18 March 2024ArticleAnalysis

Revolutionising risk transfer: the emergence of 144A cat bonds in captive

Marcus Schmalbach, chief executive of Ryskex, describes some of the latest developments in the captives industry, as previously niche tools have become more widespread.

Insurance-linked securities (ILS) represent a unique convergence between the insurance and capital markets, offering a mechanism to transfer insurance risks to investors. Originating in the mid-1990s, the ILS market has evolved from a niche concept into a vital risk management tool, addressing the growing need for innovative solutions in a world of complex, evolving risks. 

ILS instruments, predominantly in the form of catastrophe (cat) bonds, sidecars, and collateralised reinsurance agreements, enable insurers and reinsurers to distribute risks associated with natural disasters and other significant events to the capital markets. This risk transfer is not only crucial for mitigating potential financial impacts on insurance entities but also plays a significant role in stabilising insurance premiums and enhancing the resilience of the insurance sector against catastrophic events. 

The growth of the ILS market is attributed to several factors. First, it offers investors a chance to diversify their portfolios, as ILS returns are typically uncorrelated with broader financial market movements. Second, the increasing frequency and severity of natural disasters, partly due to climate change, have heightened the focus on robust risk transfer mechanisms. Last, advancements in modelling technologies have improved the understanding and quantification of insurance risks, making them more palatable to capital market participants.

The importance of 144A cat bonds

Within the ILS spectrum, rule 144A catastrophe bonds have emerged as a prominent instrument, allowing for a broader range of investors to participate in the insurance risk market. Rule 144A, a US Securities and Exchange Commission regulation, facilitates the resale of privately placed securities to qualified institutional buyers, thereby increasing liquidity and access to a wider investor base. 

The significance of 144A cat bonds lies in their structure and appeal. These bonds provide insurers and reinsurers with capital to cover losses from specified catastrophic events, with bondholders receiving attractive yields in exchange for assuming a portion of this risk. 

The specific conditions under which the capital is paid out are clearly defined, often based on the magnitude of the event (such as the Richter scale reading of an earthquake) or the total economic loss it incurs. 

The 144A cat bond market has seen exponential growth over the past decade. This surge is driven by the increasing sophistication of institutional investors, who are actively seeking alternative investment opportunities that offer yield premiums in a low-interest-rate environment. Moreover, the improved transparency and standardisation in cat bond structures have further bolstered investor confidence. This growth trajectory reflects a broader trend in risk management strategies, where traditional methods are increasingly complemented with capital market solutions. The appeal of 144A cat bonds is evident in their ability to provide insurers with cost-effective, collateralised risk transfer capacities, and investors with a diversified, non-correlated asset class, making them a cornerstone in the modern insurance and reinsurance landscape.

The evolution of parametric solutions in ILS

The insurance sector’s adoption of parametric solutions in ILS represents a significant shift toward efficiency and responsiveness. This transition, however, brings its unique set of challenges, most notably the management of basis risk. In this evolving landscape, artificial intelligence (AI) emerges as a crucial tool in refining these innovative financial instruments. Parametric catastrophe bonds are designed around specific triggers, such as earthquake magnitude or hurricane wind speed. Unlike traditional indemnity bonds, which rely on actual loss assessments, parametric bonds offer simplicity and rapid payout mechanisms based on objective, measurable criteria. This shift enhances transparency and expedites financial responses in the aftermath of disasters.

Parametric triggers have to be precise. This is where the crux of basis risk lies: the potential mismatch between the parametric trigger and the actual losses suffered. AI, with its advanced data analytics and predictive modelling capabilities, steps in as a game-changer in this domain. By leveraging vast datasets, AI algorithms can more accurately model and predict loss patterns, enabling the design of parametric triggers that more closely mirror actual risk exposures. 

AI’s role extends beyond the initial design of these instruments. It offers dynamic recalibration of triggers based on emerging data and risk patterns, ensuring that the parametric solutions remain relevant and effective over time. This continuous improvement mechanism is crucial in an environment where risk profiles are constantly altered by factors such as climate change and urban development. 

AI aids in expanding the scope of parametric ILS. It allows for the exploration and incorporation of non-traditional risk factors into the bond structures, thereby addressing coverage gaps in the traditional insurance market. For instance, AI can analyse complex variables contributing to flood risks in urban areas, enabling the creation of more comprehensive flood-related parametric bonds. 

Incorporating AI into the parametric ILS framework does more than just mitigate basis risk—it propels these financial instruments towards greater precision and relevance. As insurers and investors navigate the complexities of modern risk landscapes, AI stands as a beacon of innovation, driving the evolution of ILS towards a future where risk transfer is not only efficient but also intricately aligned with the nuanced realities of risk.

Case study 1: The Beazley and Lloyd’s London Bridge 2 deal

The Beazley and Lloyd’s London Bridge 2 deal represents a pioneering step in the ILS market. This transaction, brokered by Aon, introduced a 144A excess of loss catastrophe bond worth $100 million. This bond is specifically designed to provide multi-year protection against named storm and earthquake events in the US, Canada, and parts of the Caribbean. It was issued through the London Bridge 2 protected cell company investment structure of Lloyd’s of London, marking a significant moment for both Beazley and Lloyd’s. The bond benefits Beazley’s Lloyd’s syndicates 623, 2623, and 3623, along with its North American and European operations.

Significance in the ILS market

The Beazley and Lloyd’s deal is a milestone in the ILS market for several reasons. First, it’s the first 144A property catastrophe bond to utilise the London Bridge platform, demonstrating the platform’s efficiency and appeal in the ILS landscape. Second, the successful issuance of this bond underscores the UK market’s, particularly Lloyd’s, growing capacity to attract institutional investors and facilitate sophisticated risk transformation vehicles. 

The deal is testament to the market’s adaptability and innovation, confirming that London remains a central hub for global re/insurance risk management. The transaction’s smooth execution speaks volumes about the evolving sophistication in structuring and marketing catastrophe bonds, contributing to a more dynamic and resilient ILS market.

This case highlights the expanding capabilities of the London insurance market and sets a precedent for future transactions, potentially leading to more diverse and innovative risk transfer solutions within the ILS space.

Case study 2: Swiss Re’s first industry loss cyber cat bond

Swiss Re has achieved a significant milestone in the ILS market by successfully issuing the first industry loss-triggered cyber catastrophe bond. This groundbreaking deal involved a $50 million tranche of Series 2023-1 notes, known as class CYB-A notes, under the Matterhorn Re banner. 

The bond is designed to provide retrocessional reinsurance against systemic cyber loss events affecting the US. It’s a pioneering venture being the first of its kind to utilise an industry loss index trigger, focusing specifically on cyber industry insured losses in the US.

Significance in the ILS market

This transaction is a significant advancement for the ILS market, particularly in the burgeoning field of cyber risk. The use of an industry loss trigger, rather than traditional indemnity coverage, represents a novel approach in managing cyber risks. It demonstrates the market’s acceptance of innovative structures in catastrophe bonds and highlights the growing sophistication and diversity of risks that can be covered through ILS.

Swiss Re’s deal is indicative of the evolving nature of ILS, where complex and emerging risks such as cyber threats are increasingly being transferred to the capital markets. This development provides reinsurers such as Swiss Re with new avenues for risk management and opens up opportunities for investors seeking non-traditional, non-correlated assets. 

The successful issuance and pricing of this bond signal investor confidence and interest in cyber risk, a domain that is becoming increasingly relevant in today’s digital world. In summary, Swiss Re’s industry loss cyber cat bond is a landmark transaction, expanding the horizons of ILS and showcasing the market’s capability to adapt and cover contemporary risks such as cyber threats.

Case study 3: Innovative cyber risk transfer by Aon

In a recent groundbreaking move, Aon has demonstrated its leading position in the ILS market by facilitating a novel cyber ILS solution for Andersen, a large European corporate. This initiative, revealed by Aon president Eric Andersen during the company’s fourth quarter and full year 2023 earnings call, marks a significant milestone in the evolution of cyber risk management. Aon leveraged the structure it had previously developed for the first 144A cyber catastrophe bond, repurposing it to cater to Andersen’s unique needs. 

This transaction showcases Aon’s innovative approach to risk transfer as well as its ability to harness its comprehensive suite of capabilities—combining technical expertise, human capital, and structuring skills—to create bespoke solutions across different segments of its business.

The cyber ILS solution provided Andersen with an unprecedented level of coverage, addressing the significant challenge of obtaining sufficient limits for traditional cyber programmes in the current market environment. By taking systemic cyber risk and transferring it to the capital markets, Aon facilitated a mechanism that allows insurers to enhance their limit offerings and ensures that such systemic risks are valued and placed appropriately within the right capital sources. 

This transaction underscores the increasing connectivity between commercial risk, reinsurance, and risk capital markets. Aon’s ability to use its expertise across insurance and reinsurance domains to deliver such innovative solutions highlights the firm’s role in driving the integration of risk capital frameworks. 

The cyber catastrophe bond structuring experience provided Aon with invaluable insights, which were then applied to enhance its risk analytics offerings, including the Cyber Quotient Evaluation product. This product, tailored for the middle-market segment, illustrates how data and analytics can drive growth in reinsurance and in commercial risk segments.

The success of this cyber ILS placement for Andersen by Aon through its investment banking arm Aon Securities, acting as the sole structuring agent and bookrunner for the Axis Capital’s Long Walk Reinsurance (Series 2024-1) cyber catastrophe bond, represents a pioneering step forward in the cyber risk transfer domain. It reflects the dynamic nature of the ILS market and its potential to expand into new risk areas, offering innovative solutions for complex challenges faced by corporates and insurers alike.

Benefits for the captive insurance industry

The evolution of ILS, particularly the growing prominence of parametric solutions and innovative deals like the Beazley and Lloyd’s London Bridge 2 and Swiss Re’s industry-loss cyber cat bond, holds significant implications for the captive insurance industry. Captive insurers, which are insurance companies established by a parent firm for the purpose of insuring its own risks, stand to benefit greatly from these developments. 

The integration of ILS solutions, including parametric triggers and cyber risk coverage, provides captives with more diverse and sophisticated tools for risk management. This diversification is crucial, especially in managing risks that are difficult to insure traditionally. 

The Beazley and Lloyd’s deal and Swiss Re’s cyber cat bond demonstrate the expanding capabilities and appetite of the ILS market for covering a broader range of risks. This expansion is a positive signal for captives, which often deal with specific, sometimes unconventional risk profiles. The ability to transfer these risks to the capital markets via ILS enhances their risk management and potentially improves their financial efficiency and resilience.

In conclusion, the advancements in the ILS market, as exemplified by these case studies, provide the captive insurance industry with innovative tools to navigate an increasingly complex risk landscape, offering a path to more robust and flexible risk financing solutions.

Conclusions and outlook 

On the future outlook for the ILS market, we expect a trajectory marked by innovative growth and diversification. The strides made in parametric solutions and the inclusion of complex risks such as cyber threats illustrate the market’s dynamic adaptability. This evolution is not just a response to current demands but a proactive step towards addressing future challenges and opportunities in risk management.

The integration of advanced technologies such as AI in refining risk assessment and bond structuring, points to a future where ILS solutions are more precise and effective. This technological edge will be crucial in managing the ever-evolving nature of risks, especially in sectors like the captive insurance industry, which often confronts unique and nuanced risk profiles.

Moreover, the successful ventures of Beazley and Lloyd’s, along with Swiss Re’s pioneering cyber cat bond, set a precedent for other players in the insurance and reinsurance market to explore and embrace the ILS mechanism. This trend indicates a broadening scope of ILS, potentially leading to a more resilient global insurance landscape that is capable of absorbing shocks from various emerging risks.

In summary, the ILS market is poised for a future characterised by innovation, expansion, and a greater alignment with global risk management needs, promising enhanced stability and efficiency for insurers, reinsurers, and investors alike.

Marcus Schmalbach is the chief executive of Ryskex. He can be contacted at:

Did you get value from this story?  Sign up to our free daily newsletters and get stories like this sent straight to your inbox.