Swiss Re Insurance-Linked Fund Management

Original Risk: A Society for Change Agents

Have catastrophe bonds become competition for traditional reinsurance?


The risk transfer provided by a catastrophe bond or insurance-linked security transaction can be looked at as a form of insurance or reinsurance depending on who the issuer or sponsor is. That’s something the market has been aware of since day one and the reason that this market has grown around insurers and reinsurers who have been looking for complementary, diversifying sources of fully-collateralized reinsurance cover. But have we now reached a tipping point where cat bonds and ILS are in competition with more traditional sources of reinsurance?

An article in ratings agency Moody’s latest Reinsurance Monitor publication discusses the recent Everglades Re Ltd. catastrophe bond and how a deal of this size might have ‘moved the yardsticks’ in the issue of competition between cat bonds and reinsurers.

Everglades Re was groundbreaking in a number of ways, the largest single cat bond issuance ever at $750m and the fact it came from Florida’s Citizens Property Insurance, both of these are signs of the cat bond markets continuing acceptance as a source of reinsurance cover for peak risks.

Moody’s highlights a number of reasons to think that this deal shows an increasing ability of the cat bond market to compete directly with reinsurers and sources of more traditional reinsurance cover. The deal upsized significantly from $200m to the $750m it closed at and they say that this shows the willingness of cat bond investors to take on risks that are on a par with, or even more adventurous than, those that a reinsurer is willing to accept. The Everglades Re cat bond covers Citizens coastal insurance account which is an area of Florida where Citizens has a 60% market share, so by investing in this deal investors are essentially gaining some exposure to 60% of the Florida markets catastrophe risk.

We believe, and always have, that catastrophe bonds and ILS are perfect vehicles for these higher risk tranches of a reinsurance program and that capital markets investors are now savvy enough to appreciate the risk they are assuming. Good investment managers rigorously model transactions and balance their portfolios to ensure they aren’t over exposed to any one risk or geographic region, so we feel investing in a deal like this was not the groundbreaking factor. The fact that such a risky tranche upsized so much is testament to the growing sophistication of the cat bond and ILS space and in that respect this could be seen as a growing ability to compete with reinsurers for these risky tranches. This is though, we feel, the natural progression of a market which is gaining acceptance as a valuable contributor to overall risk transfer programs.

Moody’s has some interesting points to make on the pricing the Everglades Re cat bond achieved when compared with traditional reinsurance. Apparently, few reinsurers chose to invest in the deal as they felt the 17.75% (above Treasuries) coupon was not as good a return as if they sold reinsurance directly to Citizens. This is true, but there is another factor at play here, reinsurers may not have wanted to participate as they already have significant exposure to Florida wind risks. For cat bond and ILS investors though this was a great opportunity to make a solid return. Moody’s notes that of more than 44,000 non-convertible fixed income securities issued this year, only 69 have offered a better return than 17.75%. That’s pretty astounding to hear that a cat bond was one of the best investment opportunities of the year and will again help to build investor appetite for the asset class.

On the subject of competition between cat bonds and reinsurers this does suggest that high coupon cat bonds may become cheaper than reinsurance for sponsors as investors seek out these kinds of returns but reinsurers prefer to underwrite traditional covers. This could point to a real opportunity for the cat bond and ILS market to double-down and focus on the really high-risk tranches of reinsurance programs to grow the markets size, while continuing to offer cat bonds on lower risk, lower reward tranches as complements to reinsurance.

Another unusual feature of the Everglades Re cat bond deal which again points to cat bonds pushing reinsurers out of this layer of Citizens risk is the fact that this layer has no co-insurance at all. Moody’s says: “CPIC does not retain any portion of the layer covered by the cat bond. Even though CPIC retains risk below the attachment point, having no skin in the game in the covered layer is uncommon in both the cat bond and traditional reinsurance market.” We’d imagine that comes down to price and it was more cost-effective for Citizens to pass this entire portion of their risk transfer program to the capital markets.

Moody’s also says that they are noticing a trend for the state-sponsored issuers of cat bonds, such as Citizens and the CEA, to leverage the alternative capital sources offered by cat bonds and the capital markets to help them keep reinsurance renewal prices in check. This is an interesting trend and one we do expect to see more widely used to enable those with some cat bond cover to pick and choose where to issue further cat bonds and where to involve traditional reinsurers. Again, we’d say this is what the cat bond market is designed to facilitate, a broader selection of ways to transfer risk and secure reinsurance cover which a sponsor can optimise to be most cost-effective by choosing which layers of risk to transfer where.

Finally Moody’s discuss a current disconnect between the catastrophe bond market and reinsurance market on hurricane risk, use of risk models. As our readers will be aware, AIR Worldwide currently dominates the cat bond markets use of risk models for issuance of hurricane linked bonds. This has been the case since the launch of RMS v11 last year and RMS has not been the model used on any hurricane cat bonds since then. So, cat bond sponsoring re/insurers have used AIR Worldwide models for issuance but still likely use RMS v11 internally for capital modeling purposes (alongside other models). Reinsurers are using a blend of models or sometimes have even moved over to the new RMS model. What this means is that there is a disconnect of sorts in the pricing between an AIR modeled cat bond and an RMS modeled tranche of reinsurance cover.

We suspect that this will eventually become resolved as people in the reinsurance and cat bond market move towards a blended view of risk. However right now it could be offering the cat bond market a slight pricing advantage over RMS modeled reinsurance cover. Is that an issue? Maybe not, as the pricing denotes what people are willing to pay for the cover in a lot of cases and also what investors in cat bonds believe an acceptable return for taking on the risk. If investors understand the return-periods, probability of loss etc and are happy with that then perhaps pricing difference between two models does not matter so much. It’s likely that most investment managers and dedicated cat bond investors fully appreciate these differences anyway and in most cases will have assessed the risk of a hurricane cat bond tranche under the RMS v11 model anyway.

So, there are a number of factors evident in this recent cat bond deal which suggest that cat bonds are becoming more competitive with reinsurers, however we don’t foresee this competition becoming anything for reinsurers to worry about. This is a natural evolution of the broader risk transfer markets as cover moves to the capital markets, the only source of capital large enough to assume many of the risks cat bonds seek to address. Reinsurers need to look at this as an opportunity for themselves to innovate their business models, embrace capital markets risk transfer and work out how they can best tailor their offering to ensure it continues to complement cat bonds and other convergence market, fully-collateralized offerings.

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