Contingent Equity Capital: What’s Missing?

By Gary Kerney September 27, 2012

When a catastrophe strikes, the ability to absorb losses is only one side of the challenge insurers and reinsurers face. In the wake of significant losses, carriers often need to raise equity capital, and that can become an expensive proposition in certain economic climates. The absence of a plan for post-loss recapitalization is itself a risk — but one that insurers and reinsurers can mitigate. By using contingent equity capital transactions — supported by trusted, reliable triggers — carriers can plan for the worst and return promptly to business as usual.

Contingent equity capital allows insurers and reinsurers to generate common equity capital when a particular event occurs. The “triggering” event can range from the declaration of a macroeconomic event by a regulator to aggregate annual catastrophe losses of a predetermined amount. Carriers can also use a combination of triggers to customize their protection. A recent contingent equity capital transaction completed by Scor, for example, includes an indemnity trigger for catastrophe losses as well as a trigger based on a decline in share price of a given amount (based on a daily-volume-weighted average).

Contingent equity capital deals can provide an important source of post-loss liquidity, allowing insurers and reinsurers to return quickly to writing business. Yet the industry has not widely adopted such deals. The reasons for not doing so may vary, but a potential factor does stand out: the triggers themselves.

The indemnity triggers in contingent equity capital transactions are certainly attractive to issuers, but they may not resonate with investors. When left to their own devices, issuers can over-allocate losses to catastrophes, ultimately hitting trigger levels sooner. In some cases, that could mean sticking investors with the bill for suboptimal underwriting.

To remedy the situation, issuers could structure contingent equity capital facilities to include only losses from PCS-declared catastrophes. Several catastrophe bonds already do that. While some room for moral hazard remains, using PCS-declared catastrophes provides increased protection for investors.

To mitigate moral hazard still further, issuers may want to use the PCS Catastrophe Loss Index instead of an indemnity trigger. The Index, which has been an important part of the catastrophe bond market for more than 15 years, uses PCS catastrophe loss estimates to determine when to issue common equity, eliminating the need to rely on issuer data. The determination to trigger the bond comes from an independent and trusted third party, resulting in another layer of investor protection.

Added flexibility could come from using the PCS Catastrophe Loss Index to provide per-event protection, rather than just aggregate annual loss, and from customizing triggers to reflect industry loss estimates by peril and region in the United States and Canada. Carriers would be able to customize their post-loss recapitalization plans to align specifically with certain types of catastrophes — a significant step forward for strategic capital management.

As the contingent equity capital market evolves and achieves wider adoption among insurers and reinsurers, it will have to demonstrate flexibility to meet a broad range of issuer needs. The catastrophe bond market has succeeded because it has demonstrated such flexibility, along with the ability to cover a number of perils with several triggers for varying amounts of time. The contingent capital market shows the same potential, particularly when you look at the covered risks in Scor’s transaction, which include seaquake (or underwater earthquake), winter weather, and asteroid impact, among others.

The tools needed for post-catastrophe recapitalization are available, and market conditions indicate a role for contingent equity capital. The next step, of course, is to see how that approach fits into your overall capital management strategy. Learn more about the PCS Catastrophe Loss Index now. >>

Gary Kerney

Gary Kerney, one of the most prolific contributors to this blog, retired from Verisk in 2013. Mr. Kerney served as assistant vice president, Property Claim Services (PCS). Since joining PCS in 1981, he worked on catastrophe identification, loss estimating, and catastrophe response and mitigation.