The insurance-linked securitization (ILS) market is beginning to feel the credit pinch as malfunction in the financial markets touches every corner of
the economy.
Even insurers are finding that where they once added value for investors looking for some shelter from the wider securitization market, they've now become part of the problem.
Such lost immunity is likely to add pressure to ILS volumes. Still, the industry feels it has some advantages that will continue to make insurance linked structures appealing - even in the current environment.
Dr. Karsten Bromann, managing partner at the dedicated ILS fund Solidium Partners AG, said that the first half of 2008 saw a demand-driven market, though this has shifted to become a supply-driven market. He spoke at the Information Management Network's (IMN) inaugural summit on insurance linked securities, last week.
As a result, Bromann doubts the market will see the same 40% growth it saw last year. The first nine months of 2008 have already seen a decrease in the issuance of catastrophe bonds to about $2.73 billion from $5.38 billion over the same period last year, according to figures reported at the IMN summit.
"Over the last two months the insurance market has lost its independence from the rest of the financial market," Bromann said. "We've seen increased correlation risk, but the correlation is much lower than what has been seen in other areas of the financial market. Nonetheless, everyone is sitting like a rabbit in front of a snake - nobody moves."
While most transactions are performing well, the counterparty credit issue is at the forefront of most investors' worries. These life securitizations, whether for the financing of acquisition costs or monetizing embedded value, are by nature indemnity covers, as the performance of the investment is directly linked to the underwriting risks (persistency and mortality) within the underlying portfolios.
Lehman Brothers acted as a swap counterparty in the Newton Re Limit Series 2008, Class A $150 million; Willow Re's Class B Series 2007-1 $250 million; Ajax Re Ltd's Series 1, Class A $100 million; and Carillion Ltd's Series 1, Class A-1 $84.5 million.
Since Lehman went under, the value of the collateral in these transactions has decreased greatly.
Emmanuel Modu, managing director and global head of structured finance at AM Best, said that some key solutions to consider in the future are the credit quality of the asset, a daily mark to market update, and better liquidity for these assets.
"In our view, the Lehman default has had limited implications for ILS structures, and while concern about counterparty risk has always been an issue, the problem now with such big names going down is that no one knows who to trust," said Dirk Lohmann, managing partner, Secquaero Advisors, and also a speaker at the ILS summit. As a result, Lohmann suspects the market will see increased regulatory pressure on solvency and more of an emphasis on rules, as well as a greater conservatism.
Moving Beyond CAT Bonds
Most of the activity in ILS has been driven by CAT bond structures that are primarily structured for risk transfer. The market has yet to realize true diversification opportunities.
Wilhelm Zeller, chairman of the executive board of Hannover Re, in a commentary on ILS issued earlier this year, said that the limited number of structures driving the development has stalled growth, and that more talents and broader market expertise are needed to support market development. The predominant risk securitized to date is event-driven risk. And its often-binary structure bears a greater potential for volatility simply because of the assessment risk.
"The focus is on capital relief through risk transfer, especially for peak perils," said Zeller in the commentary. "Changing the focus to capital efficiency where more frequency rather than severity is the problem might offer significant future opportunities. This holds for non-life (e.g. motor, credit) as well as for life (embedded value, extreme mortality, reserve relief)."
However, market participants have not yet developed an appetite for such long-term risk, and have only recently started to show an interest in insurance securities covering higher frequency events. One of the biggest problems in the ILS industry is a general lack of transparency, and one clear benefit of the credit crunch should be a shakeout of the rigidity implicit within the asset class. Insufficient data and modeling capacity make it hard to repackage insurance risk for the markets. Additional impediments include the lack of standardization of underlying risk and the industry's reluctance to disclose proprietary underwriting information.
"Now is the time to have discussions for changes that would be for the long term benefit of the industry," said Dr. Erik Manning, a member of the alternative risk markets group at Deutsche Bank AG London.
Soon industry players expect to see credit risk of insurance company as well as longevity risk of its customer base as part of the securitization pool. "Longevity risk is a very interesting area just for the pure size of this asset class," said Stephan Otzen, portfolio manager, vice president at Horizon21 Alternative Investments AG. "There has been lots of talk in the U.K."
But the natural takers of such long term paper, such as insurance companies and pension funds, are precisely those trying to sell the risk. "How do you develop a market with that needed level of liquidity?" asked Simeon Rudin, a partner in the structured finance practice of Freshfields Bruckhaus Deringer. "The natural step will be in the short term liquid market."
Fundamentally and at the core of this, is that the industry can have the transactions but it needs to develop a far broader investor base. "We can make this industry bigger if we provide the requisite transparency that investors need," said Jonathan Spry, senior vice president in capital markets at GC Securities. "We need to find a way to structure risk for investors with more short term hunger by creating more liquidity in the market."
Not an easy task, given that the industry has already tried, but failed, to set up indices to facilitate the trading of these assets. Despite the presence of a sizeable ILS market, the market has been slow to develop the necessary trading platforms to create better liquidity. In 1992, the Chicago Board of Trade introduced catastrophe derivatives based on underlying indices, which reflected insurance property losses. They consisted of futures and options written on futures contracts. But trading never took off, and three years later the contracts were replaced by spread options on loss indices provided by Property Claims Services. In 2000, these were also withdrawn, again on account of insufficient interest. The Bermuda Commodities Exchange also undertook a similar task when it opened its index in late 1997. Two years later, it too was suspended and eventually liquidated.
However, this year Deutsche Borse Group's market data and analytics team said it was expanding its Xpect data platform to include Dutch longevity data. In March, the platform started delivering monthly data on life expectancy and mortality risks in Germany, broken down according to region, year of birth and gender. The data provides complete generation life tables based on substantial official and proprietary data sourced, cleansed and processed by Deutsche Borse. Deutsche Borse is to offer various Xpect indices, which will serve as securitization for life and pension insurance risks. Insurance companies and pension funds will thus increase their capital efficiency and lower their required risk capital. The Xpect indices will also serve as a basis for financial instruments.
"An essential condition for the sustainability of any market is that it creates transparency and liquidity," wrote Dieter Wemmer, a member of the group executive committee and chief financial officer of Zurich Financial Services, in a paper he authored on the ILS industry earlier this year. "One specific lesson of the subprime debacle was to remind us that investors want to know eventually what kind of commitments they are engaged in, and they also want to ensure that there will always be sufficient liquidity to trade and price the products. Where these conditions are not met, investors will withdraw and the market will suffer a setback." He said that the development of suitable secondary trading platforms will be essential for the ILS market to grow to maturity and will consequently contribute to favorable trading environments.
Robert Hut, managing director at Insurative Premium Finance Jersey, said that he believes demand for securitization will increase in the short-to medium-term, because the asset class fits naturally with this financing tool and all of the necessary components are present for a straightforward vanilla transaction, which is what buyers want.
"It may appear preposterous to discuss securitization of insurance-linked securities at a time of financial market turbulences caused by securitization having seemingly gone astray," Wemmer wrote. "But the wheel of innovation cannot be turned back. Securitization is here to stay, and ILS will play an important role in the future."
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