public cat bond issuance, a private placement could end up paying a higher spread.


The Drive To Reduce Costs


At the same there has been a trend to reduce the frictional costs for public cat bond placements, and the number of rated transactions has decreased (see Chart 4). In addition, sponsors and arrangers are calling for more standardization in legal documents to reduce the legal costs involved with public cat bond placements. The next push is for modeling costs to be reduced when sponsors want to issue bonds based on their own internal modeling. This is already common practice for privately placed transactions, but with all the uncertainty in the different models it may not be possible for publicly traded bonds. As set forth in our criteria, we would likely not rate a nat cat bond that used a model generated by a ceding company. However, it is possible for us to rate a transaction in which the ceding company did its own modeling using a model from either Risk Management Solutions Inc., EQECAT Inc., or AIR Worldwide Corp. (for more information, see Credit FAQ: What Should The Market Expect From The Rating Process For Catastrophe Bonds?, published June 4, 2014, on RatingsDirect). Recently we have seen various market intermediaries set up platforms to issue cat bonds more efficiently and allow smaller cedents to access the cat bond market. We expect the absence of an independent risk analysis and/or credit rating to act as a barrier to entry for investors that lack specialized ILS experience.


Chart 5: 2013 Trigger Distribution


Modeled & industry loss 3%


Modeled loss 4%


Parametric 12%


Indemnity 42%


Industry loss 39%


Industry loss 38%


Indemnity 62%


U.S. hurricane/named storm 91%


Table 1: Characteristics Of Product Offerings Through Which Alternative Capital Has Accessed Insurance Risks


Industry loss warranty


• Tradable • Triggered by industry losses above certain thresholds • Loss amounts typically determined by PCS or PERILS • Party providing coverage does not have to be an insurance company • May contain an ultimate net loss clause • Amount of collateralization depends on protection provider’s credit risk • Can use insurance or ISDA documentation • Short-term contracts with varying maturities


Sidecar


• Gives investors exposure to unique asset classes (usually at lower attachment levels than cat bonds)


• Allows reinsurers to leverage their underwriting expertise and distribution networks


• Coverage typically documented via a quota-share reinsurance agreement • Investments can take the form of equity or debt • Liquidity of invested capital is a main issue for investors


Equity investment in start-ups


• Provides venture capital for small insurers or reinsurers • Allows investors to form strategic partnerships • Can secure investor right of first refusal to participate in cedent’s future reinsurance programs


More Volume Threatens Underwriting Discipline


For us, underwriting discipline in the alternative market is already a concern, especially for cat bonds. Most deals issued so far in 2014 have been on an indemnity basis, which means that investors provide protection on an ultimate net loss (UNL) basis to the cedent. Because it helps cedents to reduce their basis risk, investors are exposed to the risks inherent in the underwriting and claims processes of each cedent. This requires participating investors to have a detailed understanding


Chart 6: 2014 Trigger Distribution


of each transaction sponsor. Available data must also be complete and of good quality. This year we saw the first European (Lion I Re Ltd., which we didn’t rate) and Japanese (see Aozora Re Ltd., published May 30, 2014, on RatingsDirect) indemnity deals issued. As the alternative market moves more and more into writing UNL business (see Charts 5 and 6) and away from parametric or modeled loss trigger covers, questions are surfacing as to whether fund managers have the same level of underwriting expertise as traditional reinsurers.


Chart 7: Primary Covered Peril Distribution


Japan typhoon 3%


Health 6%


© Standard & Poor's 2014.


© Standard & Poor's 2014.


© Standard & Poor's 2014.


Global Reinsurance Highlights 2014


35


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