Insurance Linked Securities And Cat Bonds

In the aftermath of the Christchurch earthquake, I wanted to learn as much as I could about how the insurance industry functioned. Why have insurance firms returned to profitability when households are still struggling? While Campbell Live has shown that state owned EQC is performing worse than private insurers, there’s still a lot of angst amongst New Zealand households who feel like they’ve been ripped off by the insurance industry.

Insurance linked securities are one product that enables the insurance firms to shift risk from their balance sheet to investors willing to shoulder the risk of natural disasters and other events that would lead to an insurance company having to pay out a lot of money in claims in a short period of time.

They are also a key tool that a prudent insurance firm can use to lower the premiums it charges to customers, increase the return on equity for shareholders and deliver better customer service when a disaster strikes. Insurance linked securities are exactly the sort of product a competitive industry comes up with when they need to protect their balance sheet and stay true to their contractual commitments to policyholders.

I’m of the opinion that insurance companies have been poor in communicating how complex the process of managing premium calculation, reinsurance expenses and balance sheet risk is. The average policyholder doesn’t understand why everything has to be so complicated. But, if we think about this from a precedent point of view, if an insurance company makes a decision on a specific claim, that could lead to a flood of claims that requires premiums to rise or the product to no longer be offered in a region.

The cat bond is one such example that makes it more likely that your insurer will be able to meet claims made under the policies they’ve written in the aftermath of something like the Christchurch earthquake.

A cat bond is a bond issue by an insurer. Let’s say it’s a 5 year $1 billion dollar bond. If a disaster within the remit of the cat bond occurs, the principal of the bond is forgiven and the insurance firm that issued the bond is able to use that $1 billion dollars to meet claims linked to the cat bond.

Because of the high risk involved in purchasing a cat bond, and lower credit rating of cat bonds, investors will demand a higher return on their investment. So in a low interest rate environment, yields on cat bonds could prove quite attractive and incentivise some asset managers to hold cat bonds as a high risk / high reward component of their securities portfolio.

This flexibility means that the insurance firm can invest its float elsewhere and essentially have an option on raising additional capital when the cat bond is triggered. They pay an annual premium and if a disaster happens, they benefit from the $1 billion in cash they’re entitled to immediately.

How might a cat bond be triggered? Well, that $1 billion cat bond may only be triggered if total claims exceed, say, $4 billion dollars. While many people would say that this sort of esoteric financial engineering is dangerous, they’re forgetting that products like this are key in enabling insurance to be provided at all.

In the case of New Zealand, we have a small risk pool exposed to a lot of different risks – earthquakes, tsunamis, whatever. Any way for an insurance firm to spread the risk more widely is a good thing. It helps keep premiums competitive and while policyholders might complain about an insurance firm taking ages to process their claim, they need to acknowledge that when something like the Christchurch earthquake strikes, there is a massive learning curve for the industry.

Yes, it’s more than 2 years since the last big earthquake, but because of New Zealanders consistent refusal to expose themselves to capital market risk, we have less insurance linked securities and cat bonds – in fact we have none I could find that would in any way be tradable by wholesale investors.

This is not a good thing! Financial engineering in the insurance industry is essential for countries like New Zealand. While reinsurers paid out promptly, the massive increases in reinsurance premiums since 2011 is offset over a small population.

Just like fixed costs and a small population are a factor in lots of stuff sucking in New Zealand, a small population and less developed capital markets are a factor in the complaints about the insurance industry.

The introduction of “give us a number” home insurance is a good thing. While homeowners will need to fork out for a valuer or quantity surveyor, in the long run, risky properties will pay more accurate higher premiums and less risky properties will pay more accurate lower premiums.

It might sound crazy – but in a low interest rate environment, I am very surprised that insurance firms in New Zealand have not taken advantage of that to gain access to potential liquidity through cat bond issues.

Yes – you could lose your capital if disaster strikes, but you could lose your term deposits if your big bank is admitted to the Open Bank Resolution process! At least with insurance linked securities like cat bonds you know your maximum loss upfront and can expect a high yield in return for that risk.

We need more insurance linked securities and cat bonds. Insurance firms have returned to profitability, and that’s a good thing. But reinsurance is not the only way for insurance firms to transfer risk from their balance sheet to investors willing to bear that risk.