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 the World Economic Forum/Swiss Re, as of 2012 year-end, insurers and reinsurers made up about 5% of all insurance-linked securities investors. This represents a decline from 7% in 2011 and 20% in 2007. As insurers and reinsurers have decreased their share in the overall investment in the ILS market, asset managers and pension funds have increased their participation while dedicated hedge funds remained the largest investor 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.
Despite recent volatility in global financial markets, catastrophe bonds remain a useful diversifying risk tool for investors’ portfolios and a valuable risk transfer tool for sponsoring insurance companies. 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 are required to file them with the NAIC Capital Markets & Investment Analysis Office for determination, as they are 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.
The catastrophe bond market was presented with a new type of event in 2012 in the form of the unique Superstorm Sandy, which was designated a “Post Tropical Cyclone” by the National Hurricane Center (NHC). Sandy was only the second event since 1851 to actually make landfall in New Jersey with hurricane force winds. There is still a lot of uncertainty around the final industry loss figures for Sandy as it was an unusual event hitting a densely populated area. Despite the increasing frequency of such events, both sponsors and investors have shown resilience keeping demand for new issuance strong, confirming the stability of the ILS market. Furthermore, it is important to note that by the end of 2012, there were no reports of any cat bonds impaired due to Sandy.
The 2012 cat bond market was dominated by U.S. wind risks as most of the multi-peril bonds contained that peril. According to both Swiss Re and Willis Capital Markets & Advisory, the year ended with about $6.3 billion of new volume behind only the record issuance of 2007. 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.
U.S. natural disasters dominated insurance losses this year, with the top five insured-loss events taking place between March and October of 2012. Insured and reinsured losses from catastrophic events totaled $65 billion globally in 2012, which put it above the ten-year average. But the year still trailed 2011, in which the insurance industry experienced $120 billion loss.
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.