Monday, June 16, 2014

Bermuda: The Domicile of Choice for ILS Entities - Sophisticated Counterparties, Light Regulation - Property Catastrophe Arena - Earthquakes and Hurricanes - Calibrating Models to Predict Outcomes - Impact on Traditional Markets - More Money Coming Into the ILS Space - Moral Hazard

KPMG in Bermuda: Deciphering Insurance Linked Securities


Published on Jan 28, 2013

With Bermuda fast becoming a central player in the ILS market, KPMG in Bermuda has brought together an experienced team of structured finance professionals across our services lines to form the Insurance Linked Securities ("ILS") Group.

Deciphering Insurance Linked Securities
with Jason Carne
Managing Director | ILS Insurance Practice | KPMG in Bermuda

Hi. I'm Jason Carne. I'm the managing director in charge of our ILS insurance practice here in Bermuda. I've been a partner for about 15 years, I've been in Bermuda for 20 years, and during that time I've worked predominantly in property catastrophe reinsurance business. So I have a unique insight into a number of these ILS types of products. And I think that's why the firm asked me to take the lead in the ILS market here.

What is an Insurance Linked Security (ILS)?

An insurance linked security is, essentially, it's an instrument that provides protection for a buyer, in a collateralized form, against an insurance loss. And that insurance loss could be an event such as an earthquake in California, or a hurricane in Florida, or an extreme mortality type of a loss – let's say it's a pandemic flu or something like that – and the unique thing about them are that it takes away the counterparty risk, from the buyer's perspective. So within the traditional market, you had insurance contracts between two companies; and when one insurance company buys protection from another, that buyer assumes the credit risk – the counterparty risk – of the company it does business with.

But in an insurance linked security structure, that counterparty risk is removed, and replaced by funds that are placed in a dedicated trust account that is only available for use by the purchaser, in the event of a loss. So it really takes away the counterparty risk from the buyer's perspective, and that's one of the reasons we've seen some growth in this area in the last several years.

Why has there been such rapid growth in this area in the last few years?

I think these products have been around for a while; so they've been around for 15 years or more – certainly the early catastrophe bonds were done 15 years or more ago. And I think we've seen a few things happen over the last several years. Firstly, the costs of doing these have come down substantially. The costs really were somewhat prohibitive in the early days, but now we've got a greater volume of these bonds. There's more parties that have got the necessary knowledge and experience to bring these to market a little bit on a more cost-effective basis than perhaps we've seen in the past.

We've also seen some larger events: so World Trade Center, we've seen Hurricane Katrina – some of those events have really challenged the stability of traditional reinsurers, and we've seen some companies go to the wall as a result of that. And I think investors are really looking for the security that a collateralised ILS product brings. So that has certainly helped with growth.

The other thing I would say is that we've seen some improvement in modeling over the last 10 to 15 years or so. So where we talked about a 2 percent risk of default, that is really driven by a modelled analysis of, let's say, the impact of a Category 4 hurricane hitting the Florida coast. And the sophistication of the modelling, and the ability of the modellers to predict the magnitude of an event happening, and the probability of it happening, have really improved substantially. As we've had more events, they get better at calibrating their models to predict outcomes. And I think that's led to some investor confidence – greater investor confidence. And I think that's led to more money coming into this space.

And then finally I would also add that we are in an environment at the moment where there is very little in the way of yield in the traditional markets. And a lot of institutional money, and other money, is looking for yield and looking for a home to get a good reward without taking undue risk. And I think that has also driven some money into this space, because the yields are very attrative relative to the risk. So if you bundle all those things together, I think we've seen some fantastic growth in this area, certainly in the last 5, 6 years. And I personally expect it to continue for the foreseeable future as well.

Why has Bermuda emerged as the domicile of choice for ILS entities?

Bermuda is the natural home for these vehicles. We already have some of the world's top talent in the property catastrophe market on the island. Some of the world's top underwriters are here, that are working for the Class 4 commercial property catastrophe reinsurers; we have some of the world's top modellers here; we have some of the world's top legal brains in the reinsurance industry, that are here; we have some of the world's top accounting brains that are in the reinsurance industry, that are here; and we have one of the world's leading regulatory jurisdictions, that is used to regulating the reinsurance market and the property catastrophe market, is also here. So when you bundle all those things together, Bermuda is an overwhelming leader in this field.

So I think, because of that, we've seen a lot of these ILS structures, and a lot of these ILS vehicles, come to the island to be able to tap into the expertise that we have on the island. And certainly, the regulatory environment is sensible and appropriate here. So it's not overly burdensome, it doesn't regulate an ILS vehicle the way that it would regulate an insurance company, because an insurance company is dealing with members of the public that are somewhat, let's say, unsophisticated in insurance, whereas the ILS market is really a… it's done between grown-ups. And you have sophisticated counterparties that really don't need the heavy level of regulation that an insurance company would have. And I think we've designed a regulatory framework that works extremely well for these vehicles: it's cost-effective, you can do some of these structures in a special purpose insurer that only needs a dollar of capitalisation to set up, and I think you have a fee structure here that is extremely competitive. When you wrap all those things together, it makes Bermuda a really, really attractive jurisdiction to base these vehicles.

What does the future hold in store for the ILS industry?

I think the future's bright. I think some of the capital that are come into the ILS space is permanent, and a little bit maybe opportunistic – we may see some institutional investors just taking advantage of the enhanced yields that are available, relative to the corporate bond market. But overall I think the capital that's here is largely here to stay. I think in terms of growth, I think we're seeing more and more investors looking to diversify their investment portfolios and get some exposure to this market. As a result of that, I think that will drive growth. I think we'll see growth through the same perils: so windstorm and earthquake, I think we'll see those – the buyers of those risks diversify. So at the moment, the buyers tend to be North American, European, Japanese; I think in the future we'll see a greater geographic spread of some of those types of bonds.

And I also think we'll see growth in the types of perils that are covered. So we've seen some interest around things like satellite, offshore energy; we've seen a little bit of these already, but I think we may see some greater growth in these types of products as well. So I think we'll see diversification geographically and diversification in types of risks that are covered. And when you marry that up with the increased funds that are looking to get into this space, I think we will see continued growth in the ILS market over the foreseeable future; so, I think the future's bright.

How can KPMG help? 

Well, KPMG's been working in this space for 15 years or more. And we've really been at the centre and the forefront of a lot of what has happened. Our role… people tend to think of us just as auditors, but we do so much more than that. We have an actuarial team here of 5 people – 5 actuaries: they have fantastic experience in property catastrophe arena; they are sophisticated modelers; they have great insight into the types of reserves that need to be held whenever these catastrophe events happen.

And then we also have a lot of experience around the audit of the claims orders. So when an event happens, investors generally would like confidence around the moral hazard of an insurer paying the claim and not making fraudulent claims into the ILS structure. So what a claims reviewer would do – and what KPMG would do in this role – is actually go in, inspect the claims, make sure that the claim is covered under the insurance policy, make sure there's been appropriate due diligence around the claim itself: that the valuation is acceptable, and that the claim has been appropriately paid and authorised. That can be extremely invaluable in adding a level of credibility and confidence to an investor, when they're looking to invest in these types of products.

We also do tax work; so certainly to the extent that there is U.S. investors in catastrophe bonds or ILS funds, we could certainly help investors with some of their compliance returns. We also can do tax planning, for individuals and for corporations, around this space as well. So there's a real wealth of expertise we have in this area. And I would venture that we are the leading firm in this space.

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Thank you

The Divine Comedy: "Here Comes the Flood"

XTC: "Great Fire"

Peter Tosh: "Igziabeher (Let Jah Be Praised)"

KPMG in Bermuda: ILS and the impact on traditional markets


Published on Feb 4, 2014
In this Podcast, we sit with Jason Carne, Head of ILS, to discuss Insurance Linked Securities and its impact on the traditional market.

Questions include: What are Insurance Linked Securities (ILS)?
What is the traditional market?
What are the benefits for the buyer and the seller?
Why has ILS grown so significantly?
What impact does ILS have on traditional markets?
What services do KPMG provide?
Why KPMG in Bermuda?

ILS and the impact on traditional markets
with Jason Carne

What are Insurance Linked Securities (ILS)? 

Insurance linked securities are instruments where the insurance company – the buyer – is buying a limit of cover that is either fully collateralised or fully funded by the counterparty. Examples of insurance linked securities would be catastrophe bonds, or collateralised reinsurance, and things like ILS funds, where ILS funds are maybe buying catastrophe bonds and/or collateralised reinsurance. And we're seeing great growth in this area, and it's brought a lot of new capital and new ideas into the reinsurance market.

What is the traditional market?

So if you go back in time, the traditional market is really an insurance contract of utmost good faith between a buyer and a seller. So the insurance company would buy cover from another insurance company, in the form of a reinsurance agreement; and in the event of a loss, the reinsurance company would pay losses to the insurance company; and in the event of no losses, the reinsurer walks away with the premium.

So the catalyst – or one of the catalysts – for the insurance linked securities market, is the buyers, in some situations, were getting concerned about the counterparty risk of just buying from another company. Because in the event of a very significant, or series of significant catastrophes, the reinsurer could become insolvent. Then the insurance contract that the buyer has purchased becomes worthless, because the reinsurer has no funds to make good on its obligations.

Whereas in a collateralised or ILS structure, those funds are kind of firewalled, and they are readily available for the buyer, in the event of a loss. And that's all constructed under the legal documents of the transaction.

What are the benefits for the buyer and the seller?

So the buyer, apart from getting the fully collateralised cover, the buyer may also be able to get multi-year pricing. So rather than just buying a contract for a year, in a softer market – and we're in a softer market at the moment – a buyer can maybe go out several years – typically 3, let's say – 3 years, and lock in a price over an extended period of time. And that's attractive to them because, you know, if we have a large event in any given year – in the past, pricing would respond to that; in other words, it will increase. Whereas you bought a multi-year cover and you lock that – we have some agreement around the parameters of pricing early on – then you can benefit from over the 3 years if the market does harden subsequently.

From a seller's perspective, the sellers as I said are typically, you know, institutional investors or hedge funds and other types of sophisticated investors. They like the idea of owning an asset where their returns and their risk of loss of principal are not linked to the financial markets. So, you know, if they're buying a corporate bond, their risk of losing money is driven by the creditworthiness of the issuer of that bond; where in an ILS environment, their risk of principal is linked to a natural catastrophe, for example: so an earthquake, or a hurricane, or the like. And that means that, from an investor's perspective, it gives them greater diversity in a portfolio, in theory; it would mean that, over time, they should get enhanced return with low volatility. And that's very attractive to investors, and it's really attracted a lot of money into the space.

And I think the financial crisis – to the extent there are some silver linings coming out of that – that, you know, investors saw that the ILS asset class, even though it did come off a little in the financial crisis, it did not come off anywhere near as much as more traditional asset classes. And the reason for that is the fact that it's a non-correlated opportunity for them.

Why has ILS grown so significantly?

It's grown because there are advantages for both the buyer and the seller. And I also think it's grown because we're in a low interest rate environment, so sellers are – investors are struggling to get good yield elsewhere, and they've been attracted into the ILS space because they could get a very good yield relative to the risk that they're taking. And I think that's drawn a lot of money into the area. So that's been very positive for the ILS industry.

What impact does ILS have on traditional markets?

So we already talked about the softening rates, which is certainly a negative for the traditional market. On the positive side, a lot of the traditional resinsurers have formed sidecars or other vehicles that they will use their underwriting expertise to benefit them. So, for example, they will write business directly onto the balance sheet of their sidecar, and charge a fee and perhaps a proper commission for doing so. So the traditional reinsurer is earning underwriting income and other fees whilst writing against somebody else's capital. And it's good for the other capital, because of all the reasons we just talked about – why sellers are benefitting from this. But it's good for the traditional reinsurer, because they're actually enhancing their own return on capital by getting fees where they're not actually having their own capital at risk.

What services do KPMG provide? 

So I've been involved in the ILS area for well over 15 years, and over that time we've done a number of things: doing audits, through some more advanced work around helping companies structure some vehicles and, you know, general advice to the industry; we've done claims review services, where we will go out and inspect claims in the vent of a loss; we do actuarial work around, you know, assessing the amount of reserves an entity has to hold, and/or a settlement price that should be struck between counterparties to close a deal out; and of course we also do tax services. So we've done tax services primarily around tax planning, and then tax compliance for investors – people looking to start up these types of vehicles.

Why KPMG in Bermuda?

Well, I think as a jurisdiction, Bermuda has become the domicile of choice for these vehicles. We have a great infrastructure here, incredible depth of talent; we also have the reinsurance market itself. So you have some of the best and brightest intellectual capital that the reinsurance community has to offer, within the 21 square miles of Bermuda. So that's a massive competitive advantage.

And then, as a service provider that's been working in this industry for 20 years, you know, we've developed a real leadership position in this. We were involved with the very first cat bond in Bermuda; we're the only firm that's performed claims review of procedures subsequent to an event; and we have a very senior and talented group of partners and staff in the office. And we really have what it takes to differentiate ourselves from the competition.

So I'd like to thank you for listening to me today. If you'd like more information, please feel free to visit our website – – and you can find my contact details there, and please feel free to give me a call or drop me your number.

Hubert Smith: "Bermuda Is Another World"

Jonathan Richman: "Down In Bermuda"

Jonathan Richman: "Monologue About Bermuda"

Mighty Sparrow (Trinidad): "Bang Bang Lulu" 

Bob Marley (Jamaica): "Stiff Necked Fools" 

Further viewing:

2013 Bermuda Reinsurance Conference: ILS and Alternative Capital 

911 Resolution Trilogy: Pattern of the Crimes 

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