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 The fact is its outdated, somewhat boring, and represents an expense none of us actually want to pay.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.
Catastrophe Bonds
The most prominent type of ILS is the catastrophe bond. Essentially an SPV 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.
This is why I am still on WSO, every now and then you find gems like this. Thanks!
Awesome post, definitely not an area I know I ton about. Who are the top firms in the Cat bond issuance space, and would the career path for an analyst at one of these firms be similar to a general FIG capital markets/investment banking role?
I assume this is a pretty recent innovation in the insurance space. What commercial insurance companies are likely most at risk?
Also, what are the risks of these cat bonds? That is, how can you lose money if you were to buy as an institutional investor, for example?
The top banks are basically Guy Carpenter, Aon, Swiss Re, Goldman, CS. There are a number of big hedge funds/asset managers that have specialty funds that invest in these too. It is a relatively small market still.
To answer your question about the risk, it is not very different than traditional insurance risk. Hurricane happens, company has a loss, and then they draw down on the proceeds from the issuance of the bonds to indemnify themselves. Basically investors principal isn’t at risk from a credit standpoint, the principal is in MMFs in a trust and doesn’t leave, but if a covered event triggers a payout the trust will release funds to the insurer/gov/corporate causing a loss to investors. I can’t speak much to your other questions as I don’t have any experience on that side of banking.
Used to work for the woman who ran the Insurance structured finance desk at GS after Mike Millette left to found Hudson Structured Capital. Nephila is a big player in the cat bond investing space - by far. There are a couple of other funds that invest heavily in ILS. Career path for an analyst is in the Structured Finance group, not FIG capital markets, although at Goldman they were both run by this woman. Reinsurance and captive reinsurance etc. is not a recent innovation. Munich Re, Swiss Re Gen Re. etc. have been around for a long time.
What are the risks of these cat bonds? Take a look at Cal Phoenix Re (CALPHO Corp on bbg if you have it) - this was a cat bond insuring PG&E against California wildfire risk.....
You lose money by hurricanes, wildfires, earthquakes, floods (it's mostly hurricanes that are the root tbh) that exceed certain parametric thresholds or dollar loss amounts.
Is there a potential for cat bonds to almost go the same way of credit default swaps? CDS were originally intended to hedge credit risk, but naked CDS buying allowed investors to take risk exposure on securities they didn't even own. Using the same parametric method of payout, could certain investors anticipating increased disaster activity in a certain region issue cat bonds despite having no risk to actually hedge, thus using cat bonds to speculate on meteorological risk?
Yes that is absolutely possible just relatively uncommon. Players in the space (both insurers and funds who invest in these products) buy products that pay out when certain losses are exceeded ($10bn Florida Hurricane trigger, $50bn aggregate cover that covers Hurricane, Earthquake, Wildfire, over the USA, or worldwide, etc.) as a purpose of hedging losses against their own insurance portfolio. I'm not aware of investors that do buy these instruments similar to how naked CDS' were purchased in the past but they certainly may exist. My guess is that there are very few to none because the industry is just so esoteric to anyone who is not a catastrophe modeling or insurance expert.
Wow, very interesting stuff. Insurance is always made out to be boring but there's so many different niches and nuances to it.
Contrarian view: these will be popular until rates go back up. Didn't the holders of the PGE Catbond get wiped after the Camp Fire?
Don't get me wrong - I think the math is cool and there are some interesting structuring opportunities, but there's a reason that the market is so small and illiquid and mostly made by massive insurers stuffing these things into a GA - it's impossible to make a market on these things. \So it effectively becomes what...some sort of alt-hedge for the insurers or another product with outsized risk in an environment with too many dollars chasing too little yield?
What happened with COVID? Most insurance has a Force Majeure clause, but isn't a cat bond FOR the Force Majeure?
I think it's a great business if you're a specialist, especially because with climate change catastrophe is only going to become more prevalent, I just don't think it has the ability to become as liquid as other products because of how nuanced it is especially as rates go up and investors don't need to go as risk-on to make their hurdle.
You make some good points, however, I disagree with most of what you wrote.
To answer your first statement, yes. These securities are incredibly risky and you can lose your entire investment quite literally overnight. But so is traditional insurance/reinsurance, cat bond or not PGE needed to insure themselves against wildfire risk. The loss happened regardless of who ended up paying it, unfortunate for those investors, but it is the reality of the market. If traditional reinsurance agreements were traded and a catastrophe occurs, anyone holding that paper would be wiped as well. It says nothing about cat bonds as a security, just the risks they cover. I’ll add too many hedge funds are already heavily involved in the reinsurance/insurance industry outside of cat bonds through sidecars, joint ventures, and other structures so they are already well aware of the risks.
Secondly, you’re right. This likely won’t be a massive highly liquid market ever, but there has been significant increases in trading activity as well as investor demand for cat bonds. In fact something like 75% of issuances this year have priced well below initial guidance and have also upsized. They’re little known securities with a lot of nuance which absolutely hampers the speed at which investors will get drawn into the market, but certainly investors are increasingly finding value here. Catastrophic events are random and very difficult to predict, however, this doesn’t necessarily make cat bonds inherently more risky. It all depends on the underlying risks covered and the structure of the bond, many would be rated investment grade if they were rated by the agencies if you compare probabilities of loss. In many cases they are priced at a premium to traditional bonds given a specific probability of loss.
Sure, when rates go up investors purely chasing high yield instruments might take their money elsewhere, but that’s not necessarily the largest benefit of allocating a portion of your portfolio to cat bonds. They are diversifying by nature. They are a near zero beta asset, hurricanes and the financial markets don’t have a large correlation. Even in the event of default on premium payments, your principal is safe as the coverage is automatically canceled and you are still entitled to receiving the coupon payments that weren’t paid.
COVID-19 is a tough example and frankly a lot of litigation is happening around the issue to determine if insurers should have to pay regardless of the language in their policies. That said, the World Bank successfully issued a pandemic cat bond, so it is certainly being used to cover that risk.
I think it will be interesting to see how the market develops, but I stand by my belief that the market will only continue to expand and gain traction. They change the way insurance works, of course it won’t replace the traditional insurance industry, but there are many areas where I think you’ll see increased use in the future.
How exactly do you even go about diligencing these cat bonds? I mean, unlike something like defaults (which can, to a certain degree, be predicted by people), how do you go about predicting the risk of certain natural disasters short of hiring meteorologists into hedge funds?
As an incoming college student, how can I position myself to get involved in this. It looks interesting and definitely looks like it will have a significant place in the future.
Isn't this berkshires bread and butter basically? And essentially the foundation with which the company actually makes money eg through float. Or is what they do related but slightly different
Not at all related. BH underwrites risk, collects premiums, and invests in securities (money on the float). This is capital intensive, they still wear the insurance risk. What we're talking about here is risk transfer - actually securitizing that insurance risk and selling it to capital markets investors like you or me. So now even though we are not licensed insurance companies, we are still backing the insurance risk. We are effectively stepping into the shoes of reinsurers.
What I've never understood is why investors in this space think they can get an edge. The risk is being underwritten by an insurance / reinsurance company that presumably has access to advanced pricing and analytics engines, as well as public data sets and their own internal actuarial experience. What edge does some 'to the moon' Reddit clown have in pricing the risk of relative to, say, Travelers? The answer is they don't. Buyers of these securities are still a pretty small group who are highly specialized - AlphaCat, Nephila, Hudson Structured....these are not institutionals anyone outside P&C insurance nerds have heard of. Trying to build a book for these deals isn't a 4 week process, it's a 6 month roadshow and requires jetting all over the damn world.
They dabble in this space but their reinsurance strategy by and large is providing an ample source of float for the broader BH investment franchise.
Super interesting, thanks for the write up! Is each SPV designated only for one catastrophe in which case the whole amount is given?
Something I can't wrap my head around is, who in their sane mind is investing on this knowing that they have a LGD of 100%? The margins you mentioned do not seem to compensate for this kind of risk. I assume though for a very large fund investing in multiple of this it could be profitable, given that the protected events have such a low correlation.
They don't. It was a simplification, I apologize for the miscommunication. The payout structure is very stratified, you can have a total loss, but in most cases this is not what occurs. Basically a map of the company's exposure is created and catastrophe events are modeled on top of it to give an idea of what losses would like in a given are for a given event. If the bond covers the entire state of Florida and a hurricane only clips the southern tip and only triggers a loss in that location, the bond will pay only a fraction of the original principal. There is often a balance between severity and location in the payout structure. And to answer your first question, no. Each SPV can issue multiple classes of notes in multiple series which cover as many perils as needed
The only thing to note here is that while SPVs can continually issue new series of notes (i.e., 2021-1, 2022-1, etc.) many of them will only do a few issuances out of a certain SPV. The reason for this is that investors have constraints on how much capital they can allocate to a certain SPV.
Great write-up. Really interesting.
Really enjoyed this write-up and found it very interesting - thank you for your contribution.
You mentioned these bonds are exchange-traded instruments - do they rise and fall in value based on things like weather predictions? Can traders speculate on weather with these tools?
Yes, for example when storms start to approach land you will see specific transactions start to get marked down. Traders at funds can then speculate on whether they like the pricing and speculatively trade them.
They can certainly be very volatile during times of trading. As Hurricane Katrina approached New Orleans, some of these bonds were being traded internationally at 10 cents on the dollar from what I remember.
I was a baby monkey back then but that sounds about right
FIG with its first dub
Part 2 on other structured products (collateralized re), career paths post banking, etc. and ILS funds more broadly would be interesting.
Very good post OP. Been doing this for about 5 years now and most of what you mentioned is spot-on. One interesting tidbit is that LPs have been shying away from more risky ILS instruments in the last few years (due to catastrophes) and have gravitated towards more risk-remote instruments in cat bonds. Thus, we have been seeing a lot of inflows in this particular area of the ILS asset class. Of course, risk-remote is relative when you are talking about low-probability, high severity that have the potential to blow your entire investment, but I digress.
Only part of your write-up I would kind of disagree with is the increasing diversification of perils resulting in materially more investment in the ILS space. Most ILS instruments flow through about ~$100bn in fund managers who are increasingly wary to such perils that are unmodeled (anything outside of established perils such as hurricane, earthquake, severe convective storms (thunderstorms), winter storm, etc.). This has been mostly driven by their experience of being burned (literally) by unmodeled wildfire and COVID losses over the last few years. The transactions you mention getting done for wildfire / terrorism pay a stupendous amount of money relative to the perceived risk and aren't particularly scalable for the ILS industry. As of right now, it's difficult to see the established fund managers who control most of the AUM rapidly expanding this since its unmodeled (or poorly modeled at best) and have been under pressure from their LPs to avoid "surprise" losses that aren't modeled. However, the pricing is so good in these unmodeled perils that we have been seeing increased activity from multi-strat and regular way financial investment firms starting to play in this space (albeit not at a meaningful scale), so its certainly possible this continues to grow.
If anyone has any further questions, please feel free to reach out.
Deleted - dupe comment.
Really great post. I recently looked at a company that did parametric insurance for flooding. Install a sensor in your basement or warehouse and the second the water hits the trigger cash goes to your account. Super cool stuff.
Are there any asset managers focused on this? Seems interesting from an asset allocation perspective given the, supposedly, low correlation to markets
There are some hedge funds who do this stuff. Fermat and RMS come to mind first, they've got a lot of math guys working for them, and they hire the services of meteorological experts, oceanographers, etc.
PGGM, a Dutch pension fund, has a insurance linked investment team that managed a $4bn portfolio back in 2018.
Interesting. What about mutual funds available for the more regular joe?
How much secondary trading goes on in this space? Are there dealers who make markets in this stuff?
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