In the past few years, the capital markets have offered products that resemble reinsurance because they provide risk financing to primary insurers, writes Michael Elliott.
These capital market products are known under various names, including contingent surplus notes, catastrophe bonds, catastrophe insurance futures contracts and catastrophe equity puts. Each product has unique characteristics and most can be tailored to meet the needs of a particular primary insurer. Providers of these products include institutional investors, investment banks, life insurance companies and investment brokers.
Capital markets defined
Capital markets consist of buyers and sellers of corporate debt and equity. Major participants include large corporations, commercial and investment banks, investment brokers and insurance companies. Capital markets also include buyers and sellers of derivatives, which are financial assets that derive their values from other assets. An example of a derivative is a futures contract traded on the Chicago Board of Trade.
The involvement of capital markets in risk financing is in its infancy. Recently, there have been several well publicised deals in which primary insurers have purchased capital market products to finance risk. Most products are designed to finance primary insurers' catastrophe risks, such as payments to policyholders as a result of earthquakes or hurricanes. Primary insurers need more capacity to transfer catastrophe risks than is available in the traditional reinsurance market, and this need is growing. Capital markets, which have access to vast capital pools, are a largely untapped source for this necessary additional risk financing capacity.
Most insurance industry observers agree that the influence of capital markets on the reinsurance business will continue to grow, and a number of reinsurers and intermediaries are purchasing, forming, or creating alliances with capital market companies. Current trends indicate that reinsurance underwriters and intermediaries will increasingly look to capital market alternatives in order to supplement the risk taking capacity of the traditional reinsurance market.
Exhibit 1 shows the risk financing relationships among primary insurers, reinsurers, and capital providers. Reinsurance intermediaries, not shown in the exhibit, are often involved in arranging transactions among these groups.
The relationships among the participants are complex. Reinsurers often act as capital providers to primary insurers by investing directly in them or by providing them with risk financing products that are similar to those offered by the conventional capital market. In addition, reinsurers might purchase capital market products in order to boost their own capacity. These overlapping roles among the market participants are all part of a broader picture in which the financial services industries, including insurance, are converging.
This article focuses on the role of capital markets in providing risk financing to both primary insurers and reinsurers and describes several different types of capital market alternatives that can be used to supplement traditional catastrophe reinsurance.
Capital market risk financing products
Capital market products that provide risk financing to primary insurers and reinsurers in the event of a catastrophe can be categorised into contingent capital securities and catastrophe risk securities (cat risk securities). The major difference between them is that contingent capital securities provide post-event capital to primary insurers and reinsurers, whereas cat risk securities make funds available to help offset the insured losses suffered by primary insurers and reinsurers.
Contingent capital securities v. catastrophe risk securities
The major difference between the contingent capital securities and catastrophe risk securities can be illustrated by looking at them from the point of view of investors. Investors in contingent capital securities agree to provide capital to an insurer or reinsurer if a loss event occurs. Investors in cat risk securities stand to lose interest, principal, or both on their investments if an insured loss event occurs. The investors' loss benefits the insurer that suffers the insured loss event.
Contingent capital securities bolster a primary insurer or reinsurer's balance sheet after a catastrophe. Alternatively, cat risk securities provide funds to help offset the effects of a catastrophe on both the income statement and balance sheet of a primary insurer or reinsurer.
Exhibit 2 lists capital market risk financing products by category. Each of these products is described in this article.
Contingent capital securities
Investors in contingent capital securities become creditors of or equity investors in a primary insurer at the primary insurer's option following a catastrophic loss. Capital can be provided in the form of a loan, surplus notes, or equity. Two types of contingent capital securities are discussed in this section: contingent surplus notes and catastrophe equity puts.
Contingent surplus notes
Surplus notes are notes sold to investors that are counted as surplus on a primary insurer or reinsurer's balance sheet. A benefit of surplus notes is that they increase surplus by increasing assets without an offsetting increase in liability on a primary insurer or reinsurer's statutory balance sheet. (Regular debt increases both assets and liabilities.) Although surplus notes have many of the characteristics of debt, their treatment as equity on a primary insurer or reinsurer's statutory balance sheet allows it to increase its capacity to write business.
Contingent surplus notes are prearranged so that a primary insurer or reinsurer, at its option, can obtain funds by issuing surplus notes. Primary insurers and reinsurers can use the funds to bolster their surplus following a catastrophe. Both Nationwide Mutual Insurance Company and Arkwright Mutual Insurance Company have used contingent surplus notes as part of their strategic risk financing for catastrophic losses.1
Contingent surplus notes are made available to a primary insurer or reinsurer through a trust, known as a contingent surplus note (CSN) trust. The trust holds the investors' funds and initially places them in fairly liquid investments, such as treasury securities. For a fixed period of time, the primary insurer or reinsurer can exchange the investments in the trust for surplus notes that it issues to the trust. Therefore, the primary insurer or reinsurer has a readily available source that will purchase its surplus notes in the event of a catastrophe. As compensation, investors receive a return higher than that available from other liquid investments because the investors (1) provide standby funds to the primary insurer or reinsurer and (2) take the credit risk involved with surplus notes. Therefore, the cost to the primary insurer or reinsurer for the option to issue surplus notes is the difference between what the investors receive and the return on liquid securities purchased by the trust. If it exercises its right to issue the surplus notes, the primary insurer or reinsurer must repay the principal and interest to the CSN trust over time so the funds are available to provide a return to the investors. Exhibit 3 illustrates the relationships among the investors (capital providers), the trust, and primary insurers or reinsurers for contingent surplus notes.
A major benefit of contingent surplus notes is that funds are available at a prearranged rate of interest to the primary insurer or reinsurer after a catastrophe. Without this arrangement, the primary insurer might find it difficult to issue surplus notes after a catastrophe.
Catastrophe equity puts
Catastrophe equity puts are another way for a primary insurer or reinsurer to raise funds in the event of a catastrophic loss. A put is a right to sell a security at a predetermined price. A catastrophe equity put is a right to sell equity (stocks) at a predetermined price in the event of a catastrophic loss. The purchaser of the put pays for the right to place the equity at a predetermined price. Exhibit 4 illustrates the relationship between a capital provider and a primary insurer or reinsurer for catastrophe equity puts.
Catastrophe equity put example
In 1996, RLI Corp and Centre Re entered into a catastrophe equity put agreement.2 If RLI's losses from a California earthquake exceed the limit of its current catastrophe reinsurance programme, then Centre Re will buy up to $50 million of RLI's non-voting preferred shares. This would give RLI an injection of up to $50 million if a California earthquake reduces its surplus. RLI pays Centre Re about $1 million per year for this option.
Just as with contingent surplus notes, a major advantage of catastrophe equity puts is that they make funds available at a predetermined price when an insurer or reinsurer needs them the most - right after a catastrophe. If a primary insurer or reinsurer suffers a loss of surplus due to a catastrophe, raising equity is likely to be very expensive. Catastrophe equity puts provide instant equity at a predetermined price to help a company regain its surplus.
Cat risk securities
Cat risk securities transfer underwriting risk to investors. If a catastrophic event occurs, the investor's return is lowered, and the primary insurer or reinsurer benefits because it has funds available to offset losses. Two forms of cat risk securities are catastrophe bonds and catastrophe insurance futures.
Primary insurers or reinsurers issue catastrophe bonds to capital providers with the provision that repayment of interest, principal, or both is reduced in the event of a catastrophe. Therefore, the capital provider (the issuer of the bond) takes the risk that a catastrophe will occur. The primary insurer or reinsurer can use the reduction in interest payments, principal repayments, or both to offset its losses from a catastrophe. Exhibit 5 illustrates the relationship between a capital provider and a primary insurer or reinsurer for a catastrophe bond.
Catastrophe bond example
In June 1997, United Services Automobile Assn (USAA) issued $477 million in catastrophe bonds to reinsure its Gulf Coast and East Coast hurricane risks. The bonds were split into two tranches: one in which the investors face no risk to principal but risk to interest payments and the other in which the investors face a possible loss of all interest and principal. To compensate for the higher risk, the investors who risk principal receive a higher return. A loss to investors in the bonds is triggered if a Category 3, 4 or 5 hurricane causes insured losses to USAA of between $1 billion and $1.5 billion. The bond offering was reported to be highly successful, with investors unable to purchase as much of the issue as they would like.3
Catastrophe insurance futures
An insurer or reinsurer can use catastrophe insurance futures to hedge against catastrophic losses on its book of business. This is accomplished by entering into a futures contract. which is an agreement to buy or sell a specific amount of a commodity or financial instrument at a particular price on a stipulated future date.4 The price of a futures contract usually is determined on the floor of an organised exchange, such as the New York Mercantile Exchange.
Futures contracts were historically used for agricultural commodities, such as pork bellies, wheat, oats, or barley. In recent years, they have been used for financial instruments, such as treasury bills, and since 1992, the Chicago Board of Trade (CBOT) has made a market in catastrophe insurance futures contracts. Today, most futures contracts traded are based on financial instruments.
A futures contract for wheat
A wheat farmer may buy a futures contract that specifies a price and quantity of wheat that he will sell three months in the future. If, at harvest time, there is an unusually large supply of wheat and the market price falls, the farmer is protected because, three months earlier, he locked in the price for a specific quantity of wheat. A cereal manufacturer may sell that same futures contract in order to lock in the price it will pay to buy wheat three months in the future. The cereal manufacturer is protecting itself from a possible price increase. For wheat futures, there are natural buyers and natural sellers - the farmer is hedging against a fall in price, and the cereal manufacturer is hedging against a rise in price.
How do futures contracts for catastrophes differ from those for agricultural commodities? Instead of agreeing on a future price for a physical item, buyers and sellers of catastrophe insurance futures contracts agree on a price for the future value of an index, which is based on the loss ratio for insured catastrophe losses that occur in a certain area over a specified loss period. For example, the index may be based on the loss ratio for insured catastrophe losses that occur on the East Coast of the United States from 1 July to 30 September (the loss period) of a particular year. If there is an unexpectedly large amount of insured catastrophe loss during this period, then the index rises, and the buyer of the futures contract gains because the contract rises in value. By contrast, the seller loses because it must put up money to compensate for the rise in value of the contract to the buyer. If there were an unexpectedly small amount of insured catastrophe loss, the opposite would occur, with the index falling and the seller gaining and buyer losing.5
The index is calculated before, during, and after the loss period. Before the loss period begins, the index is based on an estimated loss ratio, and it changes over time as information about estimated losses is discovered. During the loss period, the index will rise and fall depending on the frequency and severity of actual insured catastrophe losses that occur. After the loss period, the index will continue to fluctuate depending on the development of the insured losses that occurred during the loss period. On the date it expires, the futures contract is equal to the value of the index. Before it expires, the futures contract is not necessarily equal to the value of the index, but instead depends on demand and supply by buyers and sellers in the futures market.
A futures contract for
Insurers and reinsurers can purchase catastrophe insurance futures contracts to hedge their exposures to catastrophe loss.6 For example, assume an insurer that has a large share of East Coast homeowners business is concerned about hurricanes that could generate huge losses for it during the 1 July to 30 September quarter. The CBOT makes a market in catastrophe futures contracts based on a loss ratio index for the East Coast. Therefore, early in the year the insurer could purchase East Coast catastrophe futures contracts on the CBOT for the 1 July to 30 September loss period. If an unexpectedly large amount of insured catastrophe losses occurs on the East Coast from 1 July to 30 September, the index rises, and the value of the futures contract to the insurer (the buyer) rises.7 The insurer realises a gain on the futures contract that helps to offset the catastrophe losses it has suffered on its book of business.8
Exhibit 6 shows hypothetical loss indices based on insured catastrophe losses for the 1 July to 30 September loss period. Values for the index are shown both before and after the loss period. Two scenarios are included: one with an unexpectedly large amount of insured catastrophe loss and another with an unexpectedly small amount of insured catastrophe loss.
Exhibit 7 illustrates the relationships between an investor and a primary insurer or reinsurer for a catastrophe futures contract.
Although the catastrophe futures market is developing, it offers an intriguing alternative that can be used to supplement traditional catastrophe insurance programmes. Several organisations are constructing indices for trading catastrophe risks, which should attract more buyers and sellers, furthering the development of the catastrophe insurance futures market.
The involvement of capital markets in risk financing is in its infancy; however, most insurance industry observers agree that the influence of capital markets on reinsurance will continue to grow. Capital market alternatives will supplement the risk taking capacity of the traditional reinsurance market, particularly in the area of catastrophe reinsurance.
The risk financing relationships among primary insurers, reinsurers and capital providers are complex. The capital market provides risk financing products to both primary insurers and reinsurers, whereas reinsurers provide both traditional reinsurance and capital market products to primary insurers.
Capital market risk financing products can be categorised as contingent capital securities or catastrophe risk securities. Exhibit 8 (an expansion of Exhibit 2) summarises the capital market products for risk financing and their advantages for insurers and reinsurers.
Given the vast size of the capital markets and the shortage of traditional catastrophe reinsurance capacity, the capital markets will continue to make available a large number of innovative risk financing products. These products will enable primary insurers to better manage their catastrophe loss exposures.
1. Richard E. Smith; Emily A. Canelo; Anthony M. DiDio; "Reinventing Reinsurance Using the Capital Markets," The Geneva Papers on Risk and Insurance, January 1997, p33.
2. Gavin Souter; "New Product Trades Cat Cover for Stock," Business Insurance, October 14, 1996.
3. Rodd Zolkos; "Hurricane Bond Issue Takes Market by Storm," Business Insurance, June 23, 1997.
4. John Downes; Jordan Elliot; Dictionary of Financial and Investment Terms, (Woodbury, NY: Barrons Educational Services, 1985), p152.
5. Insurance companies are natural buyers of catastrophe insurance futures, but there are few natural sellers. The natural sellers include suppliers of materials, such as plywood, that are in high demand immediately following a catastrophe, and insurance companies that want to diversify their books of business. Most sellers are likely to be speculators, such as institutional investors looking to diversify their investment portfolios.
6. The market is still developing and has not yet attained the depth of liquidity necessary for an insurer to fully hedge its exposure to catastrophe losses.
7. This is a simplification of how the insurer might want to use catastrophe futures contracts. In reality, the insurer might purchase an option on the futures contract, which means it has the right but not the obligation to settle the contract at the final index price. By using an option, the insurer pays an amount that is similar in concept to a premium, but is protected from losing money by having to settle with the seller if the price of the futures contract falls below the expected level.
8. The extent to which the insurer can offset its catastrophe losses depends on how well its exposures are correlated with those of the insurance companies that make up the index.
Chicago Board of Trade, PCS Options: A User's Guide, 1995.
D'Arcy, Stephen P.; France, Virginia Grace; "Catastrophe Insurance Futures," CPCU Journal, December 1993, pp202-213.
Himich, Michael; "Buying (or Selling) a Capital Idea: The CBOT's Catastrophe Options Market," Journal of Reinsurance, Winter 1997, pp10-21.
Karras, Dena; "Want to Get Into Reinsurance Future Options? Here's How!" Contingencies, January/February 1995, pp50-54.
Kielholz, Walter; Durrer, Alex; "Insurance Derivatives and Securitisation: New Hedging Perspectives for the US Cat Insurance Market," The Geneva Papers on Risk and Insurance, January 1997, pp3-16.
McCullough, Kathleen; "Catastrophe Insurance Futures," Risk Management, August 1995, pp31-40.
Smith, Richard E.; Canelo, Emily A.; DiDio, Anthony M.; "Reinventing Reinsurance Using the Capital Markets," The Geneva Papers on Risk and Insurance, January 1997, pp26-37.
Michael W. Elliott is assistant vice president of the Insurance Institute of America in Malvern, Pennsylvania.
This article is an excerpt from the Associate in Reinsurance (ARe) programme of the Insurance Institute of America.