Catastrophe Insurance: Transferring Insurance Risks to Investors

Many people would like to have insurance against catastrophes, but catastrophes are generally not considered an insurable risk because the frequency and the magnitude of the losses cannot be forecasted accurately using the law of large numbers, which is how insurable risk is usually calculated. Thus, premiums cannot be calculated. Thus, private, for-profit insurance companies will not cover catastrophic risks, although some government programs provide catastrophe insurance. Although insurance is the main form of risk transfer, other methods of transferring risk have arisen to transfer not only the pure risk of catastrophes, but also speculative risks, such as certain financial transactions. Insurance companies have started to use these financial instruments — which, in essence, securitizes risk — that does not depend on the law of large numbers — to insure and transfer risks for catastrophes. Since the law of large numbers cannot be used to determine the amount of capital required to insure catastrophes, financial models are used instead. Needless to say, predictions from financial models are much less accurate than using the law of large numbers.

There are several financial instruments that insurance companies have used to transfer catastrophic risk to investors in this so-called alternative risk transfer market, including contingent surplus notes, catastrophe bonds, exchange-traded options, industry loss warranties, life insurance securitizations, and insurance sidecars.

The alternative risk transfer market is like reinsurance, but instead of transferring risk to other insurance companies, the risk is transferred to investors in the form of insurance-linked securities (aka insurance-linked notes, risk-linked securities). The advantage to the investors is a higher rate of return for the increased risk, and a more diversified portfolio, since catastrophes are not correlated to the financial markets directly. Reinsurers and property and liability insurers are the major issuers of catastrophe bonds and sidecars.

As of March 2016, there were $26.5 billion worth of insurance-linked securities outstanding.

The life insurance industry has not extensively used securitizations to transfer risk, although some life insurers have transferred longevity risk. However, most securities that were sold to transfer life insurance risk was primarily done so that life insurance companies can lower their reserve requirements, which are often too conservative for the risk.

Contingent Surplus Notes

Contingent surplus notes (CSN) allows an insurance company to pay for a catastrophe over an extended time rather than actually transferring the risk of loss, and under better terms than it might get if it issued the notes when a catastrophe does occur.

The insurance company hires an investment bank or other financial intermediary to set up a trust that buys U.S. Treasuries, then issues trust notes to investors, who receive not only the interest paid by the Treasuries, but also additional interest paid by the insurance company. The insurance company must pay this interest because there would be no incentive for an investor to buy the trust notes, since he could just buy Treasuries directly without any risk of default.

If a catastrophe occurs, then the insurer has the legal right to substitute its own notes — contingent surplus notes or its preferred stock— for the Treasuries, giving the insurance company immediate liquidity to cover losses. The insurance company continues to pay interest and principal on the notes through the trust, but now the investors are assuming a financial risk of default.

According to statutory accounting standards, the cash, or other liquid assets, received from the issuance of the surplus notes increases the net worth of the company (hence the surplus designation), but the notes are subordinated debt and are illiquid assets, making it a higher risk for investors.

Catastrophe Bonds (aka Cat Bonds)

Unlike CSNs, catastrophe bonds actually transfer the risk of loss from the insurer to the investor of the catastrophe bonds, often shortened to just cat bonds. Like other bonds, they pay interest to the bondholders, but, in the event of a catastrophe, they can skip or defer payments of interest and even principal, depending on how the bond is structured. Cat bonds have typical terms of 3 to 5 years. Hurricanes and windstorms are the major peril covered.

To issue cat bonds, a trust called a special purpose reinsurance vehicle (SPRV) is created, which issues the bonds. The insurance company buys reinsurance from the SPRV. The SPRV receives money from the investors of the cat bonds and from the reinsurance premiums, which, in turn, is invested in U.S. Treasuries or other high quality assets. To diversify their assumed risks, insurance companies also invest in cat bonds issued by other insurers, but only if they cover risks that they are not already exposed to in their primary business.

Most cat bonds are based on the severity and location of the catastrophe rather than the actual losses sustained by an insurer, but if the catastrophe is covered, then the SPRV can suspend payments of interest, and possibly the principal, to the bondholders, and pays the insurance company for its risk. Because recovery from catastrophe bonds may not be equal to the losses sustained by the insurance company, there is some risk, known as basis risk, that the recovery will be inadequate.

Cat bonds pay higher interest rates than other bonds, because of their risk of interest and/or principal. From 1995 to 2015, 10 transactions out of 300 transactions over that timespan have resulted in loss of principal to investors: 6 of those losses were due to insured loss events, but 4 were caused by the insolvency of the firm guaranteeing the bonds' collateral, using total return swaps. Nowadays, the most common collateral is money market funds consisting of US Treasuries or investment-grade securities.

Some cat bonds guarantee the repayment of principal, but, because of the lower risk, they pay a lower interest rate than bonds that do not guarantee the principal. These cat bonds are generally based on long-term zero-coupon Treasuries that will repay the principal — without interest, if a covered catastrophe occurred — when the Treasuries mature, which could be as long as 20 years. The foregone interest would represent a significant opportunity cost to the investor.

Cat bonds are only sold to institutional investors and cannot be directly purchased by retail investors. The main disadvantages of issuing cat bonds for insurers are the relatively high yields that must be paid, and the administrative costs of the SPRV. The main disadvantage for investors, besides the risk of not being paid interest and possibly principal, is the illiquidity of the bonds.

Transferring Risk Through Exchange-Traded Funds, Futures, and Options

Exchange-traded catastrophe options and futures were products first offered by the Chicago Board of Trade in 1992. These options were purchased by insurance companies and sold by speculators, which gave the insurance company the right to a cash payment if a specified index of catastrophic losses reached a certain value within a specified time. However, these options have been discontinued in 1999 because of a lack of a viable market, although weather derivatives continue to be sold. Several over-the-counter risk exchanges (catex) have been established to trade weather derivatives and other risk exposures among insurers, intermediaries, and trading groups.

Some insurance companies have attempted to transfer risk by selling futures or options based on those futures. For instance, the Chicago Mercantile Exchange (CME) began offering hurricane futures and options on those futures in 2007. Some of the futures were based on the CME hurricane index (CHI), based on a model that predicted storm damage according to the wind velocity and size of the hurricane. Some contracts were based on a single name storm, others were based on the accumulated CHI from all hurricanes over a calendar year and yet another contract was based on the damage caused by the largest hurricane during the calendar year. However, the trading of these futures and options have been extremely limited.

Industry Loss Warranties

Industry loss warranties (ILW) are another form of security that is much like a reinsurance contract but the payments are based on an industry loss index rather than the issuing insurer's loss. Using an industry index rather than the insurer's own loss gives greater confidence to investors that the return of the bond or security cannot be manipulated by the insurance company. Whether the ILW will pay depends on a trigger, usually a certain amount of total industry loss due to a catastrophic event. For instance, a trigger might be $50 billion of industrywide loss from a windstorm, as determined by a particular index. Indexes generally only cover specific perils in specific geographic regions. Moreover, indexes generally have a reporting threshold, so they will not include losses below the threshold. So that the index can be calculated sooner, liability losses are also usually excluded, since it can take many years to determine total losses due to liability. Generally, losses due to liability will be greater for man-made disasters rather than natural disasters. Losses may not include losses suffered by captives, since most captives provide insurance only to their parent companies.

The sources of information, or the methods or calculations used to arrive at the index for most indexes are not publicly revealed, so it is not generally known whether defense costs and/or loss adjustment expenses are included in calculating total losses. ILW contracts also have different reporting periods: some report only once and some report more frequently during a given duration after the loss event, such as 36 months after the initial loss event. The ILW contract will only pay if the loss exceeds the trigger within the reporting period.

Life Insurance Securitizations

Life insurance companies are also using more securitizations of both mortality and longevity risks. Because catastrophes can lead to many deaths within a short time, the death rate can greatly exceed what was anticipated with actuarial tables. Thus, securitization can help pay increased claims due to a catastrophe. Longevity risks are also increasing, since lifespans are increasing, so life insurance companies are also securitizing some of those risks. Life insurance securitization is also being used to increase reserves and to pay for acquisitions or demutualization costs. Captive insurance companies are often used to hold the funds from securitizations.

Insurance Sidecars

Reinsurers have also used the sidecar as a means of acquiring capital. Although not a form of securitization, the sidecar serves as a vehicle for which investors could earn a possible return on their capital if the loss experience was favorable. Insurance sidecars are limited special-purpose reinsurance vehicles in which reinsurers cede some of their premiums to investors in the aftermath of a catastrophe that has caused considerable financial stress, both for the insurance companies and for financial markets. The capital is invested to pay claims and to provide an investment return for investors, who are often hedge funds.

The sponsoring reinsurer cedes a portion of its business to the sidecar, usually as a quota share arrangement, and also manages the sidecar. But the investors earn the return or bear the risk of the ceded business. Most sidecars were created to serve as a temporary source of capital, usually terminating within 24 months. Sidecars were 1 of the ideas instituted by the reinsurance market to recover some of the capital that they had lost in Hurricane Katrina in 2005.

Sidecars are usually limited to and tailored for a specific cedent, and as special-purpose vehicles, there is no active management or staff. The sponsoring reinsurer sets the amount of capital requirements for the sidecar by modeling the risks that will be covered. Sidecars generally cover many more perils over a more extensive geography than cat bonds.