A valuable proposition
The ultimate test of any financial instrument is whether it increases the corporate value of its issuer. Does the instrument improve the quality of the issuer’s earnings? Does it improve return on capital? In short, does it make the shareholders richer?
Since their birth in the mid-1990s, insurance-linked securities (ILS) have provided an efficient risk hedging technique for insurance companies. They now offer a range of benefits, including attractive pricing, innovative structural features and collateralised or other high quality security.
ILS first filled a capacity gap created by massive insured losses. Then they generated sufficient price advantage and creativity to consolidate their position in the market. Can ILS now move up the value chain, creating value for issuers by improving return on capital?
It is useful to look at how banks have securitised their portfolios using securitisation as an integral part of their capital strategy. The typical large bank will manage the actual process of financing consumers, projects and companies but will maintain a lean capital base by passing most of its exposures to the capital markets This allows it to retain as much return and as little capital as possible. If ever proof were required to show how dependent banks have become on securitisation of their core business, the financial crisis of 2008–09 supplied it.
While insurers are often as dependent on reinsurance—whether delivered by conventional carrier or ILS funds—as banks are on securitisation, a look at recent large ILS issues shows that the products still look quite different. ILS currently focus on extreme severity of property insurance losses caused by identified events. Although such transactions have some capital impact (and the treatment will change dramatically with the adoption of Solvency II in Europe), they are fundamentally extreme risk hedges rather than capital management tools.
“With this convergence, ILS may now take its place as the key building block in insurers’ capital structures.”
In contrast, banks’ securitisation issues are specifically constructed around their capital requirements (and ratings). The ways insurance companies are measured for capital adequacy and ratings purposes are increasingly similar to the ‘Basel’ measures that have applied to banks for many years. With this convergence, ILS may now take its place as the key building block in insurers’ capital structures.
Understanding the drivers
We need to identify what drives insurers’ capital requirements. Evidence gathered as insurers prepare for Solvency II indicates that the key capital drivers are reserving, underwriting and market risk. All of these can be addressed through risk mitigation and transfer.
Structures that can address these capital drivers include some familiar reinsurance products: quota share, loss portfolio transfer and aggregate excess of loss.
Structured (capped) quota shares are the closest reinsurance analogy to financial securitisation in that they remove blocks of underwriting risk from the insurer, transferring both frequency and severity of loss, and they can be designed to provide a comparable benefit.
A loss portfolio transfer, by transferring an historical portfolio of claims reserves, similarly acts to remove capital requirements, leaving the insurer to focus on business origination and management. By transferring large amounts of money to secure external structures, such transactions also reduce market risk, replacing investment volatility with a predictable investment credit.
Until now, we have seen the ILS market participate only to a modest extent in quota share-based structures. More significantly, the US life insurance sector has for many years financed reserves through XXX and AXXX transactions placed into the capital markets.
If the ILS market can continue to develop superior structures within high credit quality, multi-year products, it has the potential to upend the way insurers manage risk and capital. There are, however, some important issues to consider:
