Converging markets
Insurance linked securities (ILS) issuance took off in 2006, driven by the then narrow spreads in the credit markets and hard catastrophe risk reinsurance market following hurricanes Katrina, Rita and Wilma. For investors, insurance risk appears to be an attractive proposition as it is an asset class with low correlation to other capital market segments. ILS is now a U.S. $ 35 billion market that has overcome earlier issuance and pricing difficulties, increasing the choice of products available for risk transfer across a spectrum of classes, but in particular for life and catastrophe risk.

The integration of the capital and reinsurance markets may have marked benefits in terms of capacity and pricing – but this is still a relatively young market with a lot of uncertainty surrounding it. It is unclear at this stage, for example, how the capital markets will respond to a sustained period of either lower rates or higher losses, and there are of course pros and cons for cedants associated with all risk transfer options.

Similarities shed light on potential market issues
There are in fact a lot of similarities between risk transfer solutions in the capital and reinsurance markets. This perhaps becomes clearer when we consider, for example, how both markets are susceptible to supply and demand driven pricing cyclicality, and to shock losses (reinsurers refer to ‘catastrophes’ or ‘casualty reserve developments’, while the capital markets talk of ‘credit crunches’, ‘liquidity crises’ or ‘bear markets’). Pricing cyclicality represents an uncontrolled cost deviation for cedants and investors that introduces asset volatility and complicates portfolio management. Shock losses lead to fluctuations in the level of available capital and insolvencies. Both features can be significantly detrimental to investors and cedants, and must be appropriately managed to ensure market durability.
The successful players in the reinsurance industry have made risk assumption through risk evaluation, valuation and management their core skill, rather than relying on third parties for risk evaluation and pricing. This allows them to better withstand market ‘shocks’ and to offer continuity of capacity throughout the cycle.

The products themselves
To judge the efficacy of the products at this stage, cedants should consider the following characteristics (as one of the main ILS products, we use cat bonds as the example):

• Some cat bonds are indemnity based (similar to ­reinsurance where contracts are based on a cedant’s own loss experience) but the vast majority are parametric. This means that payouts are based on an index rather than the actual losses of the cedant. As such, there is a potential that a contract may be exposed to basis risk whereby the cedant suffers a financial loss, but receives insufficient recoveries from the cat bond. Reinsurance has the significant appeal of being an indemnity product and has no basis risk.
• Ratings agencies generally do not give full capital credit for parametric or modelled cat bonds because of the basis risk, recognizing that there is a potential for a cedant to take a loss but not to receive a corresponding payment on the bond.
• Traditional reinsurance allows for annual customization of terms and conditions, whereas cat bonds are more standardized and require a longer term commitment.
• Issuing a cat bond has a different cost structure than reinsurance placements, including bank issuance cost, third party risk assessment cost, legal fees and credit rating fees.
• Reinsurance presents a credit risk whereas ILS ­products are usually fully collateralized.

The take away for cedants and reinsurers
Traditional reinsurance covers are based on an expertise in insured risk evaluation and assumption. These are tested products that offer cedants a wide coverage and continuity of capacity on offer. ILS bring an increased risk transfer choice for cedants. For reinsurers, they are also a means both to transfer risk and to access quality risks to maintain and grow a diversified portfolio.

The critical point is that the same disciplined and quality approach to risk assumption should be applied to ILS products as it is to traditional reinsurance covers. Without this, expectations will not be met and gaps will appear following market ‘shocks’, involving withdrawal of capital, reduced diversification benefit and lower capital leverage opportunity.

PartnerRe
As a risk assumer, we at PartnerRe recognize that the capital markets and traditional reinsurance are con­verging and we are well positioned to be a helpful ­discussion partner to our clients on risk management and risk transfer, whatever the form of risk transfer they ultimately choose. We have the modeling experience, underwriting capability and risk management skill, as well as the capital markets expertise, to work with and price alternative risk transfer products including cat bonds and complex reinsurance structures.

While our traditional product is risk assumption via ­reinsurance contracts, we are flexible as regards the way in which we assume risk for our clients and build our balanced risk portfolio, but are consistent in that (1) we are a discussion partner for our clients for all forms of risk transfer and (2) we apply the same core risk assumption approach for all forms of risk acceptance.