State Auto swaps quota-share for cat designated aggregate reinsurance

Primary insurer State Auto Financial Corporation has replaced its quota-share catastrophe reinsurance for a new aggregate cover featuring PCS catastrophe designation, a good example of a traditional reinsurance product that is similar to a capital market one.

The lines between traditional reinsurance treaties and capital markets or ILS backed collateralized reinsurance solutions and catastrophe bonds are increasingly blurred and features from either side can appear in either traditional or alternative product set now.

This is increasing the competitiveness of alternative reinsurance capital and also helping alternative capital and insurance-linked securities (ILS) capacity from the capital markets to participate more in traditional program renewals.

State Auto’s new catastrophe reinsurance program is a fine example of an increasingly prevalent kind of reinsurance treaty which has many hallmarks of a capital market product. While the features of the reinsurance treaty are not unusual in the traditional market, they are common in the alternative market as well and this increasing convergence of terms and structures is set to enable alternative capital to make further headway into the catastrophe reinsurance market.

When the coverage you receive is the same from either capital source and arguably the security of fully-collateralized is as good, if not better in some eyes, as a traditional reinsurer balance-sheet, the choice of where to place your reinsurance will come down to diversity among the panel of markets, relationships you have built and of course ultimately the cost-of-capital or capacity.

In the case of State Auto Financial Corporation we get a rare chance to see how an insurer is taking advantage of market conditions and likely pricing to broaden its coverage, structuring techniques and also the opportunity to use Property Claim Services (PCS) catastrophe series reports as ways to ensure its reinsurance is aligned with the cat events which most seriously impact the insurance industry.

At the January 2015 reinsurance renewal State Auto Group entered into a one year property aggregate excess-of-loss catastrophe reinsurance agreement with a panel of reinsurers. No detail is given as to whether this panel includes collateralized reinsurance or ILS capacity providers, but it seems likely given the further penetration of ILS into catastrophe risks at 1/1.

The new reinsurance deal replaces State Auto Group’s homeowner quota share reinsurance agreement, that had been in place for the prior three years, under which it had ceded to reinsurers 75% of its homeowner business.

The new aggregate excess treaty covers property business underwritten by State Auto Financials personal insurance and business insurance units, also including automobile physical damage. That suggests a much broader coverage than the replaced homeowner only quota-share, covering new areas of business that State Auto has been engaged more deeply in.

But it’s the details of the coverage itself which are interesting as they look very similar to terms of recent catastrophe bond transactions, especially some U.S. indemnity deals which use PCS for catastrophe designation.

The details are:

The new property aggregate excess catastrophe reinsurance agreement provides reinsurance coverage of $75 million during 2015 for PCS numbered catastrophes after the retention of $165 million of losses by the State Auto Group. Individual occurrences are not subject to an occurrence deductible, but are subject to a maximum amount of $55 million consistent with the Group’s retention under its existing property catastrophe excess of loss reinsurance agreement. The agreement excludes property risks underwritten by the specialty insurance segment.

State Auto receives a return of cash due to the termination of the homeowner quota share reinsurance agreement, with approximately $89 million of unearned premiums and $63 million of cash returned. The net difference between the two represents the return of ceding commission to the reinsurers.

There are no details of the cost of the new aggregate excess-of-loss arrangement compared to the old quota-share. However given the restructuring of the coverage, broadening of the protection it provides and perhaps more advanced structure, it is likely that State Auto will be making a good saving on its reinsurance spend.

As we said, there’s nothing groundbreaking about this arrangement but it is a good example of how primary insurance groups are restructuring their reinsurance spend, opting for aggregate protections, taking advantage of additional inputs such as catastrophe designation and ultimately producing something that looks very like a capital markets cover.

The new excess-of-loss agreement looks eminently suitable to be transformed to a securitisation as a catastrophe bond. Some of the coverage provided could also be achieved through the use of industry loss warrants (ILW’s) as well.

As primary insurers continue to rationalise reinsurance purchases and become more familiar with aggregate arrangements and capital market type features, it all bodes well for the ILS and collateralized markets who can hope to participate in these renewals, or win them over to pure ILS transactions in years to come.

Of course price and capital efficiency or cost is a key factor, perhaps what drove State Auto to a traditional solution instead of a capital markets one. However, as the true cost of an underwriters risk capital becomes increasingly important, the opportunity for ILS markets to demonstrate that they can sustain lower pricing without going below their technical hurdle rates could win more of these primary insurer programs over.