Cat Bonds - A Canadian Perspective

There have recently been some noteworthy events in Canada relating to catastrophic risk that suggest the circumstances are increasingly right for the development of a Canadian cat bond market.(1)
First, there have been significant natural disasters, which highlight the devastation that natural catastrophes can wreak and the corresponding potential for large insured losses.  The most noteworthy catastrophe this year has been the Alberta floods, which will likely result in the highest insured loss ever recorded in Canada.  The Ontario thunderstorm on 8 July was also significant, setting a record for insured damages in Ontario arising from a single natural disaster. 
 
Second, earlier this year the Office of the Superintendent of Financial Institutions (OSFI) released a revised version of Guideline B-9 - Earthquake Exposure Sound Practices.  This Guideline, together with OSFI’s Memorandum Draft revisions to Earthquake Financial Resource Formula and Earthquake Data Collection Form for Consultation released 31 July, 2013, sets out proposed new requirements regarding, among other things, the measurement of earthquake exposure and an earthquake financial resource formula.
 
It is also noteworthy that Canada’s Superintendent of Financial Institutions recently made a number of positive comments regarding cat bonds, stating that “Cat bonds are an effective way to transfer risk to capital markets, instead of reinsurance markets, and to spread risks” and that “catastrophe bonds can be a good addition to an insurer’s risk management program”.(2)
 
State of the Canadian Market
 
While Canadian insurers have yet to embrace cat bonds as a means of transferring risk, there have been several transactions in recent years that include Canadian natural catastrophe risks in the mix of global perils.  Since April 2012, the following cat bonds have been issued that include Canadian earthquake risk:
 

• Tradewynd Re Ltd. (Series 2013-1) - covers U.S., Caribbean and Gulf of Mexico named storms and U.S., D.C. and Canada earthquake (cedent: AIG);
• Blue Danube Ltd. (Series 2012-1) - covers U.S. hurricane, U.S. and Canada earthquake, Caribbean and Mexico hurricane (cedent: Allianz Argos 14 GmbH);
• Blue Danube II Ltd. (Series 2013-1) - covers U.S., Caribbean, Central American and Mexican hurricane and U.S. and Canada earthquake (cedent: Allianz Argos 14 GmbH);
• Tramline Re II Ltd. (Series 2013-1) - covers U.S. and Canada earthquake (cedent: Amlin AG); and
• Lakeside Re III Ltd. - covers U.S. and Canada earthquake (cedent: Zurich American Insurance & Zurich Insurance Co. Ltd.).(3)

These transactions indicate there is a desire to transfer Canadian earthquake risk, which supports the view that a Canadian cat bond market may develop. 
 
However, these transactions all packaged Canadian earthquake risk with non-Canadian risks.  As well, the transactions cited above involved AIG, Allianz, Amlin and Zurich, all of which are insurance groups based outside Canada.
 
If a true Canadian cat bond market is to develop, there are reasons to suppose it will involve larger Canadian based insurers and will focus on Canadian risks.  While the Canadian P&C market is still relatively fragmented, there are Canadian insurers with significant market share, and further consolidation in this sector is expected.  All of this augurs well for the prospects of cat bonds in Canada. 

It is also possible that sponsors other than insurers will drive the development of a cat bond market in Canada (i.e., government or corporate sponsors).
 
Canada’s Regulatory Regime for Cat Bonds
 
Canada does not have a regulatory regime that specifically addresses insurance linked securities (ILS), including cat bonds. 
 
However, there is law and regulation in Canada that is relevant in the context of cat bonds.  Of particular note is Canada’s regulatory regime regarding the granting of capital and reserve credit for reinsurance (or retrocession) with an offshore reinsurer.  By way of summary, this involves the use of reinsurance security agreements, funds withheld reinsurance or letters of credit.  This regime can be relevant as cat bond transactions typically involve a sponsor entering into a reinsurance or other financial agreement with an offshore special purpose vehicle.  A key issue in whether capital and reserve credit will be granted is whether there has been effective risk transfer and a key issue here is that non-indemnity based transactions give rise to basis risk (i.e., the risk that the compensation received by the sponsor in the event that a loss event occurs will not match the sponsor's actual losses).
 
More generally, the recent remarks by the Superintendent of Financial Institutions provide insight into OSFI’s perspective on cat bonds:
 
Given that catastrophic risk seems to be growing, going forward we may also see insurers more actively expanding risk transfer mechanisms through Insurance Linked Securities (ILS).  Catastrophe bonds can be used to help companies to reduce exposure to certain risks, including earthquakes.  Cat bonds are an effective way to transfer risk to capital markets, instead of reinsurance markets, and to spread risks.  At the same time, they do not eliminate all risk.  For example, basis risk, where the trigger for a claim might not be directly matched to the losses of the insurer, could result in the insurer experiencing losses with no protection.  From a capital perspective, if the link is not one-for-one with the expected losses, there is no capital benefit.  But such catastrophe bonds can be a good addition to an insurer’s risk management program.(4)
 
The comment that there will not be capital relief if there is basis risk reflects a strict view that will need to be considered in the context of non-indemnity transactions.  We would hope this is an area where constructive discussions could be held with OSFI.
 
OSFI’s Earthquake Guideline
 
OSFI’s revised Earthquake Guideline addresses the possibility of ILS solutions to earthquake risk:
 
Insurers can enter into innovative financing transactions designed to hedge their risk for a catastrophic event.  In some cases, these are standby capital market financing facilities that become operative when a catastrophe occurs.  Insurers also need to respect the provisions of the Borrowing (Property and Casualty Companies and Marine Companies) Regulations.  Prior approval from OSFI is required before these instruments can be recognised as a financial resource under the MCT Guidelines. 
 
Guideline B-9 gives no indication of what criteria would need to be satisfied before OSFI would provide approval to allow a cat bond to be recognised as a financial resource for capital purposes.  An earlier version of Guideline B-9 set out minimum conditions that must be met by companies seeking such OSFI approval, including that the risk has been or will be genuinely laid off to investors that meet suitable counterparty standards and that the catastrophe-linked financial instruments are subordinated to the interests of policyholders and other creditors.  We expect that some or all of these items would still be relevant considerations from OSFI’s point of view.
 
Concluding Thoughts
 
This article has identified several developments and facts that suggest the conditions are right for the development of a Canadian cat bond market.  There are, however, a number of hurdles that may need to be cleared.
 
For one thing, if a Canadian insurer were to sponsor a Canadian cat bond transaction, it would likely need to engage with OSFI (or its primary provincial regulator in the case of non-federally regulated institutions) to some degree.  Depending on the structure of the transaction, this might be relatively straightforward (e.g., if the cat bond involves unregistered reinsurance by a Canadian insurer and the normal techniques for obtaining capital and reserve credit were used) or might require more intensive discussions (e.g., if the cat bond involved a non-indemnity trigger and there were issues regarding basis risk that needed to be addressed).  Of course, to the extent that the sponsor of a cat bond was not an OSFI-regulated entity (e.g., government or a corporation other than a federally regulated financial institution), there would be no need to engage with OSFI.
 
Another hurdle is the fact that this type of transaction is still considered novel by many in Canada.  We expect that once one or two of these transactions have been completed, the market and the regulator will develop a certain comfort level and it is entirely possible that the adoption of ILS in Canada will provide a viable alternative to traditional reinsurance here.
 
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