Originally published in Euromoney Yearbooks International Reinsurance Review 2007/08.

The year 2006 was a record year for insurance/reinsurance linked securitisation ('ILS'). With a hard market for US catastrophe cover following on the heels of Hurricanes Katrina, Rita and Wilma, a wave of hedge fund and private equity fund capital poured into ILS transactions. According to industry reports, there were approximately US$4.7bn of new catastrophe bond issuances in 2006, surpassing the prior year's total by over US$2.5bn. Sidecars were further established as a viable catastrophe risk transfer tool in 2006, accounting for an estimated US$3.8bn of capital, a 45% increase from 2005. While there is no recognised source to track industry loss warranty ('ILW') transactions, ILWs cover billions in catastrophe exposure and transaction volume is growing. Reflecting broader awareness and confidence in ILS, issuers during the past year included several first time participants. ILS issuers and investors alike had plenty of reason to celebrate - as a result of attractive pricing opportunities and the mild 2006 storm season, they realised extraordinary profits. We examine below some of the recent advances in the ILS market as well as industry developments we expect to impact the market in 2007 and beyond.

Innovation and Expansion

The evolution of and innovation in the ILS market continues its rapid pace, with improved efficiency and transparency inspiring further confidence in the use of capital markets as a legitimate and effective alternative risk transfer mechanism. The attractive yields produced by ILS products compared to traditional asset backed securities, as well as the diversification they offer investors due to their weak correlation to traditional financial instruments, have contributed to their increasing appeal.

A sampling of recent transactions demonstrates that ILS solutions come in different forms and are employed in various lines of business. For example, while most sidecars assume reinsurance risk, the recently formed Concord Re and MaRI sidecars reinsure a portion of the direct commercial property business of AIG (Lexington Insurance) and ACE, respectively. Unlike many sidecars which focus on US property catastrophe risk, some recent sidecars, including Petrel Re (sponsored by Validus Re) and Sirocco Re (sponsored by Lancashire Holdings), reinsure marine and offshore energy risk. Kepler Re, a sidecar sponsored by Hannover Re, is one of the loan-based sidecars that have recently come to market, representing a variation from the more common equity-debt sidecar composition.

Outside of the sidecar realm, Aspen Insurance Group completed a novel reinsurance receivable protection transaction to guard against the financial default of its retrocessionaires. There have also been transactions which represent a departure from the conventional low frequency/high severity business that is usually securitised — witness AXA's multiple securitisations of motor insurance risk. Collateralised debt obligations ('CDOs') have recently been introduced to the ILS arena; Gamut Reinsurance Ltd., the first managed CDO of catastrophe risk, was created using a combination of catastrophe bond and CDO technology. CAT-Mex Ltd., a recent catastrophe bond transaction supporting a reinsurance agreement issued to The Fund for Natural Disasters, a Mexican government fund, was the first ILS transaction by a government entity to provide relief funds in the event of catastrophic loss.

In the life insurance/reinsurance sector; substantial growth continues in an array of products, including Triple X securitisations, which are designed to allow insurers to free up sizable 'redundant' reserves established to satisfy unrealistically high regulatory reserve requirements for term life policies, and extreme mortality bonds (Swiss Re sponsored Vita Capital Ltd. is one such example), which protect against exposure to dramatic increases in mortality following a pandemic, such as avian flu. Other recent developments in the ILS space include the emergence of catastrophe options.

Both the New York and Chicago Mercantile Exchanges recently launched catastrophe-related options and futures, providing vehicles for investors to trade and hedge their catastrophe exposures. Each of these developments should further enhance market transparency and secondary trading activity, thus making ILS products more marketable to an increasing pool of capital markets investors.

Unprecedented Legislation

In property catastrophe reinsurance circles, one powerful force — politics — pushed aside another — Mother Nature - as the big story this year In a special session held early this year; the Florida state legislature adopted an unprecedented piece of legislation, the Hurricane Preparedness and Insurance Act and related regulations (the 'Act'). Prior to the Act, Citizens Property Insurance Corporation ('Citizens') had served as the state controlled homeowners' insurer of last resort. The Act, among other things, rolls back rate increases and relaxes surplus requirements for Citizens (previously, Citizens was required to have the highest rates in the market and be adequately funded to cover a I -in-100 year hurricane). Thus, the Act allows Citizens not only to compete with, but to effectively undercut, private insurers by setting rates well below market. In an effort to keep private insurers from abandoning the state because of an inability to compete with Citizens, the Act also materially expands the capacity provided by the Florida Hurricane Catastrophe Fund ('FHCF'), the state-funded reinsurer, from an aggregate limit of US$16bn to US$28bn, and highly subsidises its pricing structure.

By making available US$l2bn of subsidised reinsurance, the Act, at least in the short term, is expected to reduce the flow of those ILS transactions built around private reinsurance of US southeast wind risk as the sole or primary exposure. Although there were early projections of a decrease in private market reinsurance premiums ranging between one and two billion dollars, recent reports suggest the impact may not be so drastic.

‘Pray Now, Pay Later’

The Act was born out of the campaign promise of Florida's Governor Crist and other newly elected state officials to reduce homeowners' property insurance rates - no matter what. It is thus a prime example of political pandering prevailing over fundamental economic principles. While this short term political fix artificially controls rising insurance costs for some homeowners, over the long term, it will almost certainly exacerbate the problems underlying Florida's insurance system.

The Act materially expands FHCF's exposure without providing commensurate increases to FHCF's premium rates and surplus, thus leaving FHCF's capitalisation inadequate to support its exposure. How then will the FHCF pay claims that result from a catastrophic storm? It is really quite simple —'play now, pay later' (or, as others have perhaps more aptly put it, 'pray now, pay later'). Specifically, the FHCF will be forced to rely on postevent bond issuances to meet its obligations. This strategy of course, turns the fundamental risk spreading concepts of insurance and reinsurance topsy-turvy. Insurers and reinsurers in the private market price policies and contracts at a level designed to meet expected losses and expenses and to enjoy a profit (whether on a pure underwriting basis or after taking investment income into account). They must also maintain an appropriate surplus to safeguard solvency in the event of unexpected frequency or severity of losses.

Even before the Act, the FHCF depended in part on post-event assessments but it did so on a much more modest basis. Post-Act, the sheer magnitude of the financing that will be required following a major hurricane is disconcerting (indeed, A.M. Best has increased its credit risk factor on FHCF recoverables and Fitch has downgraded its rating for existing FHCF bonds). Should a major hurricane, or even a series of modest storms, strike Florida this year, the FHCF would likely be required to cover as much as US$26bn of its US$28bn claims paying capacity for 2007 through post-event bond issuances.To put this in perspective, such an offering would exceed by billions the largest municipal bond offerings to date. Potentially prohibitive interest rate spreads and other strains on the market that might be expected to follow a major hurricane have left many profoundly concerned about the execution risk that would be associated with that financing.

If a major storm or series of smaller storms strikes, those billions in bonds needed to pay claims would be repaid by special assessments on Florida taxpayers to the tune of thousands of dollars per household. According to a study conducted by Tillinghast, the assessments would likely dwarf the incremental premium savings that the average policyholder is expected to receive as a result: of the Act. The irony is painful. For short-term political advantage, Florida's legislature has taken insurance risk from the worldwide reinsurance market and placed it squarely on the backs of the very taxpayers it purported to help. What's worse, those living outside the state's highest risk zones would be effectively subsidising those living on the coast (because the wealthiest individuals tend to live in the coastal areas, the Act will have the perverse impact of transferring wealth from the poor to the rich). According to the Tillinghast study, in the event of a major hurricane, Tallahassee households would incur assessments of up to 100 times their average premium savings while assessments on Orlando households would approach 70 times the average premium savings.

Thus, when the next big storm hits, Florida legislators will likely be holding their collective breath. State representative Don Brown summed it up well when he said that the Art was "more a scheme than it was a solution," and that while "the government can out-compete the private sector; it won't succeed because when the bill comes due, guess who has to pay for it."

Unfortunately, the Act may be tested sooner than later. The return period (the expected number of years between storms in a specific location) is nine years for a Category 3 hurricane in Miami Dade County. We're overdue: The last major hurricane to hit Miami was Andrew, I5 years ago. A storm with the force of Katrina that hits Miami would produce estimated insured losses of US$I00bn. Such a storm, or a series of smaller storms, such as the hurricanes of 2004, could wipe out Citizens and the FHCF. What happens then? Many proponents of the Act, perhaps relying on Florida's large number of electoral votes and its influential swing state status, assume that a federal bailout would be forthcoming. Such an expectation creates a dangerous and societally expensive moral hazard, reminiscent of the rebuilding of houses in the Mississippi River flood basin, which inevitably follows the federal bailouts which inevitably follow the inevitable flooding of the Mississippi River.

The Act makes available below market insurance and reinsurance which, in turn, promotes the continuation of frenzied land development in the state's highest risk zones. Florida already has upwards of US$2 trillion of total insured value along its coast, and that number continues to rise. By socialising its insurance system, Florida has not only shifted the cost of the next big storm from the worldwide private markets to its own taxpayers, but it has also made the price tag for that storm much higher than it would have been absent artificial rate suppression.This unhealthy situation is further compounded by the fact that more and more private insurers, including some of the state's largest, are significantly reducing their Florida portfolio of policies because they are unable to compete with Citizens, the cheap reinsurance available through the FHCF notwithstanding.This means Citizens and the FHLF have been transformed into the insurer and reinsurer of first choice rather than last resort, and are assuming ever-increasing exposure levels.The increase in Citizens' total loss exposure has been breathtaking - it has doubled from US$220bn as of December 2005 to US$452bn today in 2007.

Incentivising private markets to provide increased capacity should be a key component of any long-term solution to cover natural catastrophe exposure.Very recent history demonstrates that private markets have responded to catastrophes with minimal market disruption. Indeed, one need look no further than the fact that nearly half of the US$60bn of insured losses caused by Katrina, Rita and Wilma were absorbed by private reinsurers. Regulators on the state and federal level should examine and consider reducing regulatory, tax and legal barriers in aid of further expanding the inflow of private capital. Implementation of more favourable accounting treatment of index-based ILS transactions and relaxation of tax laws which effectively require most ILS deals to be conducted offshore are two such examples. Where private capital is encouraged to enter a market (or at least not discouraged), the investor pool will be broadened, capacity will be increased, and competition will thrive, tending to drive prices lower. If, after leveraging private market capacity to its fullest potential, insurance remains unaffordable for some, then there should be a circumscribed, targeted role for government funds. In other words, government subsidisation programs should be applied conservatively and in support of, not in place of, private market solutions.

While the Act is slowing the pace of ILS transactions focused on Florida risks, the oft predicted exodus of capital market activity there has not materialised.The Starbound II sidecar, sponsored by Renaissance Re and capitalised with US$375m to cover primarily Florida residential hurricane risk, is an example of continued ILS activity. Other opportunities in Florida have arisen precisely because of concerns about the limitations and quality of the FHCF cover. For example, because the FHCF limit will not be reinstated if there is a catastrophic event, there has been demand for second and third event 'back up' covers. Additionally, due to well-founded market skepticism about the FHCF's viability following a catastrophe, some insurers have pursued credit enhancement products to mitigate their exposure to FHCF default risk.

Beyond Florida

Beyond Florida, the forecast for continued ILS expansion is sunnier. Growth is expected to be driven by many of the same factors that initially drove the higher demand for property catastrophe reinsurance, such as the post-Katrina recalibration of catastrophe models, enhanced rating agency guidelines and increased pressure by regulators.

Many view the California earthquake reinsurance market as a continuing opportunity for ILS solutions. California earthquake exposure is monumental. If the 1906 San Francisco earthquake occurred today, it is estimated that insured losses would approach US$110bn. Notably, the assessment authority of the California Earthquake Authority, the state-run catastrophe fund, is scheduled to expire at the end of 2008. In the meantime, some of the largest insurers which had provided homeowners coverage in quake exposed areas are pulling out, creating potential opportunities for the capital markets to provide needed capacity. In Texas, several insurers have recently ceased providing windstorm coverage in coastal areas, placing additional pressure on the already overburdened Texas Windstorm Association, the state run insurer of last resort. Forecasters believe that the Galveston region is overdue for a catastrophic storm, and Applied Insurance Research estimates that a repeat of the 1900 Galveston Hurricane, which claimed 8,000 lives, could produce insured losses of over US$30bn. Outside the US, exposures such as Japanese and Mexican earthquake and Australian windstorm continue to provide fertile ground for ILS arrangements, and ILS participants continue to monitor emerging reinsurance markets such as China.

Only time will tell how this year's results in the ILS market will compare to last year's record figures. While the opportunistic nature of private capital and the external forces of government regulation and Mother Nature will cause the pendulums of deal flow and profitability to swing from time to time, the convergence of reinsurance and the capital markets will forge ahead, bringing with it increasing levels of sophistication and innovation to the insurance and reinsurance marketplace.