The number of natural catastrophes has increased every decade for the past 100 years. The purpose of insurance is to spread, manage and absorb risk and allow the economy to continually function; it does this by allowing individuals and businesses to pool resources in order to manage risk.

In 1992 Hurricane Andrew cost the industry $19.6 billion (it would have been around $50 billion if it had made landfall in Miami); at $19.6 billion it bankrupt 10 insurers overnight. A $50 billion loss would have represented 25% of the capital of the US insurance industry. The ’93 Northridge CA earthquake cost $16.3 billion. These two events alone exceeded the aggregate cat losses of the previous 12 years. Denis Mahoney in his keynote address to the ACORD Forum in London 2007 pointed out that the increasing primary retentions or use of captives meant that the primary market was moving into the reinsurance province and its loss dynamics are changing towards cat losses. He also pointed out the increasing involvement of Governments to plug the gap between losses and the capacity of the market.

In recent years insurers have had a new risk management tool: issuing securities linked to bundles of insurance risk. This transfers underwriting risk to the capital markets. The interest in securitization is easy to explain. Insurance markets operate most efficiently when losses due to a certain peril are random, unrelated, spread among a large number of policy holders and are easily measurable; in this situation the risk of failure of primary insurers is reduced. Small imperfections that distort the distribution of aggregate losses can be controlled via underwriting controls, reserves and reinsurance.

Large imperfections (or catastrophe losses) are difficult to deal with. For these risks non insurability arises because of the mismatch between the size of the actuarially fair premium pool that can be accumulated in a year and the size of a mega loss that may occur in that year. In 2003, estimates placed the capital and surplus of all US insurers at about $290 billion. This is to cover property risks of $30 trillion and casualty risks associated with an economy of over $9 trillion. Global reinsurance with about $100 billion in capital and surplus is small relative to the potential exposures.

Recognizing the limits of insurers’ and reinsurers’ to finance major cat risks the insurance industry has developed mechanisms for transferring cat risks to the capital markets. In 2003 the capital markets of the US alone represented $12 trillion in equity values. A $100 billion cat loss would have represented less than 1%, which is no more than a typical days movement in asset values rather than the devastation of the US insurance industry.

Insurance securitization may be defined as the transfer of underwriting risks to the capital markets via the creation and issuance of financial securities. Rather than transferring risk to a reinsurer within the insurance industry, the risk is transferred to the broader capital markets. Securitization involves the transformation of underwriting cash lows into tradable financial securities and the transfer of these underwriting risks to the capital markets by the trading of these securities. This is generally accomplished by the buying and selling of financial instruments, whose cash flows are contingent on underwriting experience.

Securitization is not limited to cat risks, but it has developed as a response to the awareness that the cover available from the insurance industry only constitutes a fraction of the maximum exposure. Securitization allows primary and reinsurers to gain additional capacity over that given by their capital base.

In any risk transfer mechanism there are three main considerations: the credit risk of the compensation provider; the basis risk faced by the primary insurer (the difference between the actual loss and the amount of compensation received) and moral hazard. In traditional RI, basis risk is eliminated by the reinsurer indemnifying for actual losses above a retention; credit risk is mitigated by security ratings and a diversification process and moral hazard is mitigated by retention limits, retrospective pricing or examination of cedant’s portfolio and underwriting controls.

In securitized risk transfer the same issues are mitigated via the design of the security, i.e., the mechanism that triggers compensation and the basis used in the calculation of the compensation in the event of a loss. A small number of insurance securities do have compensation based on the insurer’s actual loss experience. This however entails the capital markets having a similar knowledge to a reinsurer, which they do not have. Therefore, most securitized risk transfer products have compensation contingent upon losses reported by an aggregate loss index (index arrangement) or compensation is predetermined linked to some physical attribute of the event, such as the magnitude of a quake, or wind speed, or where a hurricane makes landfall, etc. (parametric arrangement); in these arrangements moral hazard is eliminated, but means that the insurer may be exposed to significant basis risk if its actual losses are not correlated to the aggregate losses as defined by the loss index. Therefore insurers must choose their index carefully.

Since it is easier to predict indices than individual insurer’s losses, there are shorter loss development periods and with parametric arrangements, loss development is practically eliminated. A significant point is that as investors do not need to examine the individual insurer’s exposures, underwriting practices and loss control measures, transaction costs are significantly reduced. Here we start to see the overlap with the points made by Denis Mahoney in his recent ACORD Forum address (see other Blog items). What, no reinsurance brokers touting slips round Lime Street? To be replaced with a bunch of stats grads in who knows where poring over indices?

In most securitized arrangements, credit risk is eliminated through a combination of in-trust held funds and collateralization.

The most common method of insuring natural catastrophe risks is through the issue of catastrophe (CAT) bonds. How does it work? Premiums from the insurer and funds from investors are pooled into a ‘special purpose vehicle’ (SPV), usually in a tax haven, that acts as a source of compensation for the insurer. CAT bond provisions allow for the waiving of interest and/or principal payments to the investors if a cat loss occurs. The extent of the waiving can be partial or total or relative to the loss size and can be triggered by insurers actual losses or losses associated with an aggregate loss index. CAT bonds may be for a single or multiple perils. If no loss occurs then the investors get interest and principal payments from the SPV.

Other common insurance linked securities are Catastrophe Risk Exchange (CATEX) swaps, insurance derivatives/options, catastrophe equity puts (CAT-E-Puts) and contingent surplus notes.

The basic arguments in favour of insurance securitization for insurers include: increased capacity through access to capital of the capital markets; greater coverage flexibility; no credit risk; insulation from adverse reinsurance price fluctuations and high aggregate level risk transfer. For investors the advantages are above average returns and increased diversification (Cat events usually have a low correlation with investors other portfolios).

In general, insurance securitization prices tend to be significantly more expensive than reinsurance premiums. Reinsurance prices are the key factor in the affordability of insurance securitization as a risk management tool, however reinsurance prices are volatile and tend to increase during periods of demand on the available capacity.

Main Source: Catastrophic event exposure and the role of insurance linked securities in addressing risk by Peter Carayannopoulos, PhD, Paul Kovacs and Darrell Leadbetter.  (Read this article in detail for further credits).