Vitality Re could attract the health care industry to insurance-linked securities

The Vitality Re Ltd. insurance-linked security transaction issued on behalf of Aetna in December was a groundbreaking transaction in many ways. It allowed Aetna to transfer the risks of medical benefit claims exceeding pre-defined attachment points to the capital markets in a way previously not attempted, using a catastrophe bond type ILS structure.

Law firm Cozen O’Connor have published an interesting report (available to download below) on the Vitality Re transaction and their thoughts on the potential for this deal to stimulate other health insurers to seek to copy the deal and use insurance-linked securities as a way to manage their risks and capital.

Interestingly, the report says ‘Aetna’s motivation in engaging in this uncharted venture appears motivated solely by the cost of capital and not reimbursement on potential losses’ which makes sense as health insurers medical benefit risks are not usually exposed to catastrophe. With the health care sector growing and annual revenues of the top five U.S. health care companies over $250 billion there’s a lot money which could find its way into the ILS sector should Vitality Re succeed. Cozen O’Connor suggest in the report that if Vitality Re is successful it could ‘herald the arrival of the health care industry in the ILS market and, perhaps, the reinsurance market as well’.

The report highlights that an individual medical catastrophe would be extremely unlikely to alter the loss experience of a health care companies client or the carriers own performance. So to date reinsurance and risk transfer methods such as ILS haven’t been attractive to health insurers. ‘The increasing desire for capital surplus, and perhaps the uncertainty of health care reform and medical inflation, may make offloading such risks a more common practice in the health care sector’ Cozen O’Connor said.

The report also points out the investor appetite for diversification opportunities within insurance-linked securities. A transaction like Vitality Re is a perfect opportunity for investors to offset their catastrophe bond risk with a completely uncorrelated alternative. Health insurance linked bonds could provide a much needed diversification opportunity for investors in ILS and this should mean any health insurers seeking to issue ILS should find a healthy appetite from the investment market.

The report concludes; ‘With reinsurance rates projected to level off in 2011, the ILS market could represent a cost effective and diverse method for health insurers to transfer risk, address regulatory concerns, and enhance capital surplus. Whether third-party life and health reinsurers will attempt to capture a piece of this “emerging” market remains to be seen’.

These are interesting times in the insurance-linked securities space. If ILS issuance is perceived as a potential way to manage the cost of capital, as well as the more traditional managing (and hedging) of risk, then we could potentially see other sectors with similar risk profiles begin to investigate the possibility of tapping the ILS markets expertise.

You can download a copy of the full report from Cozen O’Connor here (in PDF format).