Catastrophe bonds a vital part of insurers “financial tapestry” – John Doak

by Artemis on June 9, 2016

The Commissioner of the Oklahoma Insurance Department, John Doak, has underlined the important role catastrophe bonds play in the “financial tapestry” of insurers. A view supported by the increasing volume of ILS capacity utilised within insurers’ reinsurance programmes.

Despite the recent rise of the collateralised reinsurance sector, catastrophe bonds likely remain the most dominant force of the expanding insurance-linked securities (ILS) space, underlined by the record-breaking volume of issuance witnessed in Q1 2016.

“As the dominant form of ILS, catastrophe bonds are a critical piece of the financial tapestry that allows insurers to remain solvent and successful,” said Doak, in a recent interview with Clear Path Analysis.

Oklahoma resides within the New Madrid Seismic Zone, meaning it’s extremely vulnerable to earthquakes. Furthermore, in more recent times, fracking and the region’s positioning on the New Madrid fault line has led many scientists and experts to note the unprecedented number of earthquakes that occurred in the state through 2015, and in the beginning of this year.

With the potential for both frequent and severe earthquakes in the state heightened owing to its location and resulting vulnerability to earthquakes, insurers that operate in the region utilise reinsurance and ILS solutions to offset potential losses.

As noted by Doak, this includes the issuance of catastrophe bonds, which he describes as critical to insurers’ successfulness and solvency. In cases like Oklahoma, catastrophe bonds are typically used to protect against low risk, high severity events such as a sizeable earthquake somewhere within the New Madrid Seismic Zone.

Either as part of insurers’ reinsurance programme, or even as a stand-alone issuance, catastrophe bonds provide insurers with additional coverage to mitigate potential losses, backed by diversified and willing capital markets capacity.

A significant earthquake has the potential to seriously challenge the solvency of an insurance company that writes business in the region, something that reinsurance and ILS structures, such as catastrophe bonds, help to mitigate by providing the capital for substantial loss events.

An example of this can be seen with Merna Re Ltd. (Series 2016-1), a $300 million catastrophe bond sponsored by State Farm, which provides coverage against an earthquake occurring in the New Madrid region.

“Knowing the important role earthquake insurance is having in the broader insurance conversation in my own state, this quarter has emphasised the ability of the ILS markets to address emerging issues, as several issuances covering U.S. earthquakes have already been issued this year,” said Doak.

Merna Re Ltd. (Series 2016-1) is actually the seventh cat bond issuance from State Farm under the Merna Re platform, all of which have provided protection against U.S. earthquakes in some form. With the four most recent deals protecting solely against U.S. earthquakes in the New Madrid region.

So clearly, as underlined by Doak, the use of catastrophe bonds are vital to State Farm’s ability to operate in a region that is so susceptible to the impacts of earthquakes, enabling the firm to pass on some of the risk to the capital markets were a triggering quake to occur.

“ILS products have been operating successfully for so many years because of the rapid, innovative way they were created and their ability to adapt to the demands and needs of an ever-evolving, often cyclical financial industry,” said Doak.

Interestingly, earlier this year a Senate panel passed a bill that enables the state of Oklahoma to a establish an earthquake reinsurance fund, something that will help to ensure citizens have access to affordable earthquake insurance should there be a situation where coverage is inadequate.

A similar programme exists in California with the California Earthquake Authority (CEA), which, issues catastrophe bonds as part of its reinsurance scheme to protect against quakes in the region.

With reports from regional news media in Oklahoma in recent months claiming that the state has overtaken California as the most seismically active part of the U.S., it will be interesting to see if Oklahoma decides to establish such a fund once the bill comes into effect in November this year.

Furthermore, the successful use of catastrophe bonds by State Farm and also the CEA within its reinsurance programme, could result in an Oklahoma state earthquake reinsurance fund utilising ILS structures and capacity to improve the coverage adequacy for residents, and the capital-base of the fund itself.

Interestingly, in the last few days Commissioner Doak deemed the Oklahoma earthquake insurance market “non-competitive” saying that rate increases need to be made on a valid basis and saying that “A competitive market is healthy for the growth and sustainability of Oklahoma insurance needs.”

One way to help shore up the Oklahoma earthquake insurance market could, in future, be the use of catastrophe bonds.

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