ILS Frictional Costs: Evolution and Progress

By Gary Kerney March 25, 2013

Insurance-linked securities (ILS) transactions are not as expensive as they used to be. Five or six years ago, it could take months for a sponsor to complete a catastrophe bond, and it would cost as much as 50 basis points. Today, however, an experienced sponsor can complete a similar deal in weeks — at a cost of less than 20 basis points, depending on the size of the deal. As the insurance and reinsurance industry becomes more comfortable with the ILS form of risk transfer, frictional costs are likely to fall even further. In the end, the reduced costs should contribute to increased issuance activity, not just for catastrophe bonds but for collateralized reinsurance and industry loss warranties (ILW) as well.

So, why have frictional costs fallen? There are several reasons.

First, sponsors have become more familiar with capital market products for risk transfer. A larger group of insurers and reinsurers is using catastrophe bonds and ILWs, once considered niche alternatives. Willis Capital Markets and Advisory notes there was $15.2 billion in new limits outstanding at the end of 2012, the highest level in the history of the catastrophe bond market. And according to our most recent catastrophe bond market update, sponsors raised $5.9 billion through such vehicles last year, the second-highest annual result in the history of the market. Willis Re estimated that the market would have as much as $7.5 billion in ILW capacity in 2012, according to its publication Q1 2012 ILW Update. As the market progresses from “custom” to “common,” frictional costs should continue to decline.

Also, the service providers involved in structuring and marketing ILS transactions have gained experience. Using the knowledge they’ve accumulated over the past decade and a half, they can use information and experience from previous transactions to accelerate the completion of a deal, rather than start from scratch every time. Therefore, the process is faster and smoother, resulting in lower expenses. If the trend continues, as it should, frictional costs could decline further to the point where catastrophe bonds become much more accessible to midmarket insurers and reinsurers. In addition to the intermediaries and attorneys involved in bringing a catastrophe bond to market, other vendors have made their services more cost-effective as well. Property Claim Services® (PCS®), in fact, has made a concerted effort to align industry loss index expense with broader market frictional costs, and we continue to do so.

The continued adoption of ILS tools — particularly by the expanding base of existing sponsors and investors — will help bring frictional costs down even further. The capital markets will become more accessible to the broader global insurance and reinsurance industry. For now, the most pressing challenge is to address the fixed-cost model used for many aspects of catastrophe bond structuring. Such pricing can impede the completion of smaller deals. Standardization will help, making the issuance process more streamlined — and thus less expensive. With more participants, scale should help keep frictional costs manageable.

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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.