Reinsurance and other forms of risk transfer: financial reinsurance and alternative risk transfer (ART): securitisation and sidecars
Securitisation is another form of alternative risk transfer.
General background on securitisation can be found in the Company Finance Manual (CFM). One such instrument is a catastrophe-linked security, or cat bond, for example, to provide an insurer with protection against losses arising from an earthquake. An insurer pays a premium to a special purpose vehicle, in which investors subscribe for bonds which are in certain circumstances non-recourse. If no disaster occurs the bonds may pay out a fixed return over LIBOR, over say a 5-year period. The rate of return will be higher than usual to compensate the bondholders for the risks they have assumed. If a disaster occurs before repayment of the bond is due, the bondholders lose some or all of the capital, and/or their entitlement to interest. In this example, recoveries will be triggered by earthquakes of an agreed magnitude, where a risk model shows industry wide-losses above a certain level on the Richter scale. This is known as a parametric trigger. Other varieties may be triggered when losses exceed a certain amount, known as an indemnity trigger.
For the insurer, such securitisations may provide cheaper cover than conventional reinsurance, with less credit risk and quicker recoveries.
Sidecar is the name given to a special purpose vehicle (SPV) which is created by large investors, such as hedge funds, to provide catastrophe reinsurance capacity to a sponsoring reinsurer. It typically provides quota share reinsurance, assuming a proportion of the risk in return for a proportion of the premium. It will also generally pay ceding commission to the sponsor, dependent on the anticipated profitability of the business.
In addition to receiving premiums and paying claims, the SPV will pay interest and dividends to the investors. Sidecars are normally formed for just a year or two, typically domiciled in Bermuda or the Cayman Islands. The particular advantage to investors (apart from flexibility and potentially high returns) is the lack of correlation with returns from other asset classes.