Ten years ago, the reinsurance market was stagnating. Rates were low, competition was fierce and the market seemed stuck at the bottom of the cycle. Then typhoon Mireille hit Japan in September 1991; hurricane Andrew swept through the Caribbean and across the US eastern seaboard in August 1992; and the Northridge quake shook the US west coast in January 1994. Between these three events, the insured loss topped the $40bn mark. For many in the re/insurance industry the pain had reached critical level; capacity exited and rates more than doubled. In another typical move as the cycle moves into the upturn, buyers sought alternative forms of cover.

During the preceding years, financial innovation had grown apace, fuelled by increased requirements for risk protection. The rate of innovation was accelerated by developments in technology, as well as new pricing models and increased competition. At the same time, new forms of financial instruments were developed to reduce tax and regulatory costs.

Set against this background, it seems almost inevitable that a shortage in global re/insurance capacity and rising prices would lead to alternative forms of risk capital being developed. Although pricing stabilised after 1994, the demand for reinsurance continued to grow and exposures increase. According to figures published by Swiss Re in its sigma report, ‘Capital market innovation in the insurance industry', the potential economic impact of catastrophic events is ever increasing. After adjusting the figures to take inflation into account, there were seven natural catastrophes that passed the billion-dollar mark in the 1970s, nine in the 1980s and 32 in the 1990s. The sigma report also cites estimates that a magnitude 8.5 earthquake on the New Madrid Fault in the US could produce insured losses exceeding $115bn; a similar-sized Tokyo quake could result in insured losses of $40bn; and a Florida hurricane with sustained wind speeds in excess of 150mph could produce insured losses topping $75bn. “Because adequate insurance coverage for catastrophe exposures such as these is either prohibitively expensive or unavailable at any price, many catastrophe exposures are only partially insured,” according to the sigma report. “Thus, the uninsured losses realised in the wake of one of these catastrophes might be several times larger than the magnitudes listed above. Faced with this sobering reality, industry participants have begun developing capital market insurance solutions to help insure against property catastrophe risk.”

Capital markets have a distinct advantage over the traditional re/insurance market because of their sheer size. Publicly-traded stocks and bonds have a total market value of $60 trillion, according to sigma. Adding catastrophe-linked securities to these types of portfolios would mean that a massive $250bn catastrophe would still be less than 0.5% of the market, and as a result easily absorbed. “Fluctuations of this magnitude are a normal daily occurrence in securities market,” comments sigma.

These types of solutions can have significant benefits for issuers. On the one hand, reinsurance cover can be withdrawn or become too expensive for the buyer so securitisation products may be more readily available and a cheaper option. In addition, using these structures can lower credit risk. As sigma points out, reinsurance buyers take counterparty risk into account when choosing their reinsurers, and it is often the case that an increased demand for reinsurance synchronises with greater financial stress within the reinsurance community. By collecting funds in investment-grade securities, guaranteed by a highly rated company, catastrophe bond issues can be of higher credit quality than conventional reinsurance. The securities issued are held as collateral in a trust account which benefits the reinsured and the investors, usually in a special purpose vehicle (SPV) that holds capital dollar for dollar against potential claims, explains sigma.

As well as increasing sources of capital and improving credit quality, capital market insurance solutions also offer the ability to diversify the sources of funding – ironically echoing the basic principle of insurance, that of spreading the risk.

For investors, the major attractions of insurance-linked securities are high returns and portfolio diversification. Catastrophe bonds tend to pay rates higher than those for corporate debt and asset-backed paper with the same credit rating.

So there are good reasons why issuers and investors should look to capital market insurance solutions, and, in fact, about $12.6bn-worth have been issued since 1996. Products include:

  • catastrophe bonds. These are instruments in which if there is no loss, the investors' principal is returned, as well as coupon payments to compensate for the use of their funds and the risk exposure. If a pre-defined event occurs, investors lose their interest, principal or both;
  • catastrophe swaps. A series of fixed predefined payments is exchanged for floating payments. This can be a swap directly with the counterparties or through an intermediary, though there are credit risks involved. Alternatively, they can be structured as options;
  • industry loss warranties. These are structured as insurance transactions, with a double trigger of industry losses and actual losses over a prespecified threshold;
  • contingent capital. This allows the buyer to issue and sell securities at a fixed price for a fixed period if a predetermined event takes place. It requires no indemnification, and can be in equity, debt or a combination of the two;
  • life securitisation. An SPV purchases the rights to mortality and expense fees or policy acquisition expenses from a life insurance company, financing the purchase by issuing securities;
  • bank-funded life reinsurance. A reinsurer enters into a coinsurance arrangement, paying a percentage of all future claims in return for a percentage of premiums and investment income, paying a ceding commission. The commission is funded by selling rights to the profits to a bank in the form of commercial paper; and
  • exchange-traded options. In general, exchange-traded catastrophe options have not been successful, though sigma foresees they may become an accepted form of transferring insurance risk to the capital markets.

    Despite the variety of instruments now available, growth has recently stalled as lower prices for property catastrophe reinsurance lowered the attractiveness of securitisation deals. At the same time, insurance company managers have not displayed any great interest in these instruments, citing a lack of market liquidity and higher risk as major factors in deciding not to use them.

    But sigma sees a brighter future for the market. The relatively high start-up costs will decline over time, practitioners will become more experienced and legal problems will be resolved. The hardening reinsurance market will turn buyers' eyes to alternative sources of capital. “A major catastrophe or a downturn in securities prices that renders several insurers insolvent could precipitate this,” asserts the report, pointing out that the surge in the number of captives in the 1970s and the emergence of the Bermuda market in the 1980s were both spurred by a lack of sufficient affordable reinsurance capacity. In addition, the higher liquidity of insurance-linked securities could increase investor confidence, pushing them towards the status of a regular asset class. Investors will also be attracted by the greater transparency in the capital market insurance solutions, says sigma, and as various regulatory, tax, legal and accounting rules are clarified and honed, clearer standards and regulations will emerge.

    “Once market leaders resolve key issues such as standardisation, regulation and education, an active secondary market for insurance risk will develop,” says the report. “This in turn will make capital market insurance solutions accessible and attractive to an expanding universe of issuers and investors.” Nevertheless, it will not replace the conventional market, instead complementing it. “If they deliver on their promise of improved transparency, liquidity and efficiency for certain lines of business, they along with other ART techniques have the potential to expand the limits of insurability.”

    Sigma no. 3/2001 ‘Capital market innovation in the insurance industry' is available at www.swissre.com.