Insurance and capital markets: convergence or collision course?

"We are considering longevity derivatives and branching out into other insurance asset classes" Michael Spencer, chief executive of Icap

Setting up operations took time and it wasn’t until late last year that it completed its first deal, an over-the-counter catastrophe swap on North American windstorm risk of undisclosed size between two unnamed counterparties. Since then, business has been brisk, Michael Spencer, chief executive of Icap, tells Euromoney. "Icap-JLT began broking its first catastrophe derivatives in December 2007, and has since brokered a number of both wind and quake swaps." He says: "We have also recently expanded the business to include a secondary market cat bond broking business, and have completed a number of cat bond transactions as well."

The insurance-linked securities primary market enjoyed a breakthrough year in 2007, with 27 public deals worth $7 billion, up from the $4.7 billion issued in 2006 and just $2 billion in 2005. While hedge funds, dedicated insurance-linked securities funds and even conventional institutional investors have all taken note of rising new-issue volumes, less attention has focused on the growing private secondary market, where, depending on who you ask, volumes in insurance-linked securities are now anywhere between $3 billion and $7 billion a year compared with total outstandings of $13 billion.

The catastrophe swap market is estimated to be anywhere from $5 billion to $10 billion a year.

At first sight, those are modest sums but they illustrate how the insurance derivatives and Cat bond markets are moving to a second stage of development. New capital markets investors have taken on catastrophe risk for a diversification benefit relative to their conventional fixed-income and equity portfolios. Similarly, some money managers have taken such exposure through derivatives, typically on a buy-and-hold basis. Now active secondary trading is beginning and the intermediation of specialist brokers promises more efficient and transparent price discovery.

The main participants in the insurance derivatives markets are reinsurers looking to refine their portfolios by handing off or acquiring specific risks, hedge funds attracted to the low correlation of insurance returns, and banks managing their own and third-party money. They can each be buyers or sellers of insurance risk, which is typically quoted by three metrics: geographic territory, type of peril (often wind or quake) and attachment point, often the level of industry-wide insured loss at which a seller of protection may lose principal. So, for example, Icap might seek to match anonymously potential buyers and sellers of Florida hurricane risk to a limit of $100 million.

Insurance-linked derivatives are an advance on warrants, which principals used to exchange on a buy-and-hold basis. Robert Turner, director at Icap-JLT, says: "What appeals with OTC derivatives is their flexibility, tradability and low frictional costs. The contracts are Isda-based and the frictional costs are lower than those in the traditional reinsurance market. There can also be trading opportunities for protection buyers and sellers. If you sell, say, a $10 million limit Florida wind swap at a price of $2 million and it turns out to be a quiet wind season and prices fall, you might be able to buy that back at $1.5 million." Similarly, of course, a reinsurer or hedge fund that has bought cheap protection might look to take profits if rates rise in a season of extreme weather.

Young market

That’s the intention. But the market is still very young and hasn’t operated through a full annual wind season yet.

Spencer has no doubts though. "The potential for this market is very significant and there are a number of risks that could lend themselves to capital markets products," he says. "However, we consider our near-term opportunities to be in the catastrophe field – life catastrophe would be an obvious extension of our existing business. In the medium to long term we are considering longevity derivatives and branching out into other insurance asset classes."

The business is not a perfect one. Buyers and sellers of derivatives have to be matched anonymously and if, when terms are agreed and names of principals are finally disclosed, it turns out that one side is full to the limit on the other’s credit, then a transaction might fall away. But over time, greater liquidity, transparency and more efficient price discovery might transform the market.

Spencer says: "The traditional insurance market cycle is one of peaks and troughs, with insurance rates hardening, or becoming more expensive, in line with catastrophic events. The role of Icap-JLT is at the point where the insurance and capital markets converge and we aim to assist in smoothing out the peaks and troughs of this traditional cycle and the ensuing volatility for the markets, increasing liquidity for all market participants."

The main players in these new insurance-linked derivatives and securities market are the reinsurers. These wholesalers of spare capacity to the primary insurers play an important role in enabling insurers to generate business through their expensive distribution networks, in the comfort that they can lay off exposures if unhealthy concentrations arise. Insurers are taking an increasingly scientific approach, measuring, for example, storm patterns and incidence of large storms making landfall and matching these very precisely, using GPS technology, against their own geographic exposure. If they conclude that their front-end sales and distribution networks have produced too much exposure in one location and perhaps too little in another to give an optimal portfolio of similar risks subject to different triggers, they go to the reinsurers.