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Convergence of Insurance and Capital Markets
A World Economic Forum Report
in collaboration with
Allianz Barclays Capital Deloitte State Farm Swiss Re Thomson Reuters Zurich Financial Services
World Economic Forum October 2008
The Convergence of Insurance and Capital Markets is published by the World Economic Forum. The Working Papers in this volume are the work of the authors and do not represent the views of the World Economic Forum. World Economic Forum USA Inc. 3 East 54th Street 17th Floor New York, NY 10022 Tel.: +1 212 703 2300 Fax: +1 212 703 2399 E-mail: email@example.com www.weforum.org/usa
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Foreword and Contributors 1 Executive Summary 2 The Existing Market for Insurance Risk 2.1 Market development 2.2 Market instruments 2.2.1 P&C bonds 2.2.2 Life bonds 2.2.3 Weather derivatives 2.2.4 Industry loss warranties 2.2.5 Cat swaps 2.2.6 Exchange traded cat risks 2.3 Market participants 3 Impediments to Growth 3.1 Impediments for sponsors 3.1.1 Basis risk 3.1.2 Accounting and regulatory treatment 3.1.3 Inconsistent ratings treatment 3.1.4 Pricing of traditional reinsurance 3.1.5 Time and cost 3.1.6 Data quality and transparency 3.1.7 Limited types of risk 3.1.8 Cultural factors 3.2 Impediments for investors 3.2.1 Lack of standardization 3.2.2 Limited secondary market 3.2.3 Long payout periods 3.2.4 Valuation complexity 4 Conclusions and Recommendations Appendices Appendix A: Project Description Appendix B: Findings Appendix C: Current Initiatives References Acknowledgements Footnotes
4 6 9 9 10 10 12 13 14 14 14 15 17 17 17 19 22 22 23 24 26 26 27 27 29 29 30 31 33 33 34 37 39 40 41
Foreword and Contributors
We are pleased to present this report on the convergence of insurance and capital markets. It stems directly from an initiative of the Financial Services Governors launched at the World Economic Forum Annual Meeting 2007, when the assembled Governors agreed to carry the dialogue and work beyond Davos in line with the Forum’s mission of being Committed to Improving the State of the World. Subsequently, working groups comprised of industry representatives, academics, experts and Forum staff took up work on several projects that Governors felt were of broad interest, not only to the financial services industry but also the public. This project, examining the convergence between capital markets and the insurance sector, focused in particular on the role new financial instruments could play to better address and syndicate particular types of risk. This report could not be more timely. While the credit crisis, now going into its second year, was triggered inter alia by faults associated with securitized mortgages, insurance-linked securities (ILS) turned out to be highly resilient at a time of extreme market turbulence. In fact, ever since the outbreak of the sub-prime crisis, prices of catastrophe bonds (perhaps the most prominent ILS example) have performed strongly, easily outperforming indices of credit instruments with similar debt ratings. However, this outperformance has hardly registered with nonspecialists in light of overall market challenges.
In this environment, where the financial markets face such turmoil, this publication aims to shed light on a critical area in which the capital markets are showing signs of success. Its authors make a convincing case that insurance-linked securities are an important asset class, and that the ILS market is not only here to stay, but likely to grow at a strong pace in the future. Of course, there are and will continue to be obstacles to the growth and broad acceptance of ILS. This report identifies many such challenges. We believe that the benefits of insurance-linked securities will ultimately appeal to investors and issuers alike and have an important role to play for particular types of investment risks. The report should help to create an elevated baseline of understanding among a broader base of non-specialist investors, discussing the impediments and potential solutions to further the debate about the use of these products. A work of this caliber can only be written by many talented people pulling together towards one common goal. We thank our Governors, sponsors, workshop participants, experts and team members for their dedication to this report. The ball is now in the court of the market participants. They have it in their hands to unlock the full potential of insurancelinked securities, and we are confident therefore that the increasing convergence of insurance and capital markets will create value for all.
James J. Schiro Group Chief Executive Officer and Chairman of the Group Management Board Zurich Financial Services Switzerland
Kevin Steinberg Chief Operating Officer and Head of the Centre for Global Industries (New York) World Economic Forum USA
Katharina Hartwig (part 3) Group Legal Services Allianz Kurt Karl (part 2) Senior Vice-President Head of Economic Research and Consulting Swiss Re Steven Strauss (Executive Summary) Senior Adviser World Economic Forum USA Tom Watson (parts 4 and 5) Project Manager World Economic Forum USA
Jerry Del Missier President Barclays Capital Jim Rutrough Vice-Chair and Chief Operating Officer State Farm James J. Schiro Group Chief Executive Officer and Chairman of the Group Management Board Zurich Financial Services Devin Wenig Chief Executive Officer, Markets Division Thomson Reuters
Key Knowledge Partners
Jack Ribeiro Global Head of Financial Services Deloitte LLP Ed Hardy Insurance Partner Deloitte & Touche LLP
Daniel Brookman Head of Structured Insurance Barclays Capital Daniel Hofmann Chief Economist Zurich Financial Services Kurt Karl Senior Vice-President Swiss Re Ben Lewis Head of Strategy Thomson Reuters Stephan Theissing Head of Group Treasury and Corporate Finance Allianz Deborah Traskell Executive Vice-President State Farm
From the World Economic Forum
Kevin Steinberg Chief Operating Officer and Head of the Centre for Global Industries (New York) World Economic Forum USA Steven Strauss Senior Adviser World Economic Forum USA Tom Watson Project Manager World Economic Forum USA While not necessarily endorsing any of the specific conclusions reflected in this report, both the Steering Committee and Operating Committee provided detailed feedback and helped ensure the overall integrity of the work. Any opinions herewith are solely the views of the authors and do not reflect the opinions of the Steering Committee, the Operating Committee or the World Economic Forum.
Paul Achleitner Chief Financial Officer Allianz Jacques Aigrain Chief Executive Officer Swiss Re
1. Executive Summary
Facilitating risk transfer and increasing transparency have been dominant themes in the financial markets since the end of World War II. Transferability and transparency are widely believed to promote better economic performance – with important benefits not just to investors but also to consumers and other social stakeholders.
Some life insurance, securitizations, for example, are backed by the embedded value of future profit streams from a book of life insurance policies. In the case of property and casualty (P&C) securitization, however, the distinction between the transfer of assets and the transfer of liabilities is critical. Risks in bank assets tend to be correlated, as the recent sub-prime crisis has demonstrated. This creates a strong incentive for bankers to transfer risks to the markets in order to diversify their asset portfolios. P&C liabilities, on the other hand, are uncorrelated, or only weakly correlated. Hurricane Katrina, to cite one example, severely impacted a relatively small geographic region of the United States, but had little or no effect nationally or globally. The typical P&C portfolio, then, consists of a wide spectrum of uncorrelated risks. This creates diversification benefits, in that total risk in the portfolio is less than the sum of the individual risks – reducing the incentive for P&C insurers to transfer these risks to the market. Yet, this diversification benefit is precisely what makes insurance-linked securities (ILS) potentially desirable to investors – they are uncorrelated with their existing asset holdings. P&C insurers, meanwhile, have another incentive to transfer risk, as a means of obtaining additional capacity (mainly for catastrophic risk). Thus, liability securitization can be a tool for capital management for both buyers and sellers.
“In certain risk areas we see an increasing need for capacity. Weatherrelated insurance claims, for example, have increased fifteen-fold over the last 30 years. In this challenging situation, insurance-linked securities provide new fully collateralized and multi-year capacity for the risk-carrying industry, along with a high degree of risk diversification, which makes them attractive for investors as well.”
Paul Achleitner, Chief Financial Officer, Allianz, Germany
Financial innovation has allowed many types of risk to become more tradable including credit, interest rate, equity and foreign-exchange risk, to name but a few. However, one important category still lacks a liquid, transparent and tradable market: insurance risk. The potential market is vast, with total premiums of all the world’s insurers equalling approximately US$ 4.1 trillion. Insurance risk comes in many varieties and can be segmented into broad categories (e.g. life, property and casualty, etc.), as well as geographic markets. This is not unlike other types of risk widely traded in the capital markets. Credit risk, for example, can be divided into corporate, municipal, mortgage and consumer sectors, among others. However, it is necessary for investors and policymakers to recognize the distinctions between the securitization of assets (mortgages, car loans, etc.) and the securitization of liabilities. Most life insurance securitizations are similar to asset-backed securities (ABS) currently offered by banks – and prone to many of the same issues associated with ABS.
Although the market still lacks a clear, transparent and tradable platform, ILS issuance and trading activity has been growing at a rapid pace, albeit from a small base. The tradable insurance risk market currently has a notional value of only US$ 50 billion, but has been growing at 40-50% per year since 1997. The premium equivalent is now about US$ 3 billion, or 1.5%, of global reinsurance premiums, which were about US$ 192 billion in 2007. In more mature risk markets, the tradable portion is typically a multiple of the underlying notional value. Hence, there appears to be ample room for growth.
“The development of the ILS market has increased the ability of insurers and reinsurers to accept peak natural catastrophe risks such as US hurricanes.”
David J. Blumer, Head of Financial Services Swiss Re, Switzerland
unambiguous. The borrower is not dependent on the credit quality of the lender and has no economic or legal interest in the identity or financial strength of the ultimate mortgage holder. The lender, on the other hand, does have an incentive to understand the borrower’s creditworthiness – although the incentives for due diligence clearly can be weakened by the originator’s ability to transfer the mortgage quickly. In an insurance contract, the situation is quite different. As the ultimate risk holders, insurers must make significant investments in due diligence. To manage their exposures, they must be aware of and seek to control moral hazard. Policy-holders, meanwhile, have a very real interest in knowing the identity and understanding the business practices of their insurance providers. They want to be sure their claims will be met if losses are incurred. Obviously, the average policy-holder cannot check the creditworthiness and solvency of his/her carrier; he/she has to rely on the assessments of regulators and the rating agencies. Hence, the policy-holder will always want approval regarding any assignments of the insurance contract, while the primary insurer is unlikely to ever be completely removed from the value chain. While these interests may inhibit the growth of the risk transfer market, they also may provide some protection from the “exuberance” we have witnessed in sub-prime lending.
The need for capital, liquidity and transparency has become even more urgent for the P&C industry as it faces the challenge of global climate change, which is increasing the risks of European windstorm damage and American coastal flooding, among other hazards. Accordingly, the industry would like to move to more flexible and efficient capital structures, which would be facilitated by greater development of the insurance risk market. Even if the increased access to capital were confined to reinsurers, this would still indirectly benefit policy-holders by increasing their capacity to absorb risk. Finally, transparent pricing would also reveal the cost of well-intentioned political solutions that increase the provision of insurance but fail to adequately fund those guarantees, by making it possible to mark public sector insurance schemes to market.
Structural impediments to growth
While there are reasons to be optimistic about the development of the insurance risk transfer market, there are also some fundamental dynamics that could slow its growth. Some of these factors are rooted in the distinctions between asset and liability securitization mentioned earlier. A simple comparison to the mortgage market may illuminate the point. The originator of a mortgage loan (particularly in the American market) can completely remove itself from the risk equation by executing a true sale of the note to a third party. In effect, it can elect to have no further risk exposure to the borrower going forward, even if it chooses to retain other elements of a customer relationship. This separation is feasible because the underlying contractual relationship is simple and relatively
Over the course of this project, certain themes emerged from our workshops and interviews with market participants. Sponsors (mostly reinsurers and some insurers) identified the following key issues that will need to be addressed in order to facilitate the development of the insurance risk transfer market: • Lack of standardization: Insurance risk transfers can take a long time to complete, costs can be very high and the accounting treatment is uncertain. The latter problem often stems from the considerable uncertainty about regulatory and rating-agency treatment of the transaction. The result is a reluctance to engage in the market among institutions subject to the most uncertainty.
• Insufficient cost/benefit analysis: Traditional reinsurance is of a limited term, the list of potential counterparties is small and the ceding insurer ends up with a credit risk from the reinsurer. Capital market transfer instruments provide longer terms and reduce counterparty risk, but increase complexity. The insurance industry also lacks a language and a methodology to evaluate the benefits of these instruments and make quantitative comparisons to conventional reinsurance. • Poor data quality: In many markets, tradeable market indices do not exist. In the US, there is also a need for more granular data for parametric transactions that can potentially be used as market indices.1 • Basis Risk: Any market structure in which the insurer’s reimbursement is based on a market index or formula creates basis risk, which is the difference between the actual claims paid out and what is received from the counterparty based on the index/formula. (Note that this can result in either a gain or a loss for the insurer). For some companies, basis risk may reduce the capital adequacy relief provided by such transactions – thereby favouring transactions by other companies (such as reinsurers) that receive regulatory and/or rating-agency treatment that more closely matches the actual claims paid out. Investors and risk assumers involved in the insurance convergence project identified the following key issues: • Limited secondary market: While liquidity conditions in insurance risk markets typically equal or exceed markets for similar fixed income instruments (such as collateralized debt obligations, high-yield corporates and off the run ABS), investors still believe that many existing products “trade by appointment” – particularly if the investor needs to trade in size. This presents a challenge for market participants who mark to market or who need liquidity on short notice, etc. As is the case in the collateralized fixed-income markets, these perceptions also impact pricing. • Valuation requires specific knowledge, models and data: A wealth of material and tools exists for valuing most other risk categories. However, this store of intellectual capital does not yet exist to the same extent for the insurance risk market.
• Uncertainty concerning the probability of catastrophic loss: This presents a bit of a “Catch 22”. One of the major reasons the insurance industry wants to promote liquid transfer markets is the uncertainty regarding risks such as climate change and global pandemics. However, this very uncertainty makes the capital markets price these risks conservatively, limiting the benefits of securitization. Our recommendations for addressing these and other issues are described in more detail in the following sections. Our key point is that these impediments will not be simple, fast or easy to overcome. In order to maintain the growth of the insurance risk market, concerted action will be required from market participants over a multi-year time horizon.
2. The Existing Market for Insurance Risk
Since its infancy in the early 1990s, the market for insurance-linked securities has grown at high double-digit rates. This convergence is being driven by a number of major trends. First, financial innovation is playing a key role by developing new instruments for transferring insurance risks. Second, insurers need to efficiently manage their capital and these new products provide flexibility and access to a large pool of capital. This can be advantageous for P&C insurers who have a sudden need for extra capacity to write insurance – following a major catastrophe, for example.
Other factors are also driving the growth of the risk transfer market.
Several trends are driving the convergence of insurance and the capital markets.
• The increased visibility of catastrophe modelling firms in the capital markets, boosting the credibility of their models • Dramatically improved distribution capacity, as more investment banks and reinsurers offer ILS products to investors • The availability of senior financing, which is now obtainable at meaningful levels for ILS • Increased price transparency with the launch of exchanges trading cat risks and brokered cat swaps • Lower transaction costs made possible by document standardization and shelf financing
2.1 Market development
At other times, the most efficient way to transfer a particular risk may be through a non-traditional instrument, such as a catastrophe bond (cat bond) or swap (cat swap). Even insurers that do not themselves use these instruments may benefit from the increased availability and affordability of reinsurance as reinsurers tap into the additional capacity made possible by market growth. For life and health (L&H) insurers, using ILS to access the capital markets is an effective way to finance growth and manage excess reserves. Life insurers may also desire protection against extreme events, such as pandemics. Finally, there is growing interest in ILS among investors, because in some cases they represent a diversifying asset class with robust yields. Additional growth drivers include: • Attractive investment performance, despite major losses such as Hurricane Katrina, the largest insured loss in history • Enterprise risk management benefits, with ILS making it possible for insurers and reinsurers to supplement traditional capacity, diversify their trading partners and reduce counterparty risk • Efforts by the rating agencies to improve and document their methodologies for rating cat bonds, which especially benefits the tranched layers of multiple-peril cat bonds
ILS issuance and capacity both set records in 2007.
Issuance of insurance-linked securities totalled US$ 14.4 billion in 2007, up 40% from US$ 10.3 billion in 2006. at the end of 2007, outstanding notional value stood at US$ 39 billion, up 50% from US$ 26 billion at the end of 2006. By May of 2008, the value of bonds outstanding had reached about US$ 40 billion, with life bonds accounting for 58% of market value of bonds outstanding. The market still has significant upside potential. P&C risks transferred to the capital markets represented only 12% of global catastrophe reinsurance limits in 2007 and under 1% of other non-life reinsurance limits. There appears to be no shortage of sellers of protection – demand for this asset class from dedicated cat funds has been particularly strong. Issuance is expected to grow to US$ 25-50 billion by 2011, while the notional value of bonds outstanding could reach US$ 150 billion.
ILS issuance slowed in 2008.
Although long-term prospects for the market are robust, ILS issuance slowed in the first half of 2008 due to the turmoil in the credit markets, which
particularly affected investment-grade life and nonlife bonds. Life insurance issuance in particular slowed to a standstill, due to the credit crisis as well as issues related to embedded value and US actuarial guidelines on valuation (commonly known as Regulations XXX/AXXX). These instruments are similar to asset-backed securities, which have been dramatically affected by the current market turmoil, increasing the price of life securitizations. However, with the exception of the small investment-grade sector, non-life issuance has not slowed as spreads have generally tightened in line with the softening reinsurance markets. As expected, tightening spreads and softening reinsurance markets have dampened sidecar activity.
2.2 Market instruments
2.2.1 P&C bonds
Catastrophe bonds, the primary type of P&C bond, originated in the hard market of the early 1990s following Hurricane Andrew, when reinsurance capacity for catastrophes was limited and expensive. The earliest forms provided a simple mechanism to transfer catastrophic risks to capital markets. In a typical transaction, a fully collateralized special purpose vehicle (SPV) enters into a reinsurance contract with a protection buyer, or cedent, and simultaneously issues cat bonds to investors. The reinsurance is usually an excess-of-loss contract. If no loss event occurs, investors receive a return of principal and a stream of coupon payments that compensate them for the use of their funds and their risk exposure. If, however, a pre-defined catastrophic event – defined by a trigger – does occur, investors suffer a loss of interest, principal, or both. These funds are transferred to the cedent in fulfilment of the reinsurance contract.
The market for insurance-linked instruments is developing rapidly.
Other recent ILS developments include: • The weather derivatives market has remained healthy, with the notional value of trades rising to US$ 32 billion in the 2007-2008 period from less than US$ 10 billion in 2004-2005 • The use of industry loss warranties and cat swaps has grown at a strong pace and those instruments now have an outstanding notional value of about US$ 10 billion • Investor interest in natural catastrophe risk has increased rapidly. Dedicated cat funds attracted substantial new capital after it was seen that the prices of cat bonds remained stable even as corporate bond prices plummeted • Catastrophe risks are now traded on exchanges • Many parties are developing tradable indices, with an initial focus on longevity, cat bonds and natural catastrophe risk
The first catastrophe bonds were issued after Hurricane Andrew. There are five basic types of loss triggers.
“Our experience with ILS-transactions has been positive and these are an important part of our capital market activities and a key strategic lever.”
Dieter Wemmer, Chief Financial Officer Zurich Financial Services, Switzerland
There are five basic types of trigger, with varying degrees of transparency for investors and basis risk for the cedent: • An indemnity trigger is based on the actual losses of the sponsor and has negligible basis risk • An industry index trigger is based on an industry-wide index of losses, such as the estimates published by ISO’s Property Claim Services (PCS) unit in the United States • A pure parametric trigger is based on the actual reported physical event (i.e., magnitude of earthquake or wind speed of hurricane) and has the most transparency for the investor, but also a great deal of basis risk for the sponsor • A parametric index trigger is a more refined version of the pure parametric trigger using more complicated formulas and more detailed measuring locations • A modelled loss trigger determines estimated losses by entering actual physical parameters into an “escrow model”, which then calculates the loss
Figure 1: The different types of insurance convergence products
Transparency for Investor
Multiple peril bonds now constitute the largest proportion of outstanding cat bonds. Average issue size has grown as new sponsors have been attracted to the market and standardization has lowered the cost of issuance.
extended to new perils beyond the peak Florida wind risk that was typical in the market following hurricanes Katrina, Rita and Wilma. One bond, for example, now covers European earthquake risk in Turkey, Greece, Israel, Cyprus and Portugal, while another covers Japanese typhoon risk. Also, the average lifespan of the bonds has lengthened, from two years in 2006 to three-and-a-half years in 2007. Some now have a lifespan of six years.
Modelled Loss Indemnity
Basis Risk to Issuer
Source: Swiss Re Capital Markets
Most P&C bonds transfer catastrophic risks.
The overwhelming majority of P&C securitizations are for catastrophic risks, such as windstorms (hurricanes, typhoons) and earthquakes. These serve as collateralized protection for extreme event risk, which eliminates counterparty risk, at a multiyear fixed price. Additionally, however, bonds have also been issued that transfer liability, credit, motor and reinsurance recoverable risks. The largest proportion of bonds outstanding are for multiple perils. In 2007, almost half of total issuance covered multiple perils. Also, cover has now been
The cat bond market continued to grow in 2007, even in a softening insurance market.
The process of issuing cat bonds is increasingly standardized, lowering the cost of issuance and attracting new sponsors. The issuance of standardized “programme” or “shelf-offering” transactions accelerated in 2007, with shelf offerings accounting for 72% of total non-life issuance. At the same time, the size of the average bond increased
Figure 2: Total P&C securitizations over time and split by peril
US$ billion 32 28 24 20 16 12 8 4 0 98 99 00 01 02 03 04 05 06 07 31% Wind Earthquake Liability Credit Auto Other 6% Multi-peril 39% 12% 21% 19%
3% 2% 5% 1%
Source: Swiss Re Capital Markets
Outstanding from previous years
from US$ 141 million in 2006 to US$ 271 million in 2007. Of the bonds issued in 2007, State Farm’s Merna Re had a record value of US$ 1.2 billion, while the Emerson Re and Longpoint Re bonds were for US$ 500 million each.
2.2.2 Life bonds
Life bonds can be used to monetize intangible assets, fund US regulatory capital requirements under Regulations XXX/AXXX, and transfer risks, such as extreme mortality events, to the bond market. These bonds, and the regulatory requirements for them, differ from existing P&C bonds in a very crucial respect: they are typically used as a financing tool. That is, asset-backed life bonds are secured by the flow of future profits from life insurance policies. Risk is not fully transferred in a legal sense, since the life insurance company will always retain the obligation of its policies. However, the burden of risks, such as mortality and lapse risk, are assumed by the investors. For these bonds, investors and protection buyers share the benefits and losses in the development of the underlying policies that have been securitized. Extreme mortality bonds are similar to P&C cat bonds in that they, too, are fully collateralized and have a specified trigger.
Sponsors and indemnity-based bonds increased last year.
There was also a further widening of the pool of sponsors, which included large primary companies such as State Farm and Chubb, and corporations, such as East Japan Railway for the Midori bonds. In another sign of a maturing market, the use of indemnity triggers increased in 2007, as primary insurers sought to minimize basis risk and investors grew more comfortable with such triggers. In 2005 and 2006, growth was supported by catastrophe activity in 2004 (hurricanes Charley, Ivan, Frances and Jeanne) and 2005 (hurricanes Katrina, Rita and Wilma). However, underlining the market’s growing maturity, cat bond issuance continued to grow robustly in 2007, even with softening insurance market conditions and despite the credit crisis.
Life bonds are typically a financing tool.
Figure 3: Life bonds issued and outstanding in US$ billion
16 12 8 4 0 98 99 00 01 02 03 04 05 06 07
42% 3% XXX AXXX Embedded Value Extreme Morality Other
Outstanding from prev. years
Source: Swiss Re Capital Markets
The flow of XXX/AXXX securitizations weakened in 2007 after the credit crunch hit the financial markets.
five-year mortality cat bond (US$ 100 million) to protect against an exceptional rise in mortality in the US, Canada, England and Wales, and Germany.
2.2.3 Weather derivatives
Funding of Regulation XXX/AXXX redundant reserves in the United States has been the primary focus of life securitizations in the past few years. These redundant reserves are for fixed-length term life (XXX) and universal life (AXXX) policies. In the second half of 2007, pressure on the asset-backed securities market and on the monoline insurers slowed issuance, but this is expected to be a temporary factor. In 2007, XXX transactions were executed publicly by Genworth (US$ 790 million) and Aegon (US$ 550 million). Protective Life completed a US$ 250 million AXXX securitization to fund universal life reserves. These figures understate the true transfer of risk as substantial private transaction activity coexists with the public market. Securitizations that monetize the embedded value (EV) of a defined block of business accelerated in 2007. The Bank of Ireland closed a US$ 573 million EV transaction for its life insurance subsidiary, New Ireland Assurance. UnumProvident issued a 30-year bond (US$ 800 million) to monetize the value of its closed block of individual income protection insurance. In December, MetLife issued a 35-year bond (US$ 2.5 billion) to provide statutory reserve support for a large closed block of liabilities. Securitizations of this type hold strong growth prospects since they provide an effective tool for life companies to improve capital efficiency and profitability. Weather derivatives are primarily used by utility companies to hedge against extreme heat and cold. They are typically triggered by heating degree days (HDD) or cooling degree days (CDD) and serve to reduce the volatility of earnings by offsetting losses from higher variable costs at fixed prices when demand surges during extreme weather. HDD, for example, is the number of average degrees of temperature for a day below a reference value (usually 65°F or 18°C, which have been shown to require no heating inside buildings). Frequently, the derivative contracts are for cumulative HDDs over a season, depending on local weather patterns. Though HDDs are one of the most common types of weather derivative, derivatives have also been constructed with rainfall and other weather-related triggers.
The weather derivatives market is likely to grow by 30% per year for the next several years.
Demand for weather derivatives remains healthy, with the notional value of trades tripling in three years, to US$ 32 billion in 2007-2008 from US$ 9.7 billion in 2004-2005 (the intervening 2005-2006 period was marked by some anomalous conditions, Figure 4: Weather derivative contracts (in US$ billion)
50 45 40 35 30
The issuance of mortality cat bonds was unaffected by credit market woes.
The market for mortality risk transfer through securitization continues to expand, as these bonds were unaffected by the credit market’s woes. So far, mortality cat bonds have been issued by Swiss Re, Scottish Re, AXA and Munich Re. Swiss Re issued a fourth mortality cat bond (US$ 521 million) in early 2007. In February 2008, Munich Re issued its first
25 20 15 10 5 0 00/01 01/02 02/03 03/04 04/05 05/06 06/07 07/08
Source: Weather Risk Management Association
including the rapid entry and exit of several hedge funds as well as increased trading after the Katrina/Rita/Wilma hurricanes). Growth of about 30% per year is expected for the next several years.
2.2.5 Cat swaps
Cat swaps are over-the-counter, customized derivative contracts similar to ILWs, in that they require less documentation and are often set at lower levels of payouts than bonds. Cat swaps are very flexible and have been issued for protection against US windstorms, US earthquakes, Japanese earthquakes, Japanese typhoons, Turkish earthquakes, aviation losses, terrorist attacks, mortality, longevity and multi-perils. It is difficult to establish the exact size of the ILW and cat swaps markets since these are private transactions. However, together the two instruments are estimated to have about US$ 10 billion in outstanding notional volume.
Counterparties for weather derivatives are mostly utilities, construction companies and farmers.
North America remains the main driver of the weather derivatives market, although Europe is increasingly significant. Counterparties are: 1) Mostly utilities hedging against a warm winter 2) Agribusinesses buying yield and revenue protection influenced by temperature and precipitation 3) Construction companies hedging against precipitation or cold that can disrupt construction schedules 4) Retailers hedging against the impact on buying habits of temperature and precipitation
2.2.6 Exchange traded cat risks
Exchanges have been established to trade insurance-linked derivatives.
2.2.4 Industry loss warranties
ILWs, cat bonds and cat swaps are all triggered by specified indexes.
Industry loss warranties (ILW) provide protection against natural catastrophes. In their reinsurance form, they are based on two triggers – an agreed upon industry-loss trigger and an indemnity-loss trigger based on the buyer’s actual losses. In the United States, the industry loss data used is frequently taken from the PCS, which provides timely estimates of insured losses after a catastrophic event. In other countries, Swiss Re’s sigma data, Munich Re’s catastrophic loss data or other loss estimates are used. Single ILWs may provide anywhere from US$ 1 million to US$ 250 million of cover. By contrast, cat bonds typically need to provide at least US$ 100 million of cover to be economical.
Recently, exchanges have been re-established to trade insurance-linked, index-based risks. Such risks were traded on exchanges in the 1990s, but these listings were discontinued due to a lack of interest. The New York Mercantile Exchange has partnered with Gallagher Re to create an exchange based on an index of aggregate insurance industry losses reported by the PCS – excluding earthquake and terrorism losses. The Chicago Mercantile Exchange and Carvill & Company have set up an exchange to trade derivatives based on an index of wind speed and hurricane force radius at landfall. The Insurance Futures Exchange Services Ltd (IFEX) has initiated trading in catastrophe event-linked futures on the Chicago Climate Futures Exchange. IFEX derivatives are based on an index of PCS losses – a named hurricane must breach the trigger. Each of these exchanges lists derivatives for various geographic regions (all US, Florida, North Atlantic coast, etc.) However, all three trading venues are relatively new and it is not yet clear if they will succeed.
2.3 Market participants
Dedicated cat funds are now the largest investors in cat bonds.
Investor interest in insurance-linked securities continues to grow.
Fixed-income investors are increasingly interested in ILS and related risk-taking instruments, for several reasons: • These instruments often provide exposure to specific insurance risks, such as the risk of an earthquake in a specific area, resulting in a “pure play” investment • Their funds are held in trust, so investors face no counterparty risk with the bond’s sponsor, the insurer or reinsurer • ILS investments often offer low correlation with equity and credit markets, making them a diversifying asset class Most investors tend to focus narrowly – with relatively little overlap, for example, between investors in catastrophe bonds and investors in embedded-value life bonds. The comments below focus on investors in catastrophe bonds and related instruments.
Dedicated cat funds are now the largest buyers for cat bonds, making up 44% of the investor base. Last year, they continued to invest in higher yielding noninvestment grade bonds and often set the pace for market trends such as the growing acceptance of indemnity triggers. Dedicated cat funds continue to attract funds at a rapid rate. Interest among other investors, such as hedge funds and traditional pension plans and mutual funds, is also rising. Investors are attracted by the uncorrelated nature of cat bonds and thus their portfolio diversification value, as well as the increased liquidity of the secondary market.
Spreads on cat bonds continued to narrow in the second half of 2007, even as investors in other types of bonds saw spreads widen.
Creating loss indexes in Europe
Although Europe does not have a recognized loss index, help is on the way.
Since 2002, spreads on cat bonds have narrowed from about 400-800 basis points to 200-400 basis points over LIBOR. Spreads on US wind-peril instruments spiked after Katrina, but are now back down following two consecutive benign hurricane
Figure 5: Investors in cat bonds by type As of 31 Dec. 2007
A recent European initiative aims to develop indexes capable of measuring the scale of natural catastrophes in Europe. The initiative was launched through the Chief Risk Officer Forum and is supported by numerous major insurers and reinsurers. The goal is to develop a data service capable of promptly providing estimates of insured European natural catastrophe losses. This information could be used to develop industry loss indexes for insurance-related instruments such as ILWs, cat bonds and cat swaps.
Hedge fund 14%
Dedicated Fund 44%
Money manager 22%
Source: Swiss Re Capital Markets
seasons. This downward trend in spreads was strongly reinforced in the second half of 2007, despite the credit crunch. While yields on corporate bonds widened in the second half of the year, cat bond spreads, on average, continued to tighten. By contrast, the credit crunch and the accompanying uncertainty surrounding the major monoline insurers have had a dramatic impact on the market for life insurance bonds. These instruments became dramatically less liquid and new issuance slowed to a halt as transactions were reworked.
“Since traditional insurance and reinsurance leave gaps in customers’ cover needs, we support efforts to explore and develop innovative solutions, such as an effective transfer of insurance risk to the capital markets.”
Jim Rutrough, Vice-Chairman and Chief Administrative Officer, State Farm Insurance Group, USA
Sidecars provide capital when prices are high. Sidecar capacity shrank in 2007.
Sidecars are special purpose vehicles that are temporary collateralized capital pools funded by a third party, such as a hedge fund. The pool is structured as a retrocession vehicle for a “top flight” reinsurer, which assumes a specific type of business on its highly rated paper, and then cedes
it via a quota share – or some other reinsurance agreement – to the sidecar. Typically, sidecars are multi-year and created during “hard” insurance markets, when prices are high for catastrophic risks. Because the P&C industry is now well capitalized and returns are falling, sidecar capacity shrank in 2007. Last year, only nine new sidecars with US$ 1.9 billion in capital (mostly debt) were established or renewed, while about US$ 4 billion in sidecar capacity was retired. The remaining capacity is roughly US$ 4 billion. Sidecars may regain their popularity after future large catastrophic events.
Figure 6: New sidecar capacity from 2001 to 2007
Value (US$ billion)
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Gap in issuance illustrating opportunistic sidecar use by insurers after major hurricanes (KRW)
3. Impediments to Growth
Though growing rapidly, the insurance risk transfer market is still small in absolute size and slow in its development compared to some of the credit-linked ABS markets.2 This section will describe factors that are impeding growth. Our findings are derived from interviews with investors, insurers, reinsurers, rating agencies, investment banks, modelling agencies and other stakeholders, as well as a review of the existing research literature. Except where noted, most of our analyses focus on catastrophe bonds, which represent the bulk of the P&C instruments currently outstanding. For sponsors, the transfer of insurance risk to the capital markets is an alternative or a complement to traditional reinsurance or retrocession. Accordingly, they will compare the costs and benefits of securitization to traditional reinsurance in terms of both the scope of the protection provided and the price. Relevant criteria are that an instrument provides tailored cover with minimal basis risk, low counterparty risk and favourable treatment with respect to regulatory capital and credit ratings. For sponsors, the key impediments to market growth are the potential for basis risk in transactions with parametric triggers (as well as the accounting, regulatory and rating consequences resulting from basis risk) and the pricing of capital market transactions compared to traditional reinsurance.
Investors, on the other hand, tend to value liquid markets, objective and transparent triggers, standardized documentation and short settlement periods. Key impediments for investors include the complexity of the underlying risks and the models used to evaluate them, the lack of standardization in the ILS market and the limited secondary market this heterogeneity produces.
3.1 Impediments for sponsors
3.1.1 Basis risk
Traditional reinsurance, whether proportional or excess of loss, provides indemnity-based protection without or with only limited basis risk.3 However, some capital market instruments, if not indemnitybased, expose the primary insurer or reinsurer seeking protection to varying levels of basis risk. Traditional reinsurance or retrocession can be divided in two types, proportional and nonproportional. In proportional reinsurance, including both quota-share reinsurance and surplus reinsurance4, insurer and reinsurer share premiums and losses proportionally. In non-proportional or excess-of-loss reinsurance, the reinsurance premium is not expressed as a specified share of the primary insurance losses and premiums but rather in absolute terms. The reinsurer assumes all losses of the primary insurer in a class of business that exceed a certain amount and up to a specified limit. However, all these types of reinsurance are indemnity-based, meaning the recovery from the reinsurer is based directly on the specified losses incurred by the primary insurer. Note, however, that a limited amount of basis risk for the ceding company may result from exclusions and other contractual terms – such as the exclusion of postevent assessments – that limit the extent to which the reinsurer follows the fortunes of the ceding company. In capital market transactions, indemnity-based cat bonds are structured similarly to excess-of-loss reinsurance. Within the limits, the sponsor also receives full protection, since the risk assumed by
Two key differences between the ABS and the ILS markets
It is worth noting following two key differences between the ABS and the ILS markets: With ILS, the insurer retains a considerable amount of insurance risk. To date, ILS mostly have been used to protect insurers against peak risks. Accordingly, there is much less of a moral hazard problem, compared to the securitization of an entire credit portfolio. Secondly, there is no duration mismatch in cat bond or sidecar structures. Thus, the difficulties caused by the illiquidity of the market for short-term notes issued by structured investment vehicles in the ABS market will not be repeated in the ILS market.
the investors relates to the specific loss exposure of the sponsor’s underlying portfolio. However, in any other transaction where the trigger is based on an index or is parametric, the insurer retains a basis risk (which may be positive or negative) arising from the imperfect match between the losses resulting from the portfolio for which protection is sought and the compensatory payment under the risk transfer instrument, which are not fully correlated. Basis risk will vary according to the granularity of the trigger used – i.e. whether an index provides a geographic breakdown that allows sponsors to refine the trigger to geographic areas where their exposures are significant – as well as the deviation of the specific portfolio from the industry-wide exposure or losses. The assessment of basis risk depends on the quality of the risk model used to estimate the impact of certain catastrophic events on the specific portfolio for which protection is sought, the quality of the data available with respect to such portfolio, and on the specific peril. For example, there are only a few recalibrating events for high severity perils such as earthquakes, which adds uncertainty to the models. For the sponsor, basis risk presents an impediment because the protection obtained from the risk transfer instrument is imperfect. This must be reflected in internal risk management.
In addition, under the applicable accounting rules, as well as most regulatory regimes and rating-agency rules, basis risk may have negative impacts. This point is discussed in more detail in the next subsection. On the other hand, in indemnity-based transactions investors expect to receive a premium for moral hazard and adverse selection, the size of which is a function of the type of business covered and the associated modelling credibility, as well as the market's confidence in the sponsor's underwriting, risk management, loss and claims adjustment processes, among other factors.5 Furthermore, investors will want to undertake more extensive due diligence of the sponsor and the securitized portfolio, increasing the cost and time spent to the sponsor. Catastrophe bond issuances in 2007 showed an increasing volume of indemnity-based transactions. This trend may reflect the surge in investors seeking opportunities in the cat bond market, leading to more favourable terms for sponsors. However, many investors still express concerns over the modelling integrity in indemnity-based deals, in particular with respect to complex commercial exposures, reinsurer portfolios (where portfolio information is less granular) and portfolios outside the US6, where data quality is generally lower.
Figure 7: Instruments with and without basis risks
Instruments with basis risk Non Life
• Cat bonds with modeled loss, industry loss or parametric triggers • Cat swaps • ILW
Instruments without or with limited basis risk
• Sidecars • Cat bonds with indemnity based trigger
• Extreme mortality bonds • Longevity ILS
• Embedded value securitization • XXX and AXXX bonds
Further standardization of risk transfer instruments requires that sponsors become comfortable with retaining basis risk – from a risk management, accounting and regulatory perspective.
The standardization of risk transfer instruments can be driven much further if these instruments are not structured for an individual portfolio but instead relate to an objective index or parametric trigger. Thus, further standardization by means of standardized parametric or industry-loss triggers requires that insurers become comfortable with retaining basis risk, or have the means to cede basis risk to a third party for a price that will still make the overall transaction competitive with traditional reinsurance. In either case, it will be necessary to develop robust methodologies – ones that are understood and accepted by the rating agencies and the regulators7 – in order to evaluate basis risk and determine the levels of regulatory and rating capital necessary to support it.
If the risk transfer instrument is classified as a financial derivative, it will, under both IFRS and US GAAP, be measured at “fair value” and marked to market, with impact on profit and loss accounts. This can create considerable volatility in the insurer’s income statement compared to a traditional reinsurance claim, which, subject to contract exclusions, is measured consistent with the treatment of underlying direct insurance liability. However, this difference in accounting treatment may be alleviated in the future with the move to fair value measurement of insurance liabilities under both IFRS and US GAAP. This would increase the volatility of insurance liabilities and, correspondingly, of reinsurance assets as well.
In addition to creating volatility in the insurer’s income statement, treatment as a financial derivative has the consequence – at least in many jurisdictions –that the risk transfer instrument will be disregarded with respect to solvency capital as long as no gain is realized. Insurance undertakings and (in the European Union since the Reinsurance Directive8) reinsurance undertakings must maintain a minimum level of solvency capital as a risk buffer. This supplementary reserve over and above the technical reserves serves as protection against adverse business fluctuations and is an element of prudential supervision. In banking, the Basel I and Basel II accords have allowed credit institutions to release regulatory capital through the securitization of their credit portfolios. This opportunity has had a considerable impact on the development of credit securitization. On the other hand, the insurance solvency regimes in most jurisdictions do not yet award such favourable treatment to the transfer of insurance risks to the capital markets. In the European Union, under the current Solvency I9 regime, capital adequacy and the determination of the required solvency capital is based on the liabilities side of the balance sheet and on insurance risk only. For non-life insurance undertakings, the
3.1.2 Accounting and regulatory treatment Accounting
The accounting treatment of alternative risk transfer instruments under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP) depends on whether such instruments are classified as reinsurance contracts, and thus accounted for in the technical provisions and the insurance result, or whether they are classified as financial derivatives, and thus have no impact on the insurance result. Under IFRS (IFRS 4), reinsurance accounting applies only to risk mitigation instruments that have an indemnity-based trigger. Under US GAAP, industry loss warranties documented as reinsurance contracts are treated as reinsurance since they have a dual trigger – one relating to industry losses, such as those reported by the PCS; the other being an indemnity trigger, which relates to actual losses incurred by the protection buyer.
required solvency margin is defined as the higher of the premium index or the claims index. Under both indexes, reinsurance reduces the required solvency margin, but not by more than 50%, as shown in the following (simplified) formulas: • Premium Index = (18% x the first € 50m gross premiums + 16% x the remaining gross premiums) x the retention rate • Claims Index = (26% x the first € 35m gross claims and 23% x the remaining gross claims) x the retention rate • Retention rate = net claims ÷ three-year average of gross claims (but not less than 50%)10 For life insurance, the required solvency margin is calculated as a function of the actuarial provisions or the capital at risk, and is lowered – within certain limits – to the extent that business is ceded by way of reinsurance.
Union will not always be seen as providing adequate reinsurance supervision. For the sponsor, this could have a negative impact on the regulatory treatment of the instrument. Using a transforming reinsurer may solve this problem but may create additional costs. This dependence of the regulatory treatment on the accounting treatment is similarly found in the United States: US insurers and reinsurers are required to report their financial results consistent with Statutory Accounting Principles (SAP), an insurance accounting system that is more conservative than US GAAP. Under US GAAP (FAS 113, sections 9a and b), the criteria for a risk transfer instrument to qualify for reinsurance treatment include the “significance of the risk transferred” and a certain “probability of significant loss”. A significant transfer of risk is only achieved if there is no positive basis risk for the insurer. Similar rules apply under SAP. Therefore, in many transactions with parametric or industry-loss triggers, sponsors will use a double-trigger reinsurance contract similar to an ILW, thus capping the payout to the sponsor at the sponsor’s actual losses. This can also delay the payout until actual losses are assessed. The interest paid for this extension period can be an unintended benefit for investors. In order to achieve solvency capital release from alternative risk transfer mechanisms, sponsors must ensure these instruments receive accounting treatment as reinsurance. However, for the ceding companies this may add complexity to transactions in which solvency capital relief is an important objective. The solution should be to look at these instruments from an economic viewpoint and place the economic substance over the form of the relevant risk transfer instrument. In the European Union, progress in this direction has been made under the Solvency II regime, as rules detailing the Solvency II Directive Proposal11 are being developed. Solvency II will be a principles-based regime designed to take into account all types of risk to which the insurer is exposed and to reflect developments in the capital markets in a timelier and more flexible way. New capital adequacy standards are expected to come into force from 2012.
Solvency capital release varies by jurisdiction and inter-alia depends on reinsurance accounting.
Whether an alternative risk transfer instrument reduces the required solvency margin depends upon whether it is considered in the retention rate and, therefore, under the Solvency I regime as currently implemented in most EU member states, upon whether the instrument qualifies as reinsurance. Treatment as reinsurance under the applicable accounting rules is a necessary, though not sufficient, prerequisite for regulatory treatment as reinsurance. The reduction of the required solvency margin may further depend on the jurisdiction of the special purpose reinsurance vehicle used to transfer the risk to the capital market, and whether the sponsor's regulator accepts this jurisdiction as having sufficient reinsurance supervision. While currently it is often beneficial from a tax or capitalization perspective to locate special purpose vehicles in Bermuda or the Cayman Islands, jurisdictions outside the European
Solvency II is expected to take a more economic view on the recognition of risk mitigation tools.
risk mitigation tools. These principles rely on the economic impact, enforceability and stability of the instrument as well as the credit quality of the counterparty.12 In the United States, no such development towards a more economic view of financial risk mitigation tools is currently observed, as such a development would, inter alia, be largely dependent on a review of the statutory reserving rules. However, the issuance of certain types of life insurance instruments (such as XXX and AXXX bonds) is motivated by existing US reserving rules. These instruments can be expected to lose their benefit if US insurance regulations take a more economic view on reserving and risk transfer. In any case, the implementation of progressive principles on the recognition of non-indemnity-based risk transfer instruments will require a sound and generally accepted method for the assessment of basis risk, which should be based on a portfolio rather than a transaction view.
Solvency II envisages two levels of capital requirement: the Minimum Capital Requirement (MCR), which is the level of capital below which an insurance operation presents an unacceptable risk to policy-holders, and which will be measured with simple, robust and objective methods, and the Solvency Capital Requirement (SCR), which is the level of capital necessary to absorb significant unforeseen losses and provide reasonable assurance to policy-holders (to a confidence level of 99.5%) that all obligations will be met over a specified time horizon. Solvency II will provide for a total balance sheet approach, taking into account both assets and liabilities, to calculate the solvency capital required. It will require insurers to hold capital against market risk, credit risk and operational risk, all of which are currently not considered in the required solvency margin. Similar to banks under Basel II, insurers will have the option of calculating these amounts using internal risk models rather than the standard model. Quantitative impact studies released by the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) set forth certain principles in relation to the recognition of financial Figure 8: Basis risk, accounting and regulation
No automatic recognition as eligible assets
Insurance undertakings must cover their technical reserves with matching assets that are subject to certain investment restrictions (eligible assets). These restrictions are designed to maintain the safety, yield and marketability of the investments as well as an adequate level of mixture and diversification, while
Accounting treatment Instruments with basis risk Regulatory treatment Rating treatment
P&L volatility since qualified as financial derivative
No reduction of required solvency margin (in most jurisdictions) Uncertainty and inconsistency w/r to credit for sponsor’s financial strength rating
• Economic view with respect to solvency (see Solvency II) and rating • Development of robust and recognized methods to evaluate basis risk
ensuring the insurance undertaking's liquidity at all times. EU member states can allow these technical provisions to be covered by claims against reinsurers, subject to certain limits.13 Claims against reinsurers would thus automatically qualify as eligible assets. However, this is not the case for all alternative risk transfer instruments. Qualification does not occur per se, but rather may depend on the general rules for mixture and diversification of investments, the jurisdiction of the special purpose reinsurance vehicle, or the funding of the structure.
3.1.3 Inconsistent ratings treatment
With respect to the financial strength rating of the sponsor – particularly its capital adequacy ratio – the rating agencies do not always give full credit for risk securitizations, but rather apply "haircuts" for basis risk. As with the regulatory treatment, the development of sound methods to evaluate basis risk and allocate capital to it would be necessary for consistent recognition of alternative risk transfer instruments with basis risk. Some rating agencies have applied a cap on the rating of the ILS themselves because of the uncertainty of the catastrophe modelling. The rating of the instrument may be capped at a certain level (e.g. AA) even though expected loss or probability of loss would otherwise allow for a higher rating. This practice may increase prices in the more remote layers. It can be expected that improvements in the models, and in the understanding and acceptance of them, should allow the rating agencies to abandon such practices. The development of fully standardized methodologies for quantifying and rating insurance risk transactions would help avoid inconsistencies in the assessment of the risk transfer that, as of today, are observed in the sponsor's financial strength rating on one side and rating of the instrument on the other. As always, the transparency of the applied methodology is key, though investors should also expect rating agencies to exercise judgement in applying their criteria.
Complexity of transaction structures
Uncertainties about the accounting and tax treatment drives complexity and thereby cost of transactions.
While it has been possible in past years to establish fairly standardized transaction structures for catastrophe bonds, no such structures yet exist for embedded-value securitizations in the life insurance sector. The efficiency of transaction structures is highly dependent on accounting and tax rules, requiring in-depth analysis of the applicable rules (e.g. consolidation rules) involving external parties such as accounting firms, regulators and rating agencies. Different treatment under local accounting rules and IFRS often adds complexity. In this respect, certainty about the accounting treatment and the development of tested structures would facilitate the securitization of insurance risk. Although the clarification in 2002 of US FIN 46, which interprets FAS 94 and RAB 51, led to an increase in issuance volumes, the rules still require a time-intensive assessment of the accounting treatment for each unique transaction and lead to complex transaction structures. Unfortunately, these accounting rules remain in flux, further frustrating standardization efforts.
3.1.4 Pricing of traditional reinsurance
In an ideal world, insurers would cede risk to a seamless risk market, comprising both traditional reinsurance and alternative instruments. Risk would be placed based on price and best use, regardless of form. However, in practice the market has not yet reached such a degree of efficiency. Currently, spreads in the traditional reinsurance market, which are lower than risk spreads for cat bonds, constitute an impediment to the securitization of catastrophe risk, due to abundant capacity and further softening in the reinsurance
pricing cycle following two years of mild natural catastrophe losses. However, it is difficult to compare pricing for traditional reinsurance to pricing for cat bonds or other alternative risk transfer instruments because of the following differences: • Reinsurance cover is usually bought for one-year periods while cat bonds typically provide multiyear cover • Cat bonds and some cat swaps are collateralized and have less counterparty credit risk than reinsurance, which is generally uncollateralized • Non-indemnity catastrophe bonds may allow for quicker recovery, producing a significant time value of money advantage over most reinsurance contracts • Cat bonds usually do not include a reinstatement14, unlike most reinsurance contracts • Sponsors will want to apply a discount for transfer instruments with basis risk since they provide incomplete protection compared to traditional reinsurance As there are different pricing methods and also different dynamics in reinsurance and the capital markets, the relevance of these pricing impediments can vary over time. In traditional reinsurance, a “technical price” can be determined based on the expected loss and the expected volatility of the contract’s result. However, the “commercial price” is driven by industry capacity, by the occurrence of large loss events, and by investment returns15. This has resulted in reinsurance pricing cycles. Hard markets occur after major loss events such as natural catastrophes or terrorist attacks; soft markets occur if reinsurance capacity increases due to competition. During hard markets, alternative risk transfer instruments emerge as compelling options and are clearly a complement to traditional reinsurance. Pricing for capital market transfer instruments is primarily derived from the market and dictated by the laws of supply and demand. With respect to catastrophe instruments, the main driver is the expected loss as modelled by one of the independent modelling firms. Modelling results are key for ratings. Ratings, in turn, allow market participants to compare prices for instruments with similar characteristics, but this is of only secondary
importance for catastrophe instruments. Pricing of the instruments further takes into account the current pricing of catastrophe securities traded in the secondary market, with the yield on outstanding instruments capturing the secondary market's current return requirements. Pricing on the secondary market reflects probability of loss at any point in time – prices to sponsors for US hurricane instruments, for example, will increase at the beginning of the hurricane season. With respect to rating, it has been the case historically that most cat bonds have traded at a relative spread to similarly rated corporate securities of between 100 and 200 basis points16, due in part to their binary nature, novelty premium, low liquidity and perceived mechanical complexity. However, more recently spreads have tightened, both as a result of the higher spreads of corporate bonds during the recent financial turmoil, but also because of a reduction in the risk spreads for cat bonds. The low correlation of insurance-linked instruments with credit-related investments is shown by the stability of prices amid the recent market turbulence. An increased and more liquid market, driven by further standardization and an increasing investor base, can be expected to bring spreads down further.
3.1.5 Time and cost
Sponsors are concerned about the time spent and the costs paid for executing securitization transactions. This is particularly true for first-time issuances, where senior management involvement is usually higher than in repeated issuances. These transactional costs may constitute an impediment to market growth. Compared to traditional reinsurance, securitization poses a number of additional costs for sponsors, including rating agency services, legal advice, risk modelling and risk analysis, as well as an arranger fee (although traditional reinsurance often involves a brokerage fee). Time must be spent modelling the risk to be transferred, preparing offering documentation and assessing the transaction with auditors, tax authorities, regulators and rating agencies. In general, indemnity-based transactions require more detailed disclosure by the sponsor and, accordingly, are likely to require more time and expense.
On the other hand, it has been shown that more repeated issuance and the use of shelf programmes can bring down transaction costs. Furthermore, as deal sizes get larger, fixed costs decrease as a percentage of total costs. Finally, transformer issuance with wholesalers, such as reinsurers, can largely eliminate complexities for insurers – in much the same way that wholesale universal banks “front” for local and regional banks, giving them ready access to the credit securitization markets.
depend highly on the data input – i.e. historic loss data, historic parametric data and exposure data. The quality of the exposure data relating to the portfolio for which protection is bought is relevant to assessing the expected loss from the instrument and, if any, the basis risk remaining with the sponsor. With respect to life insurance instruments, the output of the actuarial models similarly depends on the quality of the asset and liability portfolio information fed into the model. Key portfolio information taken into account in nonlife risk models includes: • The location, construction classes, number of stories, age and occupancy of insured buildings • Values at risk (buildings, contents, business interruption) • Insurance structure (limits, deductibles) Furthermore, in indemnity-based transactions, the sponsor’s underwriting guidelines and claimsmanagement capacities are of great importance to the investors. Accordingly, due diligence extends to the sponsor’s management, track record and incentives.
Increased standardization, particularly in the use of derivative instruments, would also lead to less time consuming and less costly transactions.
Increased standardization, particularly in the use of derivative instruments, would also lead to less time consuming and less costly transactions.
3.1.6 Data quality and transparency Data relevancy
Transferred insurance risk is assessed on the basis of complex risk models developed by third-party providers. Catastrophe risk models take into account the probability of relevant catastrophic events, certain hazards resulting from such events, and the insured exposures in the relevant geographic areas. Expected losses are modelled on the basis of analytical, engineering and empirical techniques. The risk models used in capital market transactions are generally the same as those used for internal risk management by the sponsors as well as by reinsurance underwriters.
Insufficient data quality and disclosure
There are regional variations in the metrics used by the insurance industry.
Results of risk modelling depend on the quality of the model as well as of the used exposure data.
The reliability, credibility and transparency of the modelling process are crucial to both investors and sponsors. However, the results of the risk analysis
Insufficient data quality and disclosure impede the development of the insurance risk market in a number of ways: • The quality of exposure-related data tends to be lower for non-US portfolios17. In the European Union, there are no standard formats for collecting policy data nor for reporting them, and available portfolio data are in general less detailed. In some cases, different metrics are used in different EU countries. Variation exists, for example, in building valuations. Also, policies in France are not reported by insured sum as they often are in Germany, but rather by the number of square metres in the insured building. Bringing these data together in the same modelling exercise is therefore a complex task. In contrast, more comprehensive portfolio data are aggregated in the United States to satisfy
regulatory reporting requirements, and these data must be made public by the insurers (nevertheless, the development of unified mortality tables would be a useful US standardization, as it would facilitate the comparison of different life insurance portfolios). • Insurers have been reluctant to disclose portfolio data as they may be of proprietary nature and their disclosure valuable to competitors. However, less reluctance is shown by US insurers, as they are subject to more extensive disclosure requirements under both statutory reporting and the Sarbanes-Oxley Act compliance rules. • The presentation of data – i.e. not the amount of data, but the quality of its disclosure – has been criticized as not allowing the investors to perform the necessary analysis according to their methods. • Information is less granular with respect to reinsurance portfolios.
Although traditional reinsurance assumes some of the same risks now being placed in the capital markets, data quality and disclosure seem to be more of an impediment to the capital markets than to reinsurance: • Capital markets have higher disclosure requirements. This is particularly true for transactions in a Rule 144A private placement offering, and other transactions for which an offering document must be prepared. Higher disclosure requirements tend to be less relevant for the placement of reinsurance sidecar equity, where investor due diligence is more likely to focus on the sponsor's management than on its portfolio. • The capital markets are not subject to pricing cycles to the same degree as the reinsurance market, and thus do not allow investors to recover from bad transactions by increasing risk spreads for future transactions – except for sidecar equity, where a subsequent season reinstatement is standard. • Disclosure to reinsurers is not public and is provided within a long-established relationship. Thus, there may be less reluctance by primary insurers to release data. Particularly in indemnitybased transactions, substantial disclosure of internal information – often sensitive or proprietary – is required.
Granularity of US parametric wind speed data
Whereas exposure data is generally of higher quality in the United States than in Europe, obtaining parametric US wind speed data remains an impediment, as no hardened, high-density network of measuring stations currently exists. By contrast, parametric earthquake data availability in both the United States and Japan is excellent. A recent initiative by WeatherFlow and Risk Management Solutions (RMS) is in the process of building such a network, consisting of hardened weather stations specifically designed to measure hurricane-force winds up to and exceeding 140 miles per hour. A first phase of this initiative involves installing over 100 hardened weather stations in vulnerable areas in the coastal United States, based on likely storm paths and the potential for loss of property and lives. Improved parametric hurricane data will also be beneficial for risk prevention and risk underwriting.
The need for transparency is one of the important lessons learned from the current sub-prime crisis, and improvement of transparency with respect to insurance-linked securities should focus on the following two objectives: • Availability of the aggregated portfolio data needed to make an informed risk assessment. The information flow between sponsors and investors should also be improved, as this facilitates the evaluation of the issued instrument and, thus, supports portfolio management and secondary trading. • Ability to understand the transaction. This involves the clarity of summaries in offering documents as well as the detailed disclosure of cash-flow waterfall, ratings, special risk factors, business risks, etc.
The quality of disclosure has recently become more important in life insurance transactions as investors will have to rely less on financial guarantees provided by the monoline insurers, and more on their own evaluations of the assumed risks. Investors thus have a need for underwriting expertise in order to understand the insurance risks they are assuming. As of today, a degree of standardization of datareporting formats has been created by the exposure data requirements resulting from the reporting formats of the modelling firms (such as UNICEDE, the standard data format developed by AIR Worldwide Corporation). However, this standardization is limited by the differences of the formats used by different modelling firms. Furthermore, CRESTA, created by the insurance industry in 1977 as an independent organization for the technical management of natural hazard coverage, has determined country-specific zones for the uniform and detailed reporting of accumulation risk data relating to natural hazards, and has also created corresponding zonal maps for each country. The Association for Cooperative Operations Research and Development (ACORD) has also set up a working group on catastrophe exposure data standards. ACORD standards allow different companies to transact business electronically with agents, brokers and other data partners in the insurance, reinsurance and related financial services industries. They serve as a common communication method for use by multiple parties.
However, the range of securitized insurance is still somewhat limited from a diversification perspective. Even with respect to natural catastrophe risk, the scope of perils is still limited, although expanding. A number of natural catastrophes occurring in the first quarter of 2008 and causing significant insured loss were not covered by perils under any catastrophe bond. These include the earthquake at Market Rasen, United Kingdom, in February 2008, and the flood in Queensland, Australia, in January 2008.18 Also, transactions have so far concentrated on low probability/high severity risks, whereas investors have started to become comfortable with assuming lower risk layers. Increasing the transfer of risks with lower attachment probability could greatly increase the supply of insurance risk to the capital markets. There are, however, several impediments: • The availability of reinsurance capacity makes the business case for transferring non-peak and lower-layer risks to the capital markets less compelling. • There is a lack of third-party models to analyse risk, particularly non-catastrophic risk. • There is little overlap between the investor bases for investment-grade and non-investment grade insurance risk. • Where no other trigger mechanisms have been developed, only indemnity-based risk transfer is possible.
3.1.8 Cultural factors
3.1.7 Limited types of risk
The range of securtized insurance perils is still somewhat limited.
There is still a lack of common language between the insurance and the capital markets world.
Beyond natural catastrophe risk, a variety of life and non-life insurance risks has been transferred to the capital markets in recent years, including automobile insurance risk, long-term disability reserve risk, catastrophic mortality risk, the embedded value of a book of life insurance policies, redundant life insurance reserves and longevity risk.
Insurers’ lack of experience with securitization as well as a traditional insurance mindset are thought by many industry participants to pose considerable obstacles to the further development of the market for insurance-linked securities. Reflecting the relatively short history of ILS, there are still many first-time sponsors.19
The insurance world and the capital markets currently lack a common language. This begins with contract terminology and continues with the unique accounting rules for the various financial services sectors and the unique legal and regulatory treatment of certain instruments – all of which must be understood by all stakeholders despite a high degree of complexity. Sponsors are accustomed to fairly lean documentation of reinsurance agreements. Market practice has developed a very specific terminology, and disputes are solved according to such market practice. On the other hand, the practice in the capital markets is to require considerably more documentation, especially if a placement is made to investors under Rule 144A. Investors, who are typically not familiar with reinsurance terminology, require comprehensive terms and conditions. In addition, lack of familiarity can be a barrier. Capital market transactions typically involve transactional relationships with a variety of counterparties, including proprietary trading groups within large banks, hedge funds, asset managers and other non-reinsurer liquidity holders. Relationships with traditional reinsurance providers, on the other hand, often span several decades. Trust levels in these established relationships are higher (which may prove beneficial if the arranger of a capital market transaction happens
to be a reinsurer). Similarly, on the investors’ side a lack of trusting relationships was found to impede demand for insurance-linked instruments. One way to overcome such cultural impediments would be for sponsors to develop internal risk management functions that integrate traditional reinsurance and alternative risk management. However, this would require internal organizations that do not operate in “silos” with incremental decision-making20. This approach, consistent with enterprise risk management techniques, would allow sponsors to manage risk transfer more efficiently, improving capital management and profitability.
3.2 Impediments for investors
Investors are primarily interested in objective and transparent triggers, standardized documentation, liquid markets and short settlement periods. However, these needs have not yet been fully met.
3.2.1 Lack of standardization
Although basic structures now follow a standardized approach, most deals are still bespoke transactions. This lack of standardization is an impediment to growth of the ILS market in terms of both issuance and secondary trading.
Figure 9: Credit securitization – model for expansion and lessons learned
The Growth in Credit Securitization in the US$ billion
1,400 1,200 1,000 800 600 400 200
Student Loans Other HEL Equipment Credit Cards CDO Auto Other key milestones: Development started in the 1970s in the US; with national standards for documents, terms and conditions Basel I allowed/encouraged securitization Subordination and third party guarantees as credit enhancement?
Development of indices (e.g. ABX) CDOs dominate for investors in subordinate credit risk
Introduction of standardized ISDA forms (e.g. CDS for ABS)
Source: Barclays Capital, World Economic Forum analysis
The development of the credit securitization market illustrates how standardization can lead to growth (although it also demonstrates the potential for introducing systemic risks, which should be avoided in the insurance risk market). A more standardized market, with standardized products and increased transparency with respect to risks transferred and instruments traded, would increase liquidity and allow for more active portfolio management. It would also reduce transaction costs and legal risk, increase price transparency and, as a result, tighten risk spreads. To the extent this proves difficult to achieve within the securitization context, exchange-traded insurance risk contracts may achieve success as they automatically have these qualities.
triggers) allow non-insurers to sell catastrophe risk without any underlying insurance exposure but based on an objective trigger. This makes it possible for investors to hedge their ILS portfolios. In the United States, the Property Claims Service (PCS), which has existed for over 50 years, reports industry-wide property insurance losses by state and risk type from natural or man-made catastrophes in the United States causing losses of at least US$ 25 million. The PCS index is used as a trigger for cat bonds, ILWs and many catastrophe derivatives. At present, no such industry-loss indices exist in Europe nor Asia. The lack of industry-wide exposure and loss information restricts the ability of industry participants to accurately price, manage and trade natural catastrophe insurance risk. For this reason, the CFO Forum has launched an initiative to create an independent organization that will collect loss and exposure data from insurers and then provide aggregated data to insurers, reinsurers and other potential subscribers. This data-gathering effort would cover windstorm exposures and losses in Ireland, the UK, France, Switzerland, Luxembourg, Belgium, the Netherlands, Germany, Denmark, Norway and Sweden, and would be broken down by lines of business and CRESTA zones. The development of non-indemnity-based triggers also includes the Paradex Index for EU windstorms and US hurricanes, which is based on modelled industry losses, and pure parametric indices such as WindX for US hurricanes and the Carvill Hurricane Index (CHI). The United States Geological Survey (USGS) has also developed readily accessible parameters for use in earthquake indices in the United States and, to some extent, worldwide. With respect to life insurance, several longevity indices have been developed, such as LifeMetrics, launched in March 2007 by JP Morgan, and the Credit Suisse Longevity Index, launched in January 2006. Similarly, mortality indices are readily available for many developed countries.
Compared to mortgages – where national standards exist in the United States for documentation, terms and conditions – as well as to student loans and other securitized credit products, insurance policies are not standardized. Product differentiation adds complexity to transactions, increases the time spent to prepare and analyse them, and makes comparison between ILS products more difficult. On the other hand, the “industrialization” of policies is viewed with reluctance, as product particularities may also represent competitive advantages for insurers – particularly for products that do not differentiate solely on the basis of premiums. The future will show whether certain types of insurance policies will become commodities where primary insurers act as risk intermediaries while retaining some risk for themselves.
Further standardization requires transparent and objective triggers. These provide some level of comfort to investors who are unfamiliar with insurance portfolios. They can be analysed independently of an insurance book of business and are not subject to moral hazard. Additionally, parametric triggers (as opposed to indemnity
ILS products, transaction structures and documentation
A current trend is the development of catastrophe risk derivatives, such as cat swaps or futures, either exchange traded or OTC, which allow trading and assignment by any counterparty. Furthermore, derivative instruments can be collateralized or uncollateralized. Because their prices should, in theory, be lower, unfunded derivatives with comparable risk characteristics are attractive instruments for hedging cat bond portfolios. New insurance-linked derivatives include the NYMEX’s CAT Risk contracts (Re-Ex Index) launched in December 2006, the CME-Carvill Hurricane Index Futures (CHI) and the IFEX’s Event Loss Futures (binary PCS losses), launched in 2007.
type of ILS instrument. Dealers assert that the liquidity of life insurance instruments resembles that of highly structured investment grade ABS. As such, some instruments guaranteed by monoline insurers are particularly illiquid. On the other hand, liquidity for cat bonds is currently equal to or better than for similarly rated non-investment grade ABS.
“As a neutral data aggregator, we are excited to help this market evolve by increasing transparency and creating ILS specific content, bringing value from our involvement to all members of this community.”
Ben Lewis, Head of Strategy, Thomson Reuters, USA
Further standardization would simplify products and make them more accessible to a broader range of investors.
Low transparency and liquidity create inefficient markets. Pricing between different types of products, such as sidecar instruments and Rule 144A cat bonds, has not always been efficient. Increasing issue size and improving transparency would improve efficiency. Transparency is the focus of many industry efforts, including the market indices for US cat bonds launched by Swiss Re in 2006, as well as various other initiatives to make trading more transparent.
In order to reduce transaction costs and improve the comparability of instruments, industry standards should be further developed – e.g. for loss development periods (indemnity, industry loss), early redemption rights and standard trigger levels (return periods, etc.). Standardized documentation can be created in ISDA format, as shown in recent developments for cat swaps. However, because different investors prefer different instruments (equity or debt), product diversity also will be necessary. Standardization can simplify products and allow for their benchmarking, thus making them more accessible to a broader range of investors.
3.2.3 Long payout periods
Investors are interested in recovering their capital at maturity or quickly thereafter, except to the extent that they receive adequate compensation during any extension period. Losses on cat bonds with parametric triggers are determined very quickly. However, indemnity-based transactions that incur losses may have long payout periods as these losses develop following a catastrophic event. In this case, investors prefer as much transparency and information as possible on loss development. Unsurprisingly, the loss development period for a cat bond mirrors that for similar layers of excess-of-loss reinsurance contracts. An example is KAMP Re 2005 Ltd, which is the first cat bond where the investors will not get their full principal back. The
3.2.2 Limited secondary market
Today, few insurance-linked instruments are exchange traded, and the transparency of OTC trades is still improving. The ILS market also has relatively low liquidity. In part, this is because many investors are “buy and hold investors” who tend to hold instruments to maturity. However, amid the current market turmoil, trading dynamics in the secondary market have varied dramatically by the
bond was issued in August 2005, triggered by Katrina at the end of that month, and a partial write down was not achieved until December 2007. The remaining part is still outstanding. One benefit investors receive in such cases is an extended period of interest payment, based on the original principal.
3.2.4 Valuation complexity
Valuation of ILS requires specific knowledge of the insurance risk involved and an understanding of complex models. For this reasons, investors in ILS are mainly specialists – such as specialized hedge funds, other money managers and investment banks that have acquired the specific knowledge needed to evaluate ILS by hiring experienced people from the insurance industry – as well as reinsurers. Risk models are not yet used by the larger investing community because they must not only be understood but also licensed on an individual basis from the modelling firms that created them. Only certain specialized investors have obtained licenses. However, risk models are necessary to re-price instruments for secondary market trading. Compared to credit investments, the entrance level for ILS investors in terms of understanding and evaluating the underlying risk is higher. Ways to increase the understanding of ILS could include granting investors access to a more accessible and less costly basic evaluation tool for their ILS investments, such as the Risk Management Solution’s Miu platform.
Developing a better understanding of the underlying risk is particularly critical for life insurance instruments, where investors have tended to rely on financial guarantees provided by the monoline insurers. In the past, most life instruments received AAA credit ratings because they included a credit “wrap”, in which a bond insurer, typically a monoline insurer with an AAA rating, guaranteed interest and principal payments on the underlying securities. Thus, investors were insulated from direct exposure to the credit risk associated with the sponsor or the issuing company. However, embedded value securitization is similar to ABS for credit portfolios, and prone to the same issues currently affecting the ABS market. Given the recent difficulties experienced by monoline insurers, investors will want to directly evaluate the risks they are now assuming. This will require further disclosure by the sponsors. One would hope that over time, improvements in these areas will foster the development of a more mature market, one where investors are assuming the underlying insurance risk and have the ability to price such risk.
4. Conclusions and Recommendations
The convergence of insurance with the capital markets has been a topic of discussion for some years now, during which time there has been strong growth, but not the explosion that might have been expected. The World Economic Forum and its partners in this project wish to advance the debate by establishing links among stakeholders and providing them with a platform for addressing key issues. Many participants in this project aspire to increase visibility, provide renewed impetus for market development and, it is hoped, place insurance risk on the agendas of a larger, more diverse group of investors – the key to future growth. A rudimentary roadmap for the development of this market was conceived during a recent workshop and is shown below.
“Allocation to Insurance-Linked Securities has finally become an investment strategy in its own right. (Re)insurers, investment banks, intermediaries, exchanges, index providers, rating agencies and the trade press have all thrown their weight behind the asset class and it’s now being pursued by respected investment firms around the world.”
Jerry del Missier, President, Barclays Capital United Kingdom
Figure 10: Roadmap to illustrate the prioritization of solutions
Longer Term Medium Term Short Term
Develop Indu s try Lo ss Indice s Develop Mar k et Indice s S tandardized In s urance Product s S tandardized Trigger s
Broad Dialogue w ith all S ta k eholder s
Dialogue w ith CEOP S and Modeller s Common Language
S tandardized Documentation
Improve Mar k et Tran s parency
S hort Term Communication and Education • E s tabli s h a dialogue with key s takeholder s , s uch a s CEIOP S and modelling firm s • Educate tho s e unaware of or inexperienced in the ri s k tran s fer market s , including inve s tor s , in s urer s and rein s urer s • Create a common language to help capital market participant s under s tand the complexitie s of in s urance Medium Term Mar k et tran s parency • Development of market indexe s wa s ranked a s highly important and achievable in the mid-term Medium to Longer Term S tandardization • Complex ta s k s , s uch a s the s tandardization of data gathering and reporting – and ultimately, the s tandardization of in s urance product s – were rated a s long-term objective s
Source: Workshop Participants
To accelerate the convergence of insurance with the capital markets, project participants noted that sponsors and investors must both be encouraged to take a stronger interest in the opportunities this convergence trend is creating. This can be accomplished not only by making risk instruments simpler and more attractive, but also by opening up the debate on this asset class to a wider investor audience. The investors so courted must increasingly come from the mainstream investment community, rather than the specialist firms that currently dominate the market. To achieve this goal, a broad focus on educating previously untapped investor groups will be required, aided by the following recommendations: • Transaction structures should be standardized in terms of contracts, deal type and the data provided. This would both help with the accessibility to a broader investor base, while also reducing the transactional costs both in terms of arranger fees (lawyers, accountants, etc) and the time required to complete deals. • Transactions must be made more transparent, through disclosure by the sponsor of better data on the risks being transferred. This solution aims to address both the issue of trust between the sponsor and investor, as well as aiding market communication more generally. However, it will require a broad consensus across the insurance
industry to support this goal, and could require significant investment in back office data collection processes and systems. Equally there is a need to educate investors about the basic principles of insurance risk. • Rating agencies, accounting authorities and regulatory bodies must develop the capability to evaluate the risks transferred and the treatment of basis risk. This will require all parties in the transaction chain, including modelling firms, to enhance their current methods. Appendices B and C include summary tables of both the proposed solutions generated by the project participants and current initiatives. These tables comprehensively illustrate the project’s findings.
“Although this topic has been top of mind for some years, with the current turmoil in the markets, this initiative demonstrated the collaborative efforts of the Partners in creating more visibility into the potential for future growth of this market.”
Jack J. Ribeiro, Managing Partner, Global Financial Services Industry, Deloitte, USA
Figure 11: Phases of the insurance convergence project
Project Partners & Workshop Participants
This report marks the conclusion of the first phase of the insurance convergence project. The impetus will now pass to the identified stakeholder groups in the project’s second stage. This phase will aim to build off existing initiatives from project partners, as well as efforts by external parties to drive change, using the alignment shown below. The Forum and the project team welcome the participation of all stakeholders who would like to further the progress of these recommendations. Interested parties should contact one of the report authors.
Offers of Help
2nd Stage Project Initiatives
Source: World Economic Forum
Appendices Appendix A: Project Description
This project was first suggested by the Financial Services Governors at the World Economic Forum Annual Meeting 2007, under the chairmanship of James J. Schiro, CEO of Zurich Financial Services. At that session, a number of Governors expressed concern about the need to make insurance risk more transparent and tradable. After various exploratory discussions and scoping exercises the project was officially launched in late 2007. The project was divided into four phases: 1) Information gathering: The project team interviewed over 50 market participants from various organizations (these are listed in the acknowledgements on p. 41). 2) Analysis: The raw data was reviewed by the project team. Invaluable feedback was also provided by industry representatives. 3) Synthesis: An initial analysis was presented to an industry workshop at the Forum’s 2008 Annual Meeting in Davos. Extensive feedback was obtained. 4) Recommendations: Based on the feedback at the 2008 Annual Meeting, the project team held a workshop in London in April, where we received additional feedback and preliminary recommendations.
Represented stakeholder groups • • • • Academics Insurers Re-insurers Intermediaries (advisors, lawyers) • • • • • Investment banks Investors Modelling firms Rating agencies Regulators
The goal of the insurance convergence project is to develop actionable recommendations to promote the continued development of liquid capital markets for insurance risk. Success will be measured against two criteria: • Have the recommendations of this report been acted upon by industry participants? • Will future market participants view these recommendations as having significantly contributed to the further development of the Insurance risk market?
An overview of these activities is shown below. Figure 12: Stages of the insurance convergence project
• Identification of key parties
• Individual meetings
• Davos session
• London Workshop • Publication of Report
• Interviews • Review of Barriers
• Review of solutions
• Strive for buy -in from Stakeholders • Facilitate transfer of ownership
Source: World Economic Forum
Appendix B: Findings
The summary tables below illustrate the project’s findings, including proposed solutions to the impediments identified in this report. Table 1: Culture, Complexity, Cost
Insurer’s lack of experience with securitization; traditional insurance mindset Lack of common language
• Education; publications on existing transactions
• Develop common language
Dependency on and complexity of cat models; dependence on data for valuation Management of basis risk
• More frequent data updates • Some sharing/ greater access to models
• Develop internal models to manage basis risk
Lack of standardization
Complexity of transactions
• Develop trigger indices (industry loss or modelled industry loss) • Standardize triggers (parametric, industry loss, unified mortality tables in the United States) • Standardize insurance products (e.g., term life insurance) • Launch multistakeholder discussion, including modelling firms, rating agencies, accounting firms and ISDA, for the development of standardized documentation for event scenarios and certain other structural transaction features
No standardized contracts
Limited secondary market
Limited secondary market; market not yet efficient
• Standardize instruments • Increase market transparency by working with information providers, portfolio managers, etc., and by developing indices • Develop derivative instruments
Time consuming and expensive
Transaction cost; extensive management involvement in first transaction
• Use repeated issues and shelf offerings; increase deal sizes • Standardize documentation
Table 2: Data availability and transparency
Impediments Inconsistent data metrics
Inconsistent data collected in Europe Insufficient data collected in Europe
• Standardize data metrics and industry standards • Standardize insurance products • Improve data-reporting processes and formats
Poor data quality
Insurer data is not as clean or accurate as it could be
• Set quality standards for data reporting • Launch insurer-wide initiative to clean up data
Poor data disclosure
Insurers are reluctant to provide portfolio data, often for competitive reasons
• Improve transparency and technical availability of non-proprietary data • Provide a common framework for data disclosure
Lack of track record
Little historical data for insurance-linked securities
• No solution as such, need time and adequate volume of transactions • Create a robust data-collection and publishing system
Lack of Industry loss indices
Lack of Industry loss indices in Europe and Asia
• Develop such indices (definition and data contribution by the industry; aggregation by an independent organization) • Develop loss indices for other types of risk
Lack of granular parametric data
Lack of US granular parametric data
• Build hardened network of wind-measuring stations in the United States and ensure data delivery
Table 3: Regulation, accounting and credit ratings
Impediments Treatment of basis risk
Limited solvency credit for nonindemnity-based risk transfers
• Develop robust methods for evaluation of basis risk and allocation of capital to support it (principles-based reserving is a prerequisite in the United States) • Encourage third parties to warehouse basis risk • Persuade rating agencies and legislators/regulators to establish partial solvency credit for non-indemnity-based risk transfer
High complexity of transaction structures as a result of taxation and accounting rules (consolidation rules; treatment of reinsurance vs. derivatives)
• Provide tax exemption for reserving for onshore SPRVs (proposed for the United States, but topic is highly sensitive) • Clarify accounting and tax treatment for parametric risk transfer (economic substance over form)
Inconsistent rating treatment
Inconsistencies in rating treatment of risk transfer (instruments vs. credit rating of sponsor; rating of monoline reinsurers vs. rating of traditional reinsurers)
• Encourage rating agencies to set transparent and consistent requirements
Inconsistent rules for acceptance of SPVs as reinsurers (jurisdiction, capitalization)
• Develop consistent rules
Below investment grade
Many transactions are not investment-grade rated
• Potential for alternative rating strategies
Appendix C: Current Initiatives
Table 1: Ratings and regulation
Title of Initiative
Change from a rules-based approach to regulation to a principals-based approach, allowing greater flexibility for insurers Specify the financial reporting for insurance contracts
IFRS project on insurance contracts Implementation of reinsurance directive in the European Union Principles-based reserving in the United States
Acknowledgement of EU reinsurance SPVs)
Shift from rules-based to principles-based reserving
Table 2: Standardization and transparency
Title of Initiative
DescriptionTitle of Initiative
ACORD standards allow different companies to transact business electronically with agents, brokers and other data partners in the insurance, reinsurance and related financial services industries. They serve as a common communication method for use by multiple parties Exposure data reporting formats required by modelling firms (e.g., UNICEDE, developed by AIR)
Standardization and communication
ACORD working group on catastrophe exposure data standards.
UNICEDE data reporting format
Transparency & communication
Thomson Reuters launching initiative to Insurance Linked Securities Initiative aggregate and integrate ILS data for the capital markets
WeatherFlow Hurricane Mesonet in the United States
Private networks of hurricane-hardened weather stations
Table 3: Data Transparency
Title of Initiative
An independent organization for the technical management of natural hazard coverage. One of CRESTA's main tasks is to determine country-specific zones for the uniform and detailed reporting of accumulation risk data relating to natural hazards and to create corresponding zonal maps for each country Based on industry exposures, such as RMS’s Paradex WindX for US hurricane; Carvill Hurricane Index (CHI) CRO Forum/ European windstorm industry loss index; Re-Ex Index, based on US industry losses reported by PCS LifeMetrix Mar. 2007, Credit Suisse Longevity Index, Jan. 2006)
Modelled industry loss indices Pure parametric indices
Table 4: Education
Title of Initiative
Swiss Re Sigma, and numerous publications by other firms Numerous conferences, etc.
Periodic publications providing insight
New project initiative
Further education needs to be directed outside of the same group – to reach pension funds and other noncore investor types
Table 5: Development of Indices
Title of Initiative
NYMEX CAT Risk contracts (Re-Ex Index) CME Carvill Hurricane Index Futures (CHI) IFEX Event Loss Futures
Developed in December 2006
Binary PCS losses, developed in 2007
“Sigma No. 7/2006: Securitization – New opportunities for insurers and investors”. Swiss Re, 2006. http://www.swissre.com/resources/fc02f680455c6b 548a5fba80a45d76a0-sigma7_2006_e.pdf “Reinsurance and International Financial Markets (chapter 4: Insurance securitization and the capital markets)”. Group of 30, 2006. http://www.group30.org/pubs/pub_1320.htm “The Catastrophe Bond Market at Year-End 2007”. Guy Carpenter, 2008. http://gcportal.guycarp.com/portal/extranet/popup/p df/GCPub/Cat%20Bond%202006.pdf Swiss Re Special Report: Beyond Cat Bonds. Swiss Re. Zurich, December, 2007. Pennay, R. “Market loss index for Europe – expanding capital market capacity”. Swiss Re, 2007. http://www.swissre.com/resources/afa63900455c7a b8b250ba80a45d76a0-Publ07_FR_Market_loss_ Europe.pdf Modu, E. “Gauging the Basis Risk of Catastrophe Bonds”. AM Best, September 2006 Gatzert, N., Schmeiser, H., Toplek, D. “An Analysis of Pricing and Basis Risk for Industry Loss Warranties”, Working Paper on Risk Management and Insurance No. 43, Institute of Insurance Economics, University of St. Gallen, June 2007
Cummins, D. J., “Securitization of Life Insurance Assets and Liabilities”, Wharton, 2004 “Catastrophe Insurance Risk – The role of RiskLinked Securities and Factors Affecting Their Use”, United States General Accounting Office, September 2002 Banks, E., “Alternative Risk Transfer: integrated risk management through insurance, reinsurance, and the capital markets”, Wiley Finance Series, 2004 Lane, M. (ed.), “Alternative Risk Strategies”, Risk Books, 2002 Gibson, R., Habib, M., Ziegler, A., “Why Have Exchange-Traded Catastrophe Instruments Failed to Displace Reinsurance?” http://ssrn.com/abstract=964916
We are particularly grateful to the following industry partners of the World Economic Forum (and their representatives on the project steering and operating committees) for their oversight, feedback and management of this project: Allianz Barclays Capital Deloitte (knowledge partner) State Farm Swiss Re Thomson Reuters Zurich Financial Services (which chaired this project)
We would also like to acknowledge the following companies and organizations: AIR AM Best AXA Equecat FASB Fermat Capital Financial Services Authority Fitch G30 Working group on Securitization Generali Goldman Sachs Guy Carpenter IAIS Lehman Brothers London School of Economics Moody's Munich Re New York State Regulator Risk Management Solutions Sidley Austin Standard & Poor’s University of St Gallen University of Zurich University of Pennsylvania
In an indemnity transaction the insurer is reimbursed for actual losses. In a parametric transaction the payment is based on an index and a formula. For example, in the case of hurricane damage, reimbursement would be based on a formula saying (simplistically) that if a storm of strength x strikes region y, for time period z, the payment will be dollar amount a. This may or may not correspond to the actual loss. See box on page 17: Two key differences between the ABS and the ILS markets. Basis risk is the risk associated with an imperfect hedge. In quota share reinsurance, the reinsurer assumes a specified percentage of each risk in a certain class of business. In surplus reinsurance, the reinsurer assumes a specified amount of each insurers losses that exceeds a specified retention, up to an overall limit. The Catastrophe Bond Market at Year-End 2007. February, 2008. New York: Guy Carpenter. p.16. The Catastrophe Bond Market at Year-End 2007, p.15. In this regard, see: Gauging the Basis Risk of Catastrophe Bonds. September 2006. New York: AM Best; and An Analysis of Pricing and Basis Risk for Industry Loss Warranties. June 2007. St Gallen: Centre for Finance at the University of St Gallen. EU Directive 2005/68/EC. EU Directives 2002/13/EC, 2002/83/EC and 2005/68/EC (Solvency I). A different regulatory treatment of traditional reinsurance and alternative risk transfer instruments is mainly an impediment where the premium index is the constraining factor for the minimum solvency margin. Amended Solvency II Proposal of the Commission of the European Communities, COM (2008) 119 final. CEIOPS. Call for Advice on QIS4, Annex: QIS4 Technical Specifications (MARKT/2505/08). March, 2008; and QIS3 Technical Specifications, Annex B (CEIOPS-FS-13/07). April, 2007. EU Directives 2002/13/EC, 2002/83/EC and 2005/68/EC (Solvency I).
If contractually agreed, reinstatement is allowed under traditional excess loss reinsurance contracts. After the insured’s claims exceed the limit, the insured can reinstate the reinsurance coverage by paying a reinstatement premium. Banks, Alternative Risk Transfer: integrated risk management through insurance, reinsurance, and the capital markets”, 2004, p. 37. Catastrophe Bond Market at Year-End 2007, p. 33. The Catastrophe Bond Market at Year-End 2007, p. 15. Swiss Re. For example, 11 out of the 27 sponsors of cat bond transactions in 2007 were first time sponsors. The Catastrophe Bond Market at YearEnd 2007, p. 27. Banks, “Alternative Risk Transfer: integrated risk management through insurance, reinsurance, and the capital markets”, 2004, p. 194.
The World Economic Forum is an independent international organization committed to improving the state of the world by engaging leaders in partnerships to shape global, regional and industry agendas. Incorporated as a foundation in 1971, and based in Geneva, Switzerland, the World Economic Forum is impartial and not-for-profit; it is tied to no political, partisan or national interests. (www.weforum.org)
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