Convergence: Still in the cards

CAT bonds gain momentum as product is refined and catastrophe losses rise

By Michael J. Moody, MBA, ARM

It would appear that 2010 will be viewed as the year when insurance-linked securities such as CAT bonds will lead the industry’s convergence efforts.

Convergence, the combining of capital markets with insurance products, was the buzz in the financial services sector just a few, short years ago. In fairness, while the insurance industry did respond favorably to the losses associated with Hurricanes Katrina, Rita and Wilma, it left the industry in perilous condition in terms of capital in 2005. Insurers paid their claims, although these three major losses tested the industry’s ability to maintain sufficient capital and surplus, should another adverse event occur.

As a result, several new products were introduced to the marketplace to raise additional capital. While some of these products had been used within the insurance industry previously, they were now being viewed from a broader prospective. Insurance-linked securities such as Industry Loss Warranties (ILW) and catastrophe bonds (CAT bonds) became commonplace. And totally new products such as side cars and other weather risk management-related derivatives were introduced. Together, these products greatly assisted the property insurance market remain a viable source of insurance protection through the remainder of 2005 and 2006.

The current situation

However, no sooner had the ink dried on some of these innovative new concepts, than the insurance industry began to show improving financial results. And as the market has progressed, according to the Risk and Insurance Management Society’s (RIMS) latest statistics, 2010 repre­sents the seventh straight year of a soft market. RIMS Benchmarking survey indicates that this continuing soft market shows little evidence of abating.

Let’s face it, 2010 has started poorly. Earthquakes have dominated the news since the first of the year—massive quakes in Haiti and Chile and minor quakes throughout the world. Experts have estimated the losses at about $16 billion in damage worldwide, and that may be one of the highest first quarters on record.

Couple this with predictions by Dr. William Gray and his team at Colorado State University that the 2010 Atlantic hurricane season will produce above average activity. They estimate that there will be 15 named storms, eight hurricanes and four major storms in 2010. They have also indicated that there is a 69% chance that at least one major hurricane will make landfall on the U.S. coastline in 2010.

Where do CAT bonds go from here?

These facts alone could lead one to believe that 2010 will be a banner year for the CAT bond market. Certainly there are favorable signs and early evidence of increasing catastrophic loss bond activity. As always, insurance-linked securities such as CAT bonds present a number of advantages to investors. By far the most compelling is that the results from these investments are not tied to the stock market. In other words, they are considered by investors as zero beta investments. Additionally, they provide investors with an opportunity to diversify their portfolio. And, typically, they provide higher returns than traditional investments.

Despite these advantages, of late, insurance-linked products have generally had a difficult time finding investors, but the one product that continues to attract interest from both the capital markets and the insurance industry is CAT bonds. In reality, CAT bonds are not a new concept; however, the product has evolved since its introduction in 1992, shortly after Hurricane Andrew.

Some experts within the insurance industry became concerned about the industry’s capital base following Hurricane Andrew and realized that the most appropriate place to resolve this issue was the capital markets, due in part to their large pool of capital. But despite the initial efforts to develop a viable product to offer high limits for property damage from earthquakes in California, they could not compete with the inexpensive reinsurance that was available. However, the concept did appeal to a number of insurers/reinsurers, and over the next few years, several began to develop the CAT bond concept. Since that time CAT bonds have enjoyed increasing growth as a viable method for funding high layer property losses.

The original idea for CAT bonds was limited to East coast and Gulf coast wind damage and/or hurricanes and California earthquakes. One of the issues that has plagued this market is what exact circumstance qualifies an event as a loss. Over time, however, a number of different approaches have been suggested as to the “triggering” mechanism (i.e., what “triggers” a loss); and today, for the most part, this issue has been resolved. In addition, in many cases the coverage has been expanded. While the original concept considered only U.S. hurricanes and earthquakes, today CAT bonds have been expanded to cover incidents of European windstorms and Japanese earthquakes, to name just a few; and more are being added all the time.

An additional obstacle to determining whether or not a particular incident is covered was resolved by the use of an independent third-party source, Property Claims Service (PCS), a subsidiary of ISO Services, Inc., to assist in this important area. While the use of PCS was originally limited to loss events in the United States, it now also provides information about losses in Canada. This allows an independent claims source to provide an index that makes the determination as to the basis of the loss. This is an important consideration since it has allowed much more acceptance within the investment community. However, a similar third-party source was unavailable for other parts of the world until early this year, when PERILS was introduced. PERILS is an independent index that currently applies to European windstorm damage. The new index has already been utilized with windstorms such as last year’s Lothar and, more recently, with Storm Xynthia. More specifically, Swiss Re will be the first CAT bond issuer to officially use PERILS in conjunction with its new CAT bond, Successor X Ltd., Series 2010-1, which was placed earlier this year.

Conclusion

Despite the disastrous showing of the overall financial services industry over the past couple of years, the insurance industry has fared quite well and, as noted above, is in the middle of a pricing war. As a result, a number of convergence-type products have fallen by the wayside. However, many industry observers have noted that the industry is about one catastrophic loss away from a hard market. Based on this, many feel that 2010 could be an active year for CAT bonds.

The CAT bond has matured over the past few years and has worked out a number of potential stumbling blocks that limited their usage in the past. While many of the insurance-linked securities have been pushed to the back burner, many experts feel that activity in CAT bonds will begin to increase, as insurers/reinsures search for better ways to deploy their capital. At their height, CAT bonds totaling $12 billion to $14 billion were being issued in a single year, and many of those multi-year investments expire this year. So, many experts believe that just the renewal of the existing business will result in increased activity. Additionally, some bonds have expanded the scope of both the risks covered and the geographic areas included. Add this to the increase in catastrophe losses, and it would appear that 2010 will be viewed as the year when insurance-linked securities such as CAT bonds will lead the industry’s convergence efforts.

Many experts agree that utilizing the vast capabilities of the capital markets should be a viable, cost- effective method of providing capital to meet the long-term needs of the insurance industry. Many believe that the capital markets can also assist in negating the huge swings associated with traditional insurance market cycles.