Sidecars have come and gone – at least for the time being – and cat bonds are continuing an upward surge. As Lloyd’s continues its foray into non-traditional reinsurance, David Banks asks if the market is ready to embrace the full range of capital market options.

Brit’s entry into the derivates market at Insurance Futures Exchange Services (IFEX) has renewed interest in the prospect that more Lloyd’s participants will take a direct role in insurance-linked securities (ILS). Of late, talk of such capital market links have centred on the rise of cat bonds. These are gaining ever-more attention despite softening reinsurance rates, due in part to their apparent ability to sidestep the worst effects of the credit crunch.

May saw the announcement of the first dedicated ILS venture to be backed by a Lloyd’s insurer, namely Amlin. This new investment management firm, headed by John Wells and former Swiss Re ILS chief Luca Albertini, will pursue a broader range of ILS products than cat bonds alone. Also in May, Benfield announced it was backing new ILS investment management firm Juniperus Capital Ltd. The new firm is headed by former RenRe SVP Michael Cash.

The advent of Lloyd’s sidecars two years ago, in the form of Hiscox’s Panther Re, Brit’s Norton Re and Lloyd’s as-yet unused Cayman-based Thunderbird Re, begs the question of whether the Lloyd’s market will see other ILS transactions, particularly given the increasing desire to trade securities.

Alastair Speare-Cole, CEO of Aon Re UK, says many of the major Lloyd’s players are going deeper into ILS, albeit through their external business holdings. “I think that the view that Lloyd’s is a discrete and separate entity is a misnomer. Lloyd’s has become a platform where people can trade certain business with certain advantages,” he says. He adds that for large sophisticated Lloyd’s insurers such as Brit, Amlin and Beazley, ILS is part of a continuum of effort.

Trading ILS

In addition to IFEX, there are a number of other trading platforms for ILS products. The Chicago Mercantile Exchange (CME) launched the CME-Carvill Hurricane Index futures and options contract last year. The underlying indexes will be calculated by reinsurance broker Carvill. Likewise, the New York Mercantile Exchange (NYMEX) and Gallagher Re agreed in 2006 to list property damage risk contracts. This agreement has now been taken on by Aon, since it bought up Gallagher Re in March this year.

With a number of legal amendments, Lloyd’s itself could be directly involved in the growth of securities trading, according to Charles Dupplin head of the ART and private client division at Hiscox, which was the first Lloyd’s company to issue a successful sidecar. However at the moment, the Lloyd’s rules of engagement prevent this kind of trading. A syndicate cannot buy a derivative directly and has to buy through a transformer.

“It is unfortunate that Lloyd’s, which has been part of so much innovation over the years, appears to have ruled itself out in the past. However, Lloyd’s can be really commended in its efforts to get to grips with this issue. There are some very good brains with a modern and positive outlook trying to investigate the issue, but it is terribly important to get it right for the security of the marketplace,” Dupplin says. A lot of work needs to be done to convince people that insurance securities can be traded alongside the Lloyd’s central fund, according to Dupplin. How soon could such changes be made? It all depends on the will of Lloyd’s and its market participants, he explains.

An old concept

It has been ten years since a report to the Lloyd’s Market Board highlighted the threats and challenges of alternative risk transfer mechanisms, especially insurance securitisation. The conclusion was that securitisation bore a strong resemblance to what Lloyd’s had always done – assembling and pricing risk for third-party capital providers. While changes were made that permitted a more concerted pursuit of cat bond and sidecar issuances, there remains many of the “significant regulatory hurdles” to laying-off insurance risk through securitisation that existed then.

If cat bonds represent the “plain vanilla” of ILS, they present an encouraging indicator of the potential contribution of the capital markets at Lloyd’s. Cat bonds are thought to account for between 8% and 12% of the reinsurance market, with the higher proportion serving the US market. Current aggregate demand for cat bonds is said to stand at $20bn – ie the sum of issues that are still outstanding.

Cameron Andrews, director and analyst of European cat bonds at Standard and Poor’s, says some major brand names with participation at Lloyd’s are set to follow the example set by Catlin with their issuances of cat bonds. “Among the main issues for Lloyd’s participants to consider at the moment is the demand for cat bonds, which is strengthening. The credit crunch has had a positive effect on that level of demand because there has been seen to be a low effect or no effect on cat bonds. On the supplier side, there is less requirement for them because prices in the market have been so favourable.”

The effects of ILS and closer capital market links have already started to precipitate a paradigm shift in (re)insurance as a whole, including Lloyd’s. In response to the cat bond advantage of multi-year deals, some Lloyd’s companies are investigating how they might issue multi-year reinsurance products.

However, one of the more tangible effects of ILS on business at Lloyd’s and the wider market is its impact on the pricing of reinsurance. While reinsurance will continue to drive pricing for the foreseeable future, ILS and cat bonds in particular have been shown to have blunted the cyclicality of reinsurance. “It’s a simple equation that if reinsurers harden their rates too much it will drive people to the cat bonds,” says Andrews. “At first, cat bonds and other ILS had almost a novelty factor, but now cat bonds are beginning to be priced rationally as the spreads have tightened. Once you get the prices levelling off, the reinsurance market will have to respond to that.”

In the realm of cat bonds, this year’s hurricane season could be crucial, Andrews adds.

“While you never wish for a major event to happen, that is what will trigger the next phase of the market. It will be very interesting to see what happens. Ironically, it is probably only when a big loss arrives that the market can really be tested.

The downside of cat bonds can be that they take a great deal of management time and are expensive to set up. “Plus, in a falling market it can be difficult to persuade investors to lock into a multi-year deal,” explains Emmanuel Modu of AM Best. Nevertheless, the positives are outweighing any negatives in the minds of hungry investors, he adds. “The benefits of having fully-collateralised cover and multi-year cover tips the scale towards cat bonds.”

Sidecar revival

Hiscox believes sidecars will be a favoured option in future hard markets. “I would hope to see quite a lot of sidecars from Lloyd’s and they will know how to do it,” says Dupplin. “The sidecar Panther Re really did work and investors made a big return. $360m was raised along with the returns people expected. All the regulation that was put together by Lloyd’s enabled that to happen.” He adds that investors who put their money into sidecars did better than those who backed the Class of 2005 start-ups.

S&P business development director Nick Horne believes that Lloyd’s syndicates will take another look at the market’s sidecar Thunderbird Re when rates next start to harden. “Lloyd’s put a lot of emphasis on Thunderbird Re. One could understand the theory which is that if you need to launch into the market with an exposure of $100m many of the syndicates would find it difficult to do that,” he says. “The fact that a number of smaller peril risks would be involved together was a great idea... It just needs the impetus. Participants also need to be confident of the right sort of trigger level.”

David Banks is deputy editor of Global Reinsurance

ILS pioneers at Lloyd's

- Brit became the first major London-market insurer to trade in insurance-linked derivatives on the Insurance Futures Exchange Services platform (IFEX) in May 2008.
- Amlin is backing an ILS venture which will invest Amlin money and other funds. It is the first such venture to be backed by a Lloyd’s insurer.
- Catlin issued an indemnity cat bond in February 2008 covering against US wind and quake, European wind and Japanese wind and quake. Willis was the co-lead in the deal. The transaction was unusual as it provided retrocessional ‘catastrophe bond’ type coverage for a diverse portfolio of property catastrophe exposures on an indemnity basis.
- Panther Re and Hiscox Syndicate 33 agreed this year that the reinsurance partnership between them covering the 2007 year of account would not be renewed for 2008.
- Catlin Bermuda issued a cat bond in late 2006 providing it with coverage of up to $200m in the event of a series of severe natural catastrophes. The transaction, which was brought to the securities market by ABN AMRO London, was the first publicly-rated collateralised debt obligation of natural catastrophe risk. Developed in conjunction with Guy Carpenter and Risk Management Solutions, the cat bond offers very low-risk/low-volatility investors, such as pension funds and life insurers, the diversification and yield benefits of natural catastrophe exposure.