In this section, we discuss three types of ILSFootnote 8 instruments provided by the capital markets: industry loss warranties (ILWs), catastrophe bonds, and sidecars. The first two are similar to excess-of-loss reinsurance, while sidecars are more often quota-share-like coverage and hence are similar to proportional reinsurance.

Industry loss warranties

The first ILWs were issued in the 1980s to cover airline industry losses and they were developed in the property and casualty insurance industry in the aftermath of major natural disasters that occurred in the past 15 years. As the name indicates, an ILW (also known as original loss warranty) is a financial instrument designed to protect insurers and reinsurers from severe losses due to extreme events such as natural disasters. The ILW market today focuses almost exclusively on catastrophic risks, and has increased significantly after Hurricanes Katrina, Wilma, and Rita in the Gulf of Mexico.

ILWs operate as follows: The buyer who wants to hedge his risk pays the seller a premium at the inception of the contract. In return, the buyer can make a claim in the event of a major industry loss – hence the name. The payout of an ILW can be structured in a simplified way such that the buyer can make a claim equal to the limit of the ILW if a pre-defined industry loss index (IL) exceeds a threshold known as the trigger (T) for a particular state/region, regardless of the buyer's actual amount of incurred loss.Footnote 9

For example, the buyer of a $200 million limit U.S. Wind ILW in Florida in 2008 attaching at $20 billion will pay a premium to a protection writer (generally a reinsurer) and in return will receive $200 million if total losses to the insurance industry from a single U.S. hurricane in Florida in 2008 exceeds $20 billion.

In this sense, ILWs are similar to excess-of-loss reinsurance but where the insurer now has some basis risk: the covered loss of the insured's book of business does not necessarily correlate perfectly with the amount of claim collectable from the index-based contracts.Footnote 10 ILWs might thus be more attractive for single state insurers/reinsurers or companies with a higher concentration of business in a limited number of locations, thus enabling them to take on larger books of business in their primary area of operation.

The estimation of the industry losses is then critical. In the U.S., the Insurance Services Office's property claims services (PCS) index is often used as the reference for estimating these losses. In Europe, however, there is no centralized structure that estimates industry losses. Recently, there have been calls to create such a European organization in order to provide both hedgers and investors with more clarity, and then foster this market.

Note here that as an ILW is very similar to a non-indemnity cat bond, it presents the same basis risk issues (see below). To date, most of ILW buyers have been large companies who see these instruments as another way to spread their exposure. For those that write a large portion of market share, the basis risk might be reduced as well, because their losses are likely to be representative of the industry losses in the aftermath of a major natural disaster.

One of the main advantages of ILWs is that they involve relatively low transaction costs for both the buyers (insurers or reinsurers) and sellers (e.g., hedge funds). The sellers do not have to evaluate the expected loss to the (re)-insured portfolio of a specific company from the trigger event, only the exceedance probability curve of the entire industry (that typically reduces the uncertainty, thus the cost associated with a higher level of volatility).

In April 2006, Lane Financial published an analysis of the evolution of ILW premiums between 2005 (pre-Katrina), January 1, 2006, and April 1, 2006, and that for different trigger levels (from $5 billion up to $50 billion insurance industry losses) and different types of risk (wind in Florida, wind nationwide, earthquake in California). The study is based on information contained from specialist dealers over the last 5 years. Although this information is not exhaustive, we feel Table 2 provides a reasonably accurate picture of the nature of those changes.Footnote 11

Table 2 Evolution of ILW premiums compared to pre-Katrina 2005 (2005–2006) Full size table

As the table indicates, for a $5 billion trigger, estimated prices increased by 54 percent, and for a $50 billion trigger, by 113 percent due to a major hurricane in Florida, compared with prices prior to Katrina. Despite this increase, the market has grown significantly in the aftermath of Katrina, which indicates a strong appetite from insurers and reinsurers for access to other sources of capital than traditional reinsurance or retrocession. It is estimated that nearly $4 billion in ILWs were issued between September 2005 and September 2006.Footnote 12 As most of these transactions were done from company to company, though, it is difficult to precisely know the aggregate volume and prices.

Catastrophe bonds (“Cat Bonds”)

Catastrophe bonds, in a similar manner to ILWs, enable an insurer or reinsurer to access funds if a severe disaster produces large-scale damage. Cat bonds typically cover narrowly defined risks on an excess-of-loss basis. They are issued in the form of debt with high coupons.

How does this work? Consider an insurer or reinsurer, SafeCompany, that would like to cover part of its exposure against catastrophic losses. In order to do so, it creates a new company, BigCat, whose only purpose is to cover SafeCompany and not any other company. In that sense, BigCat is a single purpose reinsurer (also called “special purpose vehicle, SPV”). When the reinsurance contract is signed, the sponsor (SafeCompany) pays premiums to BigCat. On the other side, investors place their funds with the SPV BigCat; these funds constitute the initial principal for the bond to be issued by BigCat. Reinsurance premiums collected from SafeCompany will be used to provide the investors with a high enough interest rate to compensate for a possible loss should a disaster occur.

What happens next? If the losses exceed a pre-specified trigger, then the interest on the bond, the principal, or both, are forgiven depending on the specifications of the issued catastrophe bond. These funds are then provided to SafeCompany to help cover its claims from the event. In addition to the interest rate on the cat bond, there are at least four other components for the investor to consider: the protection of the principal, the nature of the trigger, the size of the bond, and the maturity of the bond. We explain each of them now.

Protection of the principal: The principal of a catastrophe bond often consists of different tranches, some of which might or might not be protected. A protected tranche guarantees that the investor will receive the principal from this tranche when the bond matures. For this tranche, if a covered event occurs, the SPV stops paying interest and can extend the maturity of the loan for several years. An unprotected tranche has both principal and interest at risk should a covered event occur.Footnote 13

Trigger: the nature of the trigger varies from one bond to another. The trigger can be indemnity-based, meaning that the transaction is based on the actual losses of the sponsor. This eliminates the basis risk for the sponsor, but also reduces the transparency of the transaction for the investors. The trigger can also be based on industry losses using a predetermined industry index of losses (e.g., the index is calculated by the PCS in the United States). The trigger can also be determined by a parametric index, such as an earthquake of magnitude 7 or greater on the Richter scale occurring in the San Francisco Bay area or a Category 4 hurricane in Florida. A parametric trigger provides transparency for the investors, but sponsors may have significant basis risk (see the discussion on basis risk above for ILWs).

Size of the bond: The size of the issued bonds has increased over time. For example, of the five bonds that were issued in 1997, only one had capitalization higher than $200 million; in 2000 there were two such bonds; and in 2005 there were four (out of a total of 10). Likewise, there were two bonds with capital lower than $50 million in 1997 (out of a total of five), but none of the 43 new bonds issued between 2003 and 2006 had a capital lower than $50 million.Footnote 14 The transaction costs associated with the complex execution of these instruments (compared to traditional reinsurance) contributes to this trend toward larger bonds.

Maturity of the bond, or how to stabilize insurance and reinsurance prices: The maturity of a bond is the period during which the SPV will cover SafeCompany. One advantage of cat bonds over traditional 1-year reinsurance contracts is that they can typically offer longer term coverage: 1–5 years. Over time, the proportion of cat bonds with longer maturity has increased, an indication that these instruments are gaining trust within the reinsurance/finance community. Table 3 describes the maturity of cat bonds that were issued between 1997 and 2006. The average maturity is about 3 years, with some cat bonds having only a one-year maturity and others having 5 years or more. In a context of highly volatile reinsurance prices that often occurred after large catastrophes, cat bonds offer an important element of stability for insurers by guaranteeing a pre-defined price over several years as far as the entire capital of the bond is not triggered (in which case a new bond has to be issued under price conditions that are likely to differ). We believe that this price-stability aspect has been largely undervalued so far.

Table 3 Maturity of cat bonds issued between 1997 and 2006 Full size table

With many firms complaining about catastrophe insurance price increase in the aftermath of the 2005 hurricane season, and with pressure from rating agencies for better catastrophe exposure management, the price stability offered by cat bonds with multi-year maturity might be a critical element for insurance companies and other issuers as well. Indeed, the sponsor of a cat bond does not have to be an insurer. For instance, Vivendi Universal (Universal Studios) issued in 2002 a $175 million bond, Studio Re, to cover its production studios against an earthquake in Southern California. Walt Disney also issued a bond to cover its large park in Japan. The first European corporate bond was issued in 2003 by EDF, the French electrical company; this $230 million bond, Pylon, covers the company against windstorm in France. In 2006, another corporate sponsor went with coverage by cat bond: Dominion Resources, an energy producer, obtained protection for oil-drilling assets located off the coasts of Louisiana and Texas by issuing a $50 million bond, Drewcat.

Bonds do not have to cover only natural disasters, nor are they issued only to protect a commercial enterprise. For example, the first bond that insured against terrorism was issued in Europe in August 2003. The world governing body of football (soccer), the International Federation of Association Football, which organized the 2006 World Cup in Germany, developed a $262 million bond to protect its investment. Under very specific conditions, the catastrophic bond covered losses resulting from both natural and terrorist extreme events that would have resulted in the cancellation of the World Cup final game without the possibility of it being re-scheduled to 2007.Footnote 15 Moreover, the government of Mexico, which through its FONDEN facility sponsored the $160 million CAT-Mex transaction in May 2006, was the first government to issue a cat bond. Whether more companies, trade associations and state and federal governments, working in collaboration with experts in the field, will diversify their coverage through ILS shall be a key factor of development for these instruments.

The maturity of cat bonds leads to an important distinction between issued bonds and outstanding bonds. Consider the following example: if a $200 million bond is issued on January 1, 2007, for 1 year, then the 2007 risk capital issuance is $200 million and the capital outstanding is also $200 million. Imagine now that this bond is issued for 5 years: the maturity of the bond is thus December 31, 2011. For 2007, the capital issued is $200 million, but for the next 4 years, the capital issued is $0. As the bond is outstanding for 5 years, each year between 2007 and 2011 the amount of capital outstanding is $200 million (if the bond has not been triggered in the meantime). In other words, issuance tells us about new deals, while outstanding capital tells us about present and past issuances.

Cat bonds have been in the market for about 10 years now, which enables one to make some comparisons as to the evolution of issuances and capital outstanding. At the end of 2004, there was nearly $4 billion in cat bond principal outstanding (including $1.14 billion of new issuances that year). At the end of 2005, outstanding risk capital grew to nearly $5 billion with nearly $2.1 billion of that issued. At the end of 2006, outstanding risk capital continued to significantly grow to $8.5 billion with nearly $4.7 billion of that being issued.

Figure 1 illustrates the evolution of risk capital issued and outstanding, and the number of bonds issued between 1997 and December 2006.Footnote 16 The market recorded a total issuance of over $4.7 billion in 2006 (20 new issuances, two times more than in 2005), a 125 percent increase over the $2.1 billion in 2005. This is a new record high, a 75 percent increase over the $1.14 billion issued in 2004, and a 20 percent increase over the $1.73 billion issuance in 2003 (the previous record). In that sense, 2005 and 2006 were a real trigger: the risk capital issued over these 2 years was equal to what had been issued over the preceding 5 years. Bonds outstanding increased significantly as well, which reflects the issuance of multi-year bonds in previous years.Footnote 17

Figure 1 Catastrophe bonds: Capital risk issued and outstanding 1997–2006 (in $ billion).Sources: Data from Swiss Re capital markets, Goldman Sachs and Guy Carpenter. Full size image

As this article is being written, the U.S. company State Farm has issued a “jumbo” cat bond: a $1.2 billion risk capital bond which is the largest cat bond ever issued. The bond is innovative in that it is cumulative: the company covers its portfolio in the case of cumulative losses due to a series of pre-defined events (hurricanes in the U.S., earthquake in Japan, among others) over the 3-year maturity of the bond.

Sidecars

A phenomenon of the post-Katrina market environment has been the development of the so-called “sidecars.” A sidecar is a special purpose company that provides reinsurance coverage exclusively to its sponsor (a reinsurer or a large insurer) by issuing securities to investors. The company that offers the sidecar has to be licensed as a reinsurer. Unlike ILWs or cat bonds that generally provide excess-of-loss reinsurance, sidecars are often based on quota-share reinsurance. The sidecar company shares the risks of certain insurance/reinsurance policies with the underwriter in exchange for a portion of the premiums (generally up to 50 percent) and dividends in shares. Figure 2 shows a simplified diagram to illustrate the stakeholders that are involved in a sidecar.

Figure 2 Operation of a sidecar.Source: Goldman Sachs. Full size image

Like cat bonds, sidecars are complex financial transactions. They typically require a larger investment (in the $200–300 million range, although there have been several sidecars with investment lower than $100 million) than cat bonds and are of a shorter duration. A sidecar company is designed to last 2 years or less, and then self-liquidates or renews, depending on market conditions. As we discussed above, cat bonds would typically cover a longer period of time. Another difference is that cat bonds are typically designed to hedge low probability/high severity events whereas sidecars (see below) allow investors to take a slice of the whole business of a reinsurance program in quota-share, which might translate into higher expected loss but also higher returns over a shorter period of time in case of a sidecar. Between November 2005 and July 2006, over $3 billion of hedge fund money has been invested into sidecars that cover natural disasters in North America. Figure 3, compiled by Goldman Sachs, indicates the name, capital and sponsor of each of the 10 sidecar companies that were created over that period of time (four in 2005, six in the first two 2006 quarters).

Figure 3 Reinsurer sidecars to cover against natural disasters in North America ($ million) – Reaction to 2005 Hurricane season: November 2005 and July 2006.Source: Goldman Sachs. Full size image

While all these sidecars were sponsored by reinsurance companies, in August of this year, Lexington Insurance Company, a member of AIG, set up its own sidecar, Concord Re, to reinsure business on a quota share basis. This is the first-ever sidecar structured for a primary insurance company. Concord Re is capitalized with $730 million from equity securities issued by Concord Re's parent holding company, Concord Re Holdings. Looking back at the year 2006 as a whole, a total of 14 sidecar transactions were completed, providing $3.55 billion of capacity.Footnote 18

To sum sup, the 2005 hurricane season has led insurers and reinsurers, along with some other issuers, to use alternative risk transfer instruments at an unprecedented level. How does the future of these markets look like? If reinsurance premiums stay high, many of the sidecars will likely renew. If the market becomes softer due to lower than average catastrophic losses, or if industry losses are so extreme that they trigger payments from sidecars and cat bonds, investors' interest in these ILWs instruments might slacken.

Capital market solutions, such as sidecar reinsurance structures do provide value, but they do not necessarily provide a cheaper alternative compared to traditional reinsurance. Sidecars are similar to cat bonds, but have key differences. Purchasers of cat bonds usually must take the product “as is” without any creative or discretionary insight into the product's formation. Further, cat bonds are typically pegged to a specific catastrophic event. Unlike cat bonds, sidecar investors can leverage their position and negotiate the product. Certain portions of the reinsurer's book of business will be targeted to maximize potential profits. Sidecars attract opportunistic capital, and usually exist for 2–3 years. Investors have flexibility to exit the market if prices decline. Despite sidecars' ability to attract private capital and increase reinsurance capacity, they fail to suppress rates because the price of risk remains high. The cost of risk will be passed down to consumers.

As we summarize this section, one important element we shall highlight here is that Hurricane Katrina swamped KampRe, a $190 million catastrophe bond arranged by Swiss Re for Zurich. It was the first cat bond issued to totally call in investor funds.Footnote 19 The 2005 hurricane season also wiped out a $650 million sidecar, Olympus Re, arranged in 2001 by White Mountain Insurance.Footnote 20 These two events might actually have had a good impact on the market. First, these losses did not stop investments in those new instruments. Investors who bet against the odds of another devastating Atlantic hurricane season now stand to cash in on them, as, contrary to expert predictions, the season turned out to be the mildest in years. Second, these were the first ILS to pay something back to their sponsors, which might make these instruments more “real” from a financial protection perspective. Indeed, companies might be tempted to seriously limit, or even cancel, their insurance coverage if they have been paying a policy for 5 or 7 years without getting anything back from their insurance company because none of their losses exceed her deductible. Likewise, the fact that cat bonds had never paid anything 9 years after their inception might have been a limiting factor to their development.

Despite recent very encouraging movements and increased traded volume, one shall consider how to increase this market more radically. Over the past 10 years, ILS market activities have been mainly a response to one element: the occurrence of major catastrophes followed by significant increases in reinsurance price, creating the need to gain access to less expensive financial protection and diversification. If this continues to be the case, we shall witness a regular but moderate expansion; that expansion will only be driven by future catastrophes. As we discussed in the first section, we think these will occur at an accelerated rhythm in the coming 5–10 years. It is very unlikely, however, that such development will be sufficient to generate a large and liquid market if it is only based on a reaction to catastrophes that just occurred. In order to think creatively as to how to enhance the ILS markets for extreme events, the comparison with the great development of other financial products over the same past 10 years is worth making. We now turn to two of them: credit and weather derivatives.