Following a short, sharp slump in demand, insurance-linked securities are back in business. Apart from a temporary increase in price, the financial crisis has in no way altered the fundamental advantages of insurance-linked securities as an attractive complement to traditional reinsurance. Munich Re’s Risk Trading Unit gives to the clients access to the whole range of products and services that this securitisation segment has to offer.
After insurance-linked securities (ILS) had successfully withstood the crisis on the securitisation market for some considerable time, they then felt the full force of the Lehman Brothers’ bankruptcy in the autumn of 2008. Insurance securitisation issues came to a complete standstill in the fourth quarter of 2008, suffering the same fate as most other financial markets. However, the demand for financial instruments that securitise nat cat risks from property insurance and transfer them to the capital market has since increased significantly, again attaining the average volume of past years. Securitisation transactions for nat cat bonds alone had reached almost US$ 2bn by the end of July. Given the backlog demand involved, this positive trend is expected to continue and a prediction of an issue volume in the region of US$ 3bn for the whole of 2009.
The Current ILS Market
The record figures from 2007, when cat bonds totalling some US$ 7bn were placed, are unlikely to be repeated. However, there are strong arguments for transferring insurance risks to the capital market in the form of securitisation. Firstly, in times of hard markets when conventional reinsurance is expensive, capital-market products such as ILS become more attractive to sponsors. As issuers of cat bonds, (re)insurers are able to ease their equity capital or avoid risk concentration by transferring risks to the capital market. Finally, ILS are a welcome reinsurance instrument where no traditional capacity is available. This applies, for example, to pandemic covers in life or to business interruption in property and casualty.
The financial crisis has actually enhanced demand for alternative risk transfer: as some suppliers of traditional reinsurance ran into difficulties, capacities for US peak risks disappeared and prompted primary insurers to consider alternative risk transfer in order to diversify their sources of reinsurance. The financial crisis showed investors that ILS offer an investment opportunity that is uncorrelated with conventional investment classes. The returns on diversified ILS portfolios were positive in 2008 in spite of the financial crisis, unlike the returns on almost all other investment classes.
However, the Lehman insolvency did change the structure of ILS. As the most recent issues on the cat bond market show, investors are more acutely aware of the credit risk, i.e. the credit risk of the assets in the collateral backing a cat bond. A higher level of security is achieved, for example, by investing the paid-in capital in government bonds or in investments with a similar security. Nevertheless, the risk premium remains higher than before for the time being, so that there are only certain segments in which cat bonds can compete with the price of traditional reinsurance. Cat bonds are currently in especially high demand to cover the peak risk US wind. If traditional capacity is available in sufficient amounts and at favourable prices, the current high returns on the capital market make securitisation solutions more difficult. In this connection, Munich Re’s objective is to develop those investor segments that reward the diversification effect of ILS (also within the ILS investment class) with more favourable risk premiums (e.g. pension funds) in order to secure the prerequisites for the further development of the ILS market.
ILS versus reinsurance
Munich Re regards insurance-linked securities as an attractive and useful complement to traditional reinsurance. They are particularly suitable for reducing peak exposures, developing additional sources of capacity or for overcoming innovation gaps. However, ILS can never fully replace traditional reinsurance because only certain risks that can be clearly quantified and modelled are suitable for transfer to the capital market. More complex risks whose evaluation requires not only quantitative expertise but also a high level of market and underwriting experience remain firmly a matter for reinsurers.
Munich Re services the whole value chain
Munich RE’s objective is to expand and develop the market for cat bonds as an additional source of capacity. Direct contact to a broad investor basis is every bit as important as their know-how in order to successfully conclude placements. For Munich RE’s clients, cat bonds usually constitute just one element of a comprehensive reinsurance concept, so that a good market overview, a wide range of products and speedy implementation are at the forefront of their services.
As a full-range provider, Munich RE are active in the ILS segment on a variety of levels: they transfer their own risks to the capital market, act as an investor on the cat bond market and, through a Risk Trading Unit, offer to the clients a wide range of ILS services – from product development to structuring and placement. The combination of the risk capacity and the understanding as a risk carrier enables Munich RE to develop individual ILS solutions which optimally link alternative risk transfers with traditional reinsurance products. As part of the latest cat bond transaction “IANUS Capital Ltd.”, Munich RE have added their own risk to a client’s risk to be transferred and thus improved the economic viability of the concept and increased the attractiveness of the transaction for the client.
Outlook – ILS under Solvency II
ILS have become firmly established with investors as an alternative investment class and with insurers as an instrument of risk transfer. Under the new framework conditions of Solvency II, ILS will continue to gain in importance for insurers as the impact of risk transfer on the balance sheet will no longer be based on the form of the instrument but on its economic effect (“substance over form” principle).
Other advantages of ILS under Solvency II result from the explicit consideration of the counterparty risk when measuring the amount of solvency capital to be held. As the transactions are usually fully secured (AAA security), the ceding insurer has lower capital requirements in this respect compared with a traditional reinsurance solution.