Capital market solutions will transform the industry, predicted delegates at our Insuring Climate Change conference. Helen Yates reports.

The transfer of peak zone risk to the capital markets “will absolutely transform the industry” said Mark Hvidsten, CEO of Willis Capital Markets. He was speaking at Insuring Climate Change, a conference hosted by Global Reinsurance, Insurance Times and Catastrophe Risk Management. The aim of the conference, held in London in October, was to address the increasing risk of weather-related catastrophes, as well as explore new opportunities.

The prospect of dealing with several Katrina-size losses every year has many insurers and reinsurers concerned. There has been an increasing trend in extreme events observed during the last 50 years, according to a report from the World Meteorological Organization and the UN Intergovernmental Group on Climate Change. It said it was “very likely” that hot extremes and heavy precipitation would continue to become more frequent.

In June 2005, before Hurricane Katrina or this year’s flooding in the UK, the Association of British Insurers released a report on the financial risks of climate change. Its experts predicted that by the 2080s the annual cost of storms could be $27bn. Wind damage losses from the most extreme hurricanes could total $100bn-$150bn. Insurers’ capital requirements could increase by over 90% for US hurricanes, and by around 80% for Japanese typhoons. The costs of flooding in Europe could go as high as $120bn-$150bn.

Capital idea

One solution to these increasing losses is to transfer peak risks to the capital markets. Hvidsten said it was reasonable to expect 10%-20% of reinsurance capacity to be provided by the capital markets in the next three to five years. Looking at rough figures, if the reinsurance market is worth $300bn, this would equate to $30bn-$60bn. Along with other delegates, he predicted that alternative risk transfer would become an increasingly important means of dealing with peak catastrophe losses. Scientists predict these will increase in frequency and severity as the climate heats up.

According to Hvidsten, an incredible $5.1bn of insurance-linked securities have been issued so far in 2007. Swiss Re puts the total non-life issuance of cat bonds in 2007 to date at $5.7bn. This already exceeds last year’s total issuance, which in itself was a record year. And there is still $14bn seeding the non-life cat bond pipeline, according to Luca Albertini, managing director and head of European ABS/ILS origination and structuring at Swiss Re Capital Management and Advisory.

“According to Hvidsten an incredible $5.1bn of insurance-linked securities have been issued so far in 2007

Credit crunch

There were suggestions that one or two proposed transactions had been put on ice as a result of the subprime collapse. Investors had apparently wanted to wait and see what effect, if any, the credit crunch could have. Writing for GR in September, Willis Capital Markets noted there had been no new cat bond issues since the credit crisis began and hence that forming a definitive view of how it would respond was difficult. Nevertheless, the team noted that anecdotal evidence was good.

“The decision to allocate assets to ILS has been validated by the recent subprime/credit market contagion,” said Jonathan Spry, senior vice president of GC Securities at Guy Carpenter, at Insuring Climate Change. “Returns that are generally uncorrelated to broader financial markets are now even more attractive to investors.” In an interview for GR, Standard & Poor’s analyst Maren Josefs put the inactivity down to the “seasonality of insurance”. Most cat bond issuances tend to happen in the first quarter or towards the end of the forth quarter, largely due to the Atlantic hurricane season. She concluded that the credit market events were “unlikely to dampen ILS investor appetite and that total issuance in 2007 will be greater than in 2006”.

According to Swiss Re’s figures, almost $8bn is still waiting to be issued in 2007. The majority of these investors come from the capital markets and 64% are based in the US. Spry looked at the explosive growth of insurance-linked securities and said this would continue. “The pipeline is strong. There are new perils coming to the fore. Pricing has come down and has remained stable in the face of credit market turmoil”.

Capital market capacity could account for half of all retrocession capacity in just a few years, predicted Spry. In 2006 following Hurricane Katrina, over $6bn went into alternative retrocession solutions such as sidecars and industry loss warranties. This was largely a response to insufficient affordable retrocession capacity at the time. Since then many players have returned to the sector and capacity is no longer an issue. As a result a number of sidecars have already been wound down.

Basis risk solutions

“The decision to allocate assets to ILS has been validated by the recent subprime / credit market contagion

Despite the departure of a number of “disposable reinsurers” in 2007, it is clear that other risk transfer vehicles are here to stay and evolving all the time. Willis’ Hvisten pointed to what he saw as encouraging signs of a maturing market. The increasing willingness for investors to take on an indemnity form of catastrophe risk is particularly telling.

Indemnity triggers are structured so that the bond pays out depending on the cedant’s individual loss experience. Other non-indemnity triggers are based on an industry’s overall loss experience or on parametric measures, eg wind speed. This introduces basis risk as it means that an individual company may experience a significant claims loss but that the overall industry loss as measured by ISO’s Property Claim Services, for example, is not sufficient to trigger the bond.

Basis risk is clearly unattractive for insurers and reinsurers but index and parametric triggers are popular with investors as they are easily understood. On the other hand, indemnity triggers have proved popular for insurers and reinsurers but less attractive to investors. Much greater due diligence is required for those investing in products built around indemnity-type structures. A lot has changed in just one year according to Albertini. In 2006 only 4% of cat bonds had indemnity triggers but this has grown to 46% so far in 2007.

Index triggers remain important, said Albertini. A lot of the “club deals – the private transactions you don’t hear about” such as industry loss warranties, swaps and weather derivatives tend to refer to market-wide indexes. He said a European index was needed so that a derivatives market could develop. It is perhaps unsurprising, with its well-established indexes, that the US still dominates the ILS market, providing 63% of global capital market non-traditional reinsurance capacity. Europe is in second place, providing 25% of capacity.

New frontiers

From a buyer’s perspective the non-traditional market is attractive for two main reasons, said Laurent Dignat, head of European solutions at Guy Carpenter. “They can become less dependent on an ever-more concentrated reinsurance market and gain some room to manoeuvre in renewal negotiations.” He said one of the main challenges was in providing cover for unknown risks and attracting new equity investors to respond to increased demand. According to Hvidsten, investors are increasingly looking for different risks and perils to invest in. Some new non-peak perils have already come into the market – including UK flood and Mediterranean quake – in an effort to cater to this.

Presently however, capital market products are more likely to focus on the well-modelled peak zone perils. To date, most ILS issuance has been for US wind and earthquake risks and European wind risks and one reason for this is the lack of an established index in Europe. But there are solutions. Swiss Re’s Albertini and Guy Carpenter’s Spry explained how the recent Blue Wings cat bond, covering UK flooding and transacted on behalf of Allianz, had been structured (see box). “The appetite is definitely there,” concluded Spry. “If the models and perils are well understood there is huge capacity within the capital markets.”

Solutions for UK flood risk

With Risk Management Solutions (RMS) predicting that insured losses from the flood events in June and July alone could reach £3.25bn ($7bn), the issue of flooding was very much on the agenda at Insuring Climate Change.

Jonathan Spry and Luca Albertini described how the capital markets could provide solutions to UK flood risk. They were involved in the only securitised UK flood risk transactions, emanating from Blue Wings Ltd. This Cayman Islands-based special purpose vehicle is sponsored by Allianz and intermediated by Swiss Re, and represents the first time a cat bond has covered flood risk in the UK.

Part of a $1bn programme, the first $150m bond was issued in April this year. The bond holds two risks – first, earthquake in Canada and the US excluding California, using a “modelled loss” trigger; and second, river flood in the UK using a second-generation parametric index trigger. It is this trigger that was unique for the project.

While the loss caused by an earthquake in Canada or the US will be based on a modelled loss of a notional portfolio of exposures, the index for river flood was created as a bespoke product for the bond. “The highly innovative part of this project was the creation of a parametric index based on flood depths, as measured after the occurrence of a significant flood event, at the strategically-selected reference locations across the UK,” explained Albertini.

Around 58 reference locations were identified across the UK in locations outside areas which RMS considered to be at risk from storm surges. At each location, a pre-event reference point was taken. This could range from a gargoyle on a church turret to the window height on a house. After a flooding event, the flood watermark would be measured against the pre-event reference point to determine if the event triggered the bond.