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CAT bonds

An evolutionary change--California Earthquake Authority starts going direct to its own reinsurer

By Michael J. Moody, MBA, ARM

Many insurance experts are beginning to see the winds of change afoot in the property and casualty industry. Several industry reporting agencies show that reinsurance results for the first half of 2011 were the worst in history. As a result, many believe that the long-awaited hard insurance market may be just around the corner (I wish I had a nickel for every time I heard that over the past half dozen years). Obviously, any large catastrophic losses in the second half of this year will serve only to hasten its arrival. Regardless of the exact date, all the signs are that 2012 will be a year of change for the commercial property and casualty insurance market. As a result, many insurance buyers have already begun to explore their risk-financing options.

Historically, the alternative risk transfer (ART) market has provided a fertile ground for corporate insurance buyers during previous hard markets. However, this soft market has proven to be quite different from its predecessors. Despite the protracted nature of the soft market, organizations of all sizes have continued to move into the ART market, primarily through the use of captive insurance companies. Many hope this movement will mitigate the effects of the upcoming hard market to some extent.

Capital market considerations

Recent years also have seen the advent of the use of capital markets as a way to supplement the normal financial needs of the P-C industry. One of the most popular approaches to utilizing the capital markets has been catastrophe bonds or CAT bonds, as they have become known. The notion of using the capital markets to backstop the insurance market has been around for a number of years. However, the concept of convergence was not taken seriously until the aftermath of Hurricane Andrew. Initial efforts began in earnest during the mid-1990s, and were helped along by both the Northridge earthquake and Hurricane Katrina. By then, the industry realized that there was limited capacity available within the insurance industry and they needed to identify an alternative funding source, such as the capital markets.

CAT bond growth occurred slowly over the next few years. While there is little product standardization at this point, in essence, an insurance company issues CAT bonds to financial investors. Many times these investors are groups of hedge funds or pension funds that are looking for the advantages that can be obtained. Among the more notable advantages are higher-than-normal rates of returns as well as offering a method of diversifying the investor's portfolios. Couple this with the added advantage that these bonds represent zero beta risk (i.e., do not move with changes in the stock market) and CAT bonds have started to become a viable risk-financing option.

A new approach was required

One of the most recent CAT bond transactions may turn out to be one of its most transformative. From the start, the California Earthquake Authority (CEA) has been concerned about three main areas of its current reinsurance program:

• Obtaining a multi-year contract

• Collateralized risk transfer capacity

• Diversify its risk transfer sources

While CEA investigated a number of viable approaches to this problem, they kept coming back to one method that would allow them to resolve all three concerns. This method and the one that was ultimately selected was to establish their own special-purpose reinsurance vehicle (SPRV), Embarcadero Reinsurance, Ltd., in Bermuda. Embarcadero will issue CAT bonds on behalf of CEA, which will be sold to investors. The first such bond has already been issued and was oversubscribed.

With regard to the collateralized risk transfer capacity, the agreement between the CEA and Embarcadero (the SPRV) provides strong collateral for the reinsurance contract. This is consistent with CEA's long-standing practice for reinsurers that do not meet their "Guidelines for Sources of Claims-Paying Capacity," where the reinsurer must collateralize its limits. In this case, Embarcadero is required to post collateral in the amount of 100% of their reinsurance limit in a trust account in a New York bank. This must be completed prior to the start of the contract being signed.

Additionally, Embarcadero is providing a three-year contract that covers losses on an annual aggregate basis and is provided with a "reset" feature that pertains to the second and third years of the contract. This feature allows the parties to re-examine both the attachment point as well as the exhaustion point used to determine the following year's premium. The limit can be reduced only by loss payments to CEA under the contract.

The use of Embarcadero will also allow the CEA to obtain additional risk transfer capacity directly from the capital markets. The CEA realized some time ago that the supply of acceptably priced traditional reinsurance capacity is not without limitation. In order to lessen the upward pressure on future pricing, the CEA and its policyholders will benefit from the diversifying effects of Embarcadero Re. Further, the CEA has designed this transaction to "be repeatable and scalable," so that it can be redone and grown in the future.

Over and above the three major benefits previously noted, CEA has been a strong supporter of the traditional reinsurance market over the past years. They have utilized a program known as Redwood that has provided competitively priced reinsurance; however, CEA has continued to be concerned about continuing the competitive pricing.

The CEA is a nonprofit, state-run insurance authority. The Authority was established shortly after the Northridge earthquake in 1996. It has been successful and currently writes about 70% of all earthquake policies in California. This amounts to about 820,000 policies which develop an annual premium of around $600 million. Despite the impressive 70% penetration, in reality only 12% of California's home owners include earthquake coverage with their fire policies. The success rate is only about 9.5% of the state's commercial accounts.

The previous program relied heavily on reinsurance, by providing $3.1 billion of claim-paying capability out of a total limit of $9.4 billion. However, this reliance on reinsurance has come with a hefty price tag that has cost more than $2.92 billion in premiums over the past 14 years. This has amounted to over 40% of the $6 billion in total premium revenue. During that same 14-year term, CEA has had excellent claims experience and collected only $250,000 from reinsurers for claims.

Landmark deal

There are a variety of reasons that this has been classified as a "ground-shaking" deal. One of the more impressive is that the bond has been structured as a three-year bond. The actual details of the deal are that investors will be provided with a floating interest rate that is set at 6.6% above one-year Treasuries. The bond, which was the first CAT bond to be offered since the massive March 11 earthquake/tsunami that occurred in Japan, was oversubscribed, which shows significant interest by the investment community.

CEA officials have noted that the bond was purchased by 25 investors. They also indicated that a number of the investors had requested that the deal be "up sized." However, keeping with the CEA's desire to make this practice both sustainable and repeatable, rather than a one-time offering, the CEA limited the initial offer to $150 million. Structuring the transaction as they did, the CEA will be able to offer their policyholders a 12% reduction in earthquake rates beginning in January 2012.


Without question, there were a number of good, valid reasons for the CEA to move forward with the formation of Embarcadero Re and the subsequent sale of CAT bonds. From all indications, the Authority was quite successful in meeting its stated objectives and reasons for this transaction.

To their credit, CEA officials have gone to great lengths to state publicly that this transaction should not be viewed as a threat to the reinsurance community. In fact, they note that a vital and robust reinsurance market is critical to the continuation of the CEA. However, it is interesting to note that when the commercial insurance market failed to respond to the desires of corporate insurance buyers 30-plus years ago, captive insurance companies (owned by the insurance buyers' corporations) soon began to be formed. And as any captive feasibility study would confirm, direct access to reinsurance was typically a key advantage.

At this point, given the attractiveness of rates of return, investor demand for alternative investments should continue to grow. And from CEA's perspective, the formation of Embarcadero Re will provide them with "negotiating leverage with reinsurers, and manage price shocks in the traditional reinsurance market." This, coupled with the fact that the transaction was designed to "be repeatable and scalable," should offer the CEA significant advantages going forward. Will we look back at some point in time and see that Embarcadero Re continued the evolution of "going direct" in the ART market?


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