A Healthy Appetite for Insurance Risk

The use of capital markets-based risk transfer products for property-casualty (P&C) insurance risk is part of the continuum of capitalisation products that are available to insurers and

reinsurers. They complement traditional

forms of capital, for example traditional

reinsurance/retrocession and recourse based financing, such as equity, hybrid capital or contingent capital.

Graph 1 shows the significant growth of the insurance securitisation market since the

late 1990s.

Capital markets investors are attracted to the P&C insurance securitisation market for several reasons. First, it is a diversifying investment risk that is generally not correlated with traditional capital markets risks. Traditional capital markets risks, credit, equity, interest rates and currencies, have all shown performance correlation, whereas they generally have a minor impact on an investment in non-life insurance securitisation structures, which are predominantly exposed to natural peril risks.

The primary factors that can cause valuation changes to P&C catastrophe bonds are

1. The occurrence of a significant natural

peril event

2. Hardening or softening premium rate cycles

3. Overall investment capacity dedicated to

the sector

4. Changes in risk modeling

Recent proof of such lack of correlation was evident in February and July-August 2007. The broader capital markets suffered significant volatility, primarily due to concerns over the performance of higher risk home loans, known as sub-prime mortgages, and broader credit quality concerns. The P&C insurance

securitisation market remained stable, as demonstrated by the continued growth in the number of investors and the all time high investment capacity.

Second, the growth of overall investment opportunities in the sector, whether it be through catastrophe bonds, institutional loans, sidecars or industry loss warranties (ILWs), now justifies the long term participation of capital market investors because there are sufficient investment opportunities. In 2000, when the overall amount of non-life insurance

securitisation investment opportunities was approximately $2 billion, it was less compelling for some investors to dedicate a portion of

their investment portfolios to the sector,

as opposed to participating in select

transactions opportunistically.

Sidecars or sidebars are companies set up specifically to allow outside investors to participate in a specific part of an insurer or reinsurer’s book of business and to reduce its effect on the sponsor’s balance sheet.

Now that the outstanding non-life insurance securitisations exceed $18 billion (excluding ILWs), new investors have continued to migrate to the sector, and existing investors are increasing their dedicated funds, all of which creates a deep and stable base of capital markets-based capacity. With the increased investor capacity, premium rates for capital markets-based protection remain attractive for sponsors, despite the continued growth of new issuances.

Over the first half of 2007, spreads tightened in the catastrophe bond market, even though new issuance during over the six months exceeded the record amount achieved in the full 2006 calendar year. Current market conditions remain favourable for sponsors. Therefore, we expect that the P&C insurance securitisation market will continue to be a permanent fixture for sponsors and investors.

Within the sector, the most interesting developments have been the forms of securitisation, as well as the distinct investor bases they have reached. The forms of capital market participation include catastrophe bonds, catastrophe triggered institutional loans, sidecar vehicles (capitalised via debt and equity) and ILWs. Sponsors use each of these structures for different purposes, such as excess of loss or quota share type protection. While all of them are permanent tools for sponsors, some of them, such as sidecar vehicles, are most attractive when the underwriting cycle has hardened.

Investor base

The segmentation of the investor base among the various forms of P&C insurance securitisation benefits sponsors, as multiple risk layers can be transferred to distinct groups of investors, increasing the capacity that can be drawn from the capital markets. For excess of loss type protection, the higher risk layers, meaning non-investment grade layers which have an annualised probability of attachment greater than approximately 0.80%, are best suited for the catastrophe bond market. Approximately 120 investors are looking for increased yields relative to this sort of increased risk profile. They are primarily hedge funds, dedicated insurance-linked funds and asset managers, with participation from certain insurance companies and pension funds.

The lower risk layers, typically rated investment grade and more recently offered in loan form, are best suited to the institutional loan market. This market consists of approximately 75 participating investors, primarily collateralised debt obligation (CDO) and collateralised loan obligation (CLO) managers, commercial banks, insurance companies and pension funds. They can also invest in such risks in bond as well as loan form.

For quota share type protection, capitalisation of a sidecar vehicle no longer consists of just equity participation. Use of the institutional loan market not only funds the sidecar vehicle to the required capitalisation level, but also helps further leverage the equity returns. Equity investors for sidecar vehicles and equity tranches of collateralised risk pools include hedge funds, private equity investors and certain catastrophe bond investors.

Figure 1 shows the different protection

types and target investor types for different

risk layers.

Catastrophe bonds

The catastrophe bond market has grown since the mid-1990s in terms of the number of sponsors, total amount of bonds outstanding and annual new issuance, as Graph 2 shows. Since Hurricane Katrina in August 2005, over $10.5 billion of catastrophe bonds have been placed into the capital markets. There have been approximately 20 new sponsors, in addition to repeat sponsors. In 2007, we have seen primary insurers embrace the use of catastrophe bonds in a similar manner to the way reinsurers have

done historically.

Shelf programmes have become the norm as they (1) allow repeat issuance in an expedient fashion, (2) lower subsequent issuance costs and (3) simplify the process of obtaining protection for sponsors. The biggest purchasers of catastrophe bonds come from dedicated insurance linked funds, hedge funds and select asset managers. Catastrophe bonds typically provides risk transfer protection in the BB rating category, which equates to an annualised probability of attachment of approximately 0.80% to 2.80%, based on Standard & Poor’s default matrix ratings table for

catastrophe bonds.

Risk layers in the catastrophe bond market below the BB layer have been growing for the last several years as investors, who have become comfortable with the catastrophe risk profile, seek further increased yields. The catastrophe bond triggers available may be indemnity or non-indemnity. Typically, indemnity triggers are used for primary insurers at any risk level

or very remote risk layers for other types

of sponsors.

Non-indemnity triggers include parametric, modeled loss or Property Claims Service (PCS) index based. Figure 2 shows the development of the catastrophe bond market since 1997.

Loan market

The institutional loan market was first used in December 2005 to fund the debt layers of sidecar vehicles, which assumed a quote share of their sponsoring entity’s risk portfolio. Such investors have also expanded their investment profile to fund excess of loss type protection akin to typical catastrophe bond structures.

The institutional loan market to date has been willing to provide such risk transfer protection on an indemnity basis for both insurers

and reinsurers.

Because of the softening rate environment, the implementation of new sidecar vehicles has slowed significantly, reflecting a reduced need for incremental underwriting capacity. As a result, sponsors have shifted their use of the capital markets in this environment toward excess of loss type protection in a loan form to manage risk concentrations. Graph 3 shows the development of the catastrophe triggered

institutional loan market.

The introduction of collateralised risk pools has also allowed further development of the insurance securitisation market, particularly with the expansion of investment grade rated investment opportunities. Through the use of risk tranching and subordination, sponsors who have multiple peril protection needs, where each peril receives a dedicated limit, or asset managers seeking to manage pools of P&C insurance risk are providing investment opportunities to the capital markets. The methodologies are similar to the use of CDO/CLOs in the credit markets.

We see the expansion of the insurance securitisation market using catastrophe risk pools as positive for investors, as well as for sponsors to achieve additional protection capacity. Figure 2 provides a conceptual overview of how these structures operate.

Risk tranching or subordination takes advantage of a structure where a single catastrophe event will not cause a full loss to the special purpose vehicle’s total capital. The senior tranches may require multiple catastrophe events to trigger a principal loss, resulting in a remote risk profile for a portion of the capitalisation that typically equates to an investment grade rating level. Using these structures, all three pools of investors (equity, catastrophe bond and investment grade buyers) can be accessed without cannibalising capacity from any one group.

Future of the market

Structural innovations over the last several years that access distinct, segmented investor bases have continued the expansion of the P&C insurance securitisation market. The continued growth of such investment opportunities has also cemented the permanence of the market as a provider of multi-year, fully collateralised capacity for insurers and reinsurers.

While this market has focused predominantly on catastrophe natural peril risks in peak zones, we forecast it will expand through the inclusion of additional natural catastrophe hazards in non-peak zones and other event-driven insurance risks, such as man-made perils, general liability risks, aviation, etc.

Sponsors continue to focus on the benefits of property-casualty insurance securitisation for capital efficiency and capital management strategies from both economic and rating agency capital perspectives. The continued growth of this market is expected to attract further investors, which will increase the amount of dedicated investment capacity.

Finally, like other capital market areas, as the sector develops, we expect a synthetic or derivative risk transfer market to become more material from an investment capacity perspective, in addition to the significant capacity currently provided by cash collateralised structures, such as catastrophe bonds.

Cory Anger is a senior vice president at Lehman Brothers, where she works in the insurance products group. Lehman Brothers has been involved in the insurance securitisation sector since 1997 and is a secondary trader of such securities.