A new convergence

It has been impossible to miss the sea change in the reinsurance industry: in the face of low investment returns and the quest for uncorrelated asset classes the market has become awash with new convergence capital. While the new capital is certainly catching the attention of the reinsurance industry, Craig Redcliffe, partner at EY, thinks that captives should be sitting up and taking notice, too.

He said: “While there is not yet a direct connection between the captive insurance industry and the changing reinsurance market, indirectly, as more capital flows into this market there is an impact on prices. It was well documented at the mid-term renewals that prices were down up to 20 percent in the peak zone wind risk areas in Florida. To the extent that captives are reinsuring their overall property risks in the peak zones, they would already be seeing the benefits of price reductions coming through.”

Redcliffe explained: “Any captive that is large enough on its own can certainly structure a cat bond deal. From a cost competitiveness perspective you have the ability to lock up your rates for a longer period of time. In addition there are other benefits of structuring cat bonds versus buying traditional reinsurance, such as the high credit quality of the structure, the large capacity in the cat bond market versus limited capacity for certain risks in the traditional reinsurance market, and less exposure to the reinsurance pricing cycle as cat bond pricing is driven by exposure analysis and relative market yields. As one captive explores the option the success is socialised, and other large captives are going to consider the concept.”

First adopters

The use of catastrophe bonds by captive insurance companies is rare but not unprecedented. In 2012, as tropical storm Sandy was making major waves in the New York metropolitan area, the New York Metropolitan Transportation Authority (MTA) was making plans.

The MTA is responsible not only for the New York subway system, but also for two railway networks and two bus companies which together are responsible for the transit of more than 8.5 million people a day. The majority of the MTA’s assets were exposed or subterranean and, as a result, Sandy was particularly costly. Economic losses incurred by the MTA reached $5 billion with insured losses totalling $1.07 billion. While the MTA’s insurance programme helped stem losses from Sandy (along with recovery funds from the Federal government) its support from the private market was sharply curtailed as a result of Sandy’s losses. Pricing doubled and capacity was cut in half. The solution, put in place by the MTA’s captive, First Mutual Transportation Assurance Co, was MetroCat Re Ltd, a special purpose insurer created to issue a series of catastrophe bond notes for 2013. The transaction provides cover for storm surge resulting from named storms.

"The ILS market will broaden and allow itself to get into new markets. Captive insurance is one of those sectors that could form a natural extension of the ILS market."

It proved to be a successful issuance. The bond provided the MTA with $200 million of protection. MetroCat features a parametric trigger based on actual recorded storm surge heights from a number of zones around New York City. Loss payments would be based on a parametric eventindex meeting or exceeding a trigger level for an applicable area, and so may not necessarily directly correlate to the losses of the sponsor. It delivers competitively priced coverage that would have been difficult to find in the traditional market and complements the MTA’s evolving reinsurance programme.

Joining the MTA in cat bond issuances are the California Earthquake Authority and other state-run programmes. Redcliffe said: “They are heavily purchasing, either on a collateralised basis or issuing their own cat bonds. Now that government and state authorities are getting involved in the ILS space, there’s no reason that captives can’t do the same thing if they have a large enough capital base to support such a deal.

“In addition, as the ILS sector evolves, it is fully expected that the costs associated with issuing cat bonds will decrease, allowing smaller deals to be structured. This is already starting to happen, as evidenced by the $20 million Sunshine Re Ltd cat bond issuance earlier in 2013. An issuance of this amount would not have been economically feasible a short time ago.”

A different kind of capital

According to Redcliffe, ILS can be a valuable and reliable source of capital. He said: “Some traditional players do not believe that the ILS market is pricing the risk that they are taking on adequately. When you look at the impact that the ILS sector has had on peak zone property catastrophe risk pricing, it is easy to come to the conclusion that ILS players aren’t pricing risk appropriately.

“In my view, however, it comes down to the funding differences between an ILS player and a traditional reinsurer. If you look at the capital from ILS players, it’s predominantly coming from pension funds. A pension fund has a different return expectation than an equity investor in a reinsurance company. Pension funds by their nature have long-term investment horizons because their liabilities are long term in nature. They have a different outlook on their investment: they’re looking at this asset class from the correlation variance perspective.

“They view this asset class as reducing the risk from an overall portfolio construction perspective. As a result of these differences in capital sources, the ILS sector has a lower cost of capital, allowing the ILS market to have different return thresholds on the risks it underwrites.”

The benefits to captives, he said, are clear. “There is no reason that a captive couldn’t source its reinsurance from ILS players. As the cat bond market evolves we’ve seen new structures come into play, allowing cat bonds to be issued at a lower price. Group captives with enough critical mass could potentially issue a cat bond instead of purchasing traditional reinsurance.”

While the ILS market is currently limited largely to property catastrophe risk—and, more specifically, peak zone risk—Redcliffe considers the eventual expansion into casualty lines and other areas of the reinsurance market as a natural forward evolution.

He concluded: “The ILS market will broaden and allow itself to get into new markets. Captive insurance is one of those sectors that could form a natural extension of the ILS market, particularly as it begins to explore risks beyond peak zone property catastrophe, such as casualty. MetroCat and other state deals already exist, so there’s no reason why large single-parent or group captives couldn’t emulate that. Eventually we will see it. There hasn’t been much headway yet, but at some point there will be a move forward.”

Craig Redcliffe is a partner in the financial services office of Ernst & Young Ltd. He can be contacted at: craig.redcliffe@bm.ey.com

The views expressed here are those of the author and do not necessarily reflect the views of EY.