As chief execs get more involved in the reinsurance buying process, there is a growing trend to attack it in the same way they approach all risks – and that means diversifying coverage. We present the alternatives to the traditional market

The traditional reinsurance market has a lot going for it. It is flexible, tailored to the individual risk profile of the cedant, and can be arranged without hiring armies of lawyers, modelling firms and investment bankers. What is more, buyers have used it for many years and know how it works.

But just as companies would not rely on one type, source or duration of instrument for other financing purposes, an increasing number of cedants are finding that it pays to diversify the types of coverage in their reinsurance programmes, which means embracing alternative structures, and indeed sources, of protection.

While traditional reinsurance’s typical one-year policy duration is one of its strengths – coverage and pricing can be renegotiated each year to account for any changes in the buyer’s profile – it is also a weakness. “In the traditional reinsurance markets, with one-year contracts you ride the pricing cycle up and down,” says global head of distribution at GC Securities, the capital markets division of reinsurance broker Guy Carpenter, Chi Hum.

Another fundamental problem with traditional reinsurance is that the entities providing it are typically exposed to the same set of risks as the firms they are protecting. In the event of a big catastrophe, for example, a reinsurer could find itself strapped for cash at a time when its cedants need it most. And if the reinsurer cannot pay, the ceding company is left carrying the can.

While the industry has largely been happy with the traditional market despite these imperfections, dissatisfaction has been growing as chief executives and chief financial officers are getting more involved in the buying process.

According to Hum, Hurricane Katrina was a big wake-up call because some reinsurers failed, many of those that remained had no capacity left for US wind, and the few that did wanted multiples of the pre-Katrina premium for the cover, leaving insurers without protection and elevating the issue to the c-suite.

“Once it gets to the chief executive or chief financial officer, they are going to draw on their experience of how they manage risks for the organisation as a whole, not just on buying reinsurance,” Hum says. “When financing a company, you diversify across duration for pricing-cycle purposes, and across source to protect against counterparty risk. A chief executive or chief financial officer will say: ‘We need to apply those same measures and risk mitigants in our reinsurance programme.’”

Little surprise, then, that cedants are looking to diversify their reinsurance portfolios beyond the traditional market. “Certainly for some of the large insurance groups, whose capacity requirements are getting bigger as they continue to grow and who are worried about counterparty credit risk, alternative risk transfer has a number of advantages,” Willis Re international and specialty division chairman James Vickers says.

“We are increasingly seeing that people are buying more of a patchwork quilt of reinsurance. They are beginning to not just risk manage their book and their relationships with reinsurers, but also diversify and risk manage the type of reinsurance they are buying.”

That is not to say that buying a range of coverage types is widespread, but it is certainly growing. “Where you had a handful of people who did it, you might now have two or three handfuls,” reinsurance broker and consulting firm US Re’s executive vice-president, Joe Fedor, says. “It is by no means a large percentage of the market but, from a buyer perspective, there is more usage. The market is becoming much more comfortable with alternatives.”

Martin Davies, who is responsible for capital-related reinsurance transactions for brokerage and consulting group Towers Watson’s capital markets division, breaks down the available alternatives into three categories: alternatives to reinsurance; alternative reinsurance structures; and alternative sources of reinsurance capacity.

Alternatives to reinsurance

The simplest alternative to reinsurance, Davies points out, is not to buy it at all. Firms faced with costly or scarce reinsurance and without the risk appetite to retain reinsurance layers of risk, could, for example, issue debt or equity to finance their exposures.

If the firm is concerned that its ability to raise capital will be impaired after the ‘big one’ hits, it could employ contingent capital structures – financing arrangements triggered by an event or loss. One example is the Catastrophe Equity Put (CatEPut), developed by broker Aon in 1996, under which the provider would buy shares in the ceding company in the event of a catastrophe.

But there are drawbacks, particularly with debt. “If you have a large loss and you are financing yourself with debt, you have to pay the money back, whereas with reinsurance there is no such obligation,” Davies says. “It depends very much on the cost and the expected frequency of loss as to whether it makes sense to transfer risk or finance risk.”

As with several other alternatives, such arrangements could also expose an insurer to basis risk – the risk of incurring a loss without the coverage being triggered. Traditional reinsurance is largely immune to basis risk because payment is directly linked to the losses of a cedant. But products with triggers other than the cedant’s payouts can be prone to basis risk. “You could have a loss or your financial position could be severely impaired, yet you haven’t had the event to trigger the capital you need,” Vickers says.

Alternative reinsurance structures

One answer to shortfalls in traditional reinsurance has simply been to amend the structure of the programmes. For example, multi-year policies are available. “There is a reasonable amount of capacity in that area, but we could probably do with more,” Davies says.

Other alternative structures include policies that have a low upfront premium that expands if losses occur and aggregate retention protections for cedants who have opted to keep a large portion of risk. There has also been a growing trend towards collateralising traditional reinsurance treaties to protect against counterparty risk. Under such arrangements, the amount recoverable by the cedant is held in a trust fund in case the reinsurer cannot pay. “That is a good alternative. There is a small market in that and it is thriving,” Hum says.

Then there are products with alternative triggers. Perhaps the best known of these is the industry loss warranty (ILW), a standardised contract that pays the bearer a fixed amount if the total industry loss according to an index, such as that provided by Property Claim Services in the USA, reaches a predefined threshold.

ILWs have traditionally been used by reinsurers to plug gaps in retrocession cover, but are increasingly finding favour with primary firms for more general tasks.

“Cedants are now looking at ILWs as an alternative capacity source that they should take advantage of as they are structuring their entire programme,” Hum says. “Our team in London are saying they have been very active this year and they expect a good market for their product.”

Also included in the category are contracts with a parametric trigger, which respond to a specific risk parameter, such as when wind speeds reach a certain level or an earthquake of a certain magnitude hits, and those that are triggered by a modelled loss.

Such products are cheap and readily available, but of all the alternatives expose cedants to the most basis risk.

Alternative sources of reinsurance capacity

The problem with using alternative reinsurance structures is that, while the triggers or conditions may be different, the contracts still expose them to traditional reinsurers. Capital markets investors have developed a growing appetite for insurance risk over the past 15 years, however, and a number of available alternatives are backed by these players, rather than the usual suspects. As capital markets investors are not solely focused on the reinsurance markets, they are less likely to face difficulties when big events strike.

Some capital markets investors simply provide capital for what look, to the cedant, like traditional reinsurance arrangements, for example by using a fronting reinsurer. Another structure that has attracted private equity and hedge fund investment is sidecar vehicles, which provide their sponsor with quota share reinsurance.

But the capital markets-backed reinsurance facility that’s most active, and generates the most column inches, is the insurance-linked security, better know as the catastrophe bond. Unlike ILWs, cat bonds are designed for a specific cedant and are not standardised.

They have a variety of triggers, such as index, parametric and even indemnity, under which coverage is closely tied to the cedant’s losses. In addition to not being correlated to the traditional reinsurance market, cat bonds are typically fully collateralised, eliminating counterparty risk.

While once the preserve of reinsurers, a growing number of primary firms are now taking advantage of them. A recent convert to the cat bond market, for example, is AIG subsidiary Chartis.

The drawback to cat bonds is that they are expensive and time consuming to set up. Risk modellers must be employed to model the deal’s risk and investment bankers used to place the bonds with investors. This puts cat bonds off-limits to those who need cover in a hurry and who are only buying small limits – a cedant would need to issue a cat bond of at least $100m to justify the upfront costs. Also, while not as prone as ILWs, cat bonds can also introduce basis risk.

Although alternatives are increasingly finding favour with cedants, they are unlikely to challenge the dominance of traditional reinsurance. This is partly because they tend to be complementary rather than a replacement, and partly because of their limited scope. A large proportion of the alternatives on offer are for catastrophe-related exposures.

While there have been insurance-linked securities covering non property-catastrophe exposure, such as AXA’s SPARC motor insurance bonds and Swiss Re’s Vita life securitisations, it could be some time before more areas get better alternative coverage.

As Fedor says: “We are probably a good four or five years away from transferring casualty risk to the capital markets.” GR

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