What Captive Insurers Need To Know about ILS, Alternative Capital, and Reinsurance

While Hurricane Irma concludes its northward trek up the state of Florida and heads inland into Georgia and beyond, massive cleanup efforts are under way in southeast Texas from Hurricane Harvey's deluge of rain and historic flooding. The original intent of this article was to focus on a new Milliman white paper titled "How Alternative Capital Is Shaping the Global Reinsurance Industry." While we will cover some of its major ideas, the concept has been broadened to include insurance-linked securities (ILS), alternative capital, and reinsurance.

It appears the ILS and alternative capital markets will see their first major test as a result of Hurricanes Harvey and Irma. Captive insurers, major users of reinsurance—especially for property coverage—should monitor what the likely impact of these events are on the ILS, alternative capital, and reinsurance markets.

The Milliman white paper, authored by Karl Goring, FCAS, MAAA, includes the following points in its beginning and ending paragraphs.

The enormous infusion of alternative capital in tandem with relatively low catastrophe activity of late has depressed prices to historically low levels, forcing reinsurers to look elsewhere for topline growth.... Its impact has reshaped the market in other ways, and continues to ripple through the industry as it expands to include new structures and cover new perils....

The influx of alternative capital (along with relatively low catastrophe activity) has driven down catastrophe reinsurance prices to historically low levels, which has caused reinsurers to try to diversify into other lines of business. Their move into other lines has led to lower prices overall, prompted underwriters to modify terms and conditions in order to compete, and finally incentivized reinsurers to pursue [merger and acquisition] activity to achieve scale and diversification.

For captive insurers, this should be welcome news since it offers enhanced options for coverage while also lowering the overall costs of reinsurance.

The ILS or catastrophe "cat" bond markets have been around since the mid-1990s after Hurricane Andrew in Florida and the Northridge earthquake in California together increased the focus on new forms of risk transfer needed to deal with catastrophic losses. From those humble beginnings, growth has exploded as evidenced by cat bond and ILS deals breaking records for the first quarter of 2017 with $9.76 billion of issuance, according to a July 21, 2017, Artemis article titled "ILS and Cat Bond Growth Strong but 'One-Dimensional'—Johansmeyer, PCS."

Mr. Goring points out the following in the Milliman report.

Like other goods and services, reinsurance follows the age-old economic principle of supply and demand: given a constant demand for a product or service, prices will fall as the supply increases. In the case of reinsurance, supply is represented as capital or the capacity available to absorb risk. What has been increasingly evident over the years is that supply has continued to greatly outstrip demand for coverage, which is the key driver in reshaping the reinsurance market. The consequences are many and far-reaching.

For buyers of reinsurance, including captive insurers, what this has meant is the ability to negotiate more favorable terms and conditions for their coverage. Mr. Goring notes, "As soft markets typically progress, underwriters, at some point, become less and less willing to move lower on prices. They may make decisions that they may not otherwise consider in a hard market, favoring the cedents...." These changes include the following.

• The use of multiyear contracts
• The addition of more perils being included within the terms and conditions
• More lenient reinstatement terms
• Other ways of enticing cedents to renew coverage

However, the question for most captive insurers is what confluence of events is sufficient to change current market conditions. Hurricane Harvey, while bringing record amounts of rainfall and catastrophic flooding to parts of Texas, appears unlikely to be such a catalyst. An August 29, 2017, Artemis article, titled "Cat Bond Funds Don't Expect Harvey Loss, Private ILS More Exposed," states as follows.

Catastrophe bond fund managers are not anticipating any loss to their investment holdings due to [H]urricane Harvey, although the mark-to-market impact witnessed in recent days could cause a limited hit to net asset values as cat bond positions thought most at risk of a major Harvey hit recover.

The latest insurance and reinsurance industry loss estimate for damage caused by [H]urricane Harvey wind and storm surge is for an impact of up to $2.3 billion, according to AIR Worldwide.

This is below the levels where it would be expected that catastrophe bonds would begin to pay out, given most cat bonds are structured to provide coverage for much larger industry loss events.

The flooding, which is a major concern in the Texas region as Harvey continues to dump heavy rains and is likely to cause tens of billions of dollars of economic flood losses, is not covered by catastrophe bonds, which are designed to cover the wind and surge aspects of a tropical storm or hurricane only.

So right now it seems that all catastrophe bonds will be safe from impact due to [H]urricane Harvey....

Additionally, a report from Kroll Bond Rating Agency (KBRA) in Captive.com predicts only a modest impact on primary insurers' underwriting results. Both of these articles predated Hurricane Irma hitting the Florida Keys as a Category 4 storm the morning of September 10 and continuing up the west coast of the state before weakening as it moved inland. By the afternoon of September 11, it was headed into southern Georgia. According to the National Hurricane Center, a Category 4 hurricane packs sustained winds of at least 130 mph leading to catastrophic damage, including damage to roofs and/or some exterior walls. Storm surges are a threat.

Therefore, while both the ILS and reinsurance markets may have dodged a bullet with Hurricane Harvey due to its major impact being flooding, this may not be the case with Hurricane Irma. Captive insurers, especially those with fourth-quarter 2017 or first-quarter 2018 renewals, would be well advised to begin planning for adverse market conditions. Time will tell.