Preparing for Catastrophe

You would have undoubtedly heard of the tragic loss of life and extensive damage to property in recent windstorms in Oklahoma. The insured losses alone are estimated at close to $3.5 billion, and the human cost would be sadly immeasurable. Now, this is not a discussion on the prudence or otherwise of building houses in a geographical oddity of a place referred to as “tornado alley”. The fact is that every opportunity has a measure of calculated risk involved. The removal of uncertainty associated with these risks is the function of insurance. Insurance has contributed to the development of international trade, entrepreneurship, and even facilitating something as mundane or common as the risk involved in driving to work. It is not sexy or glamorous, but insurance allows things to get done.

Recent developments in international capital markets over the past years have been focused on the cross-sectoral transfer of risk from insurance and reinsurance to investors, especially since Hurricane Katrina in the US. This has borrowed from risk-transfer practices in the banking sector, particularly through the use of insurance sidecars and securitisation using tax-neutral reinsurance special purpose vehicles (RSPVs).

The Malta Financial Services Authority (MFSA) recently launched a consultation on the regulation of RSPVs in Malta, which brings the importance of these instruments to the fore. The process is as follows: the ceding reinsurer/insurer enters into an agreement with a RSPV to transfer the portfolio of risk, typically through a reinsurance contract. The RSPV then issues bonds to the capital markets known as Insurance Linked Securities (ILSs). When the risk ceded involves some catastrophic risk such as earthquake, hurricane, or flooding, they are referred to colloquially as ‘Catastrophe Bonds’. The proceeds from the sale of the bonds are invested in highly-rated, short-term investment products such as money market instruments, which are used to fully collateralise the exposure of the RSPV to the exposure it may have under the reinsurance agreement with the ceding insurer. The investors in the ILSs receive an income which is based on the investment income from the collateral and the proceeds of the reinsurance contract. However, their capital is at risk and may be completely lost depending on the extent of the damage to the insured portfolio, payouts to which are based on a number of various triggers agreed between the parties. ILSs enjoy a number of potential benefits to both investors and insurers alike. Investors benefit from having relatively high income assets which have little or no correlation with other investment products as the payout/capital redemption effectively depends on the happening of specified weather events. This allows an investor to further diversify his or her portfolio. Insurers benefit from having the facility to optimise their risk portfolios, reducing the amount of capital that would have to be held for
exposure to catastrophic risk. It also allows insurers to optimise for geographical exposures.

This has the effect of increasing the return on capital for insurers, and eventually the gain is passed on as savings to the end client. The benefit also extends to society in general, as the model of “fast capital” as applied to insurers allows insurers to take on risk which they would be otherwise unable or unwilling to take on, and consequently allow business decisions to be taken without fear of uncertainty.

Naturally, it is prudent to consider the full implications of the use of RSPVs in Malta, whether in the context of domestic or international risk. The MFSA’s consultation speaks of authorisation for RSPVs, mandatory conditions for all contractual arrangements, and solvency requirements amongst others. This move is positive for instilling investor confidence by ensuring adequate protections by defining the RSPV regime in Malta, which was not previously specifically addressed by the Securitisation Act, and consequently cements Malta’s reputation as an emerging financial sector, more so in the structured risk transfer arena.

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