Christoph Weber
Insurance Linked Securities
GABLER RESEARCH
Christoph Weber
Insurance Linked Securities The Role of the Banks
With a foreword by Prof. Dr. Rainer Stöttner
GABLER
RESEARCH
Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available in the Internet at http://dnb.d-nb.de.
The present thesis of the author Christoph Weber was accepted by Fachbereich Wirtschaftswissenschaften at University of Kassel under the title "The Role of the Banks in the Alternative Risk Transfer of Insurance Companies through Capital Market Securitisations" in order to obtain the academic degree Doktor der Wirtschafts- und Sozialwissenschaften (Dr. rer. pol.). First Reviewer: Second Reviewer:
Prof. Dr. Rainer Stöttner Prof. Dr. Kurt Reding
Oral Examiners:
Prof. Dr. Georg von Wangenheim Prof. Dr. Holger Karrenbrock
Disputation took place in Kassel on May 12th, 2011.
1st Edition 2011 All rights reserved © Gabler Verlag I Springer Fachmedien Wiesbaden GmbH 2011 Editorial Office: Stefanie Brich I Sabine Schöller Gabler Verlag is a brand of Springer Fachmedien. Springer Fachmedien is part of Springer Science+Business Media. www.gabler.de No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. Registered and/or industrial names, trade names, trade descriptions etc. cited in this publication are part of the law for trade-mark protection and may not be used free in any form or by any means even if this is not specifically marked. Cover design: KünkelLopka Medienentwicklung, Heidelberg Printed on acid-free paper Printed in Germany ISBN 978-3-8349-2860-3
Foreword
The global ecooomy has been bit repeatedly by finaneial crises during the last two aod a half decades. Ecooomists are wandering abaut the reasons of the rna1fooetioning of finaneial rnarkets. Nurnerous potential reasons have becn advaoccd. For exarnple, spcculators are looked upon as mayor suspects. There basically "evil" activities seem to be the predorninant driving force produeing instability in financial rnarkets aod real rnarkets as weil, far !hat matter. The recent subprime erisis and its global ramifieations are laken as evidence for the destabilizing effects of finaneial speculation. Sceptieism surrounding money and financial mark.ets goes back to classical economists and was even reinfareed by neoc1assical aod monetarist theories. The financial sector, in general, was supposed to put a vell upon the real ecooomy thus eoocealing the really important features of the economy. Moreover, the financial sector is supposed to be a source of inflation thus putting additional destabilizing pressure on the real economy. James Tobin arnplified the list of negative impacts to be derived from the finaocial sector 00 the basis ofbis "depletion hypotheses": This hypothesis holds!hat the unproductive finaocial sector deprives the real scctor from finaneial resources that otherwise eould be invested produetively, e.g. by building produetion plaots. Tobin argues !hat the seduetive power of the finaocial sector offering a great vatiety of seerningly bighreturn assets withdraws financial resources from the real seetor thus reducing growth, employment and social welfare. He further argues that the financial sector, by luring investors with the promise of high-yield and low-risk investment opportunities, will redirect human resourees away from the real (productive) sector into the (unproductive) financial sector. Making mooey by engaging in speculative activities in the finaocial rnarket seems to be More attractive thao dedieating oneself to productive and maybe arduous wark in the real sector economy.
vi
Moreover, during the most recent financial crisis the process of financial innovation was identified as a potential source of iostability: Fioancial innovation can be observed as "new" (innovative) financial products bot it can also appear as innovative strategies of iovesting and risk management io financial markets. Mayor destabilizing potential was presnrned to go along with the so called structoring of financial products and, io particular, with the secutitization process. Asset Hacked Secutities (ABS) is a case io poiot. In general, they are launched by Special Purpose Vehic1es (SPVs) which are not easily understood and playa rather obscure role. Tbe lack of transparency in financial markets leads to a severe loss of confidence io the market Tbe broad criticism of financial markets leads to an underestimating of the doubtless merits of structured finance and securitization. Fioancial markets take care of gatheriog and allocating financial resources efficiently. At the same time they are also supposed 10 allocate risk. in an efficient way. This means that efficient risk allocation is supposed to be iodispensable for optintiziog social welfare. Tbus, it seerns to be pretty unfair 10 point the finger at structured finance, securitization and at derivative instruments in general, if it comes to find devices responsible for the repeated outbreak of financial crises. It seems cIear that the introducti.on of new innovative financial products cannat proceed free from operational and conceptual flaws. It is no surprise, either, that these products sometimes are put to uses they uriginally were not iotended for. Take options as an example: Tbey may be used as hedging iostruments; that is what they have been devised for originally. Hut they can also be used as a speculative vehicle enhanciog risk iostead of curbiog it This may be qua1ified as a perverted application, bot it should be clear that without the existence of speculators a hedger generally could not find the counterparty necessary for arrangiog risk protection or even risk elimioation. It may happen that two hedgers are offering risk protection to each other so the iotervention of a speculative agent is dispensable. But there is DO guarantee of available risk protection in a speculation-free environment. It is a well-known fact that without the availability of proteetion agaiost risks io real-market or financial-market transactions agents would canceI many economic activities all together. This fact gives a legitimate foundation to the iosurance industty. Insurance cornpanies, by offeriog proteetion agaiost a great variety of insurable risks and chatging moderate premiurns, pave the ground for engaging io the production of goods and services. Without adequate risk proteetion many of these activities would not be undertaken. Good exarnples are risks of liability and risks of material darnage, for exarnple by fire or theft. It is also a well-known fact that many essential and higbly darnaging risks are not covered by any iosurance cornpanies. Coverage is offered only for risks that show no correlation - or only a low-Ievel correlation - between the iosured clients. So called speculative or cmnulative risks are higbly corre1ated and thus are excluded from coverage.
vii This means !hat protection against the risk of unemployment or the risk of losing money in case of a stock market crash will not be insured. Unemployment risk generally is covered by national ageneies funded by the national budget The risk of price change, for example the change of stock prices or interest rates, can only be covered on the capital market itself. The market has created a broad varlety of instruments, derivative instruments in particular. They offer the protection denied by insurance companies. To be sure: Speculators are the agents offering this protection. This constitutes sort of a financial market paradox: Allegedly harmful speculators seeking unjustified profits by asking money for dning nothing turn out to be the vital pillars on which soeial and
economic welfare rests. It is DO surprise that this sort of competition is not welcomed by insurance companies. They dislike being identified as business partners that refuse to contract when things get tough. And, of course, they do not want to leave the ground to speculators who on average seem to earn considerable profits. Thus, insurance companies are fiercely searching for possibilities of somehow tuming risks !hat usually are considered as uninsurable into insurable risks, even at the expense of engaging in same sort of cooperation with speculators. The idea was spurred further by the insight that cooperating with speculators ntight be a good thing even in those segments of the traditional insurance business that tend to get out of control in case of terrorist attacks and natural catastrophes. There is no doubt !hat the insurance industry has discovered capital markets as powerful partners for their own business. To put it differently: The capital market tumed out 10 offer reinsurance proteetion to primary insurers.
The idea to use capital markets as a cushioning mechanism bad produced manifold instruments and risk transfer schemes. They have come to be potential suspects for causing the recent financial crises that fiually deterlorated into agiobaI econontic crisis of forntidable dimensions. It is no surprise that the collapse of global econontic activity led to a high degree of scepticism with respect to those innovative products and schemes. Banks offering a helping band in developing the necessary instruments for an alternative risk transfer understandably came under pressure because public opirtion turned its back on thern. Moreover, they put themselves under pressure because they used these instruments abundantly for speculative trading on their own account Thus, they not ouly got b1arned for inventing the "mass destruction devices" - a term !hat is atrributed to Warren Buffett - but they themselves turoed out to be victirns of their seentingly noxious products. Nevertheless, banks have the necessary expertise and for that reason will playavital role in establishing an alternative risk transfer process from insurance companies to the capital market. At the same time banks could take advantage of opportunities to offer complementary services to insurance companies in the traditional field of Investment Banking.
viii In bis research study, Mr. Weber analyzes the risk transfer of the insurance sector into the capital markets using Insuranee Linked Securities (ILS). Special foeus is on the roJe of the banks in the process. After the introduction, the second ehapter of the study starts by describing the basic insuranee economies like the definition of risl<, insuranee mathematics, asset-liability-management, and asset management Chapter three explains the different types of insurance eompanies. Methods of risk transfer are the topie of the fourth ehapter. While traditiona! risk transfer is taking place within the insurance sector, the different methods of Alternative Risk Transfer (ART) are effeeted among primary insurers or reinsurers and the eapital markets. ART ean be used in the form of risk carriers, finite solutions, side-cars, derivatives traded at exehanges or over-the-eounter, contingent capital, and multi-risk produets. A special form of ART are ILS as deseribed in the fifth ehapter of the study. ILS are used to transfer risk from life insurers, but also from non-life insurers. Life-related ILS are used to cover US reserve reqnirements, to pre-finance earnings or to transfer pandemie risk. Catastrophe bonds are the most popular form of non-life-related ILS. Tbey cover perils like storms, earthquakes or wildfires. Collateralized debt obligations (CDOs) as a special form of securitization are analyzed further. CDOs are used to bundle subordinated debt financings
or reinsurance claims. Chapter six analyzes interviews with market participants. The interview partners are eategorized into the following stakeholder groups: Aeeountants and regulators as the first group emphasize the differences of the European and US systems. Value-at-risk and expeeted shortfall being their main risk measures are therefore descrlbed in detail. Insurers and reinsurers forming the second group explain their motivations to sponsor ILS, especially in the context of their asset-liability-management. Duration and eonvexity as the main instruments to measure interest rate sensitivity of assets and liabilities are described. Further, the usage of hybrid bonds for eapital management is explained. Rating agencies, risk modelers, and monoliners form th.e third sponsor group. Tbey are playing an iruportant role in standardizing products in eapital markets. Tbeir approach, especially their way of modeliug risk is analyzed. Investors, the fourth stakeholder group are interested in non-eorre1ated retums and a bigh level of transparency. Th.ey need effective trigger mechanisms to avoid adverse selection and Moral hazard. Arrangers as the fifth stakeholder group are obliged to provide ao effective prieing of ILS, especially compared with the reinsuranee produets and to find appropriate investors in the products. Whenever adequate, the interviews were used to explore the relevance of banks for the stakeholders. Chapter seven of the study anaIyzes an onliue-interview providing an overview of the market during the ehallenged
environment at that time. Further, participants were questioned about their function in the ILS market, its prospects, and the role of the banks. Caused by the financial crisis the market was changing rapidly and extensively from elosing of the interview phase end of December 2008 until fina1izing the study end of June 2009 as recapitu1ated in Chapter eight. The work ends with Chapter nine ineluding the sununary aod eonelusion.
ix Weber's analysis of alremative risk transfer systems clearly closes a gap in the field of insurance and capital markets. The subject treated is of higb practical aud theoretical siguificauce. Risks of all sorts seem to be steadily increasing. Marke! price volatility has reached an uuprecedented level, catastrophe and terrorist risk also has grown up to dimensions that cannot be handled by insurers alone. So it is a logical step to include capital markets as partners of the insurance industry in order to spread risks on a large seale basis. Tbe role capital marke!s cau play in the managements risks that are difficult to insure or not insurable at all on the basis of traditional insurance standards has Inng been ignured. Tbe work of Weber must be seen as one important step to a better understanding of Ibis role. Weber shows that capital markets can offer hedging opportunities far beyond the scope that agents have been farniliar with so far: Capital markets cau help to allocate risk to a much bigger extent than could be expected so far. They virtoally can act as powerful reinsurers and thus complement reinsurance activities emerging from the insurance sector itself. Tbe pioneering work of Weber provides a convincing aud straightforward analysis of the possibilities to transfer risks from insurance companies to the capital market. It is shown how the transfer business can be supported by banks and what role can play instruments created on the basis of securitization. It is quite remarkable that already many practical schemes aud devices have been developed on a trial aud error basis by insurers and banks. This process has been going on practically unobserved by scientific researchers. Weber's stndy pinpoints the research gaps and hints at some possible approaches to elose these gaps. It is a "must" reading for practitioners as weIl as students
and researches of insurance and finance.
Kassel, in May 2011
Rainer Stöttner
Preface
Having spent more than Iwenty years in banking practice, mostly in credit analysis and loan syndieation, I was entrusted to manage the investments of my employer in the global insuranee and reinsurance sector. Rigbt from the very first day, I found myself interested in Insuranee Linked Securities, a relatively new method to place insuranee risk into the eapital markets througb the usage of banking produets. After three years of eolleeting information I presented my project of a doctoral thesis 10 universities. University of Kassel tumed out to be an excellent choice and I would like to thank Professor Slötlner for bis support of my practice-oriented approach. After having refreshed my theoretical knowledge of modem investment management and the techniques of traditional insurance I reinsurance, I started to attend CODferences in order to gain up-to-date knowledge and establish eontacts with market partieipants. Apart from the different insurance risk types covered, the hroad variety of profes-
sionals, ranging from insurance, banking, legal, rating agencies, risk modelers to supervisors, malres this market so interesting. In the middle of the expert interview phase the eapital market crisis was accelerated by the sudden eollapse of Lehman Brothers, one of the important investment banks involved in insurance linked products. Tbe event oceurted during my stay in the United States. I wisb to express my sincere gratitude to all interview partners for their warm
xü reception and openness despite the extraordinary time of stress they were facing .t that
time. The situ.tion in the global e.pital markets deteriorated further after my return to Europe in Oetober 2008. Sinee its strengths and weaknesses became obvious, the pereeption of insuranee linked securities as • slowly growing niehe market bas ebanged to • sougbt range of products. My online-survey was earried out during • time of great uneertainty and I got the opportunity to inqnire the professionals for !beir opinion regarding the most eballenging issues .t th.t time. I would like to take this opportunity to sincerely thank all respondees for their support. Fortber, I would like to thank my employer Landesbank Baden-Würt1emberg and my eolle.gues for their support. This thesis would not have been possible without the eneouragement of my wife Susanne and the p.tience of my family.
Stuttgart, in M.y 2011
Christoph Weber
Contents 1 Introduction 1.1 Problem description and definition 1.2 Objeetive of the thesis. . . . 1.3 Methodology . . . . . . . . 2
Insurance Business and its Risk 2.1 Risk and lnsuranee . . . . . . . . . . . . . . . . . . . 2.1.1 Classifieation of risk faced by lnsurers . . . . . 2.1.2 Classifieation of risk by insuranee regulators 2.1.3 Peril and hazard . . . . . . . . . . . . . 2.2 lnsuranee . . . . . . . . . . . . . . . . . . . . 2.2.1 Tbe basies of insuranee mathematies. . 2.2.2 Economical versus insured losses . . . 2.2.3 Tbe Crlteria of insurability . . . . . . . 2.2.4 lnsurance, gambling and speculation. . 2.2.5 Evaluation and qoantification of losses . 2.3 Risk management . . . . . . . . . . . . . . . . 2.3.1 Objectives of risk management. . . . . 2.3.2 Steps ofthe risk management process 2.3.3 Cbanges in risk management due to Solvency 2 .. 2.4 Risk and return . . . . . 2.4.1 Insuranee pricing . . . . . . . . . . 2.4.2 Reserves . . . . . . . . . . . . . . 2.4.3 Investments of the insuranee sector
3 Tb. Insurance Industry 3.1 Primary lnsuranee . 3.1.1 Non-life insurance 3.1.2 Life insurance. . . . 3.2 Credit insuranee and surety . 3.3 Monoline insuranee . . . . .
1 I 3 3
S 5 6 7 7 9 9 15 16 17 18 18 18 19 21 23 23 24
28 3S 36 38 40 41 43
CONTENTS
xiv
3.4
4
Reinsurance . . . . . . . . . 3.4.1 Non-life reinsurance 3.4.2 Life reinsurance
Methods of Risk TrBDSl'er 4.1 Traditional melbods . . . . . . . . . . . 4.1.1 Reinsurance and retrocession. . 4.2 Alrernative risk transfer . 4.2.1 Risk carriers . . . . . . . . . . 4.2.2 Fioire solutions . . . . . . . . . 4.2.3 Multi-risk products . . . • • . . 4.2.4 Derivatives . . . . . 4.2.5 Contiugent capital . . . . . . . 4.2.6 Reinsurance side-cars. . . . . . 4.2.7 Insurance-reIared securitisation 4.2.8 Summary and evaluation of ART instruments
S lnsurance LiDked Securilies 5.1 Securitisation . . . . . . . . . . . . . . 5.2 Life insmance securitisation . . . . . . 5.2.1 Reserve funding securitisation . 5.2.2 Value-in-force securitisation .. 5.2.3 Residual commission securitisation 5.2.4 Risk transfer securitisation . . . . . 5.2.5 Life settlement securitisation . . . . 5.2.6 Summary and evaluation of life n.s 5.3 Non-life insurance securitisation . . . . . . 5.3.1 Catastrophe bonds . . . . . . . . . 5.3.2 Non-catastrophic insurance securitisation 5.4 Insurance relared CDOs . . . . . 5.4.1 Funding CDO pools . . . . . . 5.4.2 Catastrophe bond CDOs . . . . 5.4.3 Reinsurance receivable CDOs . 5.4.4 Summary and evaluation of non-life n.s . 6
Tbe Perspectives of the Stakeholders 6.1 Accountants and regulaturs . . . . . . . . . . . . . . 6.1.1 Tbe global approach to standardisation . . . 6.1.2 Inremational Financial Reportiug Standards . 6.1.3 Supervision - Ibe changes due to Solvency 2 . 6.1.4 Quantitative assessment by means of PiIIar I 6.1.5 Digression: Value at Risk and Expecred Shortfall 6.1.6 EU-barmonisation effects in respect oflLS . . .
45 47 51 SS 55 55 65 66
70 73 76 84
87 89 90 9S
95 98 98 102 106 107 110 114 117 117
120
124 124 125 127
130
133 133 133 134 136
137 138 148
CONTENTS
6.2
6.3
6.4
6.5
xv
6.1.7 Accounting and supervision in the US . . . . . . . . . . . . . 152 6.1.8 Outlook to further reforms . . . . . . . . . . . . . . . . . . . 158 6.1.9 Results of the interviews regarding accountants and regulators 161 Insurers and reinsurers as sponsors . . . . . . . . . . . 167 6.2.1 The integrated management of risk and capital 167 6.2.2 Capital management . . . . . . . . . . 168 6.2.3 Asset-Liability-Management.......... 168 6.2.4 Hybrid bonds and risk securitisation . . . . . . 177 6.2.5 Results of the interviews regarding sponsors. . 184 Rating agencies and risk mode1ers . . . . . . . . . . . 190 6.3.1 Rating agencies' services. . . . . . . . . . . . 190 6.3.2 Importance of enterprise risk management and capital for in191 surer's ratings. . . . . . . . . . . . . . . . . . . . 6.3.3 The rating ageneies' rating methodo1ogies for 1LS . . . . . . . 203 6.3.4 Riskmodeling companies' services . . . . . . . . . . . . . . . 208 6.3.5 Results of the interviews regarding rating ageneies, risk mode1ers, and monoliners . . . . . . . . 215 Investors........................... . 223 6.4.1 General market environment . . . . . . . . . . . . . 223 6.4.2 Convergence of investor's and sponsor's interest . .224 6.4.3 1LS as zero-beta assets . .224 6.4.4 Pricing and reloms . . . . . . . . . . . . . . . · 225 6.4.5 1LS triggers . . . . . . . . . . . . . . . . . . . .230 6.4.6 Results of the interviews regarding investors . .234 Arrangers of ILS . . . . . . .244 6.5.1 Banks . . . . . . . . . . .245 6.5.2 Reinsurance brokers .. .247 .248 6.5.3 Reinsurance companies . 6.5.4 Market . . . . . . . . . .249 . ..... 6.5.5 Pricing of 1LS. . . . . . .250 6.5.6 Effects of the crisis and expected measurements .. · 252
7 ILS Ooline Survey 7.1 Methodology . . . . . . . . 7.1.1 Basic questions . . . 7.1.2 Market environment 7.1.3 About ILS . . . 7.1.4 Corporate level . 7.1.5 The banks' role . 7.1.6 Final questions . 7.1.7 Sununary of the results of the 1LS online survey. .
· · · · · · · ·
2SS 255 256 257 261 263 263 265 268
xvi
CONTENTS
8 Recent Developments
269
9 Summary and Conclusion
273
List of Figures 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8
Sampling distribution versus sampling size. . . . . . . . . Individual average underwriting risk faced by the insurer . The risk management process. . . . The three pillars of Solvency 2 . . . . . The proposed framework for Pil1ar 1 . . Flow of funds of an insurance eompany Prospective reserve of an ordinary life insurance . . Asset elasses: Limitations and reported figures - USA I EU
15 16 20 22 23 26 27 31
3.1 3.2 3.3 3.4 3.5 3.6 3.7
Insuranee penetration in the global economie regions . Distribution of non life premiums in the USA 2006 Credit insuranee and surety premiums by regions . Cessions to global reinsuranee eompanies 2007 Frequency of eatastrophes 1970-2008 . . . . . Severity of catastrophes 1970-2008 . . . . . . . Life-expectancy at birth in different eountries .
36
4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14
Reinsurance and retrocession . . Quota reinsuranee . . . . . . . . Surplus reinsurance . . . . . . . Exeess of loss reinsurance for losses > USD 1 mln Global market far !arge corporation risk transfer produets . Alternative forms of risk transfer . . . . . . . . Number of eaptives in the different locations . . Strueture of a single solution Finite solutions . . . . . . . . . . . . . . . . . Multi-risk products . . . . . . . . . . . . . . . Derivative instruments used in the finaneial market The fourbasie positions in options . Contingent eapital solutions .. Hypothetieal side ear structure . . .
39 42 46 48
50 52
56 60 61 63
65 66
67 69 71 74 77 78 85 88
xviii
UST OF FIGURES
4.15 Spectrum of risk transfer instruments . . . . . . . . . . .
90
Structural cash flows of a Collateralised Loan Obligation ILS capital issued and outstanding sinee 1994 . . . . . . The effect of XXX on long tenn reserves of life insurers Hypolbetical XXX securitisation . . . . . . . . XXX Issues of Ibe US life insurance industry . Value-in-force securitisations sinee 1998 . . . . Simplified value-in-force securltisation . . . . . Residual commission securitisation since 1997 The LI transaction ofHannoverRe . . . . . . . AXA shelf programme lOsiris transaction structure . Risk transfer securltisations since 2003 . Simplified life-settlernenl securitisation Life-settlemenl securitisations . . . Cal bond issues sinee 1994 . . . . . . . Simplified structure of a cal bond . . . . Simplified structure of Ibe AXA securitisation SPARC Crystal credil risk securitisation . . . . . . . . . . Simplified structure of Ibe Dekania Europe 11 CDO Simplified structure of Ibe Fremantle CDO . Trancbing structure ofthe Fremant1e CDO . Structure of the Merlin CDO . . . . . . . .
96 97
5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10
5.11 5.12 5.13 5.14 5.15 5.16 5.17 5.18 5.19 5.20 5.21 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9
6.10 6.11 6.12 6.13 6.14 6.15 6.16 6.17 6.18
Timeframe of the IFRS accounting I EU supervisory reforms Organisations involved in the IFRS accounting reforms Confideuce interva1 of a stochastic variable x . . . . Value-al-risk surface of the loss distribution function Steps to evaluate the VaR I ES . . . . . . . . . VaR and ES per Allianz SE stock . . . . . . . . Historlcal simulation of Ibe Allianz SE stock. . Basic ALM model for insurance companies .. Duration ofthe sampie EUR 100 bond . . . . . Approximation error of Ibe Macaulay Duration Classification of hybrid securities by Moody's and S&P's . Sponsors' criteria regarding ILS . . . . . . . . Risk types modeled by Fitchrating's PRISM .. Cal risk distribution graph . . . . . . . . . Non-life insurance: drivers of losses . . . . illustrative framework for cal risk modeling Sampie of a loss exceedanee corve . . . Residential Re - loss exceedanee corve . . .
99 101 102
104 105
107 108 109
110 111 113 117 118 121 123 125 127 128 129 134 136
140 141 144 145 147 171
175 176 182 183 193 199
· . 200 · . 208 · . 210 · . 212
UST OF FIGURES 6.19 6.20 6.21 6.22 6.23
Residential Re - eatasuophe-1inked notes sttucture . Scottish Re I Tartan - mortality risk model sttucture Marke! share of ILS investor types . . . . . Comparison of index performances. . . . . Performance of ILS funds since July 2005 .
6.24 Comparison of efficient frontiers . . . . . .
7.1 7.2 7.3 7.4 7.5 7.6
7.7 7.8 7.9 7.10 7.11 7.12 7.13 7.14 7.15 7.16 7.17 7.18 7.19 7.20
Survey respondees by sponsor type and geographie Organisational status of ILS activities . . . . . . . Distanee of ILS activities to general management . Regional foeus . . . . . . . . . . . . . . . . . . . ILS produets covered . . . . . . . . . . . . . . . . Increase of insurance sector capital requirements . The demand for ILS will inerease . New product types will arise . . . . . . . . . . . . Standardisation of ILS . . . . . . . . . . . . . . . State of the ILS secondary market standardisation . Ranking: Main ILS market drivers . . . Ranking: Main ILS market obstacles .. Ranking: Most capable ILS arrangers . Sponsor motivations . . . . . . . . Importanceoftransactionratings .. ILS arranging banks . Banks' strengths . . . . . . . Banks' weaknesses . . . . . Expected results of the crisis Expected pricing development for ILS .
xix
· 213 · 214 · 223 .226 .227 · 228 · 255 · 256 · 257 · 258 · 258 · 259 · 259 .260 .260 · 261 · 261 .262 · 263 .264 .264 · 265 · 265 .266 .266 .267
List of Tables 9
2.1 2.2 2.3 2.4
Expected Loss Example I . . . . Expected Loss Example 2. . . . Objective of risk management . Product ionovations of the capital markets .
10 18 33
3.1 3.2 3.3 3.4 3.5
Types ofinsurance companies and their products . Top 10 countries by life I non-life direct premiums 2007 . Volume of financial guarantors insuted business in 2006. . Global top 10 non-Life reinsurance companies . Global top 12life reinsurance companies .
37 38 44 47 53
4.1 4.2 4.4
The vorlous forms and types of reinsurance Global weather risk derivatives . . . . . . . Summary and evaluation of ART instruments .
57 80 93
5.1 5.3
Osiris Plc - tranche structure . . . . . . . . . . Life insurance securltisation types: Summary and evaluation of characterlstics . . . . . . . . . . . . . . . . . Crystal Credit - tranche structure . . . . Basket of perlls coveted by Fremantle . Tranche structure or the Merlin CDO. . Non-Life insurance securitisation types: summary and evaluation of characterlstics . . . . . . . . . . . . . . . . . . . . . .
116 122 126 129
Proposed key capital calculation factors of Solvency 2 . Lower quantiles if the standard normal distribution .. Example: Alternatives to raise EUR 500 m1n capital. . Exarnple: ReguIatory capital requirement table Risk Based Capital action levels .. . . . . . . Effect of reinsurance on the capital positions . . Calcu1ation of the duration of a straight bond .
139 143 151 151 153 158 174
5.4 5.5 5.6 5.8
6.1 6.2 6.3 6.4 6.5 6.6 6.7
109
132
xxü 6.8 6.9 6.10 6.11 6.12 6.13 6.14 6.15 6.16 6.17 6.18
UST OF TABLES UBS's eight categories of coupon deferrallanguage . AM Best: Minimum BCAR and rating . . . . . . . . Moody's MRAC: Charge for reinsurers' IFRS ratings Moody's MRAC: SampIe reinsurance recoverable chart . Moody's MRAC: Company one-simulation exceedence curve . Moody's MRAC: Overall required capital simulation Moody's: Gross underwriting leverage and rating S&P's: Capital Adequacy Ratio ranges. AM Best: Basis risk scoring table . . . Loss exceedance curve data table . . . . Price estimation for a catastrophe bond.
180 192 196
197 " "
198 198 200 202
"
204
.. 211 .. 251
Chapter 1
Introduction 1.1
Problem description and definition
Tbe international financial industry bas been facing deep changes. We notice a concentration process through mergers and acquisitions in all areas of the industry. Tbe
insurance seetor, since the early nineties, has been challenged by natural and man-made catas1rophes such as intensified hurticane activities and terror. In addition, the global capital markets are currently facing the most severe financial crisis ever. It started in 2007, when highly leveraged home owners in the overheated US real estale sector increasingly defaulted on their mortgage payments. On September 15th, 2008, the investment bank Lehman Brothers defaulted. A few days thereafter, the wnrld's biggest insurance conglomerate Ametican International Group got into severe financial difficulties, ouly snrviving with a total of USD 180 bn liquidity support by the US government As a result of the difficulties, mortgage backed secntities placed at
internationa1ly active banks in numerous countries were downgraded or even defaulted and tbe financial system had to be massively supported by tbe local govemments. Banks and cOlpnrates were nationalised. A number of states, among tbem Iceland, Ireland, Hungary, Latvia, and Ukraine in tnrn bad to ask for liquidity support by the IMF. An end of the downtnrn of the US housing sector is not in sight and the financial ctisis is followed by a severe recession of the real economy. IMF estimates the totallosses caused by tbe financial ctisis at USD 4.1 trillion over tbe years 2007 to 2010.' Tbese developments, combined with the need for a harmonisation of the regulatory
environment, are leadin.g the insurance industry into a new stage of evolution. Insurance companies, as well as banks, take risks and have to manage them. The companies are regulated and must meet certain capital requirements. Further, tbey need to raise funds to run their activities. Both, banks and insurance companies, have credit rating sensitive franchises. lIMF [see 2OQ9],Pleven [see 02.03.2009]
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_1, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
2
CHAPTER 1. IN1RODUcrrON
Banks addressed funding, regulatory capital and balance sheet management issues some years ago. They have developed structured finance teclmiques and bave beeu usiug them for many years now. In order to redoce the volatility of their earnings, insurance and reinsurance cornpanies foond ways to adapt products already existing on the capital markets to their needs. Further, together with international banks, they are finding new ways to transfer risk to the capital marke!s. The new products are supplementary to traditional reinsurance and its teclmiques will play an even more important role at the introduction of the new Solvency 2 regulatory frarnework of the EU. The volume of insurance-re1ated securitisation as part of the new teclmiques has grown steadily in recent years ontil the financial crisis hit the markets. Catastrophe, mortality, and new bosiness strain risk were transferred to the capital markets. Future
premium fiows were securitised and enabled companies to use their capital effectively. Smaller insurance companies found their access to the markets by issuing several categories of capitallike Tier-I, Upper-Tier-2 and Lower-Tier-2 within collateralised debt obligations. A number of them would not bave been able to enter the markets without this instrument. Tbe second chapter of the thesis describes the insurance business and the risks involved. The insurance industry includes a diverse set of business !ines with associated risks whicb are in some ways similar to those of other !inancial institutions. Some of the risks which insurers and re-insurers take into their books, however, are equivalent to the bank's balance sbeets sucb as counter party risl<, credit risk and mortgage risk. Other risks such as mortaIity, longevity, catastrophes are specific to the industry and usually little kuown outside of it. Further, actuarlal risk can be caused by mal-calculation of reserves. Basic insurance mathematics and risk management techniques are therefore exp1ained and the in1Iuence of the regulatory enviromnents on insurance pricing and investment policy is examined. The third chap!er describes the different types of primary insurance and reinsurance. It reconsiders the historlca1 development of the varleties of altemative-risk-transfer and recent market statistics in order to provide an overview of the most important insurance regions and their speciaIties. Challenges in non-life insurance caused by natora1 and man-made catastrophes and in life insurance are exp1ained in detail. The fourth chapter briefly describes the history and types of altemative risk transfer in order to provide an overview of the instruments and to enable the reader to categorise the securitisation according to the methods available.
Securitisation as a main topic of the thesis is explained in detail in chapter five. At the end of the chapter, an evaluation of the characteristics of the different types completes the review. The sixth chapter describes the different perspectives of the marke! participants. The focus will be laid on describing the benefits or potential challenges of the current capital market crisis. The analysis of stakeholders is based on academic and economic research available. This information is supplemented by sumtuaries of interviews with industry experts of the different stakeholder groups based in the US and the EU.
1.2. OBJECTIVE OF THE THESIS
3
In order 10 complete the current picture of the market, an online survey was carried out and its results are analysed in ehapler seven. The questionnaire embraees 30 questions about the situation of the ILS market. The interviews and the online survey were canied out in the midst of economic uneertainty. Since the ILS marke! has also been affeeted by the default of Lehman Brothers as one of the major investment banks involved in the business, Chapler 8 was necessary to sununarise the key developments until July Ist, 2009. Chapler 9 summarises the results of the thesis.
1.2 Objective of the thesis The thesis was written by a banking professional and focuses on the role of banks in the development of risk transfer from insuranee eompanies 10 the eapital markets by means of securitisation. This is genera1ly defined as the accumulation of risk related eash fiows and their transformation into tradable securities. The markets for straight bonds and shares issued by insurance companies are not part of this thesis. Readers related 10 the banking and insuranee industry will be helped 10 understand the distinetions and sintilarities between the two sectors of the financial industry: banking and insurance.
The thesis will analyse whether the deeper convergenee of fiuancial sectors often aunounced is likely 10 happen and feasible. The severe finaneial erisis sparked by the downtum of the real estate securitisation in the US raised sorne doubts as 10 how securitisation was handled in the past. An inleresting question is whether the market for ILS is in danger of failing sinee the negative developments of the market for residential real estate seeuritisation eharacterised by over-Ieverage and a pricing not refiecting the risks involved will not be repeated. The interviews with market professionals and the ouline-interview try 10 evaiuate whieh products are likely to survive and how the banks' role in !bis process may develop. Banks have been involved in their traditional role as intermediates between investors and eapital marke!s. Further, they invested in the produets. While mueh academie work has been dedieated 10 explaining the use of ILS in the insurancelreinsuranee sector, the banks' role in !bis process has not been exantined yet. This thesis has been written in order 10 close !bis gap.
1.3 Methodology A substantial part of this thesis is based on economic science, specialised press and economie publieations. It has been written for academies and fiuancial professionals who are not 100 farniliar with banking or insurance. Therefore the first part eoneentrates on
4
CHAPTER 1. IN1RODUcrrON
the explanation of the mechanics of the market and speeially treats ILS. The transaction record nntil the end of 2008 is included for each of the ILS product types. The perspectives of the stakeholders are reinforced by expert interviews. Due to the current developments such as for instanee the default of Lehman Brothers and the rescue of American International Group during the stay in the USA, the interviews relleet the substantial cbange of the market environment. All experts interviewed were at the time of the interviews active in the financial mark.ets and involved in the n..S business.2 Personal interviews took p1ace in New York, Boston, eineago, Washington, London, Frankfurt, and Zurieh in the timeframe between August and December 2008. A minor part of the eonversations had to be done by phone.' 4 Each of the 32 interviews with associations, banks, hedge funds, insmers, reinsurers, lawyers, supervisors, rating agencies, risk. mode1ers, and monoline insurers was guided by a catalogue of questions. Because of the substantial difference in the roles of companies and persons interviewed were taking in the process, the eata10gue of about 10 questions per interview was held ßexible.5 All interviews were recorded and transcribed. The interviewees sigued an agreement that the information can be used for the thesis on condition that neither their names nor their eompanies are disclosed. The deseription of the perspective of the stakeholders mainly uses their "language" in order to reßeet a unique picture of the market situation at that time. Due to the intensive market turbnlenees and the nncertain autlook the author was reluctant to draw any general conc1usions from the statements given. The resnlts of the interviews are summarised in the stakeholder eategories: Aecountants and regulators, insurers and reinsurers as sponsors, rating agencies and risk modelers, investors, and arrangers ofILS. Lawyers are not inc1uded in any stakeholder group sinee they work together with the majority of stakeholders involved and were able to relleet severa1 shareholders ' perspectives - they ensure that the transactions are stnJctured in-line with the regulations of supervisors and accountants. The professional internet servicer 2ask was used for the online survey6 It was sent to 225 market participants with a response rate of 20% and the retumed data was analysed with the SPSS software tool.
2Bogner [see 2005, pp. 113-130] far the sampling methodology 3Bogner [see 2005. pp. 209-222] for the interview methodology 4Helfferich [sec 2005, pp. 148-173] for thc interview mcthodology 'Kaufmann and Böhmler [see 1999. pp. 65-69] far the questionnaire methodology 6Andrews et al. [see 2003] for the online-survey methodology
Chapter 2
Insurance Business and its Risk The insurance business is vital for today's economies, sinee by means of insurance policyholders can satisfy their need for protection and accumulate additional value.' Further, insurance and reinsurance contracts are essential for the risk management of corporates. Few companies operate without some amount of coverage. 2 The typical insurance includes a risk transfer mechanism. It allows the entity buying insurance to transfer the loss arising from specific risks, perils, or hazards from its equity holder to the insurance provider and its shareholders.'
2.1
Risk and insurance
A survey of the best-known insurance literature used in universities resulted in a general lack of agreement conceming the definition of risk.. However, common elements in a1l definitions are indeterminacy and loss: At least two variables of outcome of a developmentlevent must be in question and at least one of the outcomes is undesirable. Risk is a condition in the real world. 4 In its most general form, risk can be defined as uncertainty associated with a future outcome or event. Applied more specifically to the activities of corporations, risk is the expected variance in profits, lasses, or cash flows arising from an uncertain event.' When an event is possible, it has a probability between zero and one. An undesirable event is defined as the adverse deviation from the desired outcome that is expected or hoped for. 6 ILiebwein [see 2000, p. xxi] 2Banks [see 2004, p. 63] 'Culp [see 2002, p. 311] 4Vaughan and Vaughan [see 2003, p. 2] .5Banks [see 2004, p. 3] 'Vauglum and Vauglum [see 2003, p. 3]
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_2, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
6
Objective risk is therefore defined as the relative variation of aclualloss from expected loss.7 Further, subjective risk can be taken into consideration:' Uncertllinty, the opposite of certllinty, is astate of human mind characterised by doubt, based on a lack of knowledge about the future. It is simply a psychological reaction of homans. However, whether a person is aware of the risk or not, does not alter its existence. 9
2.1.1
Classification of risk faced by insurers
DynBlnic and statie risk Tbe possibility of dynamic changes result in dynamic risk. Economic conditions like price levels, consumer tastes, saving behaviour and technology favom the entire ecODomy in the long rnn, but include risk for the market participauts. Even if there were DO changes in the economy, static risk involves lasses. Examples are fire, accidents or perils of uature. lO Fundwnental and particular risk Losses affecting a large segment of a population are caused by fundamental risk. Examples for !bis are economic, climatic hea1th aud/or political phenomena. Particular risk threatens individuals rather thau a group.u Operating and financial risk
Operating risk is classified as the risk of loss arising from the operating activities of a corporation. Financial risk arises from the financial activities of a firm. 12 Speculative and pure risk
If a situation involves the possibility of gain as weil as loss, a company faces speculative risk. A good example for speculative risk is gambling. If risk ouly has the prospect of lass, it is defined as pure rist. 13 Perils of nature or consequences of human errors are normally pure risks. 14 Pure risk can be c1assified into four categories: Personal risk: Tbe possibility of loss of income or assets. Property risk: Direct or indirect loss of possessions due to destruction or theft. üability risl<: Injury of persons or damage of 7Rejda [see 1986, p. 3] 'Rejda [see 1986, p. 4] 9Vaughan and Vaughan [see 2003, p. 3] l°Outreville [see 1998, p. 3] 1I0utreville [see 1998, p. 4] 12Banks [see 2004, p. 4] 13Banks [see 2004, p. 4] 140utreville [see 1998, p. 3]
2.1. RISKANDINSURANCE
7
Iheir property due to negligence or carelessness. Risk arising from failure of o1hers: If a person does not m.eet bis Ol her obligati.ons.l~
Uosystematic and systematic risk Modern portfolio Iheory is b.sed on Ihe basic principle Ih.t risk can be e!imin.ted by means of diversification. Tbe unique risk of a single tille of • portfolio of stocks is also known as diversifiable or unsystematic risk. Since it can be eliminated, it should have DO value. However, there exist same unavoidable components of risk which affect all market participants to a greater or lesser extent. This is called systematie risk or market risk. Since Ihe risk of a well-diversified portfolio depends on systematic risk of its single components, the only relevant risk of any security is its sensitivity to general market movements. 16
2.1.2
CIassification of risk by insurance regulators
Regulators h.ve Iheir focus on Ihe solvahility of insurance cornpanies, being defined as Ihe .bility of companies to meet Iheir obligations towards Ihe policyholders and olher creditors. Apart from supervising Ihe liquidity of Ihe companies, Ihe .ulhorities concentrate their efforts on the risk. categories as follows: Market risk consists in 1he volatility of financial markets, including Ihe risk of changes of interest rares and prices of stocks, real estate and currencies. Credit risk contains Ihe possibility of • deterioration of Ihe creditworlhiness of Ihe insurance company's debtor. As • consequence hereof, Ihe quality of 1he relevant asset decreases or a totalloss may occur. Technieal risk of an insurance company is Ihe probability of • loss occurring in Ihe following financial year. Technical risk can be divided into prentium risk meaning Ihe possibility of Ihe prentium not being sufficient to cover future losses. Furlher, reserving risl<, reflecting Ihe probability lhat losses from Ihe claim processing may occur. Finally, catastrophe risk is defined .s Ihe possibility lhat Ihe insurance company has to face nnexpectedly high losses from man-made or natural c.tastrophes. Misman.gernent, system failures, or fr.ud may c.use operational risk for Ihe insurance company, finally resulting in direct losses. Furlher, external developments or even shocks may result in negative developmentsP
2.1.3 Peril and hazard A peril is a cause of a 10ss, like a fire or a hurricane. A hazard is a condition that may create or incre.se Ihe chance of • loss c.used by aperi!. Three types of hazards can be distinguished: ISVaughan and Vaughan [see 2003, p. 7] 16 ÜUb'eville [see 1998, p. 5]
17Bundesregierung [see 09.02.2007. p. 3]
8
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
Tbe physical hazard increases fue chance of • loss. Tbe defect wiring of an older .partment building may increase fue rist of • fire. Individuals cao incre.se 1he rist of. loss due to dishonesty or eharacter. This moral hazard is difficu1t to contro! for insurance companies. If a person uses to smoke in bis hedroom, this may inere.se 1he risk of • fire. Moral hazard involves unethieal or
immoral behaviour. Moral, hazard is 1he result of protection provided by insurance contracts. Bec.use of the existence of insurance, people may get careless or indifferent towards a lass. Motorists, for instance, may leave their car unlocked because they are insured against fueft and fuerefore inere.se fue risk of • loss. Morale hazard is less serious fuan moral
hazard, since it refers to insmed persons who are simply careless about their property.18
18Rejda [see 1986. pp. 5~1
2.2. INSURANCE
2.2
9
Insurance
2.2.1 The basics of insurance mathematics For the understanding of risk and insuranee theory an elementary knowledge of statistieal coneepls is essential. Further, the applianee of the law of large numbers by the insurance industry has to be understood. The following examples are based 00 books written by George E. Rejda. 19 Probability and statistic analysis The actuaries of insuranee companies apply probability and statistieal analysis to given /oss situations. Given an infinite nurnber of trials and no ebanges of the underlying eonditions, the probability of an event is the long-run relative frequency of it. While the probability of some events ean be determined without experimentation, the probability of others can be estimated througb the analysis of past loss data. Probability distributions surnmarise evenls and their probabilities. They list evenls that eould oceur and the probability of each event's oceurrenee. Discrete probability distributions bave only distinct possible outcomes. An example for a discrete probability distribution is the t1ipping of a fair eoin in the air, where the probability !hat the coin will come up "heads" or "tails" is SO percent each. Continuous probability distributions have a range of possible outcomes Iike, for example, the risk for a human being of dying in a specified year or the risk of a driver to be involved in a car accident. The!wo irnportant measures to cbaracterise probability distributions are: central tendency and dispersion. Out of the several methods available, the measure most often used 10 define eentraI tendency of a distribution is the mean I-' or expected vaIue (EV). In insurance, the expeeted value is the probable amount of money lost, the expected loss. It is found by multiplying each outcome (Xi) by ils probability of occurrenee (Pi) and summing: (2.1)
1-'= LXixPi
The mean or expected loss of the risk described in the following examples is estimated by an insuranee actuary as USD 280 based on the ealculation as follows: Loos amount (Xi) USDO USD390 USD70
x
x x
Loos probability(Pi) 0,20 0,70 0,10 ~XiPi
=
Expected loss (Xi Pi) USDO USD273 USD7 USD280
Table 2.1: Expeeted Loss Example 1
19Rejda [see 1986. pp. 4046];Rejda [,ee 2008. pp. 17-20]
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
10
Tbe estimation of the mean or expected loss of the second risk by the insuranee actuary is also USO 300: Loos amount (Xi) USD 175 USD350
x x
Loos probability (Pi) 0,40 0,60
Expected 1088 (Xi Pi)
=
L;XiPi
USD70 USD210 USD280
Table 2.2: Expected Loss Example 2 Although the two examples result in the same expected loss of USO 280, the first distribution is riskier, sinee the USO 390 range of potentialloss amount of between USO o and USO 390 is higher than the USO 175 range between USO 175 and USO 350 in
the second example. To characterlse the variability or dispersion about the mean value, the two standard measures varianee (u 2 ) and standard deviation (u) are employed. Tbe variance of a probability distribution is calculated as the sum of the squared differences between the possible outcomes and the expected value, then weighted by the probability of the outcomes. It is therefore the squared deviation between the possible outcomes and the
mean: u 2 = LPi(Xi - EV)2
(2.2)
In order to get the central tendency and the dispersion measure in the same unities, the square root of the variance has to be taken; the result is the standard deviation. Tbe two example distributions above result in the following variances and standard deviations: Example 1:
u 2 = 0.2(0 - 280)2 + 0.7(273 - 280)2 + 0.1(7 - 280)2
+
u
= 15,680 8,470 = 28,560 = y'28,56U = 169.00
+ 4, 410
Example2:
u 2 = 0.4(70 - 280)2 + 0.6(210 - 280)2 = 4,410 + 2,940 = 7,350 u = v'7,35U = 85.73 Although the means of the two example distributions are the same, their standard deviations are different Tbe higher standard deviation of Example 1 indicates a higher risk sinee, relative to the mean, the example catries a higher uncertainty of loss. Tbe lower standard deviation of Example 2 indicates a lower loss probability.
2.2. INSURANCE
11
Frequency and severity of losses The claim frequency distribution resulting in losses for the insorer shows the probability of baving various numbers of evenls during a predefined time period. Given that a loss has occorred, the claim severity distribution shows the probabilities of the potential loss amounts. Througb the combination of !wo distributions a total loss distribution (also called pore premium distribution) for an insurance company can be obtained for the given time period. The number of accidents or los ses, Z, and the potential size of the losses, Y, are randnm variables with known probability distributions p(Z) and p(y). X represents the total possihle loss !hat the risk can develop during the time period with the probability distribntion p(X). The arithmetic mean or expected values of these random variables are denoted as E(z), E(y) and E(x) - E(.) denotes the average mean orvalue forthe relevantrandom variable Z, Y or X). The variances, defined as the dispersion around the rnean of the variables are d... noted as Var(Z),Var(y), and Var(X)' The rnean of the total loss distribntion of the insured risk is the product of the expected number of losses (mean of claim frequency) and the expected loss amounls (mean claim severity): (2.3)
and the variance of loss distribntion Var(X) is given by the following relationsbip: Var(X) = (Var(Z) x E(Y)')
+ (Var(Y)
x E(z))
(2.4)
To illustrate the calculation method, we assume as a simplified example, that 1,000 farmers in Nebraska form a mutual fire insurance company, where the fire lasses of the unfortunate are shated by a11 members of the association. Further, we assume a single loss size: If a fire occurted, the farm houses bnrned down completely. The number of losses incurted by the farmers are supposed to follow abi-nominal distribntion: Pn(Z) = 1( n! ) x 1"(1- p)"-z (2.5) z. n-z
Where n =1,000 farm hauses as exposure units Z =the number of fire losses for 1,000 exposore unils p.a. (range: 0 - 1,000) p =the probability !hat one farm house will bnrn down (111,000) Pn(z) =the probability that Z ofthe houses will burn down during a year The number of losses for a single farmer follows a Bemoulli probability distribntion; the probability of a totalloss by fire is p and the probability for no loss is (1 - p):
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
12
P(z)
=
p%
(1- p)'-%
X
wherez=Oorl For 0 single fanner, P(z = 1) = p and P(z = 0) = 1 - p. Therefore, the expected number of fire losses E(z) during 0 year also !ums out to equal p: 1
E(Z)
L
=
z x P(z)
z=o = 0 x p(z = 0) + 1 x p(z = 1) = 0 x (1 - p) + 1 x p =p = 1/1000
Tbe variance in the numher of losses for a single farmer Var(Z) is calculoted as folIows: 1
Var(Z)
=
= (0 - p)2 = = = = = = =
L
z=o X
(z - E(z))' x P(z)
P(z = 0) + (1 - p)2 x P(z = 1)
(0 - p)2 x (1 - p) + (1 - p)' x p p2 x (1 _ p) + (1 _ p)2 x P p x (1 - p) x (p + (1 - p)) p x (1- p) (1/1000) x (1 - 1/1000) (1/1000) x (999/1000) (999/1000)2
In the given example, n = 1,000 farmers are exposcd to 0 total fire loss of their hornes. Since the mean and variance of n Bernoulli trials are equal to those of 0 binominal probahility distribution with n trials, the expected number of losses E n (Z) and the associated varianee in the number of losses Varn (Z) can be calculoted os follows: 1000
E(Z)
=
L
z=o
z x Pn(Z)
=nxp
= 1000 x
(1 - 1/1000) = 1 = the expected number of losses for n=I,OOO wtits 1
Varn(Z)
=
L
t=o
(z - E(z))2
X
P(z)
= n X p X (l-p) = 1000 x (1 - 1/1000) x (1 - 1/1000)
2.2. INSURANCE
13
= (999/1000)2
As a result, it ean be seen, that the expected number of total fire losses for n farmers E n (Z) is n times the expected number of losses for the single farmer:
En(Z) = n x E(Z) = n x p
(2.6)
And the varianee Jor the total number of Iosses Var n (Z) is n times the varianee of the number of losses for the single fanners:
Varn(Z) = n x Var(Z) = n x p x (1 - p)
(2.7)
Over a long renn period, the mean number of fire losses of the mutual insurer of 1,000 farmers is one per year and a single farmer would experienee a fire loss only onee in 1,000 years. When a fire occurs, it results in a totalloss of USD 90,000, the total value of the farm bumed down. Following formula (2.4), the expeeted fire loss per farmer E(X) is the produet of the number of losses E(Z) multiplied by the expected si2e of a loss E(Y):
E(X)
= E(Z) x E(Y) = p x E(Y) =
(1/1000) x USD 90, 000
= USD 90
For n farmers, the expected total fire losses En(X) is equal to n times E(X):
En(X)
= n x E(X) = 1000 x USD90 = USD 90,000
The farmer's mutual fire insuranee assoeiation would have to earry USD 90,000 fire losses per year. 1f the losses were pooled equally, each member would bave to pay a premium of USD 90 to get proteetion. However, sinee the actual number of hornes bumed down will vary, it has to be taken into eonsideration, !hat the losses and premium ean be lower or higher. Following formula (2.5), the varianee of totallosses Var(X), ean be derived from the means and variances associated with the claim frequency and claim severity distri-
butions. Var(X) = (Var(Z) x E(y)2) + (Var(Y) x E(Z)) = (p x (1 - p) x E(y)2) + (Var(Y) x p) = (999/1000)2 x USD 90, 000 + 0 x (1/1000) = 999 x 902 = 2,844.622
In order 10 get the central tendency and the dispersion measure in the same unities, the square root of the variance has to be taken. The result is the standard deviation of totallosses (u.), a more relevant measure of dispersion.
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
14
u. = vVar(x) = V{USD 2, 844.62)2 = USD 2,844.62 All of the values in the equation above have already been calcu1ated except the variance of the claim distribution Var(Y). It is equal to zero in this example since a totalloss was assurned. The example results in the mean of the totalloss disttibution fot a single exposure urtit E(x) ofUSD 90 and the standatd deviation u. ofUSD 2,844.62. The actual average amount, howevet, could deviate substantially from the expected value due to the randorn nature of fire lasses.
Law of!arge numbe.... If the insurance of homogenous risks like :fire insurance is assumed and underwriting considerations are ignored, the insurer basically takes a randorn sampie from a basic totalloss disttibution, because of the centrallimit theorem, stating: .off you draw randorn sampies of n observations from any population with mean p.. and standard deviation u., and n is sufficiently large, the disttibution of sampie means will be approximately notmal, with the mean of the disttibution equal to the rnean of the population (p." = p..) and the standatd errot of the sampie rnean u z equal to the standard deviation of the population divided by the square root ofn (u" = u.I.fii). This approptiation becom.es increasingly accurate as the sampie size, n, increases." Rejda [2008, p. 4]
Tbe centrallimit theorem is relevant for insurers, since regardless of the characteristics of the underlying population disttibution, the disttibution of sampie means will approach the notmal disttibution as the sarnple size increases: 68 petCent of the disttibution therefote lies within one standatd deviation of the rnean, and about 95 percent of the disttibution lies within !wo standatd deviations of the rnean. A furthet implication of the centra! limit theorern fot insurers is that the standard etrOr of Ibe sarnple mean disttibution declines as Ibe sarnple size n increases. In Ibe fire insurance exarnple above the result fot the standatd deviation of losses, for one exposure urtit was USD 2,844.62 and the standatd etror fot 1,000 exposures equals to USD 89.96:
u"
u,,= u.l.fii = USD 2,844.621 ';1000 = U SD 2,844.62/31.62 =USD89.96
2.2. INSURANCE
15
J(-,) -- n
10.000
'''''
'------------x E(Y) liaS«! On' lI.ojd •. G<0,fV' L I'rinciplo,ofln",,..«. S<."QIt. 1o",,,,,•• & Co.. Glen., iell. 1986. p. 4~
Flgure 2.1: Sampling distribution versus sampling size By increasing the number of insurcd farm houses n 10 10,000, the insurer wouId rise the size of the sampIe and, by ca1cu1ating with the formula above, the value for a-~ would therefore decrease to USD 28.45 (see figure 2.1). The W1derwriting risk, defined as the maximum losse8 insured, would increase since more insured uni.ts could suffer a 1055. The expression for underwriting risk is as follews: (2.8)
Although the sampIe size grows n-fold. the underwriting risk does not increase proportionat.ely, but by the square root of n (see figure 2.2). The insurance company therefore rcduces the objective risk: by increasing the number of contracts, due to the fact that the difference between ac1ual results and expected results decreases. The deviation of ac1ual from expected losse8 as major cancern far the insurance company, however,
"""'""'.
2.2.2 Economical versos insured losse.s The existence of risk:. a:ffects the economic performance of agents. Constraints are im-
posed on the optimum. allocation of resources and on the economic development of nations. Individual and business decisions are not made under conditions of certainty.
16
CHAPI'ER 2. INSURANCE BUSINESS AND ITS RISK
,
0'-
= a,
I;;;
BlS\.>d on Rojda. Go<>r@cE .• I>ri""ip"',ofl"",ranco '>cOlI. I'o",.man &. Co .. Glen,i.,,_ 1986. p.45
11
Figure 2.2: Individual average underwriting risk facod by the ins\ttet' The common denominator is risk. Prudent individuals engage in safe actions rather
than risky 0DeS. In genend, their objective is not to avoid risk but rather to recognisc its existence and to ensure that insurance compensation is adequate for the risks being bome.'"
:U.3 Ibe Criteria of insurability It ia theoreti.cally possible to insure all possibilities of IOS5. However, for practical rea8ons. insurancc companWs arc not willing to accept a11 the risks than other agents may wish to transfer to them. Further, many risks arc not insurable at a reasonable pricc.21 In order tu get a contract to bc considcrcd Wl insunmce for tu. and accounting purposes, it must generally fulfil the following minimum criteria:22 • the cedent must have an insurable interest • an unforeseen. unexpected or accidental risk with respect to some fortuitous events must exist at the inception of the contract
20Vllighan lDd Vaughm [_ 2003, p. 41] :1lOutrevillc [IICC 1998, P. 6] 22BIDkJ [IICC 2004, p. 64]
2.2. INSURANCE
17
• • risk of loss troosfer must take place
• the contract must provide indemnity and involve appropriate consideration • in order to make potentiallosses predietable ood measurable, a sufficiently large number of homogeneous exposure units must exist and lasses must not be catastrophie • !he loss eaused by !he risk must be definite aod measurable, !he prentium eharged must represeot the statistically expected loss (plus prentium loading)
• the transaction must be "af utmost good faith" through contractual representations and must be executed with kuowledge and legal purpose; the transaction must include offer/acceptanee ood eonsideration • !he contract must include the right of subrogation or the transfer of loss recovery rights from the eedent to !he insurer Insurance business is based on the notion of sharing lasses. The pooling of risk. is essential. Randomness in the selection of risk. is c10sely related to the requirement that loss must be non-eatastrophie. This lintitation is related to 00 ideal insurable risk ood it is given to .void !hat a large proportion if exposure units should not suffer from lasses at the same time. In the real world, however, it is impossible for an insurer to avoid all eatastrophie losses, sinee !hey regularly occur as a result of periodieal t1oods, hurricanes, tornadoes, earthquakes, forest fires, and other natural disasters. Insurance eompaoies have !wo approaches avail.ble to meet the problem of eatastrophie loss: First, reinsuranee ean be used to get indenntified from eatastrophie los ses. Second, insurers can avoid the concentration of risk by dispersing their coverage aver a large geographie area. 23
2.2.4
Insurance, gambling and speculation
Insuranee business is often eonfused with gambling. Tbe first differenee betweeo the !wo is, that gambling creates new speculative risk while insurance is a technique for handling already existing pure risk. Second, gambling is not productive for the economy sinee the profits created for the winners are eharged at the expense of the 10sers. 24 The techniques of speculation ood insurooee .ppear to be similar, sinee risk is transferred by a contract while DO new risk is created. There are two differences between the twO: First, specu1ation typica1ly covers the uninsurab1e risk while insurance contracts transfer insurable risk since the minimum criteria have to be Met. Second, speculation involves only risk transfer, not risk reduetion. The prediction of the speculator may be based only on a small number cf transactions, while the insurer rcduces the objective 23Rejda [... 1986, p. 241 "'Rejda [... 1986, p. 281
18
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
risk by applieation of Ihe law of large numbers. 111e prediction of future losses improve since the relative variation of actualloss from expected 108S will decline with an increasing number of exposure units.25
2.2.5 Evaluation and quantification of losses 111e insurance contract precisely specifies a trigger, defined as Ihe nature of risk, hazard, or peril that can cause the contingent payment by the insurance company to the cedent. Further, the contract specifies the nature of the insurer's contingent liability, ca11ed the benefit amount. Is Ihe insurance eontract a contract 01 value, this amount is fixed. A traditional life insuranee contract pays a fixed amoont if Ihe contract is triggered by 1he dea1h of 1he insured. Is Ihe insuranee eontract a contract 01 indemnity, this amount is variable. An homeowner insurance, for example may compensate for the economic damage of Ihe owner. A large loss results in a large payment, while a sma1lloss results in a small payment.
2.3
Risk management
An insurance company's risk management is one of the basic but complex entrepreneurial elements. Insurers have been practicing Ihe principals of onderstanding relevant risk and managing Ihem from Ihe early days of Ihe industry. Sophistieation and tecbniques ean vary substantially betwccn 1he different eompanies. 26
2.3.1
Objectives of risk management
Risk management is a speeialised financial aspect of management. It has a variety of objecrlves whieh ean be elassified by importanee into Ihe eategories: 27 Pre-Loss Objecti.es: Economy Reduction in anxiety
Meeting with cxtemally imposed obligations Social responsibility
Post-Los.Objecti.es: SurvivaI
Continuity of operations Continued growth Social responsibility
Table 2.3: Objeetive of risk management
Pre-Ioss, before a loss oceurred, Ihe eompany should prepare for potentiallosses in 1he most economieal way. 111e costs for Ihe safety program, insurance premium paid, and for Ihe different tecbniques regarding Ihe handling of los ses must be analysed. "Rejda [see 1986, p. 28] 26Culp [see 2002, p. 314] 27Yaughan and Yaughan [see 2003. p. 24]
2.3. RISK MANAGEMENT
19
Further, anxiety and fear associated with risk exposures have to be reduced. Existing legal obligations have to be mel. Post-loas, after a loss occurred, the prime objective of risk management is the survival of the company. Operations have to continue and the stability of earnings and growth has to be rebuill. Tbe company has to act socially responsible to minimize the effects that a 1088 will have on other persons and on society at any time. 28
2.3.2 Steps of the risk management process Tbe risk management process involves the four steps descrlbed in figure 2.3:
The first step, the identification of potentia11osses, is the most critica1 function of the process. The organisation must be aware of the risks before anything can be done about them. Tbe failure to get knowledge of the existence of one or several potential events can result in a disaster for the company.29 Tbc process centers on defining and identifying all of the company's actual, perceived, or anticipated risks. Risk management has to get a systematic and continuing overview of the organisation and its operations. Several techniques like the analysis of flow charts, financial statements, legal contracts, job/position descriptions and commonication systems are avai1able. Further, risk managers use exposure and insurance policy checklists in their approach to use a1l available techniques in combination.30 The evaluation of losses as the second step of the proces8 inc1udes the measurement of the potential size of the loss and the probability that it is likely to occur. Tbe risk manager needs information about the two dimensions of the risk: • the frequency or probability of the loss event • the severity of the loss that will occur Having collected this data about the loss exposures, frequency distributions will be prepared to summarise the portfolio. Tbe useful information gained on the causes or consequences of a phenomenon enables the risk management to rank them as: • critical (loss events resulting in bankruptcy), • important (loss events resulting in severe financial difficulties for the company), or
• unimportant (loss events which could be met with existing assets or current incorne),31
In the third step of the risk management process, the most approprlare techniques for treating loss exposures have to be selected: 28Rejda [see 1986. pp. 38-39] 29 ÜUtreville [see 1998, p. 52] 30Vaughan and Vaughan [see 2003, pp. 25-27] 31Vaughan and Vaughan [see 2003, pp. 27-28]
CHAPI'ER 2. INSURANCE BUSINESS AND ITS RISK
20
• risk control refers to teclmiques which reduce the frequency and severity of lasses, - avoidance (the 1058 exposure is not acquired) - loss prevention (measures are taken to reduce Ioss frequency) - lass rcduction (measures are take to reduce lass severity)
Idcntify potcntiallosscs
Evaluatc polcnliallosscs
Sclce\ approprialC Icchniqucs for the treatment of loss CX[lOsurcs
1. Kisk Control A"oidancc Loss prcvcntion Loss rcduction
2. Ri sk Financing Retention Non in surnncc transfers Cornmcrcial insurancc
Implement and administcr [he programme Has..-d on : Rcjda Grorgc. I'rintip loS <>f Risk
~I.nag<m
al'ld
I"",mnco. Addisoo Wesle) . Ilmlon. 200ll p. 43
Figure 2.3: The rist management process
• risk. financing mfers 10 teclmi.ques providing the funding Cor the losses - retention (the com.pany rctains part or all ofthe lasses) - non-msurance transfers (risks are transferred to another party) - commerc:ial insurance (insurance is used to cover loss exposureSJ'2 nRejda [see 1986, pp. 39-49]
2.3. RISK MANAGEMENT
21
Tbe fourth srep is the implementatioo and administration of the risk management
programme. A risk management policy statement is necessary to ouiline the objecti.ves of the eompany's risk management and its policy regardiog the treatment of loss exposures. In addition, a risk management manual forces the risk: manager to state precisely bis or her responsibilities, objectives and avai1able rechniques. Tbe support by the top management and from other departments of the company is vital for an effective risk management The risk management programme and the procedures must be reviewed periodieally and evaluared to derermine whether the objectives are being attained. 33 Onee the eompany haa decided how it wants to mauage its risk, the costs of safetyand loss prevention programmes must be monitored. Tbe eompany must regularly track and report its experienee in deeision msking and risk exposure. Inremal and exrema1 parties (e.g. executive management, regulators, creditors, investors) require this feed-
back to assess and adjust their decisioDS.34
2.3.3
Changes in risk management due to Solvency 2
Tbe reformatioo of the European insuranee regulatory framework ealled Solveney 2 is regarded as ooe of the most ambitious projects of the financial industry. Tbe involved parties, the insurance eompanies, their industry associations, and the supervisory authorities of the member stares have been working together within the legis1ation process. Whi1e the Solvency I regulation so far in p1ace specifies capital requirements in rerms of a simple set of factors to be applied to rechnieal provision or prerniurns, Solvency 2 is an inregrared risk management approach for the insurance sector. Tbe new sysrem will, in addition, require the companies to establish systems, processes and controls for
risk management.35 Tbe structure of the new Basel 11 regulatory envirooment in the EU banking sector is regarded as the blueprint for the three-pillar structure of Solvency 2. Tbe sirnilarities between the two systems, however, are limited. Tbc insurance industries • different business model eompared to the banking seelor is rellecred in its own set of prlnciples shown in fignre 2.4. Pillar I defines the finaneial resources a eompany haa to hold in order to be regarded as solvent. As shown in fignre 2.5, the rechnieal provisions are ca1eulared by a best estimare of the liabilities wbich are augrnenred by a risk margin to relleet any uncertainty in
future cash flows. Since in many cases there is DO liquid mark.et far insurance risk, the market risk is based 00 a proxy "cost of eapital". This reßects the returo on the eapital a nominal buyer would need to support the liabilities acquired from the holder over a whole run-off perlod. Hedgeable risks are consisrently market evaluared. Tbe next level represents the safety lIoor. If a company falls below this Ihreshold, the Minimum Capital Requirement (MCR), the supervisory authority will invoke severe 33Rcjda [see 1986, pp. 39-49] 34Banks [see 2004, p. 8] "Fm [see 10.07.2007. p. I]
CHAPI'ER 2. INSURANCE BUSINESS AND ITS RISK
22
r,II., (,kl."'''''' K.....irt...." Il.aio<>"" Ih<
or_",..
I"""'_
M,nomum C"""aI R«i U'mn
R
"" '. 2 O••II"'h. R'qul "M'."
f"r,"""""'of ..." ...
."..,01 ond
, ~l
~,
10 1"',1 'I ", ~" 1~ "'pll ..
1:>0",,,,,,"", ;~
S"f'<"'W<) '" "'~
"~
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~":
S"i" 'k , igm. No_ 412()()(', Soho",,) 11: An ;n'cgralcd,;sI; 'r>pm""h for Lu'''p<:.n S"issll.<. lijri"h. 2()()6, p. 8
,,,,,,,,,rs,
Figure 2.4: The thrcc pillars of Solvency 2 measures like the closing of the COmpany for new business. In addition, the Solvency Capital Requirement (SeR) enables the company to withstand advene circumstances. even severe shocks. The SCR is based on a 99.5% confidence 1eve1 of remaining solvent in the 12 months ahead. Insurers can opt for the standardised approach to calculate the SCR or. if tbey are ablc to run sophisticated modeling systems, can seek to qualify an advanced approach. The SeR includes the evaluation of operating, investment and the othcr:financial risks. If a company's ICSOUlCCS fall bclow this 1cvc1, action by thc mpervisory bodies will be triggered. 36 Pillar 2 promotes good corporate risk management and concentrates on the qualitative rcgulating thc supcrvisory process rcquirements as a supplcmcnt of Pillar 1. This also includes the mles for a potential intervention. Further, standards for the intemal risk management processes and thc aspects of operational risk are deliverod. Pillar 3 specifies the risk disclosure requirements. The focus is on transparency, open information and comparability within the industry. It completes the framework by encouraging market discipline and the risk dialogue with the stakeholders. Insurance companies cstablishing their framework well, will be rewarded by the system. They will be able to monitor their risks in a constant proccss. A company writing more profitable products due 10 a higher premium ca.lculatod will ask: for lcss capital than a company writing less profitable business. Options and guarantees in a product
J(iMcLarmet aI. [seeOlm.2OO6, p. 4]
2.4. RlSK AND REIVRN
23
,\1 .B.bk: ""pot.1 Soh.",,) .op;"'1 "'Guiro"",nIISCR\
,\S>Clcol'orinS
",chn;<.1 prol ;,ion'
,\
...... "
m",~"
1'.lu.
Sou".. , .\1< 1..,,'n. ~101ani< cl .1 .. ('Ou"IOO"" l.ondon, 2006. p. 4
'0 Soh.",,!
11. 1";<0 1I'.ICmou", Coopc",
Figurc 2.5: The proposed. framework for Pillar 1
will be taken into considc:ratiOll as well as the investment policy. Thchnical provisions and capital. requirements have to be covercd by a partfolio of asset investments. The assets are evahwed :market-to-market. Investments in high risk assets willrequire more capital than those with 10w risk. Risk. management techniques, such as the use of reinsurance, hedging, and securitisatiOll can reduce risk levels. Diversification. the principle to avoid that all risks will crystalise at the same moment, will have a lowering effcct regarding the necessary amount of capital.37
2.4 Risk and retum 2.4.1
Insurance pricing
The pric~ for insurance, also called the insurance rate, is defined as the price per unit of insurance. It should be distinguishod from the premium, which is determined by multiplying the rate by the number of units of protecti.on purchased. Comparing insurance to other industries, two main differences have to be talren into consideration: First, since the cost of production is not known until an insurance policy cxpires, the rate has to be based on a prediction. Second, insurance rates, especially in the property and the
31La MartineM md Ta.ylor Goby [see 2006]
24
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
liability coverage, are often regulare
2.4.2 Reserves In contrary to many other industries, the producti.on cyc1e of the insurance sector is reversed, since the premium payment is m.ade by the customer before the service is provided. The gross written premiums are used to pay commissions and administrative expenses. Tbe ultimative service is provided as the claims payment by the insurance company to compensate for a lass occurred. These payments are not nccessarily made in the same year as the premium payment. Therefore, the insurance company establishes technical reserves, which represent the commitments of the insurance company with respect to the insured party. Non-life insurance companies have 10 maintain two principal types of reserves, the loss reserves and the unearned premium reserves. Life insmance companies' main 3!1Yaughan and Vaughan [see 2003, p. 125] 39Rejda [see 1986, p. 547] "'Rejda [... 1986, p. 548] 41Yaughan and Vaughan [see 2003. p. 125]
2.4. RISK AND RETURN
25
reserve position consists of policy reserves. If the reserve requirements are by law fulfilled, the company may set up additional voluntary reserves. The voluntary reserves are used to strengthen tbe financial structure or for the payment of future benefils to life insurance policyholders.42 The classification of reserves is important for tbe types of assets an insurance company can take into tbeir books witb tbe surplus of cash infIow in order to cover future claims and to generate additional investment incom.e. Th.e surplus returns of the investment activities are allocated to tbe capital of tbe company. Figure 2.6 illustrates tbe earnings stream of an insurance company. The net premium stream, after payments for claims and expenses, is used to increase the reserves necessary 10 cover future obligations. The reserves form the m.ain liabilities of an insurance company. Reserves should not be defined as surplus as it is understood in the common accounting terminology. They are ratber debt to policyholders in !hat respect, tbat they form obligations to them to meet their future claims. In almost all countries
the supervisory authorities OI even laws specify the requirements
OI
recommendations
regarding the reserves. 43
Insurance companies apply two principal reserving techniques: Capitalisation CODsists in holding a portion of the premiums in reserve to be able to meet future obligations. This is the case in life insurance and annuities. The capitalisation technique generates medium and long term reserves which can be invested in capital market instruments of maturity equivalent to the contract. Compensation consists in using the premiums collected during a budgetary year to cover immediately tbe claims in !hat year. This system generates mainly short tenn reserves and is used for non-life insurance like car-insuranee and also for reinsuranee.44 The business written by property and casualty insurers requires mainly loss reserves
and uneamed premium reserves: Since insurers eollect premiums in advance for their proteetion eovering an extended time period, they are required to make provisions for the unfulfilled and contingent obligations tbeir contracls represent. Insurers are ouly permitted to include premiums as income as the premiums become eamed. This is the ease when the time for which protection is provided has passed. Further, they are obliged to establish a deferred ineome account, ealled unearned premium reserve in order to p1ace a claim against assels !hat will probably be used to compensate for claims in the future. 45 Loss reserves are established to cover all known and unknown future claims to be faced by the insurance company caused by their underwriting activities. The first type, tbe reserves for losses reported but not yet paid, can be established by tbe examiuation
of each claim and approximation of the severity. The second type, the reserves for losses incurred but not reported due to a potential time lag in claim reporting, are usually 42Rejda [see 1986. p. 575] 43 ÜUtreville [see 1998, pp. 233-241] 44 ÜUb'eville [see 1998, pp. 221-223] 4SYaughan and Yaughan [see 1995, p. 119]
CHAPI'ER 2. INSURANCE BUSINESS AND ITS RISK
26
estimatOO on the basis cf past experiencc.46 The major liability item. for llfe iDsurera are policy reserves being obligations to pay futnre policy benefits to the policy ownc:rs and therefore can be regardc:d as Iiability item.s on the company's balance sheet. They are often callc:d legal resaves sincc supervisory bodies and insurance laws speci:fy the minimum basis for their calculati.on. Thc policy reserve plus interest earnings on the assets acqujrcd with the cash ßow of the premium most be sufficient to pay aIl future benefits to the policy holder. It is the formal mcognition ofthc company's obligation to pay contractual bcnefits. The rescrvc further fonns the legal test of the company's solvency since the company must hold assets equal 10 its legal reserves. It should not be viewod as a fund but rather as a Iiability item. that must be offset by assets.
-
I I ~ " Ir ( ,rem'' ' j - ~ - - I1 5 E
Assc!s
~ •
Reserves
.~ ~
u
,
U "l'p, ,
ln,,~:~ ",d
", _ Surpll.ls
Assc!s & Liabilitics 113.<00 on:
I
[ncomc
Statement of Incomc
Qu",,, ilk kan·F"...cois. Throf) ond I'"",,;cc of Insurance "I"wer ",,,..k mio I'ubli>h
Figure 2.6: Flow of funds of an insurance company Figure 2.7 shows an example of an ordinary US Iife insurance policy covering an amount of USD 1,000. Closed at the agc of 35, it is supposed to stay in full forcc: and e:ffect for the life of the insured with periodical premium payments for the same period. At the starting point of the contract, the present value of thc oet single premium ofUSD 421.21 is equal to the present value ofthe future payment to the poIicy holder. Howcvc:r, when thc first premium installmcnt has been paid, this is no langer thc case the present value of future benefits and the present value of future net premiums are not equal anymore. The present value of thc future benefits will increase over time when thc 46YIIIlghan md Yaugbm [_ 2003, p. 143]
2.4. RlSK AND REIVRN
27
date cf death is drawing closer. Sincc lower premiums are to be paid. the present value of future net premium stream will decrease. The difference between the two forms the policy IeSCIVC. If the insurcd is still alivc at the age of 100. the face amount of the insurance is paid 10 the owner of the policy. At this point, the reserve is equal 10 the policy face amount. 47
USIlI (J(l(l
~"""""''''
~""ngI< l'<m lU'"
,m""""[;;~=~::::~J Pr<S
(J5D
V.ru.: ,,r r.. w, ..... p«m,wo>
0
"
.,~
9~
"
100
I.""""",
fJ.ao< Publo>h. flot
Hgurc 2.7: Prospccti.vc reserve of an ordinary 1ife insurance Regarding the time of valuation, the Iife inmrance policy reserve shown in figure 2.7 can be cla:ssified as prospecti"ve reserve since it is ca1culatcd as the difference between the present value of the future benefits of the policy holder and the future net premiums he is obliged 10 pay for the insurance cover. The second classification by the time of valuation, the retrospective reserve, represents the net premiums paid 10 the insurer fur a particular block of insurance policies, plus interest eamings at market rates, minus the amounts paid out as death claims. It is the excess of the net premiums collected at interest over the death claims paid out 10 the polioyholde<. Classified by the timing, when reserves are valued, the policy year begins with the initial reserve. This rescrvc 1cvel is commonly used by the companies 10 detcn:ninc dividends. The terminal reserve is the reserve level at the end of a given policy year, while the mean reserve is defined as the average cf the terminal and the initial reserves. 41Rejda [see 1986, p. 57Sj
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
28
It is used to indicate the company's reserve liabilities for the annual accounting.48
2.4.3
Investments of the insurance sector
Together with pension funds, insurance companies are main investors in the capital markets and io real estate. The returns on these investments are, together with the premium income from policyholders. an important source of income for the insurance sector. The ability of insurance companies 10 meet their future payments due, is vital at any time time and for the long term survivaI of the company. The iovestment iocome must therefore be sufficient to maintain the capital and surplus.<' The legal reserves and other liabilities of an iosurance company must be offset by liquid funds and asset iovestments. Approxirnately 80% of the assets of a life iosurer are needed to offset its
reserve liabilities. 50 In addition to the investment of the reserves as its provisions for claims, insurance companies reiovest the substantial turnover and returns from their asset portfolios. Continuously irnproviog asset-Iability-management infiuences the iovestment philosophy of the iosurance iodustry today. This ioc1udes a co-ordination of the assets se1ected for the portfolio iovestments io that respect, !hat they represent the nature of the liabilities of the companies. The efforts are on the matching of durations, delined as the average life of the cash flows from both sides of the balance sheet. In addition, companies try to immunize themselves against adverse interest rate developments by hedging therr
positions with derivative financial structures. Most iosurance companies give ptime irnportance to the priocipal of security of their
capital invested. Second, their managers are concerned about earning the highest retum possible for their iovestments chosen. Third, it is irnportant to secore the liquidity of the iovestment portfolio io order to be able to pay claims timely or to meet unexpected obligations.51 The investment income is also important for reducing the cast of insurance, the premiums to be paid by policy holders. Most pTOperty and casualty insurers, especially the US iosorers, were not able to write combioed ratios below 100 percent for most of the annual reporting periuds of the past decades. This means that their expenses and claims cost were higher than the premium iocome and their iosurance underwriting produced lasses. Tbe investment incorne was necessary for them to overcome the difficult years
facing a competitive environment.52 Ufe insumnce companies have to assume a guaranteed minimum rate of return in the calculation of the premiums. Tbe investment income in excess of the minimum rate is used to pay benefits on the contracts. Competing for clients with similar products, 48Rejda [see 1986, p. 577] 490utreville [see 1998, pp. 221-223] "'Rejda [see 1986, p. 575] 51 ÜUtreville [see 1998, pp. XX] S2Cohen et aI. [see 2007. p. 25]
2.4. RISK AND RETURN
29
profits generated from investment income is an imporllmt eriterion for eustomers to evaluate the finaneial strength and finally deeide whieh company to contract." Assels-structnre or insorance companies Fixed income investments are weIl suited to match the objectives of most insurance eompanies globally in order to maintain sufficient assets to offset their liabilities. Only
the investment types listed as "admitted assets" by the supervisory authorities and regul.tory boards are allowed to be shown on the stalutory balance sbeet. Admitted assets inelude cash, bonds, common and preferred stocks, mortg.ges, real estate, and other
legal investments.54 Investments in fixed income securities issued by governments, federa1 states and municipals are generally regarded .s risk-free investments, sinee they h.ve historieally not been endangered from def.ult or insolveney. Insuranee eompanies may usually hold an unrestrleted arnount of bonds elassified .s "risk-free". The qua1ity of corporate bonds, • forther investment elass for insurers can, in eontrary, be affeeted by eredit deterioration or def.ult of the issuer. They therefore p.y • higher return. Rating .geneies estimate the quality of borrowers and single bond issues and their likelihood of • def.ult. Appendis A sbows the mting definitions of the main
rating agencies. An alternative to fixed income investments are mortgages and private loans. These are usually non-liquid, and the insurer demands • higher mte to eompens.te for the higher liquidity risk involved. At the diseretion of the policy holder,life insurers provide poliey loans resulting from provisions in life insuranee eontracts. The polieyholder borrows the cash value of the policy. Due to the long term nature of the oblig.tions of life insurers, they are traditional investors in the real-estate ownership whieh gener.tes stable returns .t. high level. Investments in common and preferrcd shares have been limited duc to negative experienees during the crisis of the main stock markets in the late 199Oies. These investments are eharacterised by non-guaranteed periodie p.yments of dividends. Further, the insurance company carries the rist of a deterioration of the market value of the shares. 55 In recent years, other legal investments of the insuranee sector in struetured credit products have inere.sed. Inuov.tion has been the main driver of Ibis market Changes in credit markets, like the strong involvement of hedge funds providing liquidity and economie leverage inere.sing the demand for innovative products, have also been pl.ying • fundamental role of its development. Insurance companies in all regions particip.te actively in the whole range of products across the several tranches from super-senior down to equity. Regarding the different produets launched by the market participants, insurance eompanies participate in all produets explained in table 2.4. 53Goecke and Will [see 2001, p. 75-79] "Rejda [... 1986, pp. 585-586] 550utreville [see 1998, p. 249]
30
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
Insuranee companies are strong cash generators. Due to high liquidity, they were important partieipants in the synthetie struetured finance markets. In the peak year 2rxn, the purchase of risk assets represented 80% of their transaction volume. However, they also seil risks to the market to diversify their exposures. These transactions represented 20% of the volume tomed over.'6 Regardless of the relevant legislation and the nationality of an insuranee company, a1l have in common that they have to follow certain investment guidelines. Even when these regulations may not be striet, they have to respect their own intra-eompany statotory investment guidelines providing qualitative requirements and quantitative limits. ln addition, insurance business is rating sensitive. The customer of an insurance COIDpany is eoncemed about the ability of the insurer to pay the claim when due. Sinee the ratings refleet the ability of the company to pay its obligations, the rating ageneies are also monitoring the investment behavior of the companies in their regular evaluation processes. The EU will harmonise its supervisory regulations in line with the Solvency 2 framework. In November 2007, the member states bad to implement the Markets in Financial Instrnments Directive (MlFID) of the European Union number 2004/39/EG into locallaw. The directive is regarded as a big step towards Solvency 2 sinee it harmonises the existing regulations of the different EU member states. In Germany, the most important investment limitation elements are based on the supervisory 1egislation ealled "Anlageverordnung" as deseribed in figure 2.8. In the USA, the supervisory authorities are based at federal state level. The state insurance commissioners belang to the National Association ofInsurance Commissioners (NAIC), founded in 1871. AIthough the NAIC has no legal authority, most states have accepted the NAIC model1aws in mous areas. 57 US insurance companies must file their investments with the Secorities' Valuation Offiee (SVO) of the NAIC. The SVO rates the credit quality of the secorities and establishes rules for their valuation.58 The main regulations described below are based on the actnal insurance 1egislation of the State of New York. There is an ongoing diseussion supported by the supervisory harmonisation in Europe about the formation of a regulatory authority at federallevel." Figure 2.8 gives an overview of the percentages of investments allowed in the different investment eategories in the USA and the EU, each based on the admitted eapital. Bonds are the main type of investment followed by the mortgages'" As per end of 2006, the maiority of the investments in new produets were transacted in CLOs, CDOs and ABS. Depending on the region, insurance eompanies have a share of 5% to 20% in the new investment products. The other market partieipants together with hedge funds are mainly banks and investment managers. 61 56King et a1. [see 20.06.2007, pp. 3-7] "Rejda [see 1986, pp. 584-592] S!lYaughan and Vaughan [see 2003, p. 104] 59Miani and Dreassi [see 30.04.2007. p. 8] 600ECD [see 2006, p. 505];CEA [see 01.08.2007, p. 63] 61King et 81. [see 20.06.2007. pp. 4-6]
2.4. RlSK AND REIVRN
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Sourccs: Bundesanstalt ftIr FinanzdicnstlcistungsaufsirJrt, An1agcvcrordmmg: AnlV, BOBL I S. 1373 22.05.200S; CEA, European insurance in figures, ~ Europccn des Assuranccs, Bruxcll.es, 2008, p.44; GDV, Insurancc Ycmbook 2006, Gesamtverband Deutscher Vcrsichenmgswirbchaft, Bcrlin, 2008, p.44; m, InvestIIICIIts Property/Casualty and Life WUImI 2003-2007, InSUDIICC Infonnation lnstitute, www.ili.orgIfactbookl1hJinancia1investand .. Jpc....:financial invest; last checked: 21.07.2009; New York State Insurance Department, Inaurance - authorized investments: ANYCCCH.IV.-Art.14.01-14.14
Ft.gUre 2.8: Asset classes: Limitations and reported figures - USA I EU
32
CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
Supervisory authorities have been allowing insurance companies to invest into structured credit like Collateralised Loan Obligations (CDOs), Asset Backed Secorities (ABS) and Collateralised Debt Obligations (CDOs). The investments into hedge funds are inc1uded in the position: other investments. The EU plans to increase the allowed share in other investments from 5% to 10%.62 Furtber limitations exist in the quality of assets. The minimum Standard & Poor's (or equivalent) rating of investment into corporate debt for the USA is "A", and real mortgage loans must be secnred with prime property titles. The investments into nondomestic assets are also Iimited to 10% for non-life insurers and 4% for life insurers in the USA. 6' European insurers are allowed to invest up to 10% in debt issued by borrowers which are not based in the European Economic Area. 64 Due to the experiences doring the stock market crisis of the 1ate 199Oies, the global insurance sector is hesitating to invest heavily into high yielding assets or stocks. For exan3ple, investments in shares have decreased in Germany from 8.0% at the end of the stock exchange boom year 1999 to 2.0% in 2007.6 ' In the VI{, where insurance companies traditionally invest strongly in stocks, investments in this assel type fell from 61.0% in 1999 to 45.8% in 2007. 66 It has to be stated that the regu1atory framework infiuences the insurance companies in the selection of seniority and product diversification. Tbe valuation of assets is usnally regulated by law in all countrles. Cash is valued at its face value. Since the market value of a bond usually differs from the face value because of the changes in interest rates, it is recommended that bonds shall be listed at their an30rtized values (bonds in default are valued at market prices). Tbe usnal practice to value common stocks at market value results in adjustments in the surplus account. Since a reduced surplus account limits the possibility to pay dividends to the own shareholders, the position of the insmance company in the competitive environment may be weakened. Mortgages are valued based on the an30unt of outstanding debt Real estate assets are listed at book value (original cost minus depreciation) or market value, whichever is lower. However, in many cases it is difficult to estimate the real martet value of a real estate asset.67
62promme [see 18.06.2007] 63New York State Insurance Department [see 30.06.2007] "Bafin [see 22.05.2007, § 2 Art. 2 d] MODV [sec 2008, p. 44] 66 ABI [see 2009] "Outreville [see 1998, p. 253];Rejda [see 1986. p. 585]
2.4. RISK AND RETURN Type
Product Characteristics
CDO
Securitised interests in pools of generaIly non-mortgage assets called collateral usualIy comprising loan or debt instruments. If structured as casb-CDOs, investors bear the credit risk of the collateral. They can invest in several tranches with different quality reßected in the tranche rating. Synthetic CDOs expose investors to credit risk in the form of Credit Default Swaps If CDOs inc1ude loans as collateral, they are called Collatoralised Loan Obligations - if they inc1ude bonds as collatera1, they are called Collatoralised Bond Obligations Assel Bac1red Securities are pooled and placed into a trust vehic1e. Investors bear the credit risk of the underlying risks. Asset bac1red securities may inc1ude a vatiety of debt auto loans, credit card debt, student loans, private with floating or fixed rates Conunercial real estate related debt is pooled and placed into a trust vehicle which issues tradeab1e securities CDO bonds resulting from cash or synthetic CDOs are p1aced into a trust vehic1e issuing tradeable securities. Investors carry the credit risk of the issues Assels with an embedded value are pooled an placed into a trust vehic1e which issues tradeable secutities Emerging market sovereign or corporate debt is pooled and p1aced into a trust vehic1e which issues securities. Altematively, Credit Default Swaps may be used to create a synthetic portfolio. The investors take the credit risk of the underlying debt The bonds of synthetic CDOs are pooled and placed into a trust vehic1e issuing tradeable secutities
CLO I CBO
ABSCDO
CRECDO
CDO Squared
MVCDO'
EMCDO
Synthetic CDO Sq.
Market Value Collateralised Debt Obligation
Table 2.4: Product innovations of the capital markets
33 Sector Involvement Moderate
High
High
Low
Low
Low
Low
Low
Chapter3
The Insurance Industry Tbe insurance sector is a very diversified industry. Table 3.1 summarises the main types of primary and reinsurance available with their produet !ines. Basieally, there are two !ines of primary insurance: Tbe first !ine eonsists of the life insurance eontracts paying at the death of the insured or alternatively earlier, when the insured is still a1ive, together with the health insurance, covering for the 10S8 caused by illness or injury of individuals. Tbe second group of insuranee 1ines are non-life insurance, also ca1led property and casualty insurance or general insurance. It covers far damage to or lass of the polieyholder' property and takes legalIiability for darnages eaused to other people or their property.' Credit insurance is rather specified and protects from monetary losses resulting from the non-payment of a trading counterparty. The growth of exports and the increasing use of internet for retail and wholesale Irades is increasing the demand for this type of insurance. Further, surety, the insurance against contract frustration is classified as credit insurance.2 In the USA, a special type of insuranee, ca1led the monoline insurance sector was established in 197Oies. Tbe previously bighly rated eompanies are specialised in the enhaneement of credit by ensuring the repayment of debt. Tbe result is a bigher rating of the obligation insured and therefore a reduction of the refinaneing costs for the borrower. Monoliners insure munieipal bonds, projeet finanee and structured finanee bonds. The insurance companies are called monoliners since they are limited to this 1ine of business by the underlying Artic1e 69 of the relevant law of the State of New York.3 Reinsurance is agiobaI industry providing backup for primary insurers. ReinsurILife Office Management Association [see 20.07.2007] 2SwissRe [see 2000, p. 3] 'Rasul [see 2005, p. 11
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_3, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
36
CHAPTER. 3. 11lE INSURANCE INDUSlRY
ancc companies, in their rolc as seoondary iDsurers, do not dircctl.y pay claims to policyholders. Instead. they reimburse the insurers far claims paid. The reinsurer covers part of the ri.sk and part of thc premium. originally taken by thc insurer. Rcinsurance etIectively increases an inmrer's capital and therefore its capacity to seil more coverage. Reinsurers do have their own reinsurers, called retrocessionaires.4
3.1 Primary insurance Primary insmance companies either deal directly with clients through their distribution netwoIks or act tbrough brokcrs. The c1icnts can be individuals or cmporations. Supported by the new information technologies, brokers have gained more and more importance. Customers like 10 choosc between several insurance compames to get tailor-made solutions far the best price available. 1he distribution networks are under constant ro-organisation in order to keep up with thc competitive environment.
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Figure 3.1: Insurance penetration in the global economic regions
According to the latest survey covering 147 countries, the total direct premiums written were USD 4.1 trillion. dividod by non Iife insurance USD 2.4 trillion and Iife insurance 4SwislRe [aee OU19.2005, pp. 4-14]
37
3.1. PRlMARY INSURANCE Insurance Line Typ.. Life (in 1he US: Life and healtll
insmance)
Healtll (InEurope: Life- is often separate from healtll insurance Non-Life Property & Casualty Persona! & Commercial
Credit Monoline
Insurance Producls Term life (deatll indemnity) Savings produels and savings insurance products Produets witll guaranteed interest (policy holder hears no inveslment risk) Unit (index)-linked products (policy holder hears tlle investment risk) Lump-sum retirem.ent Annuities Pensions-related products (savings or annuitics) Disability Critieal illness Healtll
Motor physieal damage motor tllird-party liability Property Aeeident healtll Employer's liability/worker's eompensation Third party and otller labilities Credit insurance Legal expenses Trade receivablcs and politieal risk Surety and eontract frustration Repayment of tllird-party debt in publie and structured finance
Reinsurance
Source:
Wholesale insuranee providing reinsuranec protecti.on for the above primary insurance types
Batchvarov, Alexander and Dinesen, Christian, Securitisation and Insurance: Marriage of Convenienee, Merri1l Lynch, London,2006,p.3
Tablc 3.1: 'IYJ>cs of insuranec eompanics and tllcir products
CHAPTER 3. TIlE INSURANCE INDUSJRY
38
USD 1.7 trillion. Table 3.2 below gives an overview about the ten biggest markets in tenns of US dollar premiums volumes before reinsurance transactions:5 Country United States~
Rank 1 2 3 4 5 6 7 8 9 10
United Kingdom
Japan' F= Gennany ltaly
South Korea" Netherlands Canads PRCIrina Thp 10Thtal Gnmd Thtal
Non-life 651.311 113,946 94,182 81,907 120,407 54,112 35,692 66,834 54,805 33,810 1,307,006 1,667,780
Lire 578,357 349,740 330,651 186,993 102,419 88,215 81,298 35,998 45,593 58,677 1,857,941 2,393,089
AmouDt 1,229,668 463,686 424,833 268,900 222,826 142,327 116,990 102,832 100,398 92,487 3,164,947 4,060,869
% change year +4.7 +28.2 -3.3
+7.5 +10.1 +1.3
+16.3 +11.9 +14.7
+30.8 +8.4 +10.50
% total 30.28 11.42 10.46 6.63 5.49 3.50 2.88 2.53 2.47 2.28 77.94 100.00
1 non-life premiums incL accident and health insurance 2
non-life premium! incL state funds; life premium! and an estimate of group pension business
, 01.04.2007 - 31.03.2008 4 Iife business expressed in net pre.miums 5 nominal change in USD without inßation-adjustment
Sourco:
SwissRc., sigma No. 3flOO8: World insurance report, Swiss Reinsurance Company, Zurich. 2008
Table 3.2: Top 10 eountries by life I non-life direet premiums 2007 Figure 3.1 gives an indieation about the importanee of the regional markets for the insurance industry. It can elearly be seen, that the USN Canada, Western Europe and Japan plus the newly industrialised Asian countries are the most important insurance mark.ets. Tbe stronger the output of anation measured by the Gross Domestie Product (GDP) per eapita is, the higber is the demand for insurance t.o secure the wealth of the nation and its inbabitants measured by the insurance premiums per eapita This strengthens the argument, that the development of the insuranee markets is ciosely linked t.o the growth of the relevant economies. Tbe strongly growing economies of Centra! and Eastem Europe and Asia are eurrently attracting the attention of the global insuranee eonglomerates. China and India are especially on the agenda of the insurers and reinsurers. 6
3.1.1
Non-Iife insurance
In the USA and the live biggest markets in Europe the non-life insuranee sector has, measured by premium income, a market share of 60.0% and 36.4% respectively as 5Insurance Information Institute [see 2009];SwissRe [see 2008, pp. 36-39] 6Suess [see 11.09.2007]
3.
3.1. PRIMARY INSURANCB
shown in tablc 3.2. The recent natural. catastrophes have shown that, cspecially in the USA. the insurance companies are not free in their rate making. When it comes down 10 insurance covcrage for individuals. US :fcdcral statc rcgulators are rcluctant 10 allow premium increases in order 10 cover lasses caused by major catastrophes.7 This let 10 thc dcvclopment that scvcra1. cspccially smaller companics, arc considcring 10 discontinuc the writing of covcrage in the cndangercd stares. Examples arc Califomia. with a high likelihood of earthquakes and wildfires. Louisiana. tbreatened by Humcanes and New York City as target for terrorist attacks with a high density of valuable real-estate. 8 In the ease of Florida, the state authorities decided 10 set up a state fund in order 10 compensate their citizens for losses caused by natural catastrophes. This was done to stop thc high rate increases announced by the property and casualty insurance companies.'
O l ',i,'." C.. Uobili'J U1% ) • 110",.0" nc. "ulli I'"il ( I } % )
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lI "rt... i~. l( o brrt and Ih rl (.II . SI.n. Fin" ncial S~" i c " Fact !look. Propt.I)' and Casually " •• mi . ml W r illen b,. L.in t . InSU<3nef Inror mation l"stiI UI., N..., Yorl<, 2008
Figure 3,2: Distribution cf non lifc pmniums in the USA 2006 Figure 3.2 shows the split among product Iines of the biggest market, the USA. The statistics difIerentiate regarding muIti-peril and ear-msurance between penonallines, rcpresenting private customers and c:ommercial Iines. rcpresenting corporate po1icy'Research [seeOl.09.2007, P. 9] 'Ward [see 16.10.2006]
'P1even md McDo:JWd [see 08.02.2007]
40
CHAPTER 3. TIlE INSURANCE INDUSJRY
holder. lO Car insurance is a highly competitive and standardised business with little variation across international borders. Rates have been under pressure for severa1 years now and the cost-efficient and price-transparent online distribution has been very successful. l1
3.1.2 Life insurance Life and health insurance are related industries coveting individuals against the risk of death, illness or accident. In the recent years the sector has gone through a period of change. The strongest catalyst for life insurance was the stock market crisis in combination with a low interest environment end of the 1990ies. In many countries, life insurance companies are committed to pay the holders of endowment policies a minimum re!um on their savings. Further, some regulations oblige them to share the majorlty, in many countries up to 90%, of their annual profits with them. The insurers had to pay out their profits to the customers and got under severe pressure when the value of their stock portfolios deteriorated and they could, due to the low interest environment, not earn enough interest income to compensate the los ses. In the EU it is being discussed whether with the introduction of Solvency 2, the fixed quotas should be canceled to enable the insurers to strengthen their capital basis, when necessary. In the USA, supervisors are of the opinion that the competitive market ensures attra.ctive terms of the products and the participation of the policyholder in the profits. As a result of Ibis, there is no regulation about profit sharing. '2 Further, the withdrawal of the state pensions schemes in the industrial countries favours private solutions. It is expected !hat the growth of retirement products will exceed the GDP growth rates of the years ahead. The high growth economies of Central Europe will most probably gain irnportance. While insurers active in the asset management have bad difficulties to compete with the high retums offered by investment funds, their traditional strength is the term life insurance and the accumulation of annuities. 13 The health insurance sector is faced with rapid medical advances causing high increases in costs due to the involvement of u!'-to-date technology. Further, the withdrawal of public support by the states increases the demand for private coverage. An important innovation of the sector has been the insurance against critica1 illness. It provides the payment of usually one lump sum in the case !hat one of a list of weil defined diseases may be diagnosed. Pandemics and new scientific developments like the nanotechnology or genetically modified food can potentially lead to rising health costs in the future beyand the current reserve calculation of the insurance indUStry.14 Both !ines, the health and the life insurance, are challenged by inereasing longevity of the population covered. The average age of the population in the industrialised na"'Frank and Shanker [see 2005, p. 3] lICEA [see 01.12.2007, p. 7] 12Lang [see 2QOS] 13Quack Grobecker [see 29.01.2005] 14SwissRe [see 01.09.2005. p. 16]
3.2. CREDlT INSURANCE AND SURETY
41
tions was 29 years in the year 1950, 39 years in 2005 and is estimated with 46 years in the year 2050. Longer life means rising health cost for older people and longer payment period of
their annuities. 1S Product innovations like the variable annuity products, granting the policy holder wide ranging guarantees are challenging the reserve ca1cuIations of the life insurance industry. Customers are protected against the fall of their investments in underlying mutual funds and are given the full rights to participate in value increases. They may also bave the contractual right to partly or fully withdraw the amounts invested at any time. The products are regarded as being diflicuit to bedge against the fall in value of equity investments. Further, the volatility of the investments may stress the necessary equity basis of the insurance companies. 16
3.2 Credit insurance and surety Credit insurance is used to secure the trading streams of the global economy. The insurance protects the seiler of a good from the risk of non-payment by the buyer, which can occur from commercial or, in the case of exports, also political risk. The commercial risks covered are insolvency of the buyer or extended late payment. Political risk is usually caused by government action like the prevention of the payment transfer, the cancelation of a license or the enactment of laws, war or civil conflict Surety compensates the beneficiary for the case that a contractual, legal or regulatory obligation is not met. It is closely tied to regulation; in the largest market for surety, the USA, companies undertaking projects for govemment or semi-public institutions must guaranty their work with surety bonds. Both forms of insurance are closely linked to the real economy and the premium growth can be expected to be more or less in !ine with the growth of the GOPs. However, stronger growth than the GOP increase was experienced, for instance, after the opening of the former commuuist states for free trade and in pbases of extraordinary growth of the world trade volume, like in times of strong growth of the Asian economies, especially ChinaP Tecbnological cbanges like the increasing anonymous online-trading accelerated the demand for credit insurance. The total premium volume of credit insurance was estimated to be USO 6.2 bn covering more than USO 2 trillion of sales for the year 2fXY1. 18 The latest figures available estimate the volume of surety premiurns as USO 7.9 bn, covering notional amounts of USO 1,000 bn for the year 2005. Figure 3.3 shows the geographie distribution of credit insurance and surety. The coverage provided by private credit insurers usual1y taking shorter terms of 60 - 120 days into their books, whi1e 15Wiesemann [see 29.06.2007] 16Spehar et al. [see 2007, pp. 119-143] 17SwissRe [see 2006, pp. 3-37] 18EuIer Hermes [see 2009. p. 13]
42
CHAPTER. 3. 11lE INSURANCE INDUSlRY
the export credit agencies cover for longer terms up to five years. Surety is provided by so caUed surety companieS.19
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Figure 3.3: CIcdit insurancc and surcty premiums by regions Crcdit insurancc and SUIety compctc wi.th othcr products: Stand-by Letten 0/ Credit and Guarantees provided by banks oblige the issuer to pay irrevocably and unconditionally for a customers draft or obligation within a specified period up to a certain amount. Assel Bar:1ced Commercial Papers are short-term discount instruments issued by COßduits to rcfinancc liquidity requirements from ovemight up tu a period of 270 da}'! through the capital markets. Conduits are special purpose vehicles (SPV) - special entities establishod to deaI with tbe asscts - formed by big companies trading merchandise intemationally. The SPV usually gets a credit enhancement resulting in an improved ra1ing qualifying it far a cheaper funding through the issuance of commercial paper into the capital markets. Credit Defawt Swaps are also used as a substitute for credit inmrance. They provide coverage against the impact of a negative credit cvent by a reference party. Tbis could be a faUme to pay, debt restructuring, default, bankruptcy or other problems. Factoring, a financia1 service in wbich a firm sells its rcceivablcs tu a company callcd 19SwislRe [aee 2006. pp. 3-37]
3.3. MONOLINE INSURANCE
43
factor for immediate eash payment at discount is on the one hand a eompeting produet with credit insuranee. On the other hand, the factors often demand credit insoranee to protect themselves against the risk of not collecting their Irade receivable. Credit
insurance therefore complements factoring. 20 The market for eredit insurance has gone through a strong phase of eonsolidation during the past 15 years. While in 1990, the top live eredit insurers bad a combined market share of 40%, the remaining top foor players Euler Hermes, Coface, Atradius and Credito y Caution held 85.4% ofthe global marke! in 2007.21 Credit Insoranee has
a lang tradition in Western Europe, where the main markets Germany, the UK, France, the Netherlands and Spain, account for an aggregated volume of approximately 60%.22 The US surety providers faced eataslrophie losses with the default of large eorporations like Enron, Modem Continental, Dillingham and J.A. Jones. The losses showed the weaknesses of the underwriting and risk management of the industry. As a result, six of the ten largest eompanies of 1998 have merged, became insolvent or exited business. The ten biggest underwriters today belong to international insoranee conglomerates whieh should be strong enough to withstand ehallenging market eonditions. 23
3.3 Monoline insurance Monoline insurance companies have, until the credit crisis, usually been AAA rated and offer credit protection to holders of insored credits. Policyholder ean be banks, pension
funds structured investment vehic1es, conduits or similar institutions. The financial guarantee insorance provided is unconditional and irrevoeable. To demand payment, it is sufficient !hat the bond holder verifies the failure to pay prineipal or interest by the issuer of the debt. Bond insorers provide credit enhancement for a lower rated issuer of an obligation. This results in a eheaper funding due to the enhaneed rating. The insored bond, however, needs to be at least rated investment-grade. The business bas been inereasing sinee the early starts in 1971 substantially, when the USD 650.000 obligation bond for the Greater Juneau Boorough Medieal Arts Building in Alaska was insored by the monoline insorer Ambac. Today, the eompanies do not only insore several types of bonds but also structored credit. Insuranee ean be provided on a primary basis when the Iransactions are struetured and the bonds to be placed on the market are rated, or on a secondary basis. This is often the case, when a bank. or investor asks a monoline insurer to enhance an existing portfolio in order to free up regu1atory eapital or to protect hirnself against market volatility or ratings migration. While the bulk of the business is done in the USA, the monoline insurance eompanies started to enter the European market providing protection for bonds issued to linanee 20SwissRe [see 2000, p. 7] 21Eulcr Henncs [see 2009, p. 13] 22SwissRe [see 2006, p. 22] 23SwissRe [see 2006, p. 20]
CHAPTER 3. TIlE INSURANCE INDUSJRY
44
toll roads, sehools, rall projeets, tunnels, and publie buildings.24 Table 3.3 gives an overview of the latest available transaction volumes in the different types of monoline insurance.
Net par outstandiDg (USDrolo) Public FiDance
31.12.06
Net par outstanding (USDrolo) Structured FiDance
General obligation Tax backed revenue Utility revenue
463,564 Mortgage-backed USA 200,426 O1her aaset·baclred USA 202,481 Mortgage-baclred intern. Health care revenue 95,337 Other asset-baclred intern. 109,862 Transportation revenue Utility obligation 67,871 University revenue O1hcrUSA 38,337 Housing revenue Other international 27,697 Student loans Total structured finance International 84,643 57,564 O1her 1,347,782 Thtal public financc Tota1 Net Financial Guarantees in Fo.... (P&I)
Somce:
31.12.06
154,889 379,828 46,646 154,673 49,609 27,584 10,505 2,171,518
3,259,189
AFGI, Annual Report 2006, Association of Financial Guarantor lnaurers, New York, 14.05.2007
Table 3.3: Volume of financial guarantors insured business in 2006 In 2007, tbe financial erisis in tbe overheated US real estate sector worsened as higbly leveraged homeowners inereasingiy defaulted on tbeir mortg.ge p.yments. Monoline insurers as • result may be expused to p.y billions of dollars in def.ulted mortg.ge related securities and CDOs. The eornpanies took tbe following steps to stahilise tbeir finaneial situation:
• Most monoliners discontinued to write insurance for structured finance concen!rating on the less e.pital intensive and less volatile municipal finauce sector. 2S
• They are establishing new, weil capitalised monoline insurers either as subsidiaries or by e.pitalising an alre.dy existing entity, ideally witb extemal funds. Berkshire Hathaway, in addition, entered the market by founding • new monoline insurer for publie finance. 26
• They started to work on commutations meaning that they unwind their insurance policies .gainst • fee p.yment to the beneficiary.27 "Rasul [see 2005. pp. 5-8] 2S.Alaander [see 01.12.2008] 26Kaufmann [see 09.03.2009] 27 van Duyn [see n.p., 22.06.2008]
3.4. REINSURANCE
45
• Tbey are working on split-ups of their operations. MBIA, for instance, split its
business into a public finance insurer and a structured finance insurer.28 Unfortunately, in most of the eases, the e!forts were not fruitful and most of the former higbly rated finaneial guarantors were downgraded to low investment-grade, subinvestment-grade, or even default levels. Under the current circumstances, the business model based on eredit enbancement does not work for the lowly raled monoline insurers anymore. Further, future bosiness prospects are rather bleak sinee eustomers lost eonfidence in the value of the wrap for longer-terms. Due to the insecure prospects, capital from new investors is difficult to attract and rating agencies are hesitating to
grant newly established monoline insurers excellent ratings. 29
3.4
30
Reinsurance
Reinsurance provides insurance for insurance companies. Tbe sector is a global industry with 250 companies operating in 50 eountries. In accordance with the primary
insurance, it can be divided into non-life reinsurance and life/health reinsurance. Non-life reinsuranee dominales the market with a total volume of USD 123.1 bn as per year end 2007. Life reinsurance with a total volume of USD 66.7 bn accounts for proportionally less than non-life reinsurance because life products mainly consisting of savings have a small insurance risk. component and therefore are, in general, not reinsured. Tbe geographical breakdown of figure 3.4 shows the dominanee of North Ameriea and Western Europe. Tbe benefits of reinsuranee are redueed volatility of underwriting resuits, capital reliefs, and flexible refinancing. Reinsurers provide, in addition, access to expertise and services, especially in the fields of produet development, the prieing of underwriting, and claims management.3 '
The regulation of the reinsurance sector in Europe is currently undergoing an harmonisation process launched by the EU Reinsurance Directive. It was published in the EU Official Journal end of 2005 and due to be irnplemenled in all 27 member stales by year end 2007. Up to its introduction, some countries have not regulated reinsurers at all. Others, like the UK, regulaled them on the same basis as the primary insurers. Tbe EU Reinsurance Directive aIlows EU-based reinsurers to do their business in aIl memher stales, as long as they bave the license from the responsible supervisory authority of their horne state ("single-passport regulation"). Non-EU-based reinsurers will have to get an authorisation from eaeh single state they like to underwrite business in. All supervisors will work on the same EU-wide standards, bnt will not be either allowed to demand any eollateral, nor to regulate any terms or conditions. The Solvency 2 regulations with their risk-based capital approach will be introdueed for the primary and the 28 van Duyn [see n.p., 13.05.2009] 29Kaufmann [see 09.03.2009]
30The effects of the monoline downgrades will be further discussed in chapters 6 and 7 31IAIS [see 17.12.2008, p. 2]
CHAPTER. 3. 11lE INSURANCE INDUSlRY
46
5' % J6 °1.
O."oclh ,\mtd ••
• L.,;" Am";"
Sou .. t: lAIS. Global rtin,uran .. m.r~. t ""pOr1 . I not,n . lionol """"i"i.n or In, u... n.. 5"1'<"';...... H.,.I. 2008. p. 31
Figure 3.4: Cessions to global reinsurance companies 2007 reinsurance sector aIite. 32 In the USo the regulation cf reinsurance claseIy follows that of primary insurance companies. That means, that there is no federal system of control. However, most fedend rcgulators havc adoptcd thc NAIC capital models. On thc condi.tion, that a rcinsurc:r licensed in one federal stare provides a guarantee to honor its technical provision, it can do business in another state. Foreign insurers, not registered in the USA. have to proviele guarantees, normally in the form of bank. Iett:ers cf credit or trust funds. 33 There bad been several efforts to reform the US regulation or to create a federal regulator which faiWd in the past.304In the recent years. the market has gone through a concentration process especiaIly in the US wbere foreign companies havc taken over a number of the bigger players. The marltet today can be divided into three groups: FlISt, the Buropcan reinsurancc compani.cs Munich Re, Swiss Re anti Hannover Re with their US mbsidiaries, the insurance market Lloyds and SCOR. Second. the US reinsurers Iike Berkshire Hathaway (owning General Re), Everest Re, Transatlantic Re, Nationallndemnity, Employers Re, Odyssey Am Re, and Berkley
Insurance Co. Third, the ofJshore compani.es in Bermuda sparked by the Iiability insurance crisis J2Earopem Commisaion [see 21.04.2004]
"KPMG [see 2002, pp 64-66] MIntmnationalTradeAdminiatraoo [see 2001]
47
3.4. REINSURANCE
in the USA of the mid 1980ies, hurricane Andrew (1992), and the terrorist attack against the World Trade Center in New York (2001) causing high damage to the industry. The offshore reinsurers were founded in three W8ves as new companies: In the first wave ACE Limited and XL Capital, in the second wave Partner Re and Renaissance Re, and in the third wave AXIS Specialty and Arch Capital. Most offshore reinsurers are registered on Bermuda which offers them a benign regnlatory envimnment and the
absence of corporation taxes - ideal conditions for sustained growth.35 After the Hurricanes Katrina, W11ma and Rita (all in 2005), the offshore industry was able to attract a total of USD 18 bn of additional capital in just a few weeks. This was required to re-establish their reserves after historically high total insured losses of USD 71 bn the insurance marke! had to absorb. Capital investors, mainly private equity and hedge funds, generally expect to benefit from attractive income after premium increases in the years after natura1 and man-made catastrophes.'6
3.4.1
Non-Iife reinsurance
The non-life reinsurance sector is a cyclical industry (see table 3.4 far the major companies by net premiums written 2007). In times with low damages, the rates get under heavy pressure and in times of catastropbes, the mies increase heavily - new capital is attracted. llaDk 1 2 3 4 5 7 8 8 9
10
Compauy Lloyds MunichRe SwissRe Berkslrlre Hathaway Re
Country
Net Premioms
UK Gennany
26,621 18,486 15,622 13,316
Switzcrland
USA
Hannover Re Transatlantic Holdings Partner Re EverestRe
Gennany
S""
France Bermuda
XLCoptial Thp 10Thtal
USA Bermuda
Barbados
Top 30 Total
Source:
5,'J:73 3,953 3,185 3,122 2,994 2,111 94,683 116,741
% Share 22.8 15.8 13.4 11.4 5.4 3.4 2.7 2.7 2.6 1.8 81.1 100.0
Rouele, Mark et al" 2008-2009 Global Reinsurance Review & Outlook. Fitch Ratings, New York, 02.09.2008, p. 12
Table 3.4: Global top 10 non-Life reinsurance companies One of the dominant reasons to buy reinsurance is to protect the capital base against large deviation of losses. The cession of risks helps to avoid serious financial distress and potential defaults in tim.. of severe natural catastrophes like windstorms, floods or 3!lPrank and Shanker [see 2005, p. 10] 36Lansch [see n.p., 29.12.2OO5];SwissRe [see 2009. p. 37]
CHAPTER. 3. 11lE INSURANCE INDUSlRY
48
earthquakcs. In!lUlCl'!l also benefit from cconomies of sca1e. sincc due to the rcinsurance cover, they are able to underwrite !arger amounts of business. Reinsurance companies play an important role in thc dcvcl.opmcnt of thc professional ri.sk assessment and underwriting. Further, they detennine the wording cf legal contracts and the efficient
mitigation and adjustment of claims, to the benefit cf the primary insurers and their policyholder. Relnsurers are able 10 diversify geograpbica1ly, and, if not specialised, within the different business lines available.
~
,. ", ,. -",, ,.,. •
f\
0
/\.1",
0
z•
l' .~
~~
• ~~ _ , , , ...1"'•• ,........ ' (ra'.': J.~J ['-' . "1 -O-\lOD-...
~~ .. ""
n·... ,' uw 1;.·• • "1
Soure.: $" iss~. _ sigma 212009. Natural ,otastrophc_, and man·made disaSlcrs in 200K I.Urich. 2009. p. S
Figure 3.5: Frequency of catastrophes 1970-2008 Ta operate dficiently, rcinsuren need legal security: The originally agrced claims must be legally valid and they must be able to be exercised in the future. International
oper-
ations need a free ftow cf:funds and the ability cf global. risk transfer. Capital requjrements of the market participants must refiect thc diversification of risks by reinsurance
in a fair way." The statistics of non-life insurance distinguish between natural catastrophes and man-made disast:ers. Both types are being weil reported in the media. Appendix B shows the most costl.y events since 1970. r1SwislRe [aee 01.11.2004, p. 16]
3.4. REINSURANCE
49
Natural catastrophes are caused by natural forces. One can see, that the tropical stonns affecting the Gulf of Mexico during the typical hurricane season from Jone 1st to November 30th cause heavy damage to the industry. Figure 3.5 gives an overview of increasing trend of the natural catastrophes and man-made disasters sinee 1970 adding up to 8.483 events with substantiallosses of human life. 38 All events have in common that their frequency and severity are diflicult to predict. Tbe insurance sector therefore is supported by risk modeling companies to estimate the severity of lasses caused by catastrophe scenarios using the most recent computer software and statistical methods available. In the case of hurricane Katrina, however, a1l estimates of the damages were 100 low since they took into consideration the damages caused by the wind, but not by the floods. Tbe models are onder constant developm.ents. 39 Figure 3.6, shows !hat natural catastrophes cause the highest amount oflosses, followed by man-made disasters. Earthqualres are rare, but can cause heavy damage to the region affected. Tbe most endangered mega-eities are Tokio, Mexico OF, Los Angeles and San Francisco. After a study done by the modeling company Risk Management Solution together with Stanford University, a repeat of an earthquake in San Francisco with the intensity of the one experienced in 1906, would cause damages of USO 150-200 bn, while the insured part is estimated at USO 75-95 bn.40 Tbe high concentration of the petrochemical industry and offshore oll riggs in Louisiana and Texas is vulnerable to hurricanes. Alone the two storms Katrina and Wt1ma in 2005 have caused losses to the oll sector of an estimated USO 11.6 bn of which USO 5.0 bn were insured.41 Beneath the increase in intensity of weather related natural catastrophes, the increase of population and wealth in coastal regions is one of the main reasons for higher damage in the USA. In 2003, 53% of the population, or 153 million people lived in the 673 US coastal coonties which cover 17% of the land area. This is an increase of 33 million people sinee 1980.42 But also in Europe, a higher frequency and severity of winter storms is expected. MunichRe regards a heavy storm like "Kyrill" in 2007, but with higher damages up to EUR 60 bu as likely.43 Heavy floods regularly cause damages in Germany, Franee, Switzerland, the United Kingdom, the Czech Republic and other coontries. In contrary to !bis, Europe experiences longer periods of drought. Summers willlikely become hot and dry, causing withering crops and water shortages.44 Wtldfires in the Mediterranean region and California can be a natural phenomenon or man-made by real estate speculators. Due to the climate change, the warmer regions are increasingly threatened. 38SwissRe [see 2JXJ7, p. 4] 39Pe1sted [see 16.10.2006] 4OGrossi and Muir Wood [see 2006, p. 2] 41Hartwig [see 22.07.2006. p. 20] 42lnsurance Information Institllte [see 2007] 43promme and Hagen [see 21.02.2007] 44Burnett [see 04.08.2006]
so
CHAPTER. 3. 11lE INSURANCE INDUSlRY
110_000
~ " ] ] .E
100.000
-1-
30.000 MI.ooII
40.000
•
--
f--
I
.,~~-~I:i6~.~
,~'\.. ,...'1'" ....'1"-,. ,...'\'" ,,,,,.. ,
,......",,-" ...~'o ...<1>"
"''''",[>10.. (f.,.,: I SU ~8J.j "'"
-0- \, ulh
-
sn 105.3
boo)
t:. ......... kt> (1'0101: I SIJ ~U t>o)
Sou", S" 'ssll.<. S1gm. 112009. Nat"'" """"<:>pO<> ond ",,,,,·made d.;asl'" on 2008. ZO""h. 1009. ~ 7
Figure 3.6: Severity of catastrophcs 1970-2008 Examples for further disasters caused by human activity are blasts of industrial plant!. Ieaking oll-pipelines, railway- or shipping accidents likc.. far instance., leaking oll tanken or burning femes. The ever increasing mega-cities are main targets of terrorists. It is impossible to mjnimize the risk cf a terror attack to zero without giving up the personal freedom of the inhabitants. Large-scaJ.e terror acts are not insurable in the private sect:or. A nuclear orbiological attack in higbrisk areas withdense population would cxceed theindus1:ry's
entire capacity.4S In contrary to other politi.cal risks. terror risk was, before the attacb against the World Trade Center in New York on September 11th, 2001, in most ofthe states insurable without limitation. In Europe, only the states threatenod by terror, the UK and Spain, bad govemment rcinsurance of last resmt solutions to cover lasses cf terror attacks in place. Others, like Germany. France and Austna. implemented solutions shortly alter the attacks.-46 The US indumy was, after the events, protected by the Terrorism Insurance Act
4!lWard [see 16.10.2006] 46Schaad [see2OO2, pp. 27-28]
3.4. REINSURANCE
51
whieh was due for porential prolongation by end of 2007.47 The act was not only prolonged for another 15 years, but expanded to cover group life insuranee and rerrorist attacks by Amerieans as weil as by foreigners. Cornmercial property and easualty insurance lines are required to cover lasses from terrorist attacks involving nuelear, biologieal, ehemical or radiologieal weapons. Before the prolongation, such policies exeluded that coverage.4' Most fonns of stare partieipation have in eommon !hat they are temporary regulations covering the acute shortage of coverage until the private insurance sector is able to provide sufficient capacity.49
3.4.2 Life reinsurance There are three types of risk that can be transferred to reinsurers: mortality risk (also eatastrophie claims), surrender risk (early rermination by the c1ient) and investment risk (a rather small market eovering the risk of guaranrees given in eomhination with annuities).50 Life reinsurance was in the past regarded as a stable and low risk bosiness eompared to the highly cyelieal property and casualty sector. However, two trends have ehanged the pieture: First, the higher life expectancy of the ageing population in the industrialised nations requires higher reserves to cover future annuity payments to the policyholder. Figure 3.7 shows that the life expectancy in all eountries shown is prediered to eontinue to increase substantially in the decades abead. 51 Second, pandemies like the bird-flu or drug-resistant tuberculosis strains are difficult to forecast and can, due to today's travel streams, porentially eause high fata1ity in a very short time. The los ses for the life and health insurers for this scenarios would be substantiaI." Table 3.5 gives an overview of the globallife reinsurance groups. In the recent years, there has been a strong concentration process. Several US groups have been taken over by European reinsurers like Transamerlea Re by Aegon (1999), Caledon Re by Hannover Re (1999), Ameriean Re (1995) and CNA Re (2000) by Muuieh Re and Life Re (Life & Health business 1998), Lincoln Re (2001), and GE Insuranee Solutions (2005) by Swiss Re.53 The leader of the US market, Seottish Re based on Bermuda, has laken over the eompany ERC Life Re (2003) and the life reinsurance business of ING Group (2004). AfIer liquidity problems it has itself been taken over by a eonsortium of the investment subsidiary of the US insuranee Group Mass Mutual with the privare equity company 41Dalton et al. [see 2006. p. 1] 48Labaton [sec 20.09.2007] 49Bertram [see 17.04.2007, p. 4]
50Spehar et al. [see 2007. p. 262] 51 Jobnson [sec 14.05.2007, p. 1] 52Reich [see 24.04.2007];Finn [see 04.05.2007, p. 8]
53Spehar et al. [see 2007. p. 251]
52
CHAPTER. 3. 11lE INSURANCE INDUSlRY
-'~
"
-
"
/~
"
"
"
/"
,ff?"
-
Jij'
...ß!f
~
",,$ ," ,~.. ,4!0" ,~'" ,4>" ,#' ,.E- ",#",# "-",,.. -;>-1 S,\
",,,,,0,
"'f~ "'s-" ",$' ,,<»"
",..t .'f"
_F",,,,,.
Sourcc: S";,,Rc, sigma No. 312007. Annuilics:. pri"alc sol ution 10 longe';l) risk. S\\;SS Rcin$urancc Compan}. Zürich. 2007. p. 6
Hgure 3.7: Life-expectancy at birth in differentcountries
eemeru. (2006)." After it has recovered from difficulti.es, the French seDR Group has integrated Revios (the farmer Iife reinsurance operations of the German Gerling Group) in 2006 and the Swiss reinsurer Converium. in 2007 with substantial positions in continental Europe and improved scale in the UK and the USA. SCOR is at current the only global
rcinsurer with more Iife than non-Iifc business.55 The main benefit cf life reinsurance is the possibility for primary insurance COInpani.es 10 cede the mortality risk which ean vary over time and the risk caused by pandemics to the market. Further, they can reduce concentration risks caused by group insurance contracts offerod by employers 10 their staff. Through Iife reinsurance cootracts, the primary insurec gains acccss to the know how cf the globally operating reinsurers. Those normaIly have a deep understanding of the markets and their products and provide statisticaJ. data of the population insured. In addition, they support thc primary inS\lre1'8 in the development of new products and their pricing. Through the transfer of a great part of the highcr risk c1emcnts like mortality and disability risk. the primary
SlHmdeliblatt [_ 27.11.2006]
"ClarkandPetlmv [_2006.p. 1]
3.4. REINSURANCE RaDI< 1 2 3 4 5 6 7 8
9 10 11 12
Source:
53
Compay SwissRe
CODDtry Switzer1and
MunichRc
Gemumy USA Gemumy France USA NL Bormuda
Reinsurance Group of America HannoverRc Sc",
Berkshire Hathaway Re Aegon Scottish Re Group XL Re p"""", Re
Ace MaxCapitai Thp 12 ThtaI
Bermuda Bennuda Bennuda Bormuda
Ne! premiums 10,615 9,512 4,909 3,785 2,967 2,462 2,173 1,890 701 571 368 302 40,255
% Share 26.4 23.6 12.2 9.4 7.4 6.1 5.4 4.7 1.7 1.4 0.9 0.8 100.0
Rouck. Mark: et al., 2008-2009 Global Reinsurance Review & Outlook, Fitch Ratings, New York, 02.09.2008, p. 13
Table 3.5: Global top 12life reinsurance companies
insurer can concentrate on the savings and investment business. In general, life insur-
en with higher risk elements !end to cede more tban those with a high percentage of savings products io !heir underwriting portfolios. S.
S6SwissRe [see 01.11.2004, pp. 5-7]
Chapter4
Methods of Risk Transfer 4.1
Traditional methods
4.1.1
Reinsurance and retrocession
Tbe traditional way to transfer underwritten risk by primary insurers was to buy reinsurance and for reinsurers to buy retrocession. The insmance company transferring the risk. is called cedent and the reinsurance company taking the risk is called cessionaire. If a reinsurer is transferring risk to anather reinsurer. the risk transfer is called retrocession, while the reinsurer is the retrocedent and the risk-taking company the retrocessiolUlire (see figure 4.1). Tbe outward risk transfer is ealled cession, and the taking up of insmance risk assumption. The main reason to transfer risk is the creation of additional eapacity. This may be necessary to write large risks, e.g. in the insuranee of natural eatastrophes or to increase the premium eapaeity, e.g. the ability to write large volumes of policies in the same business 1ine. Another reason for the cession of risk is diversifieation. 1f the diversifieation of risks in a portfolio is low, the inOuence of single !arge losses can be strong. This effect ean be reduced through diversifieation. Tbe volatility of earnings after the diversifieation of risk is lower.' Reinsurance products are under continuous development Tbc following explanations concentrate on the main types and techniques of reinsurance and retrocession. Tbe fonns of the risk transfer, eharacterised by the reinsurance methodology, are obligatory,facultative and semi-obligatory reinsurance, as described in table 4.1.2 The basis for transfer is a contractual agreement voluntatily entered into by the cedent and the the cessionaire, while the two companies are the sole parties to the agreement.3
ICUlp [see 2002, pp. 333-334] 2Liebwein [see 2000, p. 52] 'Schwepcke and.1 01. [see 2004, pp. 97-102]
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_4, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
56
CHAPI'ER 4. METIlODS OF RlSK 1HANSFER.
By contractual terms. only two types cf coverage can be distinguished: Proportional and non-proportional coverage.4
C.,.ion
_________________ ..
,\»"mp';Qn
C.d.. ,
11.".<.....",
1Po; ... ,), la'''nla« C ... )
(lI,in," ran • • Co. l
-
I"·r
i! c _
,j ...,-
A,,,,mpt'Oß
1I.,m.... ;on ..... (lI.in, . ",n.. CO.)
F1gure 4.1: Reinsurance and retrocession
Primary insurcr and reinsurer agree to a contract called treaty, 1lIlda which the former is obliged to rede to the latter a share of rist he has insured. The reinsurer is also obliged 10 takc the risk by accepting cach cession. The treaty is a fairly Iengthy document and includes the kind cf risk. defined by the business line, the region. and the time-frame covercd. In addition. the amounts and the furthcr tcrms and conditi.ons undcl" which the risk is ceded are agreed. The primary inmrer can be sure that he will automatically get reinsurance for every risk written which moets the speci:fied rcquirements. The sum of all ri!!ks covered is callcd the reinsured portfolio. Widlln the reinsured portfolio. the amount payable by the reinsurer can be limited by the agreement of a maximum underwriting limit, a cover limit, a cession limit andIor an annual aggregate limit. The risb reinsured can be specified in positive terms by Iisting the risks to be included or in negative terms by listing the risks to be excluded. Once the parti.es have gone through the careful documentation process, the advantage of the obligatory reinmrance is simple and cf low-co!lt administration, since the direct insurer does not have to provide details 4Ki1D. andKi1D. [_ 2001, pp. 1-2]
57
4.1. TRADlTIONAL METHODS
on every risk he wishes to cede. Tbe rein,urer, however, takes blind particip.tion in Ibe business and can potentially accumulate risk or get vulnerable 10 Ibe impact from specific, highly expo,ed ri,k. S Oblig.tory reinsurance requires • high amounl of trusl belween Ibe counterparties involved and is often used for insurance products wilb • high frequency and low severity of claims. 1YPicai insurance products ceded by Ibe w.y of oblig.tory Ire.ties are personal accident, fire insurance, or car insurance.6
Form. or reinsurance (contractual relationsbip)
'IYPes or reinsurance
Obligalory reinsurance
Proportional reinsurance
Formal agreement whereby the insurer undertakes to cede all risks matching specific description. The reinsurer is obliged to accept al1 cessions offered by the insurer UD-
Baseline:
der the treaty.
Facultative Reinsurance
The insmer has the option of ceding specific, usually larger risks. The reinsurer can choose whether to accept or decline each cession. SemI-obligalory reinsurance
Combination of option to cede coupled with obligation to aceept (facultativelobligatory), or obligation to cede coupled with option 10 accept (obligatorylfacultative).
(possI'bilities ror covering risk)
sum insured I probable max. lass Premium calcu1ation: pro-rata (proportional) splitting of original premium
Main treaty types: quota share, surplus Non-proportional reinsurance Baseline:
the 10ss Premium calcu1ation: not re1ated to original premium (non-proportional) Main treaty types: excess of loss, stop loss
Source: Schwepcke. Andreas, Reinsurance. Verlag Versicherungswirtschaft. Karlsruhe, 2004. p. 102
Table 4.1: Tbe varlous forms and types of reinsurance
.5Schwepcke and et al. [see 2004, pp. 99-101] 'Kiln and Kiln [see 2001, pp. 33-511
CHAPTER 4. METHODS OF RISK TRANSFER
58
Facultative reinsunmce Tbe primary insurer decides facultatively, on a case-by-case basis, wbether he likes to cede a risk to the reinsurer. This means that he will assess each single risk: individually. Tbe reinsurer is also free to aceept, to dec!ine, or to negotiate the term of the reinsorance contract. The primary insorer will offer the risk by providing the reinsurer information about the cover, the reinsored risk, and technical details. Having agreed to do the transaction, the counterparties will draw up an agreement on the individual risk
covered. Very often the basis for facultative reinsurance is an a1ready existing relationsbip in form of a obligatory reinsurance for other business !ines. Examples for risk transfer by facultative reinsorance are: Cover for objects like department stores, manufacturing plants, oll refineries, steel works, but also for exhibitions, erection risks, or product liability policies. 7 Tbe insured risks vary widely and are normally !arge, unusual, or hazardous. In contrast to the obligatory reinsurance, the reinsurer can freely aceept to cover the risk after analysis of the perlls. Tbe primary insurer has the advantage that he can benefit from the experience of the globally acting reinsurer and is able to cede large and hazardous risk. Getting advice from a person engaged in sharing the risk with him will be more rellable. However, since each risk has to be considered individually, facuitative reinsurance is time-consuming and expensive for both parties. The direct insurer has 10 arrange the coverage before be commits to take the original risk. If he does not find a reinsurer in time in a competitive environment, the situation may get disadvantageous forhim. s Semi-obligatory reiDsurance
While one party is under contractual obligation, the second party of a semi-obligatory reinsurance agreement is free 10 choose the risks it wants to cede or accept. Tbe first form, the facultative-obligatory reinsurance (also known as open-cover), gives the primary insurer the freedom to decide which risks from a portfolio be likes to cede within the terms of the treaty. Tbe reinsurer is obliged to take all risks offered.' While the primary insurer gets an automatie mark.et for its cessions, the reinsurer ensures its exc1usivity and is able to underwrite bigger, more diversified volumes compared to the pore facuitative reinsurance at lower costs due to standardised legal documentation and administration. Tbe reinsurer, however, has to live with the risk that the primary insurer cedes the less attractive high-risk business, while keeping the profitable, low-risk business. Since the reinsurer is in a very weak. position, facultative-obligatory reinsurance contracts are very rare. They may be useful in a situation when the direct insurer writes increasing amounts of facultative reinsurance and both parties like to lower their costs. 7Schwepckc and et al. [see 2004, p. 99] 'Kiln and Kiln ["",2001, pp. 11-16] 9Schwepcke and et al. [see 2004, pp. 99-100]
4.1. TRADlTIONAL METHODS
59
Tbe basis must be a long-term relationship of special trust between both parties. 1O The second form, obligatory-facultative reinsurance (also known as compulsory cession reinsuranee), obliges the primary insurer to eede all risks within the terms of the treaty, but gives the reinsurer the right 10 accept the cession in part, in full, or to decline it. This form of reinsurance is in practice nearly non-existent, sinee it olfers the cedent DO reliable reinsurance
cover. ll
Proportional reinsuranee lbrough proportional reinsurance (also known as pro rata reinsurance or size-based reinsuranee), the primary insurer passes a certain pro-rata-share of its portfolio to the reinsurer who is getting the similar share of the original insurance premium for the risk. Tbe obligation to pay is divided between the primary insurer and the reinsurer on the basis of the sum insured (size) defined in the primary contracl whieh defines the probable maximum lass. If claims arise, the reinsurer will reimburse the primary insurer to the same proportion. 12 Tbe main treaty types of propurtional reinsurance are quota reinsurance and surplus reinsurance: A reinsmer signing a quota reinsurance treaty is participating in the primary CODtracl. Tbe seope of the cover is seI down in the original policy of the primary insuranee eompany with its elienl. Tbe reinsurer participates with a fixed percentage in the losses of the specified eontracts on a silent basis. This quota ean be ehanged through mutual agreemenlomy. Figure 4.2 shows how a 25% quota reinsuranec eontract works. Tbc reinsurer will normally agree to a limitation of capacity in terms of sums insured or indemnified whieh limils the primary insurer in ils underwriting eapacity, the probable maximum loss (PML) taken. Further, the reinsurer ean agree limitations, ealled sublimits: obligations in claims for certain causes or specific events ean be limited. Tbe cedent is able to underwrite more risk andJor bigger volumes by automatically transferting a part of every risk to the reinsurer. Each risk is shared irrespective of ils size,
severity, or c1ass as long as it is within the tenns of the treaty. The primary insurer needs 10 allocate a lower amount of capital 10 the business written, when part of it is ceded 10 areinsurer. In some countries, the reinsurer has 10 secure its ability in order 10 meet the obligations from the contracts by providing guarantee funds or baok letters of credil. 13 Quota reinsuranee provides a limitation in the absolute obligation aod reduces the eapital usage of the eedent. In times of a markeI entry or introduction of a new produel !ine, this is an advantage for a primary insurer. Since the company ean write more bosiness, the financing of the start-up is easier and the administration of the quota reinsurance contract is simple and inexpensive. Further, the reinsurance company can provide IOUebwein [see 2000, pp. 56-57] IlLiebwein [see 2000, p. 57] 12Uebwein [see 2000, p. 101] 13Schwepcke and et al. [see 2004, pp. 115-117]
CHAPI'ER 4. METIlODS OF RlSK 1HANSFER.
60
I= =:---"m,
Portel.... lII.
_
Pnmary InsurerQuota
Porter,.llIe . !'ter Q.oto • Tre.ty
_
ReiosurerQuota
Sou",c: Lid",,,in. l'c\cr.lc und ~ l oocmc !'(lm><:" der I\Ocl1crsich.:",ns. Verlag Versichcru ngs\\insch,n. Ka.I,ruhe. p. M
Figure 4.2: Quota reinsurance statistical infonnation to be used for the calculation of premiums. 14 In case of a big loS8, however. the remaining absolute Ioss for the primary insurer
can be high iIrespect.i.ve of an existing quota reinsurance contract. The reinsurer is interested to participate in profitable, stable smaIl sized business - the primary insmer
in this esse shares relati.ve1y stable profits. Quota reinsurance is used in insurance lines covering relatively similar rists such as third party liability, automotive, transportation
or hail and storm insurance. OOt also in life insurance. Further. it is usod in the coverage
for nuclear energy and aireraft full hull. 15 In Iife insurance business, a special form of quota reinsmance is common: Pm:linancing quota share agrcements he1p to offset the expensive acquisition costs through the pre-financing of the amounts by the reinsurer in anticipation of future profits. The
ccdcnt can factor-in the start-up losscs far a markct entry er product innovation which he expec1'8 to fully recoup at a later stage, but may not be ahle to bear the costs in the short term without outside help.16 In several. cases it may be useful to agrce on variable quotas in orda to increase 14SchwqK:b andet 11. [see 2004.pp. 125-126] l!!Liebwein [_ 2000, pp. 62-66] 16SchwqK:b andet al. [see 2004.pp. 125-126]
4.1. TRADffiONAL METHODS
61
:Ilexiliili.ty. Whilc the obligation of the reinsurer rcmains constant, thc eedent's retention is variable among different risk classes reßecting the probability of claims to arise. 17 The primary insurer, when ceding business to thc reinsurance company, has to take into considerati.on that, in the eyes of elients, investors. and competitors the image of the company ean suffer. One of the criteria for the rati.ng of the primary inmrer is how much premium ean bc gcnerated in order to build thc basis for a profitable operation over the long_run. 11
..."'.....,....
,., _
l'rimal) Insurer l.oss
_
I" R"in,urer Los<
c::J 2nd RC'in,"rer Los.
lIascd (In ; Lieb"ein. Po'e'. "lassische ",Id M<xkrne Furmcn der ROcb~rsichenJllS. Verlag Versicherung'" insch"tl. ,,",Isruhe. p. 69
Figme 4.3: Surplus reinsmance Surplus reinslUtl1lCe is anothertype of proportional reinsurance based on fixed sums. The ccdent's intention is to pass on sums that are "surplus" to what he is abIe to keep as retention on to the reinsurer. In other languages like in German the term "Exzedent" and in French the tcrm "exc6dent", derivcd straight from the Latin "excedere", refer to the intended limitation of the primary insurer's obligation. In form of obIigatory or semi-obligatory contracts, the primary inmrer will pass on only that part of a risk 00derwrittcn which excccds thc defincd retention limit. This can bc regarded as the fint dimension of the treaty. Normally. these are rists which exceed the primary insurer's ability to carry in teIms of magnitude in the event of a total1oss (or expected maximum l1Liebwcin [see 2IXX), pp. 62-66] 11Schwepcb md et al. [see 2004, pp. 115-116]
62
CHAPTER 4. METHODS OF RISK TRANSFER
loss). Tbe reinsurer will take a much higher participation in bigger risks than in minor risks which do not exceed the retention limit. Tbe system enables the primary insurer to transfer only those risks which he actually needs to reinsure. Tbe insurer's total obligatory capacity can be increased by adding successive surplus layers with different reinsurers. Tbe layers are defined as multiples of the primary insurer's retained line. Tbe .teOM dimension of the treaty defines the capacity in terms of the number of lines
or units covered. The primary insurer, next 10 the increase of capacity, benefits from the homogenisation of its portfolio since he will always participate in the losses up to the retention limit only. This is, however, subject to the fact thaI, in case of a totalloss or probable maximum lass, the capacity of coverage from the different layers is sufficient. 19 Surplus treaties are usua1ly employed in sectors where the potential for major or partial non-uniform claims rises in line with the amounts underwritten. This is the case in fire, theft, accident, and life insorance. Surplus treaties, measored by premiums, are the most employed form of reinsurance treaties.20
Non-proportional reinsurance In non-proportional reinsorance, the /0.. amount forms the baseline which triggers the reinsurer's cover. The primary insurer and the reinsurer agree in their treaty the 1088 and the cause which trigger a compeusation. This is done independently from the prim.ary insurance contract, since not a1l perils insured originally may need reinsurance cover. Further, the scope of the cover has to be defined precisely; the contract partners stipulate which risks, persons or property are inc1uded or excluded. Tbe contract can relate to just one peril, like a horricane or an earthquake, or severa1 risks. In addition, it may bc defined whcther the events may happen simultaneously or within a certain time frame. Tbe reinsurer gets a premium for the commitruent which is calculated independently from the premium agreed in the primary insorance contract. In case of a
lass, the reinsurer indemnifies the primary insurer in excess of a specified deductible 10 bc cartied by the primary insurer and up to a specified limit. Tbe deductible plus the reinsorance cover form the ceiling of the treaty. No reinsorance company will bc able to agree on an un1imited cover. Tbe limit can bc a fixed amount or alternatively defined as a percentage of the gross net premium income of the reinsurer or a per mille amount of the aggregate sums reinsored. Tbe purpose of non-proportional reinsorance is to limit the borden on the primary insurer from losses caused by the defined cause. The advantage is that the primary
insurer can agree 10 a tailor-made solution for its needs and does not have 10 give away a fixed proportion of the premium. However, it has to be remembcred that the range of the
cover is much smaller. Non-proportional reinsurance is used for natural and man-made catastrophe cover, but also in the insorance of liahility or professional indemnity. In 19Schwepcke and et al. [see 2004, pp. 127-136] 2Or..iebwein [see 2000, p. 67]
63
4.1. TRADffiONAL METHODS
case of cxcess of less reinsurancc, cach individual settlement of the primary insurance has to be monitored, while the stop less cover is directly geared to the primary insurer's de.m.onstrablc claims IiabiliticS.21 Thc forms and typcs of non-proportional trcatics diffcr with respect to thc definition of the reinsured loss, while the main types used are excess of loss and stop loss conttacts: The exce;r" of loor;r contract male! thc reinsurer's cover conditional upon a clearly defined loss cvent. The reinsurer will compensate the primary insurer minus the predefined deductible, also callcd excess point The example in figme 4.4 shows that the reinsurer has to pay if the loss excced.s the amount ofUSD 1 mln. Having predefined an objective relationship betwcen thc losses, it figures the aggregate number of individual lesses covercd into a single 1000s evcnt. Howcver, thc problem is to cxactly dcfine thc objective rclationship.
[ 'CO" I'"in!: I S IJ I min
-----1-1----------
lass 1 lass 2 lass 3 _
Prima!) In$Uf'" I..o ss (Dcd uclible )
_
Rein,"""
l.o~<
Based on: Schwerd.e. And",as. Reinsurance. Bi ldungsnd/,lIerl.: Ve",icherung~. wirtschaft Vc,lag Vcrsichcrongswirtsch;lfl. Karlsruhc. 200~. p, 09
Figure 4.4: Excess of lass reinsurancc far losses > USD 1 m1n With cxcess of loss reinsurancc, the primary insurec is ablc to kcep the complete premium within the dcductib1c for himself. A great amount of insurance business is regulated with fixed tari:ffs wbich reinsurcrs may find unattractive. Since thc cxcess of less llSchwepcb md et al. [u:e 2004, pp. 136-171]
64
CHAPTER 4. METHODS OF RISK TRANSFER
reinsurance does not follow Ihe primary contract., it may be More .ttIactive for 1he reinsurer to take special element. of Ihe risks only. Tbi. can ••ve time, .ince 1hey are only concerned wilh Ihose exposures which penelr.te 1heir speciallayer. That means, lhat Ihey need limited underwriting inform.tion only. While it may be able to reinsure risks which olher. consider nnknown, unsound or underrated, Ihe market for Ihe f.coltative excess of 108S reinsurance may be limited, since many direct or pro-rata reinsurers may not be willing to provide • market.22 If a primary insurer is looking for • coverage for windstorm damage, he will agree an excess of 1088 coverage to get compensation for • single windstorm. Exce.. of loss policies are typically stroctured in order to involve
More than one reinsurer or reinsurance treaty.23 Tbe primary insurer will take an additional stop loss cover if he likes to be allowed to add up alilosses within • specified time period.24 Tbe stop loss reinsurance contract provides cover against the aggregation of individua11osses, for instance, measured by a percentage amount of Ihe net eamed premium., wilhin • pre-defined time period, usually 12 monlhs. Tbis means lhat 1he cover is not related to • single risk, but provides protection .gainst • deterioration of Ihe profit and 10.. calco1ation of Ihe primary insurer. Stop loss is normally an additional cover to olher forms of reinsurance already in place. Tbe contracts are relatively expensive and bear Ihe risk of moral hazard for Ihe reinsurer. Tbe time-frame between Ihe loss event and Ihe reirnbursement by Ihe reinSUTer is relatively lang compared to other reinsurance types, since the overall results of 1he financial year have to be known. 25 Stop 1088 cover is aften established to cover primary insurers against extreme events, e.g. hail in agricu1ture or fire in forestry, extreme mortality developments in life insurance and potential hazardous part. of an underwriting account like war, confisc.tion or riots.26
"Kiln and Kiln [see 2001, pp. 19-22] 23Schwepcke and et al. [see 2004, p. 141] 2ASchwepckc and et al. [see 2004, p. 141] "Kiln and Kiln [see 2001, pp. 322-325] "Kiln and Kiln [see 2001, pp. 322-325]
4.2. .AL1ERNATIVE RISK TRANSFER.
65
4.2 Alternative risk transfer No clear definition of alternative-risk-transfer (ART) has been crystallised in the economic literature. 27 All fOl'lDS of ART bave, however, in common that the insuranceeconomical risk transfer is not being effected within the insurance and reinsurance sector, but tbrough the global financial markets. 2S ART products Me important for the risk transfer by large. multinational corporations. Fi.gure 4.5 shows an estimation of the global volume of ART products compared to traditionaI insurance in terms of global insurance premiums paid to oommercial carriers and alternative carriers in 2007.
Traditional Carriers US I) 287,5 bn (69.8~.)
[)al. 5ou,«s (;""·c-s. JOMlhan Cl.[, ~o~l (;ell<,.""n C.p"w~, Ma"h, No" YOfk, 200&, P. 3,
111, Cap"'-<' and olhe, R.. k·Fmanomg Opuon" In,uf1U>C<.' Inrom,.uon In'Utule, Nc,. Y"r\(. 2009. MMC ScCU'I1IC'. lhc Cal.SIr"!''''' Ilood Mar~cl aI Year End 2006. Gu)' Ca"",nl« 11:: Comp"nh No,. Y o,k. 2007, "on Cap"a] Mar~,-"". In'uron«·L,nkeJ Sc"'" ' "'O' 2008, AON, O.oago 2008
Figure 4.5: Global market for large corporation risk transfer products Following the methodology of Swiss Re, it will be differentiated in the description of the varions ART type! bclow whether the reIevant form inc1udes the transfer andIor the ftnancing of rist. Further, it will be included in the relevant description whether the form is an aItemative carrier taking the risk or an alternative product solution.29 The subsections below will then go through the characteristics of each form, followed by Z'lBanb [see2OO4, p. 49];SwilllRe [see 1999.p. 3] ZlAlbed:Jt andSc:hndin [see OI.OS.l998,p. 2] ZIISwUsRe [see 2003. P. 16]
CHAPI'ER 4. METIlODS OF RlSK 1HANSFER.
66
cxamples how they are used and which pros and cons they include. Figurc 4.6 gives a mmmarised overview cf the different forms of ART.
Rh;k Carriers
Muhi-risk l'rod"cI'
• C.pl"CS
• los! ""nfolio 1mnSre,
• pools
• 'lo(hcr'SC dCI-clopmcm
•
• sprc.d lu>S
• blcndcd
•
ris~
retontion
• nlU lli_peril n\ul(i_(r ; ~cr
• finite qoota share
groups
gmups
\
--------------'\!tern. ti,-t Ris k Tnlnder
,\RT
C""lingonl Capiwl
• agr':"n1cn!s • pUl options
Sou,,,,- o..n Dal.
("s ur.nrt ••;" k.d • ,·.Iut_in_forct -
S.~ uri(if$
/----
SidcCar.;
• futures • rorwards • (triions • swaps
Figure 4.6: Alternative forms of rist transfer
4.2.1 Risk carriers Captives The captive insurance industry originatcd from the formation of mutual and co-insurance companies in the 192Oies. The market grew rapidly. when 1arge US corporations with a strong capital base in thc 19SOics startcd 10 crcatc captives in offshOIe tu. havens. Thc main driver of the development was the fact that the corporations st:arred to question thc efficiency of the risk: transfer via traditional CQIDDlC:rCialline insurance. The socond boost for the creation of captives started with the liability crisis of the late 1980ies in response to limited availability of liability coverage. .According to the most rccent cstimation available, the volume of insurance business written by captives in 2007 was USD 57.5 bn for ]arge corporations representing 14% of global risk. trans:fers cffectcd. The 5.422 captivcs retroceded a total. volwne of approximately USO 8 bn to the global reinsurance market and hold USD 138 bn in
4.2. .AL1ERNATIVE RISK TRANSFER.
67
assct investments. 57% of the captives are owned by US corporations. followed by the UK 10%, Sweden 6%, France 5%, and other nationalities with a share cf 22%, each writing 2% or less of the total volume. While thc traditional COIIIIIlCIcialIines business stagnated, the captive market grew by 10% per year since 1998. Figure 4.7 gives an overview cf the leading locations by the number cf captives incorporated.30
i
..,, "
Figure 4.7: Number of captives in the different locations A captive is an insurance or reinsurance carrier owned by a company or a group of companies whi.ch are not active in the insurance busmess themse1ves. It mainly insurcs the risks cf its parents, also called sponsors. Single-parent captives of multinational corporations. having the biggest share cf the market with about 70% cf premi.ums. only underwrite the rists of their parents. Multi-parent captil!es. regu1arly founded by mcdium-sizcd corporations. underwrite the remaining 30% cf the premiums. Association captives are multi-parent captives whi.ch serve the needs of members of industry or trade associations. They are often used 10 covec liability risks like medical malpract.i.ce. In case that a cOIpOllltion is too small or not willing 10 set up an own captive. ~nt-a-captives can be used. The corporation pars a fec for the use of the captive and has 10 provide some form of collateral to protect the 3OGroves andHusbmds [see 2008.p. 1-20]
68
CHAPTER 4. METHODS OF RISK TRANSFER
captive from any underwriting risk. Diversified captives are a variety which, in addition, underwrite business which is unrelated to their parents. Captives are efficiently used for the transfer of high-frequencyllow-severity perlls. Tbe corporation, through the foundation of a captive, is able to efficiently self-insure risks. TraditionaI insurance premiums are calculated to cover the present value of expected claims, the insurer's acquisition costs and overhead expenses, plus a profit 10 compensate their shareholders' cast of capital. The non-claims portion of a captive's premium income represenls as much as 30% to 40%. By establishing a captive, the corporation can comparatively save the cosls of the highly predictable cash-flows, especially when their operation has a better-than-average risk profile which may not adequately be recognised by the insurancelreinsurance marke!. Since insurance premiurns have to be met in advance, but claims are normally paid with the lag of time nnill the damage is recognised, the cash flows to the captive are held within the corporation. This is especia1ly beneficia1 for companies with higher financing cosls. In addition, the investment income generated by the captive's reserves may be taxed lower in offshore places than in the home country. Further, specific low-frequencylhigh-severity risk, for which no reinsurance may be avai1ahle on the marke!, can be insured by a captive. The instrument is very ftexible, there are many forms of captives available.
Hincorporated as an insurance company, captives have access to the global reinsurance market. Due to regulatory issnes, it may be easier for captives, instead of acting as a direct-writing company, 10 act as reinsurance captive as shown in figure 4.8. The loeal subsidiarles of the multinational corporations cede their risks to fronting insurance companies. This saves the establishment of a local insurer in each country having different legislative requiremenls. Tbe fronting insurance company then passes the risk
10 the captive through a reinsurance agreement Reinsurance captives are subject 10 their horne country control, but can be involved in cross-border activities. This means that they can retrocede their risk into the interna-
tional reinsurance markets. In the early years, premium payments to captives were tax-deductible. However, this has been massively reduced in the industrialised countries. In the US, ouly premium payments to captivcs with a substantial third-party business are Iax-deductiblc. In Europe, a substantia1 risk transfer must be proved - premiurns have to compensate the underwriting risk. Supporte
been used further as financing instruments. Special reinsurance companies were established with little or no risk transfer.3l This practise has, however, been heavily opposed by the home-regu1ators. Risk retention groups were introduced in 1986 as an alternative mechanism for US corporations to access professiona11iability insurance. Tbey are a special type of captive 31SwissRe [see 1999. pp. 14-18];SwissRe [see 2003. pp. 16-17]
4.2. .AL1ERNATIVE RISK TRANSFER.
69
,\ luUin.!inn.l Co rp OU lion
Cap!i,·c of!~ Multinational Corporation
Profcs
R~i nsuran""
,\Iarkel
Sou""': S\\ issRe. Sigma No. 211999: Altemali"e ri,k !ran,fer,ART) for corpor-.uions: a passin~ fashion or rhk ma''''gcmcnt for t1le 21.1 cerotul). S"issRc. 1999. p. 14
Figure 4.8: Structure of a single solution restrictcd 10 writing liability cover only. The spccialiscd mutual insurancc compamcs need to be capitalised by their members. The business is dominated by the insurance of liabilities for professional services and health care. A foderal charter allows the risk retention group to write business in any US state without becoming licensed in each single state or using a fronting insurer. Alternatively, the oompany can have a state
cbarteronly.32
Pools are risk transfor arrangements between corporations or insurers in order to creatc sufficient capacity for very 1arge risks. They are organised in a similar way to mutual insurers with tbe participating corporations as po1icyholder. Tbe first form of pools is Ihe co-msurance pool, where the pool itself is organised as a risk carrier. In this case, the members act as intermediaries. They write the business on behalf of tbe pool. which itself operates as an insurer in thc form of a legal cntity. The pool cedes a ccrta.in percentage of each rist to the pool members. Examples are the co-insurancc pools to cover nuclear risk and tecrorlsm risk in Gmnany.
70
CHAPTER 4. METHODS OF RISK TRANSFER
Through the second form, reinsurance-pool rnembers close the insurance contract bi-laterally with the original policy holder and in most cases cede 100% of the risk into the pool, while the other pool mernbers are acting as reinsurers. Examples are the reinsurance pools for natural perils in France and Spain, as weIl as for terror in the UK. 33 Self iDsurance Self insurance is a special phenornenon of the US market and covers mainly worm's compensation, generalIiability, product liability, automobile liability and property risk as a substitution of traditional reinsurance. 111e biggest share of the volume is worm's compensation, which, like auto liability, can only be self-insured as a state-regnlated programme. The ernployer acting as insurer must qualify by means of an application process and meet financial requirements to receive the self-insured status. The 10S8 reserves must be covered by cash, bank letters of credit and/or high-quality bonds. Within non-regnlated self-insurance programmes, the corporation is allowed to determine the lass reserves. The benefits are cast effectiveness and increased control of lasses and moral hazard. Self insurance, by definition is a solution !hat does not include any risk transfer. The volume, which is self-insured and financed, however, is substantial. 34
4.2.2
Finite solutions
Finite solutions are also known as financial insmance/reinsurance. They are a combination of risk transfer and riskfinancing, while the emphasis is on risk finance. 3S 111e primary insurer acting as cedent closes with the reinsurer, in contrast to traditionaI reinsurance, mnlti-year contracts which re-arrange the timing of losses. The premium incom.e transferred from the primary insurer to the reinsurer is used to purchase assets. 111e expected returns of these assets are taken into account when calcnlating the price for the reinsurance. The cedent can count on lang-tenn coverage at stahle terms and conditions, the reinsurer on a continuous flow of premiums. Although the cessionaire takes investment risl<, the fact that the cedent bears the ultimate risk out of the original underwriting is not changed. The cedent, however, is able to smaath the lasses aver time in order to reduce the year-to-year eamings voIatility.36 Finite contracts can be constructed as prospective (pre-funded) or retruspective (post-funded) agreements. Prospective agreements refer to losses which have not yet occurred at the time of the closing of the contract. They oblige the client to pay aonnal or single premiums into an experience account. 111e funds plus the contractually agreed returns are used to pay far lasses or fiaw back to the customer. Retrospective transactions refer to losses which have aiready occurred and oblige the client to pay back :33Schwepcke and et al. [see 2004, pp. 15-17] 34SwissRe [see2003,p. 17]
"Culp [... 2002, pp. 380-382] 36Schwepcke and et al. [see 2004, pp. 103-105]
4.2. .AL1ERNATIVE RISK TRANSFER.
finil ~
71
Soh,l ions
Pro;pec/;'..,
I. OSS I.... rtfolio Irand ...
Time an" di51an«
Sp ru cllo..
Acl'·.... c d.... lopn' . n'
Source: Own Graph
F"1gure 4.9: Finite solutions
the claims payments by the reinsurer over time. While the credit risk: of a prospective transaction is bom by the cedent. the reinsurer has to take the risk when a retrospective transaction is agreed. The ratings of the contractuaJ. partners therefore mainly detennine the economics of the transactions. Apart from their smoothing function. finite solutions can be used in many different circumstances. Be1ow, the main types of finite reinsurance are explained: um portfolio transfers are contracts to cede losses which have already been incurred and reported to the insurance er reinsurance company. The cedent pays an up front amount to the reinsurer who is obligcd to settle the claims in the defined time period. The up front payment is the equivalent of the discounted value of the claims plus the costs to compensate the reinsurcr fer the administration and a profit margin. 'lbe discowrted value ca1culation is critica1 for the reinsurer, since the timing of the payments is unknown. NOIIDally, the reserve calculation of the cedent's actuaries is taken as a reference. Further, the reinsurer takes the investment risk fer the placement of funds in the capital markets during the li:fetime of the transaction. Since profitability is based on the time value of money, loss portfolio t:ransfers are used in business with leng-tail risks like third party liability. Loss portfolio transfers are mainly used by primary insurers which decided to stop the underwriting in certain regions er business
72
CHAPTER 4. METHODS OF RISK TRANSFER
segments. Alternatively, it may be the case that the insurer decided to seil parts of its activities and the interested buyer is not willing to take over long tail risk underwritten. It has to be taken into consideration by the buyer that incnrted but not reported claims are not part of the contracts. Tbe cedent or the acquiring company still runs the risk!hat unexpected claims may atise from the remaining portfolio. To solve this problem, in recent years reinsurers offered a variation of loss portfolio transfers called retrospective aggregate loss covers. These contracts. in addition to the timing risk, also take over the underwriting risks covering lasses incurred but not reported. Reinsurers, however, normally set maximum 10S8 covers in these type of structures. The 1088 portfolio transfer contract improves the financial condition of the cedent in the year of the closing, sinee future investment income is converted into "underwriting profit". Further, the solvency ratio and the combined-ratio of the insurer can be improved. The benefits are, however, temporary since the insurer, anee he has ceded tb.e business, cannat realise the investment income of the following years. In many countries, lass portfolio transfers are not possible since the regulators da not allow any discount of the lass reserves while in same countries they are allowed on a very restrictive basis.37 Tune anti distance transactions were designed as an instrument to discount the time value of money of loss reserves of predictable risi<. They are very similar to loss portfolio transfers, except for the fact that the reinsurer agrees to pay a certain schedule of losses, while the ceding company agrees to pay a certain premium in return, representing the net present value of the future loss payments. This means !hat the payment of the reinsurer is unlikely to correspond with the time and value of the claims payments of the primary insurers. Tbe reinsurer is not obliged to pay in addition to the agreed fixed schedule, even if substantial irregular losses may occur. He neither takes the timing nor the underwriting risk, but only the investment risk. This may result in a substantial mismatch of payments for the cedent, even leading to liquidity shortages. Because of the limited risk transfer involved in these transactions, the contracts in many legislations are not recognised as insurance contracts but rather as financing CODtracts, and the expected balanee sbeet effects like the capital relief cannot be provided.38 Adverse development covers include the incurred but not reported losses - they lock in the maximum liability resulting from existing insuranee contracts. The reinsurer covers the risk of realised losses on an existing liahility being higher than the terminal value of the reserves. Unlike lass portfolio transfers or time and distance contracts, there is no transfer of claims reserves needed. Tbe policy holder pays a premium for the transfer of the lasses exceeding the reserves. This facilitates mergers and acquisition, sinee the insured can oftload the timing and the reserves development risk. 3• Finite quota share agreements are similar to quota reinsurance explained in subchapter 4.1.1. Tbe main differenee, however is !hat the obligation of the reinsnrer is in any case limited by the policy. If the underlying primary contract does not include a 37Hess [see 1998, pp. 47-53] 38SwissRe [see 2003, p. 25];Hess [see 1998, pp. 61-63] 39SwissRe [see 2003. p. 25]
4.2. ALTERNATIVE RISK TRANSFER
73
policy limit, the obligation of the traditionaI reinsurer may be unlimited. Finite quota reinsurance is often used to finance start-np operations with high acquisition costs. Tbe primary insurer, together with the relevant liabilities, cedes part of its unearned premium income to the reinsurer. In retum, the cedent receives a ceding commission in order to finance the start-up. The unearned premium, through the finite quota share agreement, is converted into current income. In the early years of the operation, the reinsurer may pay to the primary insurer a higher premium to avoid a lass in its earnings schedule. Th.e ceding commission, together with the investment income resulting from the unearned premium reserves, is expected to cover claims out of the new business line. In later years, the primary insurer may get a lower compensation than usual to balance out the start-up support.40 Spread loss covers are long-term contracts designed to provide risk financing. The cedent pays a one-off or annual premium minus expenses, capital costs and a profit margin for the reinsurer into an experience account. Tbe investment income of the reserves is credited, and eventuallosses are debited to the account. The reinsurer has the obligation to pay timely far the lasses, even if the experience account runs into a negative balance. The losses are cumulated and then redistributed over the remaining term of the agreement. If the fund goes into deficit, the primary insurer is obliged to pay a bigher premium into the account to compensate for the lasses. The cedent basically gets a secure pre-funding ofthe losses from the reinsurer - he is able to spread the losses over a very long time and therefore secures bis liqnidity. The reinsurer takes the contingent credit risk and some underwriting risk wbich, however, is normally reduced through an annnal or aggregate policy limit. Spread loss contracts are particularly popular for captives, since their parents/sponsors are interested 10 smooth the volatility of the captive's
claims payments and hence their earnings.41
4.2.3 Multi-risk products Integrated multi-risk products are used to combine various exposures into a single product. resulting in a efficient and cost-effective risk transfer solution. They are a more recent development used in the ART for corporations and can be regarded as a subelass of their enterprise risk management. Traditional insurance often provides coverage on a per peril basis. That means that each element of coverage has to be negotiated, documented and managed separarely. Multi-risk solutions, in comparison, provide the advantage that all designated exposures within a firm's portfolio can be combined into a single, multi-year policy. Subelasses of multi-risk products are multi-peril programmes and multi-trigger programmes .•2 .3 "'Culp [see 2002, pp. 395-396];Hes, [see 1998. pp. 68-73] 41CUlp [see 2002, pp. 396-397];SwissRe [see 2003, p. 26] 42Banks [see 2004, pp. 103-105] 43SwissRe [see 2003, p. 28]
74
CHAPI'ER 4. METIlODS OF RlSK 1HANSFER.
,\ 1uUi . ri Sk (>rodu
Mul,;" I. ~ril
M ulril"t lriggu
Multilin. p<>lk)"
Cono"'tr
Souree: Bank <;. Erik Ahernal;,e Itisk rransfer John \\'ik)' & Sons Limilcd. ChichcSI~r. 2004. p. 104
Flgure 4.10: Multi-risk products
Mulü-peri! programmes Coverage on a per peril basis of traditional reinsurance with verticallayers, e.g. in
natural catastrophe reinsurance severaJ. reinsmers may take excess-of-Ioss sequences of a rist. Multi-peril programmes are used to consolidate the designated exposures within a firm's portfolio and combine them into a single, multi-year policy. The codent can choose betwcen the atbtched. method where severaJ. polieies are grouped together under a new master agreement. Alternatively, the single teIl method redrafts existing covers into an complere new single agrc:ement. The result of both methods is a horizontal diversification cf the rist; the insurers may participate alongside one another within a risk silo. The lifetime of the treaty usually is between tlm:e and seven years. It defines an aggregate premium, deductible and is capped. The cedent ge15 a package for all
exposure covers in unison. rather than getting each exposure individually reinsurcd. The markct has developed several sub-forms of multi-peri1 programmes: Multi-liDe (also known as commercial package policies) provide to the cedent specific coverage with Ihm own declarations, coverage forms and causes of 1055 forms. A typical package may e.g. cover commercial property, business inrenuption, geneml liability, equipment, inIand marine and automobile. The cedent is covered up to the
4.2. ALTERNATIVE RISK TRANSFER
75
net amount which is calcul.ted .s the amount of the c.p minus the .greed deductible. Commercial generaI liability progranunes cover exposures related to li.bilities of • company. inc1uding premises, products, contracts, contingencies, environmental dam.ge or directors and officer's fiduciary breaches. Commercial umbrella programmes provide to the cedent protection for very large amounts which lie weil in excess of the commercial property or commercialli.bility policies. UmbreIl. progranunes cover a wide variety of insurable risks, but are designated to pay out the ultimate net loss after certain minimum liability covers which have to be paid out by other reinsurers involved before the umbrella finally gets drawn. The benefits of multi-peril agreements are lower transaction costs - the eedeut norma1ly can negotiate the cover with a lower nurnber of insurers with a standardised legal documentation with lower premium rates since the risks covered are usnally low or even non-correlated. Further, there is a lower probability !hat the codent gets expensively overinsured. However, on the other hand, the cedent must take care that he does not get underinsured, especially when his financial condition may have changed after the contract has been effective same time, and that he gets coverage far the severa1lines from a few or even one insurer ouly. This means !hat, if claims arising, he runs a credit risk. 44 In times of hard markets, the availability of multi-peril programmes is norma1ly insufficient. In the past, corporate risk. management in many insmance companies has been divided into dislinet areas of responsibility. While the finance deparnnent may be responsible for covering interest rate, exchange rate and price ftuctoation risk, the risk management department was responsible for the underwriting risk. Holistic risk management as the pre-condition to use multi-peril programmes was not in p1ace. 4S Supporte
76
CHAPTER 4. METHODS OF RISK TRANSFER
and 1herefore the insuranee rate. The insurer/reinsurer providing coverage reduees the risk of moral hazard, sinee normally a parametrie or index whieh is outside 1he inOuence of the poliey holder is used to deline the triggera for the loss event. Multi trigger programmes are attractive for corporations whieh have eaming struetures depending heavily on the developrnent of interest rates, eommodity prices, or eurrency exchange rates. 47 The programmes experieneed a sharp rise in demand after the Northridge earth quake in Califomia 1994. In that year, direct insuranee companies suffered from losses eaused by the quake and a sharp dee1ine of the bond market values in 1he same quarter. So the foeus of the earIy variations was to combine the cover of a natural catastrophe (non-life event) and the cover of a fall in the values of the investments (linancia1
event).48 Today, dual, tripie OI even multiple trigger solutions are possib1e. The reduetion of the likelihood of payment enables the cessionaires to take risks whieh have not been regarded as insurable before. There are severa1 types of triggers whieh ean be agreed between the parties: While fixed triggers simply determine whether an event bas occurred or not, variable triggers deline the value of the payment related to an event. Switching triggers vary on 1he basis of how individual risk exposures in the eedent's portfolio are performing. Per occnrrence triggers are reset after each event, and aggregate triggers allow the accnmulation over multiple events.4' Blended-cover programmes Blended-cover is the eombined use of multi-line and multi-trigger programmes together with finite reinsurance. Th.e result is a solution which combines risk transfer with risk. jinancing. On their own, they ean be regarded as synthetie equity. If eombined with finite reinsurance, they help firms to pre-fund their losses. The result is a synthetie hybrid security or mezzanine-like stmcture. The term blended-cover is also used to describe traditional reinsurance solutions used in combination with finite reinsurance.50
4.2.4 Derivatives Financial derivatives Figure 4.11 shows the variety of the main linancia1 derivative instruments developed by 1he eapital markets. The derivatives ean ei1her be exchange traded, or elosed as individual over-the-counter eontracts. Further, 1hey can be uneonditional with an obligatory execution or conditional, in which case the counterparts can decide whether to execute 1he contracts or not. All derivatives derive their value from a market reference. 47SwissRe [see 2003. p. 28] 48Culp [see 2002, pp. 423-4251 "Banb [... 2004,pp. 107-109] soCulp [see 2002, pp. 423-425]
77
4.2. .AL1ERNATIVE RISK TRANSFER.
Financial Mar1c:et
.~---- '-. Money Mar1c:et
~Pltal Ma~
•
/
~vatives M0
"-Financial Derivatives
Commodities Denvatives
==.-----:::I
IFowards I
I
uncondibona l
I
Futures
Cash Mar1c:et
I
'-. ISwaps I
conditional
loptions l :Caps, Floors, Collars
Soure,,: Liebll"in . Pele,. Klassische und Modeme rOm"," de, ROcherskh"ru"g. Verlag V"rsichcrungs\\irtschat\. Ka,lsruhc. 2000. p. 379
Figure 4.11: Derivative instruments used in the financial market The focus cf tbis subchapter will be on the main derivative products wbich were developed by the capital markets, but are sometimes aItematively used 10 place insurance
risks: Futures are contract:& wbich represent an obligation 10 buy or sell a specific quantity of an underlying reference asset. The prk:c is agrced OOt not exchanged at the trade date for settlement at a future time. Futures, like all Iisted contract:&, are traded through physical er electronic exchanges and cleared through centralised clearing houses. The buyers and seIlers have 10 post an initi.al margin 10 the clearing hause; the positions are evaluatod daily. In case of a deficit, the clearing house will send a margin call wbich must be met by the OOyer er seller if thc position is 10 be preserved. The contract may feature financial settlement (i.e. cash exchange) er physical settlement (i.e. commodity/assct cxchange). The contracthas a fixed maturity from. one day to ninety days. The leng future position purchased, or owned, rises in value when the price cf the reference entity rises, and loses in vaIue when it falls. S1 Forwards are traded over-the-counter as customised, bi-lateral, single-period contracts referencing a specific assel. They were developed by the producing industry 10 hedge deliveries of natural rcsources like oil, gold, agricultural products, but also spc'lBanb [see2OO4, pp. 151-152]
CHAPI'ER 4. METIlODS OF RlSK 1HANSFER.
78
cilic payment obligations in foreign currencies.S1 Like a future contract. a forward defines that a specified volume cf the underlying will be sold or bought at a fixed price for scttkmcnt on a future date. In contrast 10 thc:futwe, howevcr. 00 initial margin has to be posted, and there is 00 daily evaluation of the position. 'Ibis exposes seilers and buyers 10 a potential credit risk. The profit and loss re1ationships of forwards are similar to tbose offutures.n
I.ong Co ll
Profil
'/
x
'""
I'runl
/ s,
.
P",fol
",,'
"~
.
S,
S,
x
Sh ort PUl
V
x
.
'" "
I'mnl
Short Cl.1I
, I.,<)ss
I.ong PUl
/ X
lASS
S,
Soure,: Ku« . ""nelle. Abgre nzung traditioneller Rßcherskhcrung ,on Kat.,trophcn. nsil"n Zu ausg.:wähltcn Konzepten des ART. VVW. Karlsn,h<:. 2000. p. 68
Figure 4.12: The four basic positions in options
Options include the right, but not the obligation to buy (call option) or sell (put option) a specified volume of the underlying reference asset at a level known as the strike price spcci.fied in the contract American option! allow to execute the right at any time until an agreed expiry date. while EuropMtl options are executable on the exact expiry date only. The seller of the option.. by accepting the premium payment, agroes to the obligation to buy er seil the underlying asset at the strike price when the option is exereised. Reference assets can be stocks, bonds, currencies, but also indices.54 Flgure 4.12 shows the four basic option positions a participant in the market can takc. Being 32Kuck [&Ce 2lXXI, P. 83] "BIIIJb [_ 2004, pp. 151] SlBIIIJb [_ 2004, pp. 151-155]
4.2. ALTERNATIVE RISK TRANSFER
79
/ong in • call option means th.t one h.s purchased the right to buy the underlying for the strike price marked "X". In c.se of falling prices, the maximum the holder can lose is the option premium. In case of rising prices, the holder of the call h.s unlimited upside - the value of the option is the differenee between the market price of the underlying ST and the strike price "X" .t the time of maturity.
Tbe seiler of the call is short in the call and holds the opposite position. He has limited upside to win the premium if the share falls in priee, bot unlimited downside if the value of the share rises. lf a market participant expoots rising prices, he will boy a call option. He will seil • call option when he expects fa11ing prices. Tbe buyer of a put expects falling prices. Being long in the put oprion, he is interested in limiting the loss, when holding the underlying, to the premium of the option. Tbe profit is limited to the strike price of the option, sinee the value is the difference hetween the strike priee and the lower actua1 price of the underlying .t the time the option is executed. Tbe seiler of a put, heing long in the option, expects rising prices. lf the actual priee at execution is higher than the strike price, there is DO reason for the buyer to execute, and the option will expire. Tbe seiler will then get the premium which marks the maximum profit for him, while the maximum loss would he the difference between the strike priee and an eventually lower actual priee.S5 Swapo are bi-I.tera1 agreements ca11ing for periodie (e.g. annual, semi-annual, quarterly) exchanges of cash-ftows which are based on • defined asset, • referenee rate or an index. Tbey can also he regarded as • package of forward contracts for e.ch interest and principal p.yment date. Sw.ps are denominated in notioual terms and can h.ve long maturities of up to 30 years. Tbey can expose the counterparties to credit risk, unless collateralised. [nteTest rate swaps and currency swaps are the most widely used forms. Interest rate sw.p .greements can regul.te the exchange of fixed rate p.yments (i.e. of. fixed bond coupon) .gainst variable rate p.yments (i.e. Euribor plus a margin for the underlying risk), but also variable rate payments (Le. floating bond coupon) against variable rate payments (i.e. Euribor plus a margin). CUTrency swap agreements regul.te the exchange of currency payments .t fixed exchange rates agreed .t the trade d.te. Imagine \hat • German corporation likes to expand its business in Japan and needs to borrow money in Yen. Since the corporation is unknown in the Japanese market, it may be cheaper to borrow in Euro and to elose a currency swap with a Japanese bank, fixing the interest and principal payments of the loan at • pre-defined EuroIYen rate. At the heginning of the contract, the German corporation exchanges the notioual Euro arnount into the foreign currency Yen and pays interest in the currency of the operation abroad. When the contract is due, the Yen amount is exchanged at the fixed currency exchange rate into Euros.
55Kuck [see 2000. pp. 68-69]
CHAPTER 4. METHODS OF RISK TRANSFER
80
Insurance derivatives Insurance derivatives are special products of the financial derivative market and can, like a1l derivatives, be divided into exchange ttaded and over-the-couoter products. Table 4.2. sbows the development of the notional amouots in USD of global weather risk derivatives 2003-2008. Cbicago Mercantile Exchange (CME) trades accounted for 95.6% of the notional value and 99.96% of the contract numbers for the season 04/2007 to 03/200856 : Season
2003104 2004105 2005/06
71J06/07 2007/08
Source:
OIc
CME
.m-
Vol-
ume
um.
2,842 4,169 2,347 1,869 1,472
1,868 9,696 45,244 19,193 32,008
Total Volume 4,710 13,865
47,591 21,062 33,480
= -
294.4 343.2 44.3 159.0
Volume
eon.......
Share
CME
CME
traus-
Number Share CME
acted 39.7% 69.9% 95.1% 91.1% 95.6%
109,839 227,196 1,043,619 730,057 984,750
97.12% 98.21% 99.79% 99.89% 99.96%
Hartwig, Robert and Bartlett, Steve, Fmancia1 Services Fact Boot. 2009, Insurance Information Institute. New York. 2008. pp. 93-94
Table 4.2: Global weather risk derivatives
Excbange-traded insurance derivatives are characterised by standard terms, meaning that a1l participants trade the same underlying instruments. Tbe standardised market helps to generate a greater critical mass and higher liquidity with tighter bid-offer spreads. Tbe market for insurance-related risk is still small compared to the total derivative mark.ets.57 Exchange-traded insurance derivatives bad a slow start after their introduction in the ruid-1990ies. Few insurers, reinsurers or policyholder were willing to shift from traditional insurancelreinsurance markets to the new products; the liquidity was therefore modest. Capacity in the traditionaI reinsurance sector was at !hat time available and cbeap. It was regarded as being difficu1t to exactly hedge an existing insurance contract with a standardised derivative product. Tbe newly establisbed Bermuda Cornmodity Exchange did not take off and had to be c10sed after two years oflittle activity in 1999. 58 Tbe trading of weather future contracts of the London International Financial Futures and Options Exchange (LIFFE) which started in November 2001 was stopped, just one year after its introduction, because of low demand - despite the fact !hat Europe is regtt1arly affected by droughts, tloods and windstorms. At that time, the European energy market where the highest demand for the products was estimated was too fragmented, and a harmonisation of cross-border regtt1ations was far away. Further, the 56Hartwig and Bartlett [sec 2008, pp. 93-94] "Banb [.oe 2004, p. 156]
SIISouter [see 20.03.2000]
4.2. ALTERNATIVE RISK TRANSFER
81
costs for weather derivatives was not recognised as deductible by the lax regimes.59 Tbe only remaining exchange trading weather derivatives today is the Chicago Mercantile Excbange (CME). In recent years, some instruments like catastrophe-related non-life risk and non-<:atastrophe-related weather risk have been increasingly accepted by end-users and intermediaries for risk management purposes.60 A second company regularly mentioned in this context, the New York based Catastrophe Risk Exchange (CATEX), is not a regulated excbange. It has, however, in the years after its foundation 1995, changed into a web-based platform for insurers and reinsurers 10 exchange catastrophe risk covers. This is done in an organised fashion, but not on the basis of standardised terms. 61 Tbe volumes traded at CATEX with customers on five continents have experienced strong growth rates in recent years. Over 120 customers, mainly brokers, insurers, and reinsurers have concluded transactions in excess ofUSD 4 bn in 2008.62 Tbe first exchange-traded product, the index-based C8tastrophe futures exist since 1992. They were launched by the Chicago Mercantile Exchange in a revised form in February 2fXJl. Tbe new one year contracts start and end on the last day of March. Tbe settlement of the contract is done against the Re-Ex index, being based on data supplied by a company called Property Claim Services (PeS). Tbe data contains property damage estimates for a range of natural perils. Tbe index is posted and revalued on a daily basis, when the losses observed increase by USD 25 mln or more after a catastrophe event.63 Several regions traditionally affected by natural catastrophes are included, like the geographical band between the US federal States Texas and Maine, or the States of Florida and Ca1iforoia. Alternatively, contracts can be traded on the USA as a whole. Tbe final settlement of the value of the forward contract is calculated based on the data for the relevant region, dates and perils covered. Tbe index is valued as insured losses divided by USD 10 mln. Tbe individual contract value is 10 times the index (with a minimum tick of 1.00 index point or USD 10 contract value).64 As areaction to the strong 200S hurricane season, the CME has, in addition, started to cover pure hurricane risk in February 2007. Tbey have developed three types of contracts for hurricane futures and options on futures: for numbered events, seasonal accumulated events and seasoual maximum (related to the strongest event). Geographically, they cover events in the most affected regions of the south-eastern coasta1 areas of the USA. All products are based on the group of Carvill Hurricane Indexes, using publicly available data generated by the US National Hurricane Center. The maximum wind velocity and size in terms of the radius of each official storm is used to calculate the potential for damage.65 "Rao [see 23.04.2004] 60Banks [see 2004, pp. 156] 61Banks [see 2004, pp. 157] 62CATEX [see 10.03.2009] 63Ellenbuerger [see 20.08.2007] 64Commodities Now [see 12.02.2007]
6SCommodities Now [see 14.02.2007]
82
CHAPTER 4. METHODS OF RISK TRANSFER
Tbe second exchange-traded products are weather derivative•. The most common form of these products are temperature-based index futures and options that are geared to seasonal, or alternatively, monthly weather in eighteen US, nine European and !wo eities in the Asia-Pacific region. Weather is quantified in terms of degrees below or above monthly or seasonal average temperatures. Based on a specific index, a dollar amount is attached to the number of degrees the month's or season'. temperature deviates from the average. Weather contracts for the winter months in the US and a lintited nomber of European eities are based on an index of Heating Degree Day (HDD) valnes. These are days in which energy is used for heating. In summer, the basis are Cooling Degree Day (CDD) values. Both values are calculated according to how many degrees an average c1aily temperature varies from a baseline of 65 degrees Fahrenheit (18 degrees Celsius in Eorope or Japan). This temperature is laken from the moment, when lower heating or when higher air conditioning is norrna1ly starting to be used. It has to be mentioned !hat the average daily temperature is calculated as the average of the maximum and the minimum on a 24h basis from ntithtight to ntithtight. Further, frost day products for Amsterdam are offered as futures and options on the number of days that frost is recorded on weekdays from November to March.66 There are m.ain differences between weather derivatives and weather insurancel reinsurance: Derivatives norrna1ly cover low-risklhigh-probability events. 67 The strongest users of the products have been utilities with 70% of the volume, followed by the agricultora1 sector with 7%, and consumer retail chains as weil as construction companies with low and le.. constant pereenlages. According to an esrimation of CME about 20% of the US economy is som.ehow weather related.68 In contrast, weather insurance covers the low-probabilitylhigh-severity events defined in custontised polieies covering damages caused by a flood or a hurticane.69 In times of high hurticane activities, the insurance marke! tends to go through a lack of capacity and high prentiums, ca11ed hard market. Provided!hat there is enough capacity in the exchange traded derivative market, transparency regarding prices and risk should be higher. This should lead to a quicker recovery of the market after a calastrophe event. Insursnce derivatives are regarded as an effieient way for non-insursnce related entities to participate in the risk market. Thcy norrna1ly see an opportunity to enter the marke! at attractive prices after a catastrophe. It does not m.ake a difference in the use of the derivatives whether the partieipant likes to hedge a risk or to mske a bet. Since natural developments can be regarded as uncorrelated to the financial markets in general, portfolio managers, hedge funds, and other sophisticated investors have been increasingly interested in investing in weather derivatives in order to diversify their portfolio correlations. "CME [see 2005. pp. 2-51 67CME [sec 2005, pp. 2-5] 68Billich [see 30.06.2006]
"CME [see 2005, pp. 2-51
4.2. ALTERNATIVE RISK TRANSFER
83
Insurers and reinsurers can diversify their geographic concentration and, unlike reinsurancelretrocession do not have the risk of finaneial recovery if claims arise. 70 However, there are some obstac1es regarding insmance derivatives: The basis risk th.at the contract may he very different from the loss suffered remains. It has to be taken into consideration that the derivative is based on an index, not on the detailed risk insured. Regulators and rating agencies may not give credit for the protection bought, and transactions therefore may not be capital-effective. The market llquidity hence is low with high hidloffer spreads, or it may even be impossible to unwind a position if necessary. Regarding the accounting, the reinsurance premium is treated as an expense, while a catastrophe futore, for instance, is a derivative instrument, requiring mark-to-market accounting. 71 Non-exchange traded weather derivatives are over-the-counter products - their main strength is flexibility. Itmovative products are heing continuously developed to meet the requirements of market participants and regulators. Main products are pure catastrophe swaps, temperatore derivatives and other weather derivatives. Contingent reinsurance swaps are synthetic financial transactions exchanging a commitrnent fee to be paid by the primary insurer for a contingent payment by the reinsmance company in case of a catastrophic event. The transaction is tied to a parametric even!, an index or a level of indemuity. The reinsurer compensates the cedent in case of a loss event and assumes the claim rigbts through subrogation. Pure catastrophe swaps are synthetic financial transactions allowing the exchange of non-correlated catastrophe exposnres. Transactions are c10sed in order to diversify the insurance and reinsurance companies' portfolios. They can exchange different types of cat risks as weil as regional exposures. Also referred to as industry loss warranties (ILWs), they are the most common form cf insurance derivatives used for reinsurance and retrocession of natural catastrophe risk among globally active counterparties. In addition to insurerslreinsurers, the market for ILWs is open to a1l types of investors like hedge funds, insurance brokers, or banks. Over-the-counter swaps are also used in life insurance business in order to cover catastrophe mortality risk and to hedge adverse mortality developments. While catastrophe mortality cover runs for terms up to three years adverse mortality hedges run up to 30 years. The long maturities usually need collateraIisation. Temperature derivatives are conceptua11y sirnilar to the standardised products of the CME. The over-the-counter transactions are c10sed mainly in the USA and Europe in form of forwards, swaps, calls, and put-options as weIl as multiple options strategies to cover special needs of energy companies. They have also been used by insurers, banks and special investment funds for arbitrage reasons. Since a rellable long-term temperatore record for about 50 years is required, their usage in the Asia-Pacific region is stilllirnited. The over-the-counter market allows the usage of alternative temperatore, humidity or heat indexes. 70Ellenbuerger [see 20.08.2007] 71EI1enbuerger [see 20.08.2007]
CHAPTER 4. METHODS OF RISK TRANSFER
84
Further, non-standard reference cities and longer tenors can be agreed between the counterparts. As a rule it can be stated that, the IDOre specialised the derivative products are, the less liquid they are. This is also the case for other weather derivatives like precipitation derivatives providing proteetion against, or exposure, to rain or snowfall. Further, stream-flow derivatives are used by hydro-electric power producers to protect thernselves against falling water levels which lower their energy production and therefore their returns. Wind derivatives pay an economic compensation against lower than expected wind activity, necessary for the operation of their wind generator facilities. 72
4.2.5
Contingent capital
Contingent capital solutions are contracts enabling an organisation to raise cash by issuing debt or selling stock at pre-arranged terms. Tbe different structures are shown in figure 4.13. Tbe solutions are usually provided by insurance or reinsurance companies, as an option on paid-in capital. Since the facility is arranged in advance, the COlpuration has the benefit !hat costs can be materially lower compared to an eventual fioancial distress situation after a 1088 event lbis makes contingent capital a cost-efficient solution across a range of financial scenarios. Contingent capital is a way to finance low-frequency/high-severity losses at pre-defioed terms, especially, when other ways of reinsurance are difficuit to realise in hard marke! phases. Tbe corporation identifies an amount and specification of the capital and agrees with the reinsurer the event 10 trigger the debt issuance. In return to firm commitment received, the organisation pays a non-refundable regular or up-front fee. Tbe solutions are used by many industries. A bank may arrange a facility against unexpectedly !arge credit losses. An insurer or reinsurer may cover high lasses resulting out of a catastrophe event. A corporation may securc the miuimum capital necessary to stay investment-grade rated for the case!hat financial distress may occur. However, contingent capital is not an insurance but rather a balance sheet and cash flow arrangement"
Contingent debt structures A committed capital facility is a funded capital arrangement with a fixed maturity prior to a loss. Tbe contract typically defioes two trigger events: Tbe first trigger is usually irnplicit - the option to receive the debt will not be exercised unless it has value, i.e. when the loss event has occurred and the organisation is not able to get funding from another source. The second 10ss event depends on the organisation's exposure, but is unlikely to be under its control in order to minimize the risk of moral hazard. Tbe contingent capital facility may contain additional covenants in order to protect both parties involved, like material adverse change clauses, change of control clauses or fioancial 72Banks [see 2004. pp. 163-165] 73Banks [see 2004. pp. 135-147]
85
4.2. .AL1ERNATIVE RISK TRANSFER.
~ CO"I;ng~nl [)~bl
I
("on"n;l1r d ("api l al ra. il il'"
,
("onlin~,,"1 S ur~l u.
'01<>
-I Su'plu, NOlCS
---i f inonri. 1G.....nl. ..
L
R.... ,du.1 Val""
Sou"..::; Banks. Erik.
I
Gua,"n~
Ahcrn~ti,c
Risk Transr, r. lohn
Wik~.
ChichcSlcr 200t. p. 136
Figure 4.13: Contingent capital. solutions
strength ratios to ensure that the reinsurcr docs not become financia11y subordinated to other lenders.'4 Contingent mrpha 1Wks are pre-arranged solutions enabling an insure:r, at its option, to obtain funds by issuing notes at prearrangcd terrns. The funds enable the insurer to bolster its surplus (another apression used in the US for equity), since according to US regulations. insurance companies are allowed to treat surplus notes mther as policy holder's surplus than as liability under an insurer's statutory balance sheet. The notes are:made available to the insurer via a "contingent surplus nol:e8 trw;:t" cstablished by a financial. intermediate. The trust recci.ves the funds from. investors and places them into liquid investments like US Treasury Notes. In case of a los5 event, the trust liquidates the assets and delivers the cash to the insurer. The trust then holds the surplus notes at the pre-defined terms. The insurer before the loss event has to pay the investors a higher yield than that achievable from. other investments with comparable maturities, since the investor takes the credit risk of the insurer, whi.ch can deteriorate substantially after a loss. The insurer. however. gets a contingent re:financing at pre-defined costs which may prove advantageous compared to a hanl reinsurancc marltet after a substantialloss event7S 74Banb [see2OO4, pp. 139-140] 1'ElIiott[see2001,pp.1_2]
86
CHAPTER 4. METHODS OF RISK TRANSFER
Contingency loans are bank lines of credit arranged at pre-defined tenns for the occurrence of a trigger event. The loan is provided to cover lasses resulting from the specified eveot and can therefore only be drawn wben the event has occurred. Since the probability of a draw-down and the flexibility of ils use are lower, it pays less than a standard bank line for corporate purposes. It protecls the organisation from higher fioancing cosls after an eventual rating-downgrade or in the case of fioancial dislress."" Tbe main role of jinancial guarantees is to transfer risk. Tbe capital provider aod the COIporate customer simply agree on a trigger event aod the terms of the underlying paid-in capital to be provided. When the trigger is activated, the curporate can access the capital - the guarantor theo pays all the default-related losses up to the policy amount Tbe documentation for a guarantee is short and to the point. It contains very few covenants and restrictions.77 Guarantees can also be used to create a form of contingent financing when an organisation agrees with a reinsurer the access to funds if a pre-defined trigger is breached. Financial guarantees are commonly used to protect special purpose entities against credit losses or residual value claims. This may be the case in the sector of collateralised-debt-obligations or assel-bac1red-structures. Before the financial crisis, weil rated mono1ine insurers e.g. committed in exchange for a fee to the special pnrpose entity a capital infusion in case !hat credit losses out of an underlying portfolio are greater than expected. The support, also called monoline wrap, helps the senior tranches of the transactions to achieve a higher rating. Tbe monoline insurers da not wrap lower tranches ofthe structures.78 Residual value guarantees were developed by the leasing sector for capital-intensive industries 10 weather the cyclical sales and income developments caused by the economyrelated volatility for the prices of capital goods. Especially the aircraft industry has been interested to secure the value of their long-life assels against technical developmeots and rapidly changing environmental standards. A residual value guarantee secures a minimum value for the leased assets, and the corporation can calculate a minimum capital infIow if a shortfall may occur.79 Contingeot equity structures
Lo.. equity puts, if related to a natural disaster even!, represent the right to issue new shares at a predetermined price wben the pre-defined trigger is breached. Tbe shares are normally issued on a private placement basis. In other terms, the purchaser, by paying a premium, buys a put option from an intermediary !hat gives the right to seil a fixed arnount of the newly issued shares. Loss equity puls are strongly standardised agreements including terms and conditions like the exercise event, the form of securities, the time period of coverage and issuance, the strik.e price, and certain covenants like financiaI ratios and change of control. The most important covenant is the minimum 76Banks [see 2004, p. 141] nCUlp [see 2002, pp. 433-434] 78Banks [see 2004, p. 142] "Culp [see 2002, pp. 439-4411
4.2. ALTERNATIVE RISK TRANSFER
87
net worth in order to protect the policy writer to be forced to invest into the company at a time period when it may experience severe financial distress. However, in contrast to the quite simi1ar contingent debt structures, contingent equity structures normally do not inc1ude material adverse change c1auses. Further, compared to reinsurance contra.cts, where the cedent can go into default and the obligation of the reinsurer is unaffected, the purchaser of an equity put has to stay solvent in order to be able to issue the equity. The risk of Moral hazard is reduced by the agreement of !wo triggers: First, a trigger level of the company's stock price, and second, a specific lass event which has to occur to enable the company to pul Ta avoid dilution issues resulting from the issuance of new shares, the company will normally agree to issue preferred rather than common equity. Alternatively, the equity can be issued as convertible preferred shares which can or must be repurchased by the corporation prior to any conversion. 80 Pul prolecled equity enables a company to put its own stock in the aftermath of a loss event which normally results in a decline of the stock price. This exactly forms the eredit event, the company likes to protect itself. The company is able to generate an economic gain against the seiler of the pul The put is bought by an intermediary at predefined conditions usual for put options incl. the number of shares, the strike price and the maturity. Shares can either be purchased in the open marke! or newly issued. Put protected equities, however, can be viewed negatively by the market, since the investor community, if they gain information that a company buys puts on its own stocks, will natorally expect negative news to follow. 81 As an alternative to loss equity puts or put protected equity, the company may issue reverse convertible bonds. These are not regarded as ART, but allow the company to swilch debt into equity. In contrast to the convertible bond where the holder decides when the swilch tskes place, the issuer of the reverse convertible decides the tinting of the switch. The company will exercise the conversion when the issuance of debt is more expensive than the value of the equity offered. This helps to offset or fund the costs of the adverse loss forming the trigger event for the conversion (often, a second trigger event must occur 10 enab1e the company 10 convert). Conversion improves the debt-1oequity ratio, and the reduction of the leverage increases the effective debt capacity.82
4.2.6 Reinsurance side-cars After the insurance and reinsurance sector was confronted by severe and frequent catastrophe losses for several years, the industry sought an alternative solution to stabilise the availability of reinsurance capital as weil as to reduce the volatility of their eamings and
capital positions. After the record hurricane season 2005, the first reinsurance sidecars transactions were created. They typically have a lifetime of less than !wo years. 80Banks [see 2004, pp. 142-147] SIBanks [see 2004, pp. 142-147] "Culp [see 2002, pp. 448449]
88
CHAPI'ER 4. METIlODS OF RlSK 1HANSFER.
Si.decars are special-purpose reinsurance vehicles (SPRVs) set up to takc underwriting risk from ceding insurers or reinsurers. F1gure 4.14 shows the typical structure of a side car solution. A newly creatcd holding company issues cquity and dcbt. Thc proceeds from the securities are transferred to a collateral trust. The risk transfer from the coding insurerlreinsurer is effectod by a standard quota reinsurance contract with the SPRV. The trust pays the claims to the cedent in case of a 1058 event. If no cvent occurs, the trust pays to the SPRV the debt interest and profits. The SPRV collects the premium income from. the cedent and the investment income from the collateral trust and paytl a dividend to the holding company. The holding company pays the interest on theil bonds 10 the investors and a dividend to the share holden.
'-,pi'"
'-s-;,-,-c-, ,---;
c-: ~
SPRV
Il oiding
1~'id''''l
Sl'o ",or
.
Bascd on:
~IUrrd}.
:::d lr
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-==:::::;
I
---',~ ••~;~---; 11ot>,
,'&1
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O" .'.llti.~
r.....;•.::,
Sid. Car SPRV
All ." CI.1.. Rein,um"", Si
~ 'ood) ·s. N.\I
Ft.gure 4.14: Hypothetica.l side car structure Reinsurance side-car structures include traditional reinsurance components: The underlying quota-sharc agreement is reinsurance standard. Thc legal structure is a specialpurpose holding with a licensed and regulated reinsurance subsidiary. The capital fund-
ing includes debt and equity, with the ability 10 add additional capitaL The performance of the side-car is closely linkcd to \1IlIk%wri.ting and claim-setIling capability cf the cedenl The diffi:rcnces to traditiona1. reinsurance is private ownenhip potentially provided by non-insurance-related investors. Further, the structures are set up with a defined risk
4.2. ALTERNATIVE RISK TRANSFER
89
period and finire lifetime. The nature of the transactions is highly complex and with a limired, ciearly defined purpose to serve the needs of a single cedent. They provide significant flexibility for a high degree of customised structuring. Sidecars normally do not have an active, independent management. Risk models (loss simulations, premium rare levels, investment retoros) derermine the capital needs of the side car and serve as the basis for calculating the probability of default and expecred loss given default for the debt investors. Side cars serve cedents as capped quota-share agreements on their underwriting portfolios in force. They provide the benefit to customise the terms and conditions and to creare a capital structure which uniquely suits their needs. Since the funds are already placed into the collareral account, the cedent does not have to care about the solvency risk of areinsurer in times of stress. Equity investors get the opportunity to invest in a cyclical sector which, during the time of sharp price recovery after a natural catastrophe had occurred, can deliver high reloms. This is especially the case in the absence of major loss reloms like in the hurricane season 2006, the year after Katrina. Debt holders invest in higher-yielding debt instruments linked to clearly defined risk caregories and pararnerers. They provide funding to cover losses ceded to the sideear in excess of the equity up to the total limit of the sideear facility. The debt layers normally have their attaclunent point at or above the once-in-l00-years relom period (roughly equivalent to a BB+ rating frorn Standard & Poor's). Since they are not linked to the general credit profile of the cedent, they are exclusive of legacy or litigation issues, management disruptions or credit deterioration. The flexibility to customise terms and conditions allows the parties involved to creare a tranching structure which meets the investors' requirements to get engaged in the same structure at various levels. These have, however, to be aware that the shareholders are not likely to be willing to recapitalise the side-car after sustaining sigoificant losses. Traditional reinsurers are in contrast willing to manage risk. and capital in order to maintain a going-concem status. Side car structures attracred substantial capital arnounts from privare equity investors like hedge funds and institutional investors. In the peak year 2006, 15 sideear transactions were complered for 12 sponsors with a total volume of USD 4.2 bn. For the details of the transaction see Appendix C.83
4.2.7
Insurance-related securitisation
Insurance-related securitisation includes a wide range of products which will be analysed in detail in chaprer 5. 113Murray et a1. [see 2006. pp. 1-5] ;Securities [see 2007. pp. 36-38]
CHAPI'ER 4. METIlODS OF RlSK 1HANSFER
90
4.2.8
Summary and evaluation of ART instruments
Rist carriers such as captives, risk retention groups, and se1f-insurance were introduced by 1mge US corporati.ons to overcome capacity shortages. Captives developed in10 a global business with a growing number cf locations, among them the offshore financial centers competing with each other to provide al1Iactive business environments and taxation benefits.
_
AU ......... .
O·T..... _'_
,..... _u ...... _.ri''''' I........" Il
" .. dirio. .lllri.,..... d IIM_..,; ••
Figure4.15: Spcctrum ofrisk transfer instruments Pools have been used by several industries 10 cover liability risk but also for !Ita1:es and multinational organisations to cover natural or man-made catastrophe rist. FInite solutions are a bespoke form of ART for prospective ar retrospective cover. Multi-risk products reduce the oumber of reinsurance COUDterparties. since they com.bine a oumber cf perils for several non-Iife insurance lines. Derivatives are bi-lateral, standardised products and rather inexpensive. Only a sma1l oumber cf counterparties are today qua.lified far and interested in exchango-traded products. Therefore, Iiquidity is still mther low, and secondary market pricing is difficult. products lik:e n..Ws are more liquid and. if traded as derivatives, based on ISDA standard terms and conditions. n..Ws formed as derivatives are a bridge bctween rein!lUlllDCC and capital mark:ets since, if an investor signs an n..W, this is not treated as insurance business. Altmnati.vely,
orc
4.2. ALTERNATIVE RISK TRANSFER
91
\LWs can be traded as reinsurance contracls and are comparab1e to traditionaI single-
or double-trigger cover. Contingent capital is a rather limited resource, since it may hit the investor at a time when he may run into own diffico1ties due to a low probability, high severity event. Reinsurance side-cars are another product bridging the traditional reinsurance sector and capital markets. Investors are able to participate in the reinsurance market for a liutited time frarne and follow the fortunes of the sponsor. Tbe investor can chose between perils and further between tranches with different risk profiles. Figure 4.15 gives a categorised overview of the instruments available differentiating between risk transfer versus risk financing and between the market for reinsurancelretrocession and the general capital market Table 4.3 further summarises the main cbaracteristics of the different products.
carriers
not relevant
indemnity
TrIggers
ttansfer of high frcquencyllow severity risk also low frc.qococylhigb severity (insurance pools to transfer otherwise non-insurablc risk) singIo- or mu1tiporent
risk management:
warm's compensation, also: nuc1ear, terror)
captives. pools. self-insurance non-life (liability risks: modicaI malpractice. autD,
_
Enbpncement
Strocture
ObJective
_Types
Produd
Type
increase of
based
indemnityfmdex bued
indemnitylindex based
collateral
based
pUß
indemnitylindex
counter, mainly standardisod prodncts
dicated agreement with trigger event standefinition; dardised loss equity
tradedlover-the-
none I trust collatcral (surplus note structure) I monogwmmtee, 1ine (wrap against credit lasses or residual value claims) indemnity/index
and
bi-lateral or syn-
oxcbange
also longevity
manoge-
lowfinance freqococyl high-severity losses at pre-defined tmns
capital meD1:
risk management: hodge against natural catastropbes.
W'eIlife(=ging)
lequity life I non-life
CootiDgent Cop!taI contingent debt
collateral for longtcrm life insurance
financial)
commercial
com.bination of seveml peri1s/seveml biggers (can be
not
inclusion
of ot:herwi.ae insurable rist
terparts;
""P"'''''''
ignatcd and the number of remslll'8llCc coon-
portfolio mnnagement: consolidate the des-
autD)
interruption, geneml liability, equipment, inland marine,
business
options/futures! n.Ws/swaps non-
Derivath..
none
",re.-
retum-on-capital bi-1ateral ag=ment to pay purchase 88sets with the premiums paid from the cedent to the rein-
ment:
or retrospecti.ve; capital mnnage-
funding of losses: prospective
time-
portfolio mnnagemcnt: smooth lasses over
run-off portfolios)
Multl-_ produets prospective/retrospec °:vMulti_peril/ multiag=ments trigger programmes nOß-life (cornlife and non-life (tIrlrd party liability, mercial propcrty, Finite Solutions
-
siele-
index bued
collateral
company
quotn-share agreement with a special purpose reinsurance
ment: reduction 01 earnings and capital volatility; coverage for lowfreqococylhigbseverityrisk
capital
rcinsurance c"," non-life
SIde-ears
~
~
~~
~ ~
~
~
~
~
LS
Term
Investors
Pridng
Ratlog eIfect
lang-term
companies
premiums paid to the captivc reflcct the present values of the oxpected claims to be paid parent or group of
the mganisation improvement of rating stability
are
reduction of liabilities, predictabl.
AceountiDg
ftows within
subject to homecountry contral
Regulatory
cost kept
Risk carriers
Type
""'"
medium to
reinsurers
cootracts
mium is thao with
reinsurancc
lang
single
prolow'"
improvement of ratingstability
lack of clarity on accounting regulations
MUltI-_ produets no credit far protectionbought
managers non-life 1-3years; life up to 30 years
reinsurers, hedge funds, portfolio
premium depending on risk and term
not recogniscd
credit for protection bought DO
00 credit for protection bought
Derivat!...
Table 4.4: Summary and evaluation of ART instruments
medium-term.
"""'""'"
1-3% reinsurance premium depending on risk and term
risk
downgrades in the year of a lass; transfer of investment
avoidancc of rating
abilities i.mproved solvencylcombined-ratio in the lass ycar
reductioo
reserves} liand
of lass
counting of
'"""". (m.-
reductions
significant
Finite SoIutions
multi-year
capital credit based on evaluation of investment trost (AAA quality = 100% credit) regular payment of non-rcfundablc upfront fee; cheaper thao post-loss finnocing reinsurers, banks
treated os po1icy holder's surplus rather thao as liability (US)
ter trigger event is treatcd as equity
Contiogmt CapitaI amount issued af·
reinsurancc
hedge funds, portmanagers, folio IOinsurers finite risk period up to 3 years
premium depending on risk and term
credit if adequate collateralisation is provided
full
lies
reduction of liabili-
res""", deductioo (similar to collateralisod reinsurance)
Side-<ars
~
~
~
~
~~
~
~
t->
Chapter5
Insurance Linked Securities 5.1 Securitisation Securitisation is the process of removing assets, liabilities or cash fiows from the COIporate balance sheet and transferring them to third parties through the creation of tradeable securities. Tbe market started in the banking sector in the late 1980ies and early 199Oies, when Wall Street banks commenced to pool assets and to p1ace them into trust vehicles which issued tradeable securities with severa1 risk and retnm characteristics. The pooling of assets in a portfolio results in a lower risk in terms of the variance of retnms for investors. Tbe development started with pools of residential mortgages called Mortgage Backed Securities (MBS) and was followed by Collatera1ised Mortgage Obligations (CMO) which are pools of MBS. Shortly after the introduction of MBS, commercial MBS followed inc1uding commercial real estate. The next step were Assel Backed Securities (ABS) including pools of receivables, leases and any kind of assets which can be securitised. Beginning in the early and mid 1990ies, global investment banks started to cxtend the technology to credit markets by pooling loans into Collatera1ised Loan Obligations (CLO) and bonds into Collatera1ised Bond Obligations (CBO) which together formed the asset class Collateralised Debt Obligations (COO). Figure 5.1 shows the structural cash flows of a CLO. Tbe same principal is used for the other types of securitisation. Tbe SPY is crealed with the purpose to manage the cash ftows, Le. to administer the payables and receivables. Fnrther, it arranges the necessary hedges (e.g. the fixed rate mortgages are for some securities hedged into floating rates). Different tranches involve severa1 risk profiles for investors: The most secure tranche is called "super senior" and raled AAA. In terms of ranking it is followed by the high-quality AAA raled tranche, the mezzanine BBB and BB raled tranches, down to the residual tranche carrying the "equity" risk. Tbe SPY redirects cash ftows from the underlying assets to pay the interest and to repay the principle (P&I) in the order of the contraclual seniority. C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_5, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
CHAP1ER. 5. INSURANCE LINKED SECURlTlBS
96
This process is also called waterfalJ. principlc, sincc the most senior (securc tranches with the lowest retum) will be paid first, followed by the next lower tranche and finally the lowcst tranchc. thc cquity likc.. bigbly subordinatcd sccurity wbich pays thc higbcst return reftecting the credit risk involved in its investment. It is common that arrangers improve thc crcdit quality of Ihe senior tranches by the way of crcdit enhancement through over-collatera1isation, reinsurance er monoline wraps, financial. guarantees ar bank letters of credit. In case of a defanlt, the investors in the equity tranche will lose their investment first, followcd by the next trancbe upwards until the super senior tnmche.
I.... o, .. ilh 1'& 1
B " "~
B
Ihnk C
I
P& '.
I So""..::; Banks. Erik. Ahcrnat;,c Risk Transf,r. lohn
Wik~. Chi~hc Slcr
'---,J---' 200.t. p. 116
Figure 5.1: Structural cash fiows of a Collateralised Loan Obligation ltullTtmCe linked securiti3ation follows the same principle, but it is based on msurance-Iinked events. Through securitisation, life or non-life insurance risks are structured into bonds which are financed and transfeIrcd to the market. After SOIIW carly efforts to securitise earthquake and hurricane-related rists. the first insurance-Iinked socuritisations were closed. in 1993. In the meantime. the insurance 1inkcd sccurities were refined and customised. The basic principles, however, remained unchangcd. The insurance or reinsurance company baues sccurities through a SPV, and the payment of principle and interest is based on the lasses caused by a pre-detcrmined insurance event If the losses exceed the agreed threshold, the SPV is not obliged to pay the agreed in-
5.1. SECURlTISATION
97
terest, and if the structure involves a non-principal protccted tranche. all er part ofthe principal can be deferred or even e1iminaftod,1 Three main types of securitisations have becn developed by the international capital markets: First, various types of ure iosurance securitiaatioDs including true risk transfers ar the monetisation of future profits associated with existing business, which can be closed or ongoing operations, into securities. Second, 1lOIl-life iosurance sec:uritisatioDs mainly covering catastrophe rim. Third, securiti&ations are being arranged tI8 CDOs in order to cover the funding needs of the insurance sector. This can be done to gain capital for new business strains or to enable smaller insuren to get access to the capital markcts. CDOs are also arranged to finance reinsurance recovcrablcs.2
eS",,",,,,, .. n oHI< I... .....,. Ro' (foul USD .'6.J bo) • s..:.........nofSO""* I .........,' R5.(f .... USD.'6 I bo)
• "
" • ,,,,
.
"
,
,_
, .. ,
, ...
,__
100'
'" '
__
, ...
_
,..,
_
1),0, Soon, M.'IC s.c ..".... -n.. c~ IIooo,! Mß006. Go)' C"""_ I!o C _.. LI.C. N", Yoo\. 1001, Sc~O~4 ~oul
Figure 5.2: ILS capital issued and outstanding since 1994 Figure 5.2 gives an overview of the lIlIll'ket dcvelopment of the risk capital issued through insurance-linked securiti&ation transactions. It can be seen that the volumes issuod and outstanding experiencod a steady growth in mcent years which showcd a small decrease after the markct turbulence after the world trade center attacks in 200l. In 2008. only pre-arranged shelf-transactions were used far ILS issues. In line with the negative developments on the financial. markets, the volumes slowcd down due to the IBanb [see2OO4, pp. 115-1111] lDinesm and BaIcllvarov Alexmder [see May 2006, pp. 11-9]
98
CHAP1ER 5. INSURANCE LINKED SECURITIES
general lack of investor appetite. 111e total volume issued through 1he 214 capital market transactions until year end 2008 was USD 52.4 bn wilb half of 1he volume each liferelated and non-life related ILS. 111e non-life related volume includes 1he catastropherisk mos Fremantle (USD 200 m), Garmut (USD 240 m), and Newton Re (USD 125 m).
5.2 Lire insurance securitisation The k.ey attraction of life insurance securitisations is the enhancement o[ lhe return 0/ equity combined wilb a lower cost 0/ capital. 111e freed-up capital can be reallocated for new business !ines wilb futore growth potential. Furtber, seeoritisation can be used for risk mitigation. In contrast to other types of securitisation which wrap assets, life insuranee transactions involve the seeoritisation of liabilities. This makes the whole process More complicated. Debts of the credit card business, for example, may be packed autornatically by 1he card issuing bank into an asset-backed transaction. The customer Iberefore no longer depends on Ibe credit of Ibe bank. If an annuity contract with a life insurance company is seeoritised, the link with the customer cannot be broken, because 1he promise to pay Ibe insored Ibe annuity needs Ibis relationship to be fulfilled. Fur1her, regulators do not allow to transfer Ibe obligation from a weil rated life insuranee company into a special purpose vehicle in form of an outright sale. 3
5.2.1
Reserve funding securitisation
Reserve funding seeoritisations were developed by Ibe US insurance industry afrer a review of Ibe reserve regulations introduced by 1he NAIC called Triple-X (XXX), effective 2000. The statutoIy reserve regulations affect the reserves of insurance companies writing individual multi-year term life contracts. The contracts have been very successful, sinee customers were attracted by the guaranteed multi-year premium rates with flexible terms. However, US regulators are concerued about 1he varying, if not inadequate, reserving practices of primary insurers. Insurance compauies in the US are obliged to deliver stalotory results to Ibe regulators. Further, US GAAP based accoonts are delivered to the US Seeorities Exchange Commission (SEC) and the compauies' shareholders. 111e new NAIC stalotory reserve rules are demanding siguificantly higher capital requirements reflecting the maximum risk. The calculations are based on mortality tables and averages. 111ey impose rapidly increasing stalolory reserve requirements. 111e GAAP ca1culations are much lower, since they are determined by Ibe most likely outcome based on actuary caIculation. Until 2005, insurance companies were able to successfully reinsure the redundant component offsbore, since they could get hold cf lower levels cf reserves. In order to receive the desirable statutory reserve 3Devine et al. [see 12.04.2004. pp. 3-6]
99
5.2. LIFB INSURANCE SECURlTlSATlON
"'sc"'" ",quircn>cnts ro, "2(1 )'car tcrm lire pol ic) ro, a male non·,mole,
"
20
Yea"
Stal uto!) XXX ",sc",'.' GAAI' bcndit "'sc"'c (cconomic rcsc",'c)
Souree: I.e,it"'. J,..,I, Riegel. Roben . Ilidden Crcdit Rbl s orRegulation XXX I Guidclin.: AXXX Rcinsur~n,'C I'rogram ,ncs. Moo.Jj-· s Ne" Yort. OII2O(1.t. p. J
Ft.gUre 5.3: The effect ofXXX on long term reserves cf life insuren treatment by the US regulators, transactions were typically secured by either a bank lcttcr of crcdit or a reinsunmce truSt. holding thc sccurities to collatcralisc thc rescrvc credit. The capacity for letters of credit by banks, however, is expected to reach its limit, especiaIly :regarding the fact that estimatcs for futurc :rescrve rcquirements reach up 10 USD 200 bn due 10 the high growth rates for term lifc insurance and their extraordinary high reserving. Figurc 5.3 shows the difference betwecn statutory and GAAP rcserves for a standard policy." A similar regulation came into cffuct in 2003 for no-lapse guaranteu in umversallifc insurance contracts with the Actuarial GuideIine 38, also rcfcrred to as AG38 or AXXX. No-lapsc guanmtccs arc commitmcnts by thc insurancc industry within long term life insurance poIicies with contmctual tenns up 10 60 years. They allow the policy holder 10 pay a certain amount into a contract, then just stop or docide 10 pay morc. Thc futurc development cf the contracts, and as a result their rcserve rcqujrements are difficult 10 forccast. The first AXXX n..s was placed by Protective Life in 2007, followed by Aegon in 2008 (sec Appendix D for the hlstory cf transactions). Variable Annuities arc also being discussed as potentially being securitised. They
4Levine md Riegel [_ 2004, pp. 1-6]
100
CHAP1ER 5. INSURANCE LINKED SECURITIES
were sold in Ihree main forms: Guaranteed minimum withdrawal benefils allow the policy holder to withdraw up to about 7% of the principal per year, regardless of the in-
vestment performance. Guaranteed minimum income benefits convert the savings into an anuuity after seven to ten years. Guaranteed minimum accumulation benefils periodieally reset the principal to an agreed level after a predeterutined period and at matutity pay an agreed lump sumo Since their downside risk can be substantiaI, regulators and ratings agencies became increasingly concerned about the various farms of living benefils. The lack of predictability of casb fiows, however, makes it difficult to securitise any of the vatiable anuuity forms. 5 The introduction of the XXX guideliue sparked the creation of reserve fuudiug secutitisations, ma1ring this type of secutitisation to provide the biggest volume to the capital markeIs. Figure 5.4 shows the simplified structore ofaXXX securitisation: First, the insur-
ance company pays the capital plus an initial economic reserve into a special purpose vehic1e being a captive reinsurance company. Second, the soourities are issued by the SPV, and assels get purchased into a Regulation 114 collateral trust with the proceeds. The term Regulation 114 is detived from insurance regulations of the State of New York. Under the trust agreement, the grantor delivers to a US-regulated bank securities with a market value of not less than the full arnount of the grantor's obligations due under the reinsurance agreement. The types of securities are liruited to good quality asseIs; no equities or debt rated lower than "A" are allowed. 6 Third, during the lifctime of the transaction, the SPRV pays regular interest and the principle back to the security holders at maturity. Further, the SPRV pays experience refuuds and dividends back to the insurer who is interested to get the capital injected back as soon as possible. The financial guarantor's role is to secure the timely payment of the captive's obligations. In contrast to the insurer, the financial guarantor is interested in keeping the fuuds with the captive to reduce its credit risk: tak.en. As in other types of securitisations, the guarantor, due to his own underwriting standards, is ahle to enhance the senior tranches, only.7
Like the guarantors, investors in the transaction face several risks8 : lnsurance Risks: Secutitisation includes a distinct block of business. The block of business must be clearly defined and the ability to separate, touch and measure the included policies must be secored. lt must be transparent how the business was priced and under which underwriting standards it was acquired. The policy holders must, from the beginuing, be properly slotted into risk categories in order to avoid higher than expected mortality or lapse rates which can lead to cash fiow shortages. 5Devine et al. [see 12.04.2004, pp. 18·19] 6Ellia [see 31.10.2007] 7Devine et al. [see 12.04.2004, pp. 43] 8Devine et al. [see 12.04.2004. pp. 11-14]
5.2. LIFB INSURANCE SECURlTlSATlON
I w
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n
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lJascd on: [k,·inc. Colin cl al .. Tho: Sccuriti!a1ion Solut"'n. Ci1igroup Inc. No" Vor\:. 06.072006. p. 44
Pigurc 5.4: Hypothctical XXX sccuritisation Inv~sl1Mnt porifolio risk: The quaIity of the investment assets supporting the resecves must be adequate, since the level of cash ßows is not necessarily guaranteed over a 30-year horizon. Structural and regulatory mies: Structures have been developed wbich have suc-
cessfully separated (ring-fenced) the cash flow of the securitised business from other
activities of the sponsor. Regulators will not allow the sale of a life insurance policy and thad"ore true sales treatment is mther unlikcl.y. The target of the effo.rts of the st:ructurer!l is to get bankruprey rem.oteness status for the investors. MOtkling Risk: Determ.inistic sensitivity testing is a key for the predictability of cash ßows. It has to be made sure that the transaction will perform. under various scenarios. XXX securitisations rcquire reserve modeling of tmn life insurance wbich is rather straightforward. Mortality rates., Japse rates, interest rates and the change of the sponsor'! financial. strength rating are usually simulated for this transaction types. Since its start in 2003, a total volume of USD 11.1 bn was issued in 16 t.mnsactions as shown in figure 5.5. All issues are characterised by very long terms ofusually 20 or 30 years. Further details about the transactions can be found in Appendix D. Duo to the negative effects of the capital. market crisis on the monoline insuren, life securitisation came to a standstill.. No transacti.ons could be arranged in 2008 and 2009.
CHAP1ER. 5. INSURANCE LINKED SECURlTlBS
102
S KI,!
• P,,'nm"<
• '"'"
2003
• o
•
2004
2005
1.I1C\ll ol din ~ ,
2006
2007
2008
2009
Dola Soor«: [b In<. Co l,". <1 .1. Tbc Sc<. No"' Yf)f\,. 06012006. p IO / Carc). lan and Jan~. Tim, Lu""",,,,, I.•fe FIIC"II) &. I.,.",u'.o( Aetuar,C'<. 1. _ _ l00~ . II'o"~rp(,,nl Sild< 51
&<""" ..,,"".
Figure 5.5: XXX Issues ofthe US life in5U1'llIlCC industry
5.2.2 VaIue-in-force securitisation Value-in-force securitisation is the monetisation 0/ the future profits associated with 9:isting businesses of an insurance company. Transactions have bc:en exercisod for closed books (also refencd to as blocks of policies) where the underwriting cf business has been stopped. Further, open-end books where the underwriting of business continues during the Iifetime cf the transaction werc securitised.9 The changes of the globallife iwurance market have put life insurers lJ11der pressure 10 incrcasc their:retums on equity. 10 rcducc thcir risk profiles and to maintain an appropriate credit rating. There are several driven of the change: Insurers, until a decade ago, have operated in a capital market environment where sufficient retums were available 10 meet the retum requirements cf the po1icyholder. Further, rcinsurance was plentifully available on- and offshore. In recent years many Iife insurers. cspccia1ly in the US and the UK, have changed their company profile from a mutoal organisation into a stock company in order to be able to increase their fiexibility to grow by acquisitions or intemationally.
9Dinesm md Ba1chvarov ~ [see May 2006, p. 11]
5.2. LIFE INSURANCE SECURITISATION
103
This means, they need to be more transparent to their sbareholders and are challenged to rneet formal return-on-equity targets. Regnlators and rating compauies brought new, More sophisticated requirements to the capital and risk models. The intemationalisation of the capital markets resulted in higher liquidity and lower returns. The risks, however, increased - the stock crisis of the late 1990ies and the current capital market crisis wiped out a substantial part of the insurers' reserves. Further, pandemics like the hird f1u are threateuing the calculation
of reserves. After the consolidation of the sector, the top ten life remsurance groups increasingly use their power to put upward-pressure on premiurns. Although growth opportuuities
exist in emerging markets, today's major markets North America, Western Europe, and Japan are characterised by an ageing population involving longevity risk. 1O
These developments have caused a number of insurance companies
to
securitise
the embedded value of their business. Securitisation allows the insurer to monetise the value of traditional term life insurance with lower return-on-equity. Capital is created through aceeleration of the recoguition of the underlying eamings stream. This means that a company can through securitisation immediately reduce its capital invested in a business !ine. The freed-up capital can be used for higher-retuming activities." Figure 5.6 shows the history of the marke! since the first transaction LI was closed by Hannover Re in 1998. For a list of the 16 transactions with a total volume of USD 9.2 bn placed see Appeudix E. Embedded value refleets as closely as possible the total value of the company. It is the sum of the adjusted net asset value plus the present value of the shareholders' share of the future income stream expected from the policies in force written by a life
insurer. The adjusted net asset value essentially consists of the free assets as stated in the cornpany's balance sheet minus any included goodwill and other intangibles (like for instance deferred-acquisition-costs) plus any unrealised gains not aceounted for on the balance sheet. '2 In Europe, the CFO forum, a working group of CFOs of 19largest European insurance cornpauies, has been working on guide!ines on European Embedded Value (BEV) disclosures. The!arget is to create a realistic and comparable reporting of the EEV." The BEV calculation methodology further tskes financial options and guarantees, nonmarket risk (operational and insurance risks), and the cost of capital into considera-
tion. 14 The shareholders' share of the future income is referted to as the value-in-force. It arises as profit margins held in the insurer's reserves are released over the lifetime of the policy." Value-in-force is a rneasurement of the expected present value of the IOLa.thuil1eri.e [see 20.06.2006, pp. 2-3] l1Devine et al. [see 12.04.2004, p. 9] 12Carpenter et al. [see 27JJ2.'1JXJ7, pp. 2-51
13La.thuilkrie [sec 20.06.2006, pp. 3-4] I-4Carpenter et al. [see 27 .02.'1JXJ7, pp. 2-5] 15Carpenter et al. [see 27 .02.'1JXJ7, pp. 2-51
CHAP1ER. 5. INSURANCE LINKED SECURlTlBS
104
o
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•
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• 1"6 1'1')7
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o 1~'19
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Ci"gr<>up In<. N<'I Yor\;. 06.07.2006. p. 25 I ClrO)'. lan anti ;""""'. Tim. Eu"'l'<"" Lof. &\:U""""IOO. ~""ull) '" In>l"",,,of A
11.,,,,,1>'.'.
Figw'c 5.6: Value-in-force securitisati.ons since 1998 policies an ins1.ttal1Ce company currently has in its books. It forms the intangible part of the cmbedded value of the policies and is nonnally not incorpomted in the primary financial statement&.16 The cal.culation of the value-in-force is a result of the actuarial forecast of the future profit and loss items of the company discounted at a rid: discount rate. The evaluation on a best-efforts basis is dune in three steps: First, the discounted statutory cash ßow emerging from the relevant block: of policies is calculated as the residual value of the life insurance policies at the end of each year after subtracting the benefit payments, the cxpenses and the dividends to the policyholder. Second, the cash flows are summed. 'Ibird. the company cash ßow ia calculated by summing the value-in-furce of each polier aeroS! the lines ofbusiness.17 Although no one vaIue-in-force securitisation structure which has been closed by now is similar to a second, Flgure 5.7 gives an overview of the cash ftows of a typical structure. The issuer gets the proceeds of the securities from the investor and grants a loan to the special purpose reinsurance vehicle. The sponsoring insurer closes a reinsurance treaty with the SPRV far the relevant block. of policies. He is obliged to pay
16La11mil1me [_ 20.06.2006, pp. 3-4] 17La11mil1me [Re 20.06.2006, pp. 3-4]
5.2. LIFB INSURANCE SECURlTlSATlON
.r
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105
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Figure 5.7: Simplified value-in-forcc: securitisation
a premium. while the reinsmer pays back a commission to compensate the primary insure:r Cer its acquisition costs. It is common practi.ce that the existing actuarial reserve8 remain with the risk carrier as a deposit (modified co-insurance). Altematively, the rescrves cou1d be transferrcd 10 the SPRY. During the li:fetime of the transaction, the SPRV pays the isSW7 the principal and :int.erest agrced, which is passed on 10 the investors of the different tranches. TM issuer may buy a wrap form a reinsurer er monoline insurer 10 enhance the ratings of the securities issued. This is cspecially useful far these kinds of sccuritisations, since it is nearly impoS81ble 10 get a higher rating far the structure than the isSW7:financial strength rating of the insurance company itself. Regulators will not pennit the company 10 serve the prineipal and interest when the company is not able 10 moet the minimum solvency rcquirements. 18 In order to protect the interests of the investors and the potential provider of the wrap, further cn:dit enhancement mecbgnjsms may be agreed: The SPRV may hold a reserve fund to protect the note holders agRinst the general uncertainty of the profits (i.e. unexpected fall in market values of the assets affecting the profits). Furthec, the insurance eompany eRD add same protection 10 the note holdas by securitising a sma1ler
liLathuilli:rie [_ 20.06.2006. pp. 3-10]
CHAP1ER 5. INSURANCE LINKED SECURITIES
106
amount than the calculated present value of the future cash flows. Liquidity facilities can be put in pIace to secure the payments of interest and principal. Tbe risks for the investors can be sumrnarised as folIows: Tbe amount of Ibe valuein-force is volatile and is depending on Ibe actuarial experience of the underlying polieies such as investment risk and surrender rates. Mortality, morbidity and longevity are difficult to estimate. Embedded options and guarantees are common in life insurance policies but can inc1ude severe downside risk. An unexpected increase in expenses or lax rates may affect the cash flow projections assurned. Tbe correlation of risks is difficult to model and may result in asset-liability ruismatches. Finally, it has to be mentioned that the investors bear the risk that the sponsor is able to administer the underlying contracts correctiy.19
5.2.3
Residual commission securitisation
Residual commission securitisation is a rather small market. The first transactions were closed by American Skandia and Hannover Re in the late 1990ies. Until the !atest issue in 2006, USD 2.3 bn of securitisations were finalised. For the market development see figure 5.8 and details of the transactions Appendix F. Tbe target for Haunover Re was to balance the necessary write-off of the acquisition costs for life, health and personal accident insurance in the year of acquisiti.on. The costs were transferred into the capital markets with the effect that Hannover Re gained immediate liquidity for further growth. This enabled Haunover Re to continue its strong growth in the segments without having to show a negative result 20 Clark-Bardes e.g.
securitised the agent's trail commissions to raise funds for future acquisitions.21 Ta give an overview of a typical structure, the transaction Li issued by Hannover Re shall be explained as shown in figure 5.9. The SPRV closes a retrocession reinsurance treaty precisely defiuing the block of business concemed with the insurer. For balance sheet, solvency and tax reasons, the vehic1e is frequently established in certain countries or national territories like Bermuda or Guernsey and not coDsolidated with the insurer. Tbe agreement is treated as normal retrocession regarding the ceden!'s balance sheet and statement of income. Tbe relationship between the investors providing Ibe capital can tak.e many forms. It can be a loan or several types of securities with different layers reflecting the risk. Tbe liquidity gained is immediately transferred to Ibe insurance
company.22 Tbe benefit of Ibe structure is an improved liquidity situation of the sponsor. However, Ibe liquidity strain has to flow back through Ibe payment of Ibe reinsurance preruiurn from the second year on already. In strong growth phases, Ibe company through the securitisation is able to show a more constant profit and loss development. Tbe "Lathuillerie [see 20.06.2006, pp. 3-10] 2OBuetow [see 01.12.2001, pp. 6-7] 21Devine et al. [see 06.07.2006, p. 27]
22Buetow [see 01.12.2001, pp. 6-7]
5.2. LIFB INSURANCE SECURlTlSATlON
107
,_.
I~~O
1'1\17
I~~H
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101141
1001
1001
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[lau Soo"" [)", 'rI<. Colln. 06.07 2006, P 26 / 1I':olIIß, Uhieh. In'Uf""",,·L In~
lI.nno' ... Ik lI.nno"o,. 29.07.2007 11'0>001»0'''' 51 ,<1< 71
Flgure 5.8: Residual commission sccuritisation sincc 1997 efIects of the securitisation for cx:ist:ing business on the balance sheet cf Hannover Re, following the German regulations, are comparab1e to a normal retrocession. In case of new business securitised. the 1iquidity inßow provides re1ief for the msurer'! b!bnical result and equity capital. The asset investment volume increases. 23
5.2A Risk transfer securitisation Risk transfer securitisation in life insurance is used to secure extreme mortality risk: which may be caused by pandemics. The market started to develop the st:ructures in 2003, when Swiss Re used its SPRV named Vita Capital to issue USO 400 mln mortality-indexed-bonds. Vita 11 fo11owed in 2005 with a volume cf USO 364 mln. Scottish Re structored USO 155 mln cf mortality-linked bonds in 2006. AXA unvciled its debut mortallty risk securitisation Osiris in Octobcr 2006 with a volume cf EUR 345 mln. The retums on the notes depend on the development of mortality in Fnmce with a share of 60%, Japan with 25% and the US with 15%. The calculation is based on the parametric, age and gender weighted, combined mortality
:DBamJw [see 01.12.2001, pp. 11-23]
CHAP1ER. 5. INSURANCE LINKED SECURlTlBS
108
'um • • ou.
Kr;n, uno.« T".,;..
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.
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SPIH'
prrm,um ,
InHItO'S
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nase
Figure 5.9: The L1 transaclion ofHannoverRe index (CMI). The lifetime ofthe transaction is fromJanuary 2006 until December 2009. Thc CMI is a two year rolling index. The data from 2004 and 2005 was taken as a starting reference.24Flgure 5.10 explains the structure ofAXA's Gsiris transaction which is done within a USD 1 bn shelf programme called "AXA Cessions The issuer Dsiris Pie, a special pmpose vehicle based in Ireland. issued bonds of the classes B, C and D (class A was not used fer Osllis). The bond class BI was wrapped by a monoIine guarantee issued by CIFG. The proceeds of the issues were he1d in a collateral trust In case of the trigger event. tbe capital of the relevant tranches is transferred from the collateral to AXA Cessions. For the attachment I detachment points and the terms of the notes, see table 5.1. If no event occurs, the collateral is used 10 repay the bonds at maturity.25 The model was provided by Milliman, an actuarial company based in the USA which supported the evaluation of the ratings provided by Standard & Poor's and Moody's. A basis mortality component, a disease component, and a teIrorism. component were included in the ca1culation mode1. It was criticised by the investor community that ft
•
24Farmw [see 2006] l!ICmvcayet al. [see 17.11.2006.pp 1-4]
5.2. LIFB INSURANCE SECURlTlSATlON
109
~",n« I'Olir::.j
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Flgurc 5.10: AXA shelf programme 105iriS transactWn structure France bad a 60% share in the index, but only 13% of the underlying population.
1 3mE+O.209Io meant 3-1DODIh EURIBOR plllS 0.2 pcrecDf. DZ Bmk, AlMt Bacbd watchm: - ABS iD tödlichez: Miaion F'rInkfurt, 17.11.2006
Thble 5.1: Osiris Pl.c - tranche structure
CHAP1ER. 5. INSURANCE LINKED SECURlTlBS
110
The risk for the investor is a higher than expected increase in mortality wbich can
be caused by epidemics, pandemies or man-made catastrophes like nuclear attacks. 26
F1gUle 5.11 shows the bistory of risk transfer securitisations. The activity has becn slow since its start in 2003. USO 2.2 bn were issued in six securitisations. Further transaction details can be found in Appendix G.
•
Vi•• I
2002
2003
• 200-1
D,,,. Soure< Schu l". Poulets'" In,ur",,«
2005
Lln~.J
•
2006 2007
2008
2009
Secu""",_ AON Capt ,al M,TI<m. Ch,cll8o. 2008 . P 48
Figure 5.11: Risk transfer securitisations since 2003
5.2.5 Life settlement securitisatiOD life settlement is a business where policies are sold ror a lump sum payment by the policy owner to a licensed cntity for an amount greater than the surrender value cf the policy, bot lower than the face amount of the policy. TM purchaser of the policy becomes the new owner and continues to pay the prcmiums to the life insurance company. When the insured individual dies, the purehaser gets the death benefits. The earlier the insured person dies. the higher therefore is the yield Cor the investor.'n The business is an outgrowth cf the viatica1 settlement marltet which started in the
times cf the AIDS crisis during the latc 1980i.cs. Terminal ill AIDS pati.cnts in thc US 2(iFarmw [see 2006] 17Moda [ee24.03.2OO11, p. 1]
5.2. LIFB INSURANCE SECURlTlSATlON
111
sold their policies because they needed money for medical trcatments or wished to live their time Ieft without financial problems. The market with AIDS victims stopped when thc medical advantages thankfully allowcd thc paticnts to live longer with thc discasc. Looking for growth opportunities, the markct for seniors holding life insurance cont:ract:8 became target for the life settlements industry. Wbile the volume of the life settlement market was cstimated at USO 16 bn for thc year 2006, rccent cstimatcs forecast a potential market for US life settlements at USD 21 bn by 2012. The economic value of approx. 20% of the life insurance policies of holders over the age of 65 exceeded the surrender value.2B The life settlement bu&incss bears the opportunity to form portfOli08 of policics which can be securitised and placed to the market. Figurc 5.12 shows the proccss of a life settlement securitisation:
0 ",
0 --8 _. ,..... "", R ",~"
o 1.."'·..1-·1,·....·..,,10 -o - /' 1 I R ",~" I _I r.., ....
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Figure 5.12: Simplified life-settlement securitisation The process starts with the purchase of the individual policies by brokers acting as intermediaries for the licensed entities. The entities (providers) can aItematively purehase
the policies dllectly from. their holders. The insurance compani.cs that issued the life insurance policies most be informed ahout the transfer. They are critica1 to the process, ZIICroIsonet 11 [see 12.l19.2OO1.p. l];Hodson [_ OS.02.2OO9];Pitzb: [see 3(UI9.2OO6]
112
CHAP1ER 5. INSURANCE LINKED SECURITIES
sinee their solvency is the basis for the payment of the death benefits. The intennediaries must malre sure that the transfer-related and sale documeutation delivered by the attorneys is conform with the relevant regulations. The policies are then assigned to the bankruptcy-remote SPV. The vebicle is set up for the only purpose of purchasing life settlements, issuing securities and holding other assets in the interest of the investors. In order to co-ordinate the process, regulatory counsels are used. Tbe medical examiners provide a two-fold comprehensive review of the medical files of the poliey holders. They provide an estimated mortality profile for the portfolio including a summary of the pertinent medical conditions and a determination of the life expectancy. The proeess is supervised by a medical counsel. During the lifetime of the transaction, the tracking agent contacts the insured or their representatives to verify the corrent life/death status of the insured. Actuaries help to provide the mortality tahles for the transaction. Tax advisors provide opinions on the tax implications involved in the transaction and accountants provide OpiniODS about the recognition of expenses and income regarding the bankruptcy remote entity's country of domicile. The collateral manager supervises the choiee of policies for the portfolio. He malres sure !hat eligibility criteria for the securitisation are fulfilled. The focus is further on optimising the portfolio in !hat respec! that the premium payments are minimised and the death benefits are maximised. He delivers the doeumentation of the purchase of the policies to the trustee. The trustee acts for the benefit of the note holders holding the security granted by the issuer aver its assets, the life insurance policies. All documents referring to the single life policy settlements are held by the trustee.'" The benefit of life settlement securitisation is the attractive retorn for investors compared to other capital marke! investments availahle. Further, the risk involved has been regarded as rather uncorrelated to the capital market developments. 30 Policyholders are able to get out of their contracts if the coverage is not needed anymore. This may be caused for instance by a divorce, bankruptcy or sale of a curporation owned, but also by financial distresS.31 However, the industry has been critieised for improper practices sinee the beginuing. First, it is argued !hat the practiees of viatical settlement were immoral, sinee the fatalill policy owners do not have many options to get hold of liquidity to pay for their medical treatments. The result was a mis-pticing of the transactions. Although the providers have to be regulated companies, the practiees of the lifesettlement marke! are non-transparent Reports were published !hat policies are sold to elderly people who do not fully understand or appreciate the agreements. Life insuranee is offered for "free" with an immediate cash payout: The insurer buys a policy with the intention to seil it after a contestahility period of two years and gets the cash payout immediately after siguing the contract in the form of a loan. If the insured dies within 29Crosson et al. [see 12.09.2007, p. 3] 3ORhode [... 01.10.20091 31Pitzke [see 30.09.2006]
5.2. LIFB INSURANCE SECURlTlSATlON
113
the first two years. the heirs get the po1icy amount alter repayment of the loan amount plus interest and fees involved. After the two years, the investor decides whether to buy thc po1icy 01 nol If the hcal.th situatioo of the insuzcd has improvcd, thc invcstor may decide not to buy, and the poIicy holder remains with the obligation out of the loan plus thc future premium payment schedule due for the life insurance protection.
l ' ort'} ' o~n l,,~
• I'.. ,~". I.<\lot, OJ
0 2002 lJata Sm!«·
2003
•
I' .. ,~". !.<\lU, 64
•
'\(>0110 S I."
•
1. <1:><) Ikn,r.1
2004
2005
2006
2007
c"",). I.. ""~ Jatn<">. T,m. E"'opcM1 1.'[0 &0"""""011. ~ac"I') &: In,,,,"!< "r "CI"3f'<">. LOIIdon. 200&.11'0"·<""'101 SllIle Sl l !'......,. M",h3ocl. &."""""011 ofL,k &ulcmc"' C ..... Ho" •. Fasan<> hm&,011. 31.10.200& 1 11""."".. \\ "0," ~ I Bo..
""'''''al<>. \\ ..
""'li"'''' Tnd,o""'. R""'lll<> llonds Iss...d bj "(>0110 SIS Fund S'\. AM Iksl. Old" ,o~.
02092(1(1.1
Figure 5.13: Li:fo..settIement securitisations In August 'lOO7. the NAIC has passed an amendment of the relevant regulation called "VJ.atical Settlement Act" prohibiting the settlement of a policy during the first five years alter issuance. 'Ibis is expected to end the iIIegimate practi.ces described above and re.fcrrcd to as straDgcr-owned.-lifc-insUIllDCC. Thc lcgisl.a1ion is being ratificd in the US federal states. 32 Apart from the reputational and litigation risk, the investor in a Iife sett:lement secnritisation bean direct financiaJ risk. The assumption of Iife expectancy is difficult. Although AM Best has publi!!hed its methodology far the rating of life settIement &eCUritisation, rating agencies have not achieved a sufficient comfort level with the predictions. As per September 2006. ooIy ODe transactioo was grantcd an indicative rating by AM Best.33 ~etll [see 12.09.2OO1.pp. 2-3] "ZiIer[ee2007]
114
CHAP1ER 5. INSURANCE LINKED SECURITIES
Securitisations placed on the capital markets therefore have been limired. The total volume of the five public transactions was USD 1.4 bn <see figure 5.13 for the bistory and Appendis H for the transaction details).
5.2.6 Summary and evaluation of life ILS Apart from traditionaI reinsurance, a variety of securitisation types are available for the life insurance industry: Reserve funding is a special product for US companies to finance their increased reserve requirements instructed by the statutory rules XXX and AXXX. Due to the complexity of the reserve calculations and the very long terms requesred, the products in the past depended on additional guarantees provided by bigbly rared monoline insurers in order to malre them attractive for investors. Value-in-force securitisations pre-finance expecred profits for closed or open life insurance blocks of policies. Companies are enabled to generate cash wbich can be used for further growth or to protect themselves against adverse developments of portfolios acquired they may not like to continue.
Residual commission securitisations were introduced by companies to overcome phases of slrong growth when entering new markets in terms of geography or products.
The sponsor pre-finances acquisition costs and in favour of investors collateralises its mortality and expense fee income or deferred sales charges on unit-linked products. Risk transfer securitisations protect against adverse mortality developments wbich can be caused by pandemies or man-made cataslrophes. The products provide mediumterm coverage for a fixed price. By purchasing this protection, insurers get a stable basis for calculating their premiums for the policyholder. Most life settlement transactions are being closed as private placements sold to pension funds, asset managers, or retail investors. Pew transactions wore publicly placed in 2003 and 2004. Despite legal issues and concerns from regulators, the market experienced steady growth, but shifted from public transactions to private placements.
Table 5.2 shows the main characteristics of the severallife insurance securitisation types with total USD volumes and transaction numbers.
m
il8 statu10ry reserve requiremcnts (closed gap between regulatory and cconomic re"""ea)
Enbancement collatcral + guarantoe indemnity 1iiggera Regolatory credit for reinsurance on
SPRV reinsures a block: of life insurance business
Strodure
not qualified far a reductiOD (US)
co1lateraJ. + guarantee indemnitylindex based credit Iike with traditional reinsurance, if indcmnity based, othcrs
count
equa1 to the economic reserves 10 the SPRV procccds of the debt issue are used to purchase assets far the trust ac-
sponsor transfers assets
risk management: protertion against adverse mortality developments (e.g. pandemies, manmade catastrophes)
(7)
(1J/l)
capital management: issuance of nOD-rccourse debt to fund "excess" statutory reserves fot term life and universallife contracts
Rlsk Trlmsfer
2,210.2
ReserveFund.{XXXIAXXX)
8,686.1J2,43O.0
Objecti..
(transactlOIIS)
Os....
Type USD
DWrtality
collateral + guarantee indemnity DO restrictions, relief in combination with reinsurance possible if truly on a limitcd recourse 00sis and repayments are contmgent on the emeIgence of suflicient surplus; loan from SPRV is considered as long-term business funding
parametric index trigger
of policies or using a
protcction either fot a closedlopen-end block
capital management: raise regulatory capitaI; funding: raise liquidity
(16)
Value-in-Force 9,239.5
by a portion of future fees, expense charges and contingent deferred saIes charges collateral not relevant viatical settlement set (US); increasing CODcems of regul.ators due lo malpractice
•
provide liquidity based on percentage of value in force term life insurance or annuities; the trusts issuing the notes are collatoralised
inaurance policies
raise liquidity foe acquisitions or in the phase of demutualisation, tuming intangible assets into cash fundIDg: plUChase oflife
funding:
1,466.2 (4pub6e)
IJfe Settlement
Residual Commtsslon
collatcral + guarantee not relevant 00 restrictions ar relief
!unding: Re-finance acquisition cest and future profi" (e.g. in times of fast growth), provide liquidity based on a percentage of defer:red acquisition cast oe salcs charges provide capital block 01 business is ceded to a SPRV providing reinsurance - the reinsurer reimburses the sponsor for the origination
2,330.0 (10)
~
-'"
~
~
~
~
~
~
~
t->
far the sponsor indirect1y positive, if freed up capital is used for operations with pos-
Rating
lang-term (up to 30 years)
Term
..set insurance
furuh,
years)
companies, bedge funds, institutional loan andCLOs medium-term (3-5
numagers,
pension
rating agency fees. third party advisors, arrangers around 1.5%; Libor + 0.2% • 3%, function of duration and rating of the nates AAA down to BBB-
guarantor fee, legal fees,
the re1iance as premium p0Y'"
rating capped by the rating of the sponsor due to
demnity based. others not qualified far a reduction (US)
Residual Commtsslon
lang-tenn (5-40 years)
insurance companics, osset pension fund" managers Oong·term) I Banks (.hort term)
long term (7-10 ycars)
if rated AAA down to BBB ospension fund" set managen, private investors
Libor + 0.7% ·1.5%
Libor + 0.7% - 3%
AAA down to BBB
party advisors
medium- and lang-term (3·20 years)
banks, asset managers, private investors
usually not ratcd
ing agency fees. third
arrangers, legal fees, rat-
arrangers Libor + 1.5% • 2%
all capital raised >50% of VIF will improve rating conditions
improve leverage position, treated similar to retrocession - relief on technical result and equity captial
2,330.0 (10)
legal fces, rating agency fees. third party advisors, 2-3% margin for
Da rating effect far life insurance company
no accounting effect on life insurance co
1,466.2 (4pub6c)
IJfe SettIemeDt
hnproving liquidity and in same eases the capital position (max. 50-75% capital recognition); if not guaranteed capped at the sponsors ratings guarantor foe, Iogal fee" rating agency fees. third party advisors
off-balance
shown in the accounts ist rc:duccd accordingl.y)
increase in assets and liabilities equal to net proceeds of the issue (EV
Valne-in-Force 9,239.5 (16)
Table 5.3: Life insurance securitisation types: Summary and evaluation of characteristics
insurancc companies, pension funds, asset managers (lang·term), banks
rat-
Investors
mgs
.....
Libor + 0.2% • 1.25% de-
Investor yielcI p,"
pending on the rating of the relevant tranche AAA down to BBB-
guarantor fee, legal fees, rating agency fees. third party advisors, arrangers
CmU
itive and stable performance
credit like with tradi-
increase in assets and liabililies (reserve relief)
Accounting
-
(T)
(13/2)
issued (tnmsactions)
tional reinsurance., if in-
Risk Transfer
2,210.2
ReserveFund.(XXXIAXXX)
8,686.lJ2,43O.0
USD
m
Type
I
~
~
~
~
i
'"
~
~
5.3. NON-LIFB INSURANCE SECURlTlSATlON
117
5.3 Non-Iife insurance securitlsation 5.3.1 Catastrophe bonds Catastrophe bonds cover low-frequencyJhigh-severity risks and emerged in the hard reinsurance m.arkct conditions of the mi.d 1990ies as a product to transform insurance related risks to the capital markets. After significant lasses caused by Hurricane Andrew and the Nortbridge Earthquake. the :reinsurance capacity available was limited and expensive. The first catastrophe bond with a vo1ume of USO 85 mln called Kover was placed by Hannover Re to transfer catastrophe risk in 1994. The second issue called Kl with a volume ofUSO 100 mln followed 1996 to cover catastrophe and aviation risk. In the meantime, transactions to cover natural catastrophes caused by wind-storms, earthquakcs, but also cvent canccllation of industriaI risk were placed into the capital.market.
..
,------------------------------," .~.--, .
..-
"
... ... ...
~
-
... ,... ,... ,... ,..,
, , ,...., , ,- -,.., , •",'bi•• ••" )'" I'........, *' "'
_", ; ~ " ",
.... , ...,... "' _
, .. _
.... .
ll... So<.o« MMC S«or>t .... The C~ 'Iood ~ b-I. ", .. v<* ...... 2OOIi. v,,). C..p'"'''' & c _ LI.!;. " ... yoo;. 2\10'. S. 00"";<0. 2\IOIl
,.«!
Figure5.14: Catbond issues since 1994 Figure 5.14 gives an overview of the n.s vo1umes and transacti.on numbers issued since 1994. After a phase of steady growth, the volume reached im peak in 2007. A total of 159 transacti.ons were placed into the capital markct with a volume of USO 26.1 bn. Appendix I contains transaction details of the several issues. Similar to other securities, a cat bond is structured to pay a regular coupon, usuaIly
CHAP1ER. 5. INSURANCE LINKED SECURlTlBS
118
a :Iixed spread over the interbank offered rates as compensation ror the risk taken. The documentation specifies catastrophe trigger events which, if occurred, allow the insur-
ance company tu use thc procccds cf thc band issuc tu cover losscs rcsulting from thc exposures with poIicyholder a:ffected by the camst.rophe.34
I
p,.",I.m
p"",
~---' . p ... ..,i"",
_I."......" ' 01"~. 11")"'<"' ...,,,,
r--------,
,"j
S PK \'
I
"0''''
"0'
'0"
~ <0"'"' i
!.."
1'&1
c. ",.. , \I",~
In....'I<...
So"=: Culp. Chri'topl>c,. The ART of Ri" Mon.genlen!. Wilc) . Ne" Vor,. 2001 p.
~68
Figure 5.15: Simplified structure ofacatbond
The typical cat bond structure is describcd in figure 5.15. A SPRV is created for the only purpose to reinsure the exactly defined risk and to isme the securities. The SPRV closes a reinsurance agrcement with thc sponsoring insurer/reinsurer. The prococ:ds from the issue are paid inm a collateral trust or cash account. The interest payment of the coUateral can be fixed or floating with several interest payment dates. The proceeds arc swapped with an extemal counterpart: into the ftoating rate! necessary tu meet the timely interest payment of the investors holding the different classes ofbonds. The total rctum 5W8p counterpart, usually a higbly ratcd bank, 5CCUIeS thc paymcnt of principal and interest to investms and the payment to the sponsor in case of a catastrophe triggering the structure. Payments are &eeured no matter what the value of the securities in the collateral tru!rt may be. If no trigger event occurs, the note holdeLs get the sprcad and the principal at the repayment date. If a Ioss event occurs, the SPRV covers the losse8 MShahand I'icoDI= [see 09.02.2007, p. 7]
5.3. NON-LIFE INSURANCE SECURIITSATION
119
of the sponsor, and the investors get the remaining balance of the collateral account in accordance to the seniority of their bonds. 35 Tbe basis for the loss ratings of the agencies is the modeling of los ses. Tbey are supported by modeling firm estimates, principally AIR Worldwide, EQECAT and Risk Management Solutions. Tbe probability of a first dollar loss, the probability of a full exhaustion of the principal, and the expected 10s8 are taken into consideration. The probability of the events is referred to as once-in-IOO-years or once-in-250-years events, meaning they have a 0.01 %, or respectively 0.004% chance to occur during a calendar year. Tbe pay-off triggers of the catastrophe bonds are normally set sufficiently bigh to limit the probability of a bond being triggered. 36 Regarding the loss triggers, four types can be distinguished: 37 Indemnity triggers have been used since the emergence of n...s transactions and are 1in1red to the insurance cornpany's portfolio. Tbe catastrophe bonds are stroctured to benefit from an excess-of-loss coverage comparable to a standard reinsurance contract. When the los ses exceed a certain volume, the proceeds of the cat bonds are used to cover the claims payments. Tbe rating agencies take the modeled default probabilities of the attachment point and the exhaustion point into consideration. Forther, the expected loss for the policy holder is estimated. Tbe result is the basis for the ratings to be assigned for the several tranches. Tbe insurer does not depend on the solvability of the reinsurer, since the proceeds of the bond issue are kept in the collateral. From bis point of view it has to be taken into consideration, however, !hat, like in traditionaI reinsurance, between the occurrence of the event and the payment of the claims it can tske months for the darnage to be evaluated. From the investor's perspective, indemrtity triggers give rise to moral hazard risks. Since they depend on the insurer's book ofbusiness, he may loosen the underwtiting standards and loss control features. To avoid the negative developm.ents, the underwriting standards are usually disc10sed to the investor, and the insurer takes a portion of the lasses as retention. Industry loss triggers were an important step to open the transfer of reinsurance risk to the capital markets. Tbe cat bond losses are determined with reference to a loss index and are not based on the company's loss experience. For the US hurricane related issues, the US Property Claims Services Index (PCS Index) is often used as a reference. Tbe structures determine a series of index levels, representing the losses occurred as trigger events for the several tranches. The loss development is transparent, and investors are able to calcuiate the correlation of the bonds with other financial products. Tbe sponsor, however, has to take some basis risk: While indemrtity triggers are closely related to bis portfollo, indices can be influenced by losses which occur in areas where he is not even writing business. Parametrie index triggers use measured parameters lik.e wind speeds or the earthquake intensity of the relevant catastrophe event to trigger the payments. Tbey are used 3SCUlp [see 2002, pp. 470-471] 36Shah andPicone [see 09.02.2007, p. 8] 37Shah andPicone [see 09.02.2007, p. 9-15]
CHAP1ER 5. INSURANCE LINKED SECURITIES
120
e.g. for European windstonn coverage and Japanese earthquake related bonds. In both areas, industry loss indices do not yel exist. The benefit for the sponsor is !hat he does not have to diselose his portfolio. For the investor the risk is easier to quantify, and the securities get More liquid and tradeahle.
Modeled /oss triggers are used for synthetic portfolios of asseIs exposed to different hazardous events, such as earthquakes and windstorms in different regions of the world. Tbe synthetic portfolio is a virtual pool reflecting the existing portfolio of the sponsor. It can stay static, or the sponsor may have the discretion to reset the portfolio during the
lifetime of the securitisation. 38 Catastrophe bonds have experienced a slow, but steady growth during recent years.
From the sponsor's perspective, they affer similar risk. mitigation features as reinsurance. The exposure to peak risk is reduced similar to an excess-of-Ioss cover. Unlike reinsurance, they are set up for a multi-year period and provide known cost during the reinsuranee cycles. Tbe exposure is backed by collatera1, and therefore the trigger events are elearly defined. Payment has to be provided without any objections. Tbe investor base can be diversified - cat bonds today are bougbt by a variety of investors who get increasingly interested in the non-correlated diversification of their investments. Tbe challenges are the relatively higb costs of the structores and the quantification for catastrophe bonds with non-indemuity triggers. Althougb insurers and reinsurers have suffered substantial los ses, only one catastrophe bond issue, Kamp Re, was triggered after hurricane Katrina 39 Appendix J shows statistics with reference to the ILS market: As per end of 2008, the outstanding volume of ILS was at USD 11.8 bn. Tbe higb share of ILS with indemnity triggers compared to total volumes issued, changed in !ine with the needs of the sponsors and investors' appetite. In the past three years, the trend seems to move back to indemuity triggers. Further, mnltiple-trigger structures were placed. Wind and earthquake risk dominated the market in the early years. Tbe market subsequently has been moving into multi-peril structures and a variety ofnew perils and geographie loeations. Two thirds of the capacity have been provided by US and Bermudan investors. Tbe strongest year in tenns of capacity since the introduction of ILS was 2007 with a share of 30% of total volurne provided, followed by 2006 with 18% and 2008 with 10%.
5.3.2
Non-catastrophic insurance securitisation
Tbe !wo types of non-catastruphic insuranee securitisation described below emerged in late 2005 with underlying portfolios characterised by higb-frequencyllow-severity risks. 38 see also chapter 5.4.2 about catastrophe bond CDOs 39Lathuillerie et al. [see 06.12.2006. p. 9-15]
5.3. NON-LIFB INSURANCE SECURlTlSATlON
121
Motor inmrance securitisation AXA securitised through the FCC Spare transaction the risk of three million primary auto insurance contracts underwritten in France. The motor book. is covered by a senior deposit of EUR 200 mln paid to AXA, under a 85% quota share agreement with the SPRV Nexgen Re Lid. The FCC Spare structure supports the losses above a pre-defined yearly loss ratio trigger threshold, while the loss ratio is defined as eligible claims over eamed premiums. Losses are covered up 10 the USD 200 mln deposit. The cover has bcen agrecd for four consecutive. but independent years - Fitch annually sets out the trigger level based on the loss expectations ofthe years befure (see figure 5.16).
Quola Sh.rt ,~
_
_
A_
Tr~' I )·
_
Sal. of Rt
_
"'01. Pla •• n'tnl
_
,~
f.1 M 100 ..I. d< po-i'
Fec SPA RC AA,\ "'01••
_.
A ...... ~
RRR_ "'61tS
Bascd on:
npil.1
r,
,,
E
....
I-"Ihuillori<. Frnnz. Insurnnce Securilisalion _ Co",ing nf Ag<. Fileh !lalings. I.o ndon. 06.06.2006. p. 7
Figurc 5.16: Simplified structurc ofthe AXA securitisation SPARe The transaction has the following features: AB a Frencb. legal structurc "Fonds Commun de Cr6ance", Fee Spare is not allowed to write reinsurance cover - the reinsurance therefore was provided by thc reinsurance company Nexgen Re Ltd. The natural catastrophe components like hall, snow, wind, and also war were excluded. The maximum individualloss was capped at BUR 5 mln to ßatten thc loss deviation expoctation. The transaction locks in the reinsurance costs for a number of years and prot.ects
AXA from an unexpocted rise of claims. The cost of capital benefits depend on the transaction cxpenses and the amount of capital the regulators allow 10 release. The structure needs a sophisticated management reporting and budgeting process of the
CHAP1ER 5. INSURANCE LINKED SECURITIES
122
eeding insurance eompany. It depends on effeetive claims processing, reserving, and the availability of sufficient bistorica1 data. The risk of moral hazard is inherent.40
Credit risk securitisation Through their transactioo Crystal Credit, Swiss Re securitised BUR 252 mIn of reinsured trade receivables. The holders of the notes listed in Table 5.3 are exposed to losses if claims within the three underwriting years reach the attachment level of BUR 666 mIn, a figure wbieh takes bistorically experieneed losses sinee 1984 into eonsider-
ation. Swiss Re covered the risk of an unexpected increase of c1aims-frequency due 10 an economie downtum. Credit insurance provides the seiler with protection if the buyer of bis goods or services defaults or fails to pay. It usually covers a short period of time, and the seiler retains a share of 10-20% of the losses as retention. Swiss Re provides reinsurance for the portfolios of credit insurance companies and in retum gets premium income. The diversified portfolio in terms of geography (mainly eustomers based in different countries of the BU) and industry sectors is constantly revolving. Class
A B C
Volume EURI08mln EUR81mln EUR63mln
Maturity
12f2008 12f2008 12f2008
Attach I n _
Legal
ment
FlDaI
PoInt 810 729 666
3m1l+nwgin 3m1l+nwgin 3mE+margin
0612012 0612012 0612012
S&Ps
BBBBB B
1 3mE+2Obp means 3 month European Interbank offered rate; the margin will reduce if the transaction cxtends beyond expcctcd maturity Source:
Josefs, MaIen ct al., Presa1e: Crystal Credit, Standard &Poor's, London, 19.12.2005
Table 5.4: Crystal Credit - tranche structore The structure ofthe transactioo is shown in figure 5.17. Swiss Re seeures a portfolio of
reinsurance receivables through an excess-of-Ioss retrocession agreement with Crystal Credit Lid, arestricted Class-B insurer registered on the Cayman Islaods. Swiss Re obtains an exeess-of-loss protection of BUR 252 mIn and is obliged to retain a minimum of 10% of the aggregated losses retroceded under the agreement. The retention will inerease with future premium growth. The note holders are exposed to a reduced eapital repayment if the underwriting losses during the three years of the lifetime of the transaction exeeed BUR 666 m1n. The reduction would effeet the junior C notes first. The notes are seheduled to mature in December 2008, but Swiss Re has reserved the option to extend the maturity to June 2012 in the ease!hat losses may be expected to exeeed the BUR 666 m1n. This regulation allows Swiss Re to exc1ude existing reinsurance treaties still on risk for the underwriting year 2008 and to determine the los ses. During
""Lathuillerie et 01. [,ee 06.12.2006, p. 6-7[;Jo,efs et a1. [see 18.01.2006]
5.3. NON-LIFB INSURANCE SECURlTlSATlON
123
the extension period, Swiss Re will not be covercd for the underwriting of the year 2009 and beyond. The investors will get a reduced coupon if the facility is extended. Swiss Re will, howevcr. not gct any msUIllllCC premium for the ycars 2006 to 2008 whcn the coupon payment is not continued. When the facility was st:ructured, 96 cremt reinsurance t.reaties were collateralised consisting of EUR 7.8 mln assigned single credit limits resulting in a total protected pool amountofEUR 113.5 bnofwhich44% werenamedand 65% were unnamed. The majority of the treaties with a share of 95% were proportional and the rema;n;ng 5% excess-of-loss.
CoU"",• •
I
",I. and rttl t mphnn
in
.." "".dttl p,O<<
r~ c, >"c .,ccc,,"c;,c,.-,"c.---,
not<.
SPII.V
~~ r=l.".,"'" Capilal
"' ork" Imn'ors
of,"
S",,, 11.. geTS 0110< .. 00 , .. ,""" sl"",nl sa"" ond ,".;",,'" collato,al."" rompenSOIOS for onH'
Source: Culp. Chrislopher. 1l>c AKT ofRisk Management. Wile}. Ne" Yor'. p. 468
Figure 5.17: Crystal cremt risk securitisation Crystal Credit issued DOIes of three cat.cgories and invested the proceed in10 eligible securities under a total :retum swapo The swap agreement, closed with Swiss Re Financial Products Corp as swap counterparty. results in a constant payment of Euribor minus 11 bp at each interest payment date. This payment, 10gether with the retrocession premium. enables Crystal Crcdit 10 pay the coupons of the notes. Each time an invesbnent has to be sold or matures, the swap counterparty pays the positive difference between the purchase price and the redemption or liquidation proceeds. Crystal C:redit will thus dispose of enough funds 10 redeem the notes at maturity or 10 pay claims of Swiss Re under the retroccssion agrement, if necessary. The swap counterparty receives
124
CHAP1ER 5. INSURANCE LINKED SECURITIES
the income out of the investmeots and an eveotual redemptioo or liquidation boous. The notes were placed to a variety of investors in the capital market. They are exposed to a reduced prineipal repayment in case that aggregate losses of a diversified purtfolio of trade receivables exceed the attachment level for the relevant tranche. They were enab1ed to invest in a reinsurance risk they normally cannot get access to. Swiss Re achieved economic, regulatory, and rating capital relief for the securitised ris!<. Compared to traditional retrocession, they do not have to be concemed about the solvability of the retrocessionaire in times of stress. 41
5.4
Insurance related CDOs
5.4.1
Funding eno pools
The first insurance-related funding CDO pool in Europe, called Dekania Europe I, was lanncbed in September 2005. The issue followed the concept used for trust-preferred securities issued by small insurance companies in the USo Dekania was the first transaetion to primarily pool subordinated debt issued by small and medium sized insurers and reinsurers based in Europe.42 The transaction structure of the most recent similar transaction Dekania TI which was closed in August 2007 is described in figure 5.18. In contrast to Dekania I, the second transaetion allows to include debt issued by baoks or real estate companies. Dekania Europe CDO TI, incorporated in Ireland with limited liability, issued the various notes. The subordinared securities purchased are transferred to the collateral manager. The 33 securities, issued by mainly Eoropean insurance holding or banking institutions, constitute the USD 300 mIn purtfolio. HSBC was engaged to protect the note holder's interest by monitoring the performance triggers and collatetal guidelines and to maintain the accounting database. All bonds issued are due in September 2037.43 The structure was highly appreciated by the market, since it opened up an avenue for smaller and mutual insorers to issue subordinated debt. 44 They normally do not have the volume or the credit quality to issue hybrid securities in the capital markets. These issues are debt which, due to its subordination structure, is qualified to be treated as equity by the regulators and the rating ageneies. Further, it would not he economically viable to issue single transactions for the following reasons: Raising of debt through a eno was less time consuming far the management, since they are not required 10 spend time on road shows or to deal with a leogthy due diligence process.45 The costs involved, however, were at the time of the closing of the transaetion higher than for a 41 losers et al. [see 18.01.2006]~osefs et al. [see 19.12.2005, pp. 1-12] 42Josefs ct al. [see 18.01.2006] 43Morlok. [see 02.10.2006] 44see subchapter 6.2.4 for an explanation ofthe subordinated debt structures 45Josefs ct al. [see 18.01.2006]
125
5.4. INSURANCE RELA1ED CDOS
IlSIJC T ,u" •• C I. LId (l'ru,lCe)
.[~I C[)O II 1'I,u;lo:I~)
Target Portfolio
[) .~.ni
EUR 300 mln Subordinated Hybrid Bonds
j CI... <., .~
Ihn~rul
j
j
IM. <·N
IM. <.>1
j
.....
r
15., CI , 35.0'It
fuR 5", (I , l5.0'It
'.,.ong
' '.ong
'.'
'u~
,
'u~
n,
Sou,e.: Morlok Markus cl aL.
U ..
'~ . l'"
Collalcral Man
j
j
j
j
j
' .... e
(IM. D·'
'IM, •
.~
11 .. 'Ul '1.510 CI, I>-O'It (I, 11.l'Io .u~
~
[)e~nnia
Copi,.1 U .C
~
- - - .•- - .• .- .- .-
165", " " 5.0'It
.u~
>I'y R.m~;.
SI' V
Il .~."i.
\Ioß. ~.m. n '
' uR 1", (I,1l.l'Io
.~
.~
11 .. (I ' .......
'u R 1'.510 CI, O'J!o
.u~
~
..
~
Europe CDO IIPIc. Fileh Ralin gs. I.ondon.
02.10.2006. p. 2
Figurc 5.18: Simplified structure ofthe Dekania Europe 11 CDO
comparable bank financing tbrough a subordinated loan or a schuldschein. 46
5.4.2 Cataslrophe bond CDOs Thc transacti.ons cover multiple catastrophc pcrils. Thc qualifying risk cvcnts are dcfined parametric or index-based, and a loss of the principal occms after multiple loss
cvents wcrc expericnccd. In Iune 2007, Brit Insurance covered several catastrophic periIs by the arrangement
of a USD 200 mln CDO with a threc-ycar tenor callcd Fremantle limitcd. Thc loss of principle occurs aftec the fourIh qualifying event. The qualifying events, for European rim dcfincd parametric and for the US rim industry-based, are describcd in 'fable 5.4, wbile the same peril can cause more than ODe trigger cvcnt: Fremant1e, a SPV bascd on the Cayman Islands was formcd 10 issuc the notes. H during the threc ycan after closing of the structure the defined natural catastrophes happen, it will pay to Brit Insurance the relevant amounts of the notes. Thc payment is based on a catastrophe swap contract closed by the two compani.es. The capital collected from the investors is kept in a collateral trust with The Bank: ofNew York: until
46Gohü [see 09.10.2001]
126
CHAP1ER 5. INSURANCE LINKED SECURITIES Region
Zone
I.UK 2. Europe 3. Japan 4. Japan 5. USA 6. USA 7. USA 8. USA 9. USA 10. USA Source:
cxcluding UK
California NcwMadrid Florida only Gulf
EastCoast Bypassing
PeriI UK windstorm European windstorm Japanese typhoon Japanese typhoon Califomia earthquake New Madrid cartbquake Florida hurricane FI.ori.da hurricane Bast Coast hurricane Bypassing hurricane
Thorpe. Donald; Jcbjerg, Lars, Fromantlc Limited Fitch Ratings, London 21.06.2007, p. 1
Table 5.5: Basket of perils covered by Fremantle
a trigger event occurs or the tranches are due for repayment. The risk of the security investments kept in the custodian is secured via a total return swap with ABN Amro as counterpart. HSBC Financial Services (Cayman) Limited acts as administrator for the payments, being Fremantle's principal representative in the Cayman IsIands. The modeling for the transaction was done by Risk Management Solutions.47 Each note c1ass issued covers two lass events. When the industry lasses are subsequently revised downward, note holders will bave the possibility to c1aw back the protection payments. If qualified losses occur, Fremantle will make a digital payout of half of the amount ofthe effected notes perevent (see figure 5.19 for the cash flow and 5.20 for the tranching Structure).48 The sponsor of the cat bond structure benefits from the multi-year protection provided. He is not involved in any credit risk of areinsurer. Catastrophe risks are relatively simple to calculate with established models. Non-indemnity triggers are transparent and can be quickly and accurately determined in terms of losses to the investor. The structure, however, can take much longer for the set-up compared 10 traditionaI reinsurance contracts, and is more costly in times of soft markets. The basis risk remains with the ceding insurer. The structure allows capital market investors, which are comfortable with the CDO structures, to invesl in insurance related risk being geographically and loss-event diversified. Further, the risks are regarded as totally uncorrelated to other capital market products. The transaction is non-binary since the relevant tranches will be liquidated if losses start to accurnulate.49 47Thorpe and Jebjerg [see 21.06.2007]
481borpe and Jebjerg [see 21.06.2007] 49Gohil [see 09.10.2007]
5.4. INSURANCE RELA1ED CDOS
127
I.ibo' _lU bp Tmal
I
, - -_
L_--,-_ _,---_-'
I
. opi .. 1 "" <><,drtl I",,,,"
I
• i"rom.
cu,l""i.1 >
1I.~lurn
S.... p
Counl.rPllr. o
. . ,h 1\0.."
r----:c::-----, SPV
not<>
Fr.manllrl.l d.
,<.."io" '---'-----'-'---'---,--'
""m,"",
I
~~.",,,,
no",
I'& I~ F"--'" Capi,.1 ~ br~ •• •
ABN Am,o
hc~g«I
,hc ",ue,'s .'f'OOutO ,othc asS
.,"'''''" ' b) w"r of. 'otal .. ,run swap PO)''"B Libor mmuS 10 b.,,, .. <JIOWopt>e." ap a&r
10 , ..10n!
po'""
Bas.cd on : Toorpr. Donald cl aL F.. mal1llc Limilcd. Fileh Rat ings, London, 2 1,(16,2007, p, 2
Figure 5.19: Simplified structurc cf the Frmnant1e enD
5.4.3 Relnsurance recelvable CDO. The receivables of an insurance company. resulting from contracts with its rcinsurers. can form a significant part cf its assets. The insurer is exposed to extensive credit risk from the reinsurer's potential failure 10 pay claims. The credit risk can be removed through securitisation. In January 2007, Hannover Re came to the market with the enD sbucture McrIin, a EUR 95 mIn issue cf credit-Iinked ßoating rate notes. The transaction was the first synthetic CDO cf insurance entities rated by Standard & Poor's. The noteholders sold protecti.on on a portfolio of 100 reference entities wholly or partly operating in the insurance and reinsurance sector. Reinsurance companies bad a participation cf 48.4% cf the initial. portfolio, fo11owed by non-Iife insurance companies with 38.1% and life insurance companies with 13.5%. The majority cfthe companies are based in the USA (66%), followcd by Germany and the UK with 10% cach, and Bermuda with 7%. The remaining 7% are split among Japan and West European locations. The companies ratcd AA- or hettcr bad a share of 55%, whilc furthcr 43% are ratcd A- upwards. and the remaining 2% are rat.ed investment grade. The transaction is shownin figure 5.21 and was st:ructurcd as follows: Malin issued notes which are credit-linked 10 the performance of the EUR 1 bn portfolio of reference
CHAP1ER. 5. INSURANCE LINKED SECURlTlBS
128
-
I~)"
hent 7
I SI> 30 ",In
1.0" hcm6
l SI) 30 mln
" rotee,cd E\"CIII
CI." B
Loss hem 5 LS n JO mln
Un l,rotected I.M" [ wn! 2
[>,cut
Lo<s EWnl I
So uree: lhorpe . [)onald 01 al .. F",manlle Limit"cl. rilch Ratings. London. 21.06.2007. p. 2
Figure 5.20: Tranching struct\n'c cf the Frcmant1e enD
entities reßecting Hannover Re's credit exposure 10 insurance and reinsurance counteIparties. At closing, the note proceeds were investcd into a guarantred-investmentcontract. This contract with a highly rated bank: secured the timely payment of interest
and principal of the notcs, wbile the note holders are insulated from the risk of the bank's default. Hannover Re then closed a credit-default-swap with Merlin. Merlin sold to Hannover Re protoctiOll on the portfolio fur lasses exceoding the tbreshold amount of BUR 60 mln and up 10 BUR 155 mln. The CDS premium is paid quanerly by Hannover Re to Merlin. A credit event occmred has to be confirmed by an independent verification agent and is linked to the bankruptcy, insolvency, or inabili.ty of a reference entity tu pay its reinsurance obligations. The loss would then immediately be calculated as 65%
of the notionat amount of exposure.so Through Merlin. Hannover Re was able 10 transfer its crodit risk exposure 10 wurance and reinsurance compames into the capital markets. The product is very flexible. Since reinsurance cont:racts nm for a period of 364 days only. Hannover Re has agreed the right to replcnish names once a year. Therc are certain criteria tu be met, e.g. the maximum national amount per reference enti:ty er group cf 5% of the portfolio and a
3Oo-iagnuolo etaL [see29.01.2007]
12.
5.4. INSURANCE RELA1ED CDOS
~ ,f",ntt
"o. lf.. I."
j j j ,bi..,
H.. nO'.r~ . (S''''p 'oun"'I""~·1 L _ __ _ _ _--l
sr\'
...i .. ,
,\ I.rlin C OO 1
,.,
II.\'.
p.... i ...,
i".... '
Base
~Icrlin
I<>.i,,'
1'·,.. 0." " 1·-
1'·'. . n ." H 1·_· ~ I , .,.. no .. , I· . , I'·'. . n ... u 1·-·
CDO I ILV .. Sla,ldartl &. I'oor' s.
FlgUlC 5.21: Structureofthe Merlin COO minimum Standard & Paar's insurer financial strength rating ofBBB-.
1 Legal maturity 6 yemI wilh fint call1bte Ifter 3 yeIIB
Guadapuolo, Lapo, et al., Merlin CDO I B.Y., Stmdan!. and Pom's, LondoD, 29.01.2007
'fable 5.6: 'Ihmche structure er the Merlin CDO The structure further has to pass the Standard & Paar's evaluation test in order to maintain the original ratings. The investors were offered a rare opporbmity to invest in a reference portfulio of insurance and reinsurance assets. Most of the debt was owed by small counterparties,
130
CHAP1ER 5. INSURANCE LINKED SECURITIES
in most cases not publicly traded. 111ere was no CDS protection for the names available in the capital marke!. Hannover Re agreed to take tbe first loss part on tbe portfolio. 111e credit events were clearly defined as failure to pay and !berefore narrower as tbe usual ISDA tanguage. 111e interest payments on tbe notes are generated by tbe investment income and tbe up-front premium payment by Hannover Re.
5.4.4
Summary and evaluation of non-life ILS
Non-life n...S offcr non-insurance related investors alternatives to diversify into new areas. Cataslrophe bonds offer collatera1ised multi-year protection for adverse loss developments. Non-cataslrophe ILS are a further mutation. AIthough volumes have not been picking up yet due to the high administrative burdens and cost, the products are being recognised. and their attractiveness may increase after the introduction of Solvency 2. CDOs use structured linance techniques. Funding CDOs enable investors to participate in capital-like investments into the insurancelreinsurance sector. Catastrophe bond CDOs combine exposures to several perils aud geographic regions. 111e traucbing of the transactions offers the potential to choose between a participation in higher or lower risks in terms of attachments points and exhaustion probabilities. Reinsurance receivable CDOs offer avenues for investors who otberwise would not be able to participate in the markets, and sponsors may secure medium term linancing. Table 5.6 shows the main characteristics ofthe several non-life insurance securitisation types. Total USD volumes and number of trausactions until end of 2008 are listed in tbe headlines.
Catastrophe Bonds 25,434.8 (156)
indemnity, industry lass, modeled los8, parametric credit like with traditional reinsurance, if indemnity based, athers not qualified for a mluction (US)
Triggers
full credit u indemnity b..oo, othen not qualified fot a mluction (US)
like normal reinprotection: s=e
depends on the level of basis risk (parametric: Iike nonna1 reinsurance protection I parametric: modeI ootputs)
RatiDg
e/fect
risk: transfer
risk. transfer
;",uren
suborlang-term dinated capital far
in
compared
investments
weigbting
get risk:
single issues due to 1rBnching funding
with
do
More favourablc
investors
mance triggers not relevant
to
change
remote
collateral and perfor-
banhuptcy SPV
;",..."
credit
industry
risk.-transfer; rn-t-rn gain if sponsor swap liability decIines improved stability
DO regulatory
parametric, lass
coIlatcral
catastrophe swap with SPRV
perlIs
catastrophic
""""aJ
tat markets especiaIly for mutual and small
multi-peril management: protection agamst
Bond
risk
CIlO 665.2 (3)
Catastrophe
diverse lifeInon-life subordinated functing: easier access to capi-
FuDdlngCDO 688.2 (2)
Solvency2)
(may
nrinhna1 release of capital regulatory
Hulemnity
high-frequencyllowseverity risk:; increase of capacity SPRV for a defined block: of businesss collateral possib1e
motor/credit Risk risk management: protecti.on agajnst unexpected rise of
Non-catastropbic 1,128.6 (4)
AcoountiDg
Regu1ato'Y
collatcral
finedrisks
SPRV far exact1y de-
Enbpncem ent
Structure
frequeny/high severity risks; increase of capacity
protection against low
(_008) PeriI natural catastrophes Objectlve risk management:
USDm
Type
portfolio
invest-
stability profit&1oss opmeots
devcl-
of
off-balance risk: transf",
no regulatory credit
10S8
Hulemnity
ment contract
guaranteed
Dotes
against default; funding: transfonnation of illiquid into liquid assets credit-linkcd floating
rem.ure.:
protection
ReinsIll'JUlCe ReeeivableCDO 122.7 (1) re;",unmce risk management:
w
--
~
;
~
~
~
~
1,128.6 (4)
USDm
banks
dedifunds,
short/medium (1.5-4
re-inSlll'8llCC,
manag""', c&red ca!
hedge funds, money
00
tranche
medium-term
modenlte modenlte
multiple bond issuers
high high single cedent {single contract
not relevant
multiple cendents I multiple contracts
high high
nooe
long term (30 years)
nooe
(4
uumag"'"
(3
hedge funds. money
Ubor -Kl.7% - 7.0% depending on tranche ruk AAAtoBB-
yems)
tenn
banks. money manag"'"
Libor +0.2% - 1.5% depending on tranchc risk AAAtoBBB
nated issues
interest on subordi-
y""")
medium
!und" managers, re-insurance, banks
hedge money
risk AAAtoBBB-
c1cpencling
prefee" rating agency fees, third party advisors. ammg... Ubor -Kl.15% - 3.4%
<eimunmce mium, legal
lsingle cootracts
sing1c cedent
modenIte
high
nooe
yems)
medium-term
ag=
(5
bankst money man-
Ubor -Kl.5% - 2.5% depending 00 tranche risk BBB- toB
Reinsnrance ReeeivableCDO 122.7 (1) premium foc CDS protection
Table 5.8: Non-Life insurance securitisation types: summary and evaluation of characteristics
/single contract
risk C....,miaotim Cmnplexity low PartIes single cedent
mo_
yems) Counterparty none
Term
Issoe ratlDgs Investon
Investor Yre1dp.a.
rating agency fees, third party advisors, arrangen Libor +3.0% - 11.5% depending 00 tranche ruk BB+toB-
<eimunmce mium. legal
665.2 (3)
lIcmd
rctrocession premium
Catastrophe CDO
c-
FuDdlngCDO 688.2 (2)
(_0")
pmfces,
Non-catastrophic
Catastrophe Bonds
25,434.8 (156)
Type
~
I
~
~
~
~
i
ld
Chapter6
The Perspectives of the Stakeholders 6.1 6.1.1
Accountants and regulators The global approach to standardisation
Driven by the globalisation of the insurance sector and the eapital markets, there bas been a significant effort to improve and harmonise insurance regulation among the variDUS continents and countries. Standardisation helps to reduce barriers of trade and establisb eertain international aecounting and regulatory frameworks that eould inerease the confidence in accounting and supervision. 1 Mter a series of restatements of eamings, reva1uations of accounting fraud, and other corporate seandals in 2002/03 - both in the US (e.g. Worldcom and Enron) and Europe (e.g. Parmalat) - the trust of the publie eonfidence in financial reporting was undermined. Investors, rating ageneies, analysts and regulators were pressing for accounting standards which more accurately re:H.ect the economic nature of the business, smeter eorporate govemance and greater transparency.' The increasing amount and heigbtened complexity of risks whieh became obvious through the scandals and natura1 eatastrophes has eaused a necessary transformation in the environment of the insurance seetor. In respect of insurance accounting, the responsible International Aecounting Standards Board (IASB) started areform of the International Financial and Reporting Standards (IFRS) in two pbases. The first phase in the adaptation of the accounting rules bas been operational since 2005, and the second phase is expected to be implemented around 2012. Figure 6.1 shows the time frame of the combined reforms IFRS and Solveney 2. The IFRS reform has the objective to offer lIAA [see 2004, p. iv] 2SwissRe [see 02.11.2004, p. iv]
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_6, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
134
a better view of all compani.es, parti.cularly with regard to the rillks they run. Whilc IFRS in principle lock at the contracts an insurer writes, Solvency 2 delivers the principles far an intcgra1cd risk approach taking into account thc mies an insumr is facing. Security for the rists taten has to be held in the form of solvency capital.3 Although the scope of the twin framework differs and both reforms serve fundamentally different purposes, they have in common that they move the market to a more economic basis of eval.uation and disclosure. Extensive disclosure cf risk and capital management will expose insurance to ever-greater market scrutiny. The implications include fundamental changes to the measurement of insurance liabilities.4
I'- RS I'hase 11
•
I"s"",ncc sl.ndanl publishcd
2007
"'"
20118
QI S 4
2010
2011
2012
\10'" QI S?
Dr.n frnmcwor' din:cl;"c publishcd
•
Soh'cnc}' 2
•
Figure 6.1: T':uneframe of the IFRS accounting I EU supervisory refonns
6.1.2 International Financial ReporIiDg Standards Since the insurance business by its nature is highly complex, it has been a challenging task far the many parties involved to establish a specific framework far insurance-
relatod accounting (see figure 6.2 fOt' the main organisations involvod). 'EDHEC [_ 2006, p. 11] 4McLarmand etal. [_ 2006, P. 13]
6.1. ACCOUNTANTS AND REGUlATORS
135
IFRS Phase I laid down Ihe revised accounting rules for insurance companies wilh the main changes as follows: 5
• Disclosure of a substantial amount of additional information on their insurance contracts in Iheir annual reports, e.g. sensitivity of profits to changes in underly-
ing assumptions; the definition of the insurance contract was altered • Equalisation anti catastrophe reserves, previously used in certainjurisdictions in order to absorb exceptionallosses, were prohibited • Embedded options and guarantees, often used as attachments in life insurance, have to be carried at fair value • Investments hold-to-maturity and fixed income investments are exempted from 1he measurement to fair value
Phase n is concentrating on the remaining issues of insurance accounting. Tbe objective is to transfer the accounting of results of an insurance company to the assetliability approach instead of 1he present cost-based profit and loss approach. Assets and liabilities will have to be accounted for on a discounted fair value basis every quarter. The revenue recoguition is expected to change to a value-in-force approach: Future discounted net present value of the insurance contract issued is accounted for instead of Ihe premium collected and Ihe cost incurred. While in Ihe traditional model premium income and claims are recoguised in Ihe year Ihey occur, 1he new IFRS accounting introduces Ihe fair value (expected present value) of premiurns, claims and costs for new business written. Acquisition cast is recognised in full in the year the business is written - based on the experienced variations on the fair value assumptions, the business in previous years is adjusted. The most irnportant challenge is 1he fair-value treatment of liabilities (includiug Ihe value of options and guarantees). Since Ihere is a very limited market for insurance liabilities at present, as a provision it is proposed to add a market-value-margin on top of its estimated fair value.6 The IFRS framework is obligatory for all EU-listed companies, and beyond Ihe EU, Canada and Australia have switched Iheir local GAAPs to IFRS. Furlher, Ihe FASB of Ihe US has eotered into an agreement wilh Ihe IASB to hannonise Ihe US accounting standards wilh IFRS.7 .5SwissRe [see 02.11.2004, p. 3] 'Walhofet 01. [see 01.11.2005. pp. 13-14] 1SwissRe [see 02.11.2004, p. 7]
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
136
lAIS
[ C[ SR
"PRA
[IOSCO
, CFO Forum G~nc'a
ASS
Non-EU Insurance
associalioo. (ACLI. PCI. GN /\ IE. LlAJ) Sou,«;; "CU Ame""an Cooncll or LIre Insurers. "CSB ACOO\Inllng Standards Ik>ard (Canada), "PR,\ AuS-
nah." 1'11.1<1<01001 Rcgul'l<>l) /lud.o",). CFlOrs Comn1l11cr ofEurop lnsurane< aod Oceup.lIonal Pens"," SUf'C,,'isors. CESR Con"nu,,,, of Lu'"",,"" SecuntIeS Regulators. EBr [urpoc.n Ban, ing Federal l"" . •:FRAG [u,,,,,,,an l'on""c,.1 Rcporllng Ad" I>Or) Groop. FEE '-.""rallon.Jes hpcnsComplablcs Luropc<ns. GNAIE (;''''' 1' ofNMh A,n
SUPC"'S<~. IA~U
Int,rn'hO." ""oounH"g Standards II<>ard. IQSCO InlcmiUoQnal
Orga"'sauoo or Sccurn.<s Co.m"""0II5, LI"! LIre InSurance A'SOCi"IIOO cf Japan. !'CI I'rop<; lmpacl of I FRS On thc ,nlu"",",,< ,ndu,,'). SntS;R~. ZUrtch. 2QO.1
Figure 6.2: Organisations involved in the IFRS accounting reforms
6.1.3 Snpervlslon - the
ments of insunmce compani.es. The cunent system. cal1ed Solvency 1 was introduced in the early 1970ies and harmonised for the member states of the EU in 2002. It defines capital requirements by specifying simple. blanket solvency margins. In certain cases, the framework rulcs are risk. insensitive and can conflict with good risk. management since it focuses on underwriting risk. and not market risk. In sorne states like the UK, Demnark/Sweden, Germany and the Nether1ands, reforms of the old Solvency 1 system have already led to more sophisticated solvency models for supervision. Further, stress tests similar to the Swiss model were introduccd in order to lest the solvability of
6.1. ACCOUNTANTS AND REGUlATORS
137
Ihe insurance sector in respect of disastrous developments.' Solvency 2 will hannonise Ihe supervisory systems of Ihe 27 EU member states. Benealh Ihe capital requirement, it will set a three pillar framework for Ihe quantitative reqnirement, 1he qualitative re-
quirements and the market discipline of the insurance and reinsurance sector.9 EU regulators are in constant dialogue wilh Ihe stakeholders of Ihe process. These are Ihe supervisory bodies of Ihe EU membership states and 1heir industry and actuary associations. The EU comntission launched four quantitative impact studies (QIS) which resulted in a permanent discussion between Ihe stakeholders: After QIS 3, Ihe proposal for EU regulatory directive for Solvency was published on July 12th, 2007. Solvency 2 will harmonise 13 existing regulations for the life, non-life insurance, and the reinsurance sector of Ihe EUlO The main regulatory objective, protecting the consumers, means preventing excessive high pricing and opportunistic behaviour. Policyholders face 1he problem of asym-
metrie information and are therefore vulnerable 10 moral hazard or adverse selection of an opportunistic or incompetent insurer. 11 The regulator has to secure the continuing ability of Ihe insurance or reinsurance company to meet its contractual and financial obligations towards its policy holders. '2 The second objective is 10 ensure the stability 0/ the system. The system must be prepared to resist shocks like an econontic crisis or natural catastrophe which may unIeash systentic risk affecting a !arge part of Ihe financial system. The 1hird objective is to ensure the competitive efficiency of the sector. The regulator in charge should ensure and strenglhen efficient comperitive structures, particularly in Ihe areas of public trust and Ihe quality of information. This can be done Ihrough Ihe definition and monitoring of codes of ethics, Ihe stimulation of intemal control mechartisms, and 1he intrnduction of transparency and disclosure rules for fair and stable markets. Pillar 3 of Solvency 2 is airned at reinforcing Ihe market discipline and selfregulation of Ihe market,13
6.1.4
Quantitative assessment by means of PiUar 1
Pillar I of 1he proposed Solvency 2 regirne will regulate Ihe quantitative assessment of Ihe insurers' regulatory capital requirements. The ntinimum capital requirement (MCR) will depend on Ihe size and activities of Ihe insurer and act as Ihe trigger for mandatory supervisory action. The higher solvency capital requirement (SCR) will be Ihe key quantitative assessmenl. It is reqnired to ensure wilh a high degree of confidence, that the insurer is ahle 10 meet bis obligations in case of adverse developments in the 8CEA [see 01.02.2007, p. 4] 9The main elements ofthe framework are described in chapter 2.3.3 IOCommission [see 10.07.2007, p. 4-5] 11Moral hazard and advcrse seloction are dcscribed in chaptcr 6.4.47 12IAA [see 2004, p. 1] 13Bäte et al. [see 2006, p. 59-60]
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
138
12 monfus following the assessment. The basis for the calculation will be a 99.5% confidence level over the one year timeframe for the onderwriting, markel, credit, and operational risks tsken by the insurer. '4 Tbe SCR sball be calculated as to insure that all quantifiable risks to which an insurance or reinsurance company is exposed, are taken into account. It shall cover onexpected losses and at least the following risks:" • Underwriting risk from non-life, life andlar health insurance operations meaning the risk of loss or of adverse change in the value of insurance liabilities due to inadequate pricing and provisioning assumptions • Market risk meaning the risk of 108s or of adverse change in the financial situation, resulting directly or indirectly from ßuctuations in level and volatility of market prices of assets, liabilities and financial instruments
• Credit risk meaning the risk. of lass or of averse change in the financial situa-
tion, resu1ting from fluctuations in the credit standing of issuers of securities, counterparties and any debtors to which insurance and reinsurance undertskings are exposed in the form of coonterparty default risl<, spread risk, or market risk concentrations • Operationa/ risk meaning the risk of loss arising from inadequate or failed interna! processes, or from personnel and systems, from external events (including legal risk, and exc1uding risks arising from strategie decisions as well as reputation risks) • Liquidity risk meaning the risk that the insurance or reinsurance undertaking is onable to rea1ise investments and other assets in order to settle their financial obligations when they fall due
Table 6.1 summarises the key factors of the corrent proposal. Tbe following seetion exp1ains the value at risk method in detail.
6.1.5
Digression: Value at Risk and Expected Shortfall
Challenged by increasing volatilities within the financial markets, the value at risk concept (VaR) was developed in the early 199Oies. It was intended to measure the market risks caused by price vo1atility, but can also be used for credit-, insurance- underwriting, and operational-risk. Tbe concept was first introduced by the investment bank JP Morgan in their internal model Risk Metrics. The banking supervisory authorities in 14CEA and Towers Perrin Tillinghast [see 01.06.2006, p. 3] 15Commission [see 10.07.2007. p. 48]
6.1. ACCOUNTANTS AND REGUlATORS Faetor: (1) Confidence level (2) TIme horizon
(3) Kcy risks ofl08. (4) Risk measure
Source:
139
Currenl Pl'Opo8Ill:
This is proposed to be 99.5% (i.e. a once-in-200-years risk of insolvency) This is proposcd to be one year (Le. over a one-year time horizon assets should be suflicient to cover liabilities up 10 the confidence level. including technical provisions for aIl future losses from business written up 10 the end of the year) Exposure to insurance-underwriting riBk.,:market riBk., credit risk. and operational risk Value at Risk: (VaR), which measures the amount of capital to avoid insolvency at a defined confidcnce level over a defined time horizon
Cantle, Nei1 et al., Implications for Insurers of Solvency II, Milliman, London. 2007. p. 5
Table 6.1: Proposed key capital calculation factors of Solvency 2 many conntties have beeo acknowledging inrental, VaR-based risk management systems as proper standard for Ibe measurement of Ibe overall risk position of financial institutions. 16 Tbe risk of a financial instrument of a portfolio of assets is infIuenced by Ibe fluctuation of its nnderlyings, called risk factars. Examples of risk faetors are single stock prlces, the DAX 1ndex, Ibe 3-monlb LIBOR rate or Ibe USDlEuro exchange rate. Tbe value of a portfolio is a function of Ibe changes of Ibe risk factors over time which cao be described as stochastic processes, which change Ibemselves within stochastic processes. VaR is defined as a quantile of a disttibution desctibing Ibe upper bonnd for the loss incurred by a portfolio of assets (or liabilities). In econontics and finance, VaR is defined as ""The 11UlXimum lass not exceeded within a given probability defined as the confidence level, over a set time period". The time period t5t analysed can either refer to Ibe maximum holding period of an asset or, alternatively, Ibe time period Ibe financial institution requires to liquidate Ibe position. Typical time periods are I day, 10 days, or 1 year. Tbe confidence level C of a statistical variable x is Ibe interval estimate in which Ibe VaR would not be expected to exceed Ibe maximum 10ssP As explained in table 2.5, Ibe SCR nnder Solvency 2 retlecting Ibe VaR for Ibe business of insurance compauies is proposed to be calculated wilb a 99.5% confidence level over a one year time period. VaR is given as a unit of the relevant currency. Assunting an investment portfolio is analysed, Ibe uuit describes a threshold level of lasses not expected to be exceeded within one year, given the defined confidence level. Anolber important factor is the shape of the distribution. Earlier models of risk management which were developed when computers were slow and sophistication was 16Schulte andHorsch [see 2004, p. 214 - 215] 17Schulte andHorsch [see 2004. p. 214 - 215]
140
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
10w as!llllIled that asset returns and loss evcnts were normally distributed. The distribution mathematically is the scenario for a portfolio being defined by speci:fying a value for cach cf its ri.sk:factors. Espc:cially mgarding investment portfolios, howcvcr. history shows that the assumption of a normal distribution is rather not realistic. There is Iimited upside. and the downside can be the experience of severe losses with 10w frequency. The result are skewed distributions with low-frequency, high-severity losses. la The following cxp1anations are bucd on the publications. both IlIIIIICd "Value at Rist", by D-fine19 andPhilippeJorion. 20 The confidence intervaJ cf the stochasti.c variable x is the subset of the variable's range. the intervaJ. attained with a confidence c. The ~mmetrir: confidence interval of the function with the probability density p( x) around the mean Il is defined as follows. while Pisthe distribution function (see figure 6.3):
)'-(1
)1+(1
s urfacc c,
surfar e c,
,,
-00
JI
x Source: Own C,raph
Figure 6.3: Confidencc intcrval cf a stochasti.c variable x
I ct=P(ts-a<x
llMartin [see 29.10.2004, p. 214 - 215] 19Jorion [see 2007, p. 114-108] 20Daitlch [see2OO4, p. 6 -11]
1"+· "-.
p(x)da:
6.1. ACCOUNTANTS AND REGULATORS
141
Sincc the VaR conccntratcs on the loss potential only, the
ODe
sided confidence
interval has to be used:
C:!
~ P(x > a) =
1 - P(x
~ a) =
1- i~ p(x)dx
Value Qc is associated with the quantile or percentile Q with a probability
Co
The
quantile is defined as a cutoff value - the surface to its left represents the given probability c. Therd'ore, the probability that a random. value x is less than, or equal to, Qc is equal to surface c (see figure 6.4):
(a.
P(x ~ Qc) = c {:} Loo p(x)dx = c
p(x)
"al~~_.t_ri,k
Qu.ntil~
Q, ..,
"ith
.unfiMnc~
• • Q<
,
.. i>«trd ,hUrTf.1I (.... ndition.1 So urce:
, ' ~Iu. - .t - ri,k)
x
0"" Grap h
Ft.gUI'e 6.4: Value-at-risk surface of the l08S distribution function
Thus the pen:entile is the "inverted" cumulative distribution function P
142
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
and the boundary a of a one-sided confidence inrerval is the (I-c) percentile: I - P(x ~ a) a) = 1- c
c'!" P(x > a) = P(x
~
Q,-c = P- 1 (1_ c) TbeVaR of the value V caused by a financial instrument or portfolio is the upper bound for the loss which will not be exceeded within a given probability defined above as the confidence level C, over a set tinle period ot: C
I
=
cp!w(W > -VaR(c))
Tbe change of V is denoted by OV. Inslead of P, cp!.V denotes the cumulative probability function of the random variable OV - more explicitly:
c'!" 1- cp!w(oV ~ -VaR(c)) =
j
-V"R(C)
1- _~
pdJ.v(x)dx
Where Pd/w(x) denotes the probability density function of the random variable
W. Tbe negative VaR is therefore the (1 - c) percentile ofthe distribution of OV:
VaR(c) = _Q~~~v = -cp!w -1(1_ c) Tbe VaR is defined by the probability distribution of OV and not by the probability distribution of the relevant risk factors. If this distribution is standard nOmull, its quantiles can be taken from statistical tables which report:
c
= prob(x ~ -00) =
j
Qo
_~ iI?(x)dx
One of the main weaknesses of the VaR is !hat, even if the institution can calculate the maximum level of lass, this does not give any information how severe in tenns of the relevant currency amount the loss may be. Not only the cutoff loss !hat will happen c percent of the tinle, but also the average size of the 10s8 when it exceeds the cut off value has to be known. In order to answer this question "how bad is bad", the expected shortfall (ES) confidence inrerval, also referred to as "conditional value at risk (CVaR) "• "conditionalloss". or "expccted tail loss", was developed. Not only the cut-offloss that will happen within the time frame at the given confidence level, but also the average size of the 1088 when it exceeds the cutoff value has to be found. This gives an es!imate how much the institution could lose ifit is hit beyond the VaR. Tbe expected shortfall ES(X I X < Qc) can be calculated
6.1. ACCOUNTANTS AND REGUlATORS
143
wifu fue following formula:
ES(X I X < Qe) =
f
Qo
xp(x)dx
~-:ii~c-:-:-
f,!~p(x)dx
For a standard normal variable, fue integration of fue equation for 1he expected shortfallieads to fue following formula: -<Pa
ES(X I X < -al = F(-a) Table 6.2 shows fue lower quantiles of fue standardised normal distribution which will be used in fue examp1e below. CODf. Ievel % QuaDtiIe ( a)
ES(X< Source:
a)
'19.'19
'19.50
'19.00
-3.719 -3.959
-2.576 -2.891
-2.326 -2.667
97.50 -1.960 -2.338
95.00
75.00
-1.654 -2.062
.{).674 -1.272
SO.OO -0.000 -0.798
Jorion, Phlippe, Value at Risk, McGraw-Hill, 2007,p. 92
Table 6.2: Lower quantiles if 1he standard normal distribution The lower 1ine of fue table shows fue expected shortfall. The tail of 1he normal distribution decreases at a very fast rate fue higher one gets wifu fue confidence level; fue ratio between fue CVaR and fue VaR approaches I as fue confidence level inereases. The following example is based on fue mefuod described by Jorion: The VaR and ES of a portfolio of 1000 Allianz SE common stocks for a ten day holding period and a 99% confidence level is calculated wifuin fue steps explained in figure 6.5. The data of fue sampie is based on 1he elosing price levels reported by fue information system Bloomberg. The distribution is assumed to be standard normal as shown in figure 6.6: 21 First, fue position has to be valued at market prices (as per 02.01.2008). Opening Value EUR 147.97 x 1.000 shares = EUR 147,970
Second, 1he variahility of fue risk factor (fue stock price volatility) has to be calculated. The mean and fue standard deviation have to be evaluated. The Allianz SE stock was EUR 157.66, and fue standard deviation for fue 225 trading days of1he year 2007 was EUR 10.92.
u=
VL (I-' - x)2 In =
EU R 10.92
== 6.92%
Third, fue time horizon for fue holding period has to be set: 10 trading days (time is measured in terms of trading days), since volatility arises More unifonnly over trading 21Jorion [see 2007,p. 107-108]
144
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
I Mari;
2 Moas"",
""''''on 10m"",,.,
,-,,,"M I')
,
or ",I. (""IOn
~,
,,,,,ruk,,,,<
S
""n"",
10,-01
"'"
~" O
'1.1""
Val""
11..""" pol<"""
4Sct
UnI<
'1.1""
~
~
• .....
~
...
~
--- --- ----
TI"'" Soutee:
Jorion.I'~;I;ppc.
1101''''''
Valu<: a, Kisl.
\
J
IOd"~s
-.
~kGr'."
I",
"hI Ilo"m.
I!ill. Ne\\' Vor\:. 2007. p. 107
Figure 6.5: Steps to evaluate the YaR I ES
days than calender days. The adju!llment for time is cxpressed in tenns of the square 10 days for 2 trading weeks. divided by 252, which is usually the number of trading days per tuIIlUIIl. Fourth, the worst loss by processing all the prcceding information is reported as the VaR (for the quantile factor see table 6.2).
root of the number of days;
Value x st.deviation x time x quantile factor = VaR EUR 147,970 x 6.92% x JlO/252 x -2,326 = BUR 4,727
Ftfth. the ES. the expected 1085 in case of the 1085 event, is estimatcd (for the expected shortfall value see table 2.6):
VaIue
x st.deviation x time x ES factor x y'lO/252 x -2.667
BUR 147,970 x 6.92%
= ES (CVaR) = BUR 5.443
6.1. ACCOUNTANTS AND REGULATORS
p(x)
"al~~ _. t _ ri,k
,,
t
145
- _ .:U R ~.73
o
,
x
11 = EUR 10.92
.... nditi .. n. 1 '·alu ..... t_ris k - _ EUR S.44 SO~rce:
0" n Graph
Figure 6.6: VaR and ES per Allianz SE stock
Value of risk types Depending on the usage, different types of VaR can be categorised: The 1IIIlTh!t VaR measures the price changes of a financial instrument (as explained with the share price example above), wbile the credit VaR measures the default risk cf an investment. In contra!lt to the market VaR. cremt VaR focuses on langer time horizons, mch as the one year proposed by Solvency 2. This is important if the insurance company mvem in illiquid assets.
When the risks are regarded on an enterprise level, it is not sufficient to know the aggregated VaR or ES figures of the assets and Iiabilitics. In order to get thc shape cf the risk profile, the contribution of the individual instrument to the overall VaR has to be quantified. A portfolio manager, far instance, might like to know how much the removement of a single exposure may change the VaR of bis portfolio. 22
UFe1~et aL [see 2005, pp.
372-373]
146
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
Value of risk concepts Jorion suggests three re1ated concepts: The marginal VaR quantifies the change in the portfolio VaR driven by a small change (one USD) in the exposure to a given uoderlying. The meTernental VaR quantifies how the portfolio VaR changes due to a specific position - it takes the non-linear change of the VaR into account. The component VaR is the result of the marginal VaRs multiplied by the real exposures in the portfolio. The component VaRs sum up to the portfolio VaR.23 Value of risk models Among the several stochastic modeling concepts to calculate the VaR available, three main types can be cIassified: 24 Analytical models use theoretically fouoded distributions. As expIained in the example above, they ideally use the standard normal distribution which enahles the user to define the standard deviation u and the expected value fJ, for the relevant risk factors. The calculation leads to the expected value of the assel infiuenced by the risk factors. Historical simulation models can either be based on the actual development of the
value of assets or compute a simulation of the relevant risk factors. The model is based on the opinion !hat risk factors and correlations e.g. for a stock price are included in the price development. In order to evaluate the VaR of a stock position, the positive and negative changes of the daily prices of the recent 1.000 days are plotted on a graph. To see the VaR of a 95% confidenee level, the value ofEUR 2.81 at position 950 offigure 6.7 showing the historic stock prices is laken as an estimate. Mante Carlo simulation models assume a functional dependence between the asset values and the risk factors. For the conceivable developments of the risk factors, a random generator estahlishes distributions. The structure of the distributions may neither be normal nor based on historical data. The generated x random values for the risk factors lead through the basic cohesion to x conceivable values of the assets. The generated values are sotted by size, and the VaR for the relevant confidence level can be determined in accordanee to the historical simulation by taking the value at the relevant confidence position. Strengths and weaknesses of VaR and ES VaRlES are among the most popular risk measures. The strength of the VaRlES method is that it can be used for a variety of risk types financial institutions have to take. It is easy to communicate extemally and intemally. The danger using VaRIES is !hat they may give a false impression of accuracy, sinee the models depend primarily on the calibration of the risk measure with respeet to the !wo parameters time horiwn and confidence level. They give approximations of risk. 23Jorion [see 2007, pp. 166-179] 24 Schulte and Horsch [see 2004. pp. 216-227]
6.1. ACCOUNTANTS AND REGULATORS
,•
, •
<
147
___J
.
J.,i~
olM S2J
~7
~I
6.l9
~9'l
,~_\
5U 571 929 987
.,
Thc 95% VaR ist dl'fincd
a~
the loss valul' 31 da!.1 ooint 50 or LOOO
Source: O, ... n Graph bascd on data providcd by ßloombcrg Financc LI'.
Figure 6.7: Historical simulation of the Allianz SE stock
Traders may try to arbitrage the VaR system by moving into markets or securi.ties that appear to have low risk for the wrang reasons. The statistica1 accmacy of the risk estimate of historical simulation depends on the available observation points. Historical simulation my create the problem that, if the window is very short, 9:treme price changes within days can create a VaR measure of risk that is predictably lower or higher than the true or implied risk.25 In order to achieve the same statistical significance, the length of the sample pcriod and thus the amount of historical observation points needed must increase in proportion with the time horizon. To compute a l-day VaR for a stock price with a 99% confidencc level 250 observations points are necessary. Ifthe time horizon is changed to 10 days, 2,500 observations are nccessary in order to get the same level of significance. Thus, l-year VaR calculation already needs parametrie models like Monte Carlo in order to get around the data problem (especially regarding the fact that no historical data may be available to measure the relationship between several risk factars). The VaR measure is non-coherent. Coherence enmres that, the greater the risk, the greater the risk measure must be. A central characteristic is mb-additivity, which does
1!IJorion [see2007, pp. SS2-5S3j
148
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
not hold for VaR: It is possible Ihat VaRA+B > VaRA + VaRB. This violates Ihe principle of diversification staring lhat risk decreases wilh diversification. The ES, in contrast, is a coherent risk. measure - it gives an estimate about the significance aflasses if they arise within the time period and confidence level. However, Ihe most severe problem may be 1he implementation in practice. To acbieve Ihe applicable level of sigrtificance, ES requires a much larger data sampie 1han VaR. 26
6.1.6
EU-hannonisation effects in respect or ILS
Oue to Ihe 1ack ofharmonisation wilhin Ihe regulatory framework, differences regarding Ihe development of insurance linked securitisation among Ihe single EU member states can be observed. The supportive regulatory, accoontiog, and lax environments of Ihe UK, Ireland, and Ihe Nelherlaods have helped Iheir fioancial centers to dominste Ihe
innovation process. '2:l While Ihe foll specification and final implementation of Solvency 2 is not expected to take place before 2012, Ihe EU Parliament on JOlle 71h, 2005 approved Ihe Reinsurance Directive as a first step to harmonise Ihe locallegislations of 1he membersbip
states. The directive is an interim measure in order 10 harmonise the regulation of the reinsurance industry, and Ihe states were obliged to implement Ihe appropriate regulations into Iheir nationallaw before Oecember lOIh, 2007. Prior to Ihe Reinsurance Directive, Ihe regulation of reinsurance in 1he EU could at best be desctibed as a patchwork of inconsistent regimes. While in some states like Ihe UK, Finland, Oenmark,
Luxembourg, and Portugal, reinsurers were regulated in the same way as direct insurers, Ihere was no supervision of reinsurance at all in Belgium and Greece. The management of primary insurers was viewed as having sufficient expertise to adequately evaluate 1he financial strenglh of Iheir reinsurance coonterparties. In most of Ihe states, Ihere was DO solvency requirement far reinsurers. In certain EU member states, collateral requirements were in p1ace, wbich obviously Made it obligatory for foreigu reinsurers to provide assets as a collaterai for Iheir liabilities from onderwritiog activities. Oue to 1he lack of simple transformer structures combining lax efficiency, flexible regulatory and prodential reqnirements, insurance structured finance products have been difficult to establish. 28 The key improvement regarding securitisations was lhat Ihe Reinsurance Directive allows member states to establish Insurance Special Purpose Vebicles (ISPY). The di-
rective recognises that the ISPV can "... assume risks from insurance or reinsurance undertakings and wbich folly funds its exposure to such risks Ihrough Ihe proceeds of a debt issuance or some o1her financing mechanisms where Ihe repayment rights of Ihe 26Bäte et al. [see 2006, pp. 66-73] 27Klein and Wang [see 2007, p. 53] 28Prebble [see 01.06.2007, pp. 1-29]
6.1. ACCOUNTANTS AND REGUlATORS
149
providers of such debt or ofuer financing mechanisms are subordinated to fue reinsurance obligations of such a vehicle."[Commission, 15.11.2005, p. L323.7] ISPVs have to fund fueir liabilities completely furough fue issuance of an appropriate financial instrornent, e.g. debt. Once 1he funding is in place, fuey have to maintain sufficient assets to cover their liabilities. Regarding the selection of assel investments, fue Reinsurance Directive sets out a "prodent person approach" consisting of a set of principles which firms must apply. Further, the "single passport regime" allows the reinsurers to operate without limitations in the common mark.et, while the responsibility for supervision remains with the horne state. Portfollo transfers among insurance companies and reinsurers were permitted as long as fuey are in !ine wifu fue aufuorisation of fue horne country. Tbe regulation is regarded as 1he basis for fue transfer of run-off bonks between EU jurisdictions. The Reinsurance Directive provides the member states with a framework to be used to establish additional reinsurance capacity. Tbe EU capitaI markets expect a rise in embedded value securitisations, reserves financing, and non-catastrophe risk transfer
securitisations. EU member states have some flexibility in designing fue jurisdiction for fue local ISPVs. Some efforts have been made by 1he member states, especially by fue UK, Ireland, and Germany in order to position fuemselves as fue ideal horne state for 1he ISPVs 29 Since most of fue transactions have been done in fue UK, fue regulation of fue ISPVs shall be explained by fue approach of fue local supervisor FSA having taken fue role as lead counsellor for fue introduction of fue Reinsurance Directive. Wifu 1he introduction of fue Reinsurance Directive, fue FSA has a1ready specified fue regulatory treatment of securitisations: Tbe FSA aufuorises and supervises ISPVsand, subject to fue receipt of a waiver, amounts recoverable from ISPVs may be considered as reinsurance or retrocession in calculating the cedent's solvency margin requirements. Amounts outstanding from an ISPV may be treated as reducing, or inc1uded as assets covering technical provisions. Subject to actoarial principles, fue regulations fuerefore allow fue recognition of an EU-based ISPV for 1he reductions of fue solvency requirements on fue same basis as for reinsurance or retrocession wifu an aufuorised reinsurer. The ISPV further has to be taxed and is obliged to hold a regulatory surplus level as would be required of an insurance company. Tbe supervision is taking place furough fue oversight of fue ceding cornpany, while fue ISPV is treated as reinsurer wifu minimal reporting requirements. On a case-by-case basis, fue FSA examines to what extent risks are mitigated or transferred from 1he cedent to 1he ISPV. Based on fue principle of senior management responsibility, fue FSA checks how risk is managed and whe1her fue risk transfer is genuine and sufficient. Tbe case-by-case approach could, however, create some uncertainty among fue insurers as to how a specific transaction may be treated by fue regulators. 30 29Prebble [see 01.06.2007, pp. 1-29] 30Klein and Wang [see 2007, pp. 4649]
ISO
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
Tbe UK lax aufuorities "Her Majesty's Revenue aud Customs" have introduced a new lax regime for securitisation wifu 1he effect fuat fue ISPV is laxed on fue actual profit it retains under 1he terms of fue arrangement, normally a minimal amount, and not on its profit as determined for accounting purposes. The new regime was modified for ISPVs and took effect for accounting periods begiuning on or after January Ist, 2007. Before fue implementation of 1he new UK lax regime for securltisations, fuere was uncertainty for a number of years about the treatment of interest on nOD-recourse debt SPV issuers of ILS were fuerefore established in More favonrab1e jurisdictions such as Ireland or fue Nefuerlands, even if fuey held UK assets. 31 Example Tbe following example shows fue effects on fue regulatory capital for fue different alter-
natives an insurance company can choose to raise BUR 500 mln of additional capital. Walhof et al. have shown 1he effects wifu a model balance sheet wifu total assets of EUR40 bn (table 6.3) and a model regulatory capital statement (table 6.4) offue insnrance group Friends Provident, one of fue leading life insnrers in Europe. Tbe company at fue time offue calculation was rated A+ by Standard & Poor'S.32 The model compares fom different alternatives: First, the insurer decides to issue additional debt. Second, fue company may issue additional stocks. Third, fue value-inforce securitisation (VIF) aims to strengfuen fue regulatory capital to potentially finance new business !ines. Fourth, fue Deferred Acquisition Cost (DAC) securitisation can be arranged in order to fiuance 1he take-over of anofuer insnrer. Tbe first altemative, issuing perpetua1 subordinated debt, is fully treated by fue regulators as equity. Under normal market conditions, fue costs can be estimated at 250-300 basis points per annum plus additional 25 basis points of commission costs for fue arrangen3ent of1he debt.33 In stressed markets, fue costs can rise to 700-1,000 basis points or even higher. Tbe debt issue has to be subordinated and to fulfiI certain requirements in order to be recognised as regulatory capital.34 Tbe second alternative, issuing equity, is ra1her costly for fue insnrer. Tbe costs for raising EUR 500 m1n equity are estimated at 500 basis points. 3S In times of difficult markets like fue cnrrent capital market crisis, fue costs were estimated at 1500 basis points. Tbe capital raised is treated as regulatory capital. Through fue securitisation of a AAA Floating Rate Note of EUR 500 m1n of fue value-in-force (Alternative ill) or fue deferred acquisition costs (Alternative IV) in form of a AAA 10 year floating rate note, fue costs in times of favourable market conditions like fue period 2003-2007 can be estimated at around 25 basis points plus 125 basis points of ioitial costs including fue mono!ine insurance guarantee and fue interest swap 31Davis [see 2006, pp. 1-4];HMRC [see 2007, pp. 1-6] "Walhofetal. [seeOl.l1.2005,pp. 16-17] 33Data Source: Bloombcrg Fmance L.P. 341be different types of subordinated debt are described in chapter 6.2.4 35erean et al.
[see 20,CJ7,2007. p. 18]
6.1. ACCOUNTANTS AND REGUlATORS Bcfom
.......
151
Afta'
Inv
36.700 2.000
36.700 2.000
100 1.000 200
100 l.S00 200
100
Alternative m VIF Sec. 36.700 2.000 100
1.500
1.500
1.500
200
200
200
1bta1 .......
40.000
40.500
40.500
40.500
40.500
Alternative IV DACSec. 2.000 1.000
40.500
Alternative I DebtIssue
Befme
TechnicaJ. provisions
2.000 1.000
2.000
34.000
34.000
Alternative II Equity Issue 2.500 1.000 34.000
3.000
3.000
3.000
Alternative m VIF Sec. 2.000 1.000 34.000 500 3.000
40.000
40.500
40.500
40.500
DebtIssue
-
SPVloans
Other crediton 1bta1 LIabIIIIHo
Alternative IV DACSec. 36.700 2.000 100
Afta'
Alternative I Llablli... Capital and rescrves Subordinated liabilities
Al.ternativell EqwtylMuo 36.700 2.000
1.500
-
34.000
500 3.000
Source: WaIhof, Pictcr cl al., llic Insurancc Sccuritisation in Europc, Nycmodc R.cscarch Group.
Breukclcn, 2005, p. 16
Table 6.3: Example: Alternatives to raise EUR 500 mln capital
agreement. Due to the transferred risk of future cash fiows, the regulator recognises the amount as 11er-1 regulatory capital, while the accounts under lFRS will recognise the financing as loan. Table 6.4 shows the effects on the capital requirement from the perspective of the regulator: B ....
Afta' Alternative I DebtIssue
Alternative 11 Equity Issue
Alternative m VIFSc:c.
Alternative IV DACSec.
2.000 300 2.300
2.000 300 2.300
2.500 300 2.800
2.000 800 2.800
2.000 300 2.300
700 1.600
700 1.600
700 2.100 500
700 2.100 500
700 1.600
31 ..
31 ..
Capital requirement
Shareho""""""" Other rcgulatOIy capital Thtal available c:apital Capital rcquirement Overall surp].UI capital In=uc in ..
Somce: Walhof, Pi.et:er et al., Life Insurance Securitisation in Europe, Nyemode Resean:h Group, Breuke1en, 2005, p. 16
Table 6.4: Example: Regulatory capital requirement !able Tbe example shows !hat, through the VIF secutitisation alternative, the capital available was increased from EUR 1.6 bn to EUR 2.1 bn (+31 %). Subject to favourable market conditions and the availability of monolioe-wraps, the costs compared to an equity ur
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
152
subordinated debt issue are lower. Further, Ihe sbareholders do not need to be involved in Ihe process. The insurer may increase its future profitability and is able to compete at lower margins. 36
6.1.7
Accounting and supervision in the US
Insurance regulation in Ihe US historically lies wilhin Ihe responsibility of Ihe Federal States. Reinsurers are treated similarly to primary insurance companies. The approach regarding Ihe regulation of Ihe financial condition of insurers has been prescriptive or roles-based, and Ihe market practices are heavily infIuenced by an accounting perspective. A voluminous set of laws, regulations, roIes, and other measures govem insurer's acti.ons. The regulators tend to concentrate on insmers' compliance with the prescriptions. The companies have to deliver two sets of accounts: Th.e statutory accounts are based on Ihe Statntory Accounting Principles (SAP) which are determined by Ihe insurance regulators at state level. Tbe second set of accounts is based on Ihe Generally Accepted Accounting Principles (GAAP) determined by Ihe Federal Accounting Standards Board (FASB). Tbe!wo sets of accounts are ra1her similar, but have some important differences. SAP is intended to determine the liquidation value 0/ an insurer
whereas GAAP is intended 10 measure lhe value of a firm as a gomg cancern. Therefore, SAP does not recognise certain assets, for instance goodwill or franchise values which are recognised by GAAP. As to life insurance contracts SAP requires to bnok all acquisition expenses in Ihe year a policy is written ralher 1han to arnortise Ihese expenses over 1he lifetime of 1he policy. Currently, US insurers are not subject to any requirements to perform intemal risk modeliug - Ihey are not allowed to use it as an optional approach to demonstrate Ihe adequacy of Iheir capital and financial risk management. In 1heir interaction, Ihe regulators have not embraced an enterprise risk management perspective. Tbe full range of risks insurers face in Iheir action is not evaluated - Ihe system classifies underwriting risk, pure marke! risk, asset-liability risk, credit risk, and operational risk only. Tbe regulatory aulhorities do not provide any incentives to evaluate interna! risk modeling, e.g. for Ihe belter management of catastrophe risk. Regarding risk mitigation, regulators grant "credit" for reinsurance and olher forms of risk transfer. Tbe company may Ihen count Ihe payments owed by Ihe reinsurer on claims it has paid as an asset or as a deduction from its liability and decrease estimates for potentiallosses. In doing so, Ihe insurance company can increase Ihe reported earnings on its financial statements. Tbe credited accounting values are reflected in Ihe calculation of 1he surplus and 1he risk based capital requirement The amount of capital needed to meet the risk based capital requirements is lowered. The reinsurer must be authorised; foreign reinsurers are considered to be authorised when they collateralise 1heir liabilities resulting from activities in Ihe USo 36The difficu1ties
monoliners insures are facing at cur:rent are described in chapter 3.3
6.1. ACCOUNTANTS AND REGUlATORS
153
Tbe authorities also credit for 1LS issued through US-regulated entities. Tbe regu-
lators tend to be cautious in accepting cr approving new approaches to risk financing by insnrers of their participation in alternative 1inancing mecbanisms for !he insnred. Transactions involving the traosfer or hedging of risk are not prohibited, but nei-
ther do insurers gain any credit for such transactions. Tbe use of derivatives is c10sely watched and ra!her 1imited by the regulators. 37 38 Regulators impose two types of capita! on insuraoce companies: The fixed minimum capita! requirement is an amount raoging from USO 0.5 mln to USO 6 mln, depending on the individual state regulations, while the mean requirement is USO 2 mln. Apart from this amount, insurers are subject to risk based capita! requirements calculated with a formula developed by !he NAlC. Tbe capita! has to exceed the higher cf the two standards. Tbe application of chosen factors to various accounting values results in the charges for the five components. Tbe charges are summed into seveta! baskets, subject to a covariance adjustment to refiect the independence of certain risks. Tbe formula to calculate the RBC is shown below: 39 • RO: Investments in Affiliates • Rl: Fixed Income Assets (interes! rate and credi! risk) • R2: Equity Assets ("marke! value" risk) • R3: Credit (risk associated with reinsuraoce recoverables) • R4: Loss Reserves (higher charge for adverse loss development) • R5: Premiums (higher charge for high loss ratios and rapid growth)
• RBC = 0.5[RO+ VR,' +R?+R?+R.' +R.'] If the ratio of the Total Adjusted Capita! of an insnrer available to the RBC requirement falls under certain 1imits, the company or regulatory actions shown in table 6.5
are authorised.40 Action Level: Company Action
RegulortO')' Action Authoriaed Control Mandatory Control
TAC/RBC: 200% 150% 100% 50%
Requirement: Company must file plan
Regulator must examine insurer Regulator authorised to seize insurer Regulator requirc:d to seize insurer
Table 6.5: Risk Based Capita! action levels 31K1ein and Wang [see 2007. pp. 6-11] 38GAO [see 2002, p. 23] 39Klein and Wang [see 2007, pp. 6-11] 40Klein and Wang [see 2007. pp. 6-11]
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After the industry faced big losses caused by the Nortbridge Earthquake, Hurricane Andrewand the terror attacks on September 11th, 2001, several efforts have heen made to inerease the capacity of the non-life sector througb securitisations. The US Congress and the US Interna! Revenue Service have identified the problems of capacity sbortages in states exposed to natural cataslrophes like Flotida and Califoroia. A hearing took place before the responsible subcommittee 00 oversigbt and investigations to discuss the following solutions proposed by the supervisory authorities and industry represen-
tatives: 41 NAIC has proposed !wo key accoootiog legislations in order to enable onshore transactions in the USo Protected cell structures allow domestic insurers to segregate certain assets and liabilities. Protected cells could he used by an insurer to hold funds, e.g. raised by issuing catastrophe bonds. The investors back ooly predefined risks under certain contractually-specified circumstances. The protected cell is a subsidiary of the primary insurer and for purposes of state law classified as areinsurer. Similar to rein-
surance, where the creditors of an insurer in default have Da claim against the reinsurer (ooless a indernnity-based trigger event happened), the general creditors of a bankrupt insurer are not able to claim against assets of the protected cello Creditors of the protected cell do not have access to the insurer's general account. According to the SAP accountiog rules related to the protected cell, proposal insurers are allowed to reduce their written and earned premiums by the amount paid to the protected cell to underwrite the risk that has been securitised. The payments would therefore be treated like
premiums ceded in authorised reinsmance transactions - the reduction of the net premiums is a proxy measure for its potentialliabilities. Any recoverables from the protected
cell are, similar to reinsurance, recognised as a reduction ofthe insurer's gross incurred lasses and 1088 adjustm.ent expense incurred. Until the end of 2006, a number of federal states, among them Vermont, South Carolina, lllinois, Kentucky, and Rhode !sland, adopted the NAIC Protected Cell Model Act. 42 Apart from the administrative hurdles to set up the structure, investors are still concemed that the protected cell's assets may be vulnerable to seizure 10 cover an in-
surer's general account, despite the intention to prevent this. A forther hurdle for onshore protected cells is that the sponsor, when settiog up a segregated unit, is not allowed to deduct paymcnts to the protected cell in calculating its tax liability. Interest paymcnt to investors would be deductible, wbile profits earned by the protected cell would have to he fully taxed. The protected cell model depends on a certain tax treatment wbich may require amendments to the tax code. The segregated unit needs to be recognized as part of the insurance company. The insurer would then be able to increase its reserves with-
out paying taxes on their reserve contribution and accumulations, or on the equivalent transfer of risk to the protected cello Reinsurance paymcnts Made to protected cells for
contingencies would also be tax deductible. The provisions would minimise taxes on 41 House of Representatives Committee on Financial Services [see 2002, p. 1] 42David [see 03.11.2006]
6.1. ACCOUNTANTS AND REGUlATORS
155
profits for the protected cell.43 The well intended Protected Cell Model Act and its accounting treatment unfortunately have failed to produce any realised benefits regarding ILS - no insorer has actoally used the model to issue a cat bond. As the second proposed model, the Special Purpose Reinsurance Vehiele (SPRV) gives investors a greater comfort that creditors or regulators of aceding insorer cannot access the funds in a SPRV (unless a trigger event has occorred). The structore is similar to the protected cell with the difference that the SPRV is a separate company set up for the holding of the assets pledged to support obligations of the sponsor if a triggering event occors. The Special Purpose Reinsurance Model Act desires changes to the federal lax code: Premium paid to the SPRV would be lax deductible for the insurer. The regulation would be beneficial to the SPRY, since the difference of investment income and interest paid to investors would be taxable, only. Since this would result in a profit of more or less zero, no corporate lax would be charged to the SPRV. The sponsor and investors would gain a retum of principal rather than an cquity dividend and would therefore not be subject to the double taxation of profits. The bond holder's investment income, however, is taxable.44 At current, the use of a SPRV in a catastrophe bond securitisation involves a number of complex financial accounting issues in the USo Unless all of the following criteria are Met, the sponsor of a SPRV has to report all assets and liabilities in its financial statements: 45 • At least 3% of the investment in the SPRV's total debt and equity or total assets must be owned by an independent third party • The independent third-party owner has a controlling financial interest in the SPRV (Le. the owner holds more than 50% of the voting rights) • The independent third-party owner must possess the substantive risk and rewards of its investment in the SPRV (e.g. the owner's investment and potential retoro is "at risk" and not guaranteed by a another party)
Due to this set of regulations, many US insurers have continued to issue cat bonds through offsbore SPRVS. The trost funds associated with these instroments hold their deposits with US certified institotions acting as trostees. This effecrively provides the collateral required for the SPRY acting as areinsurer to be treated as authorised under US regulations. 46 Onshore SPRVs until now have not been established due to the following reasons: First, there has been a lack of an accepted regulatory framework that could govern and provide insurers accounting credit for insurance securitisations. Second, onshore 43K1ein and Wang [see 2007. pp. 38-40] 44Klein and Wang [see 2fnl, pp. 41-42] 45GAO [see 2002, p. 24] 46K1ein and Wang [see 2007. p. 38]
156
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
SPRVs have been subject to US corporare taxation while US insurers have been allowed to deduct payments to offsbore SPRVs in calculating their tax liability. Regardless of the
eventual outcom.e of the coverage, premiums paid to an offshore reinsurer are subject 10 an excise tax based on the gross premiurns paid - profits earned by offsbore reinsurance affiliates of the US insurer (and by implication offsbore SPRVs) are not taxed in the calculation of the consolidated profits of the US insurer.47 Third, current accounting
guidance requires that reinsurance agreements must indemnify the company against 1088 or liability associated with insurance risk in order to qua1ify for reinsurance accounting.
The credit for reinsmance is designed to ensure that a true transfer of risk has occurred, and that any recoveries from reinsurance are collectible. By the way of traditional indemnity-based reinsurance, an insurer gets credit for reinsurance on its balance sheet in the form of adeduction from liability for the risk transferred to the reinsurer, and can teduce the arnount of regulatory risk-based capital required. Tbe ca1culation of the credit with indenmity-based coverage is fairly straigbtforward. In contrast, it is a very complicated challenge for the regulators to value the true arnount of risk transferred to
determine credit for reinsurance with non indemnity-based coverage.48 Until the end of 200S, a number of federal states adopted the NAIC SPRV Model Act, arnong them Vermont, South Caro1ina, and Delaware. Tbe model bas not been successful, since the federal government has been hesitating to grant this so-called "passthrougb tax treatment". Further, there has been continuing opposition against the model from the reinsurance industry, claiming that the NAIC model act creates a new class of reinsurers !hat will opemte under regulatory and tax advantages not available to existing US-licensed and -taxed reinsurance companies. Tbe SPRV will act as a reinsurer, bnt will not be subject 10 insurance regulation. This is criticised for endangering solvency regulation and creating an uneven playing field for reinsurers. 49 As a third approach, NAIC is currently reconsidering the appropriate statutory accounting treatment fOT non-indemnity-based insuTance, which would include insurance
linked securities.50 Regulaturs in general do not allow the fuH outrigbt sale of life insurance liabilities. As such, the life insurer must ultimately retain the guarantee to the individual policyholder. Althougb, due to the changes in the reserve regulations called XXX and AXXX,
the industry moved towards a securitization model, the transactions will most probably not get true sale treatment because regulaturs will not allow the sale of a life insurance policy. Policyholders rely on the financial solvability of the life insurer when signing a
contract to secure their financial wea1th. Tberefore, from a legal standpoint, creating bankruptcy remoleness without having a true sale is important to find investurs, since they need to be protected from the insurers' liability to policyholders. Structures have been developed !hat have successfully 47K1ein and Wang [see 2007. pp. 38-39] 480AO [sec 2002, p. 23] "GAO [.... 2002, p. 28] soGAO [.... 2002, p. 23]
6.1. ACCOUNTANTS AND REGUlATORS
157
defined and separated, so-ca1led "ring feneed", the ceded block of polieies from cash
flows in ather areas of the sponsor's business. This was partieularly important to financial goarantors because they do not want to take corporate eredit risl<, as it eould bave strained their own AAA finaneial strength rating. Fnrther, guarantors of life insurance securitisations are eoncerned that the regulatory uncertainty may be used by a rebabilitator in the event of an insolvency for seizing the assets within a seeurltis.tion trust in order to equally support the p.yment of all policy li.bilities,sl Bcyond the regulatory environment of the SPRY, the regul.tory environment of the sponsoring insuranee company has to be taken into consideration. It is important to b.ve an ide. of how the transaction is going to perform if the regul.tor w.s ever to get involved as the result of. eeding eompany's insolvency. Althougb the parties involved will never get absolute eertainty with respect to Ibis, they ean, through due diligence, get. very good ide. ofhow the situation may develop overtime.52 As per July 2006, ouly South Carolina bad the statutory .uthority to allow securitisation, while most other federal states have • regulatory order in p1ace th.t earties the remote but potential risk !hat • decision eould be reversed by • future director of insurance. The New York State Insuranee Departrnent h.s publicly stated it views securitisations as appropriate. However, other state regulators could intervene. As • result, almost all US ILS have been exeeuted in South Carolin•. 53
Example
The implications of a securitisation are comparable to those of reinsurance contracts (as per today, Ibis is the ease for indemnity-b.sed, risk-linked securlties issued by an SPRV). The NAiC SAPs allow an insurance eompany obtaining reinsurance to refleet the transfer of risk on the statutory finaneial statements. Many reinsurance contracts include a commission to be paid by the reinsurer to the ceding company in order to
compensate for the acquisition cast, premium taxes and fees, assessment and general overhead. The example in table 6.6 shows a reinsurance contract where an insurer receives reinsurance for USD 10 mln, having negotiated a 20% ceding commission of USD 2 mln. The reinsurer p.ys the primary insurer USD 8 mln net. The transaction reduces the eeding eompany's .ssets by the USD 8 mln paid for reinsurance, while the eompany's liability for unearued premiurns is tedueed by the USD 10 mln transferred. The USD 2 mln are recorded by the primary insurer as eommission ineome. Since the eommission ineorne inere.ses the equity (also defined as policybolder's surplus), the eeding company gains an economic benefit. The reinsurer has assumed • USD 10 mln 5l Devineetal. [sec 06.07.2006, pp. 3-14] 52Devine et al. [see 06.07.2006, p. 66] 53Devine et al. [see 06.07.2006. p. 3]
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
158
liability and reports a mirror entty having the opposire effects on the aecount."
cam
25.000
"""""
17.000
~
'oupI..
~
"""""
.,...
3U.UUO
Tobol
30.000
Source:
Afuz
=
""'"
".UUO
38.000
~
GAO, Catastrophe insurance risks - The role of risk-linked securities and factors afIocting their use, Wasbington OC, 2006, p. 42
Table 6.6: Effeet of reiosurance on the eapital positions Reiosurance eontracts, however, do not relieve the eeding iosurer from bis obligation towards policyholders. Failore of the reiosurer to honour bis obligations eould therefore result in lasses to the cedent.5S
6.1.8 Outlook to further reforms The "Working Group on Supervision and Regulation of The Group of Thirty"56, has
identified several caveats regarding the securitisation of insurance risks arising from the current supervision and aceounting frameworks. They have suggesred solutions to work on wbieh would help to overcome constraints and to develop agiobaI reiosuranee marke! where securitisation eould playa key role regarding the risk transfer to the eapital markets:
Intemationally harmooised oversight framework Harmooisation bears the porential to iocrease transpareocy, facilitare a better under-
standing of risks, and enable comparisons across the insurance and reinsurance sector. The harmonisation of the EU framework will eoable a eompany lieensed io one eountty to operare io any other membership eountty of the eommon market. No sueh sysrem currently exists between regulatory regieres elsewhere, notably between the USA and "GAO [see 2002, pp. 41-43] "GAO [see 2002, p.43] S61be Group of 1birty is a private, non-profit consultation group of international economic and moncy affairs consisting of a body of senior representatives of the private and public sectors and academics
6.1. ACCOUNTANTS AND REGUlATORS
159
Ihe EU. Global hannonisation would reduee Ihe harmful regulatory arbitrage, Ihe trend to ehoose Ihe jurisdiction wilh Ihe lightest regulation. 51
Supervision on a consolidated basis
The raison d'@treoftheinsuranceJreinsuranceindustryisrisk.diversification. 58 Therefore, reinsurance is almost necessarily a global business. Due to the consolidation of the sector, Ihe bigger reinsurance units spread Iheir portfolios globally and view Ihemselves as multinational enterprises. They are interested in consistent standards for supervision across jurisdictions and in elose cooperation when implementing them. Nationa11aws, directives, and insolvency mIes are inefficient and complicate the achievement of this objective. Consolidated supervision would gain Ihe potential for Ihe supervisors to focus 1heir often lirnited regulatory resoorces where Ihey are most needed. A eonsolidated supervisor would playa key role and would be relied upon by olher reinsuranee supervisors. The risk-based eapital requirements could be ealculated on a eonsolidated basis and securitisation of insurance risk. as a result would be much easier.59
Enhance the role of the IAIS Tbe mutual recognition of olher jurisdictions would lirnit Ihe number of distinet regulatory frameworks aglobaI insuranee firm needs to address -Ihe overa1l regulatory burden would be reduced, and duplieative regulation would be e!iminated. Tbe level of mutual reliance irnplied would require higher supervisory standards in some jurisdictions and a strong frarnework for intemational cooperation. IAIS offers Ihe necessary framework and is a1ready warking on severa1 issues. It is being suggested that the organisation should become a more signifieant polieymsking body. The eight major reinsuranee jurisdictions, the US, the UK, France, Germany, Switzerland, Ireland, Bermuda, and Japan should mske a strong eommitment to 1he IAIS in terms of resources and by leading 1he way in adopting its intematioual standards. Furlher, different regulators should work toge1her more closely nationally and promote intemationa1ly within Ihe IAIS organisation. Tbe interaction between 1he IAIS and 1he industry should be earefully eonsideted - Ihe IAIS has to get input from Ihe industry, bot must be able to tske diffieult decisions. Tbe ties to olher international bodies like Ihe IMF, Ihe World Bank, Ihe FSF, and 1he Basle Committee for Banking Supervision need to be strenglhened. Overall, Ihe reputation, international standing and funding should be irnproved in order to fulfil its task. 60 57prenkcl et al. [see 2006, p.69] 58prenkcl et al. [see 2006, p. 9] s9Prenkel et al. [see 2006, pp. 70-75] 60prenkcl et al. [see 2006, pp. 70-77]
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CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
CoUateral requirements
Collateral requirements have been used in the past 10 overcome concems about reinsurance regulations and accounting differences across countries and continents. However, the practice has a number of disadvantages: By immobilising assets that cannot be used elsewhere, Le. because of collateraIisation requirements in one jurisdiction. it may not be able 10 use these assets to overcome challenges in another jurisdiction. An efficient use of capital resources is undermined, due to the fragmenled capital base of the reinsurer split among several jurisdictions. Tbe company has to bear the cost to provide the coUateral. Higher raled and lower raled companies have to deliver the same amount of coUateral, Le. the rules are not correlaled with the credit risk of the reinsurer. FinaUy, banking institutions in their function as intennediaries between insurers and reinsurers are put in a position to take credit risk by providing the collateral in the form of letters of credit. Prom a financial system perspective, the likelihood of systemic CODtagion inereases. Wbile the EU jurisdiction has raised the bar by e1iminating collateral requirements,61 the announcement of the chief supervisor of the New York Insurance Department to cancei the collateralisation requirements in the State of New York62 is facing the opposition of other regulators. Tbe proposed new framework is likely to be vigorously debated by the industry and will be revisiled by regulators at the NAIC and at the individual state level before it is enacted by state legislatures. There bas been Da consensus among either regulators or the industry on how to proceed, and the supervisors are a long way from changing current practice."
Risk management practices Tbe introduction of a "risk based capital measure" within the supervisory framework helps to ensure that the calculation is taken seriously. Companies whose financial condition is deteriorating will use the powerful device for spurring necessary action. Tbe market needs to develop tools for understanding, parsing, and pricing risk. Tbe su-
pervisors need to set the foeus on the broader risk measurement and risk management processes that are being used by the sector in order to assess and control risk on a firm-wide basis. This approach is consistent with the broader financial sector trend in favor of increased resources and attention to enterprise-wide risk: management. Since the companies may be interested not to disc10se their approach to risk management 10 the general public, direct regulatory reporting may be required. Tbe supervisor needs to get a fuH picture of the porent companies and their supported subsidiaries. Disclosures therefore need to reflect the consolidaled financial condition of the increasingly
complex finaneial institutions.64 61Frenkel et al. [see 2006. p. 71] 62promme [see 19.10.2007] 63F1eckenstein et w. [see 2007] "_etal. [see2006,pp. 73-74]
6.1. ACCOUNTANTS AND REGUlATORS
6.1.9
161
Results or the interviews regarding accountants and regulators
General 111e interest of any supervisor is the interest of the policyholders. ILS are usually purchased as an alternative to traditional reinsurance. Regulators are indifferent to the
form of that insmance or reinsurance. While traditional catastrophe reinsurance is almost always based on indemnilication and therefore follows the fortunes, ILS can be paramettic or model-based which introduces elements of basic risk the supervisor has to take into consideration. ILS have been adding capacity into the markets for catastrophe cover and, due to the collatera1isation of the majority of the products, are seen as a
stable source of reinsurance.65 By all supervisors, it is regarded as positive that the insurance sector is able to tap the capital markets through the issuance of ILS. By piacing cat bonds, insurers and
reinsurers are able to get multi-year protection in contrast to the mostly annual renewal of their reinsurance contracts. Supervisors analyse the whole reinsurance structure of a company. ILS in the non-life sector should cover the higher attachment points for low frequency risks. 111e basis risk for these structures is rather !intited, sinee either a storm triggers the transaction or not Same sponsors, however, try to use cat bonds as a working layer of reinsurance for frequent sma11 claims - this causes same concern, sinee it bears the potential for moral hazard.66 Regarding ttiggers, the regulators are flexible. 111ey are as concemed as the sponsors of a transaction about the underlying models and ttiggers heing appropriate for the risk covered. It was stated !hat innovative ttigger structures bave not pushed them to their !intits yet 67 In general, it is irnportant !hat the sponsor is transferring real economic risk. The structures have to pass the supervisors' test far real economic risk transfer. If!bis test is passed, the accounting rules ought to work. Where the involved parties got into trouble in the past were those cases when sponsors were trying to get accounting treatment as if they were transferring risk but effective1y did not transfer it
economically. lbis was not allowed. 68 Regarding the decision process about the loeation of the SPRV, sponsors operate in their basic econontic model whicb normally requires a low-tax treatment. 111e biggest obstaele for onshore SPRVs in the US, the UK, or Germany remains the corporate tax problem. In order to get them as attractive as offshore loeations (incl. Iteland), work has to be done on the corporate tax issues. Whether a transaction is done onshore or offshore depends on the specific nature of a structure and the sponsor's organisatinnai
setup. Most regulators and organisations would welcome a registration onshore because "INT-I4-SUP [19.09.20081 "INT-I4-SUP [19.09.20081 67INT-I4-SUP [19.09.20081 "INT-24-INS [28.10.2008]
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of the familiarity, reliability, and transpareney.69 International supervisory standards are being worlred on. In North Ameriea and
Europe, committees among the supervisors and insurancelreinsurance associations are in eonstant dialogue. Regulators of both areas are aware about the developments of the
other supervisory systems.1° USA In the early days of the ILS markets, US regulators hesitated to cede authority to the eapital markets and thereby ereate vebieles that undermine their authority. Tbey irtitially used their authority to sign off on every eatastrophe ILS to certify that the transaction either m.et the requirements of the insurance regulations or perhaps was not subject 10 them. 71 Today, NAIC operates througb the Securities Valuarion Office defining wbat is an acceptable investment for all regulators of the 50 states.72 US regulators are willing to accept ILS struetures and usnally grant equal eapital relief for them as for reinsurance sinee, due to the lintited counterparty risl<, they regard them as more secore than
traditional reinsurance.73 US insuren and reinsurers underlie the same regulations and corporation standards.74 Tbey are not allowed to hold eatastrophe equalisation reserves, and they also do not ebarge any eredit risk eapital for reinsuranee that is not a1ready receivable. This means that, from a solvency point of view, it is almost irrelevant whether a company issues
a catastrophe bond or buys reinsurance.75 The US may revise their collateralisation regime. New York and Florida are reporred to work on an at least part-eliurination of the collatera1 requirements and there are discussions at NAIC level whether a federa1 reform may be implemented. However, there have been coneerns for decades that foreigu reinsorers benefit from low taxes offshore and eompete with lower pricing than US insurers. At the time of the interview, there were discussions and hearings to lintit the tax deduction for premiums paid by US subsidiaries to affiliated non-US reinsuranee holding companies. Tbe basis for tax deduetion is planned to be set at 10-20% of premiums paid, reflecting the industry-average of risk-transfer ceded to reinsorers. Tbe argument that US jobs are exported as a result does not seem to hold, since BemlUdan reinsurers, for instance, employ 10.000 penple in the US. If this business went to the US insorers, they eould not be expected to employ the same amount of people, since they would simply have the economies of seale there they would take the business without employing extra slaff. Tbe eapacity brougbt by non-US insorers into the natural-eatastrophe exposed US market improved the stability of the system. Althougb the outcome was "INT-20-LAW [20.IO.2008];INT-28-ASO [03.11.2008] 7<)INT-14-SUP [19.09.2008] 71INT_12_INV [14.09.2008] 72INT-19-ASO [26.09.2008] "INT-I-MOD [19.08.2008];INT-14-SUP [19.09.2008] 74INT-14-SUP [19.09.2008] "INT-5-BNK [04.09.2008]
6.1. ACCOUNTANTS AND REGUlATORS
163
still unclear at the time of the interviews, there was some cerlllinty that at least picking single offshore centers or geographica1 regions would be against international trade agreements.76 Ufe ILS have to meet a number of regulations which are pretty specific about the type of risk transferred and the structure of the transaction. Since the sponsor is not allowed to true-sale the policies, it tries to have a non-consolidation treatment of the ISPY. This is then not a sale of the underlying policies, bnt a reinsnrance of the risk. The ISPV is a licensed insurance company, and as such it can sell reinsurance. It has a license in its state, countty, or domicile, bnt generalIy does not have a license in the state where the ceding cornpany is domiciled. Because it has no license in that state, it is obliged to fund a trust for the full amount of the reinsnrance of the reserves recoverable. The formation of the trust is the pre-condition that the sponsor is able to get the capital relief. The transaction is therefore fully collateralised. The ceding insurer is stililiable for the risk, but gets indemnification for il The ISPY has to be adequately capitalised. There must be real equity capital7' The location of choice for ISPYs are the Cayman Is1ands, since they require low capital and do not charge any corporate lax. The infrastructure is weil established there are sufficient lawyers, trustees and accountant offices available.78 Most ILS in the US fall under SEC Regulation 144A (Reg-I44A) in order to be eligib1e for US investors. Ouly a few are regulated by REG-S and thus cannot be sold to US investors. The regulations require striet filings of the infornuuion about the transaction and the financials of the sponsor.79 Further, the transaction needs a trust bank in order to get the reinsurance credit. While reinsurers are required to co11ateralise claims which have been submitred but are unpaid, SPRYs have to collateralise the trust in full from day one.'o For Reg-I44A secnrities, the offering memorandum is key, and everything which is not defined as available information must not be disclosed to the markel As a result, not much infornuuion about the consistence of the collatetal was disclosed in past ILS transactions. After the information memorandum was handed out, there norma11y were no regular updates - the transparency to investors was therefore limited. 'I Another set of important regulations for the US market are the ERISA mies. They are valid for US pension funds which are important investors in ILS. The mies do not allow the trading of the collateral. Thus, oncc the investments are done, the trust has no chance to react to adverse developments by selling or exchanging the bonds. It has to be kept in mind that, even if this may be allowed, the collatetai banks at cnrrent da not have the resources or systems 10 manage margin ca1ls or exchange collateral on a frequent basis.82 76INT-6-ASO [05.09.20081 nINT_8_LAW [1O.09.2OO81;INT-IO-RAT [12.09.20081 "INT4BNK [04.09.2008] "INT4BNK [04.09.2OO8];INT-I4-SUP [19.09.2008] "'INT-7-RE1 [OS.09.2OO81;INT-14-SUP [19.09.20081 81INT-29-INV [14.11.2008] "INT-25-BNK [29.10.2008]
164
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
A refonn of the fractural stare-regulation sysrem, porential1y from the risk-b.sed c.pital to • principle-based .pproach, is constantly beiog discussed. Regul.tors are aware of Solvency 2 and see some need for harmonisation. 83 Sponsors are following the regul.tory regimes regarding the mioimom requiremenls. For iostance, the regul.tory reinsorance credit is b.sed on the coll.teral of the transaction: if ils value falls, the sponsor gels less credit. 84 In .ddition, they have to follow the requiremenls of the rating agencies putting on extra layers of security. The discussions with them therefore infiuence Ibe final structore of. transaction. 85 Especially io the US, the govermnent has • particu1ar iorerest io Ibe coverage of extreme catastropbe risk, sioce they are recognised as so large th.t Ibe effects can get sysremic to the financial sector. The privare sector prob.bly did not do • good job io man.giog these risks io the p.st. There are concerns th.t the regul.tors regard this neither as • market failore nor as • success, but may finally decide to srep io and elimio.re the market mechanisms. Effectively, as with the Florid. funds mentioned .bove, this wou1d mean !hat laxp.yers may need to srep io for the c.tastropbe los ses. Insread of. direct involvement as insurer, the government could, for instance, provide an infrastructore which eases the market mechanisms, establisb • network of wind-speed merers, or provide • regisrer of real estare qua1ity. The easing of Ibe the lax status for c.tastrophe bonds, .s it was done for mortg.ge secoritis.tion, wou1d accelerare the development of Ibe ILS market.86 US supervisors wou1d be ioreresred in an efficient w.y to cover rerrorism risk. Every time the TRlA is due for prolong.tion, there is • lot of concern .bout wh.t will happen if it is not renewed. 87
Europe In Eorope, solvency and c.pital considerations do not pl.y • role io Solvency I, but they will come into effect with the Solvency 2 world.88 Reinsorance is expecred to be charged with. hair-cut for Ibe coun1erparly risk depeudiug on Ibe credit rating, wbile ILS, especia11y catastrophe bonds, may be accepred wilb its full coll.teral and wilbout any deduction.89 Solvency 2 does not seem to become an obstaele; it will help to develop the ILS market. It is more difficu1t to buy • stop-Ioss reinsurance than to place • stop-Ioss ILS ioto Ibe market.90 Companies will be .ble to employ freed up c.pital, for instance as a result of a life-securitisation to be used for unit-linked or even non-life
business.91 "INT-5-BNK [04.09.2008];INT-I4-SUP [19.09.2008] 84INT-17-MON [24.09.2008] "INT-19-ASO [26.09.2008] "INT-18-INV [24.09.2008] 87INT-14-SUP [19.09.2008] "INT-I-MOn [19.08.2008] "INT-4-BNK [04.09.2008] "INT-I-MOn [19.08.2008] "INT-23-BNK [28.10.2008]
6.1. ACCOUNTANTS AND REGUlATORS
165
At the time of the interviews, an increasing number of eountries in Europe were getting worried about the introduetion of the Solvency 2, since, due to the financial erisis, a number of insurance eompanies ean be expected to be under the p1anned solvency eapital requirement standards. However, it is common sense that Solvency 1 is too emde, allowing too mueh arbitrage. The process hit a roadblock but certainly will not stop.92 The uneertainties are not being seen by the ILS market as an obstacle for further growth. Sponsors have been looking for opportunities to diversify their capital and reinsurance sources. They search for possibilities to transfer the real economic risk. when deciding to issue ILS for their protection. 93 Regarding the natural eatastrophe bonds, Solvency 2 does have a limited impact only. Sponsors do not issue eatastrophe bonds for eapital relief, but for risk protection. In life seeuritisation, the uncertainty is overcome through the usual agreement of a regulatory capital eall: If, after Solvency 2 has been introdueed, the eapital relief would fall away, the protection buyer ean eall the transaction. 94 In conversations between arranging banks and sponsors, the uncertainties around Solvency 2 have not come up as a reason not 10 da an ll...S structure. 95 As a result of the erisis, EU regulators together with the rating ageneies and, in order to avoid moral hazard, are eonsidering an up to 10% vertieal sliee of risk the sponsors will have to take in a securitisation. The sponsor then will have to bring in eapital for the slice. Since Europe has a weil funetioning reinsuranee market in the natural catastrophe business, only the top layers were securitised, and the lower layers reinsured"· The frarnework established with the reinsuranee direetive elearly favours onshore solutions - the regulatory wish to minirnise tax leakage. 97 Although Europe is not as exposed as the US regarding natural eatastrophe, a transparent and independent eatastrophe index would be appreciated by the regulators." The loeation of ehoiee for ISPVs is Ireland, while, after the introduction of the Reinsurance Directive, there is a trend to unifomtity in the UK and other EU states. The main obstaele, however, remains to be eorporate taxation and the non-existence of pass-through regulation." Bermuda
The main ehallenge for the independent regulatory authority of Bermuda is to meet an equivalent level of the rules that the international standard setters are proposing. While Europe is working on Solvency 2, the US are beading towards a moderuisation of the reinsurance collatera1 regulations. Bermuda is willing to create a great degree of eompliance with the international standards. The regulators are actively involved in "INr-22-BNK [27.10.2008] "INr-24-INS [28.10.2008] "INr-26-INV [29.10.2008] "INr-27-BNK [29.10.2008] 96INr-26-INV [29.10.2008] "INr-28-ASO [03.11.2008] "INr-29-INV [14.11.2008] "INr-24-INS [28.1O.2OO8];INr-25-BNK [29.10.2008]
166
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
the IAIS working groups and interested to enter memorandums of understanding with o!her insuranee regulators. One benchmark to be aehieved in the years abead will be the implementation of Solveney 2 in Enrope. A1J a result of its implementation, Bermuda expects greater transparency and a group regulatory regime for the international markets. Transpareney would mean published annual financial statement issues and, in addition, more risk and eorporate governance diselosures. Currently, the transparency is based on the SEC regulatory regime, sinee 18 of!he 20 rnembers ofthe loeal association are publiely traded in !he USo Bermuda is cnrrently evaluating the SEC, the Swiss, the UK and Solveney 2 proposals in order to figure out whieh transparency rules are appropriate for their insuranee sector. Lean regulation and highly qualified slaff offers a high speed to markets. Tbe island has reached eapacity - a fnrther wave of reinsnrance foundation is regarded as ra!her un1ikely. However, the system is leading the side-ear business whieh can be done with few personnel ouly.lOO Some Bermudan reinsnrers bave been volatile in their earnings; they are not able to show the track record and the eapital resoorces of the well-establisbed and diversified European narnes. Tbe correlation of their results with those of the cedents is ra!her high - in terms of high eatastrophe losses both, the cedents and the Bermudan reinsnrers, suffered substantially in phases of high hnrrleane activity. Bermuda is eharacterised by higher eapital requirements, but lower lax, the eorrent net benefit eompared to the US bas been approximately 4-5% in the past years. 101
lOOINT_6-ASO [05.09.2008] 101INT_5_BNK [04.09.2008];INT-22-BNK [27.10.2008]
6.2. INSURERS AND REINSURERS AS SPONSORS
167
6.2 Insurers and reinsurers as sponsors 6.2.1
The Integrated management of risk and capital
'The management of capitaI focuses on delivering the optimal balance sheet, being composed of assets, equity, and debt. The intemal capitaI models of thc company deliver information about the usage of capitaI by the different activities. The target should be the minimisation of the cost of capitaI. The calculation of the solvency capitaI by using stochastic models is part of today's enterprise risk management, the holistic management of the assets and liabilities of an insurance company.l02 Traditionally, risk management in insmance was referred to the roles of the risk manager, being respansible for the operational risk of the underwriting, and the treasurer, being responsible for the refinancing to cover the operational risk and the investments in the capital markets. Some years ago. most insurance business models were based on the warehousing of risk. Risk was underwritten, pooled, and borne by thc insurance sector, while part of it was transferred within traditional reinsurance progranunes. The result was a concentration on diversification and underwriting standards. Products with high retoms were favoured without measuring the risk and vo1atility involved. Insnrance cornpanies required a relatively large amount of capitaI which was not always efficiently used. The management of assets was independent from the management of liabilities. Most companies were not raled, and the assets and liabilities were not marked-to-market. Due to the lock of ratings and transparency, institutionaI investors were not involved in insurance underwriting. 103 The emcIgencc of enterprise risk management has been motivated through the recog-
nition that the separation cf risk. management from treasury is not consistent with the shareholder's demand to maximise profits. Intra-firm opportunities for the diversification of risk were not recognised. It became clear that failing to realise existing natural hedges and adverse correlations among risks, can lead to high hedge expenditures or high risk exposures. 104 Although thc Solvency 2 regulatory framework is not likely to be introduced befare 2012, some of the kcy elements of the reform are already aJIecting the strategic decisions of thc companies: First, insurance companies are getting capitaI models in place in order to enable their operating units an effieient usage of capitaI. Together with thc regulators and rating ageneies, up to date techniques like VaR and ES are implemented to calculate risk measures for underwriting and investment activities. Second, the management of assets and liabilities is being constantly improved, partly as a result of the stock market crisis of the late 199Oies. Third, a wave of hybrid bond issues with long maturities or perpetual structures was placed into thc capitaI markets. Although thc bonds can nonnally be ealled after 5-10 years, they count as regulatory capitaI and 1tr20ctenga and GroBpietsch [see 2006, p. 1-3] l03Robinet rlee 27.05.07, p. 3] 104Cumm.ins [lee 2005. p. 190-191]
168
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
improve the solvency basis. The former practice to issue senior bonds at holding level and to transfer it to the subsilliaries as subordinated capital will not be possible under Solvency 2 any more. ILS are getting inereasingly attractive as tools to free up eapital. Fourth, diversifieation of the insuranee groups is strongly incentivised by the regulations. Beneath the economies of seale, one of the key drivers of the acquisition of Revios, a German life reinsurance company, and Converium, a Swiss reinsurer by the French reinsurance group Seor, for instance, was to get a lower solvency capital requirement because of diversification benefi:ts. 105
6.2.2
Capital management
Adequate risk-bearing capital is an essential prerequisite for the underwriting of insurance risk. It acts as a buffer against unexpected losses. Also called economic net warth of a company, it is calculated as the difference of the market value of its assets and the present value of its liabilities. As already explained in previous ehaplers, the insuraneeJreinsuranee eompany pools sufficiently independent and halanced risks into its portfolio in order to reduce the volatility of the aggregate claims to a manageable level. Premium income is invested in the capital mark.ets to generate the cash fiow for future claims. The surplus generated is held as economic net worth. The market capita1isation, measured for a public1y listed company by the total value of stocks outstanding, is generally higher than the economic net worth of the company. This is due to the fact !hat investors value the insurer's ability to generate economic profits through future business done by its human capital with the clients. The difference between the market capita1isation and the economic net worth is called franchise value. To keep up the franchise value, especially for times of stress, insurers tend to hold more capital rather than less. However, they do not hold arbitrarily !arge amounts of capital, since the higher the capital base, the higher are the capital costs in terms of dividends to be paid. These are passed on as eharges to the insurance policyholder as loading to their insurance premium. However, there is a 1irnit the policyholders are willing to pay for additional security. The insurer needs to find the optimal balance between adequate security and appropriate premium levels in order to maximise the franchise value. '06
6.2.3 Asset-Liability-Management Asset-Uability-Management (ALM) is defined as the practice of managing a business so !hat decisions and actions taken with respec! to assets and liabilities are coordinated. It inc1udes the ongoing process of formulating, implementing, monitoring, and revising strategies which concern assets and liabilities to achieve an organisation's financial objectives. Risk. tolerances and other constraints influence the process. ALM is critical l05Raymond [see 12.03.2007] ' ' ' ' _ et a1. [see 2006. pp. 95-100]
6.2. INSURERS AND REINSURERS AS SPONSORS
169
for any organisation managing its investments in the capital markets in order to meet its futore cash ßow needs and capital requirements.
ALM focuses on economic value. Th.e value of future cash tlows is derived in such a way as to be consistent with market prices or using market consistent principles methodologies and parameters. The distribution of futore asset and liability cash ßows is taken into consideration to determine the exposnre to ALM risk. Where available, values are derived by direct observation or by considering replicating portfolios, i.e. if values are not avai1able, models are used. The models are calibrated to observable and appropriate market prices. They recognise the cbanges of cash ßows and the change of the economic value of cash fiows arising from a range of possible scenarios. In addition, the ALM framework needs to consider accounting and regolatory values !hat may involve non-economic considerations and conventions. 107 The m.ain traditionaI metries used 10 m.easure the exposure of economic surplus to cbanges in the financial variables are the following: 108 Insnrers monitor their liquidity ratio. They estimate the normal expected amount of liqnidity that is requined to meet the demands of their underlying liability portfolios for various time horizons. By taking this amount plus a margin to cover unexpected liquidity requirements on top, a ratio can be defined which is inc1uded in the insnrer's investment portfolio. The airn of cash flow management is to compare the cash ßows of liabilities with the cash ßow of assets. Changes of interest rates, including parallel curve shifts, twists, and bends have to be tsken into consideration. The size and timing of the cash ßows may be difficult to forecast. The insnrance company further may be challenged to find assets matching with the cash ftow stream of its long-term liabilities, especially to find appropriate assets to meet the investment standards in terms of qua1ity. Insnrers with a higher risk tolerance may be in a position to accept a lower precision in cash ftow matching standards in order to achieve their rate of retnrn goal. Insnrers use risk models which help to calcuiate the adequate amount of capital to maintain the given level of security. Deterministic scenario testing models project business results into the futore. They are appropriate for eaiculating a small nomher of sets of cash ftows, aod the results obtained are valid for these specific scenarios. Deterministic modeling is justified in stable, long term businesses like the projection of mortality in life insurance. If cash flows depend on future economic conditions, more complex models such as stochastic scenario testing are used. 109 Risk is grouped into categories, mainly according to how they are managed. Similar to supervision, they are normally categorised into financial marke!, underwriting, credit, and operational risk. l1O All risk categories affect the economic value of hoth assets and liabilities: The ecolO7IAIS l08IAIS l09IAIS lloIAIS
[see 2006, pp. 3-4] [see 01.10.2006, pp. 3-13] [see 01.10.2006, p. 11] [see 01.10.2006, p. 11]
170
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
nomic value is exposed to mterest rate risk, sinee it is the present value of future claims payments. Conversely, interest rate risk affeets the mar1ret value of bonds in the investment portfolio. At the same time, these bonds are exposed 10 credit default risk. Additional credit risk may result out of proteetion written by the insurer on credit risk in favour of its clients. Exposure 10 man-made or natural catastrophes bears insurance undeTWriting risk. Operational risk cannot be quantified, but may not be underestimated, since it has often been the ultimate cause of company faHures. Tbe company's capital acts as protection against operational risk related los ses. One source of risk can possibly affect several other positions of the economic balance sheet. The potential interdependencies among the various sources of risk require an integrated approach 10 risk and capital modeling (see figure 6.8). The combined effeet of all relevant individnal risk exposures and their dependencies needs 10 be quantified; figures like underwriting liabilities or asset investments are balanced and carried forward. ALM takes internal and extemal assumptions into consideration. ALM models generally are run in six steps: First, the setting of capital market assumptions includes the general economic environment such as changes in interest rates, foreign exchange rates, liquidity conditions, economic shifts, and possible market events. Related 10 the business, premium levels and the stated dividendlbonus philosophy, in addition, have 10 be determined. Assumptions need 10 be relevant and reliable. Second, a stochastie scenario generatoT is needed 10 develop scenarios based on the assumptions. The stochastic processes are applied sirnultaneously for assets and liabilities. The process is performed under 100 10 10,000 independent scenarios. The insorer gets information about the impact on its financial position of asset allocation strategies considered and of various new products under simulated mark.et conditions. Third, scenarios are transformed by a projection model, basically acting as a financial calculator into financial results. Fourth, these are selected and assessed by the optimizer before fifth, a series of output data is produced. As the sixth step, a risk adjusted and market value based analysis is following. As a result of the process, the probability of the company's profit and loss can be derived. The distribution of data contains all the ex-ante information on how the random behaviour of the performance of the insurance business and investments may affect the economic net worth of the company. Based on so-called summary risk measures, the entire probability distribution can be condensed into a single figure. The report contains risk measures like the mean, standard deviations, VaR quantiles, ES, all describing a performance corridor resulting from the scenarios. 11l As described in chapter 6.1, VaR and ES are widely-used sununary risk measores, since they allow 10 specify the amount of capital required to ensure a desired level of security. Hence, 10 express its risk tolerance, the required capital could be defined as being equal 10 a multiple of, for instance, 1% VaR or I % ES of the overall portfolio. If the insurer holds the defined amount of VaR equivalent capital, it will be able 10 withstand a loss ofthe size ofthe once-in-1OO-years loss. With the ES equivalent capital, it llIZwies1er [see 2005. pp. 122-127]
6.2. INSURERS AND RElNSURERS AS SPONSORS
.J1:1-rc;\ '-_'_"_"_·C "'_'"_"'---.JI
Li
171
I'rojr
_ rOCt~n ",h.n~t .alt> _ 'nn.tion _ <,,,,,"1 n... ~" lmt." _ di,id,ndll>o no, , o.~ l u, ,h.nn~
-"""o •• n«
L-'"--'""-'-" ---,I
~
Sr.;<> 01 _ h. lon« - pmrol .nd 1.-." ,1.I,n"nl,
,ht."
. ,um,,," n,~ m.. ,o...
Bascd on: Zwiesle •. lIan ... luachim. A,scI-Liabilil)-.\ bnagcmcm. in: Sp",mann an
Figure 6.8: Basic ALM model for insurancc companies will be able to absorb a loss of the siz.e of the average loss occurring with a frequency of less than once-in-lOO-years. By comparing the available amount cf capital (being the economic net worth) with the requircd amount cf capital (VAR or respectively ES), the adequacy of the insurer's capitalisation can be established. YaK and ES measures an: bascd on extrapolation of past cxpcrience, which is not necessarily representative of systemic risk. They have limited ability to accurately capture what may happen in exceptional circumstances ar extreme events. The main challenges far insurers an: the COII'CCt choice of the assumptions and exact interpretation cf the results. Internal assumptions bear the risk. that decisions cf the management, e.g. surplus sharing policy, are anticipated, which may finally be taken under different conditions in the future. ll 2. Therefore, the implementation cf tkcision mies is cf tey importance: The company must have a clear concept how it intends to behave under the different market conditions, since the quantitative risk model cannot be a surrogate for management decisions and common sense. Back testing is necessary in order to compare the assumptions and projections with the results ex post Stress km can also be used by insurers to identify and quantify the impact cf dif-
lUzwiesler [see 2005, pp_ 122-123]
172
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
ferent stress scenarios on the financial condition of the company. They are used to cross-check the plausibility of the model used. Based on simulations, future expected cash ftows under various scenarios are calculated. By constructing many possible scenarios, the outcomes result in statistical distributions. They reflect the risk exposure in the portfolio of an insurer who, by studying the results, can evaluate different ALM strategies. While sensitivity tesling examines the effect of changing just one or a few variables, scenario testing may go beyand deterministic scenarios, e.g. inc1uding the modeling with reference to severe bistorical events and to risk databases. The test must be appropriate 10 the activities of the insurer, taking the c1asses of risk underwritten, the level of risl<, the distribution systems, the investment policy, operational systems, and controls into consideratioD. Stress tests cannat predict what will happen, but are useful to examine what may happen in the future. With the results, insurers are able to manage risks and maintain adequate financial resources to dea1 with them. 113 114 The tesling of ALM therefore includes risks arising from assets and liabilities. Apart from liability risks these consisl of markeI risks and liquidity risks. Market risk is the impact of the financial condition of an insurance c0n3pany due to the following reasons: 115
• a severe economic or market downtum leading 10 interest rate movements o price shifts within assel classes of the entire portfolio o inadequate valuation of assels such as real estate and bespoke derivatives o currency devaluation effeets on the portfolio
• any mismatch of assets and liabilities, also reinvestment risks o a dran3atic change in the spread between a markeI index of rates and the risk free rates
• non-linear market moves between sectors resulting in non-linear effects on values o effeets of downgrades and changing credil spreads on assel values o the impacl of interesl rate changes on the potential exercise of options embedded in insurance policies Liquidity risk, defined as the possibility that the insurer will be unable to meel bis obligations when due, has to be examined. It may resulI from: 110 o thc mismatch of assel and liability cash flows 113IAIS [see 01.10.2006, pp. 12-13] 114Zwieslcr [see 2005, pp. 125-126] 115IAIS [see 01.10.2006, pp. 12-13] 116IAIS [see 01.10.2006, p. 12]
173
6.2. INSURERS AND REINSURERS AS SPONSORS • ehe inability to quicldy liquidate assets al fair and reasonable prices
• a liquidity shortage because assets cannol be sold, since !hey bave been pledged • the insurcr having to withstand sbaIp, unexpected outllows caused by high claim payments, or an unexpected drop in cash inllow from premium, • Ibe in.urer not being ,uccessful to reduce large asset position, in time and probably al high costs because of difficoll markeI condition, wilb an environmenl of low liquidity
Duration and convexity are important measures of interesl rate risk for fixed incorne securities and interest bearing liabilities. Duration is a measure of sensitivity of an asset to changes in inte:rest rates, while convexity measmes the rate cf change of the duration wilb respect to Ibe interest rate. To meel Ibe objective of immunisation of a portfolio, Ibe presenI value of the asseIs musl equal Ibe presenl vaJue of Ibe liabililies. Furthet, Ibe duralion of the assets and liabilities must be equa!. FinaJIy, Ibe convexity of Ibe assets must be greater than !hat of the liabilities. 117 11. DIgressIon: DuratIon and convexlty
Tbe duration concepl developed by Frederick R. Macaulay in the 193Oie, explains the inftuence of the changes of interesl rates on the value of fixed incnme securities: 119 First, the Macaulay Duration formula provides Ibe weighted average maturity of
the discounted cash j/ows of abond: D
M
=
~
time to ooshflow x ,,!& ~
L..J
DM=1"X~+2X
DM
=
DM
=
""'
L.J
txG (1+0)1
&_1
V
(lV)
+~ ... xM
f: (PV~CF. f: ..!m..X
t=l
V --
t=l ll+iJ-
where: DM = Macaolay Duration G = coupon vaJue M = maturity par value t = time to maturity 1171AlS [see 01.10.2006,
pp. 9-10]
lUIpreokcl Cl aJ. [lee 2006, pp. 95-100] 1I9Schulte and Horscb [sce 2004. pp. 203-208]
pruent valuc: 01
+ ...
ca." ffow
pr'ce 01 the band !1n±!! +nx~
174
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
n = number of cash flows V = bond price i = required market (discount rate) CF = cash flow Tbe following example (see lable 6.7 and figure 6.9) explains the methodology in practice and the terms used in the formula ahove. Suppose we are dea1ing with a EUR 100 mln bond that carries a coupon of 8% having a remaining life of 5 years. Tbe marke! rate (discount factor is 10%). Tbe Macaulay Duration ofthe bond is 4,28 years:
_:
Term:
Paymenl:
PV
PV Paymenl:
PV IPrice:
y
CtandMt 8.00 8.00 8.00 8.00 108.00 MarIret Value
(1 + i)'
.&.v 7.27
mar~et tla!ue
... x t
0.07866 0.07152 0.06503 0.05908 0.72572 1.00000
0.07866 0.14304 0.19509 0.23631 3.62854 4.28165
1 2 3
4 5 Sum
0.90909 0.82644 0.75131 0.68300 0.62090
-
(1+!)1
6.61 6.01 5.46 67.06 92.42
Duration yoars:
Table 6.7: Calcu1ation ofthe duration of a straight bond Tbe Macaulay Duration of the bond is shown in figure 6.9. It is determined by the following factors: • the remaining lifetime of the bond (the lower the remaining life, the higher the duration) • the coupon (the higher the coupon, the lower the duration) • the market rate to discount the payments (a higher market rate leads to a lower duration) Portfolio durations DM P are calculated by the weighted average of the Macaulay Durations of the single positions DMa. It has to be taken into consideration that the concept assurnes one discount yield for the fixed incorne investments, regardless of their tenn: n
DMP""
L: DMa x G. a=l
n
with
L: G. =
I
a=l
where: DM P = Macaulay Duration of the portfolio G. = Share of marke! value of the single asset a of the portfolio
6.2. INSURERS AND RElNSURERS AS SPONSORS
175
D Ma = Macaulay Duration cf the single asset a 0= oumber cf single assets a
Second, the Macaulay Dnration can be used to show the price elasticity of a band, i.e. the percental change in the price of a bond in relation to the percental change of the discount factor i.
w X (\t~) and V = L.J ~ (I+i~' CF D M = 6(H~) t=1
w (1+i) _ _ D M - 6{1+i) X v D M --
~ -tx (C~~. L.. l+i
t=1
n
~
~ (1+i) L.J - t (1+i}t+1 X v
,-,
x \1-Fij (Ho) Xl V
(0'..
DM=E-tx~ t=1
DM =
t -t ,-,
X
{P~CF.
Cash Flow and Duration Balance
loo F======t'lR 5 0 ~----------~
O ~1~~2~~3--~4~ , ~5~O';"~"~"'~"'~'"~'1
a .
Nom illal
I
Flgure 6.9: Duration of the sample BUR 100 Jxmd The formula above results in a negative value: As the market rate (yield) decreases, the duration increases, since the factor gets tower. The duration is not constant, it docreases during the lifetime of the Jxmd and changes due to cxternal factors. Thc calculation is linear and does not tae the conye;rity cf the bond yietds into consideration. Therefore,
176
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
the Macaulay Duration overstates the price sensitivity (see figure 6.10). Yield changes abow 1.5% and calcu1ations for bonds with lang lifetimes result in improper values. Furthcr. thc duration is not fcasiblc for bonds with implicd options since thcir sensitivity to interest changes is not calculated.
oi <0
Si = 0
oi > 0
Figure 6.10: Approximation error ofthc Macaulay Duration
Modißed Duration was introduced by John R. Hicks in 1939 as a method to refine the cak:ulation of the price sensitivity of a bond for a one basis point change in yield as follows: 120 (1) Sensitivity fonnula:
5V =
-~
X
DM
X
V x 6i
(2) Modified Duration is defined as:
MoD = (li.) x D
W = -MoD 120Sclmlte andHorso:h [IR2OO4, pp. 209-214]
x V x öi
6.2. INSURERS AND REINSURERS AS SPONSORS
177
Supposed we are dealing with the bond in the .bove example with • market value ofEUR 92.42 and. M.caul.y Dur.tion of 4.285. The bond will lose EUR 1.98 ofits value when the interest rate rises by 0.5%:
8V= -MoD x Vx 8i 8V = -4.285 x EU R 92.42 x 0.5% = -EUR 1.98
When 8i = +0.5%, the value of the bond will be EUR 90.44; when 8i = -0.5%, the value of the bond will be EUR 94.40. There is • positive coherence between the dur.tion and the risk of rate changes, i.e. the higher the dur.tion, the higher the risk.
Characteristics and usage of the Duration Concept Duration can be categorised as a tool to measure sensitivity rather than risk. The risk. is determined by the sensitivity of the Modified Duration and the change of the market yield, the risk factor. Knowing the sensitivity of the assets and liabilities enables • financial institution to manage them. A 30 year tenn life insurance contract with a guaranteed minimum return is comparable with • zero bond. Since there are no interest payments over the lifetime, the duration is 30 years. The insurance company may further have obligations and loans with • variety of different durations. The portfolio dur.tion of the liabilities forms the benchmark for the strategie investment decisions of the company. The assets principally consist of bonds and real estate assets, again, with different durations. The m.easurement of the durations helps to get. matched asset-I.bility structure. The insurance company may furtber hold positions with market risk depending on the development of short term interest rates. The calculation of the duration of the assets enables the company 10 set up tactical hedge positions with derivatives to seeure the value of the assets. Duration h.s • clear focus on the yield changes. It is rel.tively e.sy to calcul.te and can be used to assess portfolios of assets and liabilities. The deviation between real yield changes and duration based yield changes exists, but is rather marginal for trade.ble bonds (especia1ly if the problems c.used by the complete registration of all assets and liabilities are tsken into account).121
6.2.4 Hybrid bonds and risk securitisation Hybrid issues Hybrid bonds are designed with characteristics of both: debt and equity. They are intended to provide protection to the issuer's senior note holders. According to the l2ISpremann andBamberg [see 2005. pp. 133-160]
178
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
definition of the NAIC, they are securities whose proceeds are .ccorded some degree of equity treatment by one or more of the nationa1ly recognized statistica1 rating organizations and/or which are recoguized as regul.tory c.pital by the issuer's primary regul.tory .uthority. [22 Tbe regul.tors differenti.1e between two types of c.pital: TIer-l capital has no maturity and is typically .ble to .bsorb losses. It h.s no fixed costs and ranks for rep.yment upon winding-up after all other debts and liabilities. 11er-1 capital includes share capital and shareholder's reserves. Further, it includes perpetual non-cumulative preference shares and innovative Tier-I c.pital (deeply subordinated instruments with
a potential conversion into non-cumulative preference shares). According to EU rules, innovative Tier-I c.pital is limited to 15% of total 11er-1 capital. TIer 2 capital includes forms of c.pital which are perpetual but cumul.tive, where inlerest p.yments can be deferted but not waived (Upper Tier 2). It also includes d.ted debt where fixed service costs cannot be waived or deferred (Lower Tier 2). According to EU rules, an insurance company must not cover its capital requirements with more than 50% of 11er 2 debt, including no more than 25% of Lower 11er 2 debt. [23 In the USA, hybrid bonds emerged in 1996 when the US Federal Reserve Bank allowed trust preferred securities (TRUPS) issued by US bank holding cornpanies to be included in Tier-l capital. TRUPS are cumulative preferted instruments issued by bank holding companies through. wholly-owned SPV, usually. trust. Tbe TRUPS are sold to investors, and the proceeds are used to buy subordinated bonds issued by the bank holding. The favorable treatment of TRUPS was based on the deeply subordinated status of the underlying securities, the ability of the issuer to skip coupon payments, and the long final maturity of the securities, miuimum 30 years. Tbe products are attractive for issuers, since they get equity credit by regulators and rating agencies while minimising the cast of capital. Issuers get a debt-like refinancing at lower cast compared to a share issue. Furiher, the issues get debt-treatment by lax authurities (Le. inlerest payment is Iax-deductible business expense in contrast to dividends on preferred shares which are non-lax-deductible). Hybrid proceeds are used for different activities like acquisitions, stock buy-backs, capital expenditures, and for pension liability offsets. From the year 2000 on, several institutions issued TRUPS which were pooled into CDOs. As a result, the market volume has grown dramatically and has become • siguificant souree of c.pital for stuall and medium sized US banks. According to US regulations, up to 25% of a bank holding companies 11er-1 capital may comprise TRUPS or direct1y-issued preferted stock. TRUPS have also been issued by insurance
holding companies. l24
125
Tbe hybrid market has experienced strong growth globally in recent years. Different lax rules and regulations enabled a wide vatiety of issue types. The pricing of the 122Regent [see 15.09.2006. pp. 133-160] 123Regent [see 25.11.2004, pp. 4-5] 124Regent et al. [see 05.04.2006, p. 3] llSHolton [see 2008]
6.2. INSURERS AND REINSURERS AS SPONSORS
179
relevant security is affected by a number of features related to the subordination lan-
guage of the underlying bond documentation. 126 The more senior an instrument is in the capital structure of a corporate, the more protection is there for the bondholders, sinee the high ranking may lead to a lower loss severity when the issning company is liquidated: Senior debt is repaid first, leaving subordinated bondholders with higher losses. Even for bonds issued by high quality companies, this justifies differenees in the pricing of bonds. Tbe maturity of the debt instrument and call features a!so has a noticeable infiuenee on the level of risk tsken by the investor. Dated bonds are less risky than perpelußl bonds, since they offen rank senior in liquidation. Usually, the issues have call options, with margin step-ups if they may not be called after the agreed non-call period (5 to 10 years). Call options give the issuer the right, but not the obligation, to repay the debt. Tbe step-up is a strong incentive for the issuer to call. If the bond is not ca!led, the interest coupon increases. If interest payments are suspended, bondholders may at least be able to claim accumulated interest at maturity, even if this may be 10 to 15 years away. The situation could be less clear with perpetual issues without a fixed maturity date. The market prices most issues to the call date. Tbere is a strong expectation that they will be called at time. l27 Tbe level of structural subordination is important for the risk tsken by the investor and therefore infiuenees the pricing of the debt. Tbe creditors in a pure holding company issue are subordinated to creditors in operating subsidiaries, since for the service of debt they rely mostly on dividends upstreamed from subsidiaries. Since the subsidiary's debt is closer to the operating cash flows and assets, the holding company debt is structurally subordinated. 128 Nearly all bonds issued include an interest deferra! provision, enab!ing the issuer to defer interest payments without triggering adefault in times of stress. This is in !ine with EU directives that proceeds of a subordinated debt issue are admissible in the solvency margin and that the insuranee undertaking must be enabled to defer the payment of interesl. Darnien Regent has introduced an eight step ranking of the deferrailanguage of subordinated bonds, ranging from debt-like and cash cumulative instruments to instruments where unpaid coupons may be cancelled (see table 6.8). In a stress scenario, the weak interest deferra! wording is more likely to result in spread volatility and falling bond prices. Bondholders could rapidly question whether the issuer is able and willing to pay interest in a timely maoner. Further, regulators may press the insurance company to suspeod payments, at least temporarily.l29 Duriug favourable market conditions, for instanee in the beginning of 2007, insuranee companies issued deeply subordinated debt, includiug mandatory coupon deferrai provisions based on accounting tests. In stressed market conditions, the sponsor's CODsolidated eamings are related to its capital position, and issuers may be forced to defer 12'Regent [see 04.01.2007, p. 127Rcgent [see 09.01.2006, p. 1"Regent [see 04.01.2007, p. 12'Regent [see 04.01.2007, p.
121 12]
151 141
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
180 Category: A
Hybrid ])pe, No interaIt deferrallanguage
B
DeferraJ. liDked to a breach aI. the miDimum solYmCJ ratio
C
De:ferral Unked to • breach of •
scivenc:y threshold bigher tban the regulatory minimum, or 10 an IICCOUIltiDg _
1)picaI defernd strocture: TheIe is no intcrcst defenal provision. Not payiDg coupons on time therefore leads to a defanlt The instrument is as close as it gets to a senior bond, but in thc cvent of a liquidation. ia subordinated to senior debt. Intcrest dcferral is only possiblc - er mandatmy - if thc issucr or thc guarantor of the instrument has breached minimwn capital requirements. Since insurance compaoies C8nnot operate when they are in breach of solvency minima, thc risk of interest deferral appears 10 bc low. Interest deferral is possible - or mandatory - if the company is in breach of a solvency threshold higher than tbc regulatory miniID.D.JD, which is a morc likcly !ICCIllIrio than B. AIrears of intercst llCCIlIIl1llatc and are repayable in cash as soon 118 solvency rcaches
pa- tho""'''''''''_ ..- pa.. ......,
liDked to the paymmt aI. a lIIum!bolder divideDd. Arre111'5 01 interest are 1ett1ed in cash. These instrameDU are CIIDlDlatiTe and the lauer does not
1be issuer has 1he option to suspend coupon payments until shareholder dividend is paid again. Arrean; of interest accumuIate and arc repayable in cash. Investonl are given Iittlc protection, since dividend payments Ire likcly to be suspended at early stages in die case of
need 10 iuoe equlty to Idde
stress.
OptiODal
D
"""'" 0pti0DaI
E
_
~,
Dcferral language similar to D, bot instru-
liDked to the payment 01. a
ments are not cumu1ative in cash. AIrears of
""""""-
interest are settled wi1b. an additional. equity issue, and not with cash resources. Tbere may bc cxecution riJks regarding tbe capital issue.
settled wlth eqaity issuaDce
......
... """'" .......
....,.-~ accotIIlting tesII, bat mo.dly CDmalative for Investors
F
w_
G
coupoDS are lost iD smne or aB
""'" MaDda....,.
H
-
tri..... AND non-eumulative Ceature!l
Sourcc:
and the oompany may bc unable In reise additional capital in times of stress. Coupons may then be lost. ~. ~ OI coupons is Iinked to eaming andIor to changes in capital position. Tbc issuer is foroed to dd'er coupons er to raise additional cquity er alternative capital. CouPImII paymcnts are lost and th=fon: do not accumnlate. Instruments O18y or O18y not contain mandatmy defmal provisions based on camings and change! to capital position. The instruments are non-cumuIativc; missed coupoIlll are canccUcd er lost. Mandatory Becounting triggen put thc issum: into a position that it may not be able to prevent 1he loss of the coupon, if breached.
Regent, Dmnien, Credit Research: European Insurance, UBS Investment Bank, London, 05.02.2007, p. 6
Table 6.8: UBS's eight caregories of coupon deferrallanguage
6.2. INSURERS AND REINSURERS AS SPONSORS
181
coupon payments or to raise additional capital in order to be enabled to pay Ihe coupons. The key drivers for sub-debt market growth have not been Ihe regulators, bot 1he rating agency models granting higher equity credit in 1he calculation of geating ratios to Ihese types of bonds,!30 Issuers, in consultation wilh investment banks, stmclure hybrid debt in a way lhat Ihe rating ageneies will view Ihem as significantly equity-like. The ageneies judge 1hree general characteristics: 131
• Maturity: The longer the better. The issues are compared wilh equity which has no stated maturity. The equity consideration for a ca11ab1e bond will be higher, if it includes a rep1acement language in Ihe documentation specifying Ihe tenns of replacement or even a1ready inc1uding a contractual obligation, (hybrid issues can run up to 60 years). • Non-payment: Slwuld not constitute adefault. Dividends on equity are not guaranteed. Mandatory deferra1 provision is Iherefore granted higher equity credit. • Subordination: Needs to be below senior debt. Hybrids should ideally be subordinated to all existing creditors similar to Ihe loss-absorbing featore of common equity. The five-scale c1assification of hybrid bonds by Moody's and Standard & Pool's wilh Ihe relevant corresponding equity credits is shown in figure 6.11: Insurance linked securitisation The introduction of integrated risk and capital management, especially wilh Ihe implementation of Solvency 2, is expected to increase Ihe demand of reinsurance cover. The most important changes in terms of the risk. environment of the insurance company as cedent of risk are 1he following: '32
• the integrated monitoring of business lines • the inc1usion of non-actuarial risk. components (e.g. financial risk on the asset side) • Ihe inc1usion of off-Ihe-balance-sheet risk (e.g. political risk)
• 1he standardised valuation of assets (hidden reserves will partially disappear) • Ihe standardised valuation of reserves (loss equalisation funds will become equity and will disappear) '30Rogettt [see 04.01.2007, p. 16] 131Regentet al. [see 05.04.2006, p. 16] 132Renggli [see 09.11.2005. pp. 8-9]
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
182
-----'S_&e''--------'
_
LI
.....,
c_~
.,.._..,l"..,.,,_ C....
h
~_
...
-
n._....-.. .
....,,,. ........
• ..-........, . . .- _ _
""".,..-.
"... _ _ 'b.....
" , _ , - " , , , '0, __ .. _
.'.........
,_ ' ~""~ T' .... _ _
.- ""...
_-~
...
... p
_--
'F.qU>'Y
J"""'" ..""'", ...... _ >«<1<,"" ~ I1h ,m<=O
Soo,,,,,
Regen •. [)aol1lcn. Credu Rcscar
Il",,~.
1.00don. OH'-I2006. p 7
Figure 6.11: Classification ofhybrid securiti.es by Moody's and S&p's
The process is expocted 10 result in an increase of the volatility of some ba1ance shoet positions. Otherwise, the integrative approach will havc a smoodllng dfect, intcmationally diversified multi-line companies will be in advantage of national companies
and monoline msurers. Ccdents will be interestcd in risk transfer products with the following specifications: 133
• products with multi-line or even holistic cover • multi-year products to be able to withstand cycles • products wbich do not completely Dse up the reservc lines held by the rcinsurcr
_ou=
• bcspokc products. improving the "follow the fortuncs" among the ccdcnt and the
Insurance soclttitisation seerns 10 be the ideal product according with the noeds of the cedent. In addition, the cover providcd through securitisation lowers the sponsor's
tnRmsgli [see09.11.200S, pp. 11-9]
6.2. INSURERS AND RElNSURERS AS SPONSORS
183
cxposure to counteIparty risk. againlrt its rcinsurance providcrs. Thc different types of securitisatien havc alrcady been described in chapter 5. Figure 6.12 summarises thc critcria rcgarding ILS from. thc cedcnt's pcrspcctivc.
T )'p~s
of I nSur" not l. inkf1l
S ~Curi!its
P''',n,i •• \I",i, .,ion
eh ....... i;'i.,
,\pp'i,.'ion
Ilolanc< Sl>t
• [m,I
• [mbolldtd ,a lO< S«u"'ISO"",, (hfe In,,,ra,,,,,,) • S"e of tc-IIISur."". "'''''".... k:s
• ') 1""" )'"~ be,"",," ",~. ar;j
• r"plc·X SC<,,"''''''''''
C.pllot
Man~emc"l '
Mb 11f"S<.c""wie",,,,,",
oo>ode,."",,,
• A,blt",ge be1\lCO" ",~.
8 • Rorogn""'" as",k ,,,,,,,fo'!»' ."" ',&ul"'O<)' ......... ,,""' Ri,l Manag<m
• C.... lfopho >ngcr l<:m" ,bon «'ns"","cc
I'onr~l i o
• l'h J"':'"," aga in" an adwrso ...., dc".klpn",o,
Man.ge..,.."
• Se
Sou""': S'ahlmann . Ben. Te ll er. Niool." Weid", .\IOgliohlei'en biN<" die Ve rsicherungs. ,erbriefung rut die beleiligten I'an~icn'·. in: Krcdilwcscn. FranLfun 2007. p. J I
Figurc 6.12: Sponsors' criteria regarding ILS
The business models of insurers are evolving towards thc management and intcnncdiatien of risks: Risks are taken from. the policyholder. poolc:d, structurcd, and cxtemaliscd through :reinsurance programmes or transferred to thc financial markets via securitisation. Pre-conditions for this process are an cffective diversification supported by thc risk managcment and a moderate amount of capital. Further. a well functioning ALM most be in place in order to handle thc cash fiow Streams. l34 Securitisation is further used by the insurance sector as an effective tool to achieve a grcater diversi:lication in assct sources or to tap ncw investor groups. The liquidity attracted through thc creation of tradeab1e securities may be employed to finance future new business generation or co-finance acquisitions.13S In a demutualisation process the nced for funding is acute, and in many cases securitisation solutions were favoured. The increasing importance of capital management, especially in the EU, may be an ad134-~ [see 27.05.07, p. 4] I"Wa!bof etal [eeOl.ll.200S, p. 7]
184
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
ditional driver for securitisation. 136 Securitisation can help to res1ructore and manage the balance sheet and to sustain solvency relief benefits. Even if regulatory capital relief is not granted, the economic capital of insnrers may be released, and they further benefit from the process, since they want to be seen as heing active in a market which is perceived to be innovative. Tbey like to ensure that the company is able to build an alternative to traditional reinsurance. 137 138 Tbe products may be used further as risk management tools to manage the matority mismatch between assets and liabilities. Although costs for securitisations are high, they can increase the underwriting capacity at lower cost compated to the issue of additional equity. Traditional reinsurance premiums lIuctuate cyclically. Since securitisations are structured as multi-year transactions, the cedent is able to fix the cost for a number of years instead of closing reinsurance contracts for one-year periods only. In the context of portfolio management, existing risks in a specific sector can be reduced via the transfer of risk - securitisation provides protection against adverse developments. 139 140 Securitisation creates the possibility of separating the insurance policy origination function from the investment management and risk beating functions. Tbe instrument is cleaner and quicker than traditional reinsurance, since the trigger event is usually wen defined and the payment in case of the loss event is due on first demand. Compated to traditional reinsurance, there is no timing risk because of a potential delay in payment in case of any objections by the obligor.'4'
6.2.5
Results of the interviews regarding sponsors
Regarding the acceptance of ILS products, one has to differentiate between reinsurance companies, bigger insurance conglomerates, and smaller insurance companies. Further, one has to differentiate between strategie issuers coming permanently to the markets and opportwristic issuers which temporarily take advantage of attractive marke! environments. 142 Drivers Leading reinsurance cornpauies usually have their ILS programmes in place. Due to their sophisticated internal models, they feel comfortable to bear the basis risk and therefore are able to s1ructure transactions with indemuity, modeled loss, or parametrie triggers. 143 The intention is to increase capacity as weIl as to transfer risk to the 136FSA [see 01.05.2002, p. 51]
137Stahlmann and Teller [see 2007, 17] 138FSA [sec 01.05.2002, p. 50] 139Walhofetal. [see 01.11.2005, p. 7] '''''FsA [see 01.05.2002, p. 49] 141FSA [sec 01.05.2002, p. 50] 142INT_I_MOD [19.08.2008] 143INT_I_MOD [19.08.2008]
6.2. INSURERS AND REINSURERS AS SPONSORS
185
markets. Reinsurers normally lever 1heir capital base 4-6 times. 111erefore they are interested in diversifying their portfolios internationa1ly and among perils in order to protect themselves against concentration of risk. 144 The bigger insurance conglomerates also use ILS transactions in order to diversify their capital source.'45 In Europe, the activity of primary insurers depends on their business: Allianz, for instance, was acti.ve in catastrophe bonds, while AXA introduced the transferted of motor risk to the markets. 111e life insurers Aviva and Royal & Sun Alliance further announced !hat they will use lLS as part of their capital strategy.l46 While smaller European insurers and mutual players are rarely seen on 1he market as sponsors yet, their US peers regularly plaee n..S. 111e reason for 1he evolving of US transactions was the lack of capacity in 1he years 2004 and 2005, causing 1he insurance compaoies to search for alternative capacity and lower, stable pricing which they found on the lLS market. 111e PeS index helped to establish parametric n..S in the USo European primary insurers rather favour indemnity structures, since there is almost DO difference to the reinsurance protection they are used to. 147 There have been phases of hard mark.ets, when primary insurers were dominating the issuance activity because reinsurers were writing their business restrictive at high rates, and weak market phases, when reinsurance sponsors dominated the issuance activity.l48 In Europe. mutual insurance companies are expected to become interested after the introduction of Solvency 2, since 1hey will have to intensify their ALM.14. Sponsors have been attracted to lLS for several reasons, and several drivers of the market today were mentioned: Pricing: Wben lLS started after 1he Northridge Earthquake in 1994, 1he market needed a jump-start pricing for the first issue by USAA. I50 Today, sponsors will be interested in 1LS, when the costs of the structures are lower than the yield they have to pay to equity holders. 111e return-on-equity after the p1acernent of a transaction should improve by a minimum of 0.5% to m.ak.e the issue attractive. 151 Diversification of reinsurance source: Sponsors are interested in a broad capital basis to prntect themselves for times when capacity is short. I '2 It was stated !hat. regarding non-life, compaoies purchasing coverage of more than USD 400 m1n should consider lLS as an alternative, especially for 1he higher layers and remote risk. 1S3 Primary insurers, through ILS, get the possibility to sponsor risk transfer transactions without the 144INI'-4-BNK [04.09.2008] 14SINI'_1_MOD [19.08.2008] 146JNT_23_BNK [28.10.2008] 147INI'_1_MOD [19.08.2008] 148INI'_20-BNK [20.10.2008] 149INI'_1_MOD [19.08.2008] 150INI'_12-INV [14.09.2008] lSIINI'_26-INV [29.10.2008] 152JNT4-BNK [04.09.2008];1NT-7-REI [22.09.2008] lS3INI'-4-BNK [04.09.2008]
[08.09.2008];JNT-I4-SUP
[19.09.2008I;JNT-15-RAT
186
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
involvement of reinsurers at all. ILS as an alternative may enable them to put pressure on reinsurance when negotiating the terms and pricing for their cover. 1S4 Multi-year prieing: Closely linlred to the diversifieation argnment is!hat sponsors bave the ability to lock in multi-year prieing. Especially in traditionallife reinsuranee, the market for long-term eoverage up to 40 years is rather limited. 155 Througb the issuanee of 1LS, sponsors get independent from the vagaries of the fast-ehanging reinsuranee prieing cycle. 1So Collatoralised natnre of the product: Sponsors do not bave to he coneerned about the eredit risk of the eounterparty.157 Clean payout mechanism: From day one, every party in the process has agreed to the method for triggering the bond, no matter wbether it is indemnity-, modeled-, or index-based. This means that there is no time delay and limited litigation risk. 158 Rating and repotational effects: Tbe sponsor, through the involveroent of the ratiog agencies in the process, ean prove to the market !hat he has a functioning enterprise risk management His eompetitors are getting aware of the ability of the sponsor to struetnre an ILS transaction. 159 Regulatory enviroornent: Sponsors in the US life sector got attracted to ILS through the introduction of XXXIAXXX regulations. Tbe eapital reqnirements suddenly were so bigh !hat there is an exeess that ean be securitised and arnortised. Solvency 2 may favour already establisbed structures like mortality catastrophe bonds, the monetisation of future premiums, or struetnres wbieb eash out expected futnre profits. l60 Ob.tael.. In many cases, especially in the life sector, the management is rather reinsurance oriented. Wbile CFOs usual1y are in permanent dialogue with banks and some of them worked in banks hefore, CEOs usually have their rools in insuranee and maintain close eontacts to reinsurers. The person promoting ILS internally may run a career risk by introducing new reinsurance structures. Tbe organisations' mindset may have to be ehanged, people have to bave some vision and strategie perspective to buy into the ideas of ILS. 161 There is a certain amount of insecurity of sponsors putting too much stake into ILS, sinee they need to maintain long-term relationsbips with reinsurers as weil.
Not evetybody in the insurance sector has been convinced that it is in the best interest to invite the broader capital markets into their tetritory.l62 "'INT-22-BNK [27.1O.2008]:JNT-23-BNK [28.10.2008] 15SINT_2-BNK [02.09.2008] "'INT-4-BNK [04.09.2008];INT-15-RAT [22.09.2008] 157INT-16-REI [23.09.2008];INT-2-BNK [02.09.2008] '''INT-2-BNK [02.09.2008];INT-4-BNK [04.09.2008] "'INT-2-BNK [02.09.2008] 160INT_28_ASO [03.11.2008] 161INT_27_BNK [29.10.2008] 1O'INT-19-ASO [26.09.2008]
6.2. INSURERS AND REINSURERS AS SPONSORS
187
Hard markets may be the right timing to start with multi-year ILS. However, despite the benefits an ILS structure offers, there remains a tension between reinsurance protection and 1LS in terms of pricing.'63 Although it is not necessary !hat the sponsor is a public1y listed company, they need to prepare the offering circular in aceordance to the strict 144A standards. Smaller companies may not have the data necessary for the periodie reports avai1able. They may not have the expertise and the IT systems avai1able in order to generate the historicaI pool information which is necessary for the rating agencies and investors. New reguiations corrently being discussed can be expected to require a significant amount of due diligence procedures by investors, and they need to have aceess to sufficient data. 164 Especially regording smaller sponsors, there is a hurdle to get around the structoring complexity of 1LS products compared to wriring traditional reinsurance which they are familiar with. The lack of supply is holding back the ILS market from growing. The creation of new perils and structures at attractive retums is important for keeping the interest of the investors alive. Tune, cost and expenses have to be invested by the sponsors in order to reward investors for deploying the resoorces and the time to evaluate the sector. '65 Even for ILS with indenmity triggers, raring agencies do not give full equity credit if there is basis risk involved. Sponsors therefore face higher rating agency capital
requirements than for reinsurance cover. l66 They further demand the reguiatory aceeptance of products and would appreciate a capital relief similar to reinsurance. Tbc market is influenced by regulators concentrating on the controlling of prices inslead of allowing a competitive market. Govermnents stepping in and e1iminaring private marke! mechanisms are seen as an obstaele. For instance, Florida taxpayers not only pay for supercat risk which is defined as once-inlOO-years events, but also for cat events, which are defined as once-in-lO-years. Govermnents should be involved in a constructive way: they could, for instance, establish a census bureau for cat damages, get uniform wind speed recording stations installed. or create tax pass-through regulatioDs. 161 Sponsors are not ahle to reinsure terrorism risk through ILS, since there is no model for it - the availahility of models in generailimits the growth of the business. l68 Life 1LS in EU take time to develop - but signs are encouraging. Insurers' enterprise risk management regording valuation of life book versus annuity book is pretty unsophisticated. Some insurers have a poor grasp of morta1ity risk in general, and only a few actuaries within the organisations are familiar with the problems. In general, sponsors need more education. New prnducts for longevity risk transfer with indexed swaps 163INf_S_BNK [04.09.2008[:INf-ll-CON [l2.09.2008[ 16'INf4BNK [04.09.2008[:INf-28-ASO [03.11.20081 l"INf-2-BNK [02.09.2008[;INf-II-CON [12.09.2008[ 16'INf-I-MOD [19.08.2OO81:INf-ll.coN [12.09.20081 167INf-<;_ASO [05.09.2OO81;INf-II.coN [12.09.2OO81;INf-18-INV [24.09.20081 168INT_16-REI [23.09.2008]
188
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
versus mortality risk coverage are emerging.'69 PeriIs
Non-life products cover US regions exposed to wind risk by almost 100%, and there is a liquid market. Califomia earthquake cover is weil establisbed, but less dernand for the bunds is recorded. ILS covering floods have emerged after hurrlcane Katrlna. A substantial nornber of market participants regard the current discussions in the US congress to establisb a federal flood insurance programme by the state as counterproductive. Tbe govemment should leave as much as possib1e with the competitive private sector. Th.ere have been ILS to cover potential earthquakes in Mexico and the Caribbean elosed by Swiss Re. Additional European wind and earthquake exposures, also for Turkey, are being discussed. Japan traditionally has a weil established marke! for earthquake aod typhoon risk, and ILS have been placed for catastrophe risk in Australia Tbe market expects substantial growth for the Asian markets, especially China.'70 Life secnrltisation offers a wide spectrurn of peri1s which can be covered. Emhedded value curves out part of the risk for a better pricing and is the elosest product to the c1assical securitisation of banks. 171 XXX is financing the lack of reserve capacity. Due to the deterioration of the monoline insurance sector, alternative products to ILS are being developed. Tbey p1ace the life insurance tail-risk to the capital market for long terms ranging from 10 to 30 years. 172 Arrangers are offering customised hedging with arc mortality swaps. Tbe contracts are closed between the hedger. usually a life insurer or a pension plan provider, and the end-investor. In order to limit the credit risl<, an investment bank is in between as intermediary. Transactions effected anoong pension plans and banks can be fu11y p1aced to end-investors. Tbese transactions are regulated by the ISDA or CSA standsrd and do not require a SPRV. Cash flows are exchanged every month, after a new mortality report about the portfolio is delivered. Tbe cash flows are calcuIated by adding the discounted net value of each swap-Ieg. Tbe investor then pays the hedger the pension obligation, while the hedger pays the bank a fixed payment including a risk premium. Tbe bank is backed by its swaps with the end-investors. Tbe investor takes the risk !hat mortality is less than expected. Tbe long term up to 40 years is certaiuIy a cha11enge, but is identical to reinsurance with the benefit that it is col1ateralised - the transaction requires a daily collatera1 exchange managed by the bank who does stochastic calcuIations about the risk taken. Tbc transaction can be carried out without the involvement of areinsurer or a monoline insurer. arc mortality swaps got fu11 capital release by UK regulators aod the rating agencies. They were treated simi1ar to reinsurance. Simi1ar relief is expected under Solvency 2. A potential delay of Solvency 2 is no reason for sponsors not to enler '''INT-27-BNK [29.10.2008] 17<)INT-4-BNK [04.09.2008];INT-19-ASO [26.09.2008] 171INT_7_REI [08.09.2008]
172INT-6-ASO [05.09.2008]
6.2. INSURERS AND REINSURERS AS SPONSORS
189
long-term transactions, since investors get the contractual commitment \hat they may unwind the transaction if an unexpected change of the legislation may occur. 173 Another alternative are oIc morta1ity swap structures based on indices taking for reference a national population index rather than a block of life insurance policies. 174 Due to the uncertainties involved, longevity transactions are much harder to model than mortality catastrophe risk. Further, a block of deferred annuities still open for new business and starti.ng to pay out in one or !wo decades in the future, is harder to model than a block of life insurance policies for a1ready retired people. [75 Life products are a method to recycle business. Cornpanies are enabled to write more or acquire longevity businesses by using them. More standardisation would ease the risk transfer in this market and would allow trading of packages. Investment banks are interested in putting in p1ace infrastructure with more dealers if demand picks up. [76
173INf_27_BNK [29.10.2008] 1741NI'_27_BNK [29.10.2008] 17.5INI'_27_BNK [29.10.2008] 176INT_27_BNK [29.10.2008]
190
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
6.3
Rating agencies and risk modelers
6.3.1
Rating agencies' services
Rating agencies are service providers giving c.pital market participants an independent view of the general creditworthiness of • borrower or of tbe creditwortbiness of • borrower witb respect to its .bility to meet • debt security or specified financial oblig.tion, b.sed on certain risk factors. Tbey oper.te witbout • government mandate and are indepeodent of any regnl.tory body. Further, tbey are independeot of any corporation, bank, or similar bOdy.177 Tbe .geocies genera11y provide tbree types of insurance ratings: Debt ratings .ssess tbe ability of tbe company to repay a specific issue. Counterparty credit ratings
assess the company's creditworthiness from a general creditor's perspective. Financial strength ratings judge the company's general .bility to meets its policyholder's claims and its oblig.tions in time. Ratings help to address tbe information asymmetries betweeo differeot groups of market participants. Tbey are .ble to compare tbe ratings of different companies active in tbe market. High ratings play an important role, especially when buying insurance or reinsurance for longer terms. Customers buying a life insurance contract get more comfort witb • higher r.ted company. Primary insurers judge tbe robustoess of tbeir reinsurance "hedge" by tbe rating of tbeir couoterparty. Regnlators justify tbe capital relief for tbe primary insurers for reinsurance purch.sed on tbe b.sis of the reinsurer's financialstrengtb ratings. Tbe majority of tbe r.tings are interactive, meaning !bat • r.ted company requests • rating providing tbe .gency witb uopublished intemal information. Altematively, tbe r.ting .geocy may use publicly .vailable information about tbe rated eotity onlyP' Especially regarding reinsurance, rating .geocies are coromonly viewed by tbe insurance sector, investors, and otber market participants as tbe "de f.cto" regnlators. In some jorisdictions, rating ageocies h.ve developed a much closer relationship to tbe reinsorers tban tbe regnl.tors and therefore have • greater knowledge tban tbe supervisors. Further, the agencies analyse the entire groups on a global basis, while many regnl.tors take • local approach only. Altbough tbe rating process cannot replace an effective prudential supervision, tbe tbre.t of neg.tive rating change may sometimes be more effective tban supervisory analysis. Ratings enable marke! participants to quickly
obtain an overview of the financial strength of the insurerlreinsurer. 179 Due to the adverse development in many asset c1asses they were involved in, the further need of rating .gencies was questioned by the general market. Regarding ILS, tbey were accused for not having recognised tbe ruismatch between .ssets and liabilities. FortIIer, tbey did not grant full transparency of tbeir metbodology and included too many soft facts in their rating analysis. However, there is a common understandlnStandard and Poor's [see 27.09.2004, p. 9] 178Prenkel et aL [see 2006, p. 27] 179Frenkel et aL [see 2006, p. 72]
6.3. RATING AGENCIES AND RISK MODELERS
191
ing among stakeholders Ihat, on Ihe condition lhat 1heir melhodology is fully disclosed in Ihe future, Ihey will be able to provide a valuable Ihird-party view on transactions, knowing Ihe sponsors very weil and having detailed legal and insurance know-how.'80
6.3.2
Importance of enterprise risk management and capital for insurer's ratiogs
Caused by 1he catasttophe events in recent years, Ihe risk management tools and practices of 1he insurance seetor have advanced significantly. Tbe trend to holistic "enterprise risk management" (ERM) including eeonomic capital models, more sophisticated catasttophe management, and dynamic hedging programmes, has increasingly been impacting Ihe overall rating process of Ihe agencies. l81 AM Best has published its melhodology regarding Ihe assessment of risk management and Ihe rating process for insurance companies. It outlines Ihe importance of the development of enterprise-wide risk management systems in the insurance sector, stating Ihat it is not Ihe objective of risk management to eliminate risk, but to understand and manage it. 182 ERM is characterised by adding value in Ihree areas: First, it inftuences corporate culture, since Ihere need to be clear directives established by senior management and Ihe board. Tbe directives have to be followed up by a sttong risk-aware cu1ture among officers and directors working on a common language and understanding of risk. Tbere needs to be a common set of rules governing accountability and incentive compensation. Second, Ihe corporation needs to identify Ihe key risks for Ihe organisation and to establish detailed conttols and procedures to manage Ihe impact of Ihose risks on its value. Beside 1he wide variety of risk identification and management provided by traditional risk management, ERM adds a more comprehensive approach. It includes Ihe deve10pment of a consistent, corporation-wide set of guidelines forma1ising Ihe risk management activities and Ihe shating of information across business lines and functions. Third, individual risks are managed wilh respect to Iheir correlation. Tbe ability to consistently quantify 1he risks wilh sophisticated tools and data-collection procedures is key to ensure Ihe data's integrity. The impact of risk correlations on the corporation enables natural hedges across business lines. A.M. Best is evaluating Ihe ERM wilh a detailed catalogue of sttong and weak criteria. l83 Benea1h ERM, Ihe final ratings judgement is based on Ihe company's balance sheet strenglh, operating performance, and business profile. Tbe rating approach by AM Best concentrates on balance sheet streng1h. Tbe "Best Capital Adequacy Rating" score (BCAR), defined as Ihe ratio of adjusted statulory capital to required capital, is one of Ihe most important factors in determining a company's rating. 18' Tbe adjusted capital 180Lathuillerie et W. [27.10.2008] l!1lEasop et al. [see 25.01.2008. pp. 1-2] 182Easop et al. [see 25.01.2008, pp. 1-4] 183Shimpi [see 2007, p. 2] 1ll4Easop et al. [see 25.01.2008. pp. 3-7]
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
192
is a company's reported surplus afrer adjustments reflecting the after-tax impact Of: '85 • adding equity in uneamed premium reserves
o adding equity (discouot amouot) in 10ss reserves o adding redundancy or deducting deficiency in 10ss reserves o adding or deducting market value versus book value of fixed income portfolio o deducting one oet catastrophe 10ss (the higher of a once-in-l00-years windstorm or a once-in-250-years earthquake) Tbe required capital is the amouot of capital !hat AM Best estimates the company needs 10 support its risk profile. Asset, credi!, uoderwriting, and reserve risks are takeu into consideration, while catastrophe risk is a1ready inc1uded in the adjustment of the statutory capital. Tbe Minimum BCAR scores for the AM Best rating categories are shown in table 6.9. 186 MlnImmn BCAR 17>
160 145 130 115
100 Source:
-. A++ A+ A AB++ B+
Fleckcnstein, Micheie; et al., Rating Agency Update Guy Carpenter, New York, 01.11.2006, p. 29
Table 6.9: AM Best: Miuimum BCAR and rating Althougb BCAR is an assessment of capital adequacy at a point in time only, it helps 10 differentiate between compaoies and indicate whether a company's capitalisation is approptiBte for its rating level. Tbe operating performance evaluation includes the vatious financial management practices and operating elements dictating the company's performance and its exposnre 10 capital volatility. Tbe hosiness profile enables the analyst 10 estimate a company's ability 10 generate fotnre profits 10 optintise stakeholder value and to strengthen its capital basis. Strong performers are companies with consistent, sustainable earnings. 187 Fitch Ratings introduced PRISM, a methodology and model for the capital assessment of insurauce corupaoies, in 2006. Fitch changed its approach by incorporating the results of iusurers' "in-house" capital models into its ratings analysis. PRISM determines the capital adequacy of the rated company using a stochastic measnre of required capital across sectors and counmes of operation on a CODsistent basis. The eore of the 185Fleckenstcin et al. [see 2006, p. 29] 186F1eckenstein et W. [see 2006, p. 29] lB7Easop ct al. [see 25.01.2008, pp. 3-7]
6.3. RATING AGPNClES AND RlSK MODELERS
193
model ja an integrated economic scenario generator providing results based on 5.000 scenarios of the primary sources of risk found &cross the global insurance industry as sbown in figurc 6.13. The system can be lUD solely on public data. Divenification cremt is generated directly by the system. PRISM enables the user to compare the capital adequacy of companies. for instance those of an UK automobile insurer. with a life insurance company in France. Fitch decided to build tbe model because insuras in Europe increasingly start to use "in-house" models which differ substantially :from. com.pany to company. their outputs being difficu1t to compare with one-another. The risk is primarily measmed by ES and secondarily by VaR.
1
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Rist types modeled by Fitchrating's PRISM
Fitch ca1ibratcs the simulated losses to rating standards within the fo11owing steps: First, historical bond default rates are used u a starting point Capital requirements are allocated by rating category bued on historical ratings experlence. Second. YaR tbresholds are calculated by rating category. The target pereentile is calculated by subtracting 1 default rate. e.g. for a 100year horizon, if the cumulative default rate at level "BBB" is 5%, the targeted VAR to define ~BBB~ risk capital would be the 95th pereentile. Third, the YaR thresholds are converted into ES thresholds. Fourth. the insurer's liability duration is considercd. Fifth, the required capital is determined bll8ed on a comhination of liability time horizons. The focus of PRISM is to measure risk &cross the entire CQ-
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
194
terprise. It ensures Ih.t adequate consideralion is provided to risk factors potenlially offsetting one another. 188 Moody's .pproach, ra1her 1hao building its own model, is b.sed on "interrog.lion, not replic.tion". The ratiog company performs an in-deplh qnantitative and qualitative analysis of Ihe company's risk man.gement and econontic c.pital framework. '89 Risk management is viewed as • core competency and • critical dtiver for Ihe insurance companies. Moody's publisbed 1heir detailed rating melhodology for global and regionallife and non-life insurance companies.'90'9' Furlher, detailed guidelines inc1uding questionnaires exist far the assessment of risk management of life and non-life insurers. '92'93 The output of Ihe company's econontic capital calculations is included in Moody's overall risk management view. The c.pital strenglh ratiug is • result of Moody's confidence in the economic capital m.ethodology used and the agency's own view of Ihe insurer's c.pital streoglh. Important factors of Ihe analysis are listed below: l94
• extent of integration of the model into the regular business and risk management processes
• us.ge of Ihe results of Ihe model by Ihe senior management for decision processes
• future sustain.bility and extendability of Ihe model
• comprehensiveness of the risk: identification process • exposure to extemal checking by .uditors or consultants • c.p.bility to perform sceuarlo testiog on short notice • whe1her Ihere is any public diselosure of Ihe results • us.ge of prudent melhodologies, especially regarding areas of greater uncertainty • us.ge of sophislic.ted and recoguised software packages
• availability and usage of extensive experience analysis • evidence of consider.tions of stress-tests (hypolhetical scenarios) • re1iance on recoguised external data or model providers where required and .ppropriate (especially for economic scenario generation or natural catastrophe modeling) 18!1Mohrenweiser et al. [see 06.06.2006. pp. 1-4] 189Hunisett et al. [see 01.06.2006, pp. 1-2] 190Collins et al. [see 01.09.2006] 191Perry et al. [see 01.09.2006] 151 2Geny ot al. [see 01.03.2007] 1513Bergetal. [see 01.03.2007] 1945hhnpi [see 2007, pp. 1-2]
6.3. RATING AGENCIES AND RISK MODELERS
195
Tbe insurer's balance sheet is regarded as a mix of sold complex loog-dated optioos on both the asset and liability side. Variable annuities on the liabilities side and mortgages or mortgage-backed securities on the asset side are examples which are susceptible to prepayments triggered by finaocial (interest rates) and non-finaocial (personal) drivers. Tbe companies just started to include the complex products into their models. A wide range of regulatory, accounting, aod taxation regimes add to the complexity of issues. In Moody's opinion, these differences are such that building aglobaI or even pan-Europeao model would result in significaot loss of specificity and oversimplification of the particular business being considered. Tberefore, the optimal approach in their opinion is to concentrate on thorough interrogation of the companies' interual models.'·' Although they decided not to develop a general insuraoce capital model, Moody's uses maoy quantitative models for the rating process. One model framework used by Moody's helps to understand the methodology regarding reinsuraoce exposure and the underwriting of natoral catastrophe risk: In order to quaotify the various sourees of risk within a US noo-life insuraoce group aod to gauge the adequacy of a group's resourees for covering those risks, "Moody's Property & Casualty Risk Adjusted Capital Model" (MRAC) was developed.'·6 MRAC is a ooe-year timeframe model which employs Monte Carlo simulations, typically 60,000 iterations, to develop the estimated probability distributioo for the aggregate future performaoce of the group. Certain adjustments are made to discount cash f1ows, e.g. for claims payments !hat are expected to stretch out over a longer period. Tbe NAiC Annual Statements are the main souree of basic data input. For companies outside the USA, features of the model may be adapted to refleet different data sets available and appropriate. To cstimate the required capital, MRAC simulates the exposures in the four key areas: investments, reinsurance, reserves, and underwriting. Tbe results of the simulations are combined, allowing for correlation effects to get ao aggregate probability distributioo of the expected performaoce of the compaoy.'97 Tbe informatioo gained is used in different ways within Moody's rating process: Tbe quantitative data produced about the discrete sourees of risk within a non-life insuraoce group is used by aoalysts to focus their inquiry and investigatioo of certain business risk areas. Further, the information is used to establish an estimated rank ordering of creditworthiness among non-life insuraoce groups hased on a fairly extensive and consistent examination of their different risks. The MRAC ratio is computed by dividing the available capital by the required capital estimated by the model. Tbe ratio as well as its estimatcs of default risk and expected loss for ao insuraoce group arc used to compare the existing rating to other independent indicators of creditworthiness such as option-adjusted trading spreads or CDS spreads.'·8 195Hunisettetal. [see 01.06.2006, pp. 1-2] 196Barker et al. [see 01.08.2006, pp. 1-2] 197Barkeret al. [see 01.08.2006, pp. 1-2] 198Heerde and Martin [see 01.09.2007. p. 6]
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
196
By ceding risk to areinsurer, the company is exposed to the risk of a shortfall in collection of reinsurance assets. This is the case for both on-balance sheet and off-balance sheet if contingent reinsurance assets were agreed. The reason may be a deterioration in the creditworthiness of the reinsurer or his unwi1lingness to pay due to legal disputes. Tbe sampie in table 6.10 shows that MRAC applies higher charges and staodard deviations to reinsurance recoverables from companies with lower ratings.
""""" ......... s_ _
..... '
S
Bu
1% 2% ,% 10%
1% 2% ,% 10%
All othcr ratings
25%
25%
Aoa Aa A
Source:
BaIkcr, Thomas; Cl al., Moody's Risk. Adjusted Capital Model for US Property & Casualty Insureu, Moody's Investor Sernce, New YOIk. 01.08.2006, p. 9
Table 6.10: Moody's MRAC: Charge for reinsurers' IFRS ratings
The charges are determined stochasticaIly, so that each simulation results in a different reinsurance recoverable charge although the reinsurers may be in the same rating category. MRAC first e1iminates all recoverahles from affiliates of the insurer (intra-group). Fnrther, the model distingnishes between reinsurance risk from four different sourees: I) paid loss recoverables, 2) ceded reserve development, 3) ceded underwriting, or 4) ceded catastrophes. Within the simulation, Moody's assurnes a 50% correlation between the several reinsurance rating buckets. Funds withheld, letters of credit, and other farms of collateral serve to reduce risk of non-collection and are given credit in the ca1culation of the adjusted and required capital. Tbe US staodard information provided in Schedule F, Part 5 of the statutory statements, e.g. is used to reduce the recoverahle before applying the reinsurance charge. Tbe model gives 100% credit for funds withheld and 95% for letters of credit provided. Tbe net recoverables are mapped as shown in the sampie of table 6.11 to the corresponding reinsurer, and a rating is identified. For the USD 300 mlo of net reinsurance recoverables reported by the company in the example below, MRAC charges USD 25 mlo to the capital. l99 Tbe underwriting risk calculation is intended to captore the profitability of an insurer's uneamed premium and one half year's worth of new business to incorporate one full year of business. Tbe profitahility for the new business is estimated with the loss ratio and staodsrd deviation generated by the reserve risk module of the model. Loss ratios of each business !ine are simulated using a lognormal distribution, and correlations between business !ines are estimated using industry aggregate data subject 10 Moody's judgement Tbe expense ratio and the "unallocated loss adjustment expenses" are constaot across all business !ines and for the most recent accident year in order to simplify the process (unaIlocated 10ss adjustment expenses are those claim settlement costs which either 199Barkeret al. [see 01.08.2006. pp. 9-10]
6.3. RATING AGENCIES AND RISK MODELERS
197
Source: Barker, Thomas; et al.• Moody's Risk Adjusted Capital Model for US Pmperty 01: Casualty Insurers, Moody's Investor Service, New YOlk: 01.08.2006. p. 9
Table 6.11: Moody's MRAC: Sampie reinsurance recoverable chart cannot or for practical reasons are not directly allocated by an individual claim. For instance, claim department salaries, travel, postage, rent, and equipment would be classified as unallocated lass adjustment expenses, since under typical insurance company record keeping systems these costs would not be associated with individual claims. However, attomey fees, independent adjuster fees, doctor fees, court costs, and police report costs are classified as "aIloca1ed loss expenses" because these costs are typically assigned to specific claimS).200 Catastrophe /osses from underwriting risk are simulated separately from general underwriting above. Moody's has estimated industry loss curves for the seven major catsstrophes in the US: South Atlantic Wind, Gulf Wind, Mid Atlantic Wind, North Atlantic Wind, New Madtid Earthquske (I and 2), California Earthquske, and Pacific North West Earthquske. Table 6.12 shows an exarnple of the catastrophe charge for one simulation. Tbe company is supposed to have exposure to South Atlantic Wmd and Pacific North West Earthquske only. The values shown in the table form the theoretica! exceedence curve far the company for each catastrophe. The random numbers are drawn uncorrelatedly for each catastrophe and the losses are aIl added up to form the total catastrophe charge for the single simulation.201 MRAC uses a market share approach to calculate the estimated losses of a company. Bach company analysed has an own exceedence curve based on its market share of gross wtitten underwriting premium for the relevant perils in the regions listed. For each individual catastrophe, the total of its state aIlocations will sum up to 100%. Tbe inputs for the model are the gross wtitten premiurns wtitren by the company within each state, by business !ine, and as a share of the total marke!. Tbe individual exceedence curve ofthe company can be derived from the overall industry curve (see Appendix K). The single simulation picks a random point from each exceedence curve, corresponding to the estimated loss of the company caused by each catastrophe.202 Table 6.13 shows the effect of the single simulations (in Ibis case, simulation numher I, 2, 3, 4 and 60,000) on the change of the relevant reserves either as deficiency 200Barkeret al. [see 01.08.2006, pp. 13-14] 201Barkeret al. [see 01.08.2006, pp. 13-14] 2{)2Barker et a1. [see 01.08.2006. pp. 13-14]
198
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
Barker. Themas; et al., Moody's Rist Adjusted Capital Model fot US Property & Casualty Insurers, Moody's Investor SCrvice. New York 01.08.2006. p. 14
Source:
Table 6.12: Moody's MRAC: Company one-simulation exceedence curve (figure shown in brackets) or as redundancy (no brackets). Tbe model assnmes that most risks are uncorrelated, while some positive correlations among the individual asset c1asses and lines of bosiness may be considered. After adding risk charges and offsetting for taxes, the model rnns 60,000 simulations in order to ensure robust results. Tbe required capital at the 99.9% confidence level necessary for the category, e.g. underwriting, can be taken as the 60th highest loss corresponding to the once-in-l,OOO-years level capital.
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& Casualty Insurers, Moody's Investor SCrvi.ce. New York 01.08.2006. p. 14
Table 6.13: Moody's MRAC: Overa1l required capital simulation Figure 6.14 is an example of a distribution resulting out of a ca! risk simulation. Tbe once-in-l,OOO-years value USD 300 mln after correcting the correlation benefit results in required capital of USD 171 mln for the cat risk exposnre of the company. By observing the results of the simulation, a breakdown of the company's risks at the stressed levels can be recognised. Tbe sampie of figure 6.15 shows the typical drivers oflosses at stress levels. Catastrophe risk and reserve risk. are the major risks for the company at the 99.9%, respectively the once-in-l,OOO-years confidence level. Tbe shares reflect the contribotion of each risk to total required capital.203 Fina1ly, Moody's considers the ratio of actual capital to required capital in order to 203Barkeretal. [see01.08.2006,pp. 15]
6.3. RATING AGPNClES AND RlSK MODELERS
199
Zero Loss J
in 1000 after rorrdali"n ewnl I in 1000 (60th "",,1)
=' - v -== ' Requi",d capila) (dcnomialor)
om
Soure.: lJarkcr. "rhomas: cl aJ.. Mood)'s Kisl AdjuSlcd Capital Model ror US I'rupcn} & Ca'Uall} In$u",,,. Mood)'s In"estor Sen'ie". Ne" Yor~, 01.0&.2006. p. 18
Figure 6.14: Cat risk distribution graph make judgements about tbe capital adequacy of the company. The numerator of tbe ratio is the company's book adju!lt.ed capital and the denominator is the company's total MRAC charge at 99.9% 1eve1. It is important to remind that certain adjustments are made to the nominator in order to yield an amount morc refiecti.ve of the com.pany's true, or book: adjusted, capital ODe year in tbe future. The denominator is adjusted with the same amount because it represents the amount of capital necessary to cover the difference between the expected result and the 99.9% 10ss result. If the model did not adjust the denominator as well, the ratio could potentially penalize a company in both the numerator and the denominator for the same deficiency.204Far the actual rating det:ennination, the analyst will consider the MRAC model for US insurers ar the rather basic ratios listed in table 6.14. The gross underwriting 1everage as predictive ratio for capital adequacy is calculated as the gross written premiums dividcd by thc sbareholder's cquity.20S It is interesting to note that the weigbting of capital adequacy is only 15% among Moody's seven scoring factors far the financial strength ratings of non-life insurance com.panies. Bach ofthe seven contributing factors rcceives a rating, either qualitativc1y
2I)4.Barmet 11. [see OI.08.2OO6,pp. 18-20] 2O!I~etal. [see2006,pp. 34-36]
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
200
Rcin ~ura"fe
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&Casuall) I",u",rs. Moody" •. Ne" V<:>r\;. 2006. p 1$
Flgure 6.15: Non-life insurance: drivers oflasses through ratios or quantitatively by the analyst. Business profile factors Iike market
positioning and brand. product risk and diversification weight one third of the scores. Financial. profile factors like asset quality. capital adequacy. profitability. rcserve adcquacy, and financial flexibility weight two thirds. 206
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Gur Cupcmc!r, New Yad: 01.11.2006,.p. 34 Table 6.14: Moody's: Gross underwriting1everage andrating Standard and Poar's. in their process to evaluate an insurance company. have always analysed the company's risk factors and how these are managcd. After consultation with the insurance sector, Standard & Poor's in 2006 published their formal. evaluation criteria fur ERM. Tbe evaluation of an insurer's ERM includes the assessment
6.3. RATING AGENCIES AND RISK MODELERS
201
of risk management cultnre, risk controls, emerging risk management, risk and capital
models, and strategie risk management. '1ff1 The evaluation of risk management cu1ture concentrates on the company's risk tolerance, Le. their numerica1 expression of maximum acceptable losses at a defined confidence interval of frequency. Ibe risk toleraoce depends on the compaoy's risk appetire - a starement of the broad raoge of loss outcomes or consequences that would be acceptable to management Standard & Poor's
sees the importance for insurers to have articulated their ideas and communicated them inrernally and exrernally. Further, the iosurer's general quality of governaoce is evaluated. Rist controIs inc1ude the wide range of practices to identify, measure, monitor, aod manage risk. The compaoy is expecred to leam from the ongoing risk management process and lass experiences. Standard & Paor's works with extensive examples and crirerla catalogues to be used for Ibe assessment of the relevaot risk types and as guide-
lines far the rating process. Emerging risk management is relevant for the occurrence of extreme risks. The focus is on assessing the processes insurers use to imagine, track, prepare for, aod leam from new risks that could emerge. Risk models are evaluared on Ibe qnality of Ibe processes supportiog the models aod used to provide risk information. Timely, accnrare aod compiere data has to be used to ensure Ibe robustness of the models. Ibe methodologies aod assumptions have to be adequare aod updared if necessary. Principles aod controls have to be in place in order to run, maintain, validare, and check Ibe models. 20' To emphasise Ibe importance ofERM, Standard & Poor's have introduced a separare rating caregory for the qnality of the compaoy's ERM programme. Ibe published rating
categories are as follows: 209
• Weak: lack of or incomplere control sysrems for one or more important risks. • Adequate: comperent, traditionaI, silo-type risk management programme for controlling most important risks; may not have a fully developed process to optimise risk adjusred retnrns.
• Slrong: all characrerlstics of adequate risk management, but also risk control practices that exceed the adequare level for the major risks. A weil developed overall view of risks, wilb view of making risklreward tradeoffs arnong Ibe risks, aod a process for aoticipating emerging risks.
• Excellent: all characrerlstics of strong risk management aod more advanced in the developing of new processes, in implementation or in effectiveness of execution. Consequently, optimisation of risk adjusred retnrns throughout the organi-
sation. 2071ngram ct al. [see 02.06.2006] 2{)8Ingram et W. [see 02.06.2006]
2ü9F1eckenstein ct al. [see 2006, pp. 34-36]
202
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
s_
""""""'t -yottoDg Very stroDg
Good
Source:
RatiDgEqui.....t AAA
AA A
BBB BB
CARin% 175 and higber 1 -174 125 -149 100-124 lells than 100
Fleckenstein, Michele; et 81., Rating agency update Guy Carpeltter, New York 01.11.2006, p. 33
Table 6.15: S&P's: Capital Adequacy Ratio ranges For each raled entity, Standard & Poor's ca1culares a Capital Adequacy Ratio (CAR). Tbe CAR ratio is defined as the ratio of (total adjusled capital minus asset risk charges minus credit relaled risk charges) divided by (underwriting risk plus reserve risk plus other bosiness risk). Adjustments are made for loss-reserve/redundancy and time value of money. The CAR model is static, not stochastic: Standard & PoOl's evaluation is based on eight crireria: In addition to ERM, economie eapital, capitalisation in !enns of capital adequacy, liquidity position, operating performance, managementlcorporate strategy, competitive position, investments, and
financial ftexibility are taken into consideration when rating an insurer. 210
21Üf1eckenstein et al. [see 2006. p. 13]
6.3. RATING AGENCIES AND RISK MODELERS
6.3.3
203
The rating agencies' rating methodologies for ILS
Catastropbe risk ILS AM Best's rating of catastropbe bonds relies primarily on data and information from the risk modeling companies AIR, EQE, and RMS. The models are reviewed, and the rating methodology further takes into consideration the risk characreristics of the perils covered, as reflected in the attachment probabilities. AM Best runs stress-tests on the key modeling factors. The items reviewed, evalnated or monitored inc1ude the following: • complete strnctural, legal and third party related documentation • specific natural catastrophe perils inc1uded in the transactions • granularity of exposure data put into the risk model • outputs of the model
• results of the stress-tests • eventual basis risk assoeiated with the trigger-type mechanism • existence of multi-triggers • credit risk of the SPRV and credit risk of swap counterparties • other factors such as the risk period of the transaction, annual re-setting of attachment points, extension options, and the model archiving policy Prior to 2006, nearly an catastrophe bonds were rated bb-t or lower. In the past few years, however, new catastrophe bonds were structored with very low attachment probabilities. Weather re!ated catastrophe bonds may be triggered by aseries of catastrophic events minimising the risk of an inunediate downgrade after one event Further, CDO strnctures have emerged with investment-grade !ayers. The analysts follow a methodology in order to deterntine whether the strncture's stated objective will strengthen, weaken, or has no cffect on thc finaneial strength rating of the sponsor. The criteria for a single catastrophe bond, index-triggered with single-peril, are as follows: The amount of credit in the cedent's (sponsor's) BCAR is based on an overall basis risk score and/or on the capital effectiveness ratios. Each of the metrics in the basis risk scoring table 6.16 below is rated, and the corresponding weight is applied to get the total score.211 The basis risk score is then relevant for the calcu1ation of the reinsurance credit. The highest basis risk score I results in a reinsurance credit of 90%, 2 in 75%, 3 in 50%, 4 in 30%, and 5 in 10%. However, this reinsurance credit has to be valued for a single peril bond with one tranche against the capital effectiveness ratio: 211Modu [see 22.01.2008, pp. 1-2]
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
204
Tbe ratio is equal to 90% of the difference between the probable maximum loss before adding the bond and the probable maximum loss after adding the bond, divided by the
principle amount of the issue. 212 The lower of the two amounts is then calculated as reinsurance credit. For multitranche bonds, the reinsuranee credit ascribed is determined by the aggregate eapital effeetiveness ratio (90% of the difference between the comhined aggregate annual PMLs before and after the eatastropbe bond issue, divided by the principal amounts of all bonds).213 Fitch rates all catastrophe bonds against a probability of loss eriterion. In eontrast to the eommon usage of probabilities of default for Fitch ratings, they use the probability 0/ /oss, sinee a failure of a catastrophe bond to pay principal and interest is eaused by a eatastropbe event, not the default of a eompaoy. Fitch eompares the probability of loss on each tranehe of a transaction with its historieal default grid, defining how the various loss probabilities transiate to ratings. Tbe global default grid for ILS ean be found in Appendix L. Fitch's global insurance eriteria do not have an upper limit on the rating !hat eao be assigned to ao n..S. However, it is rather unlikely that a eatastrophe bond will be assigned a "AA+" or "AAA" rating if, regardless afits probability, a single eatastrophe event ean trigger a loss of the principal. Ratings above "A+" require a high level of eredit enhancernent.
-
Probability cf > 50% shortfall (amount by which index loss falls mort of modelcd company loss expressed as % of principal
"""" Saolo [to 5
~t)
Exhaustion probability PeriJ. (e.g. F1.orida more aedit than New Madrid Independent modclcr's involvement in basis risk analysis Data quality Ccrtainty of business compollition Thbl
)
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5 5 5 5 5 5
-
w.....t 35%
".. [
[0'< [0'< [0'< [00%
Iwcd=
Source:
F1cckenstein, Miche1e; et a1.. Rating agency update Guy Cmpenter, New York 01.11.2006, p. 21
Table 6.16: AM Best: Basis risk scoring table Fitch has not developed its own models to estimate eatastrophe risk. Tbey rely on modeled loss statisties ealeulated by third party modelers like AIR, EQE, RMS, and Paterson Martin. Tbey tend to have greatest confidenee in the latest versions of models for perils and geographies that have served the longest in the insurance industry including: US horricane, US earthquake, Japanese typhoon, Japanese earthquake, and European windstorm. Tbe initial transaction rating process inelndes the analysis of the sponsor's background and motivation for the transaction. Other koy parties like sponsors, banks, and 212F1eckenstein et W. [see 2006, p. 21] 213F1eckenstein et al. [see 2006. p. 21]
6.3. RATING AGENCIES AND RISK MODELERS
205
modelers are checked. As second step, Fiwh is reviewing data provided by Ihe parties in order to get a detailed picture about how Ihe transaction works, Ihe ßow of funds, under what circumstances the investors would lose principal, and how lasses are determined. Third, Fiwh studies 1he modeled loss probability and adjusts Ihe data, if necessary. Adjustments are necessary for modeling uncertainty, exposure growlh, currency risk, unmodeled perils / territories, and olher risks. The estirnated adjusted loss probability is 1hen compared to Fiwh's default rate grid to detennine 1he implied rating. The risk of Ihe sponsor is analysed. The sponsor is a key counterparty to 1he transaction, analogous to Ihe seller/servicer of an ABS transaction. Important factors are Ihe insurer linancial strenglh rating and Ihe bistory of Ihe company wilh regard to Ihe general business and ILS. For indemnity risk structures, Ihe underwriting, reserving and claims-handling abilities are important. The ratings are reviewed at least annually, 1hey can be upgraded,
put on "rating watch", or downgraded.214 Moody '. ratings of cat bonds are based on Ihe expected loss estimations and address Ihe ultimate receipt of all interest and principal payments owed to Ihe investor as provided by Ihe governing documents of a transaction. The analysts focus on Ihe likelihood of a catastrophe to occur and Ihe severity of losses to investors as a result from such events. ForIher, Ihe analysis concentrates on Ihe credit strenglh of Ihe parties involved and Ihe effectiveness of Ihe documentation regarding 1he risk transfer. Moody's rating approach entails Ihe following steps: First, Ihe promise to investors to pay principal and interest when due is assessed. The terms, conditions, and legal structure of Ihe transactiOll are analysed. Second, Ihe poteutialloss sceuarios and Iheir associated probabilities are assessed. This includes 1he independent review and testing of Ihe underlying models provided by Ihe external servicers. The results of Ihe models are usually expressed as Ihe probability of loss exceedance corresponding to Ihe particular peril considered. Third, Ihe los ses are calculated. The expected loss, delined as Ihe weighted average of
the losses, is adjusted for the relevant stresses across a1l possible scenarios considered in the analysis. It is expressed as apercentage of the amount promised to the investors. To get the average, a probability is assigned to the occurrence of each scenario considered. The expected loss is Ihe sum of Ihe losses to investors for each scenatio weighted by Ihe probability of lhat scenatio occurrlng. Foorlh, 1he expected losses for Ihe bonds are compared to benchmark notes (conventional bullet bonds wilh 1he same duration). 21S Standard & Poor'. use a four-step process to evaluate and rate catastrnphe bonds: First, Ihey evaluate Ihe structure of Ihe transaction, taking into consideration Ihe legal structure, Ihe control of funds, and 1he process of evaluation of valid claims. Second, Ihe model provided by modeling companies is evaluated in detail, identifying its parameters and making sure lhat no parameter was overlooked. Third, Ihe model is stress-tested in
order to find out how weil it incorporates each risk. Since the investor is often not an informed party, Standard & Poor's skews Ihe model slightly in Ihe investor's favour. For instance, if the model estimates a 15% surge of demand for reconstruction services after 2J.4Thorpeetw. [see 11.03.2008,pp. 3-12] 215 Araya et w. [see 23.01.2004, pp. 5-12]
206
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
• c.tastrophe, Standard & Poor's may run the model .gain with. 20% iocrease. Further, if the modeliog firm m.y use • 90% confidence level, Standard & Poor's may .sk to run the calcuIations .t • 99% conlidence level. Fourth, the def.ult risk is evaluated. After recalibration of the model 10 be appropriate with the risks involved in the transaction, the output will be • prob.bility !hat the covered event will re.cb the .ttacbment poiot of the tre.ty with the special purpose reiosurance vebicle. If the prob.bility comes out e.g .•t 1.6%, it is correspondiog with. security carrying • BB Standard & Poor's raring carryiog • def.ult prob.bility withio the one year horizon.21 6 The most conserv.tive version of the catastrophe models available, e.g. for hurricanes at current those of AIR, RMS, and EQE, are used to evaluate the bonds. Due to the risk exposure concenu.tion, Standard & Poor's use. rating ceiliog ofBB+ for c.tastrophe bonds from. siogle-event, iocludiog those lioked to multiple perils and A+ for third-event bonds. For bonds with • suffieiently large numher of n.tural perilloss evenls, the mioimum is live and they must be less correl.ted, Standard & Poor's m.y assign • maximum rating of AA. However, the presence of • fifth-event p.yout trigger is not. gnarantee for an AA r.ting. The occurrence cf any trigger event cannat result in a downgrade of more than one rating c.tegory, based on the prob.bility of .ttacbment.217
Special coosiderations regarding Iife-insurance-related ILS
Reserve funding transactions, the so-ca11ed XXX securitisations, are Iong term transactions runniog up to 30 years. Their r.tings are b.sed on the review of the methodology and models of the actuarial model firm iovolved. Cash flows are stress-tested - effecls of changes io Japse r.tes and mortality rates are addressed. The rating company runs deterministic sensitivity tesring and stochastic modeliog resulting io estimated percent.ges for the failure-to-p.y of several tranches of the transaction. The ratings are further b.sed on the quality of coll.tera1 and the strength of the sponsor. The checkiog of the structure iocludes the legal terms and the terms of the note gnarantee iosurance policies provided by the external gnarantors.218 The ratings of risk transfer securitisations are usua1ly iodex-based. They strongly rely on the results of the actuary models and the quality of the gnarantees provided by the externa1 gnarantors. The raring agency analyses frequency and severity of an event reachiog the iodex attachment poiols. Collatera1 asseIs and ioterest obligations are taken ioto account. The total return and ioterest swap counterparties must be of high quality. The diversification of the exposure io terms of geographical location, age and gender are evaluated in line with the rating agency's catastrophe bond ctiteria.219 The analysis of an embedded value life iosurance securitisation by the 1eadiog ratiog ageneies would be similar and expected to focus on the follow key aspects of the
transaction: 216Levin et al. [see 22.03.1999. pp. 3-5] 217Fleckenstcin et al. [see 2006, p. 20] 2181borpeetal. [see 17.05.2006,pp. 1-11] 219parrow [see 2006]
6.3. RATING AGENCIES AND RISK MODELERS
2m
• legal structure • exposure on the financial strength and operational risk of the sponsor and the impact of the transaction on the insurer itself • assel coverage ratio (embedded value vs. debt outstanding) aud debt payment ratio (ernerging surplus vs. debt service obligations) • actuarial models used
• other features such as guarantees, derivatives, and swaps Without an external guarantee from a suitably higbly rated counterparty or other suitable credit enbancement features, the rating of the bond issue is likely to be capped at the claims payiug ability of the sponsor reflected by its financial strength ratings. The sponsor is key to the development of the transaction going forward. If the financial strength or condition starts to weaken, healthier policyholders may start to leave. All things eqnal, the securltised block of business may behave very differently from what has been projected. The agency will further stress-test the transaction regarding the parameters: investment returns, interest rates, expenses, termination rates, and mortality.220 221 Life settlement securitisation complicates risk management for life insurers, since they require a whole new area of focus due to the risks of all parties involved. Fraud and criminal activity are key concerns - the original investors have the legal right, and often the intention to seil the policy acquired immediately to third parties (e.g. investors in securitisations). Fitch's analysis e.g., given the importance of ordinary life insurance to the industry as a whole, concentrates on the product risk and its pricing. The key pricing assumptions are mortality, lapse rates, investment spreads, and expenses. The actual experience is compared to pricing expectations. Tbe understanding and management of risk by insurers and their reinsurers are assessed.222 Ratings for Residual Commission securitisation transactiODS rely on actuarial models representing the block of business. While historically similar policies were mapped into cells, models have become more granular, moving into a seriatim or policy-bypolicy calculation. Rating agencies test the model fit with a static validation testing the
reserve and face amounts at some point of time, usually the validation date of the issue. They further perform adynamie validation testing the soundness of the projecrions over different periods of time. 223 22OGemmelletal. [see 1O.1O.2000,pp. 17-18] 22IDevineetal. [sec 06.07.2006, pp. 73-84] 222Crossonetal. [see 12.09.2007,pp. 1-6] 223Devine et al. [sec 06.07.2006, p. 4O];Karapiperis [see 01.05.2005, p. 2]
208
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
6.3A Risk. modeling compames' services Overview of probabilistic natural catastrophe risk modeIs Probabilistic models developed to assess insurance losses wen: designed to help the insurance sector quantify im profile and set business strategies to effectively manage and transfer risk to optimise its finqncial perfmmance. Further. they he1p rating agencies and investors to evaluate the risk of an n..s. Ifutmy "'" been longeot fm tIw development of """'tropbo riok, "'!"'cially oorthquake risk in Japan and the US, and windstonn risk in Japan, the US, and Europe. The approach 10 catastrophe modeling of the tbree main firms AIR, RMS. and EQE :is ralber similar. They consin of thrc:e modules, the hazard module, the damage module and the financial module as shown in figure 6.16:22.4
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Figure 6.16: IDustrative framework for cat risk modeling
The inputs of the hazard module consist cf historical data from stonn catalogues or earthquake history, being replenished by expert opinions and scientific tnowledge. Side characteristics. such as terrain roughness and soil conditions. further are taken into account. The outputs of the hazard module consist of a set of stochastic events with determinant characteristics, such as wind speeds and earth motion. :z:MAnden!m etal. [_1998. pp. 5-7]
6.3. RATING AGENCIES AND RISK MODELERS
209
Tbe damage module determines the damage c.used by • natural c.tastrophe to the infrastructure, such as hauses or industrial installations. Tbe modeling firms use structural engineering expertise in combination with claims experienced by their customers, the insurance companies. The finaneial module applies the damages against the insurance or reinsurance contract specific.tions in order to determine the impact of the estim.ted event and to ca1culate the ultim.te financiallosses which can be expected. Apart from hurricanes and earthquakes, models h.ve been developed for other perils like tornadoes, straight-1ine windstorms, winterstorms, wildfires, earthquake, worker's compensation, flood, hall, ground liquefaction and landside potential.22S 226 Tbe outcome of the models can vary quite substantially among the different modeling firms. Tbe differences are • result of the density of data .vailable and the variety of simul.tion methods used. Further, the estim.tions of loss severities c.used by n.tural catastrophes vary.
Hurricane risk is the major contributor to lasses of non-life insurance in the USo Tberefore, the characteristics of. typical model shall be exp1ained in more detail: Tbe historical insurance loss data .vall.ble has to be collected and .djusted for the effects of inflation, popo1ation growth and changed property values, huilding materials,
and construction designs. Contract changeslike the details of coverage, co-insurance, deductibles and maximorn insured loss h.ve to be amended. In some are.s, the modeling firm faces small sampies only. To overcome these problems, the risk modeler makes parametrlc assornptions .bout the prob.bility distribution of the characteristics of the
hurricane. Tbe first step, the hazard module of the modeling process, is therefore the simul.tion of. hurricane database for • discrete coastal are. by estimating r.te of occorrence and prob.bility distribution of the clim.tological characteristics (centra! pressure difference, forward velocity, track angle, landfall location, and radius of maximum wind). Tbe
hurricane characteristics in coastal areas are simulated by selecting a series of joint values of the above mentioned key storm parameters. Tbe storm behaviour is then simul.ted, since tracks change as the storms move inland. As second step, the damage module is developed. Horricane systems can bting • varlety of associ.ted perUs such as storm surge and w.ves, local flooding, ruissiles, and tornadoes or very localised highly torbulent wind conditions. As experienced in horricane Katrina, these perils can cause far more damage than the storm itself. Wind hazard is generally represented by maximum wind speed, influenced by terrain fe.tures, and dur.tion. Sorge hazard is characterised by its hydrostatic effeet called surge level, and hydrodynarnic consequences due to w.ve actions. Topographic conditions, tide level, and ftood protection structures are taken into consider.tion. In. validation process to follow, the results of the hazard module are compared with historical data. Third, the financial module estimates • mean dam.ge r.tio (MDR) which is defined "'EQE [... 2007] 226RMS [see 2007]
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
210
as the ratio of the infrastructure's repair cast divided by its rcp1acement costs. FOI' each location, tbree MORs are calculated: st:ructure, contents, and time element losses (e.g. business interruption or additionalliving cxpcnscs). Buildings are classificd by construction material, usage, heigbt, and unit (e.g. single-familylmulti-family). MDR damage tab1es typically consist cf a matrix ofhazard leve1s (wind speed or ßood leve1) by construction class. Sponsors use the models in summary first to determine a hurricane hazard level, then 10 look up the corresponding MDRs ror the classified (insmed) buildings and their CODtents in order to determine the damage leveI. while the creati.on of the damage function is based on several enginoering disciplines. In addition to tbese studios. a substantial nwnber cf insurance companies provide their actual financialloss data which is updated
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Models finally deliver calculated loss distributions by convoluting losses calculated for each simuJatei! storm (L.) with the probability of occurrence (T(L.» ofthe storm. The result is shown as a graph called loss excc:edance curve, where Ll+l > Li, A sample 1088 cxceedance curve including a frequency distribution is shown in figure 6.17. The curve shows the probability that in a year ODe or more 1011& events will occur that are :z:l1BnilSfllJlWle and Ulrich [_1995, pp. 182-190]
6.3. RATING AGENCIES AND RISK MODELERS
211
.t le.st as great as • given loss amount. For example, if TUSD125mln = 1% (ex.ctly: 0.009950 as shown in the sampie of lable 6.17), there is • 99% chance th.t the largest event occurring in • single year will c.use • loss of Jess th.t USD 125 mln. Tbe lass exceedance curve is usually consistent with a collective risk model of event frequency and severity; the the number of events follow • Poisson distribntion. The sum of independent Poisson distribnted randorn vari.bles is also • Poisson distribnted randorn vari.ble itself - and Poisson distribnted randorn vari.bles can be decornposed into single Poisson distributcd random variables. Each point of the curve can therefore be thought of as an independent randorn variable, • single event independent of all ather events. The probability of at least one occurrence for a Poisson distribution with mean A is calculated as 1 - e-~. Tbc mean annual frequency of events at least as gre.t.s Li, is A(L;) = -Ln(l- T(L i )). The annual frequency ofthe specific event >.(Li) = A(Li) - A(LH1). Ifthe total frequency of all evenls is A(O), the size ofthe loss distribntion or individual evenls is F(Li ) = I - A(Li )/ A(O). The retum perind of a 10S8 event is the inverse of the mean annual frequency of losses at least as great, R(Li ) = 1/ A(L;). Theretumperiodis also referred to as the inverse ofthe prob.bility of cxceedancc, R(Li ) = I/T(L i ). This definition is nornerically vcry clo," to thc inverse of the annual frequency for low frequency events. However, it can become fairly meaningless for very high frequency evenls. 228 Table 6.17 shows an example of the components of a 10s8 exceedance curvc.
Calculati.on based on: Evans, Jonathan, Simple practical estimati.on of sub-portfolio catastrophe loss exceedance curves with limited information, Casualty Actuarial Society, Arlington. 2005, p. 54
T.ble 6.17: Loss exceedance curve data lable Loss exceedance prob.bility curves also provide • visualisation of loss probabilities for the different tranches of. securitis.tion. Figore 6.18 shows the loss exceedance curve for the Residential Re transaction sigued in 2001. The curve shows !hat the prob.bility otlosses increases, peaking in the range between USD 450 and 500 mln and then fa11ing with • long tail to USD 1.6 bn and higher losses with • very low prob.bility. Figore 6.19 shows the layers where the transaction is included as C.t bond. Mondy's, using the catastrophe rnndel provided by AIR, estimated the prob.bility of an annual 228Evans [see 2005. pp. 53-54]
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
212
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Figure 6.18: Rcsidential Re - los5 exceedance curve Ioss cxcecding USO 1.1 bn 10 be 1.12% and exceeding USO 1.6 bn to be 0.41% with an expected annualloss of 0.68%. This resulted in a Ba2 rating for the catastrophe bond exposing its holders to hurricane risk. in US rcgi.ons defined as high risk.
Life insurance securitisations use the services of independent actuaries to develop the model and the projections for the sponsor. In addition. an independent actuary, on behalf of the rating agency. gets involvod in order to review the projoctions and assumptions and how they intemct in the transaction model. The actuarial model of a nserve junding securitisation is a representation of the socuritised block of business. They bc:came increasingly granular with the improved computer technology and moved to a seriatim OI' poIicy-by-poIicy calculation. Setting the actuarial assumptions is key, while mortality and tapse rate are the most important factors driving the value of the life insurance securitisation transaction. Further, investment income, apenses (also rcinsurance costs), and premium patterns are taken into consideration. The experience of the sponsor is important. especially regard-
6.3. RATING AGPNClES AND RlSK MODELERS
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Figure 6.19: Residential Re - catastrophe-Iinked notes structurc ing the quality of data. The poIicy counts and face amounts, together with the assumptions, are ran through the actuarial model 10 calculate premiums, investment incomes, death benefits, expenses in order 10 derive income statements and balance sheets. Econo.mic reserves and tax reserves represent a key number, since they basically help 10 determine what the
1evel of redundancy, defined as the difference betwcen the statutory and best estimated reserve, is, This amount is being raised from the capital markets through securitisation. The outputs are cash Dows which are fed into a deal. model, and the terms of the transaction can be wrapped around them. Fmally, the actuary rans sensitivity tests for each of the assumptions, i.e, an additionallevel of mortality experience. reduced lapse rates, or a pandemie hit are performcd (also in combination with each other). Financial guarantors check. the transaction struc!ure far weak points.22!I Risk transfer .recllriti!ations have occmred to transfer catastrophe mortality risk 10 the capital IIWkets. Thereforc.. they are also referred 10 as catastrophe mortality bonds, While other cat bonds ar derivatives usually depend on underlying loss indices, catastrophe mortality bonds are triggered by a catastrophic evolution of death rates of lZIIDevine etal [see06.07.2006, pp. 3S43]
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
214
a certain population. Rating agencies base their decisions on the data cf risk modeling companies. 1he approaches of the two leading companies in this sector, Milliman and RMS. diffcr considerably. Whilc Milliman bases its analysis on an actuarial model, RMS use an epidemical approach. 230 MilUman uses actuarial and statistical models ror the future evolution of mortallty based on historical data. The base1ine component models random ftuctuations within annual mortality rates if no catastrophic event occurs. Millim.an uses time serie! models 10 develop stochastic forecasts for mortality evolution in the countries covered by the mortaIity index. The results are simulations of the weighted combined death rares. Thc discase componcnt captures the cxccss mortality duc to a pandemie outbrcak - thc data relies on past pandemie outbreaks. The terrorism component is used far mortal.ity shocks. For each component, 250,000 simulations are producod and combinod to estimate annualised as well as cumulative expccted lasses. Further, the probability of loss triggers of a certain tranche is calcu1ated (see figure 6.20).2.'U
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Pigure 6.20: Scottish Re I 'Thrtan - mortality risk model structure RMS's mode1 is based on epidemiologica1 data and research rather than historical data. The company has bcen supportcd by world-wide cxpcrts for influenza research :DOBaum: and Krama: [see2007, pp. 9-12] D1Baum: and Krama: [see2007, pp. 9-12]
6.3. RATING AGENCIES AND RISK MODELERS
215
in order to develop their methodologies. Event tree techniques are .pplied to produee 1,890 probability-weighted scenarios. RMS states that there h.s been an .verage of three pandemies each eentury and therefore .ssurnes an outbreak prob.bility of 3 to 4%. Taking industrialised livestock husbandry and other eonditions fostering mutations of viruses into consider.tion, levels of 5% to 6.7% are used for stress-testing. Parameters regarding infectiousness and lethality are based on influenza research. Tbe loe.tion of outhreak is important with regard to its demogr.phie structure and government reaction.232 Li!e settlements modeling is rather ehallenging. Therefore, life settlement transactions are significantly stress-tested. Scenarios are nm in order to find out, how solutioDs for some decrements like eancer will effect the underlying portfolio of life insoranee policies. Viatical transactions experienced an overhaul oftheir estimates when a breakthrough in AIDS medicines was achieved.'33
6.3.5
Results of the interviews regarding rating agencies, risk modelers, and monoliners
Rating Agencies
Rating agencies' scores give an idea of the relative risk. of a capital mark.et transacti.on. Investors tend to rely on the .geneies' due diligence to vaIidate the mostly external models underlying the relevant structure. Tbey further provide transparency to the markets by ehecking the offering memorandum and publishing • pre-sales report before • transaction is placed. Based on their methodology to evaluate the reinsurance risl<, they rate the prob.bility of the investor faiIing to receive interest and prineipal.234 During the structoring phase, their guidelines ensure • proper eonsideration of legal aspects, also for offshore transactions. Tbe focus is on ehecking the SPV ring-feneing, Le. the mechanisms for • full funding and eollateralis.tion of an 1LS. After elosing, they publish • final rating report to their subscribers and monitor the operating .greements. If necessary, the ratings of the structure are up- or downgraded.235 Although often referted to as quasi-regolators, they are not regolators, bot being regulated themselves. Whi1e they h.ve their own models for life insoranee in place, they usually take for non-life lLS third-party modeling into consider.tion.236 The agencies calculate the necessary capital for the insurer to mect bis obligations. Tbey have been giving fuH c.pital release for XXX structures, while the relief for ea! bonds was ealco1.ted by taking into eonsideratioo the prob.bility of the underlying event happeniog. Rating .gencies distinguish between pararoetrie, index or indemnity 232Bauer and Kramer [see 2007, pp. 10-12] 233Devine et al. [see 06.07.2006, pp. 82-83] "'INr-10-RXr [12.09.2008];INr-15-RAT [22.09.2008];INr-18-INV [24.09.2008];INr-19-ASO [26.09.2008] "'INr-10-RXr [12.09.2008];INr-18-INV [24.09.2008];INr-2O-LAW [20.10.2008] 236INr-3-BNK [03.09.2008];INr-10-RXr [12.09.2008];INr-20-LAW [20.10.2008]
216
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
based transactions. Parametric ILS can be structured as up-front transactions paying for losses before the damage is verified. Sponsors arranging indemnity coverage must be able to properly process their data about the perus, their track record in underwriting and claims processing in terms of speed and accuracy is iruportant. Indemnity cat bonds highly depend on the sponsors rating, since they are highly correlated to the underwriting and claims handling skills - a sponsor with excenent skil1s tends to be rated higber than one with poor skills. Commercial-line insurance tends to bear greater risk than personal-1ine insurance. Tbe agency evaluates how the relevant ILS issue fils into the corporate strategy of the sponsor. Tbe overall funding alternatives are tsken into consideration in order to identify tactical issuers who may have difficulties to get traditional reinsurance in p1ace. 237 Most rated non-life ILS are ca! bonds for evenls in the probahility range between once-in-50-years up to once-in-250-years events and usually rated up to BB+ (following Standard & Poor's rating methodology). Tbe charge for those events is in accordance with the outcorne of the models. Once in 250 years events, also referred to as 40 bp evenls, have been rated BBB-. Some rare once-in-500-years evenls have been rated BBB+. Tbere is no capital charge above once-in-500-years events and therefore no capital relief for a sponsor placing an ILS issue. Th.e reason to issue a bond against a very rernote once-in-l,OOO-years or even once-in-lO,OOO-years event is rather economica1than capital-driven. However, mortality cat bonds for those remote risks can get ratings up to AA or even AAA.238 While Standard & Poor's is of the opinion that it is highly unlikely that a once-in200-years event does not trigger when it is supposed to, AM Best has a limitation of credit they grant for non-indemnity or non-modeled loss triggers: Indemnity is granted 100% credit while pararnetric 80% only.239 Wrapped transactions are used to get the higber of the !wo ratings, those of the underlying risk or the wrapping monoline insurer. Both ratings can iruprove or deteriorate. If the agency withdraws a rating of a monoline insurer, the rating of the issue is also withdrawn. 24O For life ILS, the ageneies use in-bouse actuaries to model the past underwriting experience, for instance the mortality over years. Tbe fiuancial strength ratings of the sponsor are iruportant for investment-grade reserve funding XXXlAXXX transactions where proceeds are segregated into a collatera1 trust and initially not available for the sponsor. Tbe investor depends on the underwriting and reserving of the company which is rellected by its own ratings: If the best estimate reserves are adequate to pay all the claims, the trust will remsin intact, and the money will be available to be repaid to the noteholders a! the end of the transaction. If the best estimate is not suffieient, those reserves could be depleted. Ufe reserve transactions further depend on the quality 23'INT-IO-RAT [12.09.2008];INT-13-MOD [16.09.2008];INT-15-RAT [22.09.2008] 23'INT-15-RAT [22.09.2008] 23'INT_7_REI [OS.09.2OO8];INT-15-RAT [22.09.2008] 24
6.3. RATING AGENCIES AND RISK MODELERS
217
of the investment book collateralised. The SPRV has to hold mark-to-market valued assets equal to the credit taken far reinsurance in a collateral trust. The investment portfolio essentially is a credit to the sponsor. The cedent has the right to liquidate the assets to pay claims under the polieies first, over and above the right for the investors to receive money. However, the co11ateral trost does not have any recourse back on another company - it stands for itself. 241 For a value-in-force transaction, the use of the proceeds is important After having sold its share of the profits from a book of underwritten bnsiness, its ability to repay debt relies on the sponsor's futore financial strength. Since the company will no longer have the right to receive those futore cash flows, it is very important for the rating ageneies to evaluate the usage of the funds, since it may weaken or strengthen the credit profile of the company. If, for instance, the company took the proceeds and repurchased stocks or paid very !arge dividend, those proceeds will no longer be an available repay sort of unsecured debt of the company to other creditors. Conversely, if the company took those proceeds and invested them in another part of the business !hat perhaps generates a higher margin than the part !hat was securitised, Ibis could be positive. Since those funds have been invested at a higher rate, there is a larger strcam of futore cash flows that can be assumed to get generated by the company.242 Rating agencies would not lik.e to see a sponsor getting al1 its reinsurance coverage
as catastrophe bonds or XXX structures. since ILS investors may not be a reliable source of refinancing in difficult market environments.243 They are reluctant to update default tables in short frequency, since existing issues on the market as a result may have to be downgraded, and More defaults may lead to a looseuing of standards. Catastrophe bonds are not placed on wateh before an event occurs, e.g. a hurricane made landfall and any loss estimates are published. In general, rating ageneies are reluctant to downgrade n..S quicldy, since it may cause forced se11ing by some market partieipants and deteriorate secondary market prices and liquidity. The agency may decide to upgrade, downgrade, or withdraw its ratings at any time. The intent is to review the ratings annually, bnt it could also occur more frequently, depending upon whether something is happening with a transaction. This could be either on the asset side (co11ateral trost) or on the liability or insurance side (a trigger event happeuing). Their ability to change ratings every day causes marke! participants to pay attention to the evaluations.244 The credibility of rating ageneies received a blow with the ongoing crisis of the stroctored finance markets since 2007. Before the collapse of Lehman Brothers, they did not look at the asseIs in the co11ateral trosts themselves, since they did not view them as a risk. They always expected !hat if the company were to go down in credit quality, co11ateral could be posted. Their definition of an "A" rated bank like Lehman further 241INT_7_REI [08.09.2008];INT-IO-RAT [12.09.2008];INT-15-RAT [22.09.2008] 2A21NI'_10-RAT [12.09.2008] 243INT_15_RAT [22.09.2008] ""INT-10-RAT [12.09.2OO8];INT-15-RAT [22.09.2008];INT-19-ASO [26.09.2008]
218
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
was not to go into default in two days as the company finally did in September 2008. As a result of the default, the ageneies bad to downgrade the ILS transactions called Willow, Newton, Ajax, and Carillon where Lehman was acting as total return swap counterparty. The mark-to-market values of their collatetaltrust could not be regarded as sufficient to repay the face value of the bonds.245 Solutions for the Lebman transactions were heavily discussed at the time of the interviews.246 However, they did not materialise. Although market participants wanted to avoid the negative effects on the reputation of the ILS products, it was not possible to find a new TRS counterparty to replace Lebman due to the severe detoxication of the portfolio and the difficu1t market conditions.247 Tbe tremendous amounts of RMBS securities in collateral trusts are anather cause for concern. While some collatetaltrusts for long-term XXX ILS have invested in RMBS, some have avoided to take positions in this market at all. Tbe sponsor of an ILS further has the right to call the transaction in part or as a whole. The sponsor of the transaction Ballantyne Re, whose investment portfollo consisted to a considerable amount oflow performing mortgage-backed securities, decided to take back about 35% of the face value of reiusurance provided by the SPRV through retrocession, and to replace the coverage with LoCs issued by banks. The transaction was continued at a lower face value.248 Rather than for risk modeling, rating agencies are acknowledged by the ILS community for their work on validating the structure in detail, in particular the collateral safety. They provide a lot of "watch dog" functions behind the scenes, making sure !hat the deal is properly structured and has been discussed accurately. They even ensure !hat it doesn't violate any lax exemptions which require !hat the deal needs to be formed, discussed, conducted, and structured offshore. If representations and warranties are laler found to have been violated, there could be an unwinding of the structure. The rating agencies are further monitoring numerous operating agreements and documents to keep the SPV structure going even in the most challenging events and enviromnents.249 It will probably take some time for them to expand their mind-setting to include innovative structures more again. At current, they are reluctant 10 rate new products and are expected to be even more restrictive in giving high ratings for ILS issues in the nem future. 250 Tbe crisis is being regarded as a learning experience. The foeus in the future will be on improvements regarding transparency and monitoring. The intention is not to change their analytic methodologies but to add to them. Regarding XXX, the focus will be on asset risk and mortality developments. 251 24'INT-2-BNK [02.09.2008];INT-15-RAT [22.09.2008];INT-26-INV [29.10.2008] 246INT-15-RAT [22.09.2008] 247Evans [see 14.05.2009] "'INT-15-RAT [22.09.2008] "'INT-18-INV [24.09.2008] 2SOINT-2-BNK [02.09.2008];INT-5-BNK [04.09.2008] 2S1 INT-15-RAT [22.09.2008];INT-28-ASO [03.11.2008];INT-IO-RAT [12.09.2008]
6.3. RATING AGENCIES AND RISK MODELERS
219
Kisk Modelers The function of risk. modelers for the overall insurance and reinsurance market is to provide lass estimates for catastrophic occurrences such as earthquak.es, hurricanes, winterstonns, wildfires, and !loods. Essentially, they estimate any type of catastrophic activity for which the insnrance sector does not have enough information just by looking at past claims, while the post-perspective can be misleadin.g because these events are infrequent So what !hey da is simulating the cnrrent exposure or !he potential risk to the current exposure from these catastrophic events. Risk modelers provide the science delivered by their software also to rating agencies. For some ILS types like catastrophe bonds, their models are a pre-condition to get a rating. Tbe lack of use of extemal models was one of!he reasons why !he mortgage-backed-securities market in !he US went into difficulties. For some risks like terror no models at all have been deve10ped - securitisations therefore are not possible for these types of risk. Tbe avai1ability of models enablea or limits growth in the ILS market.252 Except in the hnrricane season 2005, when they underestimated the losses cauaed by Katrina by not including the !lood damages in New Orleans into !heir calculations, modelers were not as challenged as rating agencies recently. Their models are rather sophisticated and difficult to verify for third parties, since the data is rather young. 253 Life natnral catastrophe mortality risk is better understood than standard life-related risk. Models for bird !lu or terror are regarded as rather intransparent. Critical i1lness modeling is in its early stages.2S4 Indemnity triggers are used to maximise reguiatory capital while parametric triggers to attract investors. Sponsors use models to calculate expected losses for indemnity transactions, for instance by combining data about the material of buildings like roofs and walling. Modeling software is also used for parametric transactions in order to limit !he basis risk. Tbe risk modeler performs • very detai1ed analysis of the insurer's portfolio, just as detai1ed as for an indemnity deal. But then its analysis is uaed to minimize discrepancies between the individual portfolio losses and those ca1culated by the index company, e.g. PeS for the US.2S5 Investors pnrchase the very same software that they use to estimate the interplay in a correlation between the various bonds, ILWs, and any types ofILS th.t they may hold in their portfolio. Tbey aggregate their perus from !he different sonrces, run !hem together, and are enabled to get their own sort of customized view of the risk. Risk modelers provide the basis for ratings and help to grow the pool of potential investors. Tbey also provide the basis for liquid secondary market capacity.25. For life and non-life transactions, inveators like to h.ve. third party modeling in order to verify the in-house calcul.tions of the sponsors. Models are fixed for the lifetime "'INr-13-MOD [16.09.2OO8];INr-16-REI [23.09.2008] "'INr-l-MOD [19.08.2008];INr-2O-BNK [20.10.2008] "'Carey ct al. [27.10.2008b] "'INr-13-MOD [16.09.2OO8];Carey el al. [27.1O.2008b] ""INr-13-MOD [16.09.2008]
220
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
of the relevant transaction, but the discovery of compurer errors may lead to the use of a newer model. The change, however, is at the discretion of the parties involved. Risk modelers constantly develop new models for emerging perils. Tbey provide the basis for futore ILS market growth, sinee they make sure !hat investors feel comfortable with innovative transactions. Tbe World Bank has engaged modelers for projects in order to find solutions for perils threatening the developing world. In 2006, the World Bank underwrote a transaction covering Caribbean catastrophe risk. 257 Post-event, risk models deliver important estimations of damages. In case of a hurricane, the process already starts with a first loss estimation 48 hours before a hurricane makes landfall. 24 hours before landfall, a more detailed estimation folIows. After landfall, another estimation of damage is provided following the track of the hurricane. Risk modeler's estimations got more importanee after the experiences with the transaction KampRe. Tbe indemnity transaction was triggered by hurricane Katrina in 2005. Investors decided to seIl the bonds at values elose to zero. However, their values Iater recovered, since the payout was indemnity-linked and the losses were not as severe as expected. In general, the residual value of a catastrophe bond can be estimated at 20% and for an earthquake bond at 15% of the face value, depending on the peril. Risk modelers are able to provide transparency of the evaluation of the bonds after a trigger event.258 However, it has to be taken into consideration !hat models simplify reality - the more they are introduced, the greater is the risk of error. Tbe aggregate exceedenee probability curve is an important element of the analysis. It helps to quantify how many triggers may add up to the relevant attachment point.25' If storm activity increases in the years to come, risk models for Europe are expected to face recalibrations, especially for wind risk, and especially in the UK. 260 RMS further introduced its own catastrophe European windstorm index called PARAMEX in 2008. In order to bring more confidence into transaction with parametrie triggers, Renaissance Re in cooperation with RMS instalied wind speed meters in exposed regions. Tbe modeled loss is calculated using RMS technology. Some marke! participants, however, give the project a rather limited chance for general aceeptanee due to the dependence on RMS' models and the lack oftransparency provided.261 Risk models are important for providing the basis for priee calculation of the relevant risk by the market.262 Pricing of transactions for similar risk like, for instance, wind in Florida may vary. This may be based on variations of outcome of the different models used. Modelers use different methodologies and the information provided by sponsors. "'INT-I-MOD [19.08.2OO81;INT-2-BNK [02.09.2008];lNT-13-MOD [16.09.20081 '''INT-I-MOD [19.08.2OO81;INT-13-MOD [16.09.2008] "'INT-15-RAT [22.09.2008] ""INT-I-MOD [19.08.20081 '61 INT-6-ASO [05.09.2OO8];INT-29-INV [14.11.2008] 26'INT-13-MOD [16.09.2008]
6.3. RATING AGENCIES AND RISK MODELERS
221
Further, 10ss payment periods and the pricing for reconstruction of the damages are calculated in a different manner.263 Monoliners
Mono1iners regard the insurance sector as a diversifier to the rest of their portfolios, main1y consisting of gnarantees for municipal bond and structured finance issnes. 264 In lLS, most of their activity consisted in providing wraps for US reserve financing, funding-CDOs and reinsurance-receivable-CDOs. Before their rating downgrades, their AAA qnality gnarantees substantially reduced the funding costs of XXX issnes carrled by the sponsors down to approximately 25-30 bp p.a. for a 30 year term. 26S The monoliner's due diligence for XXXlAXXX transactions takes approximately two months and concentrates on the following criteria: The monoliner is exposed to the management of the portfolio, the insurance portfolio as weil as the assets. So they are looking for credit-worthy and competent partners. Their ideal c1ient would be an insurance company with high investment grade ratings in the A or AA range. They would go through all the normal kind of dne diligence and underwriting to make sure that it is a stable block of business they have underwritten. As for tenn life, the history should include 5 to 10 years of experience. They expect a sirnilar approach in the underwriting for the future in terms of qnality. So underwriting is key to the product because the monoliner takes real out of the money underwriting as weil as pandemic risk. Further, they ensure that the investment portfolio and the underlying guidelines are not too aggressive and that they were fairly constrained. The portfolio does not need to be the major source of profit or was not anticipated to be very aggressive when built. Mono1iners use third party actuaries in order to understand the levels and slope of the morta1ity of the book. They check the credibility of the historlcal information provided and project the cash t10ws and financials of the Iransaction. Further, the credit worthiness of the sponsor in terms of its ability to manage the portfolio of assets and the investment policy guidelines is irnpurtant. The monoliner sets reporting guide1ines for the lifetime of the transaction asking for regular monthly, quarterly, or annual updates and financia1 statements of the SPRV. Reports about the pool of life insurance policies and the mark-to-market value of collateral trust have to be delivered. Stricter reporting guidelines and stress-testing of the asset portfolio can be expected after the past negative experiences.266 Longevity and morta1ity are being regarded as a marke! with high volume potential. While in the US the longevity market is dominated by life settlement structures, EU pension funds are looking for support to irnprove their management of morta1ity risk they are inlerested in securing stable, long-term pricing for their hedging against risk 263Couey et 01. [27.10.20080]; ILS-pricing will be exp1ainod m Chapte< 6.5.5 "'1Nf-17-MON [24.09.2008] "'1Nf-17-MON [24.09.2008] ""'1Nf-17-MON [24.09.2008]
222
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
caused by negative mortality developments. 267 Tbe way monoline insurers evaluate a transaction is that they need to be comfortable !hat they are not exposed to a confidence level above the 99% thresbold level. Tbey look
at scenarios as weil as the stochastic models that result in a risk being above this level. Tbey hesitate to wrap structures where they can experienee a sudden 100% loss, which is the case with catastrophe bonds, but rather take out the tail risk of the distribution. Tberefore, they have limited exposure in cat mortality transactions.268 In CDOs, monoliners usually take the senior part of the risk. If there is a credit event or adefault of the underlying single CDS, monoliners anticipate that there will be a recovery they can get after a work-out of the structore. Although some loss potential in transactions exist, a !arge recovery can still be assumed after a credit event of an underlying CDS referenced on a single name occorred. However, due to the multievent trigger structore, catastrophe bond CDOs are diflicult to insure sinee a 100% loss of a wrapped tranche can happen.269 Further, monoline insurers do not like to wrap life settlements, since there is not enough experience with their portfolios. Even if medical underwriters, sponsors, originators, actuaries have been involved in the discussions, the experience was that the actoal results were coming in well below their prognoses. Tbe number of the block of policies is rather limited consisting of 100, 200, 500 policies of individuals in smaller life settlement transactions compared to 100,000+ policies in a life insurer's portfolio with at least 10 years of experience.270 Investors in the past have been relying on the due diligence provided by monoliners. However, the franchise of the monoline industry suffered severely during the crisis. Tbeir business model in ILS, enbancing long term mortality structores, is basically against the principle of risk pooling. Even if the portfolios differ in location and population, monoliners basically cover longevity risk ouly.
The future use of monoline insurance far ILS depends on regulatory environments. If the environment stays unchanged and the companies manage to restore their capital and ratings, they can continue to be capable of providing credit enbancement in the future. 27l
267INT_17_MON [24.09.2008] 268INT-17-MON [24.09.2008];INT-18-1NV [24.09.2008] ""INT-17-MON [24.09.2008] 270INT_17_MON [24.09.2008] 271INT_8_LAW [1O.09.2OO81;INT-22-BNK [27.10.20081
223
6.4. lNVESWRS
6A Investors 6.4.1
General market environment
Since the introduction of ILS 10 the capital markets, the share of the different investor types bas changed. While in the cady years the insurancelrein!lUlllIlCC sec10r dominated the investor landscape, the wider range of opportunities has attracted different types of investors as shown in figure 6.21. While primary insure:rs and reinsurers, with a share of 30% and 25% in issues outstanding respectively, were int.erested in supporting the development of the market with investments, their share has fell to 3% and 6% at the end of 2008. Dedicated funds and hedge funds have gained in market share. 272
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S'\I"lI.c. ZOrrch. 29 11.2007. (I'Q"OIII",n' S!id< 81 " T",aI ,·Qlu"...· M~ I C S«u""cs. 'Ibo c.'''''''fIh< bQnd "".. . '1 .1 )~.,..,"" lOO6. GU) ("arpon,., 8: com~."~ 1.1.(". N,,, yoo.. 2007 I SchulII. r.ul ., 11 . InStiI ..", L," ~ od S«u""cs 2008. Aon C.., .. aI Ma,k... Ch,cago. 2008
Figure 6.21: Market share of n.s investor types Banks continue 10 be involved in the arranging of the transactions, taking smallcc participations in their deals.:173 Their share has remained 10 be low, rising from 4% in 1999 10 7% in 2008. 274 l'nKmfmann [_29.11.2007, pp. 8] l'7'Klugman [IR 2004, pp. 11-9] lUKmfmann [_ 29.11.2007, p. 1I]:Ozizmir [_15.03.2009, p. 4]
224
6.4.2
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
Convergence of investor's and sponsor's interest
Sponsors and investors of ILS can be expected to act rationally. They will complete any transaction only if the marginal benefits exceed the marginal costs for both parties. Sponsors need ILS to distribute hard-to-place risks and are interested to fix the terms and conditions of their cover long-term. ILS can help investors to effectively diversify existing portfolio allocations (including stocks, bonds, property, commodities, and cash). Most investor types should have in common to be interested in managing their portfolios with respec! to !beir risk and retorn preferences. They shift between assets in order to achieve higher returns with /ess risk. AB a result, they are constantly searching for assets defined by the efficient frontier, enhancing the portfolio's risklretorn trade-off. Further, they should be interested in lowering the risk of the portfolio of asset investments by reducing lhe correlation among the assets they invest in. ILS are instruments which bring a relatively high yield bearing a low correlation with any other asset type,
and should therefore be attra.ctive far investors.275
276
While asset managers and hedge fund investors are constantly looking for yield enhancement, insurance companies in their role as investors are interested in diversifying !beir underwriting portfolio into ILS, taking those types of risk they may otherwise, due to regulatory reasons, not be allowed to take. Further, through ILS they may aceess markets in which they would otherwise only be able to participate at much higher cost. In addition, through ILS they can diversify regionally. For instance, by taking natural catastrophe risk in regions they normally do not underwrite. 277
6.4.3
ILS as zero-beta assets
Enhanced portfolio management systems in combination with regu1atory reforms are expected to refine the risk selection of reinsurers and investors. Risks which are not in line with the extemal and intemai guidelines will not be placeable to the reinsurance and retrocession mark.ets. A possible substitute for traditional reinsurance is ART, which bears the chance far capacity increases with new investor types which can be approached. 278 Investors following modem portfolio theory evaluate their expected retorn versus the risk of the investments available on the capital markets. Risk diversification is available in those cases when the development of asset values is not fully positively correlated.279 The beta of an asset compares its spread to the development of a reference portfolio universe. A beta greater (or smaller) than 1 means!hat the asset's spread will increase by 1 basis point (or less) on average ifthe reference index increases by 1 bp. 275Müller and Schaefer [see 2000] 276Cole [see 1999] 2nMUller and Schacfer [see 2000] 278 SV [see 2005] 279MUller and Schaefer [see 2000]
6.4. INVESTORS
225
Zero-beta assets are tharefore uncorrelated.280 Studies of the early days of the ILS market have already shown that ILS and other capital market investments show an extremely low correlation over time. Tbe correlation of annual percentage changes of the S&P 500 equity index and catastropbe losses was elose to zero between 1949 and 1996. 281 There is a very limited probability !hat developments on interesl, currency or stock rnarkets correlate with ILS. 282 It could be the case that natural or man-made catastrophes affect certain financial eentres and the ILS markets as a result. However, Ibis relationship cannot be proved historically. Due to the increasing size of the markets split between the main regional financial centers, Ibis risk bas been regarded as negligible.283 The academic and business literature has therefore permanently been stating !hat the risks involved in ILS are not or at least lowly correlated with the general economic developments and other investments available.284 However, the current financial crisis and the default of Lebman Brothers puts the non-correlation assumption into question. The adverse developments resulted, at least temporarily, in a general lack of investor interest. Sponsors were forced to hold back new transactions for some months, and secondary market values for existing transactions deteriorated. Further, ILS with Lebman Brothers as total retoro swap counterparty are endangered to default.
6.4.4
Pricing and returns
One of the main obstaeles sinee the early days of the market has been that structoring costs have been regarded as rather high in relation to traditional reinsuranee and that investors' return assumption was high in order to be compensated for the borne risk, novation, and low liquidity. The market for ILS tharefore faced an essential conundrom: Both, seilers and buyers of the instruments, feit to be mispriced. While in the early days the ILS market was bedeviled by the fact that there was no demand but supply, investor's demand, unti1tha current financial crisis, bas outweighed the availability of assets by far. 28'
Pricing sources for n..S are rare, and quotations have to be taken with some scepticisrn due to the low liquidity of the bonds. The history of the market is sbort, especially if one takes newer products into consideration. Cat bonds yields are often compared with corporate bonds with similar ratings in the "BB range", since the loss characteristics of an ILS are very similar: 286 A pre-defined event triggers a loss that results in a partial or even totalloss of the capital invested. Only the canse of the event and the determination rnechanics of how rnucb capital is lost are different. Tbe actual monetary 280Pe1senheimer ct al. [see 2005. p. 470] 28 ICanteret al. [see 1997, pp. 69-83] 282Hanft and Struve [see 1999]
283Müller and Schaefer [see 2000] 284Cole [see 1999] 28SZolkos [see Ol.04.2002];Schultz et al. [see 2008, p. 13] 286Tnwdetal. [see2007,pp. 35-391
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
226
losses of the sponsor may be ;ndemnjfied defined by the pre-speci:lied formula. Alternatively, the ammmt may be compensated based on the modeled size of the event and its location. In the lattcr casc, loss profiles arc cstimatcd by ODe of the main catastrophc modeling firms using sophisticated models and detailed policy level exposure data. The majority cf catastrophe n.S, far instance. have estimated annual default probabilities of around 1% (oncc-in-lOO-years) and cxhausti.on (totalloss) probabilities cf around 0.4% (once-in-25O-years). These cha:racteristics place them at the high non-investment-grade ratinJ: I'8IUtC cf corporatc bonds (Standard & Poor's: BBlMoody's: Ba).287
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Figure 6.22: Comparison of index performances Figure 6.22 shows a historical comparison between the performance of the Swiss Re Cat Bond Index ver8US several other indexes since 2002. n..s investments experienced a stcady and positive performance. In the phase of extraordinary market turbulence since the middle cf 2008, the performance was still acceptable. while other investments like those into the US BB rated corporate debt, hedge funds. or stocks lost in value. Although the iIlIiaes are quite broad and difficult to compare, it can be !IUIIIlllIlri.sed that there was an overall positive trend compared with other investment types. Flgure 6.23 further shows a comparison cf the performance of several ILS fund investments since July 2005. Details ofthe indexes and funds are explained in Appendix M. Zl7Chrlatophides [see 14.05.2004. pp. 2-4]
6.4. lNVESWRS
227
The yie1d enhancement of ILS against ccuporate bonds is based on the novation premium and as a eompensation for information asymmetry between sponsors and investors. Anothcr:reason may be the 10w liquidity of the uscts. Further. investors normally are eharacterised by their myopie loss aversion. This leads tD a stronger mental rccognition of losses than of generated profits. The modeling for ILS quic1dy reaches its 1i.mits, since e.g. catastrophe events are not characterised by the normal distribution being the core assumption of modem portfolio theory.2BB
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Figure 6.23: Performance of ILS funds since July 2005
Capltal Auet Pridng M_
Modem portfolio management is strongly influenced by the theory of Harry Markowitz: The risk of a portfolio consists of systematic risk which is non-diversifiable and unsystematic risk, also known as idiosyncratic risk wbieh is related to the individual asset. Markowitz hall proven that unsystematie risk ean be reduced or eljmjnated by the diversilication of assets. Investors reach an optimised uset allocation by using their funds for the purchase of the highest yielding assets at a given risk level or the lowest rist at a 21ITraudet al. [see 2OO1.pp. 35-39]
228
CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
prc-defined pcrformancc level. 289 Building on the work of Markowitz, the Capital Asset Pricing Model (CAPM) was independently introduced by Treynor, Sharpe, Lindner. and Mossin. CAPM is a thoory about thc way asscts arc priccd in re1ation tu thcir risk. It worts under the condition that asset retums are normally distributed and investors in a fully transparent market are foI1owing a profit maximisation approach.290 Tbe major result of the model is that the expocted retum of each aaset is solely <Je.. tennined by its systmlati.c risk which is measured by the asset's sensitivity towards the market portfolio defined as the portfolio containing every risky asset in the international economic system (stocks, bonds. but also real estate., commoditics, etc.).:l5Il
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Figure 6.24: Comparison cf dlicient fronti.ers Fm the detailcd explanation cf the following example please refer to Appendix N: Figure 6.24 shows the portfolio lines of two portfolio combinations. Combination lines plot the cxpcctcd retum E(r) against the risk in tcn:ns of tbe standard deviation O"(r) with the given portfolio weigbts. Bach point of the line represents a different set of portfolio weights in the relevant socurities. Tbe portfolio combinalion line shows how the cxpected return and risk of the portfolio change with the variation of their wcights. ZlllMarkawitz [_1'JS2. pp. 71-92];SIoettneI: [see 1994.pp. 322-32S] ZIIOSharpe [see 1964]:Treynor,I..intnm" [see 1965]:Mouin [see 1966] ZII1Gisdakis and et aL [see 11.03.200S, p. 20]
6.4. INVESTORS
229
Tbe blue !ine consists of the risklreturn coordinates of a combination of stock and bond investments. Point A of the graph inclodes a 100% share of stocks measored by the Standard & Poor's 500 index. Tbe share of the stocks falls from point A to point B until the total portfolio consists of govemment bonds only. Tbe risk return profile of the govemment bonds is calcolated with data from January 1931 until November 2008. Tbe historical correlation between the stocks and bonds was 0.077. Point C of the graph consists of a portfolio of 75% stocks and 25% catastrophe bonds. As a reference to calculate the risklreturn profile of catastrophe bonds, the average yield of 7.32% and the volatility of 2.1 % of the "Swiss Re BB Cat bond lodex" in the timeframe since its introduction in January 2002 until November 2008 has been laken. While the 25% share of the cat bonds remains stable, the 75% share of the stocks reduces down to zero, being replaced by government bonds until point D. Tbe correlation between the catastrophe bonds and stock or government bond investments, based on the results of an earlier research done by Canter et al., was defined as zero.292 293 It can be summarlsed !hat 1LS offer investors an attractive way to diversify existing investment allocations generating relatively high expected re!ums above the risk-free
rate. ILS diversification henefit measured hy the Sharpe Ratio Based on the CAPM the Sharpe Ratio (SR) was developed as a risk-adjusted performance measure. Tbe diversification benefit of an asset is calculated as the ratio of excess return above the risk free rate to the standard deviation of an asset. SR works as
an indicator for the investment risk.294
where: Sp = SR of the portfolio E(Tp ) = expected return ofthe portfolio T F = risk free rate "(Tp) = standard deviation ofthe portfolio Investors norma11y take an asset purchase into their portfolios into consideration if the SR of the investment in question is equal or bigher than the correlation coefficient of !bis asset, multiplied by the SR of the portfolio.
292Canteret al. [see 1997, pp. 69-83] 293Litzenberger et al. [see 1996, pp. 76-86] 294Cole [see 1999]
230
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS where: Si = SR of single asset i Pi,p = correlation coefficient between i and the portfolio Sp = SR of the portfolio retum
Therefore, under the condition that ILS are uncorrelated with the other asset c1asses available, the right hand side of the equation reduees to zero, and investors will enhance the portfolio perfonnance as long as their expected retum exeeeds the risk free rate. 29'
6.4.5 ILS triggers Digression: Asymmetrie information, adverse selection and moral hazard Before George A. Akerlof published bis article "Tbe Market of Lemons", the common premise of econornie theory was that all market participants act on the basis of full or at least homogenous information. It was assumed !hat the seilers and boyers of goods are able to exactly price, for instance each automobile on the mark.et, since they know its quality. At the time it was eommonly assumed !hat, for instance, insuranee eompanies evaluated the risk in the same manner as the insured and banks bad the same information regarding default risk as their borrowers. 296 Akerlof first analysed the problem of asymmetrie information. He descrlbed the market for used cars where the seIler, having used the vehic1e for same time, knows the quality of the ear better than the boyer. Tbe buyer then assumes an average quality he may be informed about through the press aud is willing to pay an average priee only. Tbe seiler of a good car then is not able any More to realise a fair price, sinee the boyer eannot evaluate the qoa1ity. Sinee the average priee may be regarded by the seiler as too low, he will not offer bis ear on the market any more with the resolt !hat low quality ears will drive out the good ears. Sinee the boyers then start to assume low qoa1ity ears (ealled "Iemons") on the market only, priees will fall further until the market comes to a point that Da cars may be traded anymore. 11ris process is called adverse selection. Adverse selection is the process of an individual to make a deduetion for uncertainty when purchasing a merchandise on the secondary market.297 In literature about insurance economies today, it is common to assume that the insured has More information ahout bis risk type and futore behaviour than the insurance eompany. Tberefore, the information is asymmetrie in favour of the insured. 298 Since the phenomenon of adverse se1ection is disastrous for any economy, the following methods to avoid the deerease of its wealth by stimnlating the information flow were developed: 29SCole and Sandor, pp. 207-208 296Emons [see 2001, p. 664] 297 Alerlof [see 1970, p. 488-492];Decker [see 2OOO];StoeUner [see 1994, pp. 322-325]
298Zweifel and Eisen [see 2000, p. 292]
6.4. INVESTORS
231
Sigoolling is the initiative of the iofonned party to avoid adverse selection. Michael Spence has written about signalling on the job market. Signals are defined as observable, variable features which can be iniIuenced by the job applicant. An example for a signal is qualification. Through signalliug the employer is able to evaluate the productivity by analysing the signals and to fix the salary.299 Joseph Stiglitz has developed screening as a method for the low infonned party to minimise adverse selection. Screening is used by banks in the credit application process. Individual and corporate customers as weIl as projects are evaluated by screening systems within the credit application process. The result is a so-called pass-grade, the credit being approved, or a fail-grade, resulting in a decline. 300 Further, screening is used by insuranee companies. Customers who know that they face large risks are more likely to buy insurance than customers who face small risks. Through the screening of their clientele, insuranee companies are able to distingnish between risk groups, trying to minimise the problem that ouly people facing !arge risks are buying their insuranee. The result is a variety of contract types, for instanee, customers with low risk profiles can be offered a low premium but have to accept a lower compensation in case of a claim. In contrast, customers with high risk profiles have to pay high premiums but will get full compensation for claims. Thus, life and health insurance companies require medical examinations and will refuse coverage to persons with terminal illnesses. Automobile insurance companies charge higher rates to people having been involved in a number of accidents or with a conviction for drunk driving.301 Credit rationing is another method used by banks due to the following reasons: Banks are not honoured for taking high risks. Their revenue is the margin on top of their refinancing costs, this means that the expected return decreases with the riskiness of their outstanding volumes due to higher los ses expected. The expected return of a bank depends on two contrary effects: The interest effect results in higher returns with higher interest rates, but the selection effect results in lower returns due to higher lasses as a consequenee of higher default risks tsken. The two effects result in an optimized interest rate for the individual hank at maxirnum returns, meaning that credit is automatically rationised. 302 Credit rationing is supported by regulatory frameworks like Basle 2: Financings to customers involving higher risk, for instance reflected by lower ratings, are charged with higher capital costs and therefore require a higher interest rate than credits to customers with lower risk. The regulatory framework automatically rations the financing volumes available on the market."l3 An insuranee company offers a pooling contracl with a general premium level for the average risk type, sinee it has incomplete ioformation about the individual risk to cover. lbis average premium, however, is too expensive for the higher quality risk types 299Spence [see 1973] 300Stiglitz and Wcis, [see 1981, pp. 393-4091 30IStiglitz and RothschildMichael [sec 1976, pp. 648-649] 302Stiglitz and Weiss [see 1981, pp. 393-409] 303Pioretti [see 19.04.2005, p. 1];Slwpe [see 1990]
232
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
so !hat the customer will be acquired by other competing insuraoce compaoies offering
bespok.e tariffs at lower levels. The first insurance company will run into the situation !hat it has to increase the premiums because of its taking bigher risks only, will lose even more customers and finally run into insolvency. The bigher risk types will bave to cbaoge to aoother company aod the whole process starts again. 304 Moral hazard is the second form of asymmetrie information defined as the result of maximising human behaviour. Insurers, for instance, are not able to write a camplete contract specifying the exact level of precaution effort the insured bas to employ in every contingency. The insured's behaviour is not observable, or it is observable but not verifiable. The insured is assumed to be risk averse. Therefore the insurance bought has a positive effeet on bis expected utility. But at the same time, the utility function is negatively impacted by the bigher premium to be paid in order to compensale for the more severe moral hazard problem. The right mix between risk shating aod incentives has to be found.'05 Costs aod benefits of an action are weighted by the insured, and the action is taken when benefits exceed costs. When the insurance contract has been c1osed, loss frequency aod loss severity cao be dependent on the bebaviour of the insured. It is under bis contral to protect himself in order to prevent damage or to limit its consequences. Hence, the insurance company charges an excess premium in order to cover its additional risk. The threat of Moral hazard malres insurance More expensive. '06 307 There are two forms of Moral hazard: ex-ant. moral hazard if the chaoge in behaviour of the insured tskes place before the occurrence of the event insured, aod expost moral hazard if the cbaoge in behaviour tskes place after the event. Ex-post moral
hazard is mostly relevant for health insurance, for instance when insured persons demand too much treatment. The unqualified term "moral hazard" therefore usually refers to ex-aole moral hazard. '08
There are severa1 methods for insurance companies to avoid moral hazard: Loss prevention, also referred to as self-protection, keeps the insured value of any misfortune less thao the value to the insured person, for instaoce buildings or automobiles are insured for less than their true worth. Altematively, both parties may agree a deductible
- the insured then receives an indemnification that is smaller than bis 10ss by the amount of the deductible. The partial insurance is ao incentive for the insured to avoid damage. Loss reduction, also referred to as self-insurance, leads to a situation where the insured's effort inlIuences the distribution of the loss occurted but not its probability. For instaoce, precautionary measures against the damages of tornadoes or ftoods are loss-reducing, but the insured does not have any inftuence on its occurrence. Exclusive contracts
avoid the situation that the insured buys protection from severa1 insurance companies to compensate loss reduction. 304Zweifel and Eisen [see 2000, p. 293];Stiglitz and Rothschild Michael [see 1976, p. 293];Pauly [see 1968]
305Sonnenholzner and Wambach [see 2005, p. 1134] 306Zweifel and Eisen [see 2000, pp. 292-293] 307Sonnenholzner and Wambach [see 2005, pp. 1133-1134] 308Sonnenholzner and Wambach [see 2005, p. 1133]
6.4. INVESTORS
233
Many period contracts with bonus-malus sehemes allow the insurer to rate the experience aver time and renegotiation contracts include the right for the insured to change the contract to full-insurance in case that the risk. of moral-hazard ceases 10 exist. 309
Moral hazard and ILS Securitisation of insurance risk depends on detailed knowledge about the developments and effects of natural and man-made catastrophes, mortality, aod other risks insured. Since there are no underlying .ssets being traded in ao ILS structure, the specific desigo of ao appropriate trigger is of significant relevaoce for investors 31O The market bas developed • variety of different trigger types: 311
• indemnity triggers are activated through actua1losses within the sponsor's portfolio • index triggers are tied to an iodex usually established by ao independent tbird party • parametrie triggers activate when a certain level of losses is reached
• modeled loss triggers activate when expected losses re.ch a certain level There are trade-offs between the trigger types. Indemnity triggers entail moral hazard bec.use the size of the claims p.yout remains within the control of the issuer. Index, parametric, aod modeled loss triggers do not entail moral hazard but give rise to b.sis risk because the p.yoff released by the trigger may differ from the actual claims
experience.312 Indemnity-based structures are attractive to issuers because they avoid basis risk. wbich they would be exposed to io • pararnetric or iodustry-iodex-based transaction. However, this raises various issues related to asymmetrie information, such as advene selection and Moral hazard: Adverse selection reflects the problem th.t the sponsor might try to securitise the most unattractive parts of bis portfolio keeping the more profitable ones. Moral hazard refers to the possibility th.t cedents might no longer try to limit their losses, since they have traosferred the risk to investors. Further, the initially estimated level of risk may increase if the cedent relaxes its underwriting policies (ex-aote) or its claims settlement in case of a c.tastrophe (ex-post). Even if the underwriting policy is not relaxed, the risk io the covered portfolio could grow aod chaoge io composition because of the underwriting of new policies. Th.e insurer gets compensated for this portfolio growth by collecting more premium iocome. The risk for the secnrity holders may iocre.se without compensation, however, if the loss on the security is 309S0nnenh0lzner and Wambach [see 2005, pp. 1136-1139] 31°Erdönmez [see 01.09.2005] 311 please find a detai1ed explanation of trigger types in chapter 5.3.1 312Csiszar [see 2007]
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
234
defined in terms of fixed attachmeot and exh.ustion points. Another issue rel.ted to .symmetric information arises out of the proprietary nature of the exposure data - the investor typically does not have full access to this inform.tion. In this respect, ILS are different from CLOs where the investor might dig down and analyse each of the loans in the portfolio securitised on bis OWD. 313 Tbe market has developed several tools to control these issues: 3l4 • adverse selection potential can he addressed by establishing in advance clear and non-negotiable rules for the selection of qua1ifying business (. forther tool may he to include the cedent's full portfolio or. complete line ofbusiness). • the cedent keeps • portion of alliosses: Tbe goals of the cedeot and the security holder can be aligned by making sure th.t first, in an excess of loss contract, the cedent could be required to retain • certain percentage of losses in the reinsured I.yer. Second, regarding losses helow or .bove the layer, there can he limits .s to how much additional reinsurance the cedent may obtain. • changes and growth of • portfolio can be controlled by defining • specific portfolio consisting only of pre-.greed contracts and exposures. Altem.tively, through periodie trigger resets or limits on the inc1usion or impact of new policies in the .greemeot. Short risk periods, or indexing the contract to the combined ratio (paid losses divided by premiums received) for the relevant lines of business may also be considered. • Catastrophe modeling firms, and to • lesser extent the rating .gencies, play an important role in controlling the problem of .symmetric information. H.ving access to details of the exposure and policy data, thcy can provide the investor with relevant information through the loss prob.bility distribution. Modeling firrns also pl.y an important role in evaluating the quality of the data provided in terms of completeness and consistency.
6.4.6
Results of the interviews regarding investors
Before the c.pital market crisis, investors Made significant allocation to the sector and were looking to deploy assets - there w.s • healthy demand for ILS. However, the demand has heen too low to bring the ILS market to • macro level in terms of volumes. On condition !hat enough supply will be .vail.ble, the traditional money managers and investment man.gers are needed to bring the market to • bigher level.3l5 313 Andcrson et al. [see 1998, pp. 11-12] 314Anderson et W. [see 1998, pp. 11-12] 31'INT_2-BNK [02.09.2008];INT-4-BNK [04.09.20081
6.4. INVESTORS
235
Investors are the last in the "food-ehain". They continue to be very sceptieal about the ILS market. While some still !end to rely on the information of the offering circulars and ratings rather than on the orulerlying documentation, an increasing nomher of market participants follows a More sophistieated approach. Newly established funds with insurance specialists employed have heen eoming to the market.31• The sector continues to be dominated by experts. The maiority of investors today are institutionaI rather stieking with the risk purehased following a buy-and-hold approach. There has been limited secondary trading, mostly in natural eatastrophe ILS. 317 A lot of investors, especially hedge fonds, have the ability to cross the produet spectrom into high yield eorporate bonds or structured finance. A side-effect of the current crisis is that ILS are getting eompetition from other high-yielding asset classes trading at high discounts. ILS, however, stay to be attractive due to their low correlation to other produets.318
Investor Types Ranked by their volomes invested as shown in figure 6.21, the following types of investors can be summarised:
Dedicatedfunds: At the time of the interviews, there were about 14 funds specialised in ILS investments, among them funds managed by Clariden Leu, Fermat, Pimeo, and Zurieh. Two of the funds with asset volumes above USD I bu and the remaining with asset volurnes between USD 350 to 600 mln. These have been the main investors for eatastrophe bonds attracted by higher returns eompared to other eredit markets - during recent years the yie1ds generated by the funds are reported to be around 12-13% p.a.. Usually funds are prepared to accept a 1% loss risl<, meaning!hat they are prepared to invest up to 1% into eatastrophe bonds with a once-in-lOO-years event risk. At the time of the interviews, dedieated funds remained to be the only liquid souree in the secondary markets. An inerease of eorrelation between the ILS and general market developments was reported in !hat respect !hat the investors in the dedicated funds ean pull out their liquidity and put it to work on alternative produets.319 Dedieated funds for individuals: ILS funds for individuals are mainly traded in Switzerland. For individnals, an allocation of 2 to 3% of the total arnounts invested is regarded as an appropriate diversifieation into a lowly eorrelated, high yielding asset class. At the time of the interviews the products experieneed a strong track record in terms of performance. They were among the few asset classes which were still in positive territory. Investments into private funds are available for small arnounts from CHF ISO whieh are allocated to investments in eatastrophe bonds only. ILS funds for 3l6INf_l_MOD [19.08.2008I;INf-5-BNK [04.09.2008];lNT-ll-CON [12.09.2008] 3I7INf_7_REl [08.09.2008I;INf-ll-CON [12.09.20081;INf-25-BNK [29.10.2008] 3l'INf-l-MOD [19.08.2008I;INf-5-BNK [04.09.2008] 3l'INf-4-BNK [04.09.2008];INf-20-BNK [20.IO.2008];INf-22-BNK [27.1O.2008];INf-25-BNK [29.10.2008]
236
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
individuals do not invest into life insuranee related ILS because of their long tenn, low yields and diverging cash flow mechanisms in comparison to catastropbe ILS. Tbe fund admistration is supported by up to date risk mode!ing tools.32• Tbe products rarely exist in the US, but may be introduced sinee there definitely is a market for them. In general, the sector is experienced to grow in !ine with the growth ofILS, and reinsuranee is finding its way into collateralised products.321 Hedge funds: In their search for high yields, hedge funds were attracted to the highyielding catastropbe bond space during low margin environments. Especially the boom year 2fXY1 brought a lot of opportunistic cash rich investors looking for attractive yields in BB rated issues. ILS were regarded as a belter investment than the usuallong-short equity funds, since they are a diversifier to the portfolio with low correlation. Tbe funds have been getting increasingly professional and employ speciaiistS. 322 Compared to dedicated funds, hedge funds are prepated to take higher risk - some of them are prepated to dedicate 10% of the volume into once-in-lOO-years, or even 20% into oncein-lOOO-years perils. Tbey have been regulated by their investors only323 Hedge funds usually act professionally and do not appear to the market as forcedseilers. However, due to redemptions by their investors caused by the deteriorating capital markets, they started to seil massively in ntid-2oo8. Although they have been professionally refocussing and re-balancing their portfolios, the market reached a point when there was just too much US wind ILS for sale in the market doring the hurricane season 2008 and priees started to fall.'24 Although hedge funds are facing adverse developments and are forced to move out of the space currently they are expected to retorn to the markets when the situation will get back to normal. C0n3petition from investment opportmtities into high yielding subordinated baok debt or CDOs is regarded as temporary, and the low correlation to the general market is still a slrong argument tu invest into the ILS space. 325 Hedge funds usnally are levered, meaning !hat they borrow money to invest. This means !hat they have to generate yields .bove 5% plus their funding cos!. Tberefore they can be expected to continue to be interested in high-yielding, low-rated risk like catastrophe bonds.'26 Money managers are interested in the lowly correl.ted asset class. Tbey see it as • long-tenn investment and stick to their allocations over disaster and pricing cycles. Tbey are prepared to accept about 1% loss in the portfolio due to a catastropbe even!. While ratings are almost irrelevant to them, they appreciate the agencies certifying the legal issues and rather look at modeled investment risks, comparing them with third 320INT4-BNK [04.09.2008];INT-3()'BNK [14.11.2008] '" INT-ll-CON [12.09.2OO8];INT-I9-ASO [26.09.2008] "2INT-I-MOD [19.08.2008I;INT-5-BNK [04.09.2008] ;INT-I()'RAT [12.09.2OO81;INT-24-INS [28.1O.2OO8];INT-25-BNK [29.10.2008] "'INT-ll-CON [12.09.2OO8];INT-2().BNK [20.10.2008] '''INT-26-1NV [29.1O.2OO81;INT-30-BNK [14.11.20081 "'INT-I-MOD [19.08.2008I;INT-3-BNK [03.09.2008];INT-4-BNK [04.09.2008] "6INT-12-1NV [14.09.20081
6.4. INVESTORS
237
sourees. Sinee they work without leverage, they are prepared to take long-term, lowyielding investments in life reiated n..S.'27 InsuTers anti reinsurers: In the early phases of the marke!:, insurers were main investors. Life insurers are interested to diversify into the eatastrophe n..S space, sinee they understand the risk and actuarial models. Today there is no signifieant trend of insurers investing directly into ll..S, either for hedging or diversifieation. Insurers rather tend to invest through dedieated funds in order to get more diversifieation and expertise. Life insurers a1ike pension funds are interested in a negative correlation with longevity and therefore also invest in indexed products through funds. Selectively they also invest in lowly-eorreiated eatastrophe risk. Pension funds eompare the products with indemnity-based reinsurance and appreciate that the produets do have limited basis risk only. Reinsurers have the ability to cross the speetrurn. They are able to seil reinsuranee and hedge the risk with the issuanee of ll..S. This ereates a eircnlar market Ibe risk
flows among the participants, like between the Bermudan reinsurance carriers who tend to retrocede their risks taken to eaeh other. Finally, the same risk may be sitting in
several companies' books. 328 Banks helped to develop the markets in its initial stages through their participations, but were less present as investors in recent years. Caused by the crisis, they were forced to take participations in recent issues arranged due to a 1ack of investor interest in recent months. However, !heir balance sheets are eonstrained, and !herefore !hey are not able to warehouse risk on large seale at present. Banks do not sponsor n..S to hedge their own books yet but the active trailers of n..S seasonally use n..Ws for the hedging of peak risks,329 Investors for funded XXX transactions will be difficult to find, since the eost for leverage is getting higher. Banks may be the only participants who are willing to take long-term risks on their books."o
Drivers Non-life ll..S started in 1992, eaused by horricane Andrew followed by the North Ridge earth quake when investors were attracted by collateralised deals and spreads whieh were higher than !he modeled price and !herefore any premium to be paid for reinsur-
ance.331 Investors follow !he supply and demand mechanisms - !hey are constantly looking "'INT-5-BNK [04.09.2OO8[;INT-6-ASO [05.09.2008];INT-I2-INV [14.09.2008] "'INT-5-BNK [04.09.2008];INT-6-ASO [05.09.2008];INT-23-BNK [28.1O.2008];INT-24-INS [28.10.2008] [02.09.2OO8];INT-4-BNK [04.09.2008];INT-5-BNK "'INT-I-MOD [19.08.2008];INT-2-BNK [04.09.2008] ''''Carey et 01. [27.10.20080] "'INT-3-BNK [03.09.2008];INT-9-EXC [l1.09.2008];INT-ll-CON [l2.09.2OO8];INT-I2-INV [14.09.2008]
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for alternatives to established markets and over-returns. Tbeir benchmark is the socalled "multiple" which is calculated by plotting the yield of an issue against expected loss. Usually the multiple is higher for a high expected loss probability, like once-inlOO-years or once-in-50-years. Investors correct deficiencies for indemnity or pararnetric triggers and take into consideration limited ttansparency, callablility, and granularity
of an issue. Seasonality has to be corrected since hurricane seasons, for instance, do not run over the whole year. Finally, care has to be taken that foreign exchange f1uctuation
does not interfere the ca1cu1ation. lbis is the case when lasses are paid in Euros, but the ILS pays out triggered amounts in US Dollars. ILS multiples have been attractive relative to corporate bonds. However, while catastrophe issues offer a relatively high BB type pricing, and the investment-grade life ILS offer a rather low yield. Investors like efficient market pricing mechanisms.332 Tbe low correlation 10 other asset c1asses like credit markets, OIe products, commodities, or foreign-exchange is attracti.ve. But correlation shows up where investors usually do not expect it. While Kattina could be regarded as system-inunanent, the results of the credit crisis bring some doubts about the non-correlation thesis. 333 Especially cat bonds are diversifying investors portfolios into new areas. Tbe products offer the benefit to be fully collateralised although the Lehman default raised some concerns about the strocture of the collateral funds. '34 Ob.tael..
Capital market investors usually are not used to insurance, especially weather risk. The majority or the big investors are not involved in the business, since they regard the market as too small to build capacities and know-how.'35 Tbere are concerns about adverse selecrion. Tbe ILS sponsor therefore has to keep a good share in the transaction. Investors usually do not have a close contact to the sponsors and are afraid that they only place risk into the capital markets they are not willing to keep then3Selves. 33• Transparency was low in cat bonds, but in3proved after hurricane Katrina. Tbe transactions were not very transparent when investors wanted to verify damages after catastrophe events. Apart from reinsurance premium to be paid to the SPRY, the cost s1ructures of the transaction were not disc1osed. The investor was not ahle to evaluate how the promised yield will be generated - in case of the Lehman ttansactions, much of the yield was based on risky investments. Tbe information f10w post-event was beller regnlated and in3proved in the issues after hurricane Katrina.'37 "'INT-4-BNK [04.09.2008[;INT-IO-RAT [12.09.2008];INT-I2-1NV [14.09.2008];INT-20-BNK [20.10.2008] '33INT-4-BNK [04.09.2008];INT-20-BNK [20.10.2008] 334INT_7_REl [08.09.2OO8];INT-12-1NV [14.09.2OO8];INT-13-MOD [16.09.2008] 335INT-4-BNK [04.09.2008] '''INT-6-ASO [05.09.2OO8];INT-12-1NV [14.09.2008] "'INT-7-REl [08.09.2OO8];INT-20-BNK [20.10.2008]
6.4. INVESTORS
239
After the depart of the monoliners, complexity is becoming an issue in life ILS. Risks involved in XXXlAXXX transactions are rather difficult to quantify, while mortality and non-life related catastrophe risk is a lot easier to model. 338 There is a psychological hurdle to invest in ILS: approximately 90% of the capital market participants are educated economists, journalists, accountants, or psychologists hut only a few of them are physical scientists specialised in meteorology or seismology. It is easier for them to predict the acts of humans than of nature and the management of the investors in many cases has to overcome its lack of familiarity. Peop1e are afraid of natural catastrophes, and insuring their risk is rather frightening to thern339
Triggers There is a permanent tension between indemnity and parametric structures. In a hard market phase, investors are in control and they like parametric or modeled loss deals. In a soft marke!, the sponsors are in control and they like indemnity deala. 340 Indemnity ILS are very similar to reinsurance, which insurance companies are used to. The mostly conservative managements of primary insmers lik.e indemnity triggers, since they are not prepared to take the basis risk. Indemnity from primary insurers seems to he More acceptahle than from reinsurers. Catastrophe bonds have indemnity perlods of 12 to IS months. 341 Indemnity bonds need a rigorous filing in the US similar to standardised IOK annual reports, heing cornbined with rather high costs. Since only one indemnity based bond, Kamp Re, has heen triggered following Katrina, there has not heen areal test to the market Investors buying an indemnity bond prefer high quality established names with a successfnl franchise to ensure the necessary underwriting and claims handling quality.342 Investors lik.e parametrie transactions due to their transparency. It is referred to as the purest risk, since parametric ILS carry less risk of Moral hazard and adverse selection. The loss can be evaluated pretty early after an event within a perlod of less than six months. Parametric ILS mainly cover catastrophe liability and catastrophe mortality. Investors like a diversity of loss triggers and new perils as long as the models are understandable - new structures with multi-triggers were placed in 2OOS. Further, an innovative ILS which disaggregates the PCS Index to county level was placed to the market 343 Index based transactions are also favoured by investors due to their transparency. 338INT_7_REI [08.09.20081;INT-12-INV [14.09.20081 339INI'_12-INV [14.09.2008]
""INT-I2-INV [14.09.2008];INT-13-MOn [16.09.2008] '''INT-I-MOn [19.08.2008];INT-4-BNK [04.09.2OO81;INT-12-INV [14.09.2008];INT-13-MOn [16.09.2008] '''INT-I-MOn [19.08.2OO81;INT-2-BNK [02.09.2008];INT-4-BNK [04.09.20081 '''INT-2-BNK [02.09.2OO81;INT-4-BNK [04.09.2008];INT-I2-INV [14.09.2008];INT-25-BNK [29.10.2008]
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A third party agency surveys the market place in order to come up with a value that represents insured lasses associated with the event. Investors da not take basis risk associated with one particular company but the broader industry's exposure to the event. After the strength of a stonn or the magnitude of an earthquake has heen announeed, the investor knows whether or not bis prineipal is at risk. Sponsors and supervisors are monitoring the market discipline regarding triggers. Tbe parameters should ideally be metries wbieh are relatively easy to quantify by scientists like meteorologists or seismologists.344 Sponsors have to keep a 10-15% retention in order to stroeture out the moral hazard
risk.. The crisis increasingly m.akes investors demand the same information than reinsurers. The creation of an independent, PCS-like eatastrophe index is planned for Europe and would benefit the market by lowering the basis risk. Tbe approach is appreciated by the rating ageneies. However, there are coneems about the indemnity aspeets involved, since even if lasses are aggregated across the insurance companies, it still stays to be an indemnity-based risk. While the aggregated indemnity risk reduces the likelihood of an individual company having a moral hazard aspect to their behaviour, it does not reduce the moral hazard at an aggregate leve!.'45 Apart from natural eatastrophe indices, life indices inciuding a limited number of lives were developed. Data about approximately 50,000 life insurance polieies are eOffibined by a servieer, and a daily mark-to-market valuation is provided by an investment bank. Index-based derivatives ean be traded as an investment or to hedge longevity
risk. 346 Modeled loss ILS follow the ealeulations of the interna1 model by the sponsor, in general verified by one or more risk modelers. Tbey are bespoke transactions with limited basis risk taken by the sponsor.'47
Portfolio Models Market partieipants entertain the whole speetrum of portfolio models: some investors are very sophisticated, while others are rather naive in their approach to portfolio management. Mathematica1 rigour is irnportant, since catastrophe models are bighly eOffiplex. Therefore, investors nonnaIly license neutral and conservative cat models but then aggregate the outcomes of the models by transforming and reworking the data. The data have to be adjusted for the purposes of investment management, since most of the modelers' customers are primary insurers who do not trade eat risk. Modelers have their strengths in natural eatastrophe and life risk. Casualty, nuelear, aviatioo, marine, or catastrophe mortality still need to be ca1eulated manually by the investors. 348 "'INT-2-BNK [02.09.2008]:INT-I2-INV [14.09.2008];INT-I4-SUP [19.09.2008] 3"INT-I-MOn [19.08.2OO8]:INT-IO-RAT [12.09.2OO8]:INT-I2-INV [14.09.2008] 346INT-3-BNK [03.09.2008] 347INT_2-BNK [02.09.2008] 348INT-ll-CON [12.09.2OO8];INT-I8-INV [24.09.2OO8]:INT-26-INV [29.10.2008]
241
6.4. INVESTORS
Investors need systems which are e.sy to use on • daily basis, they must be stable without constant adjustments of the parameters. ldeally, investors get • daily information .bout thell: portfolio. The total, aggreg.ted notional .t risk is important to them. The systems help to be exposed in • diversified risk spectrnm.349 The retum of the portfolio is calculated frequently. Investors get • monthly evalu.tion with priee sheets of market makers - usually the weighted mid-bids or bids are taken .s • reference. The retum from ILS is calculated .s the discounted .sset value. Pure cash flow calcu1ations da not work because of the seasonality of same business. Reinsuranee and ILW premium is calculated .s accrued income, sinee it is paid up-
front. 3SO Traditioual portfolio optimis.tion works among all .sset c1asses .vail.ble. Covarianee models should therefore be sufficient for investment management. Copul.s work with estimation which are provided by the risk modelers. However, today they still rather complicate the process without e1ear benefits. 351 Secondary market In the early days of the ILS market, the pioneer investors had to follow • buy-and-hold strategy, sinee • secondary market for the bonds was non-existent. In the meantime, several investment banks and brokers initi.ted secondary market trading desks providing regular pricing quotations. The pricing of ILS is the biggest challenge for investors. Insurers and reinsurers have a c1ear competitive advantage, since they have a far better know-how than the remaining investor groups. These investors are challenged to evaluate the insurance related risk and more or less have to rely on the evaluations of the rating agencies and modeling firms. Transparency and comprehensiveness are the preconditions for • liquid secondary market. Unill the capital market crisis, ILS markets were domin.ted by buy-and-hold investors doing • substantial arnount of research before they decided to invest Secondary markets have therefore been in • developing stage with low volumes. Some market participants regard thern .s rather weak, while others report sufficient liquidity to find buyers. 3S2 Regarding the fact th.t most catastrophe issues are BB or B raled, the limited liquidity, however, can be assumed to be normal. Trading ofhigh risk tranches of ABS issues, for instance, is also limited. In general, the markets should be liquid enough and pretty Mature. For small investors liquidity is sufficient .s long .s they trade professionally, i.e. they h.ve to know what risk they trade and where the price needs to be to get an offer. Secondary markets certainly are .t current not large enough to shift investor's 34'INf-5-BNK [04.09.2008[;INf-26-INV [29.1O.2008[ 35oINf_29-INV [14.11.2008] 35IINf_l_MOD [19.08.2008]
35'INf-2-BNK [20.10.2008]
[02.09.2008];INf-4-BNK
[04.09.2008];lNf-5-BNK
[04.09.2008];INf-20-BNK
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appetite to a macro-Ievel. 353 US catastrophe bonds are by far the most liquid product with 10-20% of the outstanding volume traded annually. However, since most of the activity of US hurricanes is in the three months August, September, and October, spreads use to increase prior to the season and come down thereafter. Trading usually drops off wben a disaster appears and only forced seilers trade. 354 In Europe, the only liquidly traded risk is windstorm at rather small volumes. Lüe ILS show a very limited liquidity with 5-6 active trading parties in the US market only.35' In same cases, funds seil positions, since they like to participate in new opportuuities wbich overlap with existing exposure. In the past, participants mosUy exchanged positions far diversification. The effect was that until June 2008, each trade counted double due to the fact !hat, far instance, an investor wanted to swilch wind risk against earthquake risk. Tbese kinds of trades accounted for approximately 80% of the secondary market, and participants without having something to offer had to pay bigher bid-offer spreads.356 Values were still stable in September 2008 with a limited correlation to the general downtorn, even at bigher volumes than before. Most of the trading in 2008 carne from hedge funds wbich needed to liquidate catastrophe ILS positions, either sinee they faced redemptions or since they needed to deleverage because of lasses in other areas. In addition, same investors just saw other attractive opportunities. The mark.et was then extremely liquid in 2008 with prices between 97% and 102% of par. Market participants started to seil below bid in autumn 2008. Tbe trades as a result showed lower and lower prices down 3 to 3.5% in the two weeks beginuing of October, ending at approximately 5% down in November. In comparison to the deterioration of the stock markets during the same period, Ibis was regarded as still acceptable, but negatively infiuenced the performance of dedicated funds. Overall, 2008 was a record year in trading but also in negative pricing developments.3S7 A strang and active secondary market helps sponsors to place the products. It brings down price volarility, also through standardisation, and saves time to figure out what is in the deal in terms of risk.'''
"'INT-7-REI [08.09.2OO8];INT-12-INV [14.09.2OO8];INT-18-INV [24.09.2008] "'INT4-BNK [04.09.2008];INT-S-BNK [04.09.2008];INT-ll-CON [12.09.2008];INT-I2-INV [14.09.2008] '''INT-3-BNK [03.09.2008];INT-I6-REI [23.09.2OO8];INT-22-BNK [27.10.2008] '''INT-S-BNK [04.09.2008];INT-I2-INV [14.09.2008];INT-26-INV [29.10.2008] "'INT-S-BNK [04.09.2OO8];INT-26-INV [29.1O.2008];INT-23-BNK [28.1O.2008];INT-29-INV [14.11.2008] "'INT-19-ASO [26.09.2008]
6.4. INVESTORS
243
111e US regulatory framework is bloclring transparency in secondary markets since, following Reg-l44A, investors need to buy the bond in order to get the full documentation. Otherwise they are not allowed to get the information disclosed. Further, the ERlSA rules relevant for US pension funds do not allow the exchange of assets in certain fund types. Especially after the Lebman default, investors want to have full information ahout the collatera1 truSt.359
35'INT-25-BNK [29.1O.2008];INT-26-INV [29.10.2008]
244
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
6.5 Arrangers of ILS ILS need arrangers who combine the interests of the involved parties and co-ordinate the process from the structuring to the final distribution of the product. Tbe transactions may be arranged by banks, brokers, or the insurance/reinsurance sectur itself.
Innovation in a number of assets c1asses of the capital market has been about finding risks that are incidentaIly attached to each other, separating them and making them transferable. Arrangers are putting each of the risk in the best holders' bands by distributing them to the capital markets.360 ILS arrangers are not necessarily tearning up unIess the cIient asks them to. In many cases, sponsors chose the arranger according to bis ability to successfully pIace ILS structures. Transactional lawyers pIay an impurtsnt role in arranging ILS. Tbeyact as intermediaries representing sponsors, investors, and arrangers. Therefore. they have a good insight into the ILS market 361 Tbe arranger has some infIuence regarding triggers. Arrangers tend to Iike pararnetric triggers, since these are easier to distribute. Tbere is no single story: In some cases the trigger depends on the reinsured business, in others the sponsor is restricted by the
rating agencies or the supervisor. 362 Tbe procedure of formation of the SPRV of a rwn-life ILS is defined by the regnIators (in the US at state level), even when the entity is located offshore. It is an orpban of the sponsor and therefore has to pass the test for effective risk transfer with established procedures. Tbe SPRY, formed as a reinsurance company, needs to be adequately capitaIised, and there must be areal first loss piece taken by the sponsor. Otherwise lbere is a lot of fiexibility regarding the 00- or offshore status. Since the SPRV is located in another state than the sponsor's domicile, it has to collatetaIise its obligations with funds to get the reinsurance credit similar to a collatoraIised reinsurance obligation. 363 Some sponsors of catastrophe ILS do not care ahnut reinsurance credit Examples are the ILS Studio Re covering the earthquake risk of the Universal Studios in Los Angeles in favour of Vivendi in 2002 and the ILS Pararnetric Re covering the earthquake risk of Disneyland in Tokyo in favour of Tokyo Marine & Fire in 1997. Tbese transactions were structured as derivatives in order to get market-to-market credit They do not result in a regnIatory or rating capital relief due to the low probability of the underlying events.364 Ufe reIated ILS can be structured as a cash transaction, or alternatively, as an actuaIto-expected swap, also referred to as "synthetic transactions". Synthetics in general are not regarded as a threat to the cash markets, since in many areas they have helped to develop markets for new asset types by bringing in More liquidity. Established capital market players are able to quickly understand synthetic structures. Life related ILS '60INT-3-BNK [03.09.2008] 36' INT-7-REI [08.09.2OO81;INT-8-LAW [10.09.2OO81;INT-II-CON [12.09.20081 36'INT_7_REI [08.09.20081 '''INT-8-LAW [1O.09.2OO81;INT-IO-RAT [12.09.2008] 364INT_8_LAW [1O.09.2OO81;INT-IO-RAT [12.09.2008]
6.5. ARRANGERS OF ILS
245
are recognised by arrangers as having a big potential in tenns of volumes to hedge annuities, pensions, reverse mortgages, and life settlements.3M Regulators do not allow a true sale of policies, bot economically hankruptcy nonconsolidation treatment of the SPRV issuing the securities can he achieved: The SPRV takes the obligation for the reinsurance contract, and assets securing the obligations are put into a collateral trust (usually based in the UK). The result of the structure is reinsurance and not a sale of the policies - uulike MBS or Credit Card ABS where the obligations are truly sold. The sponsor remains liable for the insurance claims payment.'"" US reserve transactions have very long terms, AXXX ILS run up to 40 years while XXX ILS have lifetimes with a range of 12 to 45 years. LoC solutions have also heen available with similar tenns. Arrangers usually hire external actuaries to monitor deviations from the base case, any extra contractual obligations, or regulatory changes during the long tenn of the transaction. Since the reinsured block changes over time, open blocks have to update and refresh the SPRV's capital on a regular basis. 367 The following statements by the interviewees highlight the strengths and weaknesses of the relevant stakeholder groups:
6.5.1
Ranks
Banks bring players together as market makers providing mark-to-market valuations and flexibility regarding the investors' and sponsors' needs. They are able to act as a one-stup shop and can take a role as neuttal advisor. They divide riaks up, warehouse basis risl<, and create transaction forms suitable for the risk-transfer into the capital markets. Banks also act as total-return and interest-swap counterparties. In their role as trustee, they further liaise with service providers, risk modelers, and rating agencies. They act as broker-dealers by handling the sale, verifying qua1ifications, and applying for legal requirements.368 Banks understand the needs of their investors in an out. The global distribution networks olfer high placement capabilities. Further, although the products themselves enable no operating leverage, they can provide financialleverage and short term liquidity to funds. Their broad custorner basis brings primary and secondary marke! liquidity
and alternative risk-takers into the sector.369 The products olfered by banks are usually rather asset-management-like with a reinsurance component. ILS are different from other capital market products - the investor is olfered an event ris!<, not a credit ris!<, e.g. with a corporate bond. Banks are the risk'''INT-3-BNK [03.09.2008[ '''INT-8-LAW [1O.09.20081;INT-24-INS [28.10.2008] 367INI'_8_LAW [10.09.2008] '''INT-2-BNK [02.09.2008];INT-3-BNK [03.09.2008];INT-5-BNK [04.09.2008];INT-22-BNK [27.10.2008] 36'INT-2-BNK [02.09.2008];INT-4-BNK [04.09.20081;INT-23-BNK [28.10.2008]
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taking entities but are not an insuranee entity per se. Pricing volatility or underwriting
risk is on their focus and monitored. 370 Due to their involvem.ent in mergers and acquisition or even owning insurance companies, they have a detailed insight into sponsors' business models. In contrast 10 reinsurers, they are able to act with less eonHicts of interesl, since their ILS desks do not face in1emal eompetition with reinsuranee underwriters. It bas been reported !hat it may be easier to convinee a customer of a produet without baving to eonsider traditional reinsurance alternatives. Products offered by banks tend to foeus on the elients' eapital.371 The decision to da a life transaction in reinsurance form, in capital markets form, or as an ILS depends on the sponsors' needs and the investors' ability to take the risks
involved.372 Banks bave helped to find and establish life relaled ILS by creating innovative solutions for the seetor, supported by modelers and actuaries. Since banks are not able, or in some jurisdictions, not allowed to warehouse indemnity risk, they pass it on direetiy 10
the investors. 373
Banks were able to use their franchise by embedding auetion rate notes into XXX struetures: Tranehes of some transactions were prieed by using auction rate mechanisms at very low yields like Libor+5 basis points or even Libor Hal Due to the crisis, however, investors currently are not willing to participate in auction rates. The illiquid
market environment caused heavy price increases. 374 Value-in-force transactions as weIl as catastrophe bonds need to be structured, sold, and potentially underwritten by banks. Tbey act as intermediaries between the insurance companies, pension funds, or other eapital market investors. After a long pause, the value-in-force market was reopened in Europe with the Portofinos transaction in 2fXY7. 375 While a single trigger eatastrophe bond is rather straight-forward, banks involved in multi-trigger, indemnity, and life-relaled ILS need a longer track record. Tbe arranging bank needs to understand the reqnirements of sponsors, investors, rating ageneies, and
regulatory authorities. 376 Aecountants and CFOs, often having a banking background, like to take the securitisation route instead of reinsurance. Being in charge of the general refinancing of the insurance eonglomerate, they maintain close eontact to bankers who are demanding
compensation for providing cheap LoCs with securitisations. 377 370INT_3_BNK [03.09.2008];INT-4-BNK [04.09.2008];INT-5-BNK [04.09.2008];INT-2O-LAW [20.10.2008] 371INT_7_REI [08.09.2OO8];INT-22-BNK [27.1O.2OO8];INT-26-INV [29.10.2008]
372 INT_3_BNK [03.09.2008] 3"INT-8-LAW [1O.09.2OO8];INT-12-INV [14.09.2OO8];INT-26-INV [29.10.2008]
374INT_17_MON [24.09.2008] "'INT-22-BNK [27.1O.2008];lNT-23-BNK [28.10.2008]
376INT_23_BNK [28.10.2008] "'INT-25-BNK [29.1O.2008];lNT-26-INV [29.10.2008]
6.5. ARRANGERS OF ILS
247
Arranging banks in the past have mainly been the big international invesbnent banks. That means that they were not able to use !beir balance sbeet to take any basis risk or to guarantee the execution of the transaction with a substantial underwriting.378 Sorne of the banks unfortunately did not act as if having the long-run growth of the market for !beir target. Negative examples were repnrted wben arrangers seern to have manipulated deals to let the produets look good but failed to do enough investigation about the spnnsors' motives. Sorne arranging banks undermined the usual fees by half in order to get mandates, especially in the eatastrophe ILS market whieh is regarded as too small to have short-sighted participants of this kind. ILS were regarded as one more asset class and the sales force, although globally present on a !arge seale, was not used enough to the produet or not very rnotivated to distribute the produets, sinee others brought More volumes and higher internal sales credits. 379
6.5.2 Reinsurance brokers Brokers are mainly involved in natural eatastrophe ILS and regard !bem as an additional product in their range. Apart frorn ILS, they are particu1arly strong in the trading of ILWs and do not need banks acting as broker-dealer for these products.380 Brokers tend to be extremely strong in understanding the structure of insuranee business, analysing portfolios, and warking out basis risks. This is the business they have historieally been doing, and they understand the insoranee/reinsuranee business in and out. Basieally, they enter the eore competenees of!be banks by acting as intermediaries and, due to their insurance know-how, are able to act as arranging intermediaries between sponsors and investors. 381 Brokers maintain elose relationships with reinsurers providing proteetion, but less with primary insurers. They have strong analyties teams in place, especially for the natura1 eatastrophe business. Intemally, however, they face eornpetition among ILS and reinsuranee brokersge. Spnnsors launehing ILS naturally da not demand reinsurance brok.erage services for the underlying business se-
curitised.382 They certainly are well-positioned knowing the business and customers' needs, but are laeking the ability to manage the eollatera1 as a trustee or to provide inlefest rate and tota1 re!um swaps. Forther, they do not bave a !arge balance sbeet volume to use and therefore are not in a position to take basis risk or to underwrite a transaction. Therefore, they usually pair with an investment bank to use its services. Brokers in recent years just started to arrange ILS transactions, and most of them do not have a sales force of the size of an international invesbnent bank. Over time eapital markets activities ean be expected to be established in the future in order to reaeb full placement eapability for any kind of ILS.383 37'INf-I6-REI [23.09.2OO8[ "'INf-18-INV [24.09.2008] '80INf-5-BNK [04.09.2008] 3811NI'_8_LAW [10.09.2008] "2INf-22-BNK [27.1O.2008];INT-23-BNK [28.1O.2008];INT-26-INV [29.10.2008] "'INf-8-LAW [1O.09.2008];INf-16-REI [23.09.2008];INf-22-BNK [27.1O.2OO8];INf-26-INV
248
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
6.5.3 Reinsurance companies Reinsurers through their underwriting activities collect a lot of rather uncapped risk. They hold a very diversified portfolio of income in terms of geographie regions and perils. The focus is 00 buildiog a portfolio with low correlation. It is un1ikely, for instance, that an earthquake in Califomia will happen at the same time as a hurricane in Florida. Life reinsurance is a different risk with its own characteristics.384 In recent yeus, reinsurers turned into intennediaries, meaning they place risk taken from primary insurers with ILS into the capital markets. Risk is the core competence of the sector. Companies are focussed to understand it and maintain strong actuarial and risk teams. Their know-how enables them to keep the basis risk after repackaging and issuance of ILS with paramettic or modeled loss triggers. Apart form third-party risi<, they actively manage their own balance sheets by using ILS 38S While understanding their clients' business and needs inside-out, they have the goal to find the best solution available. Especially in the catastrophe risk sector, ILS is an additional product in the range. Reinsurers need the primary insurers to get the ctitical mass for ILS. They take the role as service providers for risk evaluation and
distribution.386 The primary insurer finally decides which product, traditional reinsurance or alternatively which type of ILS is chosen. In the early days of the market the capital-market teams faced interua1 competition from the reinsurance underwriting teams. This has been less the case, since after hurricane Katrina capacity limits for traditional reinsurance were reached in 200S and it was acknowledged !hat ILS can provide additional capacity. 387 Reinsurers today follow an integrated approach, the management tries to avoid any confiict of interest between traditiooa1 reinsurance and ILS. However, they cannot do transactions for their competitors. Further, customers having a difficult relationship with the reinsurance side will not give a mandate to the capital markets team of the same company.388 Reinsurers, due to their business relationships in some cases lasting for 100 years or even more, usually have a lang track record with the primary insurance underwriters. The contact to the CFO office and the accounting side of the insurance companies who rather like to take the securitisation route instead of buying reinsurance, is of rather shorter term."· Reinsurers are very strong in lougevity risk - some market participants are of the [29.10.2008] "'INT-5-BNK [04.09.2008] '''INT-7-RE! [08.09.20081;INT-8-LAW [10.09.2008] ;INT-I2-INV [16.09.2008];INT-I6-REI [23.09.2008] "'INT-4-BNK [04.09.2008];INT-20-BNK [20.10.2008] '''INT-26-INV [29.10.20081 '''INT-16-REI [23.09.2008];INT-26-INV [29.10.2008] 389INT_26_INV [29.10.2008]
[14.09.2008] ;INT-13-MOD
6.5. ARRANGERS OF ILS
249
opinion Ih.t banks are far less competitive.'90 Tbe leading global reinsurers h.ve established full p1acement c.p.bilities for ILS. In some cases, however, they use the sales network of broker-dealers 10 seeure the
placement of the risk. 391 Reinsurers are leading regarding product innovations. Tbey provide Ihe classical risk ttansfer using c.pital market techniques. Munich Re managed to arrange all sorta of non-life ILS; even • mortality-sw.p in 2008, while Swiss Re arranged all sorts of ttansactions from XXX, EV, c.tastrophe ILS to morality and side-cars. '92
6.5.4 Market Its • joke in Ihe industry that in terms of growlh ILS h.ve been Ihe nexi mortg.ge backed securities for 15 years. Allhough 1here were disruptions in 1998 and 2001, 1he markei
has seen upticks in growth. However, it is still growing from a very sma11 base.393 Tbe recognition of Ihe catastrophe ILS marke! .s an assel class, supported by press articles and academic research, is happening slowly but surely. Catastrophe bonds oulstanding were.l. volume of USD 14.5 bn.1 1he time of 1he interviews plus an additional ILW volume of .pproximately USD 7.5 bn. Compared 1001her assel classes this
was a rather small market. 394 Life insurance ILS bad. big stake in volumes (USD 10-15 bn), but dropped drarn.lically and carne to • standstill after Ihe rating deterior.tions of Ihe monoline industry. Tbere were!wo US reserve securitis.tions wilh. total volume ofUSD 1.7 bnplaced in early 2008 oniy.'95 ILS h.ve not been part of Ihe general securitis.tion boom now coll.psing. Tbey are not grounded in human behaviour, bul in real physical, natural phenomenons of earthquakes, hurricanes or c.tastrophes. Bonds sponsored by ptimary insurance companies give Ihem protection back to back to Iheir uriginal business. Bonds sponsored by
reinsurance companies are not necessarily a means of protecting th.emselves. Th.ey are More of • means of acquiring additional capacity. Bul at Ihe end of Ihe d.y, Iheir sponsors have to find reinsurance contracts to securitise. And Ih.t is coming from primary insurance companies. Tbe grounding in reality has been preventing Ihe market from growiug 100 much. 396 Growlh of ILS is in line wilh 1he growlh in insored values which can roughly be me.sored by • nation's grow1h of GDP. Emerging economies like 1he r.pidly growing BRIe states (Brazi1, Russi., India, and China) are regarded as h.ving Ihe largesl growlh potential.'97 390INr_22-BNK [27.10.2008] 391INr_8_LAW [1O.09.2008];INr-16-REI [23.09.2008] 3"INr-20-LAW [20.IO.2008];INr-23-BNK [28.10.2008] 393INI'_19-ASO [26.09.2008] 3"INr-4-BNK [04.09.2OO8];INr-5-BNK [04.09.2008] 3951NI'_S_BNK [04.09.2008] 39'INr-5-BNK [04.09.2OO8];INr-13-MOD [16.09.2008] "'INr-11-CON [12.09.2008]
250
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
The ILS volume is correlated with the reinsurooce prieing eyele, meaoing that the volume of ILS increases or decreases with the demand in reinsurance. Issuance of n..S grows when reinsurance gets expensive and slows down when reinsurance gets cheap. Volumes naturally decline wheo the market experienees a lack of investor interest 398 Amistake people often malre wheo aoalysing the ILS market is to foeus solelyon the total dollars notiooal amount of securitisations inslead of looking at the eapacities heing added to the industry's eapital base to provide risk beariog eapacity for e1ieots and whieh continues to grow quite rapidly. Volumes eoo he misleading - until early 2008, wheo the effects of the erisis started to spill over ood trading activity pieked up, eaeh secondary market Irade eounted double, since market partieipants mostly exehanged risk when they lraded. These Irades aceounted for approximately 80% of the volume traded secondary. Further, market volume may fall away when reinsurers enter into quota share agreements. For instance, Swiss Re entered into a quota share agreement with Berkshire Hathaway, ood as a result of this, less issuaoce was done for them in 2008.'99 ILS is promoted by market associations as a natural extension of the product credit securitisation into the eapital markets. It is expected to experieoce its break-through when popular consciousness increases and more institutional funds with large amounts will start to invest400 Natural disaster risk is relatively easy to understaod, while liability risk or terror is rather eomplieated. The market needs to he educated in order to understaod ood feel comfortable with insurance risk.401 Katrina was a large eveot ood lragie, but not the real lest the market needed in order to find out whether the market functions as expeeted ood investors are prepared to return afterwards. This would prove !hat the market is deep enough to provide real insurooce eapacity. Further, the market eould prove whether claims management is funetioning properly.402
6.5.5
Pricing or ILS
Pricing of ILS is not different from that of other seeurities. It is determined by supply and demand, meaning that arrangers agree with the sponsors to go irrto the market for the price and then reach a market clearing level for a new issue. Similar recent issues are taken as a benchmark for pricing. Secondary markets also follow the supply ood demand mechanisms. Theoretical research has been done to explain pricing mechanisms by different perils. Up to now, however, it has been very diffieult to explain the prieing mechanisms taking pricing cyc1es into consideration.403 '''INT-20-BNK [20.IO.2008];INT-24-INS [28.1O.2008];INT-26-INV [29.10.2008] '''INT-7-REI [OS.09.2OO8];INT-23-BNK [28.1O.2OO8];INT-26-INV [29.10.2008] 4OOINT-5-BNK [04.09.2008];INT-18-INV [24.09.2008] 401INT_6-ASO [05.09.2OO8];INT-19-ASO [26.09.2008] 402INT-2-BNK [02.09.2008];INT-7-REI [08.09.2008] 403INT-7-REI [OS.09.2OO8];INT-ll-CON [12.09.2OO8];INT-16-REI [23.09.2008]
6.5. ARRANGERS OF ILS
251
In a conference, 1LS pricing was delined as a result of different components like the risk modelers' loss probability estimations, the rating of a total return swap coooterparty, the secondary market liquidity, and the trigger mecbauisms. In addition, the timing of the placement in a hurricane season or in a hard or soft reinsurance market phase, which also depends on the general capital markets, bas an infIuence.404 The average cost of an USD 100 m1n BB+ raled catastrophe bond issue was estimaled in September 2008 as follows: 405 CosIType: Riskpremium SPRV OO8t Rating agencies fess Legal counsel fees Agent. trustee fees Total cost
Per cent p.a.: 6.00% 1.00% 1.50% 0.75% 0.30% 9.55%
USDp.a.: 6,000,000 1,000,000 1,500,000 750,000 6,000,000 9,550,000
Table 6.18: Price estimation for a catastrophe bond
Pricing has often been mentioned as a hmdle far sponsors. However, it has to be compared by talting the counterparty risk of reinsurers, and the fact !hat approximately 10% of the coverage has to be paid upfront to reinsurance brokers bas to be taken into consideration. Costs can be reduced by sbelf-offerings with finalised documentation and process set-up abead of a catastrophe, and further, more competition among the involved parties.406 Traditional reinsurance offers sloping yield curves, since they rather avoid writing multi-year coverage. The longer the protection gets, the more expensive is the cost far protection. Further, some catastrophe bonds are ca11able.4U7 1LS pricing follows cycles. Taking into consideration the pure prentium without the additional benefits of an n..S issue, there have been only very btief petiods when the pricing for catastrophe bonds was in a more advantageous position than traditional reinsurance or even retrocession. In the extreme period after Katrina, it was experienced that the pricing development far ILS was not as volatile as reinsurance prices.408 Pricing basically depends on the perils and the market's fantiliarity to them. In nonlife, indemuity-based issues tend to be higher priced than parametric, modeled-loss or index-based bonds paying the lowest spreads. The expecled loss plays an important role in pricing: Single-peril bonds tend to pay a higher spread than multi-petil issnes. The reputation of the sponsor and the fantiliarity of the market to the structure is another ""'Carey et 01. [27.10.2008.] ""'1Nf-2-BNK [02.09.2OO8];1Nf-4-BNK [04.09.2008] ....1Nf-4-BNK [04.09.2OO8];McMmrougb et 01. [27.10.2008] ""'1Nf-2-BNK [02.09.2OO8];!NT-3-BNK [03.09.2OO8];!NT-4-BNK [04.09.2008] ;!NT-13-Mon [16.09.2008] """1Nf-5-BNK [04.09.2008]
[04.09.2OO8];!NT-5-BNK
252
CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
pricing factor. Permanent issuers with a good uoderwriting track record can achieve lower prices than new names.409 Tbe quality of the Intal return swap couorerparty further infIuences the pricing of the issue. Tbe expecred revenues of the collatera1 trusts, basically the difference between the nore coupon to be paid to investors for the risk and the cash income of the collareral trust, can inftuence pricing. If high retums are achieved, the spreads of the issue can be subsidised. Before the crisis, the coupon for risk was higher than the spreads gained through the investment of the collatera1. The difference, also called negative carry, will increase further now at the cost of the sponsor, since investors will accept highquality collatera1 investments only. Low quality sponsors may even be forced In pay the difference upfront.410
6.5.6
EtTects of the crisis and expected measurements
All parties involved demand more transparency. Tbe information pruvided by the offering circulars is regarded as non-sufficient. Transparency is needed regarding the uoderlying contracts, the rerms of the reinsurance agreements, and detailed swap confirmations including swap receipt definitions. Until2007, the parties involved did demand In inc1ude the investment gnidelines of the collareral trust inln the offering circular. Regular, at least annual updares of the uoderlying risk covered and the collareral trust are necessary. Monthly srep-up conditions in the Intal return swap contracts would enable investors In react if the asset value fell below the required pre-defined amount. Ar-
rangers would avoid reputational issues, since they were enabled 10 react in time being able In recognise how bad a transaction got when difficulties arosen 411 Total return swap spreads were at 5bp before the crisis and were estimared at 15bp at the time of the inrerviews. It can be expecred !hat inveslnrs will demand higher quality AAA Intal return swap couorerparties insread of the usual AA rared entities (on condition that the collatera1 trust is invesred in stable, high quality assets). As alremative collateral solutions to bonds, guaranteed investment contracts or bank. accounts are being discussed. 412 Custodians of issues pre-2007 are currently under pressure In provide more collateral information and third-party valuations to investors. One solution discussed 10 impruve the transparency regarding collatera1 trusts would be an online portal for each issue with regularly updared information about the assets invesred. Frequent mark-Inmarket evaluations must include stress rests for the asset portfolio. This may lead In the inc1usion of more cash products and govemment securities.413 409INT-lI-CON [12.09.2008] 4loINT_17_MON [24.09.2008];lNT-28-ASO [03.11.2008] 411 INT-23-BNK [28.IO.2008];lNT-26-INV [29.1O.2008];INT-29-INV [14.11.2008] 412INT_16_REI [23.09.2008] 413INT_17-MON [24.09.2008] ;lNT-24-INS [28.1O.2008];INT-26-INV [29.10.2008] ;INT-29-INV [14.11.2008]
6.5. ARRANGERS OF ILS
253
It is expected !hat in the future the proprietor holding the coll.teral must be independent from other parties involved. Further, no p.per issued by any of the parties involved as total return sw.p counterparty in the transaction may be accepted as collateral asset any more.414
In order to .void the problems faced by collateral portfolios he.vily invested in mortg.ge-backed-securities, sector and regionallimitations are recommended to be defined in the collateral trust investroent guidelines. The total amount of collateral provided should be incre.sed from 90-95% for past issues to 100% or even .bove.4!' As • result, ILS structures can be expected to become more expensive. This will especially be the case if the market participants .ccept to use the less vol.tile on-therun rates for !re.sury bills .s • reference instead of the currently used USD-Ubor. Tbey would then .gree to skip the so-called 1ED spread, defined as the difference between the rate of government securities and USD-Ubor which was regarded .s • risk-free income for them in the past. Risk free, bec.use the marke! assumed th.t banks rated in the AA c.tegory are as risk-free .s government oblig.tions. Tbe 1ED-spread used to be 50 bp, hut went up to 300bp during the crisis. At the rlme of the interviews in November 2008, it w.s back down .t .pproximately 150bp 4!6 Taking the rates of US 3-month treasury bills as • benchmark would mean !hat the returns of the collateral trusts will fall by 1-1.5% on .verage. It is assumed !hat it will be an upbill-b.ttle to get the reduction of performance sold to investors. Soroe market participants therefore suggest to increase transparency and to concentrate on informing investors .bout the risk involved. Comparing with w.tcbes, an interview partoer reported !hat some market participants propose to define structures as "w.ter resistant" instead of "waterproof' .417 It seems to be common sense that until the market finds anather acceptable solution, Uhur will continue to be the reference rate. Funds are paid their performance fees with
Libor as a benchmark - their performance is measured as net income minus the hurdle r.te (Libor). However, in order to p.y Ubor out to investors, the coll.teral trusts need to invest in Ubor assets. Generally these are bank obligations wbose values h.ve been higbly correlated with the general market and which are .t risk in the current crisis.418 Regarding the opinions .bout future developments stated .bove, one has to decide between structurers/arrangers of n...s acting as intennediaries who are interested 10 support increased transparency, and step-ups. Tbey seem to!hink!hat investors will then be h.ppy and continue to invest. Investors and sponsors, however, definitely demand more transparency and would like to invest rather based on the 3-month treasury rate .s b.sis than .t Ubor. Tbeyask for • coll.teral solution with • matching return and duration profile.419 414INf_23_BNK [28.1O.2008];INf-26-INV [29.1O.2OO8];INf-29-INV [14.11.2008] 4!'INf-I6-REI [23.09.2OO8];INf-23-BNK [28.10.2OO8];INf-26-INV [29.10.2008] 41'INf-24-INS [28.1O.2OO8];INf-29-INV [14.11.2008] 4171NI'_29-INV [14.11.2008] 41'INf-25-BNK [29.1O.2008];INf-26-INV [29.10.2008] 419INT_29-INV [14.11.2008]
Chapter7
ILS Online Survey 7.1 Methodology The questionnaire attachod as Appendix 0 was on-line through a professional survey secvicec from October 12th, 2008 until Ianurary 12th, 2009. A total cf 225 ILS cxperts seross the stakeholder groups were invited. 46 expert8 answered the inquiry representing 20.4% of the invited specialists. The distribution of rcspondecs among the staeholder groups and nationalities is shown in figure 7.1:
-"'" I .... ~
1%/1
..-."'''.'''''~
••• ' %/1
,"
'''J)
I ~ . , .~
.
.,-_. ".,." ",,,,.,, .......
~"
,..." ........ :
••.
- ,.
..
"
" %1"
-.""".,,"p.
Hgure 7.1: Smvey respondees by sponsor type and geographie
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_7, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
256
CHAPI'ER 7. ILS ONLINE SURVEY
The strongcst stakeholder groups werc investors (15), followed by banb (9), rcinsurers (5), and primary insurers (5). The answers of lawyers (4), rating agencies (3), risk
modclcrs (2), a monoline insurcr (1), and an associ.ation (1) 8IC for thc purposc of thc analysis, when appropriate, summarised asjrameworking stakeholtkn. By nationality, thc stakeholders can be split into USAJBermuda (17), the UK (11), and Continental Ewupe(18). The survey was executed in line with current data privacy regulations. The participants were assured that the survey was anonymous and all data would be trcatcd confidentially. All information would be canceled after the dissertation project was
~ Figurcs listed in brackets in the following analysis are cither refeIring tD number of responses, scores responded. or shares of total:responses of the relevant question.
7.1.1 Basic questions The average number of people within the organisations working on
n..s are 12, while
the biggest entities are employcd by reinsurers with 35 peop1e on average, followod by lawyas (22), banks (12), risk modelers (12), insurance companics (9), investors (5), associations (5), and the monoIiners (2).
9%
61 %
(
18%
So ....,., 0,," C",ph
Figure 7.2: Organisat.i.onal status of n..s acti.vitiClil The status of the ILS activities within the organisations has mostly been definod as a team (27), followed by aformal group (8), a division (5), and a department (4) as shown in figure 7.2. Fi.gure 7.3 shows the number of lIIlSWClS rcferring to the importance and communieation with the general management measured by the scale from 100 (very close) to
257
7.1. METIlOOOLOOY
o (very far). ILS activities are rather c10se 10 the management, cspecially within insurance and reinsurance companies where the average score reported was 82 and investors with 76. Btmks reported 61 and the framcworking stakcholdcrs an average of 51. The regional focus is shown in figure 7.4. It is interesting that the majority is active in Western Europe (48.8%), foI1owed by the US (48.6%) and Asia/deve1oping countries (20%). Furtber, 33,3% of the rcspondecs (15) answacd that they follow a global approach. Tbc majority of the companies with global approach are reinsurers (4) and investors (7).
'" JU
90
80
'"
SoU l'«:
O~n
C ... ph
F1gure 7.3: Distance of ILS activitics 10 gcneral management The majority of the rcspondecs, 82.2%, answercd that they are involved in non-1ife I reinsurance ILS, while 64.4% among those are also involved in lifc insurancc ILS. Regarding the products (:Iigure 7.5), the majority of the intcrviewccs are activc in lifc and non-Iife risk transfer products, followed by embedded value and US reserve funding products (XXXIAXXX). Thc involvcmcnt in catastrophc bond CDOs is strong, while other COOs are of rather limired att.racti.veness er availability 10 the broader market. Life settlements gained interest among banks and invcstors. The frameworking entitics naturaIly follow the other stakeholders.
7.1.2 Market enviromnent On a scale ranging from 0% stating "strongly disagree" 10 100% stating "strongly agree", the majority of the interviewees answered that they expect an :increase in capital rcquirements for the reinsurance sector (see figurc 7.6). Figurc 7.7 further shows that, despitc the current crisis, the majority of the interviewees expect an increase of the demand for ILS in the future.
CHAPI'ER 7. ILS ONLINE SURVEY
258
•
,-"" ,,'<',,<
". •·e
"
.' ""
~
0-
,~
"
Figure 7.4: Regional focllS
.. ",. "
, ,
, • , ,
, , ,
•
• N,;...",. , "
. I...... "I ~I
[] ,."'" ..<\", c o,,,,,,'
.;.,.-".......,....... ,,, ,......... ",
'_ '_""~"'R'"
Sou,,<:
O~n
GNVh
Flgure 7.5: ILS products covercd
The majority of the interviewees is of the opinion that innovation will not stop and therefore new product types can be expectcd to arise on the markcts (see figure 7.8).
The ILS markcts are mosdy st:andardiJJed in the life and non-life risk transfer product:s, while the remaining products are regarded as rather bespoke currently. Life settlements show a ccrtain degrcc of standardisation although a limitcd numbcr of transaction
259
7.1. METIlOOOLOOY
60% Total"'n.~ ...:
H
So",,<: 0,," Croph
Pigure 7.6: Increasc of insurance soctor capital rcquirements
10%
60% Total
"'n.~ · .
... : U
Figure 7.7: The demandfor n..s will increase
were dune as public ILS only. The majority does not agree 10 the statement that the ILS market is currently standardised sufficiently (see figure 7.9). Although trading picked up dllring the crisis, the secondary mar1ret for ILS seems 10 be far from the standardisation of other secondary financial market sec1ors. Pigure 7.10 shows that the majority of the participants regard the secondaIy market as rather
CHAPI'ER 7. ILS ONLINE SURVEY
260
10%
30%
60% So",«: 0,," G ... ph
Figure 7.8: New product types will arise
..... 11.1
M", T" .. f,,(I;fo'
I:........... ' ....
"..
lU
,,-,
" " " • Sou",.: " • Graph " O~n
Figure 7.9: Standardisation ofll..S
lowly standardised. The average value on a scale between 0 and 100 was rather low at
34.6.
261
7.1. METIlOOOLOOY
" "
30
80
40
60
Figure 7.10: Stare of the n.s secondary market standardisation
7.1.3 About 11.8 Asked to rank the driven for the n.s market, the interviewees responded with an average score of 1.57 that the market :i& mainly motivated by risl:: transfer, followed by capital considerations (1.97), and divenification (2.46) as shown in figurc 7.11.
To .. l"'n.~ ...: ~ l
Figure 7.11: Ranking: Main n.s market driven
CHAPI'ER 7. ILS ONLINE SURVEY
262
The 10w commitment cf the sponsors' management ia rankcd as the main obstaclc for n..s market development (average score 2.5 in figure 7.12), c10sely followed by the lad: cf investors' msUIlUlCC expertise (2.6). Further. tbe I.ack cf rcgulatory hannonisation (3.2), the rating agencies' requirements (4.0) and technical systems (4.0) are confirmod as obstacles. Restrictions by the sponsors' owners (4.6) are less cf an issue.
", •• I" ,,,,, ~, ........ " .. "~< 10, • • r ... ..... ~
Tot.t
"n,~'''<:
J8
.. _.~,,;..
1.
I
I
J .l
s.~ r«;
0,," G",p~
Fig..:tte 7.12: Ranking: Main ILS market obstacles
Investment bank:s (average score 1.6 in figure 7.13) and the reinsurance sector (1.7) arc regarded as the most capable ammgen cf ILS. The sponsors themselves arc less convincing as potential arrangers (2.7).
7.1. METIlOOOLOOY
263
" Soure<: 0 ... C ... ph
Figure 7.13: Ranking: Most capable ILS mangen
7.lA Corporate lem 6.5 years ago to be involved in n.S, while the time span ranges betwoen 1 year and 14 years.
The institutions started on average
The main motivation to do an ILS (figure 7.14) is pricing in comparison to other reinsurance alternatives (43.5% of answen). Further, the value-added in terms of alternative reinsurance sources plays a major role in decision-making (41.0%). The fuIl acceptance by the capital markets (35.9%) is c1ose1y linked to the availability of secondary market trading which seems to be of less importance (25.4%). Tbe complexity ofthe products is not a major issuc (15.4%). Risk models are mo.re important than ratings (figure 7.15). Especially investors, reinsurers, and banks answered that they give mo.re importance to risk moc:Iels.
7.1.5 The banks' roJe Thc major anangcrs of ILS, reinsurcrs and banks, agICC to thc statement that thcrc are enough banks able to mange n.s. This is natural since every new bank as arranger brings competition into the market. The remWning iIItervWwees are equally split of a neutral opinion or would appreciate the number of mangen to rise. The frameworking entities would be interestM. in new players. 'Ibis ja also understandable since new parti.es bring additional sources of revenuc to them (see figurc 7.16).
CHAPI'ER 7. ILS ONLINE SURVEY
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The biggest strength is the banks' capability 10 place II.S into the capital markets. followed by innovation and structuring capabilities (figure 7.17). The main weaknesses of banks are the lack of knowledge of the insurancelreinsurance solutions and the market behaviours. followed by the low speed to markcl (figure 7.18).
265
7.1. METIlOOOLOOY
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7.1.6 FiDaI questions Figure 7.19 shows the percentage of questi.onnaires agreeing to the cxpccted rcsults of the current crisis. The majority agrees to the statement that a closer monitoring of the bank counterparty risks and the collatecal trust investments will fo11ow the IIWket turbulences. Banb are expected to be challenged as stable leng-term creditors.
CHAPI'ER 7. ILS ONLINE SURVEY
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'l1i7
7.1. METIlOOOLOOY
months ahead cannot be cstimated. the majority cf the remaining respondees (69.2%) expects a rising pricing development for n..s. For the sponsors. Ibis means higher cost:s wbi1c fm the investors highcr retums (sec figure 7.20). AB per 01.01.2009, the interview participants bad an average experience in the business of 6.05 years. ranging from 1 year 10 15 years. All responded that they started 10 get involved into n..s within their professional career, wbi1c ODe professional was also involved in n..s dllring bis academic careet.
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268
CHAPTER 7. ILS ONLINE SURVEY
7.1.7 Summary ofthe results ofthe ILS online survey A broad range of stakeholders with a wide variety of functions and interests in the process participated in the online snrvey. It was not possible to find any statistical correlations between the stakeholder groups and answers given. However, the following conc1usions can be drawn: n...s related activities are mostly teams of specialists and rather elose 10 the general mangement of the companies. Tbere is a high percentage of companies involved which are big enough to operate on a global basis. Most parties involved operate in standardised products which can be risk transfer ILS (e.g. catastrophe bonds and catastrophe mortality issues), embedded value, and US reserve financing. Structured products like CDOs or life settlements are less attractive tothem. Higher capital requirements are expected to increase the demand for ILS, and the market is ready to develop new product types, while the main driver is risk transfer. Main obsta.c1es on the sponsors' side is the low commitment of the management 10 the products, while on the investment side there is still a lack of expertise. - Regulation, rating agencies' requirements, technical systems or restrictions by owners are less of an issue. Reinsurers and the banking sector are almost equally regarded to be capable to arrange ILS, while arranging sponsors need support from one of them. Price, diversification and product liquidity are the main reasons to attract market participants. Risk models are more important to the respondees than ratings. Strengths of the banks involved are their structuring and placement capabilities. Further they are able to provide innovative products to the capital market. However, they seem to have a lack of understanding of the insurancelreinsurance products and its business behavioms. The survey participants, as a result of the crisis, expect stricter supervision of bank. counterparty risk and the investments in collateral trusts. Further, investors will demand a higher arnount of collateralisation and will be less prepared to participate in structured products like CDOs. Long-term products are expected to be more difficult to place, and banks may be challenged as long-term creditors. Rating agencies will strengthen their guidelines. Tbe majority of the participants expect a rise in pricing for ILS. However, due to the market turbulences at the time of the interviews, 23% stated that they cannot estimate the further pricing development.
Chapter8
Recent Developments After Ibe eIosing of Ibe interview phase, ILS markets have gone through an extraordinary period facing rapid changes. The !atest key developments until July 2009 are summarised as follows: There is a common understanding !hat state-of-Ibe-art principle-based solvency regimes are imperative to maintain Ibe financial stability of Ibe insurauce industry globally. In Europe, Ibe last QIS 5 will be done in 2010 in order to test Ibe soundness of Ibe aunounced Solvency 2 architecture (Level I of the process). The European Commission started in 2009 with the design of the implementation measures necessary for Ibe fina1isation until 2012 (Level 2).1 Further, a comprehensive reform of Ibe EU insurauce oversight is being discussed which may result in Ihree committees, each for Ibe supervision ofinsuraoce, banking, and securities (Level 3).2 The new US administration, within its finaocial regulation reform proposals, called for arevision of the insurance supervision. Tbc creation of a Federal Office of National Insuraoce within Ibe Treasury Department was suggested to galber information, develop expertise, negotiate international agreements and coordinate policy in the insurance sector. 3
NAIC proposed in May to establish a Reinsuraoce Supervisury Board under federal law. The authority will supervise US-domestic aod licensed foreign reinsurers operating in the USo Tbc revision process is expected to address the reinsurance issues,4 The drive to revise accounting roles for finaocial instruments is gaining fresh momentum. A simplification of the standards for their valuation is being worked on. Currently, the valuation is regnlated by lAS 39 aod the US equivalent FAS 133. The ru1es were challenged by difficult market environments which made a mark-to-market evalu'CEIOPS [see 2009, pp. 23-28] 2CEA [see 2009, p. 10]
'Treasury [,ee 17.06.2009, p. 4] [see 21.04.2009];III [see 2009a]
4GoSS
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_8, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
270
CHAPTER 8. RECENT DEVELOPMENTS
.tion of securities impossible due to • lack of pricing sourees. 5 Tbe crisis swept over from banking to insurance with • time lag. Especially life insurers operating in the US face substantial capital sbortages.6 A Outch insurer and severallarge US life insurers had to .pply for Government support.7 Non-life insurers are facing USO 22 bn of claims caused by the 2008 burricanes Ike and Gustav. Further, the balance sbeets of insures are not immune .gainst the financial crlsis - the sector reported to have 15-20% Jess economic capital .vail.ble compared to 2008.' In contrary to the 2005 burricane se.son, the markets are currently not prepared to inject fresb c.pital. 9
Tbe reinsurance and retrocession mark.ets are hardening with rates for US Wind coverage up 15-20% in the recent renewal roonds. Reinsurers started to hold back c.pital on the sidelines amid investment losses and to be prepared for the 2009 burricane
season. lO Bec.use of the removal of hedge funds and low secondary market liquidity, secondary market prices for c.tastrophe bonds are moving wider .t rather low liquidity." Despite the difficu1t environment, the sponsors HannoverRe, Soor, Liberty Mutual, USAA, and MuuichRe retumed to the market after an absence of six months while Assurant joined as • new-comer with • total volume of USO 987 m1n of c.tastrophe bonds.'2 However, a number of addirional sponsors bold back, facing a price increase of 50% oompared to the previous year. Depending on peril and region, the transactions were priced at 9-17% above Libor." Tbe total volume of non-life !LS for 2009 is estintated at USO 3 bn.'4 For the !LW market, new ISOA standards were introduced to facilitate trading of the products. Pricing for !LWs also increased with a preruium of 17.5% for a USO 50 bn industry loss oompared to II % the year before. 15 AIG has, in a private transaction securitised the value of USO 8.5 bn, a siguificant amount of the embedded value of their US life business. As part of their ball-out strategy, the securitisation Dotes were transferred to the US government. 16 Otherwise, DO life related !LS bave materlalised. Tbe financial situation of the monoline insurance sector deteriorated further, and the lack of capacity will remain. This will need More specialist investment to support life 5CEA [see 2009, p. 15];Fromme [see 29.06.2009] 6Yickers [see 28.05.2009] 7Barr and Mamudi [see 15.05.2009] 8Bogg and Hipp [see 08.01.2009] 9Pelsted [see 17.04.2009] IOyicken [see 28.05.2009];Reuten [see 15.05.2009];K1ein and Mowe'Y [see 01.07.2009] lICora [see 28.05.2009] 12areen [see 09.06.2009];ZeUer [see 23.04.2009] 13Yickers [see 28.05.2009] 14Pelstcd [sec 17.04.2009] 15Reuters [see 15.05.2009] 16Green [see 09.06.2009]
271
related securitisations,17 Rating Agencies will be registered and supervised by the EU authorities from 2010 on. They are working on restoting investor's confidence by disclosing their methodologies. Any contlicts of interest are avoided through the striet separation of methodology development processes and day-to-day rating operations. I' Hedge funds facing losses continued to lose!heir investors' support. European higb wealth individuals withdraw record sums from !he funds and are being replaced to a lintited arnount by US pension funds. The EU launcbed a draft directive for bedge fund regulation and faced lierce criticism from the industry. The US financia1 regulation reform proposals also include a call for more regulation. I' Dedicated investors still are attracted by low correlation assumption despite the fact that ILS retumed mueb lower than corporate bonds in similar rating classes doring the
recent months.20 Arranging of ILS is challenging. The investors are reluctant to take credit risk, meaning that the arrangers need to find innovative collateral structures to separate credit risk from event risk. If necessary, this can be done by using derivatives. Some of the transactions stayed with enhanced total retum swaps with top-up margining, while others invested the collateral in AAA rated Dotes with matched durations or invested in money-market funds. The collatera1 investroents are goverument guaranteed and fully transparent.'1 While the avian flu virus (H5NI) has not developed into a form that would be easily transmitred in human-to-human contact, the declaration of the swine influenza A (HINI), which is thougbt to have originated in Mexico as pandemic by the WHO on June 12th, 2009, brougbt the topic back onto the agenda. 22
170'Connor [see 31.03.2009]
18Tait [see 23.04.2009] 19Sorkin [see 24.04.2009];Brewster [see 19.04.2009];Treasury [see 17.06.2009] 20Suess and Umack [see 19.01.2009];Suess and Umack [see 17.02.2009];Fields [see 04.06.2009];Reuters [see 08.06.20091 21Dankwa [see 17.06.2009];McMurrough et al. [see 27.10.2008] "Cheng and Jonlans [see 11.06.2009]
Chapter9
Summary and Conclusion Convergence between the insuranee and banking sectors is already reality. There baa been a strong tendency to follow the blucprint of thc banking supcrvisory framcwork Basle 11 when creating Solvency 2 for the Eurnpean insuranee and reinsuranee industry. Although the current crisis made evident the weaknesses of the regime and some countries have concerns that their insurance sectors may not have sufficient capital to keep up with the sehedule to introduee the new regime, it has been agreed to implement Solvency 2 unti12012. The current erisis bears the potential to leam many lessons and to create a stable framcwork. Thc US and a number of important offshore regulators arc elosely following the process in Europe, and there is a common inrerest to harmonise the global supervisory systems. As the regulators, all other stakeholders involved in the process are interested in a constructive discussion. Due to the exposure to natural eatastrophe, the US market has rather been risk transfer driven, while the European market has rather been capital-driven. The ILS market has shifted from indemnity triggers to investor-friendly parametrie and index-based triggers. ILS would gain attractivcness among sponsors, if thc usc of indemnity triggers increased. This process requires the availability of statistica1 data and eommon practiee regarding the evaluation of risk. Banks ean take responsibility in their role as intermediaries between sponsors and investors. The market was for years regarded as growing too slowly. However, there was a misconeeption when eomparing 1LS with other eapital market products. The growth rates of the MBS markets were taken as a benehmark for 1LS products. While MBS, for instanec, built up a bubblc, thc insuranec market is grounded on reality. There must be business written by primary insurers whieh baa to be ceded, otherwise ILS stroetures
da not malre sense. Further, in order to benefit from capital deduction, regulators and rating ageneies demand a full eollateralisation of the products. This prevented the 1LS market from over-Ieverage into a bubble. C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_9, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
274
CHAPTER 9. SUMMARY AND CONCLUSION
Further, investors needed to get eomfortable with writing protection against risk they usually are afraid of. Sponsors needed to get over the hurdles of being rather used to traditional reinsuraoee thao to the eapital market-like ILS. Securitisation offers a vatiety of alternatives to traditional reinsuraoce. Although some produets are not eompetitive to traditional reinsuraoee in terms of ptieing, they offer some benefits whieh outweigh the higher eosts like eollateralisation or multi-year eover at a fixed price. The produets have been providing additional eapacity aod attracted a number of new investors who were not interested or not capable to participate in the insuraoee-linked markeI. Non-life n..S will continue to be atrractive due to their high yield aod the vatiety of perils available. The eollateral trusts will go through areform aod experienee a strieter regime - portfollos will inc1ude more secure investments than in the past The crisis will further lead to arnended terms aod More traospareney for the investors. Monthlyevaluations of the assets invested and step-up conditions for the case of a market deterioration will enable the trusts to react quieker thao in the pasl. Whether Libor remains as a reference or will be replaced by short-term treasury rates depends on the flexibility of investors. At the time of the interviews, the majority of the market partieipants eould not irnagine that investors will aceept lower yields by approximately 150bp as a result of a switch to treasury-referenced prieing. The produets wou1d then get less attra.ctive in comparison to alternative investments. Sid. ears and eaptives are eompetitive products to non-life ILS. However, the eharacteristics of reinsurance overweigh those of securities attracting the broader investor space. Partieipaots in side ears provide reinsuraoce eapital for a elosely defined set of eontracts aod perils for a lirnited time-frame. They have to nnderstaod the business in order to be able to bear the risks. Regarding the location of eaptives, it eao be assumed that they depend to a substaotial part on low-tax legislation. There is a lot of diseussion regarding offshore finaocial centers. As a result of the erisis, governments eao be assumed to improve the attractiveness of onshore solutions in order to stay in contro! of the market aod to keep tax revenues in1aod. The US aod Europe are not far away from finding solutions whieh may become eompetitive through pass-through taxation roles. Li!e ILS are facing a strongly ehaoging environment: After the departore of the monoline insurers and the 10S8 of confidence in ratings, investors have 10 evaluate the traosactions on their owu. This meaos that the sector goes through a traosition phase. Swap transactions between the sponsor and investors with banks as intermediaries may bear a higher potential thao life n..S sinee they eao be done privately without the reguI.tory requirements of a REG-I44A transaction. The market, as a result, will be even More dominated by specialists exactly nnderstaoding the risk aod the actnatial modeling; More education of investors will eertainly be necessary. Some investors are very sophistieated regarding longevity risk traosfer. Dedieated funds have been irnportant participants in this market sinee they see longevity assets alongside other n..S products. Longevity is a slow buming, cumulative risk. Existing models are rare aod econometrie - they are different from the usual models aod normally
275 outside the experience range of investors. Embedded value transactions will continue to be attractive far demutualisations or portfolios sent into run-off after take-overs. The loan-to-value of embedded value transactions, however, as a result of the crisis, may come down from 80% to 50%, or even 40%. The risk of loss may therefore be reduced and the usnal monoline wraps can fall
away. The future development regarding ILS volumes depends much on the liquidity of the market. Primary markets were, until the current crisis, liquid enough to place ILS of the different varieties exp1ained. However, hedge funds among the primary investors currently lose a substantial part of their liquidity because of redemptions aod banks not being willing or able to provide leverage. Further, they have to solve a number of issnes with difficulties in their investments in mortgage-backed securities. Whether they are able to return to the markets depends much on the further development of the crisis in tenns of severity. Dedicated funds and hopefully newly emerging retail funds may be able to fill the gap and will be interested to further buy the products. Unless reformed, US Reg-I44A aod ERISA rules will stay to be a hurdle for the liquidity of secondary markets . Secondary marke!s are vital for the future gruwth potential regarding ILS. They proved to be stable and able to absarb selling efforts at acceptable prices until end of 2008, much longer than other segments of the capital markets: stock exchanges aod prices for high yield corporate debt were already in free fall at that time. Life settlements have to same extend started as ILS, but the market has shifted to private placement structures, some of thern are retail funds. They currently experience sintilar difficulties as hedge funds. Liquidity unfortonately dried up at a time when polieyholder are willing or forced to cede their life insurance contract at attractive prices.
Overall, ILS, also in combination with other ART products, affer a wide range of flexibility. There is room for further product inoovation, especia1ly regarding multiperillmulti-trigger securitisation structures. However, the marke! needs higher volumes with attractive spreads to meet investors' demand far More diversification aod high returns. Tbe premium compared to other capital market investment categories can be expected to remain over a longer term and is justified by the lower liquidity and the necessity to understand catastrophe risk mechanisms when investing in ILS. There is some possibility that reinsurers may take the role as intermediaries writing reinsurance cover aod p1acing it in a structored form into the capital markets. Supranational institutions like the World Bank are interested in ILS to cover catastrophe risk aod bring stability into the system. The ro/e of the banks has changed since the early days of the marke!. While in the beginuing they were investors to support the start-up, they concentrated on providing leverage aod arraoging transactions before the crisis. They will continne to play ao irnportaot role to provide liquidity for the primary marke! by finding investors, ar far the secondary market through warehousing and trading. Their strength compared to reinsurers and brokers is their international placement capability aod their savvy
276
CHAPTER 9. SUMMARY AND CONCLUSION
of the investor space. Reinsurers and brokers are eh.sing up, bot are yet not .ble to provide • similar sales force. Banks' weakness is the lack of kuowledge of the insurance/reinsurance space. Further. they are DO traditional investors in the BB range of ILS investments. Tbey will eontinue to be needed in the future to provide services as interest rate sw.p counterparties and trustees. Tbey will certainly stay to be .ecepted .s total return sw.p providers for short or medium term transactions (up to 5 years). However, it will take time to eonvince counterparties to accept lower quality banks for longer terms. The non-correlation assumption of the ILS market holds for the different insurance perils, but not for the general effeets of • severe finaneial crisis. Tbe recent months have proven that banks can default or run into state conservatorship and that investors are reluctant to boy any kind of securities, .t least temporarily. Tbe separation of credit risk and event risk is necessary and a1ready refiected in the new ILS structures of vintage 2009. ILS depend on the pricing cyele of reinsurance: Tbe produets are .ttractive when reinsurance prices are high in hard markets and are less attractive when the prices are low in soft markets. Tbe ILS market will pick up when traditional markets ealm down and reinsurance rates harden. When comparing the prices, the full costs of the different products h.ve to be taken into consideration. Tbe future of the market depends • lot on the severity of the eurrent crisis. Tbere will remain to be ups and downs in the capital market and the nature of insurance causes a eertain vol.tility of loss ratios. Tbe eonfidenee in structured produets has to be restored to • degree !hat sponsors further accept ILS as an alternative and !hat investors, aftaid of the bank risk involved, .ecept them .s secure investments. Less eomplex struetures with ciear documentation standards are needed. This ean only be reached when alI parties involved act in • eonstructive w.y. At current, the market is in a phase to overcome its weaknesses. The first hurdle has been taken by the successful introduetion of new e.tastrophe ILS structures with more secure standards. While .pproximately 50% of them continue to use modified total return sw.ps, the remaining are seeured by eoll.tera1 trusts holding govemment-guaranteed bonds. Supposed!hat the erisis will come to an end soon and no major disruption like a mega-catastrophe cr a severe pandemie occurred, ILS have a good chance for further sound development .ttracting more sponsors and investors willing to place and take pure insuranee risk into their books. ILS produets certainly h.ve • chance to recover earlier that other securitisation types. Interesting topies to analyse in the future m.y be the potential usage of ILS for the banks' hedging purposes. Another interesting subject would be to analyse the effeets of the global barmonis.tion of the insuranee solvency regimes sinee the use of Basle II opened the doors for global investment alIocation into the wrong direetion, resulting in the current crisis. Further it may be interesting to analyse how the products eould be used to prevent emerging eountries ftnm n.tural e.tastrophe damage.
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AppendixA Insurer Financial Strength Rating Methodologies
2••
AppendixB The 35 most costly insurance losses 1970-2008 1
ID8ta Source: Sigma.. Natural catastrophes and man made disasters in 2008. SwissRc, Zurich, 21.01.2009
61
13.
20,337
20,000 14, 13,847
3,642
., ..
---
",042001 25.
17.01.1995 27.12.1999 10.03.1993 06.08.2002 20.10.1991
OLlO.1 ••'
.-
,
-".
"
""'"
Blizzard, tomadoes, flooding Scvcrc floods Fon:st fims which spmad to mban areas, drought Hail, 1l00ds and wmadocs
"'"
Explosion on pI Piper Hmricane Opal; fiooding Great Hanshin carthquakc (magnitude 7.2) in Kobc Wmter storm Martin
Hurricane Gustav; F1oods. Offshorc damage Thnndcrstorms, tomadocs, ball HmricllIlC Floyd; hcavy rain, floods
. heavy ralll, Hurricane Jeannc; floods, landslidcs Typhoon Songda!No. 18
'
Wmtcr storm Kyrill; floods Storm and f100ds in Europc Hurricane Fnmces wmtcr stonn Vivian Typhoon Bart/No. 18 Hurrk:ane Gearges; ooding
Winte<.-Lotlw
Hnrricane Katrinaj tloods, damI hurst, damagc to oll rigs Hurricane Andrewj f100ding Terror attack on WTC, Pentagon and othcr buildings Northridgc Earthquakc (magnitude 6.6) Hurrk:ane Ike; ßoods. olIshare damage Hurrkane lvan; damage to oll Hurricane WIlma.; torrential rain, floods Hurricane Ritaj floods. damage to oll rigs Hur. Charley Hurricane Charley Typhoon MiIcilleINo. 19 Hmricane Hugo Winter starm Dm
E_
eounttr.
7.~'
~
I."", Spain, Francc. Switzedand US, Canada. Mexico, Cuba UK, Spain. Gcrmany, Austria cl al. USA USA UK
US, Caribbean, Gulf of Mcxico et 81. USA USA, Bahamas. Colombia UK USA, Mexi.co, Gulf ofMexi.co
Iapan, South Korea
USA, Caribbean, Haiti ct al.
UA
USA, Caribbean
w.
USA Cuba, Jamaica et al. I."", USA, Puerto Rico et France, UK, Belgium, NL ct al. Switzerland, UK, France et al. Gcrmany, UK, Nethcrlands, Belgium ct al. Francc, UK, Netherlands cl al. USA Bahamas Europo I."",
USA, Caribbean: Barbados et . USA, Mexico, Iamaica, Haiti ct al. USA, Gu1f of Mexico, Cuba
USA, Bahamas USA USA USA, Caribbean, GuJf of Mexico cl a1.
USA, Gulf of Mexico, Bahamas, N.At1anti.c
lUSD m insured laISes indexed. to 2008 (inct. pmperty and buBinells inremIption, excl. liability and life insurancc 1000000s); 2dead and missing
4
--
-
38
"
246
2,763 2,688 2,675
6,425
2,925
3,102
3,'" 3,493
,.
45 70 1
3,648
l3S
4,000 26.08.2008 02.05.2003 10.09.1999 .rJJ.1988
.09.1998 1 13.09.2004 06.09.2004
41 3,034
.,
26.08.2004 25.02.1990 22.09.1999
25.01.1990 .1 .1 99 18.01.2007 15.10.1987
11.08.2004 27.09.1991 15.09.1989
19.10.2005 2O.09.200S
17.01.199420.09.2008
23.08.1992 11.09.2001
25.08.200S
Start Date:
38 64 26
3,752
4,334 4,087
',222 4,663 4,
5,866 5,255
54 22
11
7,
.,
51 71
24
34
"
6,328 5,875
7,695
7,940
11,122 9,176 8,926
1
2,982
22,855
24,552
1,836 43
71,300
....., """""",
_ 8
Appendix C Reinsurance Sidecar Issues 1
IData Sources: MMC Sccurities, The catastrophe bond marlet at year end 2006, Guy Carpenter & Company, New York, 2007 and Aon Capital Markcts, Insurance-linkc:d securities 2008. AON. Chicago 2008
ThIal1iXJ7
Data source:
(9)
S",",Re
2007 2007 2007
XOL XOL
QunlaSlwe QunlaSlwe QunlaSlwe Side by Silk: QunIa SImre
,ide by Sidc QunlaS","", Sille by Sidc
_SIwe
_S","", :ontingent a Sille by Sidc
_SIwe _SIwe _SIwe
_S","", _S",", _S",",
90.9
1,959.
550.0
220.0 200.0
40.0 400.0
Proper Proper Proper
"""""" _
,
Property I
78.6 69.0
100.0 250.0 4,159.7
Property I Property I Property I
40% I Marine I Of
Shart-tailed
USj
Propcrty I
107.7
330.0
~ 300.0 70.0
360.0 200.0
3IT.O
60.0
250.0
~71.9
300.0
525.0
146.0
370.0
c energy and marine
",>,""""""" nprotcction
Aon Capltal Markets, Insurance-Linked Securities 2008, AON, Chicago 2008
Guy CaIJ?"'!ter, Ibe World Catastrophe Reinsurance Marlre~ Guy Carpeoter & Company, New York, 2008
ACE Swis! Re
lyndicate 6105
1iXJ7 1iXJ7
MopücLtd Bi_ Arl
Bi_
lYnmcate 6104
Syruoro Nr:w Point Re
NortonRe
[HcIlooc Re
.Re
Bluc Occan Re
Helicon Re
2007
1iXJ7
!
2006
2006 2006 2006
2006
2005
_S",",
_SIwe _SIwe
_SImre
Kait
2005
2.005
f'ot
[:3
AppendixD US Life Insurers: xxx and AXXX Securitisations 1
I Data Sources: Devine, Colin, ci al., The Securitization Solution: Emerging Options for Ufe Insurcrs, Citigroup Inc, New York, 06.07.2006, p. 10 I Carcy, !an and)amcs, Tim,
European Life Securitisation, Faculty & Institute of Actuaries, London, 2008, [Powerpoint Slide 5]
2006 2006 2006 2006 2006 2006 2006 2006 2006 2006 2006 2006
2005 2005 2005 2005 2005 2005 2005
River Lake Ins. Co. I-D
S""""""'"
Tunberlakc Financial
B_Re B_Re B_Re B_Re B_Re B_Re B_Re
Tht.l2OO5 River Lake Ins. Co. m Rivermont
StiDgray Th1St
River Lake Ins. Co. D-B River Lake Ins. Co. I-C Orkney Holdings Orl
Toto! 2004
Potomac 'IIust Capital I 04-6 Potomac 'IIust Capital I 04-7 Potomac 'IIust Capital I 04-8 Potomac 'IIust Capital I 04-9 Potomac 'Ih1st Capital I 04-10 Potomac Trust Capital I 04-11 River Lake Ins. Co II-A
RGA Banner Life TI (htBritishAmerican) GenworthlFirst Colony Life
_Re _Re _Re
_Re _Re
GenworthlFirst Colony GenworthlFirst Colony
_..
_Re _Re _Re _Re
_Re
GenworthIFirst Colony Life GenworthlFirst Colony Life
Banner Life (1st BritishAmcrican) Banner Life (1st BritishAmcrican) Banner Life (1st BritishAmerican) GenwortbJFirst Colony Life
Banner Life (ht BritishAmerican) Banner Life (1st BritishAmerican) Bumer Life (1st BritishAmerican) Banner Life (bt BritishAmerican) Banner Life (bt BritishAmerican) BaDDet Life (bt BritishAmerican) Banner Life (1st BritishAmerican) Banner Life (1st BritishAmerican)
GcnworthlFirst Colony Lifc GcnworthlFirst Colony Lifc
Rivm: Lake Ins. Co. I-A Rivm: Lake Ins. Co. I-B Tht.l2OO3 Potomac Th1st C8pital I 04-1 Potomac Th1st Capital I 04-2 Potomac Th1st Capital I 04-3 Potomac nult Capital I 04-4 Potomac Th1st Capital I 04-5
2003 2003
2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004 2004
0-
N....
Yoar
850.0 450.0 300.0
2,131.0 500.0 315.0 500.0 500.0 400.• 250.0 10.0 40.• 50.0
325.0
43.0 30.0
850.0 383.0
200.•
300.0
300.0 840.1
49.1 49.1
49.1 49.1 49.1 49.1 49.1 49.1 49.1
49.1 49.1
600.•
300.0 300.0
USDm
A' A'
w,
AAA' Aal' AA'
ce ce ce
CC CC CC
A A-
-
AAA AAA AAA AAA AAA AA BBB+ BBB+
-
wo
-
A A BBB+
AAAAAAAAAAAAAAAAAAAAAAA
A A
"'"
Ad.
B.1 B02
Ra~
AAA AA AAA AAA ABBB+
AAA AAA AAA AAA AAA AAA AAA AAA AAA AAA AAAAA
AA' AA'
"'"
Urig.
Ra~
XXX AXXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX
XXX XXX XXX XXX XXX XXX XXX
XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX
XXX XXX
Type
3.
31
MBlA
""'''''''
Am"'"
""'....,.--. ""'....,.--. ""'....,.--. ""'....,.--. ""'....,.--. ""'....,.--.
MBIA
3. 3. 3. 3. 3. 3. 3. 3.
FGIC 3.
""''''''' ""''''''' ""'''''''
MBIA MBIA MBlA
AMBAC AMBAC AMBAC AMBAC AMBAC AMBAC AMBAC AMBAC AMBAC AMBAC AMBAC MBIA
MBlA MBlA
........-
44
10
3. 3. 3. 3. 3. 3.
3.
20 20 20 20 20 20 20 20 20 20 20
3. 3.
fum
~
Co. IV Co. IV
I SBLI
[ Pine Folio ToW
[ 2008 2008
~
Spoouor
Co. [
of I
AAA' AAA I
Aaa 3 Baa33
Orig. Rat-
I iDg
1,0400 [ A+' 1,715.0
175.0 I n/a
550.0
1,::~
500.0 40.0
USD m
[ nI.
I n/a
AAA' A- I
A DIa
Ad.
I iDg
1 Standard &Poor's Rating;2 Fitch Rating; 3 Moody's Rating
[ Aeg=
MASS
Savings Banks Life Ins.
Aeg= Protective
Genwortb. Genwortb.
=
~~teIVDoubleOakC
N_
I 2008
y~
Ra~
I DIa
45
21 21
10nn
[ AXXX [29
I XXX
AXXX
I XXX I
XXX XXX
1)pe
MBIA
[-
I n/a
I
MBIA MBIA
M ........
51
AppendixE Life Insurance: Value-in-Force I Embedded Value Securitisations'
IData Sources: Devine, Colin, Cl al., The Securitization Solution: Emerging Options far Ufe Insurers. Citigroup Inc. New York, 06.07.2006, p. 25/ Carey, !an and James. Tim, European Life Securitisation, Faculty & Institute of Actuaries, London, 2008, [Powerpoint Slide S1 I Wallin, Ulrich, Insurance-linked securities Hann.over Re, Hannover,
29.07.1JXJ7. [Powerpoint Slide 7]
12 ThtalI999 Prudcntial Holdings ll.C Prudcntial Holdings ll.C Prudcntial HoldinglllLC Prudcntial HoldinglllLC Thtal2001
MonyHcl
1999
200l
175.0
SwissRe
SwissRe
Qw=.... Alps Capital 11
Alps Capital 11
Alps Capital n
2005 2005
2005
200S
30.0
90.0
25.0 220.0
45.0
Swissh
Qw=....
200S
SwissRe SwissRe
681.9 175.0
Swissh
Thtal2004 Qw=....
200S
'0.0
100.0
Weil Gothshal & Man.
FLAC Holdings u.c
2UU4
140.0
391.9
Notes C
NotesB
NotcsC NotesA
NotesB
NotesA
NotesB
NotesA
NotesA2
Notes Al
Note.
559.9
Note.
300.0 559.9
SharcsO. B Notes Serie5 A Notes ScriC5 B Notes ScriC5 C
Note.
Bonds Class B
Bonds Class A
-
300.0
2004
W.ll """"'" '" Man.
Friends Provident
Box Hili Life
2004
l'LAC _ . LU;
Friends Provident
2003
2004
New Barclays Life
MonyGroup
1,925.1
640.'
n6.7
332.9
Prudcnti.al Financlal Prudcnti.al Financlal Prudcnti.al Financlal Prudcnti.al Financlal
_Re
196.0 168.0 364.0 184.0 184.0
USDm
National. Provident National. Provident
S......'
Gracechun:h llie Thtal2003 Box Hili Life
Thtal2002
Mutual Securitisation Pk Mutual Securitillation Pk 'Ibtal. 1998
1998 1998
2001 2001 2001 2001
N....
V""
(10.')
20(10.2) 20 (5.5) 20 (9.1) 20
20 (3.0) 20 (7.6)
7
3
I'
12
10
I'
16 22 22
I' 25
-)
-
.
(
v....
Tonn
, ,
AAA
, BBB ,
AAA
,
BB'
Emboddod Volue
USA
USA
Emboddod Vo1ue A' BBB
USA USA
Emboddod Vo1ue Emboddod Vo1ue BB' AA-'
USA
USA
USA
EU
EU
EU
USA
USA USA USA USA
EU/USA
EU EU
ti..
Loao-
-
XLCA
XLCA
-
-
-
XLCA
XLCA
Amboe
Amboe
Amboe
Amboe
-
FSA FSA
-
-
Guanm
- ...
USA
Emboddod Volue
Emboddod Vo1ue
"""""""Vo1ue
Valuc-in-Force
Value-in-Force
Valuc-in-ForccICB
=oedBI..,.
Block Securitisation Block SecuritisaUon Block SecuritisaUon Block. SecuritisaUon
Emboddod Vo1ue
Yalue-in-Force Yalue-in-Force
Type
Emboddod Vo1ue BBB
,
BBB
A+
"""" """"
Bul
,
Bul
"""" """" ,
A3
Ao3 A>3
CCC
BB+
Rating Ac!.
A+
AAA
AAA
Aaa
Aaa
Aaa
,
AAA
Aaa A2
Aaa
-
-
AA-
Rating Orig.
il\l
I
Thbl Zeot
2008
Aegon (Scottish Equitablc)
Bank of IrcIand Lifc Ins. Bank of Ircland Life Ins.
UnumGroup
Chwdion Meilife
9.239.~
350.0
3,986. 350.0
2>.1
490.•
7 . 171.5 2,500.0 800.0
143.0 130.0
Unnum Provident
615.0
30.0
USDm
_Re
SwissRe
S.......'
Standard & Poot's Rating; 2 Fitch Rating; 3 Moody"s Rating
C':I1'Bnd Total
Thbl2008
Avondale Securities Avondale Sccuritics
Metlife Re Charleston Northwind Holdings
Thbl
2CX17
2rxn
2rxn 2rxn 2rxn
Thilwind Holdings
L6
Thbl2005
_.
Alps Capital n
2005
2006 2006
N_
v_
NotesA
NotcsA2
Notes Al
Note. Su""'"
NotesA
Notes
NotcsD
v....
Thnn
14.0
2> 2>
"
35
3.
(12)
20
-)
(n-
Ra",
A'
Am
A'
A3
,B..l Bu3 ,
A
Yalue-in-Force
Valuc-in-Forcc Valuc-in-Forcc
UK
IRL IRL
USA USA
,
UK
Valuc-in-Forcc
USA
DIA
USA
Loca-
-...
Emboddod Vo1De Block Securitisation
Redundant Capital.
Emboddod Vo1ue
Emboddod Vo1De
1Jpe
AA AAA
AA-
01.
BB'
Ra", Art.
-
,
AAA
-
BB'
Orig.
G~
-
AmbE AmbE
MBIA
-
MBIA
-
""
fJ
AppendixF Life Insurance: Commission / Acquisition Cost Securitisations 1
IData Sources: Devinc, Colin. ct al., The Securitization Solution: EmerJrim!: Options for Ufe Insurcrs, Citigroup Inc, New York, 06.07.2006, p. 26/ Wallin, OIrlch,
1nsurance-1in1red securities Hannover Re, Hannover, 29.00.2007. [Powerpoint Stide 7]
Tota12000
American SkaDdia 1997-1 American SkaDdia1997-2 American SkaDdia 1997-3 Thbll1997 LI AmericanSkaDdial998-1 American SkaDdia 1998-2 American Skandia 1998-3 Thbll1998 L3 AmericanSkaDdial999-1 American Skandia 1999-2 Thbll1999 L4 American SkaDdia 2000-1 American Skandia 2000-2 American Skandia 2000-3 American SkaDdia 2000-4
Name
1 RatingA-1
Gtand Total
2002 ClMkB.me. 2002 L5 Thbll2002 2004 Anglia Funding Ltd ' Thbll2004
2000 2000 2000 2000 2000
1999 1999 1999
1998 1998 1998 1998
V... 1997 1997 1997
Aviva
ClarkB.me. Hannover Re
SkaDdia SkaDdia SkaDdia SkaDdia
HannoverRc
Hannover Re SkaDdia SkaDdia
Hannover Re SkaDdia SkaDdia SkaDdia
Spousor SkaDdia SkaDdia SkaDdia 54.4 65.9 45.0 165.3 66.2 47.9 51.4 28.9 194.4 65.0 97.4 113.9 276.3 259,0 125.4 75.1 77.7 78.8 616.0 403.0 388.3 791.3 286.7 286.7 2,330.0
USDm
nla
20 3
7.9 7.9 7.9 7.8
3.0 7.8 7.7
3.0 6.9 7.8 6.8
Term V..... 7.7 6.0 6.9
ABia
.Acquisition Cost Commission Financing Commission Financing Commission Fmancing
Acquisition Costs Commission Financing Commission Financing
UK
USA Europe
Broker Commission Acquisition costs Premium & Commission
Europe USA USA USA USA
Acquisition costs Commission Financing Commission Financing Commission Fmancing Commission Financing
USA USA
Euro (DIA) USA USA USA
Commission Financing Commission Financing
Region
USA USA USA
Type Commission Fmancing
~
w
LV
Appendix G Life Insurance: Extreme Mortality Risk Transfer Securitisations 1
1D8ta Source: Schultz, Paul ct al, Insurance Linkod Securities 2008, Aon Capital Marlrets. Chicago. 2008. p. 48
Tartao Capital
Dsiris Capital Dsiris Capital
2006
2006
2006 2006 2006 2006 2006 2006 2006
Total 2007 NathanLtdI
2008
Thtal2008 Grand Thtal
Vita Capital m Vita Capital m Vita Capital m Vita Capital m
2007 2007 2007 2007 2007 2007
Total 2006 Vita Capital m Vita Capital m
Vita Capital m
Dsiris Capital Dsiris Capital Vita Capital m Vita Capital m
VitaCapital Thtal2OO3 Vita Capital TI Vita Capital II Vita Capital U Thtal2005 Tartao Capital
2003
2005 2005 2005
Name
Date
MunichRe
SwissRe SwissRe SwissRe SwissRe SwissRe SwissRe
SwissRe SwissRe SwissRe
Life AXA AXA AXA AXA
Scottish Annuity &
Scottish Annuity & Life
SwissRe SwissRe SwissRe
SwissRe
Sponsor
129.0 64.5 150.0 100.0 90.0 50.0 38.7 777.2 100.0 100.0 71.0 120.0 90.0 90.0 571.0 100.0 100.0 2,210.2
80.0
400.0 400.0 62.0 200.0 100.0 362.0 75.0
USDm
IA
AIV AV AVI AVll BV BVI
Bm
BU
B-I B-2 C D BI
B
A
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USA,F,J USA,F,J USA,F,J USA,F,J USA, CAN, UK. J, D USA, CAN, UK. J, D USA, CAN, UK. J, D
USA
USA
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TerrItorIes
~
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....
AppendixH Life Settlement Securitisations (Public Transactions only)!
Carey, !an and Jamcs, TIm, Europcan Life Securitisation, Faculty & Institute of Actuaries, Landon, 2008. [Powerpoint Stide 5] I Fasana. Michael. Securitisation of Life Settlement Cash flows, Fasana Associates, Washington, 31.10.2008, [Powerpoint Stide 1] I Business Wue, A.M. Best Assigns an Indicative Rating to Bonds Issued by Apollo SLS Fund SA,
I Data Sources:
AM Best. Oldwick, 02.09.2004
Thtal2004 Grand Total
Apollo SLS Fund Legacy Benefits 2004-1A LLC Legacy Benefits 2004-lB LLC
OldMutual Protecti.ve Life Leleux Associated Brokers Legacy Benefits Co Legacy Benefits Co
AIGID_anal
1 Moodyls Rating; 2 AM Best Rating (indicative)
2004 2004 2004 2004 2004
Seabury
Thrrytown Second UC Patrons Legacy 2003-1 Patrons Legacy 2003-ll Patrons Legacy 2003-rn Patrons Legacy 2003-IV Thtal2003 Patrons Legacy 2004-1 Patrons Legacy 2004-ll
2003 2003 2003 2003 2003 AIG Life Insurance Co. AIG International AIG Life Insurance Co.
Spoosor
Name
Year 63.0 231.9 170.5 238.8 188.5 892.7 171.0 143.5 189.0 61.5 8.5 573.5 1,466.2
USDm
A2' Aa3' bbW Al' Baa2'
notrated Aaa' As'l. Aaa' As'l.'
Issue RatIDg
Current
not rated Al' Baa2'
Baal l A2'
Aa3' Aa3 Aa3' Aa3'
not rated
RatIDg
14 21 10 35 35
Term Years 8 15 13 15 15
'"
~
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Appendix I Non Life Insurance: Catastrophe Bonds!
IData Sources: MMC Securities, The catastrophe bond market at ycar end 2006, Guy Carpenter & Company, New York., 2007, pp. 32-35 and Schultz, Paul et al., Insu:rance Linked
Securities 2008. AON Capital MaIkets. Chicago 2008, pp. 40-47
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AppendixJ Non-Life Insurance: Catastrophe Bond Statistics 1
IData Sources: MMC Securities, The catastrophe bond market at year end 2006, Guy Carpentcr & Company, New York., 2007 and Schultz, Paul ot al.., Insurance-linked securities 2008. AON Capital Markets. Chicago 2008
328
16000
,. ,;
., i
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,----- 16•m
4000 2000
,
J.4 ~~ 11 1.948 1
4.040 ....,u..
hTI:rl
1.503
043
2.688
2.001
!OO8
Volume of ca! bonds issued
--,i
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32.
,
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201)2
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o I ...... n~ y
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2007
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1:1 P."'rn"';"
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.,!
,•, , !1 , ·••
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o
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,,,nd
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"
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10'1.
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AppendixK US Catastrophe Loss
South Atlande Wind
Return
probabilily (pereent)
Gulf Wmd Atlande Wind
Mid North Atlande Wind
Ne.. Madrid (2)
Ne.. Madrid (1)
CaliformaEQ
NorthWeslEQ
Pacific
Source:
Barmt Thomas; et al.• Moody's risk adjusted capital model for US property & casualty insurers Moody's Investor Service, New York 01.08.2006, p. 14
EQ EQ 10,000 0,0001% 225,292 149,428 92,722 95,787 41,067 123,200 101,200 23,613 1,000 0,0010% 187,743 124,523 77,268 79,823 24,444 73,333 63,250 14,758 500 0,0020% 104,886 80,290 42,912 44,643 13,399 40,198 47,633 11,114 250 0,0040% 73,340 61,144 35,874 28,557 7,282 21,847 39,824 9,292 100 0,0100% 64,333 53,635 26,583 18,333 3,870 11,611 30,556 7,130 764 5,093 1,188 0,1000% 13,403 11,174 5,538 3,819 10 255 1 1,0000% New Madrid (2) is the outer centric region far New Madrid (1) which are assumed to be perfectly com:lated - all other catastrophes are uncom:lated. Bach valuc in thc table represcnts the loss associatod with a discrete evcnt. The estimatcd retum pcriod of such an event (column 1) can also be cxpressed as retum probabilily (oo1umn 2).
Return period (years)
US Catas....phes: Industrywide - G..... I Diroc:t A _ Annual Catas....phe Loss and Loss Rad.. (USD m)
w
ld
AppendixL Fitch Prism: 30-Year Cumulative Default Table (in %)1
ISource: Thorpe, Donald, Themas; Cl al., Insurance-Linked Ratings Criteria (Global) Fitch Ratings, Chicago, 04.02.2008, p. 9
334
••• •• ••
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!! !
o
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~
~
AppendixM DefiDition of Indices:
Swiss Re BB Cat Bond Total Return Index (Bloomberg Code: SRCATI'RR) Tho "Swiss Re BB Cat Bond Total Return Index" calculated by SwissRc marIrets is an cqually-weightod bastet ofUS Dollars denominated natural catastrophe re1ated bonds. It was constructed to track. the total rate of retum far the USD denominated issues outstanding which are rated BB by Standard & Poor's, Hedge Fund ofFunds Composite Index (Bloomberg Code: HFRlFOF) The "Hcdgc Fund ofFunds Composite Index" includes over 800 constituent funds. It includes hath domesti.c and offshore fund of funds having at least US 50 mln under management or have been actively trading for at least twelve months. Ibe index is equally-weighted and a11 funds report assets in USD. Reported are performances net of a1l fee returns on a monthly basis.
Merrill Lynch BB US High Yield Index (Bloomberg Code: HOAI)
The ''Merrill Lynch BB US High Yie1d Index" is a subset of the Menill Lynch US High Yie1d Index. It is tracking the performance of USD denominated corporate debt including an securities rated in the range BB+ through BB-, inclusivc. Qua1ifying securities must have a remaining lifetime of ODe year, a fixcd coupon schedulc and a minimum amount outstanding ofUSD 100 mln. Index constituents are capitalisation-weighted based on their current amount outstanding. Standard cl: Poor's 500 Index (Bloomberg Code: SPX) The "Standard & Poor's 500 Index" is a capitalisation-weighted index with each stock's weight in the index proportionale to its market value. The 500 stocks are chosen fot market size, liquidity and industry group representation. It iB designed to measure performance of the broad US economy. Tbe Standard & Poor's 500 iB one of the most widely used benchmarks of US equity performance. IP Morgan Global Government Bond Index (Bloomberg code: IPMX) The "JP Morgan Global Govemment Bond Index" comprises 13 markcts: Australia., Belgium, Canada., Denmark, France, Gennany, ltaly, Japan, Netherlands, Spain, Sweden, Th.e UK and the USo Th.e Index includes Govmunent bonds only and the index iB weighted by market capitalisation (i.e. amount outstanding times the dirty price). Th.e index iB rebalanced. 8t the close of the first business day each month in order to
336 accurate1y reftect the availab1e market supply of investable bonds.
Definition 01 ILS Funds SoUdum Partners SAC Fund 1/2 (Bloomberg Code: SLDEVNr BH) Solidum Partners AG is an indcpendent investment advisor and fund manager foundcd in 2004 and spccialising in ILS. After a change in ownership, the former "Solidum Partners SAC Fund 1" was c10sed and a new "Solidum Partners SAC Fund 2" was established within which the ongoing portfolio is managed. The objective of the open-ended fund registered in Bermuda is to achieve long term capital appreciation and low correlation to fixed income, oquity and non-traditional investments. The fund achieves those goals by investing in ILS. n.Ws sidecars and insurance derivatives.
Credit Suisse Anlagestifhmg ILS Fund (Bloomberg Code: CSAlDXL SW) "Credit Suisse Anlagestiftung ILS Fund" is an open-ended investment fund denominated in Swiss Francs and incorporated in Switzerland. The fund allocated 100% of its invests globally into rated ILS bonds covering natmal catastrophes in different geographical regions.
C/oriden Leu Car Bond Fund (Bloomberg CO
AlG Insurance-I.inked Strategy Fund (Bloomberg Code: AILSUSA SW) "AIG Insurance-Linked Strategy Fund" is an open-ended invesbnent fund incorporated in Switzerland. The fund's objective is to achieve an appropriatc risk-adjusted return over the mid-term. The fund invests in open- and closed-end, non-traditional funds which focus on investment strategies related to insured cvents.
AppendixN CaIculation of Ibe emcien! frontiers of the portfolios figure 6.24. Tbe monthly valuation data of the time period bctween January 1931 and November 2008
far the S&p's 500 index and the long term interest rates of US treasury bonds was taken from the web publication "Irrational Exuberance" of Robert Shiller, Princeton University. Tbe US 10 year treasury bonds experienced an average yield of 5.34% p.a with a standard deviation of 4.5%. The S%P's 500 stock index retum was 17.06% p.a. with a standard deviation of 24.5%.1 The risk free rate was determined by th.e average of 3 month US Treasury Bills for the timeframe above
being 3.89%.'
Tbe yield for n..s was measured by the pedormance of catastrophe bonds as calculated by the SwissRe BB Cat Bond index from its introduction in January 2002 until November 2008 being 7.32% p.a with a standard deviation of2.1%.3
I. Calculation of the security portfolios from point A to B: Following the methodologies introduced by Henry Markowitz4 • the return of the two security portfolio from Point A to B was calcu1ated with the following formula:
where: E(T.) = expected return of the portfolio Xi = share of tbe asset I of tbe total portfolio E (Ti) = expected return of the asset I As a measure of the risk of the relevant portfolio combinations, the risk was ca1culated as the standard deviation of the historical portfolio valuations within the am. time frames. The following formula was taten: 'Shille< [see 2000] 2Data Sourco: Wren Investment Advisors 3Data Source: Bloomberg Finance L.P. 'Marl
338 u(rp ) ~ [XA'. u'. (rA)
+ (1- XA)'. u'(rB) + 2XA(1- XA)
* a(TA) * u(rB)]1/2
*UA,B
where:
O'(rp )
= standard deviation ofthe portfolio valuations historical returns ofthe asset I u(n) = standard deviation ofthe returns ofth.e asset I rl =
11. Calculation of the security portfolios from point C to D: The return of the three security portfolio from Point C to D was calculated with the following fonnula:
where:
E(rp ) Xi
=
E( r,)
~
expectedreturn oftheportfolio
share of tbe asset I of the total portfolio ~
expected return of the asset I
111e risk was calcu1ated as the standard deviation of the historical portfolio valuations within the a.m. time frames. Tbe following formula was taken:
u(rp ) ~ [XA'. u'(rA) + X1u'(rB) +Xc'. u'(rc) + 2 ,XA' XB' PA,B' u(rA)' u(rB)]'/' where:
O'(rp )
=
standard deviation oftbe portfolio valuations
r i = historical returns of the asset i a(n) = standard deviation ofthe returns ofth.e asset i PA,B =
correlation coefficient between assets A and B
Appendix 0 Overview of the stakeholder interviews:
Company Type: Associations Banks ConsuItants
llxchange Investors Lawyen Monoliner Primary Insurers Rating Agencies
Abbreviation: ASO BNK
CON EXC 1NV
LAW MON INS
Rcinsurers
RAT RE!
Risk Modeler Supervisor
MOD SUP
Number ofInterviews: 3 10
1 1 4 2 1 2 2 2 2 1
list of interview participants (functions at the time of interviews): [!NT-1-MOD] [19.08.2008] 111e interviewee is Senior Consultant specialised on life and health insurance modeling and working in Europe for one of the leading global modeling com-
panies. [!NT-2-BNK] [02.09.2008] 111e interviewee is working in the US office ofthe global insur-
ance capital markets team of aleading international private bank. His tasks are the structuring of securitisations and side-car solutions and the hedging of catastrophe risb. [!NT-3-BNK] [03.09.2008] 111e interviewee is working as Vice President in the US office
of the longevity reinsurance group of an international investment bank. He is looking after the structuring of life contingent risk transactions. [!NT4-BNK] [04.09.2008] The interviewee is Executive Director in the US office of the insurance capital marlrets group of an international bank. He is covering property and casualty insurance companies in the US and Bermuda for structured products.
340 [INT-5-BNK] [04.09.2008] Tbc interviewee is Associate in tbe US office of tbe insurance products group of a leading international investment bank. The activities are focused on the structuring of life and non-life capital markets solutions,letters of credit, and writing direct reinsurance through a reinsurance subsidiary. Further the group is active in the ttading ofthe products. [INT-6-ASO] [05.09.2008] Tbe interviewee is Executive Director for an association rcpresenting a group of insurers/reinsurers active in the non-life sector. Tbe main task is 10 represent them on public policy issues working with foreign international regulators and policy makers on regulatory issues. [lNT-7-REI] [08.09.2008] The interviewee is Director in the US office of a leading global reinsurance company. He is responsible far the origination and structuring of II.S and related securities, primarily non-life. [lNT-8-LAW] [10.09.2008] The interviewees are Partners for the US office of an international law firm. One person is heading the business with life insurers, the other the business with non-
life insurers as weIl as reinsurers. Tbc responsibiliti.es include all kinds of alternative risk. transfer. [lNT-9-EXC] [11.09.2008] The interviewee i, Director in Ibe deparbnent Research and Product Development of an exchange. His main task is to identify possible new products that can be traded at the exchange. [lNT-I Q. RAT] [12.09.2008] The interviewee is Ibe Global Head of Ibe msuranc.,.linked ,ecurities rating activities of a international rating agency. He is responsible for the development of rating methodologies for life and non-life re1ated securities. [lNT-ll-CON] [12.09.2008] The interviewee is Ibe President of a con,ulting company for insurers and investors promoting a risk m.odel. The company occasionally acts as a broker for
n..S products. [lNT-I2-INV] [14.09.2008] The interviewee is Managing Director of a hedge fund active in ILS investments. He has worked before for a top international investment company and has bui1t up their activities in ILS. [lNT-13-MOD] [16.09.2008] The interviewee;, Senior Risk Consultant for an intemationally active risk modeling company for non-life risk. His function is 10 supervise the capital market activities including the risk analysis for new ILS issuances and 10 provide services 10 the cus10mers in the role as intersection between the cus10mers and the product developers. [lNT-I4-SUP] [19.09.2008] The interviewee is Supervising Risk Management Specialist for an insurance and reinsurance supervisor. He is in c10se contact with numerous insurance and reinsurance companies and domestic and international supervisory bodies as well as associations. [lNT-15-RAT] [22.09.2008] The interviewee, are a Director and a Rating Specialist of an international rating agency. They are responsible for financial services ratings and specialised for insurance related issues on the life and non-life side.
341 [INT-I6-REI] [23.09.2008] The interviewee is Managing Director for the US operations of an international reinsurance group. The is responsible far customer-related transaction and own retrocession-issues on the capital markets. [INT-17-MON] [24.09.2008] The interviewee is Director in the structured finance division of a monoline insurer. He is looking after insurance-linked issues.
[INT-18-INV] [24.09.2008] Tbc interviewee is Founder of one of the largest investment management firms in catastrophe bonds globally. [INT-19-ASO] [26.09.2008] The interviewee is Chief Econontist of non-profit organisation funded by international insurance companies. He is responsible iar collecting information about
insurance activities, including ll.S, and identifying trends. [INT-20-BNK] [20.10.2008] The interviewee is Analyst in the department econontic research of a regional bank. He has analysed the ILS marlet in detail and published research about the actua1. developments. [INT-21-LAW] [20.10.2008] The interviewee is Partner of an internationallaw firm. He is
responsible for legal consulting of insurance companies regarding supervisory elements of ILS. [INT-22-BNK] [27.10.2008] Tho interviewee is Head of 1LS Structuring of a global bank group. He is concentrating on the structuring and the consulting of insurers regarding the rating process of the securiti.es. [INT-23-BNK] [28.10.2008] The interviewee is Analyst in the Fixed lncome Division of a international bank: supporting the n..S team and their clients reviewing documentation, reviewing modeling results and preparing presentations far rating agencies and investors.
[INT-24-INS] [28.10.2008] Tbe interviewee is Partner of a pension insurance and annuities company. He has been involved in n.s since the early starts of the market and worlred before for a global reinsurance company. [INT-25-BNK] [29.10.2008] The interviewee is Director in the alternative risk rnarket activities of a global bank. He is responsible for the origination of catastrophe bonds.
[INT-26-INV] [29.10.2008] Tbe interviewee is Chief Executive of an asset management company specialised in the n..S investment. He has before worlred for a global reinsurance company. [INT-27-BNK] [29.10.2008] The interviewee is Managing Director of a global bank responsible for asset-liability advisory business in Europe. Tbe group further originales life related n.s from insurers. reinsurers and other providers. [INT-28-ASO] [03.11.2008] The interviewee is Managing Director of an Eoropean structored products trade association. Tbe association promotes the use of risk transfer mechanisms across
342 capital markets instruments including ns. They are involved in the development of Solvency 2. [lNT-29-INV] [14.11.2008] 11Ie interviewee is Managing Partner of an independent advisory
company specialised in insurance-linked securities. His background is natural science and economics. [INT-30-BNK] [l4. 11.2008] The interviewee is Investment Manager of a private bank. He is specialised in the investment in insurance-linked securies ior retail and professional funds. [lNT-31-INS] [14.11.2008] The interviewee is Manager working in Ibe insurance-linked securities team of an international insurance conglomerate mainly active in th.e non-life insurance business.
AppendixP
344
00Iine Survey .bout buurance-Linked-8eeuritiel
L
Buko
0_
1. How many peopte in your institution arc working on ILS? 2.
Ow- activity is a Please dick the relevant box. o
Division
o
G=p
°
T"""
3. How close is your activity to the General Management (in terms of importancc end COtnn]1m;cation)? Please dick on scale.
very
w
0
50
4. What is your regional focus? Please dick the relevanJ box{es) 0 0 0
North America Western Europe
5. Which ILS products Me covered by your entitiy? Pkase dick the relevant box{u)
° ° ° 0 0 0
° ° °
Risk transfer for non-life:insunmce
Risk tnmsfer for lifc...insurancc Embedded w1ue Reserve funding XXX Reserve funding AXXX Funding eno pools Ca! bond COOl Reinsunmce receivable CDOs Lire settlements
6. Which industry focus regarding ILS da you foUow? Please dick the relevant box(es) 0
° ° 0
non-Iife insurance life-insurancc reinsurance otho<
100
345
n.
Market Enviroament
Whkh effed:l do you expeet from the Belt' regulatory frameworkl IFRS ud Solveney2 ? 7.
Capital requjrements for the insurance I reinsurance sectm will increasc. Please cJick on scale. .1rongly
.1rongly
disagree
.gree 0
8.
100
The demand far ILS will increase. Please cJick on scale. .1rongly
.troogly
disagree
.grec 0
9.
50
50
100
New n..S products will arise. Please cJick on scale. .troogly
.....
.troogly
disagree 0
50
100
Standardisation and SecoDdary Market 10.
In wbich segments does in your opinion the market need lIlOI'C standardisation? Please cJick the relevant box(u)
o o o o o
o o
o
o o 11.
Risk transfer far non-life insurance Risk transfer far life-insurance Embedded value Reserve funding XXX Reserve funding AXXX Funding CDO pools Cd bond. CDOs ReinsUIlUWe receivable CDOs
Life settlements The ILS market is standardiaed enough aIready
In which stage is in your opinion the secondary market far n..S? Please cJick on scale.
o
higbly dovelopod 50
100
346
m.
About IIWII1UlP:e LiDked Securitiel
12.
What are the main drivers Car the ILS market sector you cover? Pleasl! auign a value to em:h answer. &eh value can be usetl only once.
Risk transfer Capi1al Diversification 14.
lease select lease select lease select
Please rank the following sources of potential obstacles regarding ILS. Please assign a value to each answer. Each value can be used only ollee.
Lack ofharmonisation of international rcgula1:ory and I or accounting standards
[plcasc selcctll
Lack: of insurance expertise of capital
lplease selectl
market investors
Lack ofharmonisation of intemational regulatory and I or accounting standards
lplease select]
Low commitment of sponsors' DUIIUIgCIDeIlt (rather favouring reinsunmcc)
(pleasc sclectl
Rating agencies' requinnents
t1)lease selectl
Restrictions by equity holders I owners ofinsurance fPleasc selcctll companies
15.
Which market participent:s do you tbink arc most capable to mange ILS? Please assign a va/ue to each answeT. Bach value can be used only once.
Investment banks Rcinsurance Sponsors on their own
lease select lease sclcct lease select
IV. Comorate Level
16.
In which year has your institution started with ILS tranaact:ions? PI_e we the format 0J/OIIXXXX.
~~~I (mm/ddIyyyy) 17.
Pleasc complete the !fI:atemeut: "ILS get I get interesting for out institution ... Plecue dick the relevant box(es)
o o o o o o
... when the pricing was IIlOIC attractive than for reinsurancc or other alternatives." ... when there is a value-added in terms of diversification of reinsunmcc sources." ... when the complexity gets manageable far out company." ... when the products got fully accepted by the capital markets." ... when Iiquidi~ secondary marketa is not an issue." 0'I:hcr IClISOOS: ~
347
18. Are transaction ratings in YOUl opinion morc important than risk. models?
o
,...
o
neuttal no
o
v. The bllllkl' role 19. Da you think that cnough banks 8IC able 10 ammgc IL8? o ".. o o
neuttal no
Pleaae cvaluate the following aDtwen to the question: "What are the Itrengthl of the bllllb in the proceu?"
19. They Imow beBt how 10 develop innovative capital market products. Please click on scale.
o
highly devcloped 50
100
20. They Imow beBt how 10 structure and arrang n..s t:ran&actions.
o
highly devcloped 50
100
21. They have a deeper access 10 potential investors in order to successfully place the IL8 products.
o
highly developed 50
100
Pleaae cvaluate the followiDg IIIIIJWeI'S tu the qUestiOD: "What an the wealmesses of the bllllkl
in the protal?"
22. They do not Imow the insurancclrcinsurancc solutions good cnaugh.
o
highly devcloped 50
100
23. They 8IC not used 10 the business behaviours ofthe insurancclrcinsurance sector good enougb..
o
highly devcloped 50
100
24. They need 100 much time 10 structure and place IL8 transactions.
o
highly devcloped 50
100
348
VI.
Ftnal OuestioDl
25.
Please click the boxes ifyou agree with the completion ofthe statement: "The current crisis will lead In .•. Please click the relevant box(es)
o o o o o o o o
a closer monitoring ofbank counteJparty risk in total retum end rate swaps." a challenged rote of the banks as stahle 1ong-teJm creditms." investors demanding a bigher level of co11ateralisation... a eloser monitoring of the quality of the investments ofthe SPV'8 trusts." stricter gu.idelincs of the rating agcncics." a More difficult placement oflang-term. products." a lower acceptance of CDO st:ructures by investors." a simplification oflLS structures available."
... ... ... ... ... ... ... ...
Irtextl
com:ments: 26.
Which pricing developmcnt da you cxpcct far the ILS products you an: fCspons1ble for in the 12 months ahead? Please click the relevant box(ea) 0 0 0 0 0 0 0 0
+30% ormore +20% +10% 0%
-10% -20%
-30%ormore cannot be estimated
,omm••'"
~
27.
How da you cxpcct the volumc 10 dcvelop in 2009 rcgarding)'OlD" product(s)?
28.
In which year havc yau pcmIOIlBlly started 10 work on ILS transactiOll8?
cotnments:
~
Pleose use theformat Ol!Ol!XXXX.
29.
In which carreer have yau started 10 work on n..S topics? o o
30.
professional academic
Which improvcments da you whish :n::garding the ILS markct (plCIISC feel fu:c 10 lcave any other comments)? PI_e click the relevant box(es)
End of questionnalre.
Abbreviations Abbreviation A
Explanatinn
ARS
Asset Backed Security
ACLI ACSB AIDS ALM APRA
American Council of Life Insurers
approx. ART AUS AVI BCAR BRIC bn bp CAN CAPM CATEX CBO CDD CDO CDS CE CEEurope CEIOPS CEO CESR CFO
Austria
Accounting Standards Board Acquired Immunodeficiency Syndrome Asset Liability Management Australian Prudeotial Regnlatory Authotity approximately
Alternative Risk Transfer Australia Aviation Best Capital Adequacy Ratio
Brazil Russia India China billinn
basis point-s Canada Capital Asset Pticiog Model Catastropbe Risk Exchange Collatoralised Bond Obligation Cooliog Degree Day Collatoralised Debt Obligation Credit Default Swap Credit Enhancement (through over-collatera1.isation) Centra! & Easlern Europe Committee of European Insurers and Occupational Pension Supervisors Chief Executive Officer
CHF
Committee of European Securities Regulators Chief Financial Officer Switzerland Swiss Francs
CLO CME
Chicago Mercantile Exchange
CH
Collatoralised Loao Obligation
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
350 CMI CMO Co.
Combined Morta1ity !odex Collatoralised Mortgage Obligation Compaoy
CRB
Commercial Real Estate Canadian Securities Administrators
CSA D DAC
DAX dev.
EBF EEV EFRAG e.g. EQ ERM ERISA
ES EU EURIBOR F FASB FEE FEIN FSA FSF GAAF GDP GNAIE HDD HMRC ffiJR I IAA IAIS IASB IFRS ILS ILW IMF Iov. IOSCO ISDA ISPV IT J
UM
Deutscblaod
Deferred Acquisition Costs Deutscher Aktien Index developing Eoropeao Baokiug Federatiou Europeao Embedded Valoe
European Financial Reporting Advisory Group exempligrata EarthQuake Enterprise Risk Maoagement Employee Retirement Iocome Security Act Expecred Shortfall Eoropeao Uniou Europeao Ioterbaok Offered Rate
France Federal Accouotiug Staodards Board
Federation des Experts Comptables Europeens Federal Employer ldenditication Number
Financial Services Authority Financial Stability Forum Generally Accepred Aeeooutiug Principles
Gross Domestic Product Group of North American Insurance Enterprises Heatiug Degree Day
Her Majesty'''s Revenue and Customs Hurricane ltaly
International Actuarial Association International Association of Insurance Supervisors Iotemational Aeeooutiug Staodards Board Iotematioual Financial Reportiug Staodards
Insurance-Linked-Securiti.es Iodustry-Loss-Warranty Iotemational Mouetary Foud
Investment International Organisation of Securities Commissions International Swaps and Derivatives Association Iosurance Special Purpose Vehicle
Information Technology Japan Life Insurance Association of Japan
351 LIFFE LoC LId
London International Financial Futures and Options Exchange Letter of Crecit
mln
million Massachussets maximum Mortgage Backed Securities Mean Damagc Ratio Markets in Financial Instruments Directive
MASS
max MBS MDR MIFID MCR MRAC MV DIa NAIC D.p. OECD
Umited
Minimum Capital Requirement Moody's Property & Casualty Risk Adjusted Capital Model Market Value
not available National Association of Insurance Commissioners no page Organisation for Economic Co-Operation and Development
orc
Over-the-Counter
PCI PCS
Property Casualty Insurance Associatinn Property Claims Services page pages principal and Interest Probable Maximum Loss Quantitative Impact Stody Risk Based Capital
p. pp.
P&I PML QIS RBC Reins.
Reinsurance
SAP
Statutory Accounting Principles
SCR SEAsia SEC SPV SPRV
Solvency Capital Requirement
S&P's
Standard and Poor's
sq. SVO
Securities' Valuation Office
sI.
TAC TED tkd.
TRIA TRUPS
South Bast Asia Securities Exchange Commission Speetal Purpose Vehicle Special Purpose Reinsurance Vehicle sqnated standard Total Adjusted Capital
Treasury Bill Eurodollar Difference takedowns Terror Risk Insurance Act Trust Preferred Securities
UBS
United Banks of Switzerland
ULAE UK USD US
unallocated 108S adjustment expenses United Kingdom United States Dollars United States
352 USA USGAAP VaR VIF
United States of America United Stares General Accepted Accounting Principles Value at Risk Value in Force
Index accidcnt bealth
Ger.: kritische Erkrankung, 32
Ger.: Unfallversicherung, 32 asset ba.cked Ger.: Vcmtögeruowert-besichert, 37 assumption Ger.: Risikoaufnahme, 49 captive
Ger.: koDZedinps Kapital, 76 continuous distribution Ger.: stetige Verteilung, 8 cmJit dcfau1t swap Ger.: Kreditausfall Derivat, 38
credit insurance Ger.: Kreditversichenmg, 31 critical illness
datcd bonds
Ger.: eodfllllige Anleihen, 157 determi.nistic scenarios Ger.: Planszenarien, 149 disability insurance Ger.: Invalidität, 32 discrete distribution Ger.: UlIStetige Verteiluog, 8 dispersion Ger.: Streuung, 8 distribotinn sbape Ger.: Verteilungsschlefe, 123 duratioo Ger.: durchschnittliche Bestandadaucr, 152 eamed premiums Ger.: verdiente PrI!mieo, 107 economic net worth Ger.: betriebswittscbaftlicher Nettowert, 148 eligible claims Ger.: berechtigte Schadcnsforderung, 107 embcdded valuc Ger.: innerer Wert.. auch: Methode zur Ermittluog des Unternchrnenswertes einer Versicherung. 68 ernployer's liability Ger.: Arbeitgeber Ihftpfticht, 32 expectcd lass
Ger.: erwarteter Schaden.umfang, 8 expectcd shortfall Ger.: erwartete Verlust.schwere. 125
factoring Ger.: Forderungsvcrkauf,38
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6, © Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
354
facultative monoline insurance Ger.: Bio-Produkt Versicherung, 38 Ger.: freigestellt, 49 mortgage-backed finite solution Ger.: hypothekarisch besich~ 85 Ger.: begrenzte Rückversicherung, 63 franchise value motor physical damage Ger.: Barwert künftiger Gewinne, 148 Ger.: Auto-Kaskoversicherung, 32 frequency motor thitd-party liability Ger.: Auto-Haf1pflichtversicheruog, 32 Ger.: Häufigkci~ 10 full hull insurance Ger.: Volldeckung aller versicherbarer RisikdlQD-life business 55 Ger.: Nicht1ebengeschäft, 34 hazard Ger.: Wagnis, 16 health insurance Ger.: Krankenversicherung, 32 hybrid bond Ger.: Eigenkapita1äbnliche Anleihe, 156
indes linked Ger.: index-basierend,32 insurance pool Ger.: Versicherungspool, 63 legal expenses Ger.: Rechtsschutzversicherung, 32 Iiability insurance Ger.: Haftpflichtversicherung, 32 life cxpectancy Ger.: Lebeoserwartung, 46 life insurance Ger.: Lebensversicherung, 35 liquidity ratio Ger.: Liquiditätsquote, 149
reserves Ger.: Schadensreserve, 22 lump-sum Ger.: Einrnalz.ahJung, 32
1088
market capitalisation Ger.: Börsenwert. 148 mean
Ger.: arithmetisches Mittel, 8 medical advisor Ger.: ärztlicher Berater, 100 medical examiners Ger.: Gesellschaftsarzt, 99
obligatoty Ger.: =htsverbindlich, 49
peril Ger.: Gefahr, 16
pcrpctuallifetime Ger.: oboe bestimmtes FäIliglreitsdatum, 147 policy reserves Ger.: Prämienreserve, 22 primary insurance Ger.: Erstversicheruog, 33 proportional reinsurance Ger.: anteilsmäßigeRückversicherung, 53
quota reinsurance Ger.: Kontingentrückversicherung, 54 reinsurance Ger.: Rückversicherung, 41 retention Ger.: Selbstbehalt, 19 run-off Ger.: Abwiclduog, 19 savings insurance Ger.: Versicherung mit Sparanteil, 32 self insurance Ger.: Eigenversicherung, 63 severity Ger.: Schwere, 10 sidecar Ger.: wörtl. Beiwagen, sachl. abgegrenzter Versicherungsbestaod, 81 solvency
355 Ger.: Eigemnittelaustattung, 19 special purpose reinsurance vehicle Ger.: Rückversicherungs ZweckgeseUscbaft, 136 sponsor Ger.: Initiator, auch Förderer des Geschäftes (i.d.R. ein Erst- od. Rückversicherer), 4 stand-by letter of credit Ger.: Solawechsel, 37 standard deviation Ger.: Standardabweichung, 9 statutoIy reserve Ger.: satzungsmäßige Rücklagen, 88 stochastic scenarios Ger.: zofaUsbediogte Szenarien, 149 surety
Ger.: Bürgschaft, 36 swplus reinsurance Ger.: Summenexzendenten Rückversicherung, 55 tax advisors Ger.: Steuerberater, 100 technical provisions Ger.: technische Rückstellungen, 19 term life Ger.: Risiko-Lebensversicherung, 32 tracking agent Ger.: Außendieost Mitarbeiter, 100 trigger
Ger.: Deckungsauslösung, 16 trustee Ger.: Treuhänder, 100 underwriting
Ger.: Risikoübernahme, 13 uneamed premium reserves Ger.: unverbrauchter Beitragsübertrag, 22 unitlinked
Ger.: fondsgebunden, 32 variance
Ger.: ntittleres Fehlerquadra~ 9 worker's compensation Ger.: Arbeitgeber Uofall, 32
