Workers compensation could be a candidate for catastrophe bonds: A.M. Best

In an article published yesterday on its BestWire service, rating agency A.M. Best discussed the maturation of the catastrophe bond market, citing the near record levels of issuance in 2012 as evidence of a rapidly maturing market. While the market may be maturing, A.M. Best agree with our position that the market needs to find ways to expand outside of the perils it is currently dominated by if it is to achieve significant growth.

2012 saw the second highest level of catastrophe bond issuance on record, a sign that the 16 year old market is maturing, said Asha Attoh-Okine, managing senior financial analyst of insurance-linked securities at A.M. Best. The $5.9 billion of property and casualty related cat bonds that A.M. Best recorded in 2012 is second only to the $7.4 billion it recorded in 2007, Attoh-Okine said.

On the prospects for 2013, Attoh-Okine said that he expects another good year for the cat bond market, adding; “I would not be surprised to see one or two new sponsors and new risks come to the market.” One new risk he singled out as a prospect for the cat bond market is workers compensation. Attoh-Okine said that a workers compensation cat bond might involve similar modelling to Aetna’s recent medical benefit risk cat bond deal, Vitality Re IV Ltd., adding; “If you can do that for health, why not for workers’ comp? It would be an excess-of-loss reinsurance transaction. It can be done.”

Attoh-Okine makes a very good point. Aetna’s Vitality Re deals use a medical benefit claims ratio to derive a trigger, so if the ratio of claims exceeds a certain percentage the deal begins to pay out. An insurer with a portfolio of workers compensation policies could likely use a similar methodology to derive the ratio and percentages of claims and so create a suitable trigger for a cat bond or ILS type transaction.

The key lies in what the actual underlying risk or peril is that you are trying to protect against. In the case of Aetna, the Vitality Re ILS deals provide them with protection against risks such as pandemic influenza that may cause massive jumps in medical benefit claims. However it would also protect them against other illness outbreaks or even a jump in medical benefit claims after a large catastrophe event, or perhaps even a terrorist attack. Of course it also provides them with protection against simply a particularly bad year, with poor claims experience from a combination of risks occurring, such as a worse than average flu season.

For workers compensation, a cat bond based on claims rates would protect against a higher than manageable number of claims, but could also protect against a large jump in claims due to specific causes such as a chemical spill at a large factory, an increased incidence of a workplace induced injury or illness and even claims resulting from natural catastrophe events which strike workers.

The only cat bond to date that covers workers compensation claims is actually linked to the occurrence of an earthquake in California. The Golden State Re Ltd. cat bond from 2011 protects the California State Compensation Insurance Fund against workers comp claims arising from an earthquake affecting the state. That cat bond uses a modelled loss trigger, so models a calculated index to determine whether an earthquake has triggered the notes. Perhaps this cat bond could have used a workers compensation claims ratio, in a similar manner to Vitality Re’s trigger, to more closely link the claims experience of the Fund to any cat bond losses.

In fact, Attoh-Okine’s idea seems a decent one. There must be a number of large insurance and reinsurance entities which could experience significant increases in workers compensation claims rates for many different reasons. A cat bond structured like Vitality Re,  which tracks the rate of those claims up to a pre-defined trigger point, could be just the answer to protect against this. Such a cat bond would likely be very well received by investors as it would bring a new risk to the market and so pricing would likely be competitive with more traditional sources of cover.

Of course, workers compensation is not the only class of insurance business that could be issued in cat bond form using a claims ratio for a trigger. Life insurance could be another popular candidate which could perhaps fit this model of claims rate increases triggering the deal, along with liability type covers including perhaps product liability, product recall, medical device liability or even pollution liability claims incidence. It will be interesting to see whether anyone in the market can encourage a sponsor to follow-up on this idea.