RiskMarketNews: Several public “funds of last resort” have issued catastrophe bonds for the first time in 2012 in preperation for the hurricane season. For example, Louisiana Citizens Property Insurance and Florida’s Citizens Property Insurance Corp. What changed their minds?
William Dubinsky: Public entities and residual markets have accessed capital markets capacity over the years both directly and indirectly. Some of the pioneers were the Taiwanese Residential Earthquake Insurance Fund (TREIF) and the California Earthquake Authority (CEA). The steady pick up in interest is simply a sign of the maturity of the market.
Cat bonds have been around since the mid-nineties and are familiar to most ceding companies with large reinsurance programs exposed to peak perils. Public entities and residual pools are no exception. Brokers like Willis Re regularly integrate cat bonds and related solutions into the reinsurance programs for clients where it makes sense to do so.
When they look at risk management alternatives – including retaining everything – there are spots in the program where risk catastrophe bonds are possible by presenting the risks to a very liquid market in a transparent manner.
RMN: Several have noted that price as a main factor. Would you agree? What it the average price difference for an ILS structure vs. traditional reinsurance during the last renewal period?
Dubinsky: Price and terms are key in decisions for public entities and residual markets the same as for any ceding company. Cat bonds offer multi-year, fully collateralized fixed price coverage with a variety of indemnity and non-indemnity triggers. They do so with an alternative source of capacity that does not cannibalize existing traditional reinsurance capacity. Unlike cat bonds, traditional reinsurance usually offers a reinstatement, which is often less important for public entities and residual markets in comparison with private entities.
While it is very difficult to generalize on pricing, capital markets capacity is quite competitive for many large programs in the U.S. and Europe at the present time. The key is that brokers and clients focus less on the average price difference and more on the marginal difference, which adjusted for the other differences such as collateralization and multi-year capacity that I have already discussed.
To put it simply, the marginal cost — which is measured by rate-on-line for the same level of risk — of adding an additional $400 million to an already existing $750 million traditional program is often greater than the average price for the $750 million already placed.
As such, cat bonds may offer a lower marginal cost than the marginal cost for the additional $400 million if placed 100% in the traditional market. This is simply Economics 101. It is similar to brokers and clients structuring a program to tap into different pockets of traditional reinsurance capacity such as Bermuda, Europe, and Lloyds.
RMN: So, is there really a “hardening” reinsurance market?
Dubinsky: There has been a hardening market in two senses: The price for traditional reinsurance has changed while cat bond pricing spreads have gotten wider. So, they cancel each other out. The underlying economics have not change from six months to a year ago. Catastrophe bonds are a maturing product residual markets have been watching for a long time and have gained a certain amount of comfort.
RMN: How difficult has the education process been to involve more reluctant public funds?
Dubinsky: I think the approach to public entities and residual markets is really the same as what we see with private entities. It takes time to educate the clients but it also takes time to have enough knowledge in the broker community to see this as simply one of many tools available. Willis Re has brokers who simply look at cat bonds on a product neutral basis as one of the tools they use to build a successful program for clients. They use it where it makes sense given the client’s objectives.
RMN: Many public funds stick to transformer structures when issuing catastrophe bonds? Why?
Dubinsky: We need to be precise about what a transformer structure means. Technically, nearly all cat bonds to date have used a special purpose vehicle (SPV) to transform reinsurance risk to bonds. As an aside there is some talk about direct issuance without an SPV, but this seems unlikely in the near term.
From our perspective, the real question is whether a public entity or residual market uses a fronting reinsurer between it and the SPV. When people in the market speak of a transformer structure, we mean a deal with two transformers; the fronting reinsurer and the SPV. The North Carolina Joint Underwriting Association/North Carolina Insurance Underwriting Association, Fonden (Government of Mexico) , and the Massachusetts Property Insurance Underwriting Association used a fronting reinsurer as did the CEA for many years. On the other hand TREIF and the CEA in its most recent Embarcadero deal did not.
Having worked on many of both types of deals, I believe there are pros and cons for both approaches and you cannot take a “one size fits all” approach.
That said a first time sponsor of an indemnity trigger deal is usually better served by a transformer with a fronting reinsurer. It does not really cost much extra and simplifies the process. The simplification increases exponentially when you talk about a public entity or residual pool. Over time a direct deal may make sense for some sponsors who started out with the transformer with a fronting reinsurer. A direct deal slightly improves the legal structure if they are willing to do some additional work. The additional work is less of an issue on your fifth deal in comparison with your first.
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