Industry the April 2016 issue

Wild About Wall Street

Are insurance-linked securities too complex for all but the largest brokerages?
By Brendan Noonan

The question for brokers is: who will be ready to make the trip with their clients, and who even has the wherewithal?

Believe it or not, the unlikely vanguard of direct risk transfer to the capital markets has been the staid bureaucrats of government and quasi-governmental agencies. A very recent example is Amtrak, which last fall transferred $275 million of storm surge, wind and earthquake risk via a catastrophe bond issue through its own captive

insurer and a special purpose vehicle set up for the deal. Amtrak’s move was part of the fallout from Superstorm Sandy, which reset the national railway company’s understanding of natural catastrophe risk.

New York’s Metropolitan Transportation Authority has done a similar deal for similar reasons, and other governments and agencies in the United States and around the world have sought protection from catastrophe risk through the capital markets. Even the World Bank has stepped in with the ability to facilitate or sponsor CAT bond placements for governments.

A corporate sponsor was among the earliest non-insurers to connect directly with investors: the owner of Tokyo Disney obtained CAT bond protection in 1999. The sponsor was concerned over cash flow and its ability to keep up payments on its debt should an earthquake close the park or drastically reduce traffic for an extended period, says Cory Anger, global head of insurance-linked securities structuring at Guy Carpenter’s GC Securities. The deal provided business interruption and property damage coverage where traditional products couldn’t.

Overall, however, corporate participation has been sparse. Players in all phases of these deals believe that’s about to change. As private entities with hard-to-place risks learn how these transactions work and become more assured of their safety—and as the dealmakers overcome obstacles to bringing alternative risk capital where it’s needed—this market should gain momentum. It might also expand into new territory, including coverage for man-made disasters.

Ideally, would-be corporate sponsors (as opposed to the usual sponsors—insurers or reinsurers) come to insurance-linked securities deals looking to stay on the cutting edge of innovation. Many bear bruises from their traditional way of doing things. Such was the case with Amtrak, for which Sandy brought eye-opening losses followed by a contentious claims settlement process, Anger says. Following Sandy, she says, Amtrak discovered it was “difficult to find in a price-effective way…capacity for flood-related risk.”

Anger says interest has “never been greater with corporate clients.” GC Securities has been bulking up to meet the expected demand, she says. The unit’s staffing needs are nontraditional for the insurance brokerage world since they include securities-licensed personnel.

Anger herself has straddled the worlds of Wall Street and insurance. Before joining GC Securities in 2008, she worked at Lehman Brothers, Merrill Lynch and the U.S. Treasury’s Office of the Comptroller of the Currency.

Paul Schultz, CEO of Aon Securities, paints a similar picture. “There’s a high level of interest to find alternatives and to roll up the sleeves and see if this makes sense,” he says. These deals are familiar ground for insurers and reinsurers, backed by a well-established infrastructure of broker-dealers, bankers and other expert service providers. It’s simply new to many non-insurers, and in a sense that makes it new for brokers, because it’s putting together clients and products that had a buffer between them. Schultz describes the strategy as “taking what we do”—the creation of insurance-linked securities deals that more commonly occur among insurers, reinsurers and the capital markets—and bringing it to “clients who aren’t buying because of price or capacity.”

The Need

It seems strange to speak of scarcity in an era of rampant overcapacity. But there are still risks that frighten off all but the hardiest carriers. The few that write these perils charge dearly. Business interruption, supply-chain risk and flood are among the stubbornly unattractive lines where it might pay for a risk manager to get creative.
“You are talking about things that can blow up in fairly unexpected ways,” says Bryan Joseph, a co-founder of London-based Vario Partners. His firm uses modeling to structure insurance portfolios as an asset class that will attract new investors to the field.

He cites the flooding that struck Thailand in 2011—an event too remote to be modeled or anywhere near top of mind for those who were caught off guard. Among those affected were automakers, principally in Japan, that depend on factories in Thailand for just-in-time delivery of automobile components. With their suppliers out of commission, the automakers’ assembly lines shut down, bringing the flooding and its financial effects to the doorsteps of companies thousands of miles from the event.

The next year, Sandy’s storm surge caused more than $1 billion of damage when it inundated Amtrak’s tunnels under New York’s Hudson and East rivers. The MTA sustained $5 billion of damage from the not-quite hurricane as it took a hard left turn into the mid-Atlantic coast. The threat of a storm driving a surge into New York Harbor and up those rivers had been bandied about for years. But with no examples in living memory, it was little more than a hypothetical event.

“You are talking about things that can blow up in fairly unexpected ways.”
Bryan Joseph, co-founder, Vario Partners

New Frontiers

The Amtrak deal was a milestone, Anger says, as the “first corporate transaction that’s multiperil.” She says GC Securities hopes to expand the market for corporate multiperil deals and to press into other types of risk, including man-made.

In Amtrak’s post-Sandy predicament, John Seo, co-founder and managing principal of Fermat Capital Management, sees one driver of real interest in insurance-linked securities deals: “gaps in insurance coverage for aged physical assets, such as rail lines or complex facilities like hospitals.”

The capital markets’ capacity available for alternative risk transfer is estimated at $3 trillion. Countless institutional investors are looking for risk that doesn’t correlate with fluctuations of traditional stocks and bonds. That would seem to offer an easy path for businesses seeking to place their trickiest exposures, but reality is more complicated.

Major brokerages have entire subsidiaries dedicated to these transactions. The big three—Marsh, Aon and Willis—are most able to muster the expertise to operate in this developing market. By the same token, more modest risks are likely to be directed into other vehicles, such as collateralized reinsurance, which smaller brokerages would find less of a stretch.

Brendan Roche, vice president of Marsh Captive Solutions, in Dublin, says $100 million is likely the minimum for most investors to consider buying into CAT bond transactions. This is because of the time and effort required to put them together.

Captive managers like Roche’s unit, which provides Marsh yet another potential touch point for these deals, are usually in the mix. The transactions often run through existing captives, such as Amtrak’s Passenger Rail Insurance Liability or the MTA’s First Mutual Transportation Assurance Co. They then cede the risks to special purpose vehicles that officially sponsor the bonds.

All Aboard?

Deals involve brokerages’ specialized units, such as GC Securities or Aon Securities. But before they can get a deal done, they often need to educate the insured on how it all works.

“We have to walk them through in detail on the structure and how it’s achieved,” Anger says. This may include reviewing the regulatory, tax and accounting requirements and simply gaining the sponsors’ confidence in the bond’s investors. Part of that process is helping clients understand how CAT bond investors think as opposed to the traditional insurance market, she says.

Brokers also might find their clients want more than a transaction with the investors; they want a relationship. Clients want to understand the predictability of renewals when they start transferring risk directly to investors, hence the interest in getting to know those investors, Schultz says. It’s part of a general push for “transparency and disclosure” as the market has grown, he says. The growing scrutiny helps build confidence these deals are safe for the insured.

“We have to walk them through in detail on the structure and how it’s achieved.”
Cory Anger, global head of insurance-linked securities structuring, GC Securities

“This is just Corporate Finance 101 in the sense that (1) a company is prudent to cultivate and maintain a good relationship with its sources of finance and (2) a company is wise to diversify its sources of finance,” Seo says. “Insureds are looking to understand alternative insurance investors better as well as be understood better by those same investors. This lowers overall cost and volatility of coverage across the loss cycle and better enables insureds to deal with, maybe even capitalize on, unforeseen future developments or dislocations in the insurance market.”

Say ‘When’

Getting deals done boils down to “triggers and transparency,” says Vario’s Joseph. Triggers are often parametric, based on criteria such as the minimum central pressure of a hurricane or winds or ground shaking as measured at specified locations during a storm or earthquake. Deals that cover property and have a natural catastrophe trigger are relatively straightforward. The event happens, or it doesn’t. The parameters are met or missed. Triggers are often matters of public record.

But it may take time to sort through the data after a catastrophe and confirm that the benchmarks were achieved or determine they weren’t. The potential for uncertainty could hold the parties back from committing to a deal, so risk modelers spend a great deal of time working on this.

The MultiCat Mexico 2012-1 CAT bond, the second of two deals Mexico’s government did through the World Bank, exemplifies the challenge of getting triggers right. That bond was triggered last fall by Hurricane Patricia. But months later, there was still uncertainty as to which of two trigger points was hit. That would determine whether the payout would be half or all of the $315 million issue.

The final outcome depended on the release of “best track” data from the National Hurricane Center on Patricia’s path, which refined the initial plot of the storm’s track. It had not become a point of contention during the waiting period, says Michael Bennett, head of derivatives and structured finance at the World Bank. The bond matured shortly after the storm hit, then went into an extension period pending the final data, allowing investors to earn additional interest.

In 2014, the bank launched its Capital-at-Risk Notes Program, adding capacity to sponsor a special purpose vehicle on behalf of governments that don’t have the technical capacity to handle that aspect of a deal. This enabled the bank to issue a $30 million CAT bond for 16 member countries in the Caribbean Catastrophe Risk Insurance Facility. The three-year transaction, in which GC Securities served as the placement agent, covers earthquake and tropical cyclone risk in those nations.

Brent Poliquin, a manager of the insurance-linked securities market segment at AIR Worldwide, describes the process of developing models and triggers. Their purpose is to give comfort to the sponsors, initial purchasers, investors and legal teams involved in alternative capital arrangements. The modeler does this by bringing an understanding of the likely frequency and severity of catastrophic events.

Working with these deal teams, the modeler assesses the data sources and the quality of historical data tapped to build the model. Simulated scenarios or historical events are then run through the model to see how it performs.

Risk Management Solutions (RMS) had a hand in the Amtrak and MTA deals. For the Amtrak CAT bond triggers, storm surge is measured at seven tidal gauges from Long Island Sound to the Delaware Bay. Wind and earthquake intensity are measured in 81 different ZIP codes along the railroad’s Northeast Corridor.

For the Metropolitan Transportation Authority, RMS used its North Atlantic hurricane model to examine in detail the impact on storm surge of local tides, the sea floor and the coastline. It developed triggers that went well beyond traditional storm parameters, such as angle of landfall, forward speed and central pressure.

An important factor in CAT bond transactions is basis risk, which can arise from drawing the parameters of the trigger either too narrowly or too broadly. If the parameters are overly narrow, the sponsor (usually an insurer or reinsurer) could be at risk of suffering a loss but missing receiving the payout from the CAT bond. This could happen, for example, if the track of a hurricane falls just outside the geographical box drawn to trigger the bond.

Parameters that are too broad may inadvertently extend protection beyond the targeted exposure. That means the sponsor pays (through the coupon on the bond) for coverage it doesn’t want or need.

The trick in structuring insurance-linked securities deals beyond the traditional property catastrophe realm—perhaps into man-made or non-property risks—lies in finding the data to build a trigger mechanism.

Poliquin says the hurdles in moving beyond natural catastrophe risk are surmountable as long the peril conforms to a couple of key principles: it exceeds the sponsor’s tolerance to self-insure or cover through conventional means, and it meets the investors’ need for risks to be largely uncorrelated with the financial markets.

AIR has had a terrorism model since 2002, and the latest update is due this summer. With scant historical data, Poliquin says, AIR has created 500,000 simulated event years and more than one million hypothetical attacks, looking at a range of terrorist threats—including conventional and chemical, biological, radiological and nuclear (CBRN). The modeler draws on the opinions of experts that include former FBI and intelligence workers with deep knowledge of past events and future threats.

RMS also has delved into terrorism risk, and in 2006 it helped to structure a $260 million CAT bond for the World Cup in Germany, sponsored by FIFA, global soccer’s governing body. It was the first, and to date the only, stand-alone securitization of terrorism risk.

AIR also has developed an extreme mortality model, which can tie into terrorism risk or be applied to perils such as pandemic and workers comp losses related to earthquakes.
Poliquin says the firm is close to deploying a cyber risk model, which would be a first step in helping potential sponsors understand their exposure and determine whether CAT bonds are a viable option for covering those risks.

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