Insurance Linked Strategies Risk Transfer Instruments

Risk Transfer Instruments
ILS risk transfer instruments

Catastrophe bonds (or Cat Bonds) are a way for insurers, reinsurers or other corporations that are exposed to catastrophe events and disasters, to transfer specific insurance risks to the capital market (e.g. ILS Fund), in a securitized format.

A typical Cat Bond involves the creation of a special purpose vehicle that provides protection to a ceding company/counterparty against the risk of specified catastrophes or events and issues floating rate notes, the proceeds of which serve as collateral to secure the special purpose vehicle’s obligations. More specifically, the obligation of the special purpose vehicle to repay the principal is contingent on the occurrence or non-occurrence of the prespecified insurance event.

There are several ways to structure a Cat Bond. It can be structured as single-occurrence cover, which means that one single event can trigger a loss, or it can be structured as multiple or aggregate cover, which means that several events need to occur within the defined risk period before the investor suffers a loss. The trigger type is another important component of a Cat Bond transaction.

Sponsors usually favor indemnity triggers, as they are based on their actual loss and consequently eliminate the basis risk. By contrast, investors mostly prefer other trigger structures, such as industry loss or parametric triggers, as they are more transparent and less exposed to moral hazard.

In contrast to ILS Private Transactions, Cat Bonds provide certain liquidity due to the secondary market. But their disadvantage lies in the fact that the cat bond market is comparatively small at approximately USD 28 bn1, and therefore imposes certain restrictions on the manager’s ability to select risks and construct a well-balanced portfolio. Furthermore, the market is heavily concentrated with approx. 65% of the outstanding cat bond volume exposed to US hurricane risks1.

Cat bond prices are typically driven by seasonal factors (e.g. US hurricane season), catastrophe events, and supply and demand in the market.  

ILS Private Transactions allow vehicles such as ILS funds to participate in the traditional reinsurance market. The structure is similar to Cat Bonds, whereby the re/insurer transfers certain risks from its own balance sheet to the capital market (e.g. ILS fund).

For each transaction, a licensed reinsurer acting as risk transformer and/or fronter is required to transform the reinsurance contract into a financial contract/instrument. In the absence of the predefined insured event(s), the total return from an ILS Private Transactions consists of the collateral yield and the reinsurance risk premium. The premium is generally paid upfront and the collateral is typically held in a trust account and invested in money-market investments.

There are different structures in place for ILS Private Transactions with regard to trigger levels and trigger types.

In contrast to Cat Bonds, ILS Private Transactions have a much higher entry barrier as profound (re-)insurance knowledge, long-standing relationships and an extensive infrastructure are required to be active in this segment of the ILS market. One important feature of these transactions is the large investment universe of approximately USD 400 bn, which offers much broader potential for diversification.

ILS Private Transactions are bilateral contracts, illiquid in nature, not tradeable and usually have terms of up to one year.

An Industry Loss Warranty (ILW) is one possible structure of an ILS Private Transaction. It is a form of derivative or reinsurance contract whose trigger is typically based on the losses experienced by the whole insurance industry in connection with a predefined coverage (e.g. by peril(s) and region(s)), rather than by a specific company. It relies on external data providers who publish indices linked to the industry losses.

The payout structure can have, for instance, a binary or a linear pay-off. In case of a binary structure, 100% of the protection limit will have to be paid-off once the defined threshold is reached. In case of a linear structure, the payout can be anywhere between 0% and 100%, depending on the defined limits and the actual event loss.

These instruments allow (re-)insurance companies to hedge themselves against specific risks (e.g. US wind) at a level that matches their portfolio exposure without being forced to disclose the underlying policies. Unlike indemnity-based transactions, the ILW buyer is typically exposed to a basis risk, as the industry loss can deviate strongly from its own losses.

Property Claims Services (PCS) is mostly used as index provider for US-related transactions, whereas PERILS, Sigma (Swiss Re), or MRNC (Munich Re) are used for the rest of the world.

At approximately USD 4.8 bn, the ILW market is rather small and dominated by capital market participants (e.g. ILS and hedge fund managers).

Quota share (QS) is another possible structure of an ILS Private Transaction. It is a form of proportional reinsurance in which the risk taker (e.g. ILS fund) assumes a pro rata share of the cedent’s (e.g. reinsurer) book of business for a specific region or risk class. The two parties share the liability, premiums, and losses according to the agreed percentage, which indicates a full alignment of interests. The risk taker typically pays a ceding and/or profit commission to the cedent to compensate for its expenses associated with underwriting the portfolio.

The advantage of this instrument is that the structure is relatively simple and allows for an efficient use of capital. Furthermore, it can offer ILS funds access to an attractive and diversified book of business in areas in which they are less experienced or have no direct access. For the cedent, it is an efficient way to limit the volatility in their own portfolio and to generate additional risk-free income in the form of the ceding commission.

Retrocession is a form of ILS Private Transactions. It is reinsurance on reinsurance; in other words, one reinsurance company cedes part of its underlying portfolio to another reinsurance company with the aim of limiting its own risk and being able to afford additional capacity. The transaction structures and trigger types can vary.

Typically, only a defined group of risks is part of the transaction, but it can also comprise the cedent’s entire book of business.

The retrocession market is dominated by ILS managers and, at approximately USD 15 bn, it is quite small. This is also the reason why pricing can fluctuate fairly strongly depending on the supply and demand in the market.

A reinsurance sidecar is a limited-purpose vehicle created to allow investors to participate in the risk and return of a limited portfolio of insurance policies for a certain period of time. Reinsurance sidecars are attractive to investors, as they can profit from the uncorrelated returns of the insurance premiums without being associated with the long-term risk of an insurance portfolio. For the cedent, this is an effective way to increase its risk-bearing capacity, as sidecars are typically independent, off-balance-sheet companies.

Reinsurance sidecars are usually fully collateralized and subject to a ceding and/or profit commission. In contrast to quota shares, the originating re/insurer can, but does not have to, participate in the reinsurance sidecar vehicle, which indicates that there is not necessarily an alignment of interests between the two parties involved.