The Regulator: Sidecars Seen as New Source of Capital
Reprinted Article from the SVO Research Quarterly
Last Updated 12/06/18
Insurance-linked securities (ILS) are products of the rapid development of financial innovation and the process of convergence between the insurance industry and the capital markets. The securitization model has been employed by insurers eager to transfer risk and tap new sources of capital market funding. Insurance-linked securities-both from the life and property/casualty sectors-hold great appeal for investors.
While catastrophe bonds remain the dominant type of outstanding ILS, there are also other non-cat-bond ILS in existence, such as those based on mortality rates, longevity, and medical-claim costs.
According to Swiss Re, ILS issuance in the first quarter of 2018 broke the record as the largest issuance for any first quarter with $3.28 billion. The second quarter saw $4.03 billion issued, falling second in history only to the second quarter of 2017. ILS issuance for the first half of 2018 did not produce a new record at $7.31 billion, but it trails closely behind 2017's $8.4 billion in new issuance. Artemis reports that the third quarter of 2018 saw $1.55 billion in new issuance, maintaining higher than average values.
ILS investors endured the onslaught of the major catastrophe losses of 2017, "displaying immense fortitude and demonstrating the discipline and importance of alternative capital to the re/insurance market," according to Swiss Re. Given the extent of the losses recorded in 2017 and their impact on ILS markets some had expected investors to either back-off from investments in catastrophe insurance risks, or to demand large price increases. However, the ILS market has proven to be remarkably resilient. The first half of 2018 was met with numerous trade deals and five new sponsors. In addition, a new innovative trigger structure was introduced by Frontline Re in which named storms that occur during an annual risk period are ranked by their size.
According to Willis Towers Watson Securities, 2018 is set to be another year of growth for ILS as the market recovers from recent natural disasters, replaces lost capital and investors show mounting interest in ILS products.
US-based insurtech Extraordinary Re is getting ready to launch a new platform to allow investors to trade exposure to insurance risk they have in their portfolios. The platform will target institutional investors that want to diversify their portfolios outside of conventional asset classes like stocks and fixed income. According to the company, investors would be now able to trade assets linked to insurance liabilities that cover disasters including hurricanes, floods, and cyber attacks.
Catastrophe bonds (commonly abbreviated to cat bonds) are a segment of the ILS market. They are used by property/casualty insurers and reinsurers to transfer major risks on their books (such as for hurricanes, windstorms and earthquakes) to capital market investors, reducing their overall reinsurance costs while freeing up capital to underwrite new insurance business. Cat bonds are structured so that payment of interest or principal to the reporting insurance company depends on the occurrence of a catastrophe event of a defined magnitude or, that causes an aggregate insurance loss in excess of a stipulated amount.
The risk inherent in cat bonds is a key reason these securities are of relatively short duration, typically maturing in three to five years. Since the catastrophe bond market's inception, ten transactions have resulted in a loss of principal to investors out of the more than 300 transactions that have come to market in its nearly 20-year history. Of these ten historical losses, six were the result of insured loss events and four were related to credit events in the vehicle's collateral due to the collapse of the firm responsible for guaranteeing the bond's collateral. Although it was once the most commonly used collateral structure, the collateral structure used in the deals that incurred credit related losses, called total return swaps, is not used in any outstanding cat bond. Treasury money market funds are currently the most popular collateral solution, followed by similar investment grade securities.
Catastrophe bonds remain a useful diversifying risk tool for investors' portfolios and a valuable risk transfer tool for sponsoring insurance companies. As interest rates remain near historic lows investors continue to look for yield in alternative assets classes. The spreads available in the high-yield markets highlight the attraction of the ILS market which has been the beneficiary of large inflows from institutional investors. The lower interest rate environment has caused returns to decline, similar to other fixed-income asset classes. Lower interest rates for ILS are in general still marginally higher than similar corporates in this market characterized by persistent low interest rates.
Insurers, in addition to being issuers of these securities, can and do invest in them on a limited basis. Insurance companies purchase these securities to diversify their portfolios. Typically, insurers are not expected to invest in a cat bond if they are already exposed to the peril in question in their primary business. Insurers that do invest in cat bonds were in the past required to file them with the NAIC Capital Markets & Investment Analysis Office for determination, as they were not eligible for filing exemption under the NAIC rule which grants an exemption from filing for securities that have been assigned a current, monitored rating by an ARO (acceptable rating organization) as prescribed in the Purpose and Procedures Manual. At the 2014 NAIC Spring National Meeting, the VOS Task Force adopted a motion to make rated cat bonds filing exempt.
Another structure for transferring catastrophe risk to investors is the sidecar, which became very popular in the aftermath of Hurricane Katrina. Sidecars are deployed mainly by reinsurers following major catastrophes to add risk-bearing capacity in periods of increased market stress. Sidecars are special-purpose vehicles through which reinsurers cede premiums associated with a book of business to investors who place sufficient funds in the vehicle to ensure claims are paid if they arise. In contrast with cat bonds, which are structured as long-term instruments covering a broad array of perils and geographies, sidecars are tactical instruments of limited duration during a hard market.
As severe natural catastrophes become more frequent due to changing climatic conditions, insurers and reinsurers may boost their issuance of cat bonds and sidecars as additional protection from the risk of incurring solvency-threatening losses.
As part of regulatory efforts to help manage catastrophe risk, the NAIC and state regulators have developed a comprehensive national plan that incorporates new risk management techniques with a solid foundation of solvency and consumer protection inherent in state insurance regulation.
Life insurance securitization is also a segment of the ILS market. Mortality and longevity risk securitizations fulfill a similar function for life insurers, as catastrophe bonds and sidecars do for property/casualty insurance and reinsurance companies-the transfer of risk to the capital markets.
Extreme risks of increasing mortality rates due to natural catastrophes and pandemics could potentially present a challenge to a life insurer's solvency. A jump in mortality rates would adversely affect the amount and timing of death benefits an insurer must pay. Longevity risk is the other side of mortality risk. A rise in longevity rates would increase cash outflows due to more annuity payments.
Apart from transferring mortality risk, life insurance companies have employed securitization techniques to: a) monetize the embedded value of a particular block of business in order to fund acquisition or demutualization costs and b) fund the extra reserves required by regulations XXX (Valuation of Life Insurance Policies Model Regulation #830). Often, a captive insurance company is at the center of Regulation XXX life securitization structures and it is used as a repository for the funds that were available from the securitization.