Ratings agency Moody’s said in a report that it believes health insurer Aetna’s series of Vitality Re medical benefit claims linked ILS or catastrophe bond type transactions provide the insurer with limited risk protection.
Aetna completed its latest and fifth of these insurance-linked security (ILS) transactions recently, with the successful issuance of $200m of notes linked to its medical benefit claims ratio. This latest deal, Vitality Re V Ltd. (Series 2014-1), provides Aetna with a source of multi-year fully collateralized reinsurance protection, but Moody’s said in its report that this protection is limited.
Aetna has now issued $800m worth of health insurance related catastrophe bond structures since its first deal in late 2010. Two of its transactions matured at the start of this month, meaning that after the successful completion of Vitality Re V Aetna has $500m of reinsurance protection provided on a fully-collateralized basis by the capital markets.
So, with Aetna clearly very happy with its Vitality Re issuances, the firms Treasurer said that its latest deal “Improves our capital efficiency and reduces our weighted average cost of capital,” what could be the issue that makes Moody’s feel that they are not providing the insurer with much protection?
Steve Zaharuk, SVP at Moody’s, notes; “Each transaction provides collateralized excess of loss (tail-risk protection) reinsurance coverage limited to the principal amount of the notes issued by the reinsurer on a portion of Aetna’s group commercial health business.”
That is typical of a catastrophe bond or ILS and exactly the reason for issuing one. Sourcing this tail risk reinsurance protection from capital markets investors to diversify the firms sources of reinsurance cover while also providing valuable coverage against the peak risks it most fears.
Zaharuk continued; “In conjunction with these transactions, Aetna has obtained regulatory approval to consider these as risk-reduction transactions that reduce Aetna’s capital requirement by allowing statutory capital credit for the assets held by the reinsurer in collateral accounts.”
Again, this is typical of any catastrophe bond or ILS deal. The sponsor will always seek to ensure that the protection provides the same kind of capital credit as a traditional reinsurance layer would. Hence Aetna’s desire to have them approved as risk-reduction transactions. Most 144A catastrophe bond sponsors will seek this kind of capital credit approval.
However, Moody’s report says that the rating agency considers the risk and required capital reduction from the transactions as quite modest and also temporary. It notes that if Aetna sought to replace a significant proportion of its long-term capital with the capital credit from these transactions it would have a negative credit implication for the insurers rating.
Moody’s then notes that the maximum reinsurance protection that Aetna has had from its series of Vitality Re ILS deals has been $600m at one time and that has now reduced slightly to $500m after the latest transaction.
Moody’s report says that when it analyses the effect that transactions like these have on an insurers credit worthiness it focuses on the risk reduction aspect of the transaction and the quality of the capital credit being supplied by the reinsurer.
In terms of risk reduction, Moody’s notes that the attachment points are quite high for the Vitality Re deals, given that Aetna’s medical benefit ratios have averaged between 78% and 81% over the last three years. The Vitality Re V transaction, for example attaches at a MBR of 96% and provides some cover right up to 116%, between the two tranches.
Moody’s says that it believes that these MBR’s are unlikely to be reached, given where Aetna’s average is. Moody’s acknowledges that this does provide some tail risk protection, against major events such as a pandemic, but says that it feels the probability of the insurers claims reaching the attachment point is fairly remote and as a result it does not believe the transactions provide much in the way of risk reduction.
This is interesting, Aetna itself clearly feels the need to protect itself against the kind of catastrophic increase in claims which could otherwise ruin an insurer without robust reinsurance protection, but Moody’s opinion appears to suggest that it does not feel this is necessary or a useful transaction to undertake.
The Vitality Re transactions are low risk, they have relatively low expected loss statistics and pay investors relatively low coupons as a result. But Aetna clearly feels the transactions benefit its risk profile and are an efficient way to source risk capital.
In terms of the capital credit insurance that regulators allow these transactions to account for, Moody’s notes that the capital is generated by the sale of insurance-linked notes with the resulting collateral held in trust until required or maturity when it is returned to investors.
Moody’s said that the funds only provide protection for the defined book of business included in the transaction and therefore are not available to support other business or risks at Aetna. This contrasts with un-allocated capital held at Aetna and subsidiaries which can be moved or allocated to wherever the business needs it.
Now, the fact that the capital is ring-fenced for the specific portfolio of policies to protect against specific risks is exactly the point of this type of transaction. Moody’s appears to be saying that cash held on balance sheet may be a better source of protection for these extreme tail risks that Aetna is protecting against.
Moody’s report also notes that the capital is temporary, as the transaction has a fixed number of years and with no guarantee off renewal at maturity. As a result of the above Moody’s calls the capital provided by this transaction more limited and temporary in the protection it actually provides to Aetna.
Again this is interesting, as Moody’s comments on the protection provided by Vitality Re is at odds with how catastrophe bonds and insurance-linked securities are designed to work, it seems.
Cat bonds and ILS do provide protection for extreme tail risks (generally) with remote probability of occurrence, that is typically by design. They do involve ring fenced portfolios of risk, with no ability to apply the capital to other areas of the business unless specified in the offering documentation. Cat bond and ILS transactions, by their nature, are limited in term and do not have a guaranteed renewal, but then neither does traditional reinsurance.
Moody’s report appears to be singling out the Vitality Re transactions as not particularly helpful to Aetna for a number of reasons which are also applicable to most catastrophe bond deals. In the case of Aetna, perhaps Moody’s feels that it is placing too much reliance on ILS at once and now risks becoming less diversified in terms of its sources of risk capital, however it does not say so explicitly in the report.
Moody’s report finishes by saying that it does give some limited recognition to the funds provided by Vitality Re in its assessment of Aetna’s capital adequacy. It allows credit for capital held in the collateral accounts of the Vitality Re deals as long as it does not support more than 25% of Aetna’s consolidated risk based capital (RBC) ratio at the National Association of Insurance Commissioners-defined company action level. Currently, Moody’s estimates that the total of $500 million of reinsurance provided by the Vitality Re deals is equivalent to between 15 to 20 percentage points of Aetna’s RBC ratio.
So that is a little clearer, suggesting that the issue is perhaps if Aetna decides to have too much of its risk capital coming from ILS type transactions, for the reasons laid out in the paragraphs above. Would the same be true if the $500m of protection was all sourced from traditional reinsurance contracts, or does Moody’s have a point?
Aetna does appear to be using the Vitality Re V transaction, in particular, to help it free up capital, enhancing its liquidity and perhaps even helping to fund acquisitions. Perhaps Moody’s is concerned that if Aetna did use its more permanent capital for other reasons and then could not renew Vitality, or replace it easily with other forms of reinsurance, then it may fall short in meeting risk capital requirements.
But again, this is one of the benefits of ILS and cat bonds. They allow the sponsor to tap a source of lower-cost capital, which on a risk capital basis may allow the sponsor to move some of its equity capital to other uses. However it is clear that there are some credit risks associated with this strategy, particularly if the capital cannot be easily replaced at maturity, so Moody’s does have a valid concern.
The subject of how the risk capital secured from issuing a cat bond or ILS is used is an interesting one. Does it just sit in collateral waiting for a potential payout or can the sponsor effectively use the collateral as an offset to its other capital sources and at what point does an over-reliance on that become an issue.
Moody’s comments about this deal are very interesting and do seem to be equally relevant to any other catastrophe bond and insurance-linked securitisation deals, particularly for any sponsors who are seeking to use them as capital credit in this way. As catastrophe bond and ILS issuance continues to grow this is likely to become a topic of more regular conversation.