Capital Markets: A Threat or a Complement for Reinsurers?

Investments from the capital markets in various forms now provide around 14 percent of the total capital dedicated to providing reinsurance – approximately $35 billion [$17 billion in cat bonds] out of $250 billion.

The question remains as to whether this poses a threat to traditional reinsurers, or is more likely a complement, which fulfills a need for their clients. Most specialists in the field consider capital market investments to be a useful adjunct to traditional reinsurance.

"It [funds from capital markets] will continue to grow as an attractive asset class," said Adam Beatty, London-based managing director of Willis capital markets and advisory. "There's lots of risk to invest in, but it's a complement as well as competition."

His colleague, New York-based William Dubinsky, managing director – head of insurance linked securities, said the re/insurance industry "needs new strategies and more reinsurance capacity to address new risks, such as [contingent] business interruption from floods."

Paul Schultz, CEO of Aon Benfield Securities expressed the same opinion in a presentation at the Reinsurance Rendezvous in Monte Carlo. He explained that the emergence of alternative capital flows should not be seen as a threat to the industry, as it needs to embrace this new source of funding to become "more relevant to clients and offer more products."

While cat bonds are the most common and most widely used form of insurance linked security (ILS), other forms of capital investment have been created in recent years to fulfill different needs. These include collateral reinsurance, loss warranties and contingent capital.

Beatty explained that these vehicles are often used in situations where it's impractical to go to a highly rated reinsurer. "But the goal of assuring that the cedant gets paid [if a loss occurs] always remains our foremost concern."

Employing an ILS is also a way to access the capital markets, which doesn't require establishing a reinsurance company. As such they have largely replaced the rapid formation of new reinsurers, which occurred after severe industry losses in the past, notably after Hurricane Andrew, the Sept. 11 attacks and most recently after the cat losses in 2005.

Cat bonds, which were introduced by Swiss Re in 2001, have become almost a common feature for reinsurers. Dubinsky, who was with Swiss Re during much of their development, explained that they were "very complex at first, but they've really become pretty simple."

As an example Willis, which acts as an intermediary, putting cedant and capital provider together, would employ a catastrophe modeling firm to assess the level(s) of risk, the capital required and other considerations.

If the proposal is accepted the bonds are constructed using the established risk parameters, and are then sold, sometimes through an investment bank, sometimes privately, to sophisticated investors. Unlike municipal bonds they are not registered for public sale (under SEC Rule 144-A in the U.S., and equivalent statutes elsewhere). They are often set up and administered outside of the U.S., particularly in Bermuda.

The main buyers of cat bonds were originally hedge funds, but this has changed. Most cat bonds are now placed with specialized mutual funds, pension funds or private placements. If there is a loss, as defined by the parameters, it is paid to the cedant up to the full amount of the bonds.

This has happened, but it is relatively rare, and as cat bonds pay a healthy premium – well above the current low interest rates on other securities – they are an attractive investment. "Investors aren't scared of them," Dubinsky said, "especially since we have streamlined the process."

Side cars, a form of collateral reinsurance, offer a somewhat different type of ILS investment. They are independent vehicles designed to take on a portion of the quota share risk, which has been placed with a reinsurer. While the quota share exposure of the ceding reinsurer is unlimited, side cars accept only a limited portion of that risk, some of which the reinsurer may have to take back, although Beatty said "the cedant usually doesn't take it back."

Forming a side car gives the reinsurer greater leeway to accept more risks, as once the exposure has been transferred to such a vehicle it is off of the reinsurer's balance sheet, thereby strengthening its capital position and increasing capacity.

Contingent capital is a more recent development. It is an engagement by capital investors to pay a certain amount to a corporation, if a loss event occurs, which is designed to restore lost capital to the company's balance sheet. Dubinsky explained that this feature acts to protect a company from an immediate ratings downgrade, which would result in greater borrowing costs, if the equity capital weren't replaced. It could also act as a support for the company's share price.

Insurance and reinsurance is after all about accepting risks, and the ILS market provides new ways of doing so. "Catastrophe risks attract people who want to take risks," Beatty said. "Cat bonds and the different products offered by the market cater to a different risk appetite."

Dubinsky added: "As the capital markets make more capital available, they also keep the [re/insurance] cycle more level. We also need to develop solutions beyond natural catastrophes, going further into casualty and fires, etc. presents such an opportunity."