S&P: Alternative reinsurance capital anticipated in terrorism risk

by Artemis on March 24, 2014

Ratings agency Standard & Poor’s said that while it anticipates some alternative reinsurance capital being allocated to terrorism risk reinsurance in the future, it expects the role of ILS and alternative capital in terrorism reinsurance to remain a minor one.

Standard & Poor’s comments were made in a report the firm has published on the potential for the U.S. government to renew the Terrorism Risk Insurance Program Reauthorization Act of 2007. TRIPRA is up for renewal at the end of 2014, however the form of the government backed terrorism insurance backstop could change and that has implications for insurer and reinsurer ratings.

If TRIPRA was not renewed then the terrorism insurance and reinsurance market could change dramatically, with many companies pulling out of providing terror cover due to the lack of government participation on the risk.

If TRIPRA is renewed but its form changes dramatically, which could result in a higher industry event trigger, higher deductibles, more co-insurance requirements, lower coverage limits and more coverage exclusions, it could leave some terrorism insurers and reinsurers more exposed.

S&P does not believe that the private insurance, reinsurance or indeed ILS or alternative capital markets can assume nuclear, biological, chemical, and radiological (NBCR) risk, something that ILS industry participants have frequently cited themselves. These risks are too big, too unpredictable and difficult to model for the private market to assume meaningful amounts of exposure to them.

TRIPRA has been a credit positive for the insurance market, in S&P’s eyes, since it was launched in 2002. But changes that may come with a renewal in late 2014 or early 2015 could change the government protection offered by TRIPRA so significantly that it could leave some insurers, and likely reinsurers, over-exposed and open to rating actions.

S&P explained in its report;

“We could take rating actions on commercial-lines insurers that we determine are less prepared and those with sizable concentrations in urban locations that we believe would be most vulnerable to potential terrorism events. We also believe insurers with smaller capital bases could be hurt more than larger insurers if deductibles and the industry event trigger are raised. These changes could wipe out the capital base of smaller companies before terrorism relief from the federal program kicks in.”

“Negative rating actions would be most likely where the losses exceed a company’s net income for the year and erode a sizable portion of capital, sufficient to revise our forward-looking view of a company’s capital adequacy. We could also make negative adjustments if it becomes evident that a particular insurer has outsize terrorism exposure relative to peers’.”

If TRIPRA is not reauthorised or if it is significantly scaled back S&P said it expects to see higher pricing for terrorism coverage. the other side-effect could be less availability of terrorism insurance and reinsurance, which could effectively shrink the market except for in areas where it is mandated that terror cover must be in force.

This perhaps presents an opportunity for reinsurers which are comfortable assuming terrorism risk, of which there are a number, alternative reinsurance capital providers and perhaps even the insurance-linked securities (ILS) market.

S&P notes that currently catastrophe bonds and other insurance-linked securities only play a minor role in terrorism coverage and it does not expect that to change. S&P says it expects a minor involvement from ILS and alternative capital in the terrorism reinsurance market whether TRIPRA renews or changes its structure.

Third-party capital from capital markets investors has traditionally been used much more in the property catastrophe reinsurance space, notes S&P, but that is beginning to change with investor appetite and acceptance of less well-modelled perils broadening the ILS markets scope.

However, S&P notes that alternative reinsurance capital, like traditional reinsurance, is facing softening rates in its core target markets and any increase in pricing of terrorism risks could attract ILS and third-party capital to start displaying more interest in terrorism reinsurance.

S&P said; “We believe that an increase in pricing could prompt alternative capacity investors to overcome their reservations and start providing marginal capacity to the terrorism reinsurance market.”

Some third-party reinsurance and ILS capital is already being allocated to terrorism risks at a number of ILS funds which deploy investment capital into private collateralized reinsurance contracts. These ILS managers have become comfortable with a certain level of exposure to terrorism risks and that confidence is likely to expand, particularly if rates improve.

One example is Swiss-based ILS manager Twelve Capital which said earlier this year that it generated attractive returns from transactions exposed to global terrorism, that the terror market was one of the best performing in reinsurance and that the transaction it undertook was a first for the ILS market.

Lancashire Holdings new third-party reinsurance capital management unit Kinesis Capital Management is another which includes some terror risk within its third-party capital backed underwriting. Kinesis is already offering its clients collateralized, third-party capital backed, solutions for short to medium tail lines of business, including some terrorism risks.

On the reinsurer side, some of the traditional reinsurers which are most prolific in managing third-party reinsurance capital and ILS have already spoken out about their desire to write more terror business if TRIPRA is no longer covering as much. In fact some, like Validus, have suggested that the government should leave the private market to cover terrorism risks as it is perfectly capable of assuming this business.

Validus Holdings CEO Ed Noonan said last year that he sees no reason for terror risks to be backed by the government and that the reinsurance industry should be pushing to obtain more of this business. Noonan also feels that the ILS market is perfectly capable of assuming more of this risk as well and has a bigger role to play in providing terror reinsurance coverage.

Noonan said; “Frankly, perhaps not on day one, it won’t take too long before you can start packaging it up into the ILS market. We know investors in the ILS market today who would like to take on that risk. And so it won’t take very long I think for ILS to start to provide the high-layer type of capital required.”

Kean Driscoll, CEO of Validus Reinsurance Ltd., echoed this; “The industry hasn’t served itself well before Congress, saying that traditional terrorism cannot be priced. We disagree with that. As an industry, we committed substantial resources on how to price the frequency of traditional terrorism. We’re of the view that the market could bear more traditional terrorism risk.”

Kevin O’Donnell, CEO and President of RennaissanceRe, said recently that his firm has the ability to write terror risk, and has done over the years, so if demand for terrorism risk reinsurance increases he also feels the capacity will be available to support it.

Another proponent of the ILS markets ability to write terrorism risk is specialist ILS investment manager Fermat Capital’s co-founder and managing principal John Seo. Seo said in a testimony about ILS’ ability to take on risks like terrorism to the U.S. House of Representatives that a risk that was once felt too unusual for the cat bond market can suddenly become commonplace afer just a few years.

Seo said that an expanded ILS, catastrophe bond and alternative reinsurance capital market could make as much as $9 billion to $12 billion of third-party reinsurance and ILS capacity available to terrorism risks in the future.

So, the ILS, catastrophe bond and alternative reinsurance capital market are seemingly ready to support any increasing opportunities to deploy capital into terrorism risks, should the TRIPRA backstop not renew or change its structure.

S&P is not as bullish but acknowledges that it could anticipate a small proportion of alternative reinsurance capital instruments, although likely as private transactions rather than public 144A terrorism cat bond issuances, being allocated to terrorism risk in 2015.

S&P notes that there are mortality catastrophe bonds which include cover for terrorism risk, but that these largely require a pandemic scale event to trigger the protection meaning that the terrorism component is not considered a major driver of the deals ratings.

S&P says that it does not anticipate being able to rate a terrorism catastrophe bond, where terror risk is the main driver of the rating, due to the fact that the available terror risk models contain significant uncertainty related to modelling the actual occurrence of events.

This means that S&P does not currently feel confident that the available models could assess the probability of a terror attack happening within the actual term of a catastrophe bond, making applying a rating extremely difficult.

The lapse of, non-renewal of or change to the structure of TRIPRA could result in new opportunities for the alternative reinsurance capital and ILS market. It would certainly result in opportunities for traditional reinsurers, which would likely bring a level of alternative capital into the market in their support anyway.

It seems highly likely that we will see more terrorism risks being assumed by ILS and third-party reinsurance capital managers over the next few years. How much is anyone’s guess at this time, but the gradual growth of third-party capital backing and collateralizing terrorism reinsurance contracts looks inevitable.

Read some of our older articles on the potential for terrorism risk ILS and catastrophe bonds:

Experts forecast a bigger role for ILS in terrorism insurance.

Is it time the capital markets helped out with terrorism risk transfer and reinsurance?

Could the alternative risk transfer market provide a terrorism backstop?

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