S&P Reports on the ‘Evolving World of Property/Casualty Securitizations’

May 2, 2008

A report from Standard & Poor’s Ratings Services analyzes the catastrophe bond and reinsurance sidecar markets, which, S&P concludes, have “experienced sharp surges of activity after 2005.” However the “growth of these insurance-linked securities (ILS) has been slowing since the end of 2006.”

S&P said “much of the pullback is because of the lack of significant catastrophe experience and the ongoing softening of reinsurance and primary insurance pricing since that time.” As a result S&P indicated that 2008 issuance levels would probably be less than those in 2007.

However, as part of an overall risk management strategy ILS products are here to stay, according to panelist Shiv Kumar, a managing director at Goldman Sachs & Co., who recently spoke at S&P’s “Insurance-Linked Securities Conference: Current Trends and Future Prospects for ILS.”

According to S&P around “8 percent of global catastrophe limits are covered by catastrophe, or cat, bonds, and even though cat bond and sidecar issuance has slowed, the ILS market remains robust. More and more perils are being modeled, and if a peril can be modeled, it can be securitized. In addition, more perils mean more diversification.

“Right now, risk in everything from wildfire, winter storms, flood, tornadoes, earthquakes, aviation, orbital satellites, business interruptions, event cancellation, and offshore hurricane risk to worker’s compensation and mortality can and has been modeled and securitized.”

Peter Nakada, managing director of RMS Consulting and a panelist at the conference, noted that more primary insurers are issuing their own cat bonds rather than reinsuring their risk. Even new securitization structures, such as securitization of reinsurance recoverables and cat bonds that can mitigate money markets’ exposure to receivables risk, are growing. Also, the number of indemnity transactions (cat bonds written against an issuer’s own portfolio of risks) is growing.

Another panelist, Beat Holliger, managing director of Munich Re Capital Markets, explained that “once the Solvency II Directive framework for insurance regulation in Europe is in place–currently slated for launch in 2012–we should expect to see even more securitization structures emerge.”

On one subject S&P remains firm. In its opinion companies should steer clear of using ILS where terrorism risk is involved, “despite modeling firms’ contention that the risk can be modeled successfully.” Gary Martucci, a director with S&P’s North American Insurance Ratings Practice stated: “We won’t rate bonds where human actions could constitute a portion of the risk. Who can be comfortable with what a terrorist is capable of?”

A principal challenge in the ILS market, the conference’s panelists said, is educating investors so that they will be comfortable enough to invest in these new securitization structures. Cat bonds are typically rated in the speculative-grade ‘BB’ category, and so, “it’s all about understanding what the investor wants,” explained panelist Jonathan Spry, senior vice president of Guy Carpenter.

Effectively managing terms and conditions is also important. “If you can freeze terms and conditions for five years, it helps to manage the cycle over time,” Holliger indicated. Shelf programs–programs that enable the issuance of separate series and multiple perils by the same issuer–are one way to increase investor comfort with property/casualty (p/c) risk securitization.

Kumar noted that a number of companies are setting up shelf programs, which can enhance catastrophe mitigation management. “I want the cat (bond) and insurance markets to be competitive with each other,” he stated.

The main challenge cat bond issuers face is the lack of long-tail risks of 15-20 years duration. Currently, ILS for the p/c market focuses on short-tail risks of no more than five years. Holliger indicated that more work will have to happen on the modeling side to make longer-tailed instruments available.

S&P concluded however that it’s unlikely, “that catastrophe bonds will ever replace reinsurance, although they will remain a force for competition. The capacity offered by cat bonds is important, but reinsurance remains a viable alternative in the mitigation of financial risk. To a degree, the interplay between the two serves as an important check to keep pricing efficient and competitive.”

Source: Standard & Poor’s – www.standardandpoors.com

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