A Bluffer’s Guide to Alternative Capital

Brokers, bankers and reinsurers have experimented since the 1990s with various instruments to transform natural catastrophe risk into investment products.

But to be popular, their new financial tools had to be cost-effective for everyone. Investors needed them to proffer enough income and liquidity to make alien weather and earthquake risks palatable, while the issuers, usually insurance or reinsurance companies, would adopt them only if they were cheap, flexible and reliable. After two decades of tinkering, the architects of alternative risk transfer have met these challenges. Now, every year, the risk-transformers easily convert billions of insurance risk into investment opportunities. They have perfected not just one new product, but several.

INSURANCE LINKED SECURITIES (ILS) is the catchall name for investment products that provide insurance or reinsurance capacity to issuers, while giving investors exposure to pure underwriting risk. Unlike shares in traditional risk carriers, ILS investments are barely correlated to the performance of financial markets. But they are not simply insurance policies issued by investment bankers. Lloyd’s notes that “funds raised through ILS instruments must however be ‘transformed’ into contracts of (re)insurance … for the (re)insurance companies seeking the cover to take credit for it in their insurance profit & loss account.”

For the carriers, one big advantage of ILS—whether tradable instruments or private arrangements—is the almost complete elimination of credit risk. When alternative capital funds an insurance or reinsurance contract, the paper the underwriters issue is typically collateralized reinsurance (see below). It is backed not by the leveraged capital and surplus of another re/insurer but by investors’ cash on deposit, almost always to the value of the maximum indemnity. The principal is usually invested in the safest of liquid securities and is therefore readily available to pay claims. Further, tradable ILS investments now provide a modest but real level of liquidity. Over the last few years, as the sector has grown, capital markets’ appetite for ILS has become sufficiently high that a market has been made. An instrument purchased can usually be sold without too much friction.

CATASTROPHE BONDS are one of the most successful transformer instruments. Sometimes called “Act of God bonds,” they are the highest-profile type of non-life ILS and provide excess-of-loss reinsurance. They are almost always “sponsored” by a traditional reinsurer, issued through a company established for the purpose (a “special purpose vehicle” or SPV), bought by investors, including pension funds, hedge funds and reinsurers, and tradable in secondary markets. They cover a specified type and quantum of loss, usually arising from a serious natural catastrophe event (a “super cat”), for periods of one to several years.

As long as the bond is not triggered, the issuer pays a regular return or “coupon” to the bondholder. Some of this return is generated by the income from the invested principal. The balance is the cost of the insurance or reinsurance, the premium. This yield to investors must be higher than the achievable risk-free investment return (and is therefore typically set at a floating rate) because cat bonds are risky investments. If the bond is triggered, the investors’ deposited cash is used to pay claims to the sponsor.

Bonds’ return rates reflect the very real risk that the entire investment, or part of it, will be burned by an Act of God. Returns vary based on modeled likelihood of expected loss, but because of the high risk, all cat bonds are considered junk bonds.

They first appeared as experiments in the hard-market years after 1995, usually on a one-off basis. Issues were more frequent from 2003 as new sponsors tried bonds and the workings of the instrument were fine-tuned. A huge rush of demand-driven bonds came to market in 2006 and 2007, as reinsurance prices soared following Katrina’s trail of devastation. More measured, steadier growth resumed from 2008, as the now tested instruments proved resilient through the financial crisis and investors cheered their superior returns in the constrained financial environment.

Today the value of outstanding cat bonds is at record levels.

INDUSTRY LOSS WARRANTIES (ILWs) are derivative reinsurance contracts that pay a specified amount when triggered. As their name implies, the trigger is the entire insurance industry’s aggregate loss from a covered event, usually measured according to an index. The buyer is typically a reinsurer, while the seller is often a specialist reinsurer though increasingly commonly an ILS-focused hedge fund. When the former sells the cover, the warranty is usually not collateralized, but when the latter does, it often is, removing the issuer credit risk. Unlike cat bonds, ILWs can be arranged very quickly. “Live cat” cover is traded as hurricanes threaten landfall and devastation and sometimes even as they wreak their havoc.

On the face of it, ILWs are simply wagers on Acts of God and therefore legally unenforceable (and illegal in some jurisdictions). Still, they have been around for a long time. In 1981 Peter Green, then chairman of Lloyd’s, prohibited “tonner” policies, referring to ILWs that paid out when vessels of a certain tonnage were lost—whether insured or not. In the 1980s they were more commonly written to pay when aircraft of a certain type had crashed.

In 1993 Lloyd’s again cracked down on tonners. “One of the principal features of such policies is that they do not contain any insurable interest, and consequently the premium paid represents a wager on a particular event occurring,” Lloyd’s reminded the market. “All contracts of gaming or wagering are legally unenforceable and therefore null and void.” 

This problem has been solved. Today’s ILW buyers must suffer a specified loss arising from the warranted event to receive their payout. For Lloyd’s, the about-face is complete: In 2013 it welcomed Nephila Capital, a specialist ILW underwriter funded primarily by pension funds, to launch Syndicate 2357. Now based in Bermuda,

Nephila was launched by Willis in London in 1997, specifically to transform risk through ILWs.

“The syndicate adds a new dimension to a market that is better known for providing more traditional excess-of-loss coverage for catastrophe risks,” says Tom Bolt, Lloyd’s director of performance management. “Nephila is well experienced in bringing in big institutional investors, so this allows Lloyd’s to access that capital and diversify its capital base.”

For the hedge fund, Lloyd’s licenses mean it can issue ILWs almost anywhere.

WEIGHTED HYBRIDS are the latest invention. By fiddling with the index—modifications initiated primarily by the largest reinsurance brokerages—weighted hybrids make ILWs more like conventional reinsurance. This is because they reduce the gap between the buyers’ actual exposures and the index-based payouts. What does this actually mean? They can be priced more keenly than their vanilla counterparts.

As their name implies, weighted hybrids typically employ a hybrid trigger, combining parametric and index-based thresholds. In 2009 Guy Carpenter and Nephila concocted CWIL (County-Weighted Industry Loss warranty), which better matches industry losses with the cedants’ actual exposures, roughly according to their county-by-county market share. Willis responded with WIIP (Weighted Index Indemnity Protection), and Aon Benfield with INCR (Indexed Non-Indemnity Customized Reinsurance). The products proved immediately popular, especially among reinsurers with U.S. exposures, state wind pools and Lloyd’s syndicates.

Nephila puts the annual volume of ILWs, including hybrids, currently traded in the global reinsurance market at roughly $25 billion. However, Guy Carpenter reports their use “decreased through 2014 as price reductions made indemnity [that is, traditional reinsurance] protections more attractive.”

SIDECARS are a wholly more flexible form of capital-markets intervention in the insurance and reinsurance sectors and can be implemented very quickly. They are simple, essentially comprising single-client, special-purpose, privately capitalized quota-share reinsurance companies. They are capitalized through debt, equity or preference shares for short, fixed terms (usually two or three years) by investors wanting access to a single reinsurer’s pure underwriting risk.

“Sidecars are more strategic than more transactional cat bonds in terms of bringing partners in to participate in the overall performance of the book,” says Paul Schultz, chief executive of Aon Benfield Securities.

The reinsurer cedes a specified portion of the relevant types of risk to the sidecar, a specially established reinsurance company (or sometimes the sidecar passively writes “companion lines”). This extends the front-line reinsurer’s capacity to accept risk without retaining it and without expanding its own balance sheet. The cedant’s larger market presence allows it to assume bigger lines and may let it offer fully collateralized insurance or reinsurance. Cedants and investors typically negotiate the level of deposited principal, although today most sidecars are fully collateralized. Cedants also receive profit and ceding commissions.

Sidecars can offer whole-account cover or accept only specified risks (commonly, property catastrophe). When bolted on to a primary insurer, sidecars operate at the lowest level of insurance risk transfer. Like ILS, they soared in popularity after Katrina.

SYNDICATED SIDECARS add liquidity and diversity to the structure’s capital. The first sidecars were private arrangements between two or more reinsurers. They were structured like swaps and were intended to diversify each company’s book of business (for example, by exchanging Californian for Japanese earthquake risk).

Later, outside investors were brought in to capitalize collateralized quota-share vehicles, which operated on a one-to-one basis. After Katrina, many such sidecars were syndicated among multiple investors. The first, driven by specialist hedge funds, fueled Bermudian insurers. Arch Capital created one of the first and largest, an $840 million sidecar called Flatiron Re, in this way in 2005. It raised money from Goldman Sachs’s hedge funds and Farallon Capital. Under the deal, Flatiron, managed by the specialist transformer Horseshoe Group, took 45% of certain property and marine business underwritten by Arch Re Bermuda.

One estimate puts the current total investment in sidecars at $5 billion, and new sidecars are being formed apace: already this year, the London reinsurer Brit Group has been ceding risks to Versutus Ltd., a new, $75 million Bermuda sidecar set up to take property catastrophe reinsurance risk under a quota-share treaty. Guy Carpenter’s GC Securities raised the money from “a number of investors.”

Despite their recent rise, sidecars, with their retro-modern name, are in a sense the oldest form of alternative capital. In Italy in the 1400s, when underwriters routinely signed marine risks on behalf of other wealthy merchants at a certain percentage, the passive investors were in effect acting as a sidecar does (although without segregating their capital within a separate legal entity). Traditional Names at Lloyd’s are similar. They are silent investors who unite to form a syndicate, each member taking a slice of the active underwriter’s signings.

SPECIAL PURPOSE SYNDICATES (SPS) at Lloyd’s link the old and new approaches, allowing today’s Names—both traditional and corporate—to participate in sidecars. The numbered risk-carrying units take a quota-share of their related syndicate’s risks, usually of a specified type, but sometimes of the whole book. Such sidecars boosted Lloyd’s capacity by about $800 million in 2014, and new SPS sidecars are on line in 2015, including one funded by Credit Suisse Asset Management. Notable among the sponsors of SPS vehicles is the ILS-ubiquitous Everest Re, which in 2012 attached a sidecar to the largest syndicate at Lloyd’s (see “Mountains of Risk”).

COLLATERALIZED REINSURANCE is on the rise. The category, sometimes known as the “hedge fund market,” is rapidly becoming the most popular of the financial alchemists’ transformational creations. Awkwardly, the nomenclature is sometimes used as a catchall for all capital markets deals that involve the transfer of the investors’ capital to the reinsured, therefore including catastrophe bonds and some ILWs. More recently, however, it is used to describe reinsurance—usually very high-level placements—made directly between cedants and investment managers by a reinsurance brokerage’s capital markets division.

A traditional reinsurer is only sometimes involved in collateralized reinsurance but does not actually issue the treaty (see the main panel). Under such deals the buyer, or cedant, holds the capital backing the contract directly (or in trust) as long as it is in force. The U.S. Treasury states succinctly that “the collateral, posted by investors, is equal to the coverage limits of the reinsurance net of the premium [and] held in a separate account to satisfy losses due to the ceding insurer.”

According to the ILS blog Artemis, sidecars are “perhaps becoming a little less popular now that collateralized reinsurance has grown in use as an alternative to the sidecar structure.” Aon Benfield reported in January that capital deployed through collateralized reinsurance deals reached $29.4 billion in 2014.