Christoph Weber
Insurance Linked Securities
GABLER RESEARCH
Christoph Weber
Insurance Linked Securities The Role ...
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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 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 risld on Rojda. Gor@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
ln,,~:~ ",d
", _ Surpll.ls
Assc!s & Liabilitics 113.h 1 .~~..," ,#' ,.E- ",#",# "-",,.. -;>-1 S,\
",,,,,0,
"'f~ "'s-" ",$' ,,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 -
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
M ulril"t lriggu
Multilin. plk)"
Cono"'tr 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.,
~ '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........" Ilnorn;' ,\> .. 1>
11
b,.., .h .. t>
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"
11
R.,....,'.
r
(I>Suing SI'\')
1CO ll att .... 1
IClo" ,\1- . I',~ I -Ino" 1I1C1." 111 '-- ,~ ICI." cln." ('1- - 10o" IIICII" ])1- -
= 1
I
Soure.: Cer,,
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 Rte." ap a&r
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
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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
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nah." 1'11.1 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 rislode,."",,,
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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
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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
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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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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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