Catastrophe bonds: another bond adventure?

With the January 2007 renewals behind us, it is a good time to take stock and reflect on the perform...

With the January 2007 renewals behind us, it is a good time to take stock and reflect on the performance of the reinsurance market in 2006. Hurricanes were expected to hit the property and casualty market but did not materialise. The sky-high US property/catastrophe rates charged in anticipation of heavy losses have led to bumper profits being reported by many (re)insurers. Throughout 2006, the reinsurance market experienced an influx of alternative capital, primarily in the form of catastrophe bonds and sidecar arrangements.

These types of alternative reinsurance have been around for over a decade, and their use has been traditionally associated with hard reinsurance markets. In this respect, 2006 provided a perfect environment for alternative reinsurance to flourish.

Not surprisingly, issuance of catastrophe bonds now stands at about $6bn, and their outstanding value has tripled in the past five years. Traditionally issued through special-purpose vehicles (SPVs), these bonds are now increasingly issued directly by insurance companies and even by the original insured. For example, the Mexican government issued a $160m earthquake bond in 2006.

However, although catastrophe bonds and sidecars raised approximately $8bn in 2006, they still only account for only 3% of the capital of the global reinsurance market, according to a recent study by Standard & Poor's (S&P). Does this suggest that despite a healthy reinsurance appetite from fixed-income investors, there are some barriers limiting the growth of these instruments? To answer this, let's examine how catastrophe bonds meet insurers' and investors' needs.

What is the benefit to traditional reinsurance buyers?

Catastrophe bonds operate by means of SPVs to provide extra capacity to the reinsurance market. They are usually used in conjunction with companies' existing reinsurance structures. A primary insurer would enter into a reinsurance contract with an SPV, which will then issue bonds to investors. The insurer would pay premiums to the SPV and the investors would receive coupon payments.

If no catastrophes occur, they get their principal back. However, in the event of a natural catastrophe, the insurer keeps all or part of the principal, provided that pre-defined parameters of the bond have been triggered.

For cedents, the main advantage of catastrophe bonds is that they are fully collateralised. In essence, this means that the cedents can limit their counter-party credit risk. Also, the cedents can improve the effectiveness of their risk- and capital-management strategies by positively influencing the assessment of performance measures, such as return on equity, carried out by the rating agencies.

But there are downsides. First, the upfront costs involved in issuing a catastrophe bond are high and wide-ranging, including capital costs, legal fees, rating-agency fees, advisory fees and so on. Therefore, for such transactions to be economical, their size has to be about $100m or more.

Second, the 'basis risk' associated with catastrophe bonds is high (see page 17) and is unique to such bonds. The basis risk arises because catastrophe bonds are usually non-indemnity; as payment is triggered by an industry or parametric loss, rather than losses on the cedent's portfolio, the bond may not be triggered even if the cedent has suffered a significant loss. Conversely, the bond could also pay more than the cedent's actual loss.

And investors?

The main attraction of catastrophe bonds to investors is their high-yield coupon payments, which combine a 'risk-free' return on the principal with the premium paid by the insured.

As an example, say we assume $100m is invested at 4% (in a high-graded investment) and the cedent is paying $10m for $100m of reinsurance cover. This equates to a 14% coupon with a high probability that the principal will be returned at maturity.

Another attraction is the low correlation between catastrophic risks and defaults on debt capital, enabling investors to improve risk/return profiles of their portfolios. This is of particular interest to fixed-income investors seeking to diversify their portfolio.

Where do we go from here?

Importantly, catastrophe bonds have come a long way since their introduction a decade ago. The earlier bonds were single-year, single-peril products, which would pay either the entire principal or nothing at all, and mainly covered low-frequency/high-severity events.

We are increasingly seeing products of a more complex nature, incorporating multiple perils and territories, and offering sliding-scale payouts. They also cover a broader range of classes, including motor (business characterised by high-frequency/low-severity events) and liability risks. The bonds are increasingly being issued in several tranches, which are individually rated according to the probability of attachment, thus affecting the pricing and rating of the tranches.

This confirms investors' continuing appetite for insurance-linked securities (ILS). It is difficult to argue with their advantages for (re)insurers in today's market. So why are we not seeing more of these?

From an investor's point of view, catastrophe bonds suffer from their relatively low liquidity. Generally, investors in catastrophe bonds are not able to buy and sell these bonds when they see fit due to the absence of a secondary market.

A more obvious reason is the lack of standardised contracts. Should a more active secondary market develop - and some reports suggest that this may not be too far down the line - we would most certainly see a greater interest from capital markets.

From a cedent's point of view, some of the benefits these bonds offer don't always get recognised by regulators and rating agencies. By transferring risk to an SPV, cedents should be able to reduce their capital requirements since such bonds are fully collateralised, offering a much lower probability of reinsurance default.

Another benefit is the fact that insurers using catastrophe bonds have a more diversified reinsurance protection. Rating agencies tend to impose a cap on their catastrophe-bond ratings that makes it difficult for well-designed products to compete, but this may change, as in September 2006 S&P raised their cap on such bonds to 'AA'.

Several factors could help or hinder the development of alternative reinsurance products. As evidence suggests, these products can respond to the needs of both insurers and investors. Their further evolution depends on the creative skills of many organisations who, like JLT Re, work with both parties to establish the way forward.

- Angela Koller is an associate with JLT Re.

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