2011 alternative market update
Interest in insurance-linked securities is increasing
By Michael J. Moody, MBA, ARM
Astring of early-year catastrophic events has resulted in a rising awareness of the insurance-linked securities (ILS) portion of the alternative risk transfer (ART) market. Already this year, events in the insurance community have been punctuated by several significant loss events that include:
• Tohoku earthquake in Japan
• Cyclone Yasi in Australia
• Wildfires in New Mexico and Arizona
• Volcano in Chile
• Tornadoes across the Midwest
These events, as well as the continuing soft commercial property and casualty insurance market, have had a meaningful impact on the entire industry. But, for the most part, capital continues to be available. Despite this, the ART market remains relatively soft. However, several other factors suggest there might be increasing interest.
What follows is a snapshot of the current ILS and ART market conditions. In addition, we will provide some insight as to the future of both.
As has become the case in recent years, attention in the catastrophic (CAT) bond market is one of the leading indicators of overall trends in the ILS sector. The first quarter of 2011 was the most active in the history of CAT bonds, in terms of new issuance. Unfortunately, the first quarter was also noteworthy because of the unprecedented amount of natural catastrophe loss activity noted above.
According to reinsurance intermediary Guy Carpenter, the second quarter of 2011 saw new issuance of CAT bonds in the $600 million range. Despite these favorable growth figures, the market remains one that is dominated by U.S. hurricane exposures. This domination by the U.S. wind exposure has been growing steadily over the past few years. Carpenter notes that this exposure now accounts for 71% of the CAT bond business, up significantly from the 38% level found in 2003. As a result, traditional institutional investors are beginning to reassess their positions regarding CAT bonds.
Wind exposure was also a major factor in the Industry Loss Warrants (ILW) as the U.S. moves to the middle of hurricane season. While there has been some price strengthening again this year, it has been a more steady growth, rather than the "big jump" that occurred last year. In part, this was the result of a change in the purchasers of ILWs. Last year, the majority of investors were hedge funds, which is in sharp contrast to this year when more investors are rated insurance carriers. Many believe that due in large part to the continuation of the soft insurance market, numbers of these rated insurers have lower than typical appetites for CAT losses in the U.S.; thus, they are trying to lay off some of this risk via bond purchases.
One of the very creative methods that came out of the 2005 property market restrictions was a concept that has become known as a "sidecar." In essence, sidecars allow capital to enter the market without the need for a traditional ILS involvement. For the most part, sidecars usually took one of two forms—either via a quota share agreement with an insurer/reinsurer, or entry via an MGA agreement. This allowed insurers/reinsurers to expand their capacity quickly and deploy their capital where it could obtain the best returns. Interest in sidecars has dwindled in recent years; however, it has seen a resurgence in the wake of the record losses incurred during the first quarter. That said, because most sidecars are completed through private placement, few facts or figures are typically made public, so the exact details are not known.
Other market drivers
There is little doubt that the awareness of and price of ART market products continues to be driven by the soft market conditions in the traditional insurance marketplace. However, the soft market is not the only driver of the current ART market. The ART market has also been affected by revisions in a number of capital models used by rating agencies and regulators. Modelers have been experimenting with a number of different approaches that could be used to provide a better predictor of the effects of CAT losses on insurers and reinsurers. For example, RMS, one of the premier modeling firms, released its latest version in late February. Known as RiskLink® v11, it was specifically developed to model North American hurricane losses.
A number of industry observers, including risk management consultant Oliver Wyman, have already pointed out that both regulators and rating agencies have dramatically heightened their standards regarding the amount of capital that insurers/reinsurers need. Wyman also points out that those carriers that can comply with the new mandates will likely gain a competitive advantage, thanks in large part to a lower cost of capital that is available to higher-rated insurers.
Another major driver of the ART market, in fact of the entire insurance market, is the advent of Solvency II. This accounting mandate will have a profound impact on the worldwide insurance industry. Certainly the major concerns come from the European reinsurance community where it is scheduled to be implemented first. While few believe that Solvency II will eliminate all of the industry's capital problems, many think that the advances in disclosures and overall market strength will ultimately help the industry, but they sense that it will come with a price: more capital commitment.
The ILS segment of the ART market is alive and well, though still trying to seek its place in the overall insurance market. Events of the past few years have not been kind to the ILS market but, despite this, investors continue to have the ILS market on their radar. In fact, many investors are eager to put their money to work in the ILS arena, since this segment provides an excellent approach to diversification for their portfolios. An added benefit for moving to one of the ILS products is that they typically provide a higher return than conventional investments. While exposures to risks can be substantial, returns from bonds and warranties outpace the general investment vehicles. Many investors believe that the additional risks are warranted and, despite the magnitude of the Tohoku earthquake, only one bond (Muteki) suffered a full loss.
As both the capital markets and insurance industry become more comfortable with each other, interest in ILS should grow. While it has not always been pretty, today there is clearly a movement towards convergence between the two groups. There continue to be some trouble spots in this movement—i.e., transactional cost of ILS, need to diversify perils, etc.—but acceptance by both segments has increased significantly in recent years. The final results of the U.S. hurricane season will have to be determined; but even without them, it is clear that, in the long term, the insurance industry must gain access to the resources that are available only within the capital markets. Bottom line, growth within the insurance-linked securities segment of the ART market will continue, regardless of the insurance industry's overall results. However, should significant catastrophic losses occur during the latter part of the year, investors are more than willing to provide additional capital.
Michael J. Moody, MBA, ARM, retired as the managing director of Strategic Risk Financing, Inc. (SuRF), a firm that had been established to advance the practice of enterprise risk management. As a regular columnist, he continues to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.
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