Insurance Linked Securities - article by Joey Garcia

Insurance Linked Securities (ILS) havebeen proven to be one of the mostsuccessful manifestations of the

convergence of the insurance industry withcapital markets. ILS provide a mechanism forinsurance related risk to be transferred tocapital market investors and Gibraltar hasdeveloped a secure but competitive regime tobecome a key European hub in the ILS space.

If we define ILS as an asset class, wemight say that they are characterised as a pooling of insurance related cash flows whichare transformed into tradable securities, typically done by utilising securitisation techniques with the underlying assets andassociated income then serving as collateral.

Risk securitisation is a product of the1990’s when traditional reinsurance marketsreached capacity limits as a result of a numberof ‘catastrophe events’. Since the 2005 lossesof hurricanes Katrina, Rita and Wilma, the ILSmarket and the market for catastrophe bonds(cat bonds) witnessed significant growth, primarily because losses sustained created acapital shortfall (with the resulting risk transfer prices skyrocketing). The sector then evolved and accepted that capital markets were not only there to offer protectionin the ‘vacuum’ of traditional capacity, butalso as a valuable source of significantamounts of high quality risk transfer capacity.

A significant portion of the ILS market is the reinsurance of high severity, low probability events through cat bonds. A catbond allows the transfer of risk relating to, forexample, earthquake risk, from an insuranceor re-insurance undertaking to an investor.

A typical cat bond structure begins withthe formation of an SPV, which issues bondsto investors. The proceeds are invested in safe,short term securities which are held in a trustaccount. The cat bond will have an embeddedcall option that is triggered by a defined catastrophic event. If the event, such as anearthquake, occurs, the proceeds are releasedfrom the SPV to assist claims payments. The

release of funds can be proportional to theevent size rather than being completely binary. However, in most cat bonds the principal is fully at risk which means thatinvestors could lose their entire principalinvestment. In return for the option, the insurer pays a premium to the investors. Thefixed returns on the securities held in the trustare swapped for floating returns based on theLIBOR rate (or another widely acceptedindex), and this in turn immunizes the insurerfrom the interest rate and default risks.Ultimately investors receive the LIBOR rateplus the risk premium in return for their capital and if no contingent event occurs theprincipal is returned to the investors at the endof the bond term. The SPV acts to isolate theinvestment risk made by an investor from thegeneral business and credit risk of the insurer.As such, the investment exposes the investorto the catastrophe risk only.

The Gibraltar propositionGibraltar has tremendous potential to establish itself in the ILS space, particularlythe growing European segment of the marketwhich is expected to continue to develop andgrow along with the increasing number of perils that have been modelled for capital market transactions. In a European environ-ment ILS is expected to complement reinsurance with the development of SolvencyII and with the total return from the cat bondmarket measured at 10.9% over 2013 (SwissRe Global Cat Bond Performance TotalReturn Index) a continued interest is expected from institutional investors seeking returns largely uncorrelated to financial markets. Gibraltar’s position as being fully EUcompliant is key. In 2009, the Committee ofEuropean Insurance and OccupationalPension Supervisors (CEIOPS, (which wassubsequently superseded by EIOPA in 2010))published the Insurance Linked SecuritiesReport which outlines the importance ofSolvency II for the ILS market. This reportproposed that the new principles basedSolvency II framework would be a majordevelopment for the ILS market and thatSolvency II would recognise securitisationand derivatives as effective risk mitigationtechniques.

While some jurisdictions are taking aview as to the legislative framework requiredto provide the legal infrastructure for ILS

business, Gibraltar has its existing InsuranceCompanies (Special Purpose Vehicles)Regulations which were adopted in 2009,along with Protected Cell Company legisla-tion enacted in 2001, which provide an idealframework for ILS offerings. Gibraltar alsohas a vibrant existing insurance sector (withgross premium income in 2012 of £3.8bn).

The initiative to develop and diversifythe insurance sector in Gibraltar has been driven conceptually by Gibraltar Finance, andin particular their insurance specialist Mike Ashton. What we have seen is a coming together of a Government initiative, supported by the Financial ServicesCommission (FSC) and by the industry locally, to put Gibraltar into a position that it isready to do business. The Gibraltar ILSGuidelines, generated in large part by the FSC,have been constructed with the input of aninternational and expert working group toensure that they work from both a practicaland legal angle. From that perspective we canbe confident that as well as being Solvency IIcompliant based on the most up to date EIOPAposition, the Guidelines also meet with theapproval of the international practitioners whooffered their input throughout the process.Critically, both in terms of pricing but evenmore importantly in terms of timing and timeto market, the Guidelines and the processes setout therein have already been met withapproval of the industry.

Initial momentumISOLAS is delighted to act for the HorseshoeGroup- one of the largest ILS managers - in itsInsurance Manager’s application in Gibraltar.Andre Perez, CEO of Horseshoe sees a goodpercentage of growth in the sector comingfrom Europe and is ‘quite bullish aboutGibraltar’s potential for ILS.’

This is positive news and we expect thisto send a strong message to the sector. Therewill be other Insurance Managers looking atdeveloping operations in Gibraltar, and thereare also managers already in Gibraltar withILS business currently existing outside ofGibraltar that we would hope to develop locally. I am confident that Gibraltar will havea good choice of service providers to supportthe ILS sector as it develops, and the futurelooks very positive.

Insurance

18 Gibraltar International www.gibraltarinternational.com

Gibraltar’s “tremendous potential” inthe Insurance Linked Securities market

Joey Garcia is a financial servicesPartner at ISOLAS lawfirm and chairman ofthe Gibraltar Funds and InvestmentsAssociation (GFIA)

www.gibraltarlawyers.com

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