A meeting of the minds—The success of CAT bonds could be the prelude to more convergence vehicles 03/08

A meeting of the minds

The success of CAT bonds could be the prelude to more convergence vehicles

By Michael J. Moody, MBA, ARM

Convergence is a topic that continues to gain attention within the insurance industry. It seems that articles for the last 25 to 30 years noted with interest the inevitability of the insurance market and the capital market combining. Several times during the past several decades, seminal events were heralded as the arrival of convergence. The Gramm-Leach-Bliley Act of 1999 was one such event. GLBA broke down some of the traditional barriers, so surely convergence would soon follow. Several high-profile attempts, such as the highly publicized merger of CitiBank and Travelers Insurance Company, were “proof” that true, long-term convergence between the two markets was finally here.

Well, we all know how that turned out. But, it did point out just how difficult developing a viable convergence vehicle was going to be.

In the early 1990s, a new concept called catastrophe bonds (CAT bonds) was quietly introduced to a reinsurance community that was suffering capacity problems following Hurricane Andrew. And while the concept that was used to develop the insurance-linked securitization that underlined the CAT bonds was fundamentally sound, little interest was shown by either the insurance market or the capital market. In fact, the insurance market’s response was to begin selling cheap reinsurance, thereby negating the reason for the bonds in the first place.

Convergence via CAT bonds

It was clear, though, that the CAT bond concept represented a major shift in thinking for both the capital market and the insurance market. While the CAT bonds did offer a number of advantages to each market, both found a number of obstacles that precluded their use. One of the primary shortcomings for the investment community was the fact that in the event of a severe claim, they could lose both interest and principal. Additionally, high transaction costs and long lead times caused problems for both parties. But despite all odds, several CAT bonds were actually written during those first few years.

The next 15 years or so found modest, but orderly growth in the CAT bond market, as it continued to gain proponents from within both the capital markets and reinsurance community. However, it was the period immediately following Hurricanes Katrina, Rita and Wilma (the three sisters) that really set the stage for CAT bonds. Essentially, several issues were responsible for the growth of the CAT bonds within the reinsurance community during this time. First and foremost, was a major capacity crunch throughout the entire southeast U.S. coastal areas. Reinsurers were forced to accept any available options, and CAT bonds became a welcome addition.

But investors were also beginning to have a “love affair” with insurance-related securitizations, mainly CAT bonds. They quickly saw that minimal losses (actually only one bond was involved in Katrina) followed the three sisters and, thus, grew more comfortable with the concept.

Additionally, both the speed to market and the transactional costs had been reduced substantially. The contractual language had also become more standardized and a secondary market for the bonds resolved some liquidity issues that were of concern to hedge fund managers. And for many capital market participants, CAT bonds represented a portfolio diversification that was highly prized in the investment community. This fact, along with the higher-than-average rates of return, soon had the CAT bonds cast as the “darlings of the capital markets.”

Other capital market offerings emerge

While CAT bonds have been the most used capital market product within the insurance industry, they are certainly not the only products available. A recent addition to the insurance-linked securitization offerings has been a couple of products that were specifically designed to solve problems in the life insurance industry. Unique accounting requirements in both the term life and universal life areas required insurers to maintain redundant reserves and either to set aside more reserves in the form of cash or to obtain additional reinsurance to cover this requirement.

The capital market was quick to develop a solution to this problem that has been a great success. The term life product known as “Triple X” and the universal life product known as “A Triple X” have been widely accepted from the beginning. Because most of these products utilize captive insurance companies, several captive domiciles have begun specializing in this form of capital market participation. Among the more popular captive domiciles are Vermont, South Carolina and Arizona. Despite being introduced only a few years ago, both of these products have found a ready market within the insurance community and with eager investors within the capital markets. Future growth and convergence in this area is likely.

Another recent addition to the capital market products is sidecars. These products were also a product of the capacity crunch that followed the three sisters. In essence, sidecars were quickly funded insurance operations that were typically formed in Bermuda and represented additional capital that could be used in the reinsurance market. They were usually structured as “quota share” reinsurance arrangements that were offered to underwriting carriers that specialized in catastrophic property coverage. Their additional capacity was one of the reasons that the hard market following the three sisters did not last as long as projected. The additional capacity and the lack of serious hurricane damage in subsequent years have helped to bring the property market back to a more traditional pricing model.

Conclusion

It appears that the capital market will continue to maintain and even grow its involvement within the reinsurance community. Some commercial insurance buyers may have short memories and abandon their insurers for the lure of lower premiums; however, the same should not be said of reinsurers. At this point, reinsurers should have well learned the harsh reality of the pricing cycles in the overall insurance market.

Convergence via the reinsurance market will provide the insurance community the ability to reduce the peaks and valleys that typically characterize our insurance underwriting cycle. One would hope that the lure of lower-priced reinsurance that may be available in the current soft market would not dissuade reinsurers from continued use of capital market products. Many reinsurers do remain interested in capital markets products; for example, most reinsurer’s portfolios now include CAT bonds.

And on the other side of the equation, the investment community remains as interested as ever in the insurance industry. In general, the investment community has become much more familiar with and accepting of the insurance industry. The advancements that CAT bonds have made in just the past few years are testament to the acceptance by hedge fund and pension fund managers. They have witnessed how well CAT bonds performed in times of extreme loss (i.e., following Hurricane Katrina), and most recognize that the time it takes to form the CAT bond as well as the costs involved have been greatly reduced.

Additionally, the contractual language has become much more standardized. In a time of falling interest rates, insurance-related securitizations still represent one of the higher investment income opportunities available to the capital market.

Finally, with the subprime mortgage mess dominating the investment news, hedge fund and pension fund managers are going out of their way to find zero beta investments that have no correlation with what is going on in the stock market.

Bottom line, reinsurance has become the poster child for the convergence of the capital and insurance markets. And despite some initial reluctance, both sides of these deals now appear to welcome the additional help. As the capital market products continue to evolve and additional products are brought to the marketplace, it is easy to see the vision of a converging of the two markets for the benefit of each. Long-term, this may well be one of those “win-win” situations that are so rare in business today.