Judith Klugman and Martin Bisping detail the evolution of insurance-linked securities and forecast market developments in 2005

Over the last five years, insurance-linked securities (ILS) have evolved from a relatively new and esoteric solution into a well-understood option for capital and risk management. Insurers, reinsurers and corporations use ILS to manage their exposure to peak insurance risks by obtaining risk cover directly from the capital markets. Since the inception of the market in 1996, over $11bn of ILS have been issued, with over $4.5bn currently outstanding (see Figure 1).

The past two years have seen a significant amount of new issuance with over $3.0bn placed in the capital markets. Along with a record number of new issues, there have been many innovations in terms of covered perils and trigger structures, such as extreme mortality risk, and Taiwanese earthquake. In addition to the annual increase in the number of transactions, the growth of the overall size of the market has been fuelled by the prevalence of multi-year transactions.

2005 looks to be a solid year for ILS market growth. The number of deals and outstanding capacity is expected to grow as many new sponsors utilise the capital markets for additional capacity. In addition to new sponsors, we expect that many previous sponsors of natural catastrophe bonds will be renewing transactions to take advantage of investor familiarity and strong demand. The ability for investors to 'roll over' their positions into new bonds by the same sponsor typically translates to tighter pricing.

Particularly if, as expected, reinsurance rates do not soften markedly over the next twelve months, cat bonds will continue to remain an attractive complement to traditional reinsurance, especially for peak risks. Credit downgrades in the reinsurance market in 2004 have emphasised how quickly reinsurers' creditworthiness can deteriorate, and the attraction of fully collateralised cover outside this market will remain a draw for deal sponsors.

The growth in issuance, capacity and understanding of ILS has meant that they are now a much more efficient solution for underwriting particular types of risks than they used to be. Structuring and other frictional costs are now much lower, and capital market familiarity with insurance risk and with ILS structures has meant that the costs of cover in these markets has come down to a level that rivals that available in the traditional reinsurance marketplace. Multi-peril layers with higher levels of risks have proven increasingly economical for sponsors and attracted strong interest from institutional investors. Figure 2 (see page 16) shows how the costs of coverage for particular risks - the spread levels for particular cat bonds - have come down over the last three years.

ILS may now be economically comparable to traditional reinsurance, but they also have a range of other benefits for issuers. For cat bonds, the most common subset of ILS, these benefits include:

- Fully collateralised protection with minimal counterparty credit risk - Cat bonds are fully collateralised - structured to minimise counterparty credit risk. Usually, the sponsor will enter into a reinsurance contract with a company set up specifically for the purpose - a Special Purpose Reinsurer (SPR). The SPR in turn sells bonds to the capital markets. The proceeds from the sale, which underwrite the sponsor's risk, are held in a trust and invested in highly rated securities. The capital held by the SPR is therefore not exposed to the counterparty credit risk of the reinsurance industry. Although efforts have been made to secure collateralised protection in the traditional markets, the availability of Letters of Credit and other collateralised trust arrangements is severely limited at economically viable levels.

- Additional and diversified capacity - Exposures to peak perils bind substantial capital at many reinsurance companies. As a result, they charge a relatively high rate-on-line for cat cover. The cat bond market offers corporations, insurers and reinsurers an alternative source of capacity.

- Multi-year coverage and fixed pricing - Cat bonds typically have a term of three to five years, allowing sponsors to hedge against fluctuations in cat bond pricing after a large event by locking in pricing for the term of the transaction. Some cat bonds are designed for this purpose, for example, the Phoenix Quake Wind bonds issued in 2003 are exposed to second event earthquake and typhoon in Japan, and are not exposed until a first event occurs.

- Systematic claims recovery - Cat bonds use triggers that are highly mechanistic and transparent for paying claims. Triggers are designed to be objective and incontestable, so they reduce coverage and payment disputes.

The typical cat bond structure predefines the loss event trigger, loss assessment and claims payment timeline in great detail. In addition, claims payments are usually verified by an independent third party, providing independence from both investors and transaction sponsor.

- Capital relief and enhanced risk management - Sponsors use ILS for the same reason they buy traditional reinsurance: to manage and diversify their risk more effectively and reduce the amount of capital they need to hold against future events. ILS are another tool in the sponsor's risk management box, a further way of reducing their cost of capital. Rating agencies understand this and have a favourable view of the capital relief and full collateralisation achieved with ILS.

ILS market capacity and trends

The ILS market, since its inception in 1996, has seen $11bn of issuance, of which about $8bn has been cat bonds, and about $3bn has been issued to cover life risk. The market for cat bonds witnessed its fastest growth spurt in 2003, with the volume of outstanding bonds increasing by more than 50% over the previous year.

To date, ILS have mostly been used to cover peak risks - catastrophe risks that would threaten a company's financial security if they were to occur. These risks are relatively expensive to cover in the traditional reinsurance marketplace compared to non-peak risks that are easier for reinsurers to diversify and for which less risk capital needs to be held.

The market is now beginning to look at underwriting volume insurance business, such as motor. These lines of risk see large volumes of premium flow through them, against which a large amount of capital must be held.

Insurers are now considering ways in which they could obtain capital relief by passing some of this volume into the capital markets.

On the life side, most ILS are designed to securitise embedded values.

But in recent years we have seen deals, which, similar to a cat bond, protect against sudden rises in mortality - a fatal epidemic, for instance.

Further innovations will expand the range of life risks that can be passed to the capital markets.

Innovations in structuring

The ILS market is also being encouraged by innovations in structuring and documentation.

One example of this is the cat bond that can be offered on a continuous basis, launched in 2002 with the PIONEER transaction. Under this arrangement, Swiss Re can return to the market on a quarterly basis and issue more bonds without having to structure a new deal or rewrite the documentation.

Frictional costs of issuing new bonds are thus minimised. In July 2002, PIONEER raised $255m in cover for a variety of peak risks and has since raised a further $257m under this arrangement.

This structure was also designed to appeal to investors. By issuing tranches on both a single and multi-peril basis, investors were able to construct their optimal portfolio based on their risk-return hurdles.

An expanding investor base

Cat bond spreads have decreased significantly over recent years, in large part due to increased familiarity with the underlying risks and greater demand from a larger investor base. While insurers and reinsurers played a significant role in early transactions, over time large institutional money managers, hedge funds and funds dedicated to the ILS sector have come to dominate the investor group as capital markets investors have become more educated on catastrophic insurance risks. Overall, institutional investors have been increasingly attracted to cat bonds due to their lack of correlation with other financial securities. (See figure 3).

As more investors become familiar with ILS and their investment characteristics, the amount of capacity available has expanded significantly. Given the size of the fixed income markets, there is plenty of capacity for growth.

Some of the larger institutional investors alone (ie, global bond funds and hedge funds) which manage billions of assets have the ability to provide significant additional capacity.

The ILS market may be relatively small, but it now functions as an efficient way of transferring risk from the insurance market to the capital markets.

It is becoming increasingly attractive to deal sponsors, and it is not going away.

Judith Klugman is managing director with Swiss Re Capital Markets Corp. Martin Bisping is head of the Swiss Re Group Retro & Syndication unit.