Insurance Linked Strategies Risk Transfer Instruments
Catastrophe bonds (or cat bonds for short) are securitized instruments that transfer a specific insurance risk (predominantly natural catastrophe risks) from the sponsor (e.g. insurance company) to the capital market (e.g. ILS fund), who in return receives a risk premium.
The cat bond investor (e.g. ILS fund) has to fully collateralize the liability, which is mostly held in a trust account and invested in money market investments. If a qualifying event occurs during the risk period, the cat bond investor faces a partial or total loss on their investment.
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 26.1 bn (as of March 2018, excluding life and private cat bonds, source: Credit Suisse), 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 approximately 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 unrated vehicles such as ILS funds to participate in the traditional reinsurance market. The structure is similar to that of cat bonds. The (re-)insurer transfers certain risks from its own balance sheet to the capital market (e.g. ILS fund).
The transactions are typically fully collateralized, which means that the total liability does not exceed the posted collateral. For each transaction, a special-purpose reinsurer or transformer is required to make the (re-)insurance risk available to the capital market. The total return from ILS private transactions consists of the collateral yield and the reinsurance risk premium. The premium is paid upfront and the collateral is typically held in a segregated account and invested in money market investments. Unless the qualifying event materializes, the capital deployed will be released after the risk period.
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. The great benefit of these transactions is the large investment universe of approximately USD 400 bn, which offers much broader potential for diversification.
ILS private transactions are not tradeable and usually have terms 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 based on the losses experienced by the whole insurance industry, rather than by a specific company.
These instruments allow (re-)insurance companies to hedge themselves against specific risks (e.g. US windstorms) 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.
Thanks to the standardized structures in place for ILWs, they are readily settled and offer only little scope for dispute, as the index data is based on independent information.
Property Claims Services (PCS) are mostly used as index providers for US-related transactions, whereas PERILS is typically used as an index for European transactions, and Sigma (Swiss Re) or MRNC (Munich Re) is used for the rest of the world.
At approximately USD 5 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. the insurer’s) 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 an efficient use of capital. Furthermore, it can offer, for instance, 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 its own portfolio and to generate additional risk-free income in 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 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.