canadian hurricane and earthquake perils, as well as tornado/hail and winter storm — a testament to the commitment to ILS as a broad-based risk management tool.
SPVs AND ACCOUNTING TREATMENT
Amid the current credit crisis and recent collapse of Bear Sterns, substantial controversy surrounds SPVs. As International Financial Reporting Standards continue to gain worldwide momentum, companies must understand the differences between the two interpretations of consolidating SPVs. Now a broader consolidation model, based on risk and reward as opposed to voting control, is being applied in certain circumstances.
Furthermore, the market-consistent valuation approach of insurance assets and liabilities under Solvency II is based on economic principles; therefore, securitizations are likely to receive appropriate credit for market values, which may facilitate a substantial expansion of property/casualty securitizations beyond catastrophe bonds.
RATING AGENCY VIEWPOINTS
Currently, the market is dominated by non-investment-grade securities (BBB- or lower) due to the expected level of risk inherent in catastrophe bonds. Typically, ratings will be capped at BB+ for single-trigger bonds (i.e., single-peril, single-territory exposure). Sometimes, even if the single event is extremely remote, rating agencies still impose a BBB+ ceiling on the rating.
Various characteristics generate additional challenges to rating agencies. If the sponsor is nonrated, for example, evaluating indemnity-trigger transactions presents a variety of complexities. To get comfortable, rating agencies evaluate full limits, concentrations and correlations with other risks or lines of business. With respect to index triggers, rating agencies are skeptical of the credibility of reporting agencies in foreign jurisdictions. In addition, "manmade" events (i.e., terrorism or arson) present significant uncertainty, explaining why bonds with this peril are rarely assigned a rating.
Central to the rating is full scrutiny of the science and conservatism in catastrophe models. In addition, rating agencies benchmark the probability of attachment against a table of historic defaults, similar to how corporate debt is rated. Overall, stress testing, balance-sheet strength, underwriting disciplines, peak zones, concentrations, diversification and enterprise risk management all play a significant role in ILS ratings.
From the cedent's perspective, after consecutive years without major catastrophes and years without industry-changing hurricanes and earthquakes (the two most popular perils to securitize), 2009 presents an excellent opportunity for cedents to lock in terms and conditions at current levels. From an investor's perspective, noncorrelated catastrophe spreads seem attractive relative to traditional corporate debt.
Overall, the mutual benefits to both parties will likely influence future activity levels. As the market for these vehicles matures, standardization of contracts, improved data and transparency will encourage more sponsors and investors to participate in the ILS marketplace. Also, continued expansion and innovation of products will entice participants away from large insurers and toward regional and middle-market carriers. At the same time, growth of investment-grade ILS will expand the population of potential investors. A hardening reinsurance market would then lead to cedents seeking capital market solutions and investors seeking double-digit returns. And, as significant trading continues, a liquid secondary market with lower transaction costs will develop.
As market participants increasingly come to understand the distinct advantages of ILS, the market will continue to develop, absent catastrophe events, and become a mainstream risk management tool supplementing traditional reinsurance.