Reinsurance Investment Banking - Why this niche industry is and will continue to change the commercial insurance industry entirely and for the better
Read this if you aren't a loser with more than a 5 minute attention span. You might learn something interesting.
Reinsurance is Effectively Insurance for Insurance Companies
While some of you may be very familiar with reinsurance, I am sure most are not and thats ok. The only thing you need to know is that reinsurance is effectively insurance for insurance companies. There are a handful of different kinds of reinsurance, but for our purposes we will only be talking about one type, a loosely defined group of securities referred to as Insurance Linked Securities (ILS), and specifically catastrophe bonds.
When you consider how old the insurance industry is (and I mean old, like multiple hundreds of years old) and how little it has changed over the course of history, it's no wonder people's eyes glaze over whenever it gets brought up. The fact is its outdated, somewhat boring, and represents an expense none of us actually want to pay. Its amazing in many ways that it has managed to continue without innovation for so long actually, which I suppose is a testament to the industry's complexity and necessity (don't fix something that ain't broke). ILS have only be around for roughly 30 years and the market is only recently starting to really develop, it is an infant from a historical view.
The Real Innovation = Securitized Risk
Insurtech is often looked at as the new innovation and disruption that's going to blow away old insurance giants and change everything, but the fact is it won't and I wouldn't even call most of it innovation. Its the same as traditional insurance, just with a leaner business model and automation of some background processes. The real innovation is where the traditional capital markets and insurance markets meet, securitized risk.
The most prominent type of ILS is the catastrophe bond.is set up and raises money via the issuance of these catastrophe bonds on behalf of an insurance or reinsurance company (we call them the cedent). Not at all different from a traditional debt raise. Where these get interesting is what determines how the insurance aspect of them works. They are derivatives by nature, with their value being derived from the underlying reinsurance agreement simultaneously entered by the SPV and the cedent. Pre-defined parameters are set to determine the payout to the cedent in the event the a covered event occurs. These range from direct indemnity contracts (basically actual dollar loss like normal insurance) to being based only on where and how bad the event was, regardless of loss experience.
No Waiting, No Claims Adjuster, No Big Lawsuits, Just Cash Deposited.
For example, X insurance company may want to reinsure itself against hurricane risk in an area like Florida where they insure a large number of buildings. They contact an investment bank to structure and issue a cat bond to insure themselves against the losses they would experience should a major hurricane occur. However, since they don't want to have to go through the long and painstaking process of determining their actual loss at the time of the event as they will have their own claims to pay to the people and companies they insured, they opt for a parametric type structure. The SPV who issued their cat bonds will payout in full immediately if the central pressure of the storm was X amount at Y time at Z location. Immediate indemnification. No waiting, no claims adjuster, no big lawsuits, just cash deposited. Even if by a miracle of god they have a $0 loss and will pay no claims themselves, they receive the funds. The kicker? That payout is largely unrestricted after the trigger has been activated, they can do whatever they want with the money.
Governments, Corporations and Investors Love These Securities
Now, I know that seems like it only makes sense for large insurers to utilize, but you'd be mistaken! Governments all over the world have already widely adopted these securities to be able to rebuild and help their populations in the wake of tragedy, but even that isn't where this market's true potential lies. Large corporates are starting to take notice and explore this insurance option. It is cheaper, faster, and easier for them to utilize this form of collateralized cover than to go through traditional insurance markets in many cases. Why pay massive commissions to a broker for a 1-year policy that will likely cost more at next year's renewal? Why pay premiums to the insurance company who pays premiums to the reinsurer who ultimately issued a cat bond themselves? They want to go directly to the top of the insurance industry indemnification ladder, the capital markets. And they are, with major success.
Google, being a prime example, issued a cat bond to protect their properties against CA earthquake risk and have praised the process quite a bit. Oh, and that bit about receiving payment even if you have no loss? Corporates love this idea. Not only do they have collateralized insurance that wont take a claims process to receive payment, there is also a chance that they will receive unrestricted cash to do whatever they please with if they don't have a loss. All that while locking in pricing for future years.
Hurricanes, EQ, wild fire, etc. are the tip of the iceberg. The market now is branching out to cover more risks like terrorism and many more. Investors love them too. The spread can range anywhere from 200bps to upwards of 2000bps, not to mention essentially being near zero beta and fairly liquid (they are exchange traded in most cases), and thats not even touching on the ESG qualities.
The Future of Insurance
This is the future of insurance for large swaths of the corporate world: probability based, rigorously modeled, and entirely bespoke. If you made it this far, I commend you. Insurance isnt the most exciting thing, but in a way the development of a new asset class is and I hope you can appreciate that along side me.