In the post-Spitzer environment, non-traditional reinsurance has become an important source of revenue for many brokers. Helen Yates looks back on how this business took off in 2006 and how, one year on, the sophistication of the products has grown dramatically.
One of a broker's most important roles is providing capacity to its clients when it is hard to come by. And by becoming the bearer of that all-important source of cover during a capacity crunch it creates a competitive edge.
In 2006, following the dramatic storm seasons in 2004 and 2005, capacity for US property catastrophe reinsurance was low. And where capacity was available, prices had rocketed so much that many insurers simply couldn't afford as much reinsurance cover as they had a year earlier. The options were limited. The consequences of jacking up their own premium rates or reducing their exposures by not renewing certain policies are only too evident in Florida governor Charlie Crist's new legislation in February and wrangles with regulators in other hurricane-prone states. And for reinsurers, retrocession had virtually disappeared off the radar. Here, rate increases of over 100% were not unusual at the mid-year renewals in 2006.
"It really started out as a function of the capacity shortages after 2004 and 2005 because traditional solutions weren't providing as much coverage, prices had gone up so high and people were looking for other alternatives," explains John Beckman, senior vice president at Carvill. As had been the case following other major catastrophes - Hurricane Andrew in 1992 and 9/11 - the capacity crunch following Hurricanes Katrina, Rita and Wilma proved an opportunity for a host of new start-up reinsurance companies in Bermuda.
The insured losses from these three hurricanes are now anticipated to be $56.5bn, according to ISO's Property Claim Services (PCS). In the months following Katrina, some 14 new reinsurers were set up on the tiny island, raising nearly $10bn. Most of this was raised privately, but many of the companies have already gone public (eg Lancashire, Flagstone and Validus). But this wasn't the only new capacity that found its way into the market. Since Katrina, over $12bn has been raised through a series of non-traditional reinsurance vehicles including sidecars, catastrophe bonds, insurance-linked securities and industry loss warranties (ILWs).
Capital raising has always been an integral part of the economic cycle following a major catastrophe. But there were some major differences in 2006. Whereas much of the capital that had been raised for previous waves of start-ups had come from inside the industry - with most of the new reinsurers backed by brokers - changes in the regulatory landscape (with a greater focus on potential conflicts of interest) made this difficult in 2006. Instead, much of the money that made its way into the new start-ups and alternative risk transfer mechanisms came from outside the industry - namely the capital markets. Hedge funds, private equity firms and institutional investors, attracted by investments that were not correlated to their portfolios, made insurance their new discovery.
But here was an opportunity for the broking industry - in servicing these new investors and bringing much-needed capacity to their clients at the same time. "Brokers have always been anxious to find new sources of capital. And in the early 1990s the broking community helped raise the money to get those (post-Andrew start-ups in Bermuda) going," explains Beckman. "Now it's something they continued to do after the World Trade Center. And now... brokers are trying to raise it in specific parts of people's programmes rather than investing in an entire company. And as the companies get more comfortable with the way that works, and the investors from the capital markets get more comfortable with insurance, they start to make more complicated programmes."
The next level
The last few months provides ample evidence that we have reached the next stage in the evolution of non-traditional reinsurance products - and the broking world is driving much of this. While the growth in 2006 was impressive, the industry is still only tapping into a very small amount of the potential capital market capacity available. "The dollars that are invested in those markets exceed the total surplus in the insurance industry by a large margin," says Beckman.
Cat bonds, in particular, have become more targeted. And there seems to be little loss in appetite for these products despite a benign storm season in 2006. According to Guy Carpenter, in two years the total annual catastrophe bond issuance more than tripled from $1.14bn to $4.69bn. In November 2006, Guy Carpenter and MMC Securities completed a multi-territory, multi-peril catastrophe bond on behalf of Catlin. Perils covered by the transaction include US hurricanes, California earthquakes, UK windstorms, Japanese typhoons and Japanese earthquakes.
Guy Carpenter also announced the launch of SelectCat, an index-based hedging product, similar in concept to a collateralised debt obligation, which allows reinsurers to rebalance their risk profiles by purchasing a basket of risk programmes selected to mimic the portfolio the reinsurer wants to protect. With traditional retro still expensive and unavailable, David Priebe, head of Guy Carpenter's specialty operations, believes there will be appetite for this more sophisticated product. "What we're finding is that our clients tend to want the more customised approach, and that helps to minimise basis risk for them," he explains. "The product extremes are traditional. You go from what is attritional reinsurance UNL (ultimate net loss) retrocessional agreement which is basically providing worldwide blanket cover... to the other extreme, which is just the pure parametric or index-based reinsurance cover on a territory and on a peril... SelectCat is a hybrid solution between these extremes. As it provides improved exposure transparency versus traditional UNL retro you can achieve a more efficient price."
Another first, is the concept of brokers teaming up with financial exchanges to provide catastrophe risk index futures. Carvill and Gallagher Re have both made strides in this area - Carvill by teaming up with the Chicago Mercantile Exchange, and Gallagher in partnership with the New York Mercantile Exchange. The concept of transferring risk to the capital markets through such weather derivatives may only be in its infancy, but Beckman believes it is the way forward. "Everyone's anxious to find the right mix that makes the financial markets happy and the insurance buyers happy," he explains. "Because if you can bring that into the market and be the person who's bringing that extra capital in, you're tapping a huge vat of potential capacity."
Appetite in 2007
"It will be interesting to see how the non-traditional products stack up as the more traditional products become more competitive as they grow their own capital bases," says John Beckman. Many are waiting to see whether the appetite for non-traditional products - from both insurers and reinsurers and the capital markets - will continue this year.
Grahame Chilton, CEO of Benfield, pointed to a decline in the take-up of ILWs at the 1 January renewals. And others are suggesting sidecars could wind up early after a quiet storm season in 2006 has seen the return of some stability to peak zone pricing and left many reinsurers well-capitalised following a year of record results. In addition, the Class of 2005 start-ups, along with a handful of more recent entrants (eg Ironshore, Peleus Re and Aeolus Re), are providing fresh traditional capacity. But Beckman believes this decline in ILW takeup could be part of a natural yearly cycle and that the true trend won't become apparent until the mid-year renewals.
Paul Delbridge, partner at PricewaterhouseCoopers, agrees that the popularity of some products will continue while others will wane. He points to the recent over-subscription of Hannover Re's catastrophe bond as a positive sign for this product, but said it was "entirely possible" that sidecars might "well take advantage of their early commutation clauses", adding that "with ILWs there's a direct correlation to how much capacity there is in the traditional reinsurance market due to the basis risk associated with such forms of coverage." Added to the mix is the potential impact of new legislation in Florida.
What is clear is that those products created when reinsurers were desperate for capacity may not be as attractive in times of plenty. "With regard to vehicle concepts such as sidecars etc, although each was/is different in nature, the primary motive for each was to provide a greater return to shareholders rather than a better or more efficient product to customers," says Mike Hernandez, a director in the treaty reinsurance division of Cooper Gay. "Two key elements of any reinsurance buying strategy are long term relationship and security. Sidecars by definition tick neither of these boxes."
The other downside to alternative solutions is the oft mentioned basis risk. This is the risk that when a company suffers a significant loss, the overall industry loss may not be high enough (as measured by an index like PCS) to trigger a payout via its non-traditional vehicle. It's something the brokers are working hard to reduce, but remains an issue for many of their clients.
So while the appetite for sidecars and ILWs may dip in 2007, it is clear that non-traditional reinsurance is here to stay, not as a replacement but as a strategic part of overall reinsurance portfolios. What is also clear is that many brokers are working hard to guarantee their role in this rapidly evolving, and highly profitable, business. "The bar is constantly being raised and our clients expect ever-greater levels of innovation from their chosen brokers," says Hernandez. "Sidecars may come or go but what is certain is that new ideas and concepts will replace. Gone are the days when our role was to simply place straight-up-and-down vanilla catastrophe programmes."