Insurance-linked securities (ILS) are financial instruments that transfer risk from the insurance industry to capital markets investors and can be used in both the property and casualty and life insurance sectors.[1] The most popular form of ILS, catastrophe bonds or “cat” bonds, deal with the risks associated with catastrophic events, such as flooding and wildfires. The ILS market in Canada remains relatively limited compared to other jurisdictions, including Bermuda, the US and the United Kingdom. The Canadian federal insurance regulatory regime does not presently guarantee capital relief for insurers participating in such instruments as an alternative to reinsurance.
Despite this, Canada’s first cat bond, Series 2025-1, was recently sponsored by TD Insurance. Series 2025-1 would protect the insurers under the TD Insurance banner against Canadian earthquake and severe convective storm perils (which we expect will include flood risk). The cat bond, issued by Bermuda-based MMIFS Re Ltd., offers TD Insurance additional reinsurance capacity of CA$150 million on an indemnity and per-occurrence basis over a three-year term. Proceeds will be invested in the European Bank for Reconstruction and Development.
The renewed interest in cat bonds and ILS more broadly, together with the increasing frequency and severity of losses arising from catastrophic events, may be the much-needed catalyst for modifications to the federal regulatory guidance applicable to insurers in Canada to encourage diversification of risk and participation in these instruments.
Background
Cat bonds were first developed in the early to mid-1990s in the aftermath of Hurricane Andrew and the Northridge Earthquake to help raise capital to cover insured losses and have been increasingly used as an alternative form of risk transfer and capital raising by insurers and reinsurers (sponsors).[2] Cat bonds are high-yield debt-like instruments that typically mature within three to five years,[3] and are set up by a sponsor through the use of a special purpose vehicle (SPV).[4] The SPV collects premiums from the sponsor and issues cat bonds to investors that are fully collateralized, helping to mitigate counterparty credit risk. The proceeds from the sale of cat bonds are invested in low-risk, liquid and high-quality securities and are held in a trust account as collateral. Once a natural catastrophe occurs that triggers the cat bond’s predetermined metrics, the sponsor collects the funds raised from the SPV to cover insured losses. If a covered catastrophe does not occur, investors receive interest earned on the invested securities and return on principal once the cat bond matures.
Climate-related losses
According to the Insurance Bureau of Canada, 2024 was Canada’s costliest year for insured losses caused by severe weather at CA$8.5 billion.[5] This amount surpasses the previous record of CA$6 billion from 2016 following the Fort McMurray wildfires, is nearly triple the total insured losses recorded in 2023, and is 12 times the annual average of CA$701 million in the decade between 2001 and 2010. The August hailstorm in Calgary was the single most destructive weather event in 2024, causing CA$3 billion in insured losses in just over an hour. In July and August alone, four catastrophic weather events resulted in over CA$7 billion in insured losses and more than a quarter of a million insurance claims. With loss claims expected to continue increasing, Canada needs to look to established forms of alternative risk transfer in the insurance industry.
These figures do not take into account uninsured losses from catastrophic events. In Canada, insurance is widely available for most perils, including wildfire, wind and hail. Widespread uninsured losses have been avoided so far. However, the increasing frequency and severity of catastrophic events and the ensuing insured losses are contributing to higher premiums and straining the insurance market. While reinsurance currently remains available to Canadian insurers at relatively stable pricing, alternatives to traditional reinsurance will become critical.
Regulatory guidance – Climate risk management
Federal and provincial regulators have implemented draft or final guidance to address climate-related risks that affect the financial industry. The Office of the Superintendent of Financial Institutions (OSFI) continues to update and refine OSFI Guideline B-15: Climate Risk Management (B-15) which outlines its climate-related financial disclosure expectations of federally regulated financial institutions (FRFIs), among other matters.[6] In B-15, OSFI recognizes the risk that insurance claims consistently exceed insurance company expectations due to climate change and there is a potential for increased insurance losses and costs to reinsure. The Autorité des marché financiers (AMF) has also released its own Climate Risk Management Guideline to manage climate change risks, which follows the principles of B-15.[7] One of the main physical hazards highlighted in OSFI’s climate risk disclosure and scenario exercise reporting is flood.
ILS as a reinsurance alternative
ILS are meant to complement, rather than oppose, traditional reinsurance by providing an extra layer of protection.[8] Capital markets are much larger than the insurance and reinsurance markets and can more easily handle losses from catastrophically large insured risks. Cat bonds are also thought to have little to no correlation with other capital markets and thus offer investors with an opportunity to diversify their investment portfolios while providing higher yields than similarly rated traditional corporate bonds.[9]
In its Discussion Paper on OSFI’s Reinsurance Framework dated June 8, 2018, OSFI stated that a reinsurer that transfers the risks it assumes to investors via ILS, may have a very different risk profile relative to a traditional reinsurer. OSFI has also indicated that ILS may be permitted in certain cases but has not provided any detailed information. Guideline B-3 – Sound Reinsurance Practices and Procedures does not address expectations for federally regulated insurers (FRIs) that cede risks to reinsurers that rely on ILS.
The OSFI Minimum Capital Test Guideline (MCT) applicable to property and casualty FRIs provides that amounts receivable and recoverable from unregistered reinsurers are deducted from the FRI’s capital available to the extent that they are not covered by premiums payable to the assuming reinsurer or acceptable collateral. OSFI’s definition of acceptable collateral is fairly narrow and does not contemplate ILS. The definition of “registered” reinsurer also does not contemplate SPVs. As a result, the transfer of risk via ILS generally does not permit an FRI to take asset/capital credit under the MCT.
Conclusion
The ILS market has grown and matured globally and is a critical alternative source of capacity and risk diversification, particularly for climate-related risks. OSFI has described climate risk as a transverse risk, impacting or considered in all other risk categories. OSFI’s previous Assistant Superintendent of Regulatory Response indicated that he viewed climate change as having “a pervasive influence on traditional financial risks such as credit and market risks, operational risks and insurance risks.”[10]
In addition to being a viable alternative to traditional reinsurance in respect of climate and other risks, ILS offers risk diversification, which is critical to any financial institution’s enterprise risk management strategy. Given the importance of climate risk management and what is at stake if claims are unpaid or if traditional reinsurance supply cannot meet future demand for reinsurance coverage, it is time for Canada’s financial markets to come of age and for federal regulatory guidance to embrace the concept of ILS as a reinsurance alternative in Canada. OSFI should not only reassess its policies affecting ILS but should also consider amending the MCT to include capital relief for ILS and cat bonds, in particular.
For more information, please contact the authors, Laurie LaPalme, Marisa Coggin and Claudia Lach.
[1] Background under https://content.naic.org/insurance-topics/insurance-linked-securities.
[2] Page 1 of the commentary by Morningstar titled “TD’s CAT Bond Issuance: A Step in the Right Direction for Canada’s Property and Casualty Insurance Industry” from https://dbrs.morningstar.com/research/448496/tds-cat-bond-issuance-a-step-in-the-right-direction-for-canadas-property-and-casualty-insurance-industry.
[3] Background under https://content.naic.org/insurance-topics/insurance-linked-securities; Pages 1-2 of the commentary by Morningstar titled “TD’s CAT Bond Issuance: A Step in the Right Direction for Canada’s Property and Casualty Insurance Industry”.
[4] Page 4 of the commentary by Morningstar titled “TD’s CAT Bond Issuance: A Step in the Right Direction for Canada’s Property and Casualty Insurance Industry”; page 2 of a public policy issue paper from the American Academy of Actuaries titled “Insurance-Linked Securities and Catastrophe Bonds” from https://www.actuary.org/sites/default/files/2022-06/ILS_20220614.pdf.
[6] https://www.osfi-bsif.gc.ca/en/guidance/guidance-library/climate-risk-management.
[8] Page 2 of the commentary by Morningstar titled “TD’s CAT Bond Issuance: A Step in the Right Direction for Canada’s Property and Casualty Insurance Industry”.
[9] Page 1 of a public policy issue paper from the American Academy of Actuaries titled “Insurance-Linked Securities and Catastrophe Bonds”; https://www.finra.org/investors/insights/insurance-linked-securities.
