Strategic Risk Solutions
ILS: Another arrow in Bermuda’s captives quiver
As the risk transfer landscape evolves, corporations are becoming increasingly comfortable using alternative structures as risk management tools. These structures are set to play an important role among captive insurance companies, says Anna Pereira of Strategic Risk Solutions.
“Smaller risks can be transferred through collateralised reinsurance or private cat bonds known as ‘cat bond lite’ deals.”
Anna Pereira, Strategic Risk Solutions
It is well established that captives are an effective mechanism for reinsuring and financing risks through alternative risk transfer. A natural evolution of that success is for captives to embrace insurance-linked securities (ILS), providing an additional or complementary source of capacity alongside traditional reinsurance.
In addition to enhancing a corporation’s risk management options, alternative capital and ILS, collateralised reinsurance and other forms of risk-linked financial instruments support physical, economic and social resilience and recovery.
As the risk capital of the world and the birthplace of captive insurance, Bermuda is well positioned to offer a one-stop shop for companies and their captives to access a broad range of risk transfer solutions across the spectrum of options, from traditional re/insurance to alternatives such as ILS.
The evolution of partner capital
For many years, the intersection of the re/insurance markets with third-party capital was referred to as ‘convergence’, a term that is rarely used now. While ILS was initially viewed as a disruptor and potential threat to traditional reinsurance, the industry has accepted third-party capital as ‘partner capital’ and a permanent feature in the Bermuda market.
Google offers a good example of the powerful impact partner capital can have on a corporation’s ability to manage risk. In 2020, Google issued its first catastrophe bond, sponsored by parent company Alphabet, using Phoenician Re, the Bermuda special purpose insurer (SPI) established for Alphabet’s catastrophe bond programme.
In this transaction, Google’s captive insurer ceded risk to a global reinsurance firm, which in turn entered into a risk coverage agreement with the Bermuda SPI, which then issued cat bond notes to investors. The cat bond was listed on the Bermuda Stock Exchange (BSX) which, for the past decade, has retained its position as the dominant market exchange for ILS listings.
Because of the concentration of its assets in California, the Google cat bond covered earthquake risk. Silicon Valley is home to a sophisticated industry for innovation, but there is an underlying exposure to this sleeping natural catastrophe because of its geographic location.
The Alphabet/Phoenician Re/Google transaction will encourage corporations looking to consider the use of captives to broaden their scope of risk transfer structures and secure access to ILS investor capital.
Does size matter?
One misunderstanding among captives owners is the perception that ILS deals must be big to attract investor attention. While a cat bond is typically used for larger risks, smaller risks can be transferred through collateralised reinsurance or private cat bonds known as ‘cat bond lite’ deals. These transactions offer the potential for secondary liquidity as well as the ability to meet certain investor and fund mandates related to sustainability and financial returns.
In recent years, the ILS market has demonstrated its willingness to invest in smaller, more customised transactions. Deal sizes of private cat bond lite transactions listed on the BSX start from as low as $3.75 million. Structures can be developed to respond to a variety of triggers, including an indemnity trigger based on a cedant’s losses at a designated level; an index-based trigger if industry losses exceed a defined level; or a parametric trigger that meets specific parameters such as location and intensity.
These options provide opportunities for cedants that do not have the scale to sponsor a full-sized catastrophe bond. Investors have been willing to sponsor innovative transactions to accommodate the needs of new cedants—an area where captives will likely take advantage.
Emerging risks drive alternative structures
Increasingly, emerging risks such as climate change and cyber are driving the consideration of alternative structures for enterprise risk management.
While it is generally accepted that climate change and certain natural perils are not correlated—earthquake risk, for example—the focus on climate risk ‘resilience’ is forcing corporations to look at ways to mitigate their financial exposure to current and future climate-related risks. These risks include flood, surge, wildfire, drought, hurricane frequency, snowstorms and the impact of rising sea levels.
The vulnerability of the cost of physical assets exposed to weather and climate impact will be factored into future insurability and cost of insurance protection. This vulnerability may be magnified in certain geographies because of corporations finding less capacity due to reduced appetite and/or increased premium costs.
As the ILS market continues to grow and mature, the next decade looks set for the market’s expansion into other emerging risks such as cyber coverage, a risk that has been exacerbated by the COVID-19 pandemic. In recent years, the market has demonstrated expansion by risk type and non-natural peril risks have been successfully securitised. Such risks include terrorism, mortgage insurance, financial guarantee, operational risk, mortality and third-party motor, to name a few.
As far as casualty risks are concerned, the low volume transferred through ILS and securitised markets indicate that this category of coverage is in its early stages of development. Product innovation, available data and accepted modeling practices will aid risk pricing, along with structures allowing the ability to match appetite with risk. Some early adopters have identified these opportunities and several transactions have been completed that show potential for increased use.
ESG comes into play
Against the backdrop of emerging risks, a mega-trend that demands attention is the adoption of environmental, social and corporate governance (ESG) performance metrics by an increasing number of global re/insurers, creating another layer of oversight with respect to appetite for risk.
Increasingly, investors are choosing cedants and reinsurers who have pledged to help close the protection gap (the distance between total and insured losses), recognising that stronger communities, cities and metropolitan areas enable countries, regions, continents, and the planet to recover from disaster and prosper.
In times of unprecedented change, expect market participants to take a step back, look at feasibility studies, see how the landscape is changing, quantify the impact to volatility in the short and long terms, and look outside the box for ESG-related risk management tools.
The way forward for Bermuda’s captives and ILS sectors
What does this mean for Bermuda’s captive insurance industry and how can the industry leverage partner capital? Is the time right for the captive industry to lead its own ‘convergence’ with the ILS sector? Can it develop its own partner-capital from capital market sources?
While this second ILS wave is in its early stages, there are promising signs that include increased transparency, data-sharing and more direct access between risk managers and capital markets. There is also exciting innovation in product development that includes insurtech solutions and artificial intelligence integrations.
With a solid regulatory and supervisory framework, a regulatory insurtech sandbox and a recognised exchange platform for exchange-traded risk, Bermuda offers all the components needed for the captives/ILS partnership to continue to evolve, innovate and thrive.
However, in the final analysis, the question is not ‘if’ but ‘when’ alternative risk transfer solutions are taken up by the captives industry. It seems clear they are destined to become more mainstream in the future.
It will be important for the industry to build on the strengths of the entire risk management chain to fulfil its pledge to address the protection gap more broadly and, as a result, build stronger, more resilient corporations of all sizes.
Anna Pereira is senior vice president of ILS at Strategic Risk Solutions. She can be contacted at: anna.pereira@strategicrisks.com
