nottheaverageactuary

Actuarial news and views from Cape Town and beyond

The rise of insurance-linked securities and their impact on the reinsurance industry

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What’s caused the reinsurance industry to come under such extreme price pressure recently? In 2014, reinsurance prices were the lowest they’ve been in the previous 10 years and prices are expected to drop even further. In the 2015 year prices are expected to drop below levels last seen in 2001. An absence of costly disasters (yes, you read that right) and increasing competition from new entrants are some of the reasons that prices have declined.

Demand for casualty and non-catastrophe insurance has not grown significantly for over a decade. As a result, the reinsurance industry shifted to writing more catastrophe reinsurance. It seems logical to shift your offering towards the higher demand. Unfortunately, the catastrophe reinsurance market came under even more intense pressure partly due to the sudden high growth in the insurance-linked securities and catastrophe bond markets since hurricane Katrina struck in 2005.

What are Insurance-linked securities?

Insurance-linked securities (ILS), such as catastrophe bonds (cat bonds), are mechanisms by which risks like catastrophes are transferred from one party (e.g. an insurer) referred to as a sponsor to the capital markets (i.e. investors). Investors put up the money to cover claims in exchange for above-market yields.

The cat bond structure

With cat bonds, the sponsor pays premiums to a special purpose vehicle (SPV) which is usually an investment bank in exchange for risk cover. The SPV sells cat bonds to capital market investors in order raise capital to cover the risks of the sponsor. The capital is invested and the investment income generated (together with premiums received from the sponsor) is used to pay coupons to investors. Investors receive a higher coupon rate from cat bonds than they would from other bonds because of the higher level of risk associated with cat bonds.

If a claim occurs, the capital received from investors is used to pay the claim. At the redemption date the investors will receive less than the value of the capital used to purchase the bond or receive nothing. If no claim occurs the investors’ capital is returned at the redemption date.

The effect of the growing cat bonds market on reinsurers

Cat bonds provide an alternative for insurers to purchasing cover from a reinsurer. Pricing of cat bonds was at historic lows in 2014 which allowed sponsors to increase coverage at competitive rates. If the cat bond market continues to grow, bond yields will decrease further. This reduction in the cost of cat bonds will lead to reinsurance becoming even less attractive to insurers than the use of cat bonds.

The loss of market share by reinsurers will not only have a direct financial impact them but may also result in loss of their influence on the insurance industry. In the past, increasing renewal pricing of reinsurance treaties was a means to “discipline” the insurance market for sloppy practices such as ineffective underwriting. Loss of this ability to rein in the insurance industry could be catastrophic (pun intended!).

References and related links:

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