Finger on the trigger

During the first half of 2014, the total volume of cat bonds issued exceeded $6 billion and total outstanding cat bond volume reached a record high, exceeding $22 billion. It is interesting to note that during the first six months of this year, only four out of 23 cat bond offerings were non-indemnity transactions and virtually all first-time ceding companies decided to go with an indemnity transaction.

Going back only a couple of years, less than 50 percent were indemnity deals, while the remainder were non-indemnity deals with triggers tied to indexes such as the PCS industry loss index in the US, or the PERILS industry loss index in Europe, or parametric payment triggers tied to event parameters such as earthquake magnitude or hurricane wind speeds. So, what is driving the current trend towards indemnity triggered cat bonds?

When seeking to obtain reinsurance coverage through a cat bond, a cedant naturally focuses on obtaining coverage on terms similar to the cedant’s traditional reinsurance treaty. An indemnity trigger would therefore seem to be the natural fit for obtaining such coverage.

However, as ceding companies quickly discover, because cat bond offerings are broadly distributed securities offerings, obtaining coverage through a cat bond involves a very different process than procuring traditional reinsurance.

Unlike traditional reinsurance arrangements, a securities offering is marketed towards sophisticated investors that do not necessarily have the same level of insurance expertise as a traditional reinsurer, and the relevant insurance risks must be described in an offering circular.

An essential component of this description is a risk analysis assessment produced by a third party insurance-risk modelling company. Due to model limitations, not all risks can be properly modelled, and there is typically much focus on what the modelling firm can and cannot model.

In prior years, this usually led to excluding from cat bond cover certain risks that would normally be covered by traditional reinsurance. However, as investors have become more receptive to covering these risks, unmodelled risks that were traditionally excluded from the cover have now been included in more transactions.

"Although indemnity triggers have increased in popularity, cedants must still be mindful of other considerations when choosing between an indemnity and a non-indemnity trigger."

In the 144A cat bond market, the focus is to expand the use of indemnity transactions even further with the ultimate goal being to match the cedant’s traditional reinsurance treaty as closely as possible. Although the indemnity cat bonds have this goal, they nonetheless remain securities and not insurance/reinsurance from a legal perspective.

Decreasing prices have also driven the move towards indemnity cover. In prior years, indemnity cat bonds would often command a higher premium than non-indemnity cat bonds due to additional modeling uncertainty and other operational and execution risks inherent in indemnity triggers.

As more capital flowing into the cat bond space has created softer market conditions, investors have been more willing to forgo the premium traditionally paid in indemnity transactions. Although indemnity triggers have increased in popularity, cedants must still be mindful of other considerations when choosing between an indemnity and a non-indemnity trigger.

The threshold question to using a non-indemnity trigger is whether such a trigger can be created without creating too much basis risk (ie, a mismatch between the cedant’s actual losses and what payout the trigger will generate). Only a non-indemnity trigger that closely aligns with actual expected losses will be considered.

Time and resources

Generally, creating disclosure documents for indemnity transactions requires much more of the cedant’s time and resources than in a non-indemnity transaction. One of the most time-consuming portions of an indemnity transaction is the development of the ceding company’s subject business disclosure to be included in the offering document.

This section of the offering document, which describes the cedant’s business that is being reinsured, usually requires the extensive involvement of a number of the cedant’s employees.

"Going back only a couple of years, less than 50 percent were indemnity deals."

Additionally, this section is subject to extensive due diligence, both in the form of management due diligence and review by lawyers of documents such as policy forms, underwriting manuals, claims manuals and other documents. In contrast, a non-indemnity transaction typically requires only a one-paragraph description of the cedant in the offering document.

From the protection buyer’s point of view, when a trigger event has occurred and the cedant expects to receive a payment under the reinsurance agreement, an indemnity transaction is inherently riskier.

In a well-structured non-indemnity transaction, the payout amount is determined and provided by a third party. The payout may be quick as full payment may often be received within a few months. In an indemnity transaction, the cedant must submit a proof of loss claim to the cat bond issuer for paid claims only.

A third party claims reviewer will sample and review claims submitted and must determine whether the claims submitted by the cedant are those which are covered by the event definition. This can be a lengthy process.

Additionally, there is more room for dispute in indemnity transactions, as investors could challenge whether the insurance risks were properly disclosed in the offering circular, or whether the cedant’s claims handling has been conducted in accordance with its established claims procedures as described in the offering document.

Additionally, in an indemnity transaction, the cedant must be comfortable with disclosing its book of business in an offering document and providing exposure data to investors. Since a 144A cat bond offering is normally listed on a stock exchange, the document is a public document regardless of the fact that the offering document claims to be confidential.

The trend towards indemnity cat bonds is most likely here to stay, as investors are becoming more willing to cover insurance risks that are not fully modelled and indemnity cat bond coverage more closely aligns with coverage provided by traditional reinsurance. However, before making a decision to go with an indemnity transaction, the advantages and disadvantages of indemnity versus non-indemnity should be thoroughly evaluated.