Alternative risk transfer solutions are set to break new records in 2006. Cat bonds, sidecars and swaps are all increasingly popular means of tapping the capital flows, explain Jonathan Barnes and Alan Punter.

Following Hurricane Katrina there has been a significant increase in the issuance of insurance-linked securities. In addition to traditional equity and debt investments, investors are providing capital to the insurance industry through catastrophe bonds, collateralised quota share arrangements (sidecars) and other collateral-backed reinsurance and derivative agreements (swaps). In its quest for non-correlating investment assets, the increasingly influential hedge fund sector appears to be developing an appetite for insurance-related risk.

Cat bonds

Almost $3bn of catastrophe bonds were issued between November 2005 and June 2006, comfortably exceeding the previous annual issuance record in just eight months. Following Hurricane Katrina and the revision of various vendor catastrophe models, the yields on US hurricane-exposed bonds increased, giving rise to market-to-market losses for existing investors. In June 2006, concerned by the impact of catastrophe model changes, Standard & Poor's placed various cat bonds on creditwatch negative.

Many of the bonds issued subsequent to Hurricane Katrina cover US windstorm, either separately or in conjunction with other perils. The increase in demand for US windstorm protection has also caused the cost of protection for this peril to rise. A number of the bonds issued recently have provided protection for events with higher expected loss probabilities than previous transactions. Bonds exposed to higher expected losses pay higher coupons, reflecting investors' appetite for higher yielding securities. The availability of higher yielding investments is attracting new investors to the sector, notably hedge funds.

As of 30 June 2006, the total coverage provided by catastrophe bonds issued but not redeemed amounted to approximately $7bn.


Investors are also participating in collateralised quota share arrangements using special purpose entities, dubbed "sidecars". Whilst the name sidecar may be new, the concept is not. Hannover Re executed the first such transaction some ten years ago.

Recent sidecar transactions utilise a variety of different structures. Some are exclusively equity financed whilst others use a combination of equity and debt capital. As of July 2006, over $2.5bn of capital has been invested in post-Katrina sidecars. A sidecar effectively enables the sponsor to act as an agent as well as a principal. The sponsor generates fees and profit commissions on the business assumed by the investors, providing it with a source of revenue while reducing catastrophe exposure to its own capital. The attraction to investors is that they obtain access to a defined portfolio of risks without having the time and expense of starting up a standalone reinsurance company. It is also easier to terminate the sidecar arrangement when market conditions become less attractive.

Collateralised swaps

Various banks and investment funds are providing catastrophe protection using derivative agreements, through owned reinsurance transformers or via third-party reinsurance companies. Much, but by no means all, of this activity is centred on industry loss warranty (ILW) products. Payment under ILW contracts is based on an assessment of the total insured loss arising from an event as published by an independent third-party authority (such as ISO's Property Claim Services). Investors find this product attractive because the protection provider is not exposed to the risk selection skills of the protection buyer.

Certain funds have established significant reinsurance subsidiaries, such as CIG Re, Poseidon Re and Arrow Re. Other funds prefer to be less visible. Although the volume of capital devoted to this sector is unknown it is likely to be significant, and a figure of $2bn is probably an underestimate.

Back to the future

So what is driving hedge fund interest? One reason is that catastrophe insurance risk is not directly correlated to the risks inherent in traditional asset classes.

Traditionally, major reinsurers had a limited appetite for catastrophe risk. Catastrophe losses cause earnings volatility, which can undermine a company's ability to generate goodwill value for its shareholders. For many years Lloyd's was the pre-eminent provider of catastrophe reinsurance. Prior to the introduction of the capacity auction process, Lloyd's members had no goodwill value associated with their syndicate investments.

Similarly, there is no goodwill value attaching to an investment in a hedge fund strategy. Hedge fund investors receive their share of the profits or losses generated by the fund manager on their behalf.

- Jonathan Barnes is senior consultant of Aon Capital Markets and Alan Punter is CEO of Aon Capital Services.