Florida Citizens plans to replace $1.3 billion in expiring coverage for catastrophic losses in 2015, and it may seek as much as $2.5 billion in additional coverage. Assuming no massive hurricanes or other catastrophic events this year trigger big payouts from reinsurers and their capital market counterparts, the state-backed property insurer anticipates pricing rivaling if not besting transactions inked earlier this year. And this year’s pricing was less than half that of its 2012 deals.

But pricing wasn’t Florida Citizen’s only bonbon this year.

“What made it so great for us is that we were able to do a big deal and also get multi-year aggregate,” said Jennifer Montero, chief financial officer of the insurer of last resort.

Florida Citizens’ previous catastrophe (cat) bond and reinsurance deals had one-year maturities and covered only a single event whose losses had to reach a pre-defined level to trigger a payout. Its most recent bond deal launched in the spring, however, is three years in length and allows the issuer to add up storm losses throughout each year to reach the trigger point. If capital is left over from year one, for example, it can be paid out in subsequent years if the trigger point is reached again.

The ability to aggregate losses has long been a feature of reinsurance, but it was new to the bond market.
“We’re currently brainstorming about our plan for next year,” Montero said. “Hopefully, we’ll be able to get additional improvements in terms.”

Given Florida Citizen’s quest for coverage volume, Montero said, the insurer was satisfied with the pricing and aggregation feature, and that may be the case next year as well. But other benefits are increasingly available to sponsors, such as including more perils, and longer “hours” clauses that stretch the window through which losses from a catastrophic event can accrue.

Those features have been available for many years in reinsurance policies, which in turn have lengthened their policies’ maturities and taken other steps that echo the terms available in cat bonds. In fact, although some fundamental differences remain between reinsurance and cat bonds, the markets are clearly converging as they respectively seek to retain and gain market share. Such convergence is an important boon for issuers, which may soon include non-insurance companies seeking to hedge catastrophe risk.

Terms of Catastrophe Bonds, Reinsurance Converging

Both cat bonds and collateralized reinsurance require transactions to be fully collateralized, so when disaster strikes the issuer can quickly draw down funds. Buyers of insurance protection, on the other hand, rely on the reinsurer’s credit rating to ensure it has sufficient reserves and can meet payout demands, and that remains a fundamental difference between the markets.

As a result, reinsurers have been able to leverage their capital by including multiple perils in their policies, under the assumption that it’s highly unlikely they will occur at the same time. Until recently, cat bonds tended to transfer the risk of a single peril, but in the last year these deals have increasingly offered broader coverage. For example, USAA’s $130 million June Residential Re 2014-1 cat bond provided protection across a range of perils, including tropical cyclones, severe thunderstorms, earthquakes, winter storms, volcanic eruption, meteorite impact and wildfires. Two of the perils in the issuer’s 22nd cat bond, meteorite impact and volcanic eruptions as a standalone peril, were very unusual, according to cat bond news service Artemis
AIG’s $400 million Tradewynd Re 2013-2, completed at the end of last year, covered both personal and commercial lines, and in addition to perils such as named storms in the Gulf of Mexico it covered engineering risks, marine and aerospace, according to Artemis.

William Dubinsky, head of insurance-linked securities (ILS) at Willis Capital Markets & Advisory (WCMA), says that cat bonds covering multiple perils aren’t exactly new and tend to be based on an issuer’s specific needs. For example, the $104 million Valais Re cat bond, issued in 2008 covered several perils including crop damage.

Sometimes including additional perils has a material impact on the cost to the sponsor and sometimes it does not, Dubinsky said; it depends on the investors’ perception of risk and how they view the issuer’s motives for including the perils.

“The more ILS looks like reinsurance, the more likely it is to grow in importance, all else equal,” Dubinsky said.

Tim Richison, CFO of cat bond issuer and collateralized reinsurance pioneer California Earthquake Authority (CEA), concurs that sponsors had previously “dabbled” in multiple perils, but says that these earlier deals were not received especially well from a pricing perspective. Richison, who was an executive at USAA when it structured its first “act of God” bond in 1997, says he has noted more interest in such deals since the spring, when rates began dropping rapidly.

“I wouldn’t be surprised if the majority of transactions in the fourth quarter are multi-peril, which might be a further threat to reinsurance, since reinsurers felt they had a leg up because they could do contracts with multiple perils,” he said. CEA itself has single-peril quake transactions in the pipeline that it plans to complete over the next six months.

Richison said about one third of CEA’s $3.6 billion reinsurance program is now 100% collateralized through collateralized reinsurance or cat bonds. “Full collateralization is like money in the bank,” he said.
The benefits for investors, however, are less clear, and for those still dipping their toes into an unfamiliar market, the risks are becoming increasingly difficult to analyze.

“I have some fear that people still in a learning stage may not fully understand the insurance risk,” Richison said.

Longer Hours, Same Pay

Another example of loosening terms and conditions, not just in catastrophe bonds but in traditional property-catastrophe reinsurance, is the hours clause. This is the time period during which claims resulting from a given occurrence may be included as part of the loss subject to coverage. It is usually measured in consecutive hours.

Krishna Mohanraj, research analyst at Diamond Hill Capital Management, pointed to a statement by Randy Ramlo, CEO of United Fire Group, on a February conference call that the company expanded its catastrophe coverage by $50 million and increased the coverage period for any single catastrophe to 96 consecutive hours from 72, all without a premium increase.

Hours clauses have loosened for cat bonds well. “In this most recent renewal period, both cat bonds and in some cases traditional reinsurance have permitted all losses from a named storm to be added up no matter how long that period is,” Dubinsky said. “So if you had hurricane make landfall in Tampa, go back to the Atlantic, brush North Carolina and end up in Providence, that could take well over the 72 or 96 hours, but all those losses could be added together.”

Previously, such clauses with a limited number of hours may have covered damage along only part of that route.

In a similar vein, EMC Insurance Group noted in its earnings report for the second quarter of 2014 that “… the January 1 renewal season included the liberalization of contract terms generally favorable to the buyer, including, but not limited to, an expansion of the hours clause (which provides a longer time period for losses to be attributed to a named catastrophic event); expansion of terrorism coverage to include, in many contracts, all acts other than nuclear, biological, chemical and radiation; and multi-year commitments on pricing.”

EMC described the “liberalization of contract terms as generally favorable to the [protection] buyer,” but its shareholders aren’t thrilled. In addition to plummeting rates, expanding coverage is ultimately another form of price reduction, since today reinsurers are unable to charge a premium for the additional risk. The push for multiyear contacts is also problematic.

“As a trend, this is undoubtedly negative for reinsurance equity investors, as this leaves reinsurance firms without the ability to re-price after a major event,” Mohanraj said. “We’re negative on the sector as a whole, especially the property-catastrophe sub-sector, and we think weak pricing is likely to continue.”
In fact, the four main rating agencies hold negative outlooks on the sector.

Pricing Plunges

Terms for issuers in most asset classes have been improving since the financial crisis. As recently as 2012, however, cat-bond coupons were nearly double those of high-yield bonds holding comparable single B ratings, and reinsurance rates were even higher. And that’s despite catastrophe risk’s lack of correlation with the financial markets, making it an attractive hedge.

What a difference two years makes. Florida Citizens issued $750 billion in one-year ILS triggered by a single event in 2012 that carried a 17.75% coupon; its $1.5 billion cat bond issued earlier this year is three years in length, and each year allows for aggregated losses. The insurer also completed a fully collateralized, $1.5 billion reinsurance contact in 2014 for an all-in rate of 8.2%, and that compares to a 21.5% rate in 2012.

Florida Citizens’ experience tracks the larger market. Willis reports an overall weighted average risk premium for U.S. wind cat bonds of 6.1% in the third quarter, compared to 12% two years ago.

Montero said that in 2011, the insurer faced an $11.6 billion assessment to build its capacity to adequate levels, potentially requiring it to tax policyholders. A program combining “depopulation,” in which private insurers voluntarily takeover Florida Citizen policies, as well as increased reinsurance and risk transfer through ILS has dropped that assessment probability to $2.3 billion. By pursuing the same strategy, Montero said, Florida Citizens aims to reduce it to zero this year.

Cost of Reinsurance Also Falling

The cost of reinsurance has also been falling, and while competition from cat bonds may play a role, it’s likely not the only reason. Leadenhall invests in all three forms of reinsurance risk, and Luca Albertini, its chief executive, said that reinsurance rates have fallen dramatically even in areas yet to be infiltrated by capital-market investors, such as specialty and casualty lines, or catastrophe programs with multiple reinstatements.

Albertini said that while cat bonds may price a certain layer of risk more aggressively than reinsurers, this is attributable to sizable ILS investors that can only put money to work in liquid assets such as cat bonds. He said these investors gravitate toward new issuance, and that there is insufficient volume to satisfy the demand for liquid assets. Leadenhall also invests in collateralized reinsurance through private illiquid transactions that give exposure to the layers of transactions that have reinsurance-type risk and where competition is less intense.

Reinsurance capital covers several risks besides catastrophe damage to property, noted Barney Schauble, principal at Nephila Advisors, one of the largest funds dedicated to reinsurance risk, and less than half of reinsurance capital is truly supporting property/casualty reinsurance. Nevertheless, he said, it’s unlikely that $7 billion in new cat bonds annually—such a small share of the overall market—is sufficient to drive down reinsurance rates. And neither is the significant capital reinsurers have generated from premiums in a practically claims loss-free environment since 2006, since they’re under no obligation to use it to bid on deals and can simply return it to shareholders.

“The current traditional reinsurance market reflects an internal battle for market share,” Schauble said, noting that reinsurers have set up sidecars and other vehicles to draw “alternative” capital from institutional investors. “New forms of capital mean that there is much more capacity in peak catastrophe zones in the U.S., which is good for reinsurance buyers, but there remains unmet demand for protection.”

Schauble said alternative capital is deployed primarily to U.S. catastrophe risk, and other risks such as European windstorm, marine or aviation are supported by traditional reinsurance at very low premiums.
The reinsurers have good reason to be concerned, given their cost of capital tends to be higher than a dedicated fund run by 20 or 30 professionals, and the arrival of just a small sliver of the bond market—there’s more than $7 trillion corporate debt in the U.S. alone—could dramatically reshape the market. In fact, the pace of change in just a few years has been dramatic.

“It’s a big change,” Albertini said. “Before, I may have paid more [to issue ILS instead of buying reinsurance,] but I diversified my sources of capital, and got multi-year coverage, and I got collateral backing. Now I’m getting all those things and I’m paying less.”

Investors Still Flooding ILS Market

Guy Carpenter Securities estimated in a September report that $20 billion in new capital has entered the market over the last two years though ILS funds and sidecars, hedge fund-related reinsurance companies, collateralized reinsurance vehicles, and other structures. News emerged in mid-September, for example, about asset-management-behemoth BlackRock striking a partnership with global P&C insurer Ace to create a vehicle that will raise capital from investors to assume premiums from the global carrier and participate in its reinsurance program.

Most of the dedicated funds now invest across the various reinsurance-exposure types, and most of them have seen their assets under management grow rapidly. Given that just $4 billion in cat bonds is anticipated to refinance by the end of first quarter 2015—a lot in relative cat bond terms but a pittance in absolute terms—some anticipate demand pushing rates down further.

Morton Lane, president of Lane Financial, a cat bond consultancy, said pricing will likely move sideways, given recent typhoons in Japan and India as well as any future storms that will indirectly impact investors and have a psychological effect. In addition, some investors from those regions may simply have less capital to put to work.

The big question is what happens when a series of major storms hits, along the lines of 2005 when five major storms made landfall, causing record damage estimated at $160 billion. Aon Benfield estimates that a $100 billion or more insured catastrophe event would be required to meaningfully disrupt market pricing.
That suggests a storm more severe than Hurricane Sandy, which although very large was not big enough to trigger wide-scale payouts. The risks transferred to the capital markets tend to be very remote--events that occur only once every 50 or 100 years.

Lane agreed that the size of the loss to investors is one factor that could move pricing. “But if the economy is still full of excess cash, calling it a ‘spike’ may be the wrong term,” he said. “Both reinsurance and ILS are riskier than they used to be relative to past premiums, but they’re still attractive relative to non-catastrophe alternative investments.”

Flight Risk?

In light of even more meager returns elsewhere, investors are steadily marching into reinsurance risk, despite lower returns and looser terms and conditions. Chi Hum, global head of distribution at Guy Carpenter Securities, said that among the steady stream of new investors interested in exposure to reinsurance risk are corporate pension funds,

“We’ve talked to companies that have up to $100 billion in pension assets they invest every year,” Hum said, adding they typically have their traditional panel of managers investing the funds, but catastrophe risk “seems like an interesting opportunity from a diversification perspective.”
Some large investors have reportedly hired underwriting expertise to analyze the assets managed by the dedicated funds, but many may be lacking sufficient understanding of the risks in a new asset class. So the issue becomes whether following a major catastrophic event they choose to stand strong or flee.
“My biggest worry is will they remain engaged?” said Richison. “There will be a day when there’s an event and the reinsurance will be triggered, and these people will lose their principal.”

Richison said the goal is to educate and develop dependable, lasting relationships with investors that will choose to hold CEA risk even after losing some money, given reinsurance-related returns should outweigh losses in the long term.

As transactions become more complex, however, it increases the risk that disgruntled investors may turn to litigation, arguing they were misled on a transaction’s true risk. At least one suit has already been filed, although the outcome was not in investors’ favor. The Mariah Re cat bond was issued in November 2010 by American Family Insurance and was one of the first to cover more frequent and smaller storms, rather than major hurricanes or earthquakes.

The report agent initially said losses were unlikely to trigger the cat bond but then changed its assessment at the last minute, triggering payment and resulting in investors losing their capital. A federal judge dismissed the claims at the end of September, determining that the terms defining the cat bond’s qualifying events were clear, despite the ambiguous trigger.

Clarifying the legal process surrounding ILS as well standardizing the process for issuers—Richison said the CEA’s first deal in 2011, which expired in August, took 18 months to complete—are among the issues the industry must work through. Hum noted several efforts afoot on the standardization front.

Meanwhile, he said, inquiries from investors including corporate pension funds and accumulators of retail money are in plentiful supply, and prospects are growing for investors to gain exposure to a broader variety of risks, with potentially higher returns.

Hum pointed to New York Metropolitan Transit Authority’s (MTA) Metrocat deal issued in July 2013. Not only did it represent exposure to a non-insurance company, but it took the place of insurance rather than reinsurance, and insurance is ultimately a much bigger market than $320 billion.

“Guy Carpenter was tapped because there was a gap in the amount of concentrated risk the reinsurance industry would make available to MTA at that time,” Hum said, adding, “When global reinsurers tell the MTA that after Hurricane Sandy losses they’re over-exposed to Manhattan, then there’s a problem that needs a solution.”

Consequently, Guy Carpenter is exploring the potential of unmet demand for concentrated risk in the insurance business because of the way the insurance industry handles its capital that creates risk concentration limits. On the other hand, from an investor perspective, Hum said, discreet, concentrated risk is ideal for constructing portfolios.

“It leads me to believe that over the next few years, as pricing continues to decrease for certain risks, ILS will become a good alternative for large concentrated insurance risk for organizations like the MTA and other transportation companies, or corporates who need a proxy for contingent business interruption for their manufacturing or other facilities,” Hum said.

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