Risk-linked bond market poised for rapid growth

ZURICH, Switzerland—The worldwide market for risk-linked securities is expected to grow rapidly over the next decade, with the volume of life bonds leading the way, followed by property/casualty catastrophe bonds, according to a study.

Swiss Reinsurance Co.'s sigma report, "Securitization--New Opportunities for Insurers and Investors," found that in the past five years, the outstanding volume of P/C securities has doubled, while the volume of life bonds has tripled to a combined total of about $23 billion. By 2016, that volume is projected to grow to $150 billion to $350 billion, driven primarily by the life industry's funding needs, Swiss Re said.

"Life bonds typically securitize the flow of future premium payments of traditional life insurance policies," the study said. Investors assume burdens such as mortality and lapse risks, although the life insurer retains the obligation to pay the policies.

The benefits of life securitizations include "improved profitability" by reducing sponsors' need to hold capital, which increases sponsors' ability to write new business. At times, life securitizations also provide tax advantages, Swiss Re said. "Life bonds also monetize intangible assets, fund regulatory capital requirements and transfer catastrophic risks" such as pandemic flu or a sharp mortality increase, to the bond market, the study said.

P/C insurers have many ways to transfer risk and manage capital, including traditional reinsurance as well as catastrophe bonds, catastrophe swaps, industry loss warranties, contingent capital or sidecars.

The most typical risk transfer is a cat bond transaction, in which a special-purpose vehicle enters into a reinsurance contract with a cedent and simultaneously issues cat bonds to investors, usually through an excess of loss contract, Swiss Re said.

"If no loss event occurs, investors receive a return of principal and a stream of coupon payments that compensate them for the use of their funds and their risk exposure. If, however, a pre-defined catastrophic event does occur, investors suffer a loss of interest, principal, or both," the Swiss Re report said.

With any securitization, "it is important to choose the jurisdiction that best fits the transaction" in terms of regulatory and tax treatment, Swiss Re said. "For example, South Carolina is often used for Triple X securitizations because these bonds are based on U.S. life business and South Carolina allows organizations to form special-purpose financial captives," it said.

In addition, "transactions need to be large to be economical," the study said. "For the life bonds, transactions are complex and need to be at least $200 million to complete the transaction efficiently. P/C bonds are often smaller, but still need to be about $100 million," even though smaller transactions are projected to become feasible as the market matures.

Even so, the growth of life securitizations and P/C cat bonds face impediments that include insurers facing more rigorous risk-transfer tests as well as rating agency and regulatory capital models "not rewarding the full value of cat bonds," Swiss Re said.

"Standardization of cat bond contracts would facilitate growth," the study said.

The Swiss Re sigma study is available online at www.swissre.com/sigma.