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BRAVE Partners LLP: Insurance Linked Securities – Cats and dogs 2009 Insurance Linked Securities: Cats and dogs BRAVE Partners Dr. No had a white cat. Hank Greenberg is reputed to have had a small white dog called Snowball. Of course there is no connection, but in the insurance securitisation market, it is interesting that the only P&C business that is securitised is property catastrophe, or cat, risk. A few other risks have been securitised, namely auto insurance and third party liability. These deals have turned out to be a dog for someone. XS loss property catastrophe Cats – that is cat bonds reinsurance has become a staple of XS loss property catastrophe reinsurance has become a staple of the the securitisation markets. The securitisation markets. The business line has a number of features business line has a number of that make it readily securitised. In particular: features that make it readily A clear limit so that the total loss is well defined. securitised. In particular: o This means that investors know exactly how much is A clear limit so that the total at risk. loss is well defined. A short risk period (1yr) and a short tail (3yr max). o This means that investors o Investors know their gains and losses and have their know exactly how much is investment returned quickly. Potential for high premiums for more risky tranches at risk. o A natural fit for high yield credit investors. A short risk period (1yr) and a short tail (3yr max). The cat bond has become a staple in the alternative (usually to o Investors know their gains credit) investment arena. and losses and have their investment returned In addition to property catastrophe there is a small, but well followed market in cat mortality bonds. These bonds lose principal if quickly. mortality rates exceed a certain index, or projection, by more than a Potential for high premiums defined percentage. For example, a tranche of a bond might lose for more risky tranches principal if the realised US mortality rates exceed the actuarial o A natural fit for high yield expectations by more than 15% - ie a mortality of 115% of the credit investors. actuarial rate. www.bravepartners.com | email@example.com Page 1 BRAVE Partners LLP: Insurance Linked Securities – Cats and dogs 2009 Whilst mortality rates under normal conditions are extremely stable in the short term, the impact of disruptions like the current swine ‘flu pandemic are difficult to predict. Dogs – that is non-cat securitisation Securitising other insurance risks has been done, but often the transactions have not worked effectively for one party or another. Golden Goal The one non-cat securitisation that stands out as a winner was the Golden Goal deal for FIFA which protected against event cancellations at the 2006 World Cup. That, of course, would be the World Cup to which other nations get invited (for the Americans in the readership). Motor (Auto) securitization Axa and our friends at CDC IXIS did put together an interesting securitization of a motor insurance book. The senior tranches were popular and worked well. The equity is reputed to have been retained within the sponsor’s group which meant that the sponsor could not obtain any regulatory capital relief. The thorny issue, which remains open, is that losses on the bond were defined in terms of the loss ratio of the underlying book of motor business. The loss ratio can increase The thorny issue, which remains for two reasons: i) claims increase or; ii) premiums are reduced. An open, is that losses on the bond equity investor in the structure is exposed to a price war between were defined in terms of the loss auto insurers. The transaction is not a clean insurance risk, it has ratio of the underlying book of elements of business risk which mean that it would work better in a motor business. The loss ratio can private equity environment where the investors are more familiar with, and willing to take, business risks. increase for two reasons: i) claims increase or; ii) premiums are At BRAVE Partners we believe that it is easy to be critical and much reduced. An equity investor in the tougher to pioneer. The firm applauds Axa and IXIS for the structure is exposed to a price war transaction which definitely set the standard in that space. Years between auto insurers. The after the deal, no one appears to have had a better idea. transaction is not a clean insurance Third party liability risk, it has elements of business risk Avalon Re was a cat bond sponsored by the OIL Casualty Insurance which mean that it would work Limited (OCIL). OCIL’s sister company OIL is Oil Insurance Limited. The better in a private equity two companies are captives for the energy industry – with OCIL environment where the investors writing the casualty, or liability, lines. are more familiar with, and willing to take, business risks. Avalon Re was a cat bond that was exposed to large claims at OCIL. The bond principal was at risk to an accumulation of events. An event was defined as something like a $150m OCIL insured loss. OCIL kept the risk of the first three events and then the bonds took the next losses; class C first; then class B; and finally class A. The following extracts from a Reuters report on S&P actions summarises the current status of Avalon Re: www.bravepartners.com | firstname.lastname@example.org Page 2 BRAVE Partners LLP: Insurance Linked Securities – Cats and dogs 2009 They were originally due to mature on June 6, 2008, but were extended after a July 2007 steam pipe explosion in New York pushed estimated losses to ceding insurer Oil Casualty Insurance Ltd (OCIL) close to the level that would trigger the bond. Under the terms of the reinsurance agreement between Avalon Re and Bermuda-based OCIL, which is rated BBB+ by S&P, the notes can be extended for up to eight consecutive three-month periods. S&P downgraded the Class C notes in April 2008 after receiving notification that the steam pipe explosion would be a covered event under the reinsurance agreement. "Given these loss amounts, the Class C notes will likely incur a principal loss. The Class B notes, given the current status of the claims, do not appear to be at risk of a loss in principal," S&P said. "However, there are currently two additional monitored claims, the first related to a spill at a Lake Charles oil refinery and the second to “I remember one of the credit claims involving exposure to lead paint." traders at my then current Lesson in cat bond investing employer proudly telling me how BRAVE Partner Christopher Cloke-Browne recalls: “I remember one of he has sniffed out this great bond; the credit traders at my then current employer proudly telling me Avalon Re. I listened to the outline how he has sniffed out this great bond; Avalon Re. I listened to the description, which is much the outline description, which is much the same as the one given here. same as the one given here. ‘Don’t ‘Don’t you think that a $150m loss in the global oil industry is a you think that a $150m loss in the reasonably common event?’ I asked him. I got a long description of global oil industry is a reasonably how it was not really like that and even if a rig blew up, it would not common event?’ I asked him. I got a necessarily trigger an event. My suspicions were confirmed later. At long description of how it was not the time, I was working on a deal with a broker who is highly familiar really like that and even if a rig with the OCIL program. When I mentioned that I had found a trader blew up, it would not necessarily who owned Avalon Re, he just shook my hand, looked me in the eye trigger an event. My suspicions and wished the trader luck.” were confirmed later. At the time, I BRAVE Partners suggest a simple rule for investing in cat bonds: do was working on a deal with a not underwrite without an experienced underwriter. Katrina and Ike broker who is highly familiar with have shown that even the risks of a property catastrophe XL loss the OCIL program. When I bond are not as straightforward as the models might suggest. mentioned that I had found a trader who owned Avalon Re, he just shook my hand, looked me in Opportunities the eye and wished the trader luck.” The credit crunch has created opportunities in the insurance risk asset class. AIG, Swiss Re and XL Capital are retrenching. The Christopher Cloke-Browne managements at several other public companies are trimming Managing Partner capacity in apparently riskier lines, especially where losses are BRAVE Partners LLP showing up. Certain markets appear to have rising demand and www.bravepartners.com | email@example.com Page 3 BRAVE Partners LLP: Insurance Linked Securities – Cats and dogs 2009 falling capacity. BRAVE Partners believes that these are the • Property catastrophe XS loss interesting markets reinsurance has become the staple of the cat bond market. BRAVE Partners’ experience • The characteristics of this Structuring a sidecar for casualty risks will take some creativity. business line make it a natural fit Casualty business is not such a natural fit for investors in capital, in for capital markets. particular credit, markets as is natural catastrophe XL loss. Pure • Attempts at securitising other insurance risks have been less casualty business: successful for both sponsor and Has no upper bound to a loss. investors. o Less certainty on the exposure level for a capital markets investor. • BRAVE Partners LLP can advise both investors and issuers on the Has a longer tail on the claims. The Avalon Re bond shows this optimal structures to transfer the as events are still being analysed to establish liability months risk of other insurance business after the bond maturity. lines to investors. o Harder to keep the bond to shorter maturities. • The BRAVE partners have a track Investors, as with Avalon Re, have to wait before their record of constructing innovative investment result is known. structures that work for both Has absolute premiums that have not been as high. issuer and investor. o Cat bonds could not achieve the target returns of high yield investors. firstname.lastname@example.org Market conditions are shifting. Returns in certain casualty lines are www.bravepartners.com looking attractive, even to high yield investors and even in stressed credit markets. The other issues are surmountable with some creativity. BRAVE Partners addressed many similar issues when structuring credit protection for the reinsurance recoverable of a respected Bermuda business. The issues and solutions are outlined in “Run off with the recoverables” which is also available from the website. BRAVE Partners services BRAVE Partners can assist both investors and issuers in identifying the best opportunities, underwriting teams and structures to assume insurance risks. Often these are not the standard structures of business lines, but if you stray off the fairway, then you need a good guide to keep you safe from the animals that lurk in the rough. www.bravepartners.com | email@example.com Page 4
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