A fundamental principal of economics is that price is determined by the intersection of supply and demand. A shift in the supply or demand curve will result in a new price. This year has seen an upward shift in the demand curve and a downward shift in the supply curve. The result has been a dramatic increase in property catastrophe reinsurance rates in the United States.
The 'perfect storm' has emerged due to several factors.
- Reduced capital - insurance companies need to replace the capital that flowed out to pay for catastrophes in 2005 or rely more on reinsurance. Reinsurance companies cannot provide as much capacity.
- Limited availability of retrocessional protection - reinsurers must retain more risk net and, therefore, have less capacity available.
- Catastrophe model changes to frequency and severity - estimated probable maximum loss (PML)has increased. To maintain the same perception of protection requires insurance companies to purchase more reinsurance. For reinsurers to maintain their PML at the same level as before the model updates, they must reduce their capacity.
- Rating agency changes to capital adequacy models - the amount of reinsurance needed by insurance companies has increased and the capacity of reinsurance companies has reduced.
These factors are all inter-related with the impetus being the major catastrophes of Katrina, Rita, and Wilma (KRW) in 2005.
Risk Management Solutions (RMS) recently estimated that the combination of its model changes and the effect of rating agency capital adequacy requirements has increased the capital needed in the re/insurance industry by $82 billion. This amount is on top of more than $60 billion of capital lost to KRW.
Given the attractiveness of catastrophe pricing, it is expected that supply would increase. Historically, supply has been increased by the formation of new reinsurance companies. Since 1992, most of these companies have been formed in Bermuda. We have seen that the barriers to entry are basically non-existent. To form a reinsurance company, it only takes a couple of recognisable names, a reasonable business plan and some cash. The most difficult obstacle in Bermuda is securing office space and housing for employees.
However, forming a reinsurance company may not be the best choice to take advantage of the improved pricing. The main drawback is the duration that an investment is tied up. It is not always possible to execute the exit strategy within the time period anticipated. Another disadvantage is that it may not be possible to achieve the scale that is necessary to keep the expenses in line with revenue.
Going long of catastrophe risk
There are alternatives to forming a traditional reinsurance company if you are interested in going long of catastrophe risk. Popular alternatives are:
- Buy catastrophe bonds
- Invest in dedicated catastrophe hedge funds
- Form a sidecar
- Sell an industry loss warranty
Catastrophe bonds have been a means of taking on catastrophe risk for more than a decade. Initially, it was an expensive alternative for the sponsor to obtain catastrophe protection. Such securitisations were expensive because of high issuance cost and because they had to pay a premium over the cost of traditional catastrophe reinsurance to attract investors. However, in the last couple years, demand outstripped supply and spreads narrowed, making catastrophe bonds cheap relative to reinsurance. Issuance costs have also reduced significantly, which has made them an attractive option to the sponsors. Supply is starting to catch up with a flurry of new issues at a pace that seems like one a week. The challenge now of issuing a new catastrophe bond seems to be coming up with a unique and clever name.
Most catastrophe bonds have relatively high trigger points which translates to a low risk/reward. Investors are, therefore, limited in the returns that can be generated by investing in catastrophe bonds. Another option is to invest in a hedge fund that specialises in catastrophe bonds. Because of their ability to diversify, hedge funds are able to use leverage to juice up their risk/reward profile and provide higher expected returns than investors would achieve by investing directly in catastrophe bonds.
Sidecars
Most of the dedicated catastrophe hedge funds also take on catastrophe risk through writing industry loss warranties (ILWs), assuming traditional reinsurance risk and investing in sidecars.
Reinsurance sidecars are relatively new and have become in vogue this year. A reinsurance sidecar is a special purpose vehicle that is 'attached' to an existing reinsurance company. In the same way a motorcycle sidecar does not need an engine, a reinsurance sidecar does not run by itself. Instead, it relies on the reinsurer to which it is attached to provide its business, typically through a quota share reinsurance agreement. The advantage to the sidecar investor is the sidecar does not need its own staff and office space. The reinsurer benefits from additional short-term capacity and is able to leverage its underwriting capabilities to generate fee income. The exit strategy is to turn the engine off and let the contracts unwind. A minimum commitment would be approximately two years.
Industry loss warranties
Industry loss warranties (ILWs) have been around for quite a few years. In its simplest form, an ILW pays if industry losses from an event exceed a certain level. The buyer of an ILW is taking the basis risk that it will not recover when an industry event is just below the trigger even though it suffered a significant loss. In 2006, in particular, with limited retrocessional protection available, ILWs have become in high demand. The advantage of writing an ILW is that there are no surprises. If you write a Florida ILW with a trigger of $20 billion, you know it will take a large storm to hit Florida to trigger it. However, you could write a high layer on a Florida insurance company that has a loss even though it was a small industry event, because the company's exposure is concentrated in the path of the hurricane.
Buyers of ILWs generally require that the form of the protection is a reinsurance contract. The reason for this is that they want any possible recovery to reduce their net loss ratio. If the protection were in the form of a derivative, a recovery would not reduce their net loss ratio although it would improve the bottom line result. Since an investor cannot write a reinsurance contract, it is necessary to have a reinsurance company front for them. The reinsurance company will sell the reinsurance and then purchase protection from the investor in the form of a derivative. The protection has been transformed from reinsurance to a derivative. A reinsurance company that fronts for the investor is often called a transformer.
A transformer must be able to cope with the accounting mismatch that is created by selling reinsurance and buying protection through a derivative. If an ILW is triggered, it will increase the loss ratio of the transformer even though the loss is offset by an equal recovery on the derivative.
Since the investors are usually not rated, the transformer usually requires collateral equal to the limit that is being provided through the derivative. This minimises the credit risk that the transformer has to the investor. The other risk to the transformer is that the outgoing derivative does not match the incoming contract. Transformers, therefore, pay close attention to the documents to minimise the basis risk.
The transformer pays less for the protection it purchases from the investor than the premium net of brokerage and taxes that it receives from the buyer of the ILW. This difference is the fee that the transformer receives for facilitating the transaction.
Most ILWs are on risk for 12 months, although it is possible to sell an ILW with a shorter risk period, for example, during the wind season. Generally, an ILW has a reporting period such as 24 or 36 months. If the ILW is not triggered by the end of the reporting period, the seller is off risk. Collateral is usually released prior to the end of the reporting period if it becomes reasonably certain that the ILW will not be triggered.
When an investor has to collateralise ILW protection that it sells, it usually is not able to obtain leverage. It may be able to do so if the transformer is willing to accept less than 100% collateral or the transformer provides a stop loss on a portfolio of ILWs that have been written. Assuming a diversified portfolio of ILWs, the senior tranche would have a low expected loss and may be able to be sold off relatively cheaply, therefore allowing collateral to be freed up to write additional deals.
The drawback of writing just ILWs is that there would be limitations on territories and perils that could be covered due to the lack of demand for this type of protection outside of the United States, Europe and Japan. However, if taking catastrophe risk in the short term is of interest, writing ILWs through a transformer is an attractive alternative to the other investment opportunities that exist.
- Edwin Jordan is senior vice president of Tokio Millennium Re, Bermuda. Email: EJordan@tokiomillennium.com Website: www.tokiomillennium.com
