Reinsurance is insurance for insurance companies. It is a way of transferring or “ceding” some of the financial risk insurance companies assume in insuring cars, homes, and businesses to another insurance company, the reinsurer. Reinsurance, a highly complex global business, accounted for about 9 percent of the U.S. property/casualty insurance industry premiums in 2008, according to the Reinsurance Association of America. The reinsurance business is evolving. Traditionally, reinsurance transactions were between two insurance entities: the primary insurer that sold the original insurance policies and the reinsurer.
Most still are. Primary insurers and reinsurers can share both the premiums and losses or reinsurers may assume the primary company’s losses above a certain dollar limit in return for a fee. However, risks of various kinds, particularly of natural disasters, are now being sold by insurers and reinsurers to institutional investors in the form of catastrophe bonds and other alternative risk-spreading mechanisms. Increasingly, new products reflect a gradual blending of reinsurance and investment banking. After Hurricane Andrew hit Southern Florida in 1992, causing $15.5 billion in insured losses at the time, it became clear that U.S. insurers had seriously underestimated the extent of their liability for property losses in a megadisaster. Until Hurricane Andrew, the industry had thought $8 billion was the largest possible catastrophe loss. Reinsurers subsequently reassessed their position, which in turn caused primary companies to reconsider their catastrophe reinsurance needs. The shortage and high cost of traditional catastrophe reinsurance precipitated by Hurricane Andrew and declining interest rates, which sent investors looking for higher yields, prompted interest in the securitization of insurance risk. Among the precursors to catastrophe bonds and other forms of securitization were contingency financing bonds such as those issued by the Florida Windstorm Association in 1996, which provided cash in the event of a catastrophe but had to be repaid after a loss, and contingent surplus notes—an agreement with a bank or other lender that in the event of a megadisaster that would significantly reduce policyholders’ surplus, funds would be made available at a predetermined price. Funds to pay for the transaction should money be needed, are held in U.S. Treasuries. Surplus notes are not considered debt, therefore do not hamper an insurer’s ability to write additional insurance. In addition, there were equity puts, through which an insurer would receive a sum of money in the event of a catastrophic loss in exchange for stock or other options. A catastrophe bond is a specialized security, introduced in 1997, that increases insurers’ ability to provide insurance protection by transferring the risk to bond investors. Commercial banks and other lenders have been securitizing mortgages for years, freeing up capital to expand their mortgage business. Insurers and reinsurers issue catastrophe bonds to the securities market through an issuer known as a special purpose reinsurance vehicle (SPRV) set up specifically for this purpose. These bonds have complicated structures and are typically created offshore where tax and regulatory treatment may be more favorable. SPRVs collect the premium from the insurance or reinsurance company and the principal from investors and hold them in a trust in the form of U.S. Treasuries or other highly rated assets, using the investment income to pay interest on the principal. Catastrophe bonds pay high-interest rates but if the trigger event occurs, investors lose the interest and sometimes the principal, depending on the structure of the bond, both of which may be used to cover the insurer’s disaster losses. Bonds may be issued for a one-year term or multiple years, often three. The field has gradually evolved to the point where some investors and insurance company issuers are beginning to feel comfortable with the concept, with some coming back to the capital markets each year. In addition to the high-interest rates catastrophe bonds pay, their attraction to investors is that they diversify investment portfolio risk, thus reducing the volatility of returns. The returns on most other securities are tied to economic activity rather than natural disasters. Catastrophe bonds have evolved into a multi-billion dollar industry. Though pioneered by reinsurers, primary insurers now frequently sponsor new issues. In addition to catastrophe bonds, catastrophe options were developed but the market for these options never took off. Another alternative is the exchange of risk where individual companies in different parts of the world swap a certain amount of losses. Payment is triggered by the occurrence of an agreed upon an event at a certain level of magnitude.