Solvency II changes may mean more EU-based cat bonds

LONDON: More European insurers will choose EU jurisdictions to domicile their catastrophe bonds as a result of new insurance solvency rules coming into force in 2013, insurers and analysts say.

Similar to the Basel II banking regulations, the Solvency II directive sets new supervisory rules for the insurance and reinsurance industry across the European Union, aiming to better align insurance companies' capital safety cushion with the risks on their books.

Under the changes, Insurance Linked Securities (ILS) instruments will be recognised as a risk mitigation tool and allowed capital relief. Previously, only traditional reinsurance was recognised as such.

Analysts say this will boost demand for capital in the industry overall with ILS instruments such as catastrophe bonds which insurers use to transfer risks associated with natural disasters to capital markets investors set to benefit as an alternative to traditional reinsurance and retrocession contracts.

Catastrophe bond notes are issued through special purpose reinsurance vehicles (SPVs), for which insurance sponsors have historically favoured offshore havens such as Bermuda or the Cayman Islands.

Under Solvency II, before the risks are transferred to SPVs in non-EU jurisdictions, they will need to be assessed for "regulatory equivalence" by the insurer's domestic regulator.

"If a sponsor will not be able to claim any credit for their SPV (outside the EU), then there is a strong incentive to move to Europe," said Cameron Heath, a credit analyst at rating agency Standard & Poor's.

Two recently launched cat bonds, Pylon II Capital Ltd and Queen Street III from French bank Natixis SA and Munich Re respectively, both used Ireland to domicile their SPV

A key requirements under Solvency II is that insurance and reinsurance providers hold eligible net assets, or 'own funds', to cover the solvency capital required. Insurers can compute this based on a standard formula or by using an internal model approved by the relevant supervisor.

But insurers and analysts say the rules under both types of model are cumbersome for any cat bond structures other than indemnity transactions using licensed SPVs in the EU.

Cat bonds are structured as either indemnity-based bonds, which are triggered by the issuer's actual losses, or non-indemnity bonds, triggered by breaching estimates made by catastrophe modelling software, or index calculations. These are known as modelled loss, parametric or industry loss index bonds.

Indemnity structures have always been favoured by EU regulators, but parametric deals should be given some credit under the new rules, said Angus Duncan, a partner at law firm Cadwalader, Wickersham & Taft LLP.

"Full capital benefit for a parametric-based deal will not be possible though, as the basis risk between the parametric trigger and full indemnity protection will need to be modelled," he said.

Non-indemnity bonds contain basis risk, meaning a cat bond may not be partially or fully triggered even when the sponsor of the transaction has suffered a loss. Rating agencies consider the basis risk when assigning a financial strength rating to the deal.

"Some of that basis risk can be estimated quantitatively, but some cannot. That will be one of the challenges for the companies that have their internal model approved - how do you account for the part that you can't quantify?," said Heath.

This is not the case for indemnity bonds as any losses are covered on a dollar-for-dollar basis.

Heath said sponsors are already looking to minimize their basis risk even before the Solvency II regime comes into play.

"In addition to industry loss and parametric structures, we have seen more modeled-loss structures which are intended to better replicate the indemnified losses," he said.

Insurers sponsors may also prefer to issue periodic tranches of catastrophe risk from a 'shelf programme' as has Swiss Re with Vita Capital.

On Tuesday, the world's second biggest reinsurer issued its fifth and sixth set of notes from the six-year mortality-linked cat bond programme.

"The SPV regulations should mean that programme-type structures will be more attractive," Cadwalader, Wickersham & Taft's Duncan said.

Copyright Reuters, 2011