The property/casualty insurance market continues to harden, but the big question is how long this will go on. This is the $64,000 question and a lot is riding on it. Views within the industry range from early next year to 2005 or beyond.
ENTERPRISE RISK MANAGEMENT
Bright future or...?
By Michael J. Moody, MBA, ARM
...Changing industry economies, ... are making CAT bonds, like many other ART products, a more cost-effective form of risk transfer.
The property/casualty insurance market continues to harden, but the big question is how long this will go on. This is the $64,000 question and a lot is riding on it. Views within the industry range from early next year to 2005 or beyond.
If people were to look only at the growth during the first half of this year, they might be inclined to believe the "over-the-next-year" scenario. After all, United States P-C insurers reported a combined $4.6 billion profit for the first half of 2002, a 66.4% increase over the same period last year, which would indicate that we are on the road to recovery--right? Well, probably not when you consider the projection from Morgan Stanley that, primarily thanks to a decade of bad underwriting, the industry is under-reserved by $120 billion.
And that's not the whole story. When speaking at Swiss Re's "Alternative Risk Transfer Solutions in a Time of Shortage" seminar, Kurt Karl, chief economist for Swiss Re's Economic Research and Consulting Division, observed that you also need to look at the significant losses insurers incurred on the equity side of the house. The combined net investment income for this first half of 2002 declined by 28.3% over 2001, and to some extent mitigated the favorable loss experience.
But these discussions about the duration of the hard market are impacting the utilization of ART solutions. Most people realize that movement to an ART solution should be viewed as a long-term solution and are somewhat hesitant to move forward if the hard market is ending soon. Despite this indecision on the part of some within the industry, some forms of ART, are actually seeing good growth. Captives, for example are flourishing, with projections indicating that 2002 will be one of the busiest years for captive formations. Another area that is seeing some growth is the CAT bond market.
For the record, Swiss Re's Karl believes that the hard market will last until 2005.
CAT in the hat
Interest in insurance-linked securities (aka CAT bonds) has been building since September 11, 2001. Karl noted that Swiss Re was experiencing between a 50% and a 100% increase in their CAT bond business this year. The reasons for this increase in interest primarily revolve around the changing industry economies, which are making CAT bonds, like many other ART products, a more cost-effective form of risk transfer.
CAT bonds are risk-linked securities, which typically have a short, one-year duration. They are usually non-investment-grade financial instruments that transfer to investors the risks that are associated with catastrophic events. Among the catastrophic perils covered are natural disasters such as hurricanes and earthquakes. By issuing a CAT bond, the risk can now be securitized so that it is borne by the capital market.
For the most part, CAT bonds are a relatively new development in the ART field. It was one of the first of a host of approaches to take advantage of the converging financial services industries. The idea was developed in earnest about 10 years ago, in the wake of two significant catastrophic events, Hurricane Andrew that was a $15.5 billion loss in 1992, and the Northridge earthquake in 1994, which tallied about $13.5 billion in losses. These losses in and of themselves did not disturb the underwriting community; what bothered underwriters was the closeness of the events and how they barely missed major metro areas.
From an underwriting standpoint, the fundamental risks from a large hurricane or earthquake have not changed. What has changed, however, is the realization that the exposure associated with these perils has increased. For the first time, underwriters realize that the P-C industry may not be able to sustain one large catastrophic loss; and with significant population shifts to the coast, it only makes matters worse. The concentration of values from this movement has greatly increased the total loss potential. A number of industry experts comprehended the significance of this movement and the exposure that it created. They knew that the insurance industry did not have enough capacity to weather such a loss in the future. The capital markets represented a logical choice.
Initially, several attempts were made to develop the CAT bond market. One of the first to receive attention was the California Earthquake Facility (CEF). The CEF was created by the state in 1996, to insure California homeowners after the Northridge earthquake. The CEF believed that an interest rate of 10% would attract significant interest from investors. However, thanks to the offer of inexpensive reinsurance, the CEF did not need to tap the capital markets for its needed capacity.
One of the first successful CAT bonds attempts occurred the following year, when USAA was able to put together a $477 million CAT bond. The bond had an attachment point of $1 billion and provided investors with an 11% yield. And like many other CAT bonds in the market, it was oversubscribed. This has been quite favorable for USAA and they have renewed the bond each subsequent year.
Structure of the deals
Many of the CAT bonds that have been done to date involve the insurance carrier forming a Special Purpose Vehicle (SPV), which is an entity that is established to facilitate the development of this risk transfer method. Many SPVs are established in offshore locations, frequently either Bermuda or the Cayman Islands. Recently, however, some U.S. domiciles have been used for this purpose. The first U.S. domiciled CAT bond was done through the Inex Insurance Exchange in Illinois. The transaction, which was completed for Kemper Insurance Co., allowed them to form a special-purpose, limited syndicate to conduct insurance securitizations on shore.
One of the other distinguishing characteristics of CAT bonds is the triggering event that gives rise to the payment of a claim. As the CAT bond market has progressed over the past few years, three primary types of triggering events have evolved:
1. Indemnified Notes--Payment is directly linked to the actual loss experience of the individual insurance company that sells the bond. While these notes represent very targeted results for the insurance carrier, they require much more research and due diligence on the part of the investor and the dealer. One shortcoming is that the settlement of loss involved a protracted time period and involved a review of the carrier's financial results.
2. Indexed Notes--Triggers are based on established insurance loss indexes. The most commonly used index is the one produced by Property Claims Services (PCS). PCS tracks U. S. insurance losses by region and peril.
3. Parametric Notes--The triggering approach utilized here is dependent on the physical parameters of the loss-causing event. Examples of these types of triggering mechanisms would be hurricane wind speed and earthquake magnitude on the Richter scale.
Initially, many of the CAT bonds were structured as indemnified notes. These were the most advantageous for the insurance company selling the bonds since they could better manage their risk portfolio. However, as the market has matured, parametric notes and indexed notes have become the norm. These are much easier for the investment community to follow and are not subject to possible data-related issues associated with indemnified notes.
Key elements
Over the past few years, several key elements have emerged as critical aspects to making CAT bonds more attractive to investors. Much of the recent growth of CAT bonds has been the direct result of improved computer modeling of catastrophic risks. The advancements made by independent, third-party vendors who have significant, demonstrated experience in this area have greatly helped investors accept the risk associated with these bonds. Today, of the handful of recognized computer modeling firms, only three provide the majority of computer simulation work. The sophistication of these firms has increased significantly over the past two or three years, so that they can now quantify catastrophic risks in specific geographic areas. In addition to the specific computer-modeling firms, the University of Pennsylvania's Wharton School has been conducting research into computer modeling and managing catastrophic risks.
The second critical aspect to CAT bond deals is the involvement of rating agencies. For the most part, investors rely on the rating agencies to perform a detailed due diligence on their behalf and to attest to the sensitivities of the computer model results. Overall, the use of rating agencies has given investors a high degree of comfort. Looking down the road, as CAT bond transactions strive for greater transparency, rating agencies will be better able to provide further confidences that investors require.
Investor interest
The current condition of the financial markets has resulted in renewed investor interest in CAT bonds. With interest rates hovering at a 30-year low and an anemic stock market, investors, particularly large, institutional ones, are under increasing pressure to produce favorable results. The American public has become used to double-digit growth on investments and is making its displeasure known to fund managers and financial advisors.
Many are considering diversification into CAT bonds to be a viable option. For the investor, this is a zero-beta investment that has no correlation to the stock market or interest rates. Further, these investment vehicles did not suffer any losses as a result of the 9/11 terrorist attacks.
While a variety of groups make up the investment buyers for CAT bonds, by far the largest group is represented by hedge funds. Other general bond funds and life insurance companies make up the majority of other investors. Property/casualty insurers, also are beginning to take an interest in CAT bonds for an investment.
One of the major stumbling blocks to better acceptance by investors has been the lack of an organized secondary market. While CAT bonds are typically purchased as a portfolio diversification instrument and, as such, are usually held to maturity, the lack of a secondary market has hampered their growth. Some investors are concerned about the liquidity of the bond should they have to dispose prior to maturity. This lack of a secondary market was one of the reasons that the CBOT delisted its CAT futures and options early this year. They had been operational since 1992.
It is widely recognized that the property and casualty marketplace does not have sufficient capacity to withstand a major catastrophic loss in a major population center. Accordingly, it would appear that CAT bonds could greatly assist insurers in proactively managing the exposures. While cheap reinsurance has been responsible for slowing the growth of the CAT bond market, today's affordability and availability issues should assure the movement to the capital markets. *
The author
Michael J. Moody, ARM, is managing director of Strategic Risk Financing, Inc.
Correction: E&O lines written by Hartford Financial Products
In an article on page 150 of the October issue, the lines of E&O business written by The Hartford were incorrectly identified. The correct E&O coverages written by Hartford Financial Products are lawyers professional liability, technology errors and omissions, employment practices liability, middle market business insurance and miscellaneous E&O.