Insurance-linked securities (ILS) are products of the rapid development of financial innovation and the process of convergence between the insurance industry and the capital markets. The securitization model has been employed by insurers eager to transfer risk and tap new sources of capital market funding. Insurance-linked securities—both from the life and property/casualty sectors—hold great appeal for investors.
According to Swiss Re, 2013 was an outstanding year for ILS in terms of issuance. The year ranks second on record with $7.42 billion in new securities across 31 transactions in 2013, behind only the $8.24 billion issued back in 2007. In its mid-year report, Swiss Re indicated issuance for the first half 2014 totaled $5.9 billion, approximately 35% ahead of the previous record pace in 2007. As of June 30, 2014, the overall outstanding ILS market is now $22.0 billion, nearly 30% larger than at the same point during 2013. Swiss Re expects 2014 issuance to continue to outpacing maturities as the outstanding market continues reaching new highs and full year new issuance for 2104 also reaching a new full year high.
As insurers and reinsurers have decreased their share in the overall investment in the ILS market in the last couple of years, asset managers and pension funds have increased their participation while dedicated hedge funds have remained the largest investors of ILS. As of year-end 2011, life insurers held $379 million in ILS, of which 80% was in catastrophe risk and 20% in mortality risk deals. Property/casualty companies held a more modest $43 million, of which 99% was in catastrophe risk securitizations and just 1% was in mortality risk. The total aggregate investment in ILS for the entire insurance industry stood at approximately $428 million. While this is still a modest exposure, it represents an increase from the $380 million the industry held as of 2010 year-end. The analysis by NAIC of the investment portfolios of the insurance industry as of Dec. 31, 2011, indicates that only a small number of insurers have any ILS-related investments.
Catastrophe bonds (commonly abbreviated to cat bonds) are a segment of the ILS market. They are used by property/casualty insurers and reinsurers to transfer major risks on their books (such as for hurricanes, windstorms and earthquakes) to capital market investors, reducing their overall reinsurance costs while freeing up capital to underwrite new insurance business. Cat bonds are structured so that payment of interest or principal to the reporting insurance company depends on the occurrence of a catastrophe event of a defined magnitude or, that causes an aggregate insurance loss in excess of a stipulated amount.
The risk inherent in cat bonds is a key reason these securities are of relatively short duration, typically maturing in three to five years. According to Standard & Poor’s, as of the end of 2013 only seven rated cat bonds had ever defaulted. Three of those were event-driven, and four were connected to the collapse of Lehman Brothers in 2008. In addition, both Queen Street II Capital Ltd. and Queen Street III Capital Ltd. are now on CreditWatch due to small losses from their MMF investments.
Catastrophe bonds remain a useful diversifying risk tool for investors’ portfolios and a valuable risk transfer tool for sponsoring insurance companies. As interest rates remain near historic lows investors continue to look for yield in alternative assets classes. The spreads available in the high-yield markets highlight the attraction of the ILS market which has been the beneficiary of large inflows from institutional investors. The increased investment in cat bonds have helped tightened spreads significantly over the course of 2013 as low interest rates continued to provide a favorable issuance environment.
Insurers, in addition to being issuers of these securities, can and do invest in them on a limited basis. Insurance companies purchase these securities to diversify their portfolios. Typically, insurers are not expected to invest in a cat bond if they are already exposed to the peril in question in their primary business. Insurers that do invest in cat bonds were in the past required to file them with the NAIC Capital Markets & Investment Analysis Office for determination, as they were not eligible for filing exemption under the NAIC rule which grants an exemption from filing for securities that have been assigned a current, monitored rating by an ARO (acceptable rating organization) as prescribed in the Purpose and Procedures Manual. At the 2014 NAIC Spring National Meeting, the VOS Task Force adopted a motion to make rated cat bonds filing exempt. The NAIC Capital Markets & Investment Analysis Office is also expected to recommend at the2014 NAIC Summer National Meeting to the VOS Task Force that those cat bonds that are not rated to be subject to the 5*-6* certification process as prescribed at the Purpose and Procedures Manual.
The 2013 cat bond market was dominated by U.S. hurricane risk, accounting for approximately 65% of the new issuance, and this risk was covered in 31 of 42 tranches. Over the first half of 2013 about of $3.1 billion in ILS bonds matured, opening opportunities for new issuances to compete for investor dollars. New cat bond issuance for the first half of 2013 was $4 billion with the total outstanding, as of June 30, 2013, hitting $17.5 billion. Over 75% of the cat bond limit placed in the first two quarters was exposed to U.S. hurricanes. New transactions with this type of exposure continued to come to market, so close to the U.S. hurricane season. Updated forecasts by the National Oceanic and Atmospheric Administration call for 13 to 19 named storms for this year.
Another structure for transferring catastrophe risk to investors is the sidecar, which became very popular in the aftermath of Hurricane Katrina. Sidecars are deployed mainly by reinsurers following major catastrophes to add risk-bearing capacity in periods of increased market stress. Sidecars are special-purpose vehicles through which reinsurers cede premiums associated with a book of business to investors who place sufficient funds in the vehicle to ensure claims are paid if they arise. In contrast with cat bonds, which are structured as long-term instruments covering a broad array of perils and geographies, sidecars are tactical instruments of limited duration during a hard market.
As severe natural catastrophes become more frequent due to changing climatic conditions, insurers and reinsurers may boost their issuance of cat bonds and sidecars as additional protection from the risk of incurring solvency-threatening losses. According to InsuranceRisk, the number of sidecars is expected to grow alongside cat bonds, as reinsurers seek to expand and capacity investors look for high-yielding assets. Sidecar market capacity is conservatively estimated at around $2 billion from a total catastrophe risk capital market capacity of approximately $42 billion.
As part of regulatory efforts to help manage catastrophe risk, the NAIC and state regulators have developed a comprehensive national plan that incorporates new risk management techniques with a solid foundation of solvency and consumer protection inherent in state insurance regulation.
Life Insurance Securitization
Life insurance securitization is also a segment of the ILS market. Mortality and longevity risk securitizations fulfill a similar function for life insurers, as catastrophe bonds and sidecars do for property/casualty insurance and reinsurance companies—the transfer of risk to the capital markets.
Extreme risks of increasing mortality rates due to natural catastrophes and pandemics could potentially present a challenge to a life insurer’s solvency. A jump in mortality rates would adversely affect the amount and timing of death benefits an insurer must pay. Longevity risk is the other side of mortality risk. A rise in longevity rates would increase cash outflows due to more annuity payments.
Apart from transferring mortality risk, life insurance companies have employed securitization techniques to: a) monetize the embedded value of a particular block of business in order to fund acquisition or demutualization costs and b) fund the extra reserves required by regulations XXX (Valuation of Life Insurance Policies Model Regulation #830). Often, a captive insurance company is at the center of Regulation XXX life securitization structures and it is used as a repository for the funds that were available from the securitization.