CEA’s risk transfer returns to $9.6bn. Short-term future needs less certain

The California Earthquake Authority (CEA) increased the size of its reinsurance and catastrophe bond risk transfer program by around 4.4% as of the end of July 2021, to reach almost $9.6 billion, but in the short-term future growth of the program seems less certain due to rising exposure and the cost of coverage.

That’s practically the same as the record size for the program, of also almost $9.6 billion of risk transfer that the CEA had in-force as of October 2020.

A relatively significant amount of catastrophe bond maturities shrank the CEA’s risk transfer and reinsurance program, back to $9.15 billion by December 2020, a figure it remained at through the end of last year.

But, the CEA secured $215 million of catastrophe bond backed earthquake reinsurance protection with its Ursa Re II Ltd. (Series 2021-1)  issuance in March 2021.

Then, at reinsurance renewals so far in 2021, the CEA has renewed a significant amount of limit and added a little more, including new placements at the January, April, June and July renewals, taking its total risk transfer program back around its record size at $9.6 billion.

Of that, just over $2.3 billion was provided by catastrophe bonds and $7.3 billion by traditional reinsurance at the end of July, some of the traditional component of which is likely collateralized or fronted on behalf of players from the ILS market.

Now, one $250 million slice of a catastrophe bond issue has matured already in September, so dropping the size of the program back down to roughly $9.3 billion or so at this time.

But things may change, in terms of risk transfer buying, at least in the short to mid-term, as the CEA is feeling the additional costs of higher rates-on-line now, after reinsurance markets have firmed.

The CEA is looking at further revenue bond issuance, given attractive market conditions, to help in marginally reducing the amount of additional risk transfer needed at this specific point in time, its board meeting documents explain.

It’s possible the CEA sees this as more cost-effective at this time, given the hardening of reinsurance markets around the world.

That said, we’d imagine the CEA will persist with keeping its large reinsurance program close to recent historical sizes and the mix of catastrophe bonds to reinsurance is unlikely to change significantly.

This is especially true when you realise the CEA continues to forecast rising exposures and so the need for increasing levels of funding, part of which will always be in the forms of risk transfer it chooses to use, cat bonds and reinsurance.

At the same time, the CEA is budgeting for additional 2021 risk transfer needs, so is likely to continue buying, as and when required, as we move towards the year-end renewals when it typically renews the largest slug of its risk transfer program.

The CEA said in the board documents that its risk transfer is projected to cost roughly $500 million this year, which it says is close to 60% of the amount of premium received from CEA policyholders.

Looking ahead, it seems the increased risk transfer costs present a slight challenge to the CEA.

This is because it is experiencing accelerating exposure growth at a time that reinsurance markets are firmer and capacity tightening, which lifts the cost of risk transfer as a percentage of its premiums coming in.

Alongside catastrophe model updates, the CEA notes that it, “faces potentially unsustainable strain on its claim paying capacity.”

With a projection that an additional $6 billion of risk transfer could be required over the next 5 years to cover its pace of claim paying capacity growth if nothing changes, the CEA team also warns that rates will need to increase by about 70% to cover rising and additional costs of risk transfer costs, unless actions are taken.

The upshot of this is that the CEA management team is set to propose to the board a possible honing of certain areas of its product offering, including potentially some reductions in coverage offered, as well as to operational processes, to try to counter the rising risk transfer costs, while maintaining its exposure at a sensible and economically sustainable level.

In essence, as it is, the CEA management teams recommendations suggest they feel the Authority may be reaching a limit in terms of practical and economically viable use of risk transfer right now, without implementing more rate rises to support the rising costs, or making other changes to products, coverage it offers and processes, it seems.

It needs to maintain its claims paying capacity, of course,

A strategic plan still suggests more reinsurance and risk transfer purchasing is likely in the medium term of around 3 to 5 years.

But in the short-term, the next couple of years, actions such as reducing sales of insurance, contraction of coverage, further rate increases and use of revenue bonds, or other efficient funding sources, are being considered.

So it’s not particularly clear-cut where the CEA’s reinsurance and catastrophe bond program will go, but as long as it maintains its exposure levels then the program is unlikely to shrink considerably, in the short-term anyway.

The medium to longer-term view continues to suggest more growth of the reinsurance and catastrophe bond program alongside rising exposures, so the CEA looks set to remain a significant buyer.

But right now it may take a bit of a pause to evaluate options and opportunities to lower costs and enhance efficiency of the products it offers and the capital sources it uses, which could have implications for its appetite for risk transfer in the shorter-term, with it likely remaining relatively stable, rather than growing at previously projected rates.

Of course, there are potential questions that could be raised about the economics of the California earthquake insurance model here. But, there are also questions about the costs of engaging in risk transfer and whether they could be optimised further as well.

The CEA Board of Governors will hear a range of options shortly, presented by the CEA’s management team and it will be interesting to hear what decisions, if any, are taken.

These are sensible proposals to mitigate what is a more challenging environment for the CEA right now, which has been driven by the CEA’s success and rapid exposure growth, alongside certain inflationary factors plus the hardening of reinsurance and risk transfer costs, it seems.

It will also be interesting to see how this changes the CEA’s projections for exposure growth going forwards, as they are the real driver of the insurers future risk transfer needs.