Recent natural disasters such as the 2005 hurricane season, in addition to a shortage of retrocession capacity in a hard market have prompted the insurance industry to examine different structured finance techniques. Jérôme Da Ros in our London office examines recent innovations in the insurance structured finance market.
In the wake of recent major natural disasters and the increased prospect of pandemics such as bird flu, structured insurance products have recently received increased interest in the industry. For example, whereas cat (catastrophe) products have traditionally been designed principally in the non-life sectors, recent insurance structured finance transactions have been completed in the life industry.
In addition to fears of a major catastrophe, several other factors have fuelled the development of insurance structured finance techniques. From a commercial perspective, the most important factor has undoubtedly been the shortage of retrocession capacity that has forced underwriters to find alternative sources of coverage in the current hard market. The emergence of new participants such as hedge funds and private equity funds has also contributed to the development of such techniques; insurance structured finance techniques provide these institutions with interesting diversification tools, as these instruments are not correlated to market risks and often feature high yield prospects.
Mortality cat bonds
A variation of traditional cat bonds, mortality cat bonds are one of the hottest developments in insurance structured finance. Three out of only five issues ever made were realised in the past 12 months, galvanised by fears surrounding a possible outburst of devastating pandemics (in particular bird flu).
Similar to the structuring of traditional cat bonds, these products protect life insurance portfolios against peaks in mortality rates.
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In particular, repayment of the principal of the bonds is contingent upon mortality rates reaching certain predetermined thresholds. Each tranche of the issue is defined by an attachment point and an exhaustion point expressed as a percentage of a notional mortality rate. If the actual mortality rate rises above the defined attachment points, the repayment of each tranche is reduced in proportion to the penetration of the actual index value within the relevant tranche, usually according to a standard formula:
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The trend seems to be that, in more recent issues, mortality cat bonds attach at lower thresholds than earlier deals. This might pave the way for securitisations aimed at transferring mass life-insurance risks on the market, along the lines of the recent securitisation developments in the motor insurance sector.
Protected cell companies
Recent legal developments have also contributed to the development of structured finance transactions. In particular, protected cell companies (PCCs) – one of the most important innovations in insurance structured finance – are now widely recognised and accepted as a securitisation device. Several jurisdictions in Europe have enacted legislation to cater for PCCs in addition to the regime already established in Bermuda.
A PCC is a single autonomous legal entity made up of different “protected cells”. Each cell has its own capital (usually redeemable preference shares) provided by the sponsor of that cell and each cell’s assets and liabilities are completely “ring-fenced” from the other cells.
The most remarkable characteristic of PCCs is that the assets of one cell are statutorily protected from the creditors of another. This statutory ring-fencing of assets and liabilities allows efficient tranching, provides enhanced protection to different security holders and enables flexible structuring of issues for different types of market and investors. In other words, structuring a special purpose vehicle (SPV) as a PCC has the advantage of enabling the segregation of different classes or categories of investor.
As cells can be authorised to conduct insurance or reinsurance business on a cell-by-cell basis, PCCs constitute attractive transformer vehicles in cat bond and insurance structured finance arrangements.
It should be noted that the insurance SPVs contemplated in the Reinsurance Directive (some Member States have already implemented the regime into local laws) will become serious alternatives to PCC structures.
Sidecars are an alternative to cat bond securitisations.
A sidecar is a retrocession captive that provides catastrophe coverage to its sponsor reinsurance company, usually through a single quota share contract.
The coverage is generally provided for a short duration (usually two years) and the sidecar is funded via the issue of short-term securities to various kinds of institutional investors, mainly private equity funds or investment banks (who see sidecars as a flexible way of diversifying their portfolios by cherry picking risks to be transferred to the sidecar).
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Sidecars can be constituted as PCC cells, which can make them more attractive.
As with mortality cat bonds, sidecars were created because of a shortage of retrocession capacity and hard market conditions, and it is likely that they will find applications in other areas of business in a hard market, such as D&O (directors and officers) or workers’ compensation insurance.
Cat bond funds
Given the increasing issues and growing variety of cat bonds, it is likely that cat bond funds will also experience substantial growth. To date, few such funds have been created; and of those there are, most were created by private banks.
Despite their small number, these funds have generated significant returns unaffected by interest rate fluctuations. As such securities are offered not only to institutional investors but also to individuals, cat bond funds provide a potentially huge capacity to underwriters and interesting investment alternatives to categories of investors that previously had no access to these financial instruments.