The Regulator: Sidecars Seen as New Source of Capital
Reprinted Article from the SVO Research Quarterly
Last Updated 10/24/16
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.
While cat bonds remain the dominant type of outstanding ILS, there are also other non-cat-bond ILS in existence, such as those based on mortality rates, longevity, and medical-claim costs.
According to Swiss Re, total ILS issuance in 2015, for the first time since 2011, did not register an increase ending the year with a total issuance of about $6.8 billion across 26 transactions and 34 tranches. In 2014 ILS issuance had grown to $8.29 billion across 27 transactions for a new high-water mark following two years of falling short of the record $8.24 billion issued in 2007. With about $6.9billion ILS maturing in 2015, a modest contraction was expected. However, total issuance for 2015 was approximately $100 million less than total maturities during the year.
As of the end of 2015, the overall outstanding ILS market increased to $25.9 billion from $24.1 billion in the previous year. A record-breaking start to 2016 saw about $2.21 billion in ILS issued pushing the total outstanding market up to $26.5 billion as of the end of March 2016, according to Artemis.
Driven by healthy investor demand, and in the absence of a large event, spreads were pushed down to new lows. At the same time, while new issue spreads have continued to tighten, it does appear that the market might have found its floor. As of the beginning of September 2016, ILS issuance for 2016 has risen to just under $4.2 billion, however the outstanding market has shrank to just over $25 billion.
While the ILS market has grown substantially in recent years and U.S insurers are active participants as bond sponsors, their ownership of these securities is limited. The aggregate investment in ILS for the U.S. insurance industry was $168 million at year-end 2013, a substantial decrease from the $428 million the industry held as of 2011 year-end. As of year-end 2013 life insurers held $134 million in ILS, of which 76% was in cat bonds and 24% in ILS-assuming mortality and morbidity risks. Property/casualty (P/C) companies held a more modest $29 million of ILS, of which 81% was in cat bonds and 19% was in ILS-assuming mortality and morbidity risks. Investor appetite for these aforementioned risks has increased in 2014 due in part to their attractive spreads coinciding with investors’ ongoing search for higher yielding investments. Also, in 2014, the cat bond market has shown a preference for U.S. hurricane risk.
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. Since the catastrophe bond market’s inception, ten transactions have resulted in a loss of principal to investors out of the more than 300 transactions that have come to market in its nearly 20-year history. Of these ten historical losses, six were the result of insured loss events and four were related to credit events in the vehicle’s collateral due to the collapse of the firm responsible for guaranteeing the bond’s collateral. Although it was once the most commonly used collateral structure, the collateral structure used in the deals that incurred credit related losses, called total return swaps, is not used in any outstanding cat bond. Treasury money market funds are currently the most popular collateral solution, followed by similar investment grade securities.
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 lower interest rate environment has caused returns to decline, similar to other fixed-income asset classes. Lower interest rates for ILS are in general still marginally higher than similar corporates in this market characterized by persistent low interest rates.
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.
According to the 2015 Global Risks report by the World Economic Forum, extreme weather events are regarded as the second most prevalent threat to global stability in terms of likelihood, following interstate conflict with regional consequences. The cat bond market remains dominated by U.S. hurricane risk. In 2015, the majority of the total issued cat bonds had hurricane as the sole or primary covered peril. According to Standard & Poor’s, a few of the new issuances that came to market during the past two years provided some sought-after opportunities for investors to diversify their portfolios into non-U.S. peak perils such as Japanese typhoon, Japanese earthquake, Turkish earthquake, European windstorm, Canada earthquake, Caribbean hurricane, and health claims payments.
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 boSost 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 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.