Expanding the insurance-linked securities and catastrophe bond universe of risks

The insurance-linked securities and catastrophe bond market covers a broad universe of risk considering its size of near $15 billion. Having begun with a focus on natural perils, with the first transactions coming to market in 1996/7, the ability to securitize risks and sell the resulting notes to investors, there by effectively transferring the risk away from the re/insurance market and into the much larger capital markets, has grown steadily and encouraged issuers to attempt to bring new classes of risk into the ILS and cat bond universe.

For the market to continue to grow, it stands to reason that a steady expansion of the classes of risks or lines of business included within cat bond and ILS transactions needs to continue. While the ILS and cat bond market would likely survive quite happily with no expansion from its current focus of peak natural perils and some life and health risks, participants would all like to see the market grow in size and importance and new classes of risk could be the key to seeing sustained long-term growth.

To date the ILS and cat bond market has covered a multitude of risks, including: hurricane in various locations around the U.S. coastline, the Caribbean and Mexico; earthquake in various countries around the world; tornadoes; Japan typhoon; life; longevity; mortality; medical benefit claims ratio; lottery winning risk; temperature risks; wildfire; flood and European windstorm. However the market is currently extremely focused on U.S. hurricane, U.S. earthquake and European windstorm as evidenced in recent data from Swiss Re.

There are a number of issues which have always held back the markets expansion; including lack of available historical data or incomplete data sets, lack of a robust model for certain perils and geographical locations, basis-risk and the appetite of sponsors and investors to become exposed to it and cost-effectiveness when compared to more traditional sources of re/insurance protection. Other issues exist which are specific to certain perils and lines of business but these are the main issues that can hinder expansion of the market.

A number of efforts are underway which could help to broaden the scope of the cat bond and ILS market thanks in the main to modelling work, newly established firms with a focus on a specific sector and regulatory changes.

For example PERILS AG have recently included UK flood loss data within their service and hope that this could lead to the creation of industry loss indices for UK and in the future European flood risk. That would allow industry loss warranties and also cat bonds to be transacted in the region using PERILS as reporting agency in the future. There could be quite a market for these instruments given the size of European flood exposures and loss events in recent years.

Also on flood risk, we have the recent extension of the U.S. National Flood Insurance Program (NFIP) which called on FEMA to investigate the use of private market risk transfer sources such as reinsurance and catastrophe bonds for covering the NFIP’s liabilities. This could help to further the research required in the U.S. to establish mechanisms for risk transfer of flood risks. It’s already possible that industry loss data from sources such as PCS could be used as triggers for flood cat bonds in the U.S. and this new focus could see that become a reality in the future.

In the energy sector, recently established firm CatVest Petroleum Services continue to work on industry-loss based risk transfer solutions for catastrophic energy loss events and parametric trigger design for oil pollution liability. We’re told that CatVest are working closely with a number of industry participants to enhance their modelling products and to bring a number of offerings to market in the coming months.

The ISO recently won an industry award for the creation of their ISO Casualty Index^TM which would allow transactions to be issued based on loss ratio and loss development trends for select lines of casualty insurance. Similar in design to their PCS industry loss data service the ISO would like to see the casualty index used in the same way for casualty type risks. To date it hasn’t been used in any transactions but it shows promise.

Solvency II is another potential driver of innovation in the risk transfer markets and it is yet to be seen how the re/insurance markets cope with the impending capital adequacy requirements which could dramatically increase the need for reinsurance risk transfer. It is likely that a knock on effect of this will be an increased use of tools such as ILS and cat bonds and the growing focus will no doubt bring forth more companies looking at opportunities to help facilitate the expansion of the market.

Investor interest could be another driver for innovation. As we are all aware, interest from the capital markets in insurance-linked investment strategies is extremely high right now and with the wider financial markets seemingly stuck in the doldrums we see no reason for that interest to reduce anytime soon. Insurers and reinsurers will be looking for ways to tap into the capacity that could flow into the market and this will likely see firms forced to innovate and look to new ways to put investor sourced capital to work while providing those investors with an attractive, stable and uncorrelated return. ILS and cat bonds will no doubt benefit from the increasing capital interest in the reinsurance sector.

So there are many reasons to be positive and to assume that the cat bond and ILS market will see further expansion over the coming years. This expansion may not be rapid, it takes time for new firms to become trusted and for potential sponsors and investors to become comfortable with new products and methodologies. There is also the basis-risk question and any new solutions will have to either give participants the comfort that it is being addressed or the sponsors and investors will need to accept it for what it is. As modelling becomes more sophisticated and new efforts, such as the ones we mentioned above, gain acceptance and traction we will likely see them appear in transactions within the ILW, ILS and wider reinsurance markets.

The market could also see an expansion into completely new areas thanks to developments in industries which create new, peak risks which then require risk transfer solutions. An example of this was written about recently by Milliman Inc., the independent actuarial and consulting firm who worked on the Vitality Re medical benefit ILS transactions and Hoplon Insurance lottery winning risk ILS deal. Their article discusses the emerging risk created by fracking, or hydraulic fracturing, and the lack of re/insurance capacity for risks such as this. The potential pollution liabilities from fracking are huge and Milliman’s article proposes a fracking catastrophe bond as a potential solution allowing extra capacity to be sourced from the capital markets. It’s an interesting idea and shows that emerging risks such as fracking could be suited to capital market risk transfer solutions as long as the modelling and structures required to facilitate transactions can be created.

It’s easy to think of many other classes of insurance business which could one day be securitized in ILS form For example lightning strikes cause over $1 billion of insured losses per year according to the ISO. We’ve discussed hail damages on a number of occasions and the need to design effective risk transfer solutions for this risk. In the casualty arena product recall, product liability and medical device liability seem ripe for risk transfer as you can easily put a number on the amount or value of claims. In fact there are a multitude of potential lines of insurance and reinsurance business that could become growth areas for the ILS market in the future.

The life risks arena is another area where growth is likely. A prime example is longevity risks which have only once been included in an ILS deal by Swiss Re in their Kortis Capital Ltd. transaction. The amount of longevity risk in the pension market is enormous and it stands to reason that mechanisms to transfer that risk to investors will be used. Securitization via ILS is a good solution for this as it allows the risk to be packaged and passed on for a premium. We suspect that longevity will be included in the ILS market again in the future.

There is also a case to be made for revisiting risks which have been included in cat bonds or ILS deals in the past but have not been repeated. For many risks, particularly those with large loss potential, the capital markets are the only capacity provider extensive enough to provide re/insurance protection. A good and timely example of this is cancellation cover for the upcoming Olympic Games. Cancelling the London Olympics could cost more than $4.9 billion according to an underwriter from Munich Re quoted in this Reuters piece. He also said that Munich Re themselves could have as much as a €350m exposure to a cancellation of the games. In the past, FIFA themselves benefitted from an ILS transaction called Golden Goal Finance which provided event cancellation cover for the 2006 world cup. Risks such as event cancellation could return to the ILS market as it truly is the only source of capacity large enough to deal with a risk so large.

A final example is the Kelvin Ltd. ILS transaction from 1999 which saw energy firm Koch transfer the risks associated with a portfolio of weather derivatives to capital market investors via a securitization. This deal effectively transferred temperature risk in ILS form, something you would imagine to be an attractive proposition today as well for energy firms. Perhaps we could see attempts to emulate this deal, especially now that temperature data is available on such granular levels. Or perhaps there are reasons we don’t know about that these deals such as Kelvin and Golden Goal could never be repeated.

We hope you’ve enjoyed this round-up of some of the thoughts we have which suggest that the universe of risk covered by the catastrophe bond and insurance-linked securities market will continue to expand. Innovation is the key to much of this and if the market continues to strive to provide cutting edge risk transfer solutions we feel sure we’ll see continued expansion in the future.

Don’t forget you can read about almost every cat bond and ILS transaction ever issued in our Deal Directory.