Like a cat chasing its tail…

Little did I expect researching catastrophe bonds could leave one feeling like a cat chasing its tail – but that’s exactly how I felt when I discovered something known as Solvency II.

…the European Union Commission has now released the first draft directive of Solvency II – the most far-reaching change to the framework governing insurance companies in the EU for over 20 years.

However, Solvency II is not only a far-reaching change to the framework governing insurance – it’s an entirely different frame that’s had considerable influence on the discussion taking place in this country.

Solvency II is the updated set of regulatory requirements for insurance firms that operate in the European Union.

The rationale for European Union insurance legislation is to facilitate the development of a Single Market in insurance services in Europe, whilst at the same time securing an adequate level of consumer protection.

Solvency II will be based on economic principles for the measurement of assets and liabilities. It will also be risk-based system as risk will be measured on consistent principles and capital requirements directly on this requirement. While Solvency I Directive aimed at revising and updating the current EU Solvency regime, the Solvency II project has a much wider scope.

…the proposed Solvency II framework has three main areas (pillars):

– Pillar 1 consists of the quantitative requirements (for example, the amount of capital an insurer should hold).

– Pillar 2 sets out requirements for the governance and risk management of insurers, as well as for the effective supervision of insurers.

– Pillar 3 focuses on disclosure and transparency requirements.

The FAQ published by the European Union is a start point for understanding more about the change expected to be in place by 2012 when we will again have presidential elections in this country – an interesting point to note IMO.

Will the new framework allow for securitisation?

The new solvency framework will recognise the economic substance of insurance activity and will focus on risk and the management of risk. Securitisations, as well as other risk mitigation techniques such as reinsurance and derivatives, can be a very useful tool for insurers in managing their risk exposures.

The new solvency regime allows insurers to use such techniques and to get commensurate solvency capital relief arising from such a use, provided that insurers can demonstrate that they understand the nature and limitations of such techniques, and provided that there is a real transfer of risk.

Cat bonds enter the framework of Solvency II at this point – hence my reference to the cat chasing its tail.

Advantages of CAT bonds are that they are not closely linked with the stock market or economic conditions and offer significant attractions to investors. For example, for the same level of risk, investors can usually obtain a higher yield with CAT bonds relative to alternative investments. Another benefit is that the insurance risk securitization of CATs shows no correlation with equities or corporate bonds, meaning they’d provide a good diversification of risks.

In other words, what cat bonds do is link catastrophic events to money.

Investors in these bonds are offered the attraction of higher returns with the quid pro quo being that they have to shoulder losses in the form of sacrifice of principal or interest or both, in the event of a catastrophe savaging a given locale.

The product, to be sure, is not for the faint-hearted. Nor is it for those who are not well-heeled. It is meant for high net worth individuals (HNIs), hedge funds and others with appetite and capacity for risks.

A cat bond has the trappings of a junk bond — it entices investors with higher rates of interest — but differs otherwise. While a junk bond is issued by a company condemned to a low credit rating, cat bonds are essentially meant to help insurers.

While a junk bond is a source of capital to bankroll a project or acquisition, cat bonds seek to transfer some or all of the insurance risks to the capital market, especially to the segment that hungers for greater rewards.

However, the Financial Industry Regulatory Authority Inc. has released an investor warning on using catastrophe bonds and other event-linked securities.

Issuance of the bonds has skyrocketed in the last two years, with some $7 billion in publicly disclosed “cat” bond coming to market in 2007, according to Guy Carpenter & Co. LLC of New York.

In light of that popularity, Finra warned yesterday that cat bonds are normally rated BB or “non-investment grade” by credit rating agencies because the holders of the securities face “potentially huge losses.”

Trigger events, another important part of cat-bond deals, are detailed in the bonds’ offering documents —information that is only available to the purchasers, because these securities aren’t SEC-registered and are therefore exempt the commission’s disclosure requirements, Finra warned.

Meaning, or so I gather, transparency as conceptualized in the Insurance Transparency Project – a new page I added to our insurance file – may be conceptualized differently in Solvency II. Save that thought for another day as it takes a lot of energy for a cat to chase its tail and this cat needs a nap.