Disaster Relief.

With reinsurance prices inching upward, the horizons of securitization expand.

During the 1990s, as the insurance industry contemplated potentially devastating catastrophe exposures and the threat of unprecedented insolvencies, the U.S. capital markets offered succor. Securitization, the process of transferring risk to private investors, soon became the industry mantra.

Since February 1994, investors have committed an estimated $4.1 billion to the capital markets for securitizing insurance risk, most commonly with catastrophe--or "Act of God"--bonds, according to Insurance Services Office Inc. Catastrophe options indices, which are based on insurers' loss information provided by ISO, have been traded on the Chicago Board of Trade.

This investment tally looks promising, but cat bonds, for one, have yet to approach the transactional volume that experts were forecasting a few years back. Many in the industry say the availability of relatively cheap reinsurance has been hampering development of the securitization market.

The level of securitization activity in 1999 was similar to that of 1998, said Charles W Kerner, managing director of American Re Securities Corp., Princeton, N.J.

"Not many deals have been done, and the major reason is the pricing difference," he said. "This field has a lot of potential, but it must overcome the relative pricing differential. In pure pricing, the reinsurance markets are more cost competitive."

But by early indications, reinsurance prices are on the rise. And that, together with efforts to remove some regulatory obstacles that proponents say have stymied growth, could be the spark needed to ignite this fledgling market.

In the early 1990s, securitization loomed like a lifeline to insurers after Hurricane Andrew produced $18 billion in claims in 1992, and a reported 63 insurers became insolvent in the wake of Andrew and Japan's Hurricane Iniki. Catastrophe computer models now indicate that the United States is exposed to hurricane and earthquake losses that could exceed $100 billion in a single year. ISO estimates that property/casualty insurers' total surplus through 1998 was only $333.5 billion, leaving them vulnerable to numerous unpaid claims and record insolvencies.

By February, Gail Belonsky, a director at Swiss Re New Markets, New York, had noticed a higher level of interest in securitized products. "There is increased interest vs. last year on the part of insurance and reinsurance companies that need to use securitization as a risk-management tool," she said.

Early Issues

The best known of the catastrophe securitizations was led by USAA, the San Antonio-based insurer that primarily markets to active and retired military members. Its $477 million catastrophe bond in 1997 was designed to insulate the company if a megahurricane hit the East Coast of the United States during the covered year.

With catastrophe bonds, an insurer places catastrophe risk with a special-purpose reinsurer, which then issues bonds backed by payment for that coverage. Typically, the bonds are sold to institutional investors, often in increments of $1 million or more. The attraction is that nearly every securitized product pays as much as several points above Treasury notes or other "safe" investments. The danger is that in the event of a catastrophe, investors could lose their interest payments or all or part of the principal, depending on how the bond is structured.

In contrast to its 1997 issue, USAA's cat bond in 1999 was only $200 million for hurricane cover. The company explained that it was largely using traditional reinsurance because it was cheaper, but it issued the bond to remain a leading player in the securitization market.

New Issues

Although this market as a whole may have been idling in 1999, there still were some groundbreaking developments.

Last April, Kemper Insurance Cos., Long Grove, Ill., placed $100 million in catastrophe bonds, the first reported large-scale offering solely encompassing Midwestern U.S. earthquake risk. Previously, options exchanges had offered risk contracts covering only portions of the New Madrid quake region. Kemper's transaction also marked the first time an insurer had set up a securitization involving a U.S.-based special-purpose reinsurer. Typically, special-purpose reinsurance companies have been based offshore, where taxes and regulation are less stringent.

William D. Smith, Kemper president and chief operating officer, said the transaction allowed the company to prudently diversify its access to catastrophic reinsurance capacity. "We obtained fully collateralized reinsurance protection on a multiyear basis against our Midwest earthquake exposures more efficiently than we could have in an offshore transaction."

Also, this appeared to be the first cat-bond offering covering predominantly commercial property exposure. Most other large-scale cat bonds have been designed to underwrite homeowner losses, such as in Florida or California.

The offering was based on an earthquake model for the central United States developed by Applied Insurance Research, a Boston-based statistical modeling and research company. Scientists believe the New Madrid region, which extends through Missouri and six other states, may be poised for a major earthquake. The last catastrophic earthquake activity in that region was in 1811 and 1812, when tremors were felt as far away as Boston.

The Kemper transaction was handled through the Inex Insurance Exchange, based in Chicago. Transactions of this type were not feasible until November 1999, when the Illinois Department of Insurance issued an order that allowed Inex to permit special-purpose limited syndicates to conduct insurance securitization transactions.

New Trigger

In November, American Re Securities Corp. placed $182 million in catastrophe bonds, called Modeled Index-Linked Securities, to help protect American Re and its subsidiaries against heavy losses from East Coast and Gulf Coast hurricanes, along with potential earthquakes in California and the Midwest's New Madrid region.

The offering was another innovation in an industry that's trying to make it easier for investors to understand their risks. These securities differ from similar transactions because the protection they provide the reinsurer is triggered by the size of an index of modeled insurance industry losses from specified types of catastrophic events, not by the actual losses that the reinsurer incurs.

Risk Management Solutions Inc., Menlo Park, Calif., developed the index of losses. In case of an event, RMS said it would use its simulation technology to estimate industry losses. That estimate, in the form of an index value, will determine whether investors lose their investment. The index will be finalized 60 days after an event and will be based on RMS catastrophe models and information from such organizations as the U.S. Geological Survey or the National Hurricane Center, RMS said.

"With a typical cat bond, it's necessary for the investor to wait to see how actual claims develop after an event occurs," Kerner said. But by using index-linked securities, American Re removes much of the uncertainty for investors, he said. "These investors know their losses exactly within 60 days. The speed of settlement is important, and it's also cleaner, with less dependence on the actual claims-adjustment processes of the sponsoring organization."

In December, Gerling Global introduced its own new form of securitization when it placed $100 million in notes to cover earthquake losses in Japan. The notes are based on a "notional portfolio" that allows Gerling to update its exposure semiannually. The notes give Gerling more reinsurance capacity and stabilize its reinsurance costs for five years, the company said.

Corporate Players

An earlier milestone came in May 1999, when Tokyo Disneyland  became the first noninsurer to issue bonds to cover catastrophe losses. Oriental Land Inc., the owner of Tokyo Disneyland, placed two catastrophe bonds totaling $200 million to protect against earthquake risk. The bonds protect Tokyo Disneyland against property damage and business interruption.

With the first bond, Concentric Ltd. of the Cayman Islands would pay Oriental Land $100 million based on the magnitude, depth and location of an earthquake. The second, through Circle Maihama Ltd., gives Oriental Land a $100 million financial facility. In case of a major quake, Oriental Land would issue a five-year bond with no obligation to pay interest for three years.

In addition to being the first corporate securitization, the transaction is part of a need to acquire risk coverage in Japan, said Risk Management Solutions. RMS analyzed the risk for French reinsurer Sorema S.A., which issued a $17 million bond to secure retrocessional capacity. That transaction also includes coverage for Japanese earthquakes and typhoons, along with European windstorms.

In the United States, utilities may be among the first homegrown corporations to use the capital markets because it's become increasingly difficult for them to buy insurance to cover transmission interruptions. Insurers have become more reluctant to cover these risks following the losses from Andrew and the 1998 winter ice storms in Canada, said EQE International, a risk-management company that has software for modeling catastrophe risk.

Corporate cat bonds, while remaining a part of risk management, aren't expected to supplant insurance, said Andy Kaiser of Goldman Sachs & Co., which managed the Tokyo Disneyland placements. "Risk managers are looking for a variety of ways to manage risk and want to diversify their protection," he added.

So do insurers. Last year, ISO issued a study showing that the right mix of securitization and reinsurance could save insurers money as they strive to protect themselves from major catastrophe claims. Using options in the capital markets can cut the cost of financing catastrophe risk by a range of about 8% to 20%, ISO said.

Besides looking to diversify protection away from the traditional reinsurance markets, some entities issue catastrophe bonds simply as a learning experience. That was the case for the California Earthquake Authority, which announced plans in September to issue a $100 million cat bond to see how institutional investors would respond.

"We don't have experience doing this, and we want to watch someone who knows how to put this into the capital market," said Tim Richison, the authority's chief operating officer.

One appeal of the securitization market is that it offers products that simply aren't available in the reinsurance market, Kerner noted.

In addition to catastrophe bonds, other securitizing tools include:

* Contingent surplus notes. Insurers buy the right to issue these notes to intermediaries or investors in case of a catastrophe.

* Catastrophe options. Insurers buy catastrophe options from investors through an exchange. If catastrophe losses--linked to a strike price or index--are high enough, investors pay cash to cover claims.

ISO says options can be among the most complex choices for insurers because of the link to the strike price. If a major catastrophe falls short of a company's claims history index, insurers could be caught paying for claims they thought they were protected from.

* Catastrophe equity puts. These options, created by Aon Corp., allow insurers to sell a certain amount of stock at a predetermined price if catastrophe losses reach a specified level.

Meanwhile, regulators have been seeking ways to make it easier for U.S. insurers to access the capital markets through securitizations.

In December, the National Association of Insurance Commissioners, which includes insurance regulators from the 50 states, the District of Columbia and four U.S. territories, adopted the Protected Cell Model Act.

The model would enable a domestic insurer to issue securitizations out of "protected cells," which would be safeguarded from the bankruptcy of the rest of the insurer. Investors consider this feature essential if these transactions are to be conducted in the United States, the NAIC said.

George Reider Jr., former NAIC president and Connecticut insurance commissioner, said this innovative solution to catastrophic risk would allow domestic insurers to securitize risk in the capital markets in an efficient and economical manner.

Investors in fully funded insurance securitization transactions provide funds that are available to pay the insurer's insurance obligations, to repay the investors or both.

Accounting Issues

On a separate issue, the NAIC last year commissioned a task force of the American Academy of Actuaries to help regulators determine whether index-based derivatives, such as the PCS index options traded at the Chicago Board of Trade, need to be treated differently on balance sheets. Current statutory accounting rules call for these instruments to be listed under assets, rather than underwriting results. Insurers maintain that this requirement is a barrier to more widespread use of these products.

For instance, if a derivative were to be listed on a company's books as reinsurance, "it would lower premium, make the premium-to-surplus ratio look better and make losses look smoother," said Glenn Meyers, chief of actuarial research and assistant vice president at ISO.

The task force planned to present its analysis at the NAIC's March 11 meeting in Chicago. "They could make this a part of their accounting procedures," said Meyers, a member of the task force.

Along with these developments on the regulatory front, there were signs earlier this year that the reinsurance market was hardening, primarily due to the heavy losses from windstorms that swept Europe in late December. Following the January renewals, underwriters, brokers and buyers in the London insurance and reinsurance market reported a halt to four years of declining prices and tentative rate hikes in many lines.

"People think that this is the year that rates will turn," said Marie-Louise Rossi, chief executive of the International Underwriting Association of London.

Broader Horizons

Early this year, Swiss Re New Markets began to detect greater interest in securitization as a risk-management tool. In the future, securitization will become a more integral part of the way reinsurers manage risk, said Belonsky of Swiss Re New Markets.

Belonsky describes Swiss Re New Markets, formed in July 1997 by Swiss Re Group, as a large secondary market trader of insurance risk and a counterparty in a number of over-the-counter option trades. Soon after its inception, Swiss Re New Markets made news as the first capital-markets division to securitize 1ese earthquake risk and to underwrite the first catastrophe-linked bonds tied to the occurrence and severity of a physical event, rather than to actual insurance losses.

The reinsurer's role as a transformer of risks "is something we're going to see more of in the future," Belonsky said. "I can see Swiss Re writing a lot of regular reinsurance policies, keeping certain parts of them, then selling various other pieces out to the capital markets."

Future securitizations are likely to address risks beyond property and catastrophe exposures. Industry experts cite credit risk, political risk and residual value insurance as ripe for securitization. "Some of those risks have more history behind them, so they might be easier to market and sell," Belonsky said.

Kerner of American Re agrees, pointing out that securitization can succeed only in sectors where risk can be analyzed in great detail, That makes life insurance, with its wealth of data on mortality experience, an obvious candidate.

On the other hand, Kerner doesn't expect securitization to embrace such risks as satellite or environmental claims because "there's not a lot of scientifically viable data available there," he said.

Whatever new prospects risk securitization promises for the future may have to wait until greater numbers of investors are willing to participate in transactions to a greater extent, Kerner said.

"To expand the universe of investors who are comfortable with insurance risk, the market will have to offer more transactions as well as some higher-rated transactions," he said. Kerner thinks that a leveling of the price differential between the reinsurance market and the capital markets will help increase the number of transactions, while the securitization of some consumer lines with more stable risks, such as life insurance, will offer higher-rated deals.

"I'm confident the market will develop further," he said. "It's just a question of time."

                     Selection of 1999 Securitizations
Company                                Size Description
Allianz (Germany)            $150.0 million Catastrophe bond option
St. Paul Re                   $45.7 million Catastrophe bonds
Kemper Insurance Co.         $100.0 million Catastrophe bonds
Sorema S.A.                   $18.0 million Catastrophe bonds
Oriental Land Inc. [1]       $100.0 million Catastrophe bonds [2]
Undisclosed U.S. insurer [3]  $70.0 million Option
USAA                         $200.0 million Catastrophe bonds
American Re [4]              $182.0 million Catastrophe bonds
Gerling Re                   $100.0 million Catastrophe bonds

(1.)Self-insured owner-operator of Tokyo Disneyland.

(2.)The transaction also provided $100 million of contingent debt.

(3.)Option issued by Societe Generale protecting a U.S. insurer against earthquakes in the New Madrid area.

(4.)American Re Capital Markets has a catastrophe-related index swap agreement with Gold Eagle Capital Ltd.

Source: Insurance Services Office Inc.