The U.S. National Association of Insurance Commissioners has received a proposal to change the capital treatment of catastrophe bonds for life insurers investing in them, which it believes could open the floodgates for a wave of new capital to enter the ILS sector.
Clarification: This proposal has not been initiated by the NAIC, rather it has been proposed to the NAIC taskforce by U.S. primary insurer Nationwide and the North American CRO Council.
The materials received are now subject to a 60 day comment period after which the NAIC will consider any feedback before any decision to take action is made. The original article below has been edited to reflect this fact. This makes it even more important that feedback is provided by the ILS market and life insurance firms that would be keen to see the capital charge regime adjusted to enable more investing in catastrophe bonds.
Life insurance companies and life reinsurance companies have always invested in catastrophe bonds to a degree, finding them a useful asset which offers both the normal low correlation with wider economic factors and markets as well as low correlation with their underwriting portfolios.
However, the way U.S. regulations force life insurance and reinsurance firms to report investments in securities makes investing in cat bonds less attractive and as a result, despite the massive amount of investment assets at U.S. life insurers they are not big investors in catastrophe risk securitizations.
The NAIC has a received a proposal to amend the capital treatment of catastrophe bonds for life insurance companies, which it believes would result in greater investment in the catastrophe insurance-linked securities (ILS) asset class by these large insurers. If life insurers increase their investment in cat bonds it would benefit the entire industry in terms of diversification of risk and risk capital.
The benefits the proposal cites are as follows:
- More risk capital available for P&C insurers and reinsurers that want to sponsor a catastrophe bond and use ILS as a source of reinsurance or retrocessional capacity.
- Life insurers investing in cat bonds would benefit from an improved risk-adjusted return, with the decorrelation factors and diversification improving their asset yield.
- Reduce the cost of capital for P&C insurers, as the additional capital flowing into cat bonds would likely drive down spreads even further. This could ultimately benefit P&C insurance customers.
- Life insurance customers would benefit from the improved risk adjusted returns that their insurers are making on their asset portfolio.
- Solvency concerns held by regulators would be eased due to the increased diversification introduced into the insurance system.
These are all compelling arguments for making it simpler for life insurers to invest in catastrophe bonds and to provide ILS risk capital as a result.
The benefits of diversification in insurance and reinsurance are well-known, however the diversification benefit between two key insurance industry risks, catastrophe risk within P&C insurers and credit risk in Life insurers, is largely ignored in the regulatory capital frameworks that are followed today, the proposal to the NAIC Valuation of Securities Taskforce explains.
As a result this potential benefit is not realised typically and this negatively impacts insurers, regulators and ultimately insurance buyers.
Catastrophe bonds can provide life insurers with a way to diversify their investment portfolios to take advantage of benefit of diversification between catastrophe risk and credit risk. But as these diversification benefits are not recognised life insurance firms are not typically active investors in cat bonds.
The capital charge totally ignores the diversification benefit that life insurers could be benefiting from, rather treating a cat bond the same as below investment grade corporate bonds. The proposers believe that this should change.
The proposal explains the barriers to life insurers investing in cat bonds and the capital treatment of cat bonds as:
- Capital charge: For life companies, Cat bond investments receive the same RBC treatment as similarly rated below investment grade corporate bonds. For unrated Cat bonds, a significant portion of issuance, investments receive equity RBC treatment. As a result, life companies do not receive any diversification credit for this uncorrelated asset risk (treated as low grade corporate credit or equity risk).For example, on a BB bond the capital charge is about 3.4% and categorized under C1 – Asset Risk component as shown in the figure below. The result is an overall capital charge of $16.9M for a $500M bond and does not provide any differentiation between a corporate bond and a Cat bond; it does not recognize the diversification benefits of a Cat bond.
- Accounting treatment: For unrated Cat bonds (categorized as NAIC 6), the bonds are marked to market under statutory accounting, driving capital volatility. They are also assessed a hefty capital charge of 19.5%, as shown in the table below. Over the past year there has been an increase in Cat bonds that are unrated, as issuing companies have seen a high demand for Cat bonds from investors and chose to avoid rating costs. If life insurance companies become larger investors in the Cat bond market, then more issuers would choose to get their bonds rated to attract more capacity.
- Information asymmetry: Life insurers typically lack expertise and/or transparency into the modeling/measurement of the risk. The risks in a Cat bond are significantly different from those of a corporate bond and it requires specialized knowledge to properly assess these risks. Typically an investment bank acts as an intermediary in the issuance of a Cat bond and can assist an investor in their risk assessment. This lack of life industry expertise would still likely pose near term challenges to broad life company investment in catastrophe bonds.
- Restrictions on amount of investments in below investment grade bonds: A vast majority of the Cat bonds in the market are rated below BB by S&P, partly due to ratings caps and qualitative considerations used in the ratings process. The ratings do not consider diversification benefits of Cat bonds. The restrictions on below investment grade bonds are primarily self-imposed by companies and well within the regulatory maximums, so this is not a highly constraining factor.
If the capital treatment of cat bonds as assets for life insurers is changed it could bring these diversification benefits to the insurance industry, as well as stimulate more capital to enter the ILS space by opening up a new pool of capital from life insurance industry assets.
In 2014 the various data from brokers on ILS investors suggests that life insurers make up as little as 1% of catastrophe bond investment capital during this year. In the last few years this percentage has been even lower, with life insurers investments in cat bonds recorded as 0% in 2013 and 2009, according to Aon Benfield Securities data.
The proposal to the NAIC taskforce says that if the barriers could be lowered, resulting in more investing in cat bonds from life insurers, a larger proportion of the bonds may be rated as a result as they would be more attractive investments in that case and more resources and talent would be dedicated to the ILS asset class by life insurers.
The life insurance industry controls trillions of dollars of assets and is a long-term investors. If it could be made much more attractive to invest in cat bonds and the capital charge issues were removed this could be a watershed moment for the catastrophe bond market, bringing a significant wave of new capital to ILS.
In fact, expanding the catastrophe bond investor base to include life insurance companies could at least double cat bond market capacity, the proposal estimates. That’s a huge change, which would lead to fundamental changes across the property catastrophe reinsurance space and perhaps help the market to open into more emerging markets as well.
This expansion of the cat bond investor base and doubling of catastrophe bond market capacity would put more downward pressure on cat bond and related reinsurance pricing, the proposal says. Increased demand from these new investors could tighten spreads by 50 to 150 basis points, the proposal suggests, and result in greater availability of reinsurance capacity in catastrophe prone regions.
“More importantly, it will also serve to stabilize the capacity in the overall reinsurance market, especially after major natural disasters, by providing a source of stable capital capacity to the P&C insurance industry,” the proposal explains.
The proposal details a number of ways that the capital charge could be treated differently, which would reduce the charge significantly in the majority of cases while also bringing the return and diversification benefits to the investing life insurance firms.
The intent of any solution should be, “To allow for catastrophe risk to be appropriately diversifying to a risk portfolio with low correlation,” the proposal continues. For the diversification benefits to be made available the capital charge needs to be dropped or removed altogether and the proposers seem intent to make this happen.
Currently, the NAIC is requesting comments on the proposal to modify the capital treatment of catastrophe bonds for life insurers by the 18th January 2015. A number of very large U.S. life insurers are said to have engaged with the NAIC in this process, in fact the initial proposal came from one we believe, and are keen to see the capital treatment of cat bond investments changed in this way.
If the capital charge is minimised or removed and if large U.S. life insurers appreciate the diversification of risk benefits, alongside the risk adjusted return and low correlation asset benefits, then this initiative could really make a difference to the ILS market.
Life insurance and reinsurance firms have such huge amounts of investment capital at their disposal that opening the floodgates to them would need to be well-managed, to ensure that any further tightening of catastrophe bond spreads was disciplined. However any influx of new investment capital into cat bonds and ILS from such a huge investment source would likely lower the ultimate cost-of-capital for ILS instruments even further.
How this would affect the already softened traditional reinsurance market and the prospects for traditional reinsurers remains to be seen, but the additional capital could stimulate greater use of cat bonds, thus further eroding the market share of traditional catastrophe reinsurers.
This initiative has the potential to be market-changing. It will be interesting to see if and how the NAIC moves forwards with this proposal.
More details can be found via the NAIC website on this page.