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CAT Bonds and ILS - Getting Bang for
your Buck in a Maturing Market
Jon Tindall
© Jon Tindall 2018
This presentation has been prepared for the Actuaries Institute 2018 Financial Services Forum.
The Institute Council wishes it to be understood that opinions put forward herein are not necessarily those of the
Institute and the Council is not responsible for those opinions.
Overview
1. ILS & Capital Markets Refresher
2. Market Update – Going from strength to strength
3. Pricing – maturing & converging, improved conditions for the buy and sell sides
4. New Risks, new markets, new structures –new opportunities for the sell side
5. What’s Next for ILS & ART Markets?
ILS Refresher• Insurance Linked Securities (ILS) are financial
instruments whose returns are dependent on
insurance outcomes.
o Generally structured as securitisations;
o Ceded risks include: Natural perils, mortality,
longevity, pandemics, mortgage risk;
o Packages insurance risk into tradeable
securities
• CAT bonds are the largest component of ILS markets
o Grew significantly on the back of Hurricane Andrew in the early 1990’s.
Sough to replace lost reinsurance capital;
o Originally dominated by US Wind and earthquake the market has since
diversified.
The Basic Setup
Swap
Counterparty
Capital
MarketsSPVOriginator
Trust
Securitised assets / liability
Deposit / Obligation
Setup Costs
Capital
Securities, bonds, equity
Swap Obligation
Swap fee
• SPV offers securities to capital markets.
• Proceeds held within the SPV and invested via a mandate.
• Deposit / Obligation is provided to the Originator by the SPV
• Swaps are entered into
Originator: The institution providing the securitised assets.
SPV: The vehicle that issues securities
to the capital markets and provides coverage to the originator.
Capital Markets: The purchasers of securities offered by the SPV.
Trust: Generally set up as a charitable trust. Provides independence of the SPV.
Swaps: TRS, credit risk, liquidity risk.
Broader Capital Markets
There are a variety of ways than an insurer
can get access to broader capital markets.
These include:
Sidecars
• Popular in the 1990s and provided the first mainstream access for investors looking for exposure to insurance risk
• Had origins in traditional quota-share arrangements
• Secondary liquidity is limited and setup costs are relatively high
• Generally not collateralised
Collateralised Reinsurance
• Reinsurance contracts that are fully-
collateralised by capital markets.
Popular in the post-GFC world.
• Provide access to insurance risk for broader investment markets via tradeable securities and derivatives
• More customisable than CAT Bonds but at the expense of liquidity
Private Placements
• Placing insurance risk directly with investors. Generally bespoke.
• Fully customisable and avoid unnecessary frictional costs – ratings, regulatory approval, SPV establishment costs etc.
MARKET UPDATERecord issuance, new issuers, new risks
2017 was a big year for ILS Markets
• Some important milestones for ILS markets
o Record issuance: ~$13bn
o Market absorbed substantial losses
• From a market that looked at risk following the GFC
o Improved structures – credit
enhancements
o Diversification of risks and triggers –
indemnity triggers have become the
dominant form
-
5,000
10,000
15,000
20,000
25,000
30,000
35,000
($m
)
Issued $m Outstanding $m* Data to May 2018
Source: Artemis - Catastrophe bond & ILS market statistics
ILS markets absorbed significant losses in 2017
• August: Hurricane Harvey – Impact on ILS markets limited as mainly
flood damage. Bonds issued by Texas Windstorm Insurance
Association traded at a discount.
• September:
– Hurricane Irma
– Mexico Earthquakes – Total loss on the $150m World Bank notes
to the benefit of the Mexican Fund for Natural Disasters.
– Hurricane Maria – large marked to market losses for some bonds
in the secondary markets.
• October: Californian Wildfires caused substantial insurance losses. A
number of bonds with exposure to North American wildfires were
further discounted as a result.
Insurance markets were hit with circa $100bn claims from 2017 events –with ILS markets at the centre of activity
ILS markets absorbed significant losses in 2017
• Secondary markets recovered substantially in early 2018 as marked-to-
market losses on several structures recovered after threats subsided.
o Investors were quick to supply replacement capital for losses incurred
and maturing tranches
• 2018 is seeing a record start to the year - providing some confidence that
the ILS market is capable of being a sustained feature of broader insurance
markets
• Willis’ CEO James Kent:
“The pricing environment for the April renewals has closely mirrored that of
the 1 January placements, with pricing dampened by the continued impact of
plentiful capacity from both traditional and ILS markets, and with the latter’s
impact most apparent on property catastrophe pricing”
“Any hopes reinsurers held for meaningful real rate increases to help offset
difficult 2017 results have been dashed”
Triggers• The choice of trigger type is one of the most
important factors influencing an ILS structure
• Indemnity triggers dominate the landscape –regaining prominence in the aftermath of the GFC
o Removing basis risk
o Slower payouts, higher handling costs
• Parametric triggers have a role to play where the speed of payout is an important feature. Efficient.
Indemnity57%
Industry Loss24%
Parametric9%
Other6%
Unknown4%
Source: Artemis - Catastrophe bond & ILS market statistics
PRICING
Maturing and converging
ILS pricing is maturing as volumes grow
• Market prices generally get summarised based on the multiple of coupon to expected
loss
𝑴𝒖𝒍𝒕𝒊𝒑𝒍𝒆 =𝑪𝒐𝒖𝒑𝒐𝒏 (%)
𝑬𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕 (%)
• The pricing multiple has stabilised and fallen substantially over the past 20 years
• A relatively crude measure that glosses over the intricacies of the distribution of returns from ILS markets
-
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
-
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
Ave
rage
Mu
ltip
le (
spre
ad:e
xpe
cte
d lo
ss)
($m
)
Issued $m Outstanding $m Average Multiple
Source: Artemis - Catastrophe bond & ILS market statistics
ILS pricing is maturing as volumes grow
• As the market has grown, pricing terms have become more competitive and
have, over time, converged with traditional reinsurance prices.
-
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
Av
era
ge
Mu
ltip
le (
spre
ad
:ex
pe
cte
d l
oss
)
Ex
pe
cte
d L
oss
/ C
ou
po
n %
Average Coupon Average Expected Loss Average Multiple
• The past 6 or 7 years in
particular have seen improving
pricing conditions for issuers
• During this time ceded risks
have had higher expected
annual losses whilst
demanding reduced average
coupons (spreads) from
investors
Source: Artemis - Catastrophe bond & ILS market statistics
ILS markets are having an effect on
traditional reinsurance pricing
• Evidence that the expansion of ILS markets has helped to limit price movements for traditional reinsurance placements
• ROL has trended downward over the past 12 years and with a substantially lower volatility
• More recent catastrophes appear to have had less impact on the ROL than previous ones such as Katrina (2005) and Andrew (1992)
o New sources of capital in
competition with traditional reinsurance capital.
-50%
0%
50%
100%
150%
200%
0
50
100
150
200
250
300
350
400
450
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
20
16
20
17
20
18
% C
han
ge
RO
L In
dex
Change % GC Global ROL Index
Source: Guy Carpenter Global Rate-On-Line Index – Mar ‘18
Buy-side Appeal
Source: Lane Financial “Annual Review & Commentary to Q1 2018”
Japan Earthquakes,
Feb 2011
Hurricane
Katrina,
2005
2017 CAT events
GFC,
2008
There is growing appeal amongst the
buy-side:
• Investors becoming more comfortable
with the risks being ceded
• Low correlation with conventional
financial markets
• Large spreads compared with other
debt on ‘like-for-like’ credit ratings
• Deeper diversification of risks and
geographies
• Increased liquidity of secondary
markets
Buy-side Appeal
• Specialist asset managers are dedicated to this growing market:
o Nephila Capital - $11bn
o AlphaCat - $3.6bn
o Fermat Capital – $5.7bn
o Aeolus - $3bn
o Blue Capital – $300m
o Coriolis Capital - $700m
o As well as some broader asset managers
o AXA - $1bn
o Credit Swiss – 8.6bn
• One year in the past 16 has had a negative return on equity:
o 2005 – Hurricane Katrina
• Low variability in returns year on year
NEW RISKS, NEW MARKETS
New Opportunities
New Risks• Once the sole domain of US Wind and Earthquake risks – the market has expanded
over the last 20 years to include natural perils from around the world:
o Japan EQ, South American EQ, European Wind & Storm, Australian Wind & EQ
o Mortaility and Longevity
• This provided the market with much needed diversity and spawned the establishment of dedicated ILS managers
• More recently a range of other risks have been ceded to capital markets, including:
o Mortgage Risk
o Pandemic Risks
o Motor XOL
o 3rd Party Motor
o Healthcare
o The potential for risks to be ceded to capital markets is only limited by the ability for risks to be isolated and for frictional costs to be manageable
Jurisdictions are competing for ILS businessStill dominated by havens such as Bermuda, the Cayman Islands & Ireland – other
jurisdictions are looking to attract ILS structures to their shores; UK, Asia
Singapore
• At the start of 2018 Singapore’s monetary authority, MAS announced the
development of its own regulatory framework for ILS transactions including a
grant scheme
o provide significant financial incentives for issuers;
o offers to fund 100% of an issuer’s up-front setup costs. Up to S$2m will be
available for complying transactions (issue size > $50m, listed on SGX)1
UK
• July 2017 – unveiled a new ILS legislative framework seeking to attract ILS
structures (Risk Transformation Regulations 2017)
o A natural fit for the home of commercial insurance and reinsurance
o UK Treasury cited research that values the ILS market at $87bn by 2019
o Certain reporting and taxation benefits will be offered to complying
structures (PCCs – Protected Cell Companies)
New Breeds of market place
• Extraordinary Re - looking to disrupt the way in which insurers (and other Cedents) access capital markets
o offer a platform for investors to trade in manageable parcels of insurance
exposure
• Speedwell – Created the weatherXchange platform to assist clients to access index-based weather protection
o Allows companies to design their own protection based around published indices
o Farming, energy, construction and hospitality industries are key targets
• ILS Blockchain – Blockchain facilitated ILS transaction completed in 2017
o $14.8m Dom Re IC Limited 2017
o 1st securitisation to be settled using a private blockchain
o No banking intermidiary or broker-dealer involved. Reduced timeframes and frictional costs
o Platform participants go through a vetting process00
WHAT'S NEXT FOR ILS & ART
MARKETS?
Challenges for the local market
• Ratings
o Getting rated can be expensive and slow
o ILS funds have typically remained unrated until recently. AM Best offers a specific I>S Fund rating methodology
o Obligation on agencies to better understand these securities – significant gaps between other methodologies – i.e. for Corporate debt
• Reducing frictional costs across the market:
o Large establishment costs make it tough for smaller issuers.
o Standardised terms are beginning to assist with vanilla placements – need to extend the standardisation of contracts through exchanges or other platforms
• Regulations & Capital Relief
o Can be onerous to gain capital relief from regulators
o Leading Cedents to avoid the ‘regulated’ capital space
o Regulators should be actively looking for ways to facilitate these transactions
The Potential for ART Market in Australia
The ART Market has many applications outside of the traditional CAT bond space.
There are lots of places on the balance sheet that have the potential for streamliningthrough risk-transfer techniques
• DAC – Securitising deferred acquisition costs has already been a feature of life insurance markets.
• Reinsurance Receivables – after CAT events insurers can hold large reinsurance recoveries on their books which attract significant capital charges.
o Securitisation could make this more efficient for the insurer
• Asset Risk Charges – The prescribed approach can be inefficient for organisations with specific asset risk profiles
o ART can transfer some of these inefficiencies to capital markets and also avoid unnecessary counterparty risk
• Default Risk Charges
• Trade Receivables
The Potential for ART Market in AustraliaState sponsored risk-transfer could:
• Assist Australia in becoming more resilient to natural disasters.
o Supplementing disaster recovery with recapitalisation from capital markets
o Provide instant access to state-level funding without impacting budgets or liquidity constraints
o Promote risk mitigation and resilience through ILS structure
• An Australian-sponsored ILS structure to provide regional assistance in the aftermath of natural disasters
o CAT Bonds covering Pacific Nations for listed catastrophes
o Premium contributions from; Pacific Nations, Australia, World Bank
o Capitalisation of SPV by broader capital markets (say $200-$300m)
o Immediate parametric payouts (say $50m per event) based on event
characteristics
o Allow incentives for member nations to mitigate risks via reduced premium contributions
