Cat bonds: structuring for success

With an increasing number of cedants beginning to enter the insurance-linked securities (ILS) market and issue cat bonds, some reinsurance buyers have voiced their frustrations towards the complexity attached to the transactions.

While they agree that these deals have many benefits—especially as the market evolves—the structuring process can be time-consuming and has the potential to be improved.

Speaking at Munich Re’s ILS roundtable at the Monte Carlo Rendez-Vous, Franco Urlini, head of group reinsurance and R&D at Generali, and Jim Fiore, chief reinsurance officer at QBE, explain the positives and the costs of entering the ILS market.

“We’ve been monitoring this market for a while, although as a European carrier, we have very limited US exposure. It’s all about finding diversifiers and at a certain point last year we recognised the opportunity. We were also very much in favour of having an ILS solution fully integrated in our insurance structure,” says Urlini.

“All of these things were potentially available a few months ago, particularly when we were more seriously thinking of a solution. We have become part of this very interesting and technical market.”

Launched in April this year, its cat bond Lion I Re provides Generali with €190 million of per occurrence protection in respect of losses stemming from Europe windstorms over a three-year period.

Fiore says that QBE had been working with the collateralised reinsurance market for a number of years before it eventually launched its first cat bond, the $250 million VenTerra Re.

“It’s all about finding diversifiers and at a certain point last year we recognised the opportunity.” Franco Urlini

VenTerra Re, which is the first such deal to cover Australian perils for a primary insurance company on an indemnity basis, provides protection against US and Australian earthquakes and Australian cyclones for a period of three years. Fiore also says the company spent a lot of time with the Australian regulator to educate them on cat bonds and to ensure the transaction was approved.

“When we decided to do the cat bond, it was a combination of US exposure as well as Australian exposure. This brought a number of challenges, for example, different currencies and getting the regulator to approve the transaction. But in the end we got there,” Fiore says.

Fiore says the deal took a long time and required a lot of work. “There were miles and miles of paperwork involved, and we had to find individuals who were 100 percent dedicated to driving the process through.”

Is it necessary?

Often ending up as bespoke deals, catastrophe bond structuring is not a ‘one size fits all’ approach, meaning that additional time and money is spent on adding features, which are “not always necessary”, says Michael Madigan, a partner in the insurance practice at Sidley Austin and head of the firm’s property and casualty alternative risk transfer practice in New York.

“Many sponsors want to add ‘nice to have’ clauses into the structures, which then delays the process and adds additional paperwork,” he says. “The real question needs to be ‘is this really necessary?’.”

Madigan explains that, on average, from the start to the closing of a transaction, it should take around three to four months, with a simple additional issuance of cat bonds under an established ILS programme being accomplished in one to two months.

“It mostly depends on the time needed for the modelling of the transaction, especially for a first-time sponsor doing an indemnity transaction. However, additional features create complexity and take time to implement, also resulting in higher costs,” he says.

“Many sponsors want to add ‘nice to have’ clauses into the structures, which then delays the process and adds additional paperwork.” Michael Madigan

These features include complicated reset features, different aggregate types of cover and new perils among others, which will align the catastrophe bond more with the traditional reinsurance treaty—a trend that is becoming inherently desired by sponsors.

“The structures are always evolving but it also means increased intricacy, especially with new regulations to deal with as a result of Dodd-Frank in the US,” says Madigan.

While Madigan says that new features are getting easier to include, as once they have been developed in one transaction, they can be used in the next, he says that the lack of a standardised document for these transactions is also a challenge.

“Many of these documents, for example the documentation on the bond side, should have been more standardised by now but there always seems to be a desire by the parties involved in a transaction to tinker with them,” he says.

An altered perspective

As an elaborate financial instrument, the structuring of a catastrophe bond will always require a certain level of complexity in order to satisfy the issuant and attract investor interest. However, altering the perspective of the industry towards the level of structuring that’s required is something that must continue, as Madigan explains.

“Since you will always have to comply with disclosure rules if you decide to do a securities offering, there will always be a certain amount of complexity,” he says. “However we often see a mindset which is to include as many features as the market will accept, even if some features may not be needed for a particular transaction.

“This will add complexity and increase legal fees. If you focus on ‘need to have’ instead of ‘nice to have’ that would in many cases make the transaction structure less complex and easier to execute.”

Urlini, who agrees on some of the negatives in terms of the complexity and the amount of time such deals take, says that for Generali, the process was much simpler than for QBE.

Lion I Re was approved in September 2013 and went to market at the end of April 2014.

Urlini is also positive around the approach to new capacity providers. “In the traditional market it takes a lot of time to accept a new insurer. Because of the type of product in ILS, we don’t have to wait as long and we are happy to establish in a number of weeks. This makes the market much more dynamic,” he says.

As the ILS market continues to rise, it’s unlikely that buyers will shy away from issuing a catastrophe bond solely due to the complexity of its structuring. However, as the market grows, it will be intriguing to see how, or if, those responsible for it choose to tackle this obstacle.