Insurance Linked Securities

Christoph Weber
Insurance Linked Securities

GABLER RESEARCH
Christoph Weber
The Role of the Banks
With a foreword by Prof. Dr. Rainer Stöttner
GABLER RESEARCH
Bibliographic information published by the Deutsche Nationalbibliothek
The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie;
detailed bibliographic data are available in the Internet at http://dnb.d-nb.de.
The present thesis of the author Christoph Weber was accepted by Fachbereich Wirtschafts-
wissenschaften at University of Kassel under the title "The Role of the Banks in the Alternative
Risk Transfer of Insurance Companies through Capital Market Securitisations" in order to obtain
the academic degree Doktor der Wirtschafts- und Sozialwissenschaften (Dr. rer. pol.).
First Reviewer: Prof. Dr. Rainer Stöttner

Second Reviewer: Prof. Dr. Kurt Reding
Oral Examiners: Prof. Dr. Georg von Wangenheim

Prof. Dr. Holger Karrenbrock
Disputation took place in Kassel on May 12th, 2011.
1st Edition 2011
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Foreword
The global ecooomy has been bit repeatedly by finaneial crises during the last two aod
a half decades. Ecooomists are wandering abaut the reasons of the rna1fooetioning of
finaneial rnarkets. Nurnerous potential reasons have becn advaoccd. For exarnple, spcc-
ulators are looked upon as mayor suspects. There basically "evil" activities seem to be
the predorninant driving force produeing instability in financial rnarkets aod real rnar-
kets as weil, far !hat matter. The recent subprime erisis and its global ramifieations are
laken as evidence for the destabilizing effects of finaneial speculation. Sceptieism sur-
rounding money and financial mark.ets goes back to classical economists and was even
reinfareed by neoc1assical aod monetarist theories. The financial sector, in general,
was supposed to put a vell upon the real ecooomy thus eoocealing the really important
features of the economy. Moreover, the financial sector is supposed to be a source of
inflation thus putting additional destabilizing pressure on the real economy.
James Tobin arnplified the list of negative impacts to be derived from the finaocial
sector 00 the basis ofbis "depletion hypotheses": This hypothesis holds!hat the unpro-
ductive finaocial sector deprives the real scctor from finaneial resources that otherwise
eould be invested produetively, e.g. by building produetion plaots. Tobin argues !hat
the seduetive power of the finaocial sector offering a great vatiety of seerningly bigh-
return assets withdraws financial resources from the real seetor thus reducing growth,
employment and social welfare. He further argues that the financial sector, by luring
investors with the promise of high-yield and low-risk investment opportunities, will
redirect human resourees away from the real (productive) sector into the (unproductive)
financial sector. Making mooey by engaging in speculative activities in the finaocial
rnarket seems to be More attractive thao dedieating oneself to productive and maybe
arduous wark in the real sector economy.
vi
Moreover, during the most recent financial crisis the process of financial innovation
was identified as a potential source of iostability: Fioancial innovation can be observed
as "new" (innovative) financial products bot it can also appear as innovative strategies
of iovesting and risk management io financial markets. Mayor destabilizing potential
was presnrned to go along with the so called structoring of financial products and, io
particular, with the secutitization process. Asset Hacked Secutities (ABS) is a case io
poiot. In general, they are launched by Special Purpose Vehic1es (SPVs) which are not
easily understood and playa rather obscure role. Tbe lack of transparency in financial
markets leads to a severe loss of confidence io the market
Tbe broad criticism of financial markets leads to an underestimating of the doubtless

merits of structured finance and securitization. Fioancial markets take care of gatheriog
and allocating financial resources efficiently. At the same time they are also supposed
10 allocate risk. in an efficient way. This means that efficient risk allocation is supposed
to be iodispensable for optintiziog social welfare. Tbus, it seerns to be pretty unfair
10 point the finger at structured finance, securitization and at derivative instruments in
general, if it comes to find devices responsible for the repeated outbreak of financial
crises. It seems cIear that the introducti.on of new innovative financial products cannat
proceed free from operational and conceptual flaws. It is no surprise, either, that these
products sometimes are put to uses they uriginally were not iotended for. Take options
as an example: Tbey may be used as hedging iostruments; that is what they have been
devised for originally. Hut they can also be used as a speculative vehicle enhanciog risk
iostead of curbiog it This may be qua1ified as a perverted application, bot it should
be clear that without the existence of speculators a hedger generally could not find the
counterparty necessary for arrangiog risk protection or even risk elimioation. It may
happen that two hedgers are offering risk protection to each other so the iotervention of
a speculative agent is dispensable. But there is DO guarantee of available risk protection
in a speculation-free environment.
It is a well-known fact that without the availability of proteetion agaiost risks io

real-market or financial-market transactions agents would canceI many economic ac-
tivities all together. This fact gives a legitimate foundation to the iosurance industty.
Insurance cornpanies, by offeriog proteetion agaiost a great variety of insurable risks
and chatging moderate premiurns, pave the ground for engaging io the production of
goods and services. Without adequate risk proteetion many of these activities would
not be undertaken. Good exarnples are risks of liability and risks of material darnage,
for exarnple by fire or theft. It is also a well-known fact that many essential and higbly
darnaging risks are not covered by any iosurance cornpanies. Coverage is offered only
for risks that show no correlation - or only a low-Ievel correlation - between the iosured
clients. So called speculative or cmnulative risks are higbly corre1ated and thus are
excluded from coverage.
vii
This means !hat protection against the risk of unemployment or the risk of losing
money in case of a stock market crash will not be insured. Unemployment risk gener-
ally is covered by national ageneies funded by the national budget The risk of price
change, for example the change of stock prices or interest rates, can only be covered on
the capital market itself. The market has created a broad varlety of instruments, deriva-
tive instruments in particular. They offer the protection denied by insurance companies.
To be sure: Speculators are the agents offering this protection. This constitutes sort of
a financial market paradox: Allegedly harmful speculators seeking unjustified profits
by asking money for dning nothing turn out to be the vital pillars on which soeial and
economic welfare rests.
It is DO surprise that this sort of competition is not welcomed by insurance com-

panies. They dislike being identified as business partners that refuse to contract when
things get tough. And, of course, they do not want to leave the ground to specula-
tors who on average seem to earn considerable profits. Thus, insurance companies are
fiercely searching for possibilities of somehow tuming risks !hat usually are considered
as uninsurable into insurable risks, even at the expense of engaging in same sort of
cooperation with speculators. The idea was spurred further by the insight that cooper-
ating with speculators ntight be a good thing even in those segments of the traditional
insurance business that tend to get out of control in case of terrorist attacks and natu-
ral catastrophes. There is no doubt !hat the insurance industry has discovered capital
markets as powerful partners for their own business. To put it differently: The capital
market tumed out 10 offer reinsurance proteetion to primary insurers.
The idea to use capital markets as a cushioning mechanism bad produced mani-
fold instruments and risk transfer schemes. They have come to be potential suspects
for causing the recent financial crises that fiually deterlorated into agiobaI econontic
crisis of forntidable dimensions. It is no surprise that the collapse of global econontic
activity led to a high degree of scepticism with respect to those innovative products and
schemes. Banks offering a helping band in developing the necessary instruments for
an alternative risk transfer understandably came under pressure because public opirtion
turned its back on thern. Moreover, they put themselves under pressure because they
used these instruments abundantly for speculative trading on their own account Thus,
they not ouly got b1arned for inventing the "mass destruction devices" - a term !hat
is atrributed to Warren Buffett - but they themselves turoed out to be victirns of their
seentingly noxious products. Nevertheless, banks have the necessary expertise and for
that reason will playavital role in establishing an alternative risk transfer process from
insurance companies to the capital market. At the same time banks could take advan-
tage of opportunities to offer complementary services to insurance companies in the
traditional field of Investment Banking.
viii
In bis research study, Mr. Weber analyzes the risk transfer of the insurance sec-
tor into the capital markets using Insuranee Linked Securities (ILS). Special foeus is
on the roJe of the banks in the process. After the introduction, the second ehapter of
the study starts by describing the basic insuranee economies like the definition of risl<,
insuranee mathematics, asset-liability-management, and asset management Chapter
three explains the different types of insurance eompanies. Methods of risk transfer are
the topie of the fourth ehapter. While traditiona! risk transfer is taking place within
the insurance sector, the different methods of Alternative Risk Transfer (ART) are ef-
feeted among primary insurers or reinsurers and the eapital markets. ART ean be used
in the form of risk carriers, finite solutions, side-cars, derivatives traded at exehanges
or over-the-eounter, contingent capital, and multi-risk produets. A special form of ART
are ILS as deseribed in the fifth ehapter of the study. ILS are used to transfer risk from
life insurers, but also from non-life insurers. Life-related ILS are used to cover US
reserve reqnirements, to pre-finance earnings or to transfer pandemie risk. Catastrophe
bonds are the most popular form of non-life-related ILS. Tbey cover perils like storms,
earthquakes or wildfires. Collateralized debt obligations (CDOs) as a special form of se-
curitization are analyzed further. CDOs are used to bundle subordinated debt financings
or reinsurance claims. Chapter six analyzes interviews with market participants. The
interview partners are eategorized into the following stakeholder groups: Aeeountants
and regulators as the first group emphasize the differences of the European and US sys-
tems. Value-at-risk and expeeted shortfall being their main risk measures are therefore
descrlbed in detail. Insurers and reinsurers forming the second group explain their mo-
tivations to sponsor ILS, especially in the context of their asset-liability-management.
Duration and eonvexity as the main instruments to measure interest rate sensitivity of
assets and liabilities are described. Further, the usage of hybrid bonds for eapital man-
agement is explained. Rating agencies, risk modelers, and monoliners form th.e third
sponsor group. Tbey are playing an iruportant role in standardizing products in eapital
markets. Tbeir approach, especially their way of modeliug risk is analyzed. Investors,
the fourth stakeholder group are interested in non-eorre1ated retums and a bigh level of
transparency. Th.ey need effective trigger mechanisms to avoid adverse selection and
Moral hazard. Arrangers as the fifth stakeholder group are obliged to provide ao ef-
fective prieing of ILS, especially compared with the reinsuranee produets and to find
appropriate investors in the products. Whenever adequate, the interviews were used to
explore the relevance of banks for the stakeholders. Chapter seven of the study ana-
Iyzes an onliue-interview providing an overview of the market during the ehallenged
environment at that time. Further, participants were questioned about their function in
the ILS market, its prospects, and the role of the banks. Caused by the financial crisis
the market was changing rapidly and extensively from elosing of the interview phase
end of December 2008 until fina1izing the study end of June 2009 as recapitu1ated in
Chapter eight. The work ends with Chapter nine ineluding the sununary aod eonelusion.
ix
Weber's analysis of alremative risk transfer systems clearly closes a gap in the field
of insurance and capital markets. The subject treated is of higb practical aud theoretical
siguificauce. Risks of all sorts seem to be steadily increasing. Marke! price volatility
has reached an uuprecedented level, catastrophe and terrorist risk also has grown up to
dimensions that cannot be handled by insurers alone. So it is a logical step to include
capital markets as partners of the insurance industry in order to spread risks on a large
seale basis. Tbe role capital marke!s cau play in the managements risks that are difficult
to insure or not insurable at all on the basis of traditional insurance standards has Inng
been ignured. Tbe work of Weber must be seen as one important step to a better under-
standing of Ibis role. Weber shows that capital markets can offer hedging opportunities
far beyond the scope that agents have been farniliar with so far: Capital markets cau
help to allocate risk to a much bigger extent than could be expected so far. They virto-
ally can act as powerful reinsurers and thus complement reinsurance activities emerging
from the insurance sector itself.
Tbe pioneering work of Weber provides a convincing aud straightforward analysis

of the possibilities to transfer risks from insurance companies to the capital market. It
is shown how the transfer business can be supported by banks and what role can play
instruments created on the basis of securitization. It is quite remarkable that already
many practical schemes aud devices have been developed on a trial aud error basis by
insurers and banks. This process has been going on practically unobserved by scientific
researchers. Weber's stndy pinpoints the research gaps and hints at some possible ap-
proaches to elose these gaps. It is a "must" reading for practitioners as weIl as students
and researches of insurance and finance.
Kassel, in May 2011
Rainer Stöttner
Preface
Having spent more than Iwenty years in banking practice, mostly in credit analysis and
loan syndieation, I was entrusted to manage the investments of my employer in the
global insuranee and reinsurance sector.
Rigbt from the very first day, I found myself interested in Insuranee Linked Secu-
rities, a relatively new method to place insuranee risk into the eapital markets througb
the usage of banking produets.
After three years of eolleeting information I presented my project of a doctoral the-

sis 10 universities. University of Kassel tumed out to be an excellent choice and I would
like to thank Professor Slötlner for bis support of my practice-oriented approach.
After having refreshed my theoretical knowledge of modem investment manage-

ment and the techniques of traditional insurance I reinsurance, I started to attend COD-
ferences in order to gain up-to-date knowledge and establish eontacts with market par-
tieipants.
Apart from the different insurance risk types covered, the hroad variety of profes-
sionals, ranging from insurance, banking, legal, rating agencies, risk modelers to super-
visors, malres this market so interesting.
In the middle of the expert interview phase the eapital market crisis was accelerated
by the sudden eollapse of Lehman Brothers, one of the important investment banks in-
volved in insurance linked products. Tbe event oceurted during my stay in the United
States. I wisb to express my sincere gratitude to all interview partners for their warm
xü
reception and openness despite the extraordinary time of stress they were facing .t that
time.
The situ.tion in the global e.pital markets deteriorated further after my return to
Europe in Oetober 2008. Sinee its strengths and weaknesses became obvious, the per-
eeption of insuranee linked securities as • slowly growing niehe market bas ebanged to
• sougbt range of products. My online-survey was earried out during • time of great
uneertainty and I got the opportunity to inqnire the professionals for !beir opinion re-
garding the most eballenging issues .t th.t time. I would like to take this opportunity to
sincerely thank all respondees for their support.
Fortber, I would like to thank my employer Landesbank Baden-Würt1emberg and

my eolle.gues for their support. This thesis would not have been possible without the
eneouragement of my wife Susanne and the p.tience of my family.
Stuttgart, in M.y 2011
Christoph Weber
Contents
1 Introduction 1
1.1 Problem description and definition I
1.2 Objeetive of the thesis. . . . 3
1.3 Methodology . . . . . . . . 3
2 Insurance Business and its Risk S

2.1 Risk and lnsuranee . . . . . . . . . . . . . . . . . . . 5
2.1.1 Classifieation of risk faced by lnsurers . . . . . 6
2.1.2 Classifieation of risk by insuranee regulators 7
2.1.3 Peril and hazard . . . . . . . . . . . . . 7
2.2 lnsuranee . . . . . . . . . . . . . . . . . . . . 9
2.2.1 Tbe basies of insuranee mathematies. . 9
2.2.2 Economical versus insured losses . . . 15
2.2.3 Tbe Crlteria of insurability . . . . . . . 16
2.2.4 lnsurance, gambling and speculation. . 17
2.2.5 Evaluation and qoantification of losses . 18
2.3 Risk management . . . . . . . . . . . . . . . . 18
2.3.1 Objectives of risk management. . . . . 18
2.3.2 Steps ofthe risk management process 19
2.3.3 Cbanges in risk management due to Solvency 2 .. 21
2.4 Risk and return . . . . . 23
2.4.1 Insuranee pricing . . . . . . . . . . 23
2.4.2 Reserves . . . . . . . . . . . . . . 24
2.4.3 Investments of the insuranee sector 28
3 Tb. Insurance Industry 3S

3.1 Primary lnsuranee . 36
3.1.1 Non-life insurance 38
3.1.2 Life insurance. . . . 40
3.2 Credit insuranee and surety . 41
3.3 Monoline insuranee . . . . . 43
xiv CONTENTS
3.4 Reinsurance . . . . . . . . . 45
3.4.1 Non-life reinsurance 47
3.4.2 Life reinsurance 51
4 Methods of Risk TrBDSl'er SS

4.1 Traditional melbods . . . . . . . . . . . 55
4.1.1 Reinsurance and retrocession. . 55
4.2 Alrernative risk transfer . 65
4.2.1 Risk carriers . . . . . . . . . . 66
4.2.2 Fioire solutions . . . . . . . . . 70
4.2.3 Multi-risk products . . . • • . . 73
4.2.4 Derivatives . . . . . 76
4.2.5 Contiugent capital . . . . . . . 84
4.2.6 Reinsurance side-cars. . . . . . 87
4.2.7 Insurance-reIared securitisation 89
4.2.8 Summary and evaluation of ART instruments 90
S lnsurance LiDked Securilies 9S
5.1 Securitisation . . . . . . . . . . . . . . 95
5.2 Life insmance securitisation . . . . . . 98
5.2.1 Reserve funding securitisation . 98
5.2.2 Value-in-force securitisation .. 102
5.2.3 Residual commission securitisation 106
5.2.4 Risk transfer securitisation . . . . . 107
5.2.5 Life settlement securitisation . . . . 110
5.2.6 Summary and evaluation of life n.s 114
5.3 Non-life insurance securitisation . . . . . . 117
5.3.1 Catastrophe bonds . . . . . . . . . 117
5.3.2 Non-catastrophic insurance securitisation 120
5.4 Insurance relared CDOs . . . . . 124
5.4.1 Funding CDO pools . . . . . . 124
5.4.2 Catastrophe bond CDOs . . . . 125
5.4.3 Reinsurance receivable CDOs . 127
5.4.4 Summary and evaluation of non-life n.s . 130
6 Tbe Perspectives of the Stakeholders 133
6.1 Accountants and regulaturs . . . . . . . . . . . . . . 133
6.1.1 Tbe global approach to standardisation . . . 133
6.1.2 Inremational Financial Reportiug Standards . 134
6.1.3 Supervision - Ibe changes due to Solvency 2 . 136
6.1.4 Quantitative assessment by means of PiIIar I 137
6.1.5 Digression: Value at Risk and Expecred Shortfall 138
6.1.6 EU-barmonisation effects in respect oflLS . . . 148
CONTENTS xv
6.1.7 Accounting and supervision in the US . . . . . . . . . . . . . 152

6.1.8 Outlook to further reforms . . . . . . . . . . . . . . . . . . . 158
6.1.9 Results of the interviews regarding accountants and regulators 161
6.2 Insurers and reinsurers as sponsors . . . . . . . . . . . 167
6.2.1 The integrated management of risk and capital 167
6.2.2 Capital management . . . . . . . . . . 168
6.2.3 Asset-Liability-Management.......... 168
6.2.4 Hybrid bonds and risk securitisation . . . . . . 177
6.2.5 Results of the interviews regarding sponsors. . 184
6.3 Rating agencies and risk mode1ers . . . . . . . . . . . 190
6.3.1 Rating agencies' services. . . . . . . . . . . . 190
6.3.2 Importance of enterprise risk management and capital for in-
surer's ratings. . . . . . . . . . . . . . . . . . . . 191
6.3.3 The rating ageneies' rating methodo1ogies for 1LS . . . . . . . 203
6.3.4 Riskmodeling companies' services . . . . . . . . . . . . . . . 208
6.3.5 Results of the interviews regarding rating ageneies, risk mode1-
ers, and monoliners . . . . . . . . 215
6.4 Investors........................... . 223
6.4.1 General market environment . . . . . . . . . . . . . 223
6.4.2 Convergence of investor's and sponsor's interest . .224
6.4.3 1LS as zero-beta assets . .224
6.4.4 Pricing and reloms . . . . . . . . . . . . . . . · 225
6.4.5 1LS triggers . . . . . . . . . . . . . . . . . . . .230
6.4.6 Results of the interviews regarding investors . .234
6.5 Arrangers of ILS . . . . . . .244
6.5.1 Banks . . . . . . . . . . .245
6.5.2 Reinsurance brokers .. .247
6.5.3 Reinsurance companies . .248
6.5.4 Market . . . . . . . . . .249
6.5.5 Pricing of 1LS. . . . . . . ..... .250
6.5.6 Effects of the crisis and expected measurements .. · 252
7 ILS Ooline Survey 2SS

7.1 Methodology . . . . . . . . · 255
7.1.1 Basic questions . . . · 256
7.1.2 Market environment · 257
7.1.3 About ILS . . . · 261
7.1.4 Corporate level . · 263
7.1.5 The banks' role . · 263
7.1.6 Final questions . · 265
7.1.7 Sununary of the results of the 1LS online survey. . · 268
xvi CONTENTS
8 Recent Developments 269

9 Summary and Conclusion 273
List of Figures
2.1 Sampling distribution versus sampling size. . . . . . . . . 15

2.2 Individual average underwriting risk faced by the insurer . 16
2.3 The risk management process. . . . 20
2.4 The three pillars of Solvency 2 . . . . . 22
2.5 The proposed framework for Pil1ar 1 . . 23
2.6 Flow of funds of an insurance eompany 26
2.7 Prospective reserve of an ordinary life insurance . . 27
2.8 Asset elasses: Limitations and reported figures - USA I EU 31
3.1 Insuranee penetration in the global economie regions . 36

3.2 Distribution of non life premiums in the USA 2006 39
3.3 Credit insuranee and surety premiums by regions . 42
3.4 Cessions to global reinsuranee eompanies 2007 46
3.5 Frequency of eatastrophes 1970-2008 . . . . . 48
3.6 Severity of catastrophes 1970-2008 . . . . . . . 50
3.7 Life-expectancy at birth in different eountries . 52
4.1 Reinsurance and retrocession . . 56

4.2 Quota reinsuranee . . . . . . . . 60
4.3 Surplus reinsurance . . . . . . . 61
4.4 Exeess of loss reinsurance for losses > USD 1 mln 63
4.5 Global market far !arge corporation risk transfer produets . 65
4.6 Alternative forms of risk transfer . . . . . . . . 66
4.7 Number of eaptives in the different locations . . 67
4.8 Strueture of a single solution 69
4.9 Finite solutions . . . . . . . . . . . . . . . . . 71
4.10 Multi-risk products . . . . . . . . . . . . . . . 74
4.11 Derivative instruments used in the finaneial market 77
4.12 The fourbasie positions in options . 78
4.13 Contingent eapital solutions .. 85
4.14 Hypothetieal side ear structure . . . 88
xviii UST OF FIGURES
4.15 Spectrum of risk transfer instruments . . . . . . . . . . . 90

5.1 Structural cash flows of a Collateralised Loan Obligation 96
5.2 ILS capital issued and outstanding sinee 1994 . . . . . . 97
5.3 The effect of XXX on long tenn reserves of life insurers 99
5.4 Hypolbetical XXX securitisation . . . . . . . . 101
5.5 XXX Issues of Ibe US life insurance industry . 102
5.6 Value-in-force securitisations sinee 1998 . . . . 104
5.7 Simplified value-in-force securltisation . . . . . 105
5.8 Residual commission securitisation since 1997 107
5.9 The LI transaction ofHannoverRe . . . . . . . 108
5.10 AXA shelf programme lOsiris transaction structure . 109
5.11 Risk transfer securltisations since 2003 . 110
5.12 Simplified life-settlernenl securitisation 111
5.13 Life-settlemenl securitisations . . . 113
5.14 Cal bond issues sinee 1994 . . . . . . . 117
5.15 Simplified structure of a cal bond . . . . 118
5.16 Simplified structure of Ibe AXA securitisation SPARC 121
5.17 Crystal credil risk securitisation . . . . . . . . . . 123
5.18 Simplified structure of Ibe Dekania Europe 11 CDO 125
5.19 Simplified structure of Ibe Fremantle CDO . 127
5.20 Trancbing structure ofthe Fremant1e CDO . 128
5.21 Structure of the Merlin CDO . . . . . . . . 129
6.1 Timeframe of the IFRS accounting I EU supervisory reforms 134

6.2 Organisations involved in the IFRS accounting reforms 136
6.3 Confideuce interva1 of a stochastic variable x . . . . 140
6.4 Value-al-risk surface of the loss distribution function 141
6.5 Steps to evaluate the VaR I ES . . . . . . . . . 144
6.6 VaR and ES per Allianz SE stock . . . . . . . . 145
6.7 Historlcal simulation of Ibe Allianz SE stock. . 147
6.8 Basic ALM model for insurance companies .. 171
6.9 Duration ofthe sampie EUR 100 bond . . . . . 175
6.10 Approximation error of Ibe Macaulay Duration 176
6.11 Classification of hybrid securities by Moody's and S&P's . 182
6.12 Sponsors' criteria regarding ILS . . . . . . . . 183
6.13 Risk types modeled by Fitchrating's PRISM .. 193
6.14 Cal risk distribution graph . . . . . . . . . 199
6.15 Non-life insurance: drivers of losses . . . . · . 200
6.16 illustrative framework for cal risk modeling · . 208
6.17 Sampie of a loss exceedanee corve . . . · . 210
6.18 Residential Re - loss exceedanee corve . . . · . 212
UST OF FIGURES xix
6.19 Residential Re - eatasuophe-1inked notes sttucture . · 213

6.20 Scottish Re I Tartan - mortality risk model sttucture · 214
6.21 Marke! share of ILS investor types . . . . . · 223
6.22 Comparison of index performances. . . . . .226
6.23 Performance of ILS funds since July 2005 . .227
6.24 Comparison of efficient frontiers . . . . . . · 228
7.1 Survey respondees by sponsor type and geographie · 255

7.2 Organisational status of ILS activities . . . . . . . · 256
7.3 Distanee of ILS activities to general management . · 257
7.4 Regional foeus . . . . . . . . . . . . . . . . . . . · 258
7.5 ILS produets covered . . . . . . . . . . . . . . . . · 258
7.6 Increase of insurance sector capital requirements . · 259
7.7 The demand for ILS will inerease . · 259
7.8 New product types will arise . . . . . . . . . . . . .260
7.9 Standardisation of ILS . . . . . . . . . . . . . . . .260
7.10 State of the ILS secondary market standardisation . · 261
7.11 Ranking: Main ILS market drivers . . . · 261
7.12 Ranking: Main ILS market obstacles .. .262
7.13 Ranking: Most capable ILS arrangers . · 263
7.14 Sponsor motivations . . . . . . . . .264
7.15 Importanceoftransactionratings .. .264
7.16 ILS arranging banks . · 265
7.17 Banks' strengths . . . . . . . · 265
7.18 Banks' weaknesses . . . . . .266
7.19 Expected results of the crisis .266
7.20 Expected pricing development for ILS . .267
List of Tables
2.1 Expected Loss Example I . . . . 9

2.2 Expected Loss Example 2. . . . 10
2.3 Objective of risk management . 18
2.4 Product ionovations of the capital markets . 33
3.1 Types ofinsurance companies and their products . 37

3.2 Top 10 countries by life I non-life direct premiums 2007 . 38
3.3 Volume of financial guarantors insuted business in 2006. . 44
3.4 Global top 10 non-Life reinsurance companies . 47
3.5 Global top 12life reinsurance companies . 53
4.1 The vorlous forms and types of reinsurance 57

4.2 Global weather risk derivatives . . . . . . . 80
4.4 Summary and evaluation of ART instruments . 93
5.1 Osiris Plc - tranche structure . . . . . . . . . . 109

5.3 Life insurance securltisation types: Summary and evaluation of charac-
terlstics . . . . . . . . . . . . . . . . . 116
5.4 Crystal Credit - tranche structure . . . . 122
5.5 Basket of perlls coveted by Fremantle . 126
5.6 Tranche structure or the Merlin CDO. . 129
5.8 Non-Life insurance securitisation types: summary and evaluation of
characterlstics . . . . . . . . . . . . . . . . . . . . . . 132
6.1 Proposed key capital calculation factors of Solvency 2 . 139

6.2 Lower quantiles if the standard normal distribution .. 143
6.3 Example: Alternatives to raise EUR 500 m1n capital. . 151
6.4 Exarnple: ReguIatory capital requirement table 151
6.5 Risk Based Capital action levels .. . . . . . . 153
6.6 Effect of reinsurance on the capital positions . . 158
6.7 Calcu1ation of the duration of a straight bond . 174
xxü UST OF TABLES
6.8 UBS's eight categories of coupon deferrallanguage . 180

6.9 AM Best: Minimum BCAR and rating . . . . . . . . 192
6.10 Moody's MRAC: Charge for reinsurers' IFRS ratings 196
6.11 Moody's MRAC: SampIe reinsurance recoverable chart . 197
6.12 Moody's MRAC: Company one-simulation exceedence curve . 198
6.13 Moody's MRAC: Overall required capital simulation 198
6.14 Moody's: Gross underwriting leverage and rating " 200
6.15 S&P's: Capital Adequacy Ratio ranges. " 202
6.16 AM Best: Basis risk scoring table . . . " 204
6.17 Loss exceedance curve data table . . . . .. 211
6.18 Price estimation for a catastrophe bond. .. 251
Chapter 1
Introduction
1.1 Problem description and definition

Tbe international financial industry bas been facing deep changes. We notice a con-
centration process through mergers and acquisitions in all areas of the industry. Tbe
insurance seetor, since the early nineties, has been challenged by natural and man-made
catas1rophes such as intensified hurticane activities and terror.
In addition, the global capital markets are currently facing the most severe financial
crisis ever. It started in 2007, when highly leveraged home owners in the overheated
US real estale sector increasingly defaulted on their mortgage payments. On September
15th, 2008, the investment bank Lehman Brothers defaulted. A few days thereafter, the
wnrld's biggest insurance conglomerate Ametican International Group got into severe
financial difficulties, ouly snrviving with a total of USD 180 bn liquidity support by
the US government As a result of the difficulties, mortgage backed secntities placed at
internationa1ly active banks in numerous countries were downgraded or even defaulted
and tbe financial system had to be massively supported by tbe local govemments. Banks
and cOlpnrates were nationalised. A number of states, among tbem Iceland, Ireland,
Hungary, Latvia, and Ukraine in tnrn bad to ask for liquidity support by the IMF. An
end of the downtnrn of the US housing sector is not in sight and the financial ctisis
is followed by a severe recession of the real economy. IMF estimates the totallosses
caused by tbe financial ctisis at USD 4.1 trillion over tbe years 2007 to 2010.'
Tbese developments, combined with the need for a harmonisation of the regulatory
environment, are leadin.g the insurance industry into a new stage of evolution.
Insurance companies, as well as banks, take risks and have to manage them. The
companies are regulated and must meet certain capital requirements. Further, tbey need
to raise funds to run their activities. Both, banks and insurance companies, have credit
rating sensitive franchises.
lIMF [see 2OQ9],Pleven [see 02.03.2009]
C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_1,

© Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
2 CHAPTER 1. IN1RODUcrrON
Banks addressed funding, regulatory capital and balance sheet management issues
some years ago. They have developed structured finance teclmiques and bave beeu
usiug them for many years now. In order to redoce the volatility of their earnings, in-
surance and reinsurance cornpanies foond ways to adapt products already existing on
the capital markets to their needs. Further, together with international banks, they are
finding new ways to transfer risk to the capital marke!s. The new products are supple-
mentary to traditional reinsurance and its teclmiques will play an even more important
role at the introduction of the new Solvency 2 regulatory frarnework of the EU.
The volume of insurance-re1ated securitisation as part of the new teclmiques has
grown steadily in recent years ontil the financial crisis hit the markets. Catastrophe,
mortality, and new bosiness strain risk were transferred to the capital markets. Future
premium fiows were securitised and enabled companies to use their capital effectively.
Smaller insurance companies found their access to the markets by issuing several cate-
gories of capitallike Tier-I, Upper-Tier-2 and Lower-Tier-2 within collateralised debt
obligations. A number of them would not bave been able to enter the markets without
this instrument.
Tbe second chapter of the thesis describes the insurance business and the risks in-
volved. The insurance industry includes a diverse set of business !ines with associated
risks whicb are in some ways similar to those of other !inancial institutions. Some of the
risks which insurers and re-insurers take into their books, however, are equivalent to the
bank's balance sbeets sucb as counter party risl<, credit risk and mortgage risk. Other
risks such as mortaIity, longevity, catastrophes are specific to the industry and usually
little kuown outside of it. Further, actuarlal risk can be caused by mal-calculation of
reserves. Basic insurance mathematics and risk management techniques are therefore
exp1ained and the in1Iuence of the regulatory enviromnents on insurance pricing and
investment policy is examined.
The third chap!er describes the different types of primary insurance and reinsurance.
It reconsiders the historlca1 development of the varleties of altemative-risk-transfer and
recent market statistics in order to provide an overview of the most important insurance
regions and their speciaIties. Challenges in non-life insurance caused by natora1 and
man-made catastrophes and in life insurance are exp1ained in detail.
The fourth chapter briefly describes the history and types of altemative risk transfer
in order to provide an overview of the instruments and to enable the reader to categorise
the securitisation according to the methods available.
Securitisation as a main topic of the thesis is explained in detail in chapter five.
At the end of the chapter, an evaluation of the characteristics of the different types
completes the review.
The sixth chapter describes the different perspectives of the marke! participants.
The focus will be laid on describing the benefits or potential challenges of the current
capital market crisis. The analysis of stakeholders is based on academic and economic
research available. This information is supplemented by sumtuaries of interviews with
industry experts of the different stakeholder groups based in the US and the EU.
1.2. OBJECTIVE OF THE THESIS 3
In order 10 complete the current picture of the market, an online survey was car-
ried out and its results are analysed in ehapler seven. The questionnaire embraees 30
questions about the situation of the ILS market.
The interviews and the online survey were canied out in the midst of economic
uneertainty. Since the ILS marke! has also been affeeted by the default of Lehman
Brothers as one of the major investment banks involved in the business, Chapler 8 was
necessary to sununarise the key developments until July Ist, 2009.
Chapler 9 summarises the results of the thesis.
1.2 Objective of the thesis

The thesis was written by a banking professional and focuses on the role of banks in
the development of risk transfer from insuranee eompanies 10 the eapital markets by
means of securitisation. This is genera1ly defined as the accumulation of risk related
eash fiows and their transformation into tradable securities. The markets for straight
bonds and shares issued by insurance companies are not part of this thesis.
Readers related 10 the banking and insuranee industry will be helped 10 understand
the distinetions and sintilarities between the two sectors of the financial industry: bank-
ing and insurance.
The thesis will analyse whether the deeper convergenee of fiuancial sectors often
aunounced is likely 10 happen and feasible. The severe finaneial erisis sparked by the
downtum of the real estate securitisation in the US raised sorne doubts as 10 how secu-
ritisation was handled in the past.
An inleresting question is whether the market for ILS is in danger of failing sinee
the negative developments of the market for residential real estate seeuritisation ehar-
acterised by over-Ieverage and a pricing not refiecting the risks involved will not be
repeated.
The interviews with market professionals and the ouline-interview try 10 evaiuate
whieh products are likely to survive and how the banks' role in !bis process may de-
velop.
Banks have been involved in their traditional role as intermediates between investors
and eapital marke!s. Further, they invested in the produets. While mueh academie work
has been dedieated 10 explaining the use of ILS in the insurancelreinsuranee sector, the
banks' role in !bis process has not been exantined yet. This thesis has been written in
order 10 close !bis gap.
1.3 Methodology
A substantial part of this thesis is based on economic science, specialised press and eco-
nomie publieations. It has been written for academies and fiuancial professionals who
are not 100 farniliar with banking or insurance. Therefore the first part eoneentrates on
4 CHAPTER 1. IN1RODUcrrON
the explanation of the mechanics of the market and speeially treats ILS. The transaction
record nntil the end of 2008 is included for each of the ILS product types.
The perspectives of the stakeholders are reinforced by expert interviews. Due to the
current developments such as for instanee the default of Lehman Brothers and the res-
cue of American International Group during the stay in the USA, the interviews relleet
the substantial cbange of the market environment. All experts interviewed were at the
time of the interviews active in the financial mark.ets and involved in the n..S business.2
Personal interviews took p1ace in New York, Boston, eineago, Washington, London,
Frankfurt, and Zurieh in the timeframe between August and December 2008. A mi-
nor part of the eonversations had to be done by phone.' 4 Each of the 32 interviews
with associations, banks, hedge funds, insmers, reinsurers, lawyers, supervisors, rating
agencies, risk. mode1ers, and monoline insurers was guided by a catalogue of questions.
Because of the substantial difference in the roles of companies and persons interviewed
were taking in the process, the eata10gue of about 10 questions per interview was held
ßexible.5 All interviews were recorded and transcribed. The interviewees sigued an
agreement that the information can be used for the thesis on condition that neither their
names nor their eompanies are disclosed. The deseription of the perspective of the
stakeholders mainly uses their "language" in order to reßeet a unique picture of the
market situation at that time. Due to the intensive market turbnlenees and the nncertain
autlook the author was reluctant to draw any general conc1usions from the statements
given. The resnlts of the interviews are summarised in the stakeholder eategories: Ae-
countants and regulators, insurers and reinsurers as sponsors, rating agencies and risk
modelers, investors, and arrangers ofILS. Lawyers are not inc1uded in any stakeholder
group sinee they work together with the majority of stakeholders involved and were
able to relleet severa1 shareholders ' perspectives - they ensure that the transactions are
stnJctured in-line with the regulations of supervisors and accountants.
The professional internet servicer 2ask was used for the online survey6 It was
sent to 225 market participants with a response rate of 20% and the retumed data was
analysed with the SPSS software tool.
2Bogner [see 2005, pp. 113-130] far the sampling methodology

3Bogner [see 2005. pp. 209-222] for the interview methodology
4Helfferich [sec 2005, pp. 148-173] for thc interview mcthodology
'Kaufmann and Böhmler [see 1999. pp. 65-69] far the questionnaire methodology
6Andrews et al. [see 2003] for the online-survey methodology
Chapter 2
Insurance Business and its Risk
The insurance business is vital for today's economies, sinee by means of insurance
policyholders can satisfy their need for protection and accumulate additional value.'
Further, insurance and reinsurance contracts are essential for the risk management of
corporates. Few companies operate without some amount of coverage. 2 The typical
insurance includes a risk transfer mechanism. It allows the entity buying insurance to
transfer the loss arising from specific risks, perils, or hazards from its equity holder to
the insurance provider and its shareholders.'
2.1 Risk and insurance

A survey of the best-known insurance literature used in universities resulted in a general
lack of agreement conceming the definition of risk.. However, common elements in a1l
definitions are indeterminacy and loss: At least two variables of outcome of a develop-
mentlevent must be in question and at least one of the outcomes is undesirable. Risk is a
condition in the real world. 4 In its most general form, risk can be defined as uncertainty
associated with a future outcome or event. Applied more specifically to the activities of
corporations, risk is the expected variance in profits, lasses, or cash flows arising from
an uncertain event.' When an event is possible, it has a probability between zero and
one. An undesirable event is defined as the adverse deviation from the desired outcome
that is expected or hoped for. 6
ILiebwein [see 2000, p. xxi]

2Banks [see 2004, p. 63]
'Culp [see 2002, p. 311]
4Vaughan and Vaughan [see 2003, p. 2]
.5Banks [see 2004, p. 3]
'Vauglum and Vauglum [see 2003, p. 3]

6 CHAPTER 2. INSURANCE BUSINESS AND ITS RISK
Objective risk is therefore defined as the relative variation of aclualloss from ex-
pected loss.7
Further, subjective risk can be taken into consideration:' Uncertllinty, the oppo-
site of certllinty, is astate of human mind characterised by doubt, based on a lack of
knowledge about the future. It is simply a psychological reaction of homans. However,
whether a person is aware of the risk or not, does not alter its existence. 9
2.1.1 Classification of risk faced by insurers

DynBlnic and statie risk
Tbe possibility of dynamic changes result in dynamic risk. Economic conditions like
price levels, consumer tastes, saving behaviour and technology favom the entire ecOD-
omy in the long rnn, but include risk for the market participauts. Even if there were
DO changes in the economy, static risk involves lasses. Examples are fire, accidents or
perils of uature. lO
Fundwnental and particular risk

Losses affecting a large segment of a population are caused by fundamental risk. Ex-
amples for !bis are economic, climatic hea1th aud/or political phenomena. Particular
risk threatens individuals rather thau a group.u
Operating and financial risk

Operating risk is classified as the risk of loss arising from the operating activities of a
corporation. Financial risk arises from the financial activities of a firm. 12
Speculative and pure risk

If a situation involves the possibility of gain as weil as loss, a company faces speculative
risk. A good example for speculative risk is gambling. If risk ouly has the prospect of
lass, it is defined as pure rist. 13 Perils of nature or consequences of human errors are
normally pure risks. 14 Pure risk can be c1assified into four categories: Personal risk:
Tbe possibility of loss of income or assets. Property risk: Direct or indirect loss of
possessions due to destruction or theft. üability risl<: Injury of persons or damage of
7Rejda [see 1986, p. 3]
'Rejda [see 1986, p. 4]
9Vaughan and Vaughan [see 2003, p. 3]
l°Outreville [see 1998, p. 3]
1I0utreville [see 1998, p. 4]
12Banks [see 2004, p. 4]
13Banks [see 2004, p. 4]
140utreville [see 1998, p. 3]
2.1. RISKANDINSURANCE 7
Iheir property due to negligence or carelessness. Risk arising from failure of o1hers: If
a person does not m.eet bis Ol her obligati.ons.l~
Uosystematic and systematic risk

Modern portfolio Iheory is b.sed on Ihe basic principle Ih.t risk can be e!imin.ted by
means of diversification. Tbe unique risk of a single tille of • portfolio of stocks is
also known as diversifiable or unsystematic risk. Since it can be eliminated, it should
have DO value. However, there exist same unavoidable components of risk which affect
all market participants to a greater or lesser extent. This is called systematie risk or
market risk. Since Ihe risk of a well-diversified portfolio depends on systematic risk of
its single components, the only relevant risk of any security is its sensitivity to general
market movements. 16
2.1.2 CIassification of risk by insurance regulators

Regulators h.ve Iheir focus on Ihe solvahility of insurance cornpanies, being defined
as Ihe .bility of companies to meet Iheir obligations towards Ihe policyholders and
olher creditors. Apart from supervising Ihe liquidity of Ihe companies, Ihe .ulhorities
concentrate their efforts on the risk. categories as follows:
Market risk consists in 1he volatility of financial markets, including Ihe risk of
changes of interest rares and prices of stocks, real estate and currencies.
Credit risk contains Ihe possibility of • deterioration of Ihe creditworlhiness of Ihe
insurance company's debtor. As • consequence hereof, Ihe quality of 1he relevant asset
decreases or a totalloss may occur.
Technieal risk of an insurance company is Ihe probability of • loss occurring in Ihe
following financial year. Technical risk can be divided into prentium risk meaning Ihe
possibility of Ihe prentium not being sufficient to cover future losses. Furlher, reserving
risl<, reflecting Ihe probability lhat losses from Ihe claim processing may occur. Finally,
catastrophe risk is defined .s Ihe possibility lhat Ihe insurance company has to face
nnexpectedly high losses from man-made or natural c.tastrophes.
Misman.gernent, system failures, or fr.ud may c.use operational risk for Ihe insur-
ance company, finally resulting in direct losses. Furlher, external developments or even
shocks may result in negative developmentsP
2.1.3 Peril and hazard

A peril is a cause of a 10ss, like a fire or a hurricane. A hazard is a condition that may
create or incre.se Ihe chance of • loss c.used by aperi!. Three types of hazards can be
distinguished:
ISVaughan and Vaughan [see 2003, p. 7]
16 ÜUb'eville [see 1998, p. 5]
17Bundesregierung [see 09.02.2007. p. 3]
Tbe physical hazard increases fue chance of • loss. Tbe defect wiring of an older
.partment building may increase fue rist of • fire.
Individuals cao incre.se 1he rist of. loss due to dishonesty or eharacter. This moral
hazard is difficu1t to contro! for insurance companies. If a person uses to smoke in
bis hedroom, this may inere.se 1he risk of • fire. Moral hazard involves unethieal or
immoral behaviour.
Moral, hazard is 1he result of protection provided by insurance contracts. Bec.use
of the existence of insurance, people may get careless or indifferent towards a lass.
Motorists, for instance, may leave their car unlocked because they are insured against
fueft and fuerefore inere.se fue risk of • loss. Morale hazard is less serious fuan moral
hazard, since it refers to insmed persons who are simply careless about their property.18
18Rejda [see 1986. pp. 5~1

2.2. INSURANCE 9
2.2 Insurance
2.2.1 The basics of insurance mathematics
For the understanding of risk and insuranee theory an elementary knowledge of statis-
tieal coneepls is essential. Further, the applianee of the law of large numbers by the
insurance industry has to be understood. The following examples are based 00 books
written by George E. Rejda. 19
Probability and statistic analysis
The actuaries of insuranee companies apply probability and statistieal analysis to given
/oss situations. Given an infinite nurnber of trials and no ebanges of the underlying
eonditions, the probability of an event is the long-run relative frequency of it. While the
probability of some events ean be determined without experimentation, the probability
of others can be estimated througb the analysis of past loss data.
Probability distributions surnmarise evenls and their probabilities. They list evenls
that eould oceur and the probability of each event's oceurrenee. Discrete probability
distributions bave only distinct possible outcomes. An example for a discrete probabil-
ity distribution is the t1ipping of a fair eoin in the air, where the probability !hat the coin
will come up "heads" or "tails" is SO percent each. Continuous probability distributions
have a range of possible outcomes Iike, for example, the risk for a human being of dy-
ing in a specified year or the risk of a driver to be involved in a car accident. The!wo
irnportant measures to cbaracterise probability distributions are: central tendency and
dispersion. Out of the several methods available, the measure most often used 10 define
eentraI tendency of a distribution is the mean I-' or expected vaIue (EV). In insurance,
the expeeted value is the probable amount of money lost, the expected loss. It is found
by multiplying each outcome (Xi) by ils probability of occurrenee (Pi) and summing:
1-'= LXixPi (2.1)
The mean or expected loss of the risk described in the following examples is estimated
by an insuranee actuary as USD 280 based on the ealculation as follows:
Loos amount (Xi) Loos probability(Pi) Expected loss (Xi Pi)

USDO x 0,20 = USDO
USD390 x 0,70 USD273
USD70 x 0,10 USD7
~XiPi USD280
Table 2.1: Expeeted Loss Example 1
19Rejda [see 1986. pp. 4046];Rejda [,ee 2008. pp. 17-20]

Tbe estimation of the mean or expected loss of the second risk by the insuranee
actuary is also USO 300:
Loos amount (Xi) Loos probability (Pi) Expected 1088 (Xi Pi)
USD 175 x 0,40 = USD70
USD350 x 0,60 USD210
L;XiPi USD280
Table 2.2: Expected Loss Example 2
Although the two examples result in the same expected loss of USO 280, the first dis-
tribution is riskier, sinee the USO 390 range of potentialloss amount of between USO
o and USO 390 is higher than the USO 175 range between USO 175 and USO 350 in
the second example.
To characterlse the variability or dispersion about the mean value, the two standard
measures varianee (u 2 ) and standard deviation (u) are employed. Tbe variance of
a probability distribution is calculated as the sum of the squared differences between
the possible outcomes and the expected value, then weighted by the probability of the
outcomes. It is therefore the squared deviation between the possible outcomes and the
mean:
u 2 = LPi(Xi - EV)2 (2.2)
In order to get the central tendency and the dispersion measure in the same unities,
the square root of the variance has to be taken; the result is the standard deviation.
Tbe two example distributions above result in the following variances and standard
deviations:
Example 1:
u 2 = 0.2(0 - 280)2 + 0.7(273 - 280)2 + 0.1(7 - 280)2
+
= 15,680 8,470 + 4, 410
= 28,560
u = y'28,56U = 169.00
Example2:
u 2 = 0.4(70 - 280)2 + 0.6(210 - 280)2
= 4,410 + 2,940
= 7,350
u = v'7,35U = 85.73
Although the means of the two example distributions are the same, their standard devi-
ations are different Tbe higher standard deviation of Example 1 indicates a higher risk
sinee, relative to the mean, the example catries a higher uncertainty of loss. Tbe lower
standard deviation of Example 2 indicates a lower loss probability.
2.2. INSURANCE 11
Frequency and severity of losses
The claim frequency distribution resulting in losses for the insorer shows the probability
of baving various numbers of evenls during a predefined time period. Given that a loss
has occorred, the claim severity distribution shows the probabilities of the potential
loss amounts. Througb the combination of !wo distributions a total loss distribution
(also called pore premium distribution) for an insurance company can be obtained for
the given time period.
The number of accidents or los ses, Z, and the potential size of the losses, Y, are
randnm variables with known probability distributions p(Z) and p(y). X represents the
total possihle loss !hat the risk can develop during the time period with the probability
distribntion p(X).
The arithmetic mean or expected values of these random variables are denoted as
E(z), E(y) and E(x) - E(.) denotes the average mean orvalue forthe relevantrandom
variable Z, Y or X).
The variances, defined as the dispersion around the rnean of the variables are d...
noted as Var(Z),Var(y), and Var(X)'
The rnean of the total loss distribntion of the insured risk is the product of the
expected number of losses (mean of claim frequency) and the expected loss amounls
(mean claim severity):
(2.3)
and the variance of loss distribntion Var(X) is given by the following relationsbip:
Var(X) = (Var(Z) x E(Y)') + (Var(Y) x E(z)) (2.4)
To illustrate the calculation method, we assume as a simplified example, that 1,000

farmers in Nebraska form a mutual fire insurance company, where the fire lasses of the
unfortunate are shated by a11 members of the association. Further, we assume a single
loss size: If a fire occurted, the farm houses bnrned down completely.
The number of losses incurted by the farmers are supposed to follow abi-nominal
distribntion:
Pn(Z) = 1( n! ) x 1"(1- p)"-z (2.5)
z. n-z
Where
n =1,000 farm hauses as exposure units
Z =the number of fire losses for 1,000 exposore unils p.a. (range: 0 - 1,000)
p =the probability !hat one farm house will bnrn down (111,000)
Pn(z) =the probability that Z ofthe houses will burn down during a year
The number of losses for a single farmer follows a Bemoulli probability distribntion;
the probability of a totalloss by fire is p and the probability for no loss is (1 - p):
P(z) = p% X (1- p)'-%

wherez=Oorl
For 0 single fanner, P(z = 1) = p and P(z = 0) = 1 - p. Therefore, the expected

number of fire losses E(z) during 0 year also !ums out to equal p:
1
E(Z) = L z x P(z)
z=o
= 0 x p(z = 0) + 1 x p(z = 1)
= 0 x (1 - p) + 1 x p
=p
= 1/1000
Tbe variance in the numher of losses for a single farmer Var(Z) is calculoted as
folIows:
1
Var(Z) = L (z - E(z))' x P(z)
z=o
= (0 - p)2 X P(z = 0) + (1 - p)2 x P(z = 1)
= (0 - p)2 x (1 - p) + (1 - p)' x p
= p2 x (1 _ p) + (1 _ p)2 x P
= p x (1 - p) x (p + (1 - p))
= p x (1- p)
= (1/1000) x (1 - 1/1000)
= (1/1000) x (999/1000)
= (999/1000)2
In the given example, n = 1,000 farmers are exposcd to 0 total fire loss of their
hornes. Since the mean and variance of n Bernoulli trials are equal to those of 0 binom-
inal probahility distribution with n trials, the expected number of losses E n (Z) and the
associated varianee in the number of losses Varn (Z) can be calculoted os follows:
1000
E(Z) = L z x Pn(Z)
z=o
=nxp
= 1000 x (1 - 1/1000) = 1
= the expected number of losses for n=I,OOO wtits
1
Varn(Z) = L (z - E(z))2 X P(z)
t=o
= n X p X (l-p)
= 1000 x (1 - 1/1000) x (1 - 1/1000)
2.2. INSURANCE 13
= (999/1000)2
As a result, it ean be seen, that the expected number of total fire losses for n farmers
E n (Z) is n times the expected number of losses for the single farmer:
En(Z) = n x E(Z) = n x p (2.6)
And the varianee Jor the total number of Iosses Var n (Z) is n times the varianee of
the number of losses for the single fanners:
Varn(Z) = n x Var(Z) = n x p x (1 - p) (2.7)

Over a long renn period, the mean number of fire losses of the mutual insurer of
1,000 farmers is one per year and a single farmer would experienee a fire loss only onee
in 1,000 years. When a fire occurs, it results in a totalloss of USD 90,000, the total
value of the farm bumed down.
Following formula (2.4), the expeeted fire loss per farmer E(X) is the produet of the
number of losses E(Z) multiplied by the expected si2e of a loss E(Y):
E(X) = E(Z) x E(Y) = p x E(Y) = (1/1000) x USD 90, 000 = USD 90

For n farmers, the expected total fire losses En(X) is equal to n times E(X):
En(X) = n x E(X) = 1000 x USD90 = USD 90,000

The farmer's mutual fire insuranee assoeiation would have to earry USD 90,000 fire
losses per year. 1f the losses were pooled equally, each member would bave to pay
a premium of USD 90 to get proteetion. However, sinee the actual number of hornes
bumed down will vary, it has to be taken into eonsideration, !hat the losses and premium
ean be lower or higher.
Following formula (2.5), the varianee of totallosses Var(X), ean be derived from
the means and variances associated with the claim frequency and claim severity distri-
butions.
Var(X) = (Var(Z) x E(y)2) + (Var(Y) x E(Z))
= (p x (1 - p) x E(y)2) + (Var(Y) x p)
= (999/1000)2 x USD 90, 000 + 0 x (1/1000)
= 999 x 902
= 2,844.622
In order 10 get the central tendency and the dispersion measure in the same unities,
the square root of the variance has to be taken. The result is the standard deviation of
totallosses (u.), a more relevant measure of dispersion.
u. = vVar(x) = V{USD 2, 844.62)2 = USD 2,844.62

All of the values in the equation above have already been calcu1ated except the
variance of the claim distribution Var(Y). It is equal to zero in this example since a
totalloss was assurned.
The example results in the mean of the totalloss disttibution fot a single exposure
urtit E(x) ofUSD 90 and the standatd deviation u. ofUSD 2,844.62. The actual average
amount, howevet, could deviate substantially from the expected value due to the randorn
nature of fire lasses.
Law of!arge numbe....
If the insurance of homogenous risks like :fire insurance is assumed and underwriting
considerations are ignored, the insurer basically takes a randorn sampie from a basic
totalloss disttibution, because of the centrallimit theorem, stating:
.off you draw randorn sampies of n observations from any population with
mean p.. and standard deviation u., and n is sufficiently large, the disttibu-
tion of sampie means will be approximately notmal, with the mean of the
disttibution equal to the rnean of the population (p." = p..) and the stan-
datd errot of the sampie rnean u z equal to the standard deviation of the
population divided by the square root ofn (u" = u.I.fii). This appropti-
ation becom.es increasingly accurate as the sampie size, n, increases."
Rejda [2008, p. 4]
Tbe centrallimit theorem is relevant for insurers, since regardless of the character-
istics of the underlying population disttibution, the disttibution of sampie means will
approach the notmal disttibution as the sarnple size increases: 68 petCent of the distti-
bution therefote lies within one standatd deviation of the rnean, and about 95 percent of
the disttibution lies within !wo standatd deviations of the rnean.
A furthet implication of the centra! limit theorern fot insurers is that the standard
etrOr of Ibe sarnple mean disttibution declines as Ibe sarnple size n increases. In Ibe
fire insurance exarnple above the result fot the standatd deviation of losses, u" for one
exposure urtit was USD 2,844.62 and the standatd etror fot 1,000 exposures equals to
USD 89.96:
u,,= u.l.fii
= USD 2,844.621 ';1000
= U SD 2,844.62/31.62
=USD89.96
2.2. INSURANCE 15
J(-,)
-- n 10.000
'''''
'------------x
E(Y)
liaS«! On' lI.ojd •. G<0,fV' L I'rinciplo,ofln",,..«. S<."QIt. 1o",,,,, •• & Co..
Glen., iell. 1986. p. 4~
Flgure 2.1: Sampling distribution versus sampling size
By increasing the number of insurcd farm houses n 10 10,000, the insurer wouId rise the
size of the sampIe and, by ca1cu1ating with the formula above, the value for a-~ would
therefore decrease to USD 28.45 (see figure 2.1).
The W1derwriting risk, defined as the maximum losse8 insured, would increase since
more insured uni.ts could suffer a 1055. The expression for underwriting risk is as fol-
lews:
(2.8)
Although the sampIe size grows n-fold. the underwriting risk does not increase propor-
tionat.ely, but by the square root of n (see figure 2.2). The insurance company therefore
rcduces the objective risk: by increasing the number of contracts, due to the fact that
the difference between ac1ual results and expected results decreases. The deviation
of ac1ual from expected losse8 as major cancern far the insurance company, however,
"""'""'.
2.2.2 Economical versos insured losse.s
The existence of risk:. a:ffects the economic performance of agents. Constraints are im-
posed on the optimum. allocation of resources and on the economic development of
nations. Individual and business decisions are not made under conditions of certainty.
16 CHAPI'ER 2. INSURANCE BUSINESS AND ITS RISK
0'-, = a, I;;;
BlS\.>d on Rojda. Go<>r@cE .• I>ri""ip"',ofl"",ranco 11

'>cOlI. I'o",.man &. Co .. Glen,i.,,_ 1986. p.45
Figure 2.2: Individual average underwriting risk facod by the ins\ttet'
The common denominator is risk. Prudent individuals engage in safe actions rather
than risky 0DeS. In genend, their objective is not to avoid risk but rather to recognisc
its existence and to ensure that insurance compensation is adequate for the risks being
bome.'"
:U.3 Ibe Criteria of insurability

It ia theoreti.cally possible to insure all possibilities of IOS5. However, for practical
rea8ons. insurancc companWs arc not willing to accept a11 the risks than other agents
may wish to transfer to them. Further, many risks arc not insurable at a reasonable
pricc.21 In order tu get a contract to bc considcrcd Wl insunmce for tu. and accounting
purposes, it must generally fulfil the following minimum criteria:22
• the cedent must have an insurable interest
• an unforeseen. unexpected or accidental risk with respect to some fortuitous

events must exist at the inception of the contract
20Vllighan lDd Vaughm [_ 2003, p. 41]

:1lOutrevillc [IICC 1998, P. 6]
22BIDkJ [IICC 2004, p. 64]
2.2. INSURANCE 17
• • risk of loss troosfer must take place
• the contract must provide indemnity and involve appropriate consideration
• in order to make potentiallosses predietable ood measurable, a sufficiently large

number of homogeneous exposure units must exist and lasses must not be catas-
trophie
• !he loss eaused by !he risk must be definite aod measurable, !he prentium eharged
must represeot the statistically expected loss (plus prentium loading)
• the transaction must be "af utmost good faith" through contractual representations
and must be executed with kuowledge and legal purpose; the transaction must
include offer/acceptanee ood eonsideration
• !he contract must include the right of subrogation or the transfer of loss recovery
rights from the eedent to !he insurer
Insurance business is based on the notion of sharing lasses. The pooling of risk.
is essential. Randomness in the selection of risk. is c10sely related to the requirement
that loss must be non-eatastrophie. This lintitation is related to 00 ideal insurable risk
ood it is given to .void !hat a large proportion if exposure units should not suffer from
lasses at the same time. In the real world, however, it is impossible for an insurer to
avoid all eatastrophie losses, sinee !hey regularly occur as a result of periodieal t1oods,
hurricanes, tornadoes, earthquakes, forest fires, and other natural disasters. Insurance
eompaoies have !wo approaches avail.ble to meet the problem of eatastrophie loss:
First, reinsuranee ean be used to get indenntified from eatastrophie los ses. Second,
insurers can avoid the concentration of risk by dispersing their coverage aver a large
geographie area. 23
2.2.4 Insurance, gambling and speculation

Insuranee business is often eonfused with gambling. Tbe first differenee betweeo the
!wo is, that gambling creates new speculative risk while insurance is a technique for
handling already existing pure risk. Second, gambling is not productive for the econ-
omy sinee the profits created for the winners are eharged at the expense of the 10sers. 24
The techniques of speculation ood insurooee .ppear to be similar, sinee risk is trans-
ferred by a contract while DO new risk is created. There are two differences between the
twO: First, specu1ation typica1ly covers the uninsurab1e risk while insurance contracts
transfer insurable risk since the minimum criteria have to be Met. Second, speculation
involves only risk transfer, not risk reduetion. The prediction of the speculator may be
based only on a small number cf transactions, while the insurer rcduces the objective
23Rejda [... 1986, p. 241
"'Rejda [... 1986, p. 281
risk by applieation of Ihe law of large numbers. 111e prediction of future losses im-
prove since the relative variation of actualloss from expected 108S will decline with an
increasing number of exposure units.25
2.2.5 Evaluation and quantification of losses

111e insurance contract precisely specifies a trigger, defined as Ihe nature of risk, hazard,
or peril that can cause the contingent payment by the insurance company to the cedent.
Further, the contract specifies the nature of the insurer's contingent liability, ca11ed the
benefit amount. Is Ihe insurance eontract a contract 01 value, this amount is fixed. A
traditional life insuranee contract pays a fixed amoont if Ihe contract is triggered by
1he dea1h of 1he insured. Is Ihe insuranee eontract a contract 01 indemnity, this amount
is variable. An homeowner insurance, for example may compensate for the economic
damage of Ihe owner. A large loss results in a large payment, while a sma1lloss results
in a small payment.
2.3 Risk management

An insurance company's risk management is one of the basic but complex entrepreneurial
elements. Insurers have been practicing Ihe principals of onderstanding relevant risk
and managing Ihem from Ihe early days of Ihe industry. Sophistieation and tecbniques
ean vary substantially betwccn 1he different eompanies. 26
2.3.1 Objectives of risk management

Risk management is a speeialised financial aspect of management. It has a variety of
objecrlves whieh ean be elassified by importanee into Ihe eategories: 27
Pre-Loss Objecti.es: Post-Los.Objecti.es:

Economy SurvivaI
Reduction in anxiety Continuity of operations
Meeting with cxtemally imposed obligations Continued growth
Social responsibility Social responsibility
Table 2.3: Objeetive of risk management
Pre-Ioss, before a loss oceurred, Ihe eompany should prepare for potentiallosses in
1he most economieal way. 111e costs for Ihe safety program, insurance premium paid,
and for Ihe different tecbniques regarding Ihe handling of los ses must be analysed.
"Rejda [see 1986, p. 28]
26Culp [see 2002, p. 314]
27Yaughan and Yaughan [see 2003. p. 24]
2.3. RISK MANAGEMENT 19
Further, anxiety and fear associated with risk exposures have to be reduced. Existing
legal obligations have to be mel.
Post-loas, after a loss occurred, the prime objective of risk management is the sur-
vival of the company. Operations have to continue and the stability of earnings and
growth has to be rebuill. Tbe company has to act socially responsible to minimize the
effects that a 1088 will have on other persons and on society at any time. 28
2.3.2 Steps of the risk management process

Tbe risk management process involves the four steps descrlbed in figure 2.3:
The first step, the identification of potentia11osses, is the most critica1 function of the
process. The organisation must be aware of the risks before anything can be done about
them. Tbe failure to get knowledge of the existence of one or several potential events
can result in a disaster for the company.29 Tbc process centers on defining and iden-
tifying all of the company's actual, perceived, or anticipated risks. Risk management
has to get a systematic and continuing overview of the organisation and its operations.
Several techniques like the analysis of flow charts, financial statements, legal contracts,
job/position descriptions and commonication systems are avai1able. Further, risk man-
agers use exposure and insurance policy checklists in their approach to use a1l available
techniques in combination.30
The evaluation of losses as the second step of the proces8 inc1udes the measurement
of the potential size of the loss and the probability that it is likely to occur. Tbe risk
manager needs information about the two dimensions of the risk:
• the frequency or probability of the loss event
• the severity of the loss that will occur
Having collected this data about the loss exposures, frequency distributions will be
prepared to summarise the portfolio. Tbe useful information gained on the causes or
consequences of a phenomenon enables the risk management to rank them as:
• critical (loss events resulting in bankruptcy),
• important (loss events resulting in severe financial difficulties for the company),
or
• unimportant (loss events which could be met with existing assets or current in-
corne),31
In the third step of the risk management process, the most approprlare techniques
for treating loss exposures have to be selected:
28Rejda [see 1986. pp. 38-39]
29 ÜUtreville [see 1998, p. 52]
30Vaughan and Vaughan [see 2003, pp. 25-27]
31Vaughan and Vaughan [see 2003, pp. 27-28]
• risk control refers to teclmiques which reduce the frequency and severity of
lasses,
- avoidance (the 1058 exposure is not acquired)
- loss prevention (measures are taken to reduce Ioss frequency)
- lass rcduction (measures are take to reduce lass severity)
Idcntify potcntiallosscs
Evaluatc polcnliallosscs
Sclce\ approprialC Icchniqucs for the

treatment of loss CX[lOsurcs
1. Kisk Control
A"oidancc
Loss prcvcntion
Loss rcduction
2. Ri sk Financing
Retention
Non in surnncc transfers
Cornmcrcial insurancc
Implement and administcr [he programme
Has..-d on : Rcjda Grorgc. I'rintip loS <>f Risk ~I.nag<m<nt al'ld

I"",mnco. Addisoo Wesle) . Ilmlon. 200ll p. 43
Figure 2.3: The rist management process
• risk. financing mfers 10 teclmi.ques providing the funding Cor the losses
- retention (the com.pany rctains part or all ofthe lasses)
- non-msurance transfers (risks are transferred to another party)
- commerc:ial insurance (insurance is used to cover loss exposureSJ'2
nRejda [see 1986, pp. 39-49]

2.3. RISK MANAGEMENT 21
Tbe fourth srep is the implementatioo and administration of the risk management
programme. A risk management policy statement is necessary to ouiline the objecti.ves
of the eompany's risk management and its policy regardiog the treatment of loss expo-
sures. In addition, a risk management manual forces the risk: manager to state precisely
bis or her responsibilities, objectives and avai1able rechniques. Tbe support by the top
management and from other departments of the company is vital for an effective risk
management The risk management programme and the procedures must be reviewed
periodieally and evaluared to derermine whether the objectives are being attained. 33
Onee the eompany haa decided how it wants to mauage its risk, the costs of safety-
and loss prevention programmes must be monitored. Tbe eompany must regularly track
and report its experienee in deeision msking and risk exposure. Inremal and exrema1
parties (e.g. executive management, regulators, creditors, investors) require this feed-
back to assess and adjust their decisioDS.34
2.3.3 Changes in risk management due to Solvency 2

Tbe reformatioo of the European insuranee regulatory framework ealled Solveney 2 is
regarded as ooe of the most ambitious projects of the financial industry. Tbe involved
parties, the insurance eompanies, their industry associations, and the supervisory au-
thorities of the member stares have been working together within the legis1ation process.
Whi1e the Solvency I regulation so far in p1ace specifies capital requirements in rerms
of a simple set of factors to be applied to rechnieal provision or prerniurns, Solvency 2
is an inregrared risk management approach for the insurance sector. Tbe new sysrem
will, in addition, require the companies to establish systems, processes and controls for
risk management.35
Tbe structure of the new Basel 11 regulatory envirooment in the EU banking sector
is regarded as the blueprint for the three-pillar structure of Solvency 2. Tbe sirnilarities
between the two systems, however, are limited. Tbc insurance industries • different
business model eompared to the banking seelor is rellecred in its own set of prlnciples
shown in fignre 2.4.
Pillar I defines the finaneial resources a eompany haa to hold in order to be regarded
as solvent. As shown in fignre 2.5, the rechnieal provisions are ca1eulared by a best esti-
mare of the liabilities wbich are augrnenred by a risk margin to relleet any uncertainty in
future cash flows. Since in many cases there is DO liquid mark.et far insurance risk, the
market risk is based 00 a proxy "cost of eapital". This reßects the returo on the eapital
a nominal buyer would need to support the liabilities acquired from the holder over a
whole run-off perlod. Hedgeable risks are consisrently market evaluared.
Tbe next level represents the safety lIoor. If a company falls below this Ihreshold, the
Minimum Capital Requirement (MCR), the supervisory authority will invoke severe
33Rcjda [see 1986, pp. 39-49]

34Banks [see 2004, p. 8]
"Fm [see 10.07.2007. p. I]
r,II., "" '. 2 10 1"',1
(,kl."'''''' K.....irt...." O••II"'h. R'qul "M'." 'I ", ~" 1~ "'pll ..
Il.aio<>"" Ih< <akul...". f"r,"""""'of ..." ... 1:>0",,,,,,"",

or_", .. I"""'_ ."..,01 ond
~,
, ~l
;~
M,nomum C"""aI
R«i U'mn<n' (MeH) S"f'<"'W<) '" "'~
\0"<11<) c op,taI "~
R<q<JlmnrnI(SL"RI
I., <>I,""" R"~

II_d ~": S"i" 'k , igm. No_ 412()()(', Soho",,) 11: An ;n'cgralcd,;sI; 'r>pm"" h for
Lu'''p<:.n ,,,,,,,,,rs,
S"issll.<. lijri"h. 2()()6, p. 8
Figure 2.4: The thrcc pillars of Solvency 2
measures like the closing of the COmpany for new business. In addition, the Solvency
Capital Requirement (SeR) enables the company to withstand advene circumstances.
even severe shocks. The SCR is based on a 99.5% confidence 1eve1 of remaining sol-
vent in the 12 months ahead. Insurers can opt for the standardised approach to calculate
the SCR or. if tbey are ablc to run sophisticated modeling systems, can seek to qualify
an advanced approach. The SeR includes the evaluation of operating, investment and
the othcr:financial risks. If a company's ICSOUlCCS fall bclow this 1cvc1, action by thc
mpervisory bodies will be triggered. 36
Pillar 2 promotes good corporate risk management and concentrates on the qualita-
tive rcgulating thc supcrvisory process rcquirements as a supplcmcnt of Pillar 1. This
also includes the mles for a potential intervention. Further, standards for the intemal
risk management processes and thc aspects of operational risk are deliverod.
Pillar 3 specifies the risk disclosure requirements. The focus is on transparency,
open information and comparability within the industry. It completes the framework by
encouraging market discipline and the risk dialogue with the stakeholders.
Insurance companies cstablishing their framework well, will be rewarded by the
system. They will be able to monitor their risks in a constant proccss. A company writ-
ing more profitable products due 10 a higher premium ca.lculatod will ask: for lcss capital
than a company writing less profitable business. Options and guarantees in a product
J(iMcLarmet aI. [seeOlm.2OO6, p. 4]

2.4. RlSK AND REIVRN 23
,\1 .B.bk: ""pot.1

Soh.",,) .op;"'1
"'Guiro"",nIISCR\
,\S>Clcol'orinS
,\ ......
",chn;<.1 prol ;,ion'
m",~""
1'.lu.
Sou".. , .\1< 1..,,'n. ~101ani< cl .1 .. ('Ou"IOO"" '0 Soh.",,! 11. 1";<0 1I'.ICmou", Coopc",
l.ondon, 2006. p. 4
Figurc 2.5: The proposed. framework for Pillar 1
will be taken into considc:ratiOll as well as the investment policy. Thchnical provisions
and capital. requirements have to be covercd by a partfolio of asset investments. The
assets are evahwed :market-to-market. Investments in high risk assets willrequire more
capital than those with 10w risk. Risk. management techniques, such as the use of rein-
surance, hedging, and securitisatiOll can reduce risk levels. Diversification. the principle
to avoid that all risks will crystalise at the same moment, will have a lowering effcct
regarding the necessary amount of capital.37
2.4 Risk and retum

2.4.1 Insurance pricing
The pric~ for insurance, also called the insurance rate, is defined as the price per unit of
insurance. It should be distinguishod from the premium, which is determined by multi-
plying the rate by the number of units of protecti.on purchased. Comparing insurance to
other industries, two main differences have to be talren into consideration: First, since
the cost of production is not known until an insurance policy cxpires, the rate has to
be based on a prediction. Second, insurance rates, especially in the property and the
31La MartineM md Ta.ylor Goby [see 2006]

liability coverage, are often regulare<! by the government authorities. 38 Tbe objectives
of the regulators are to protect the public: Rates must be adequate to cover alllosses
and expenses in order to protect the insurer from becoming insolvent and faiIing. Pol-
icy owners and beneficiaries may be harmed in case their claims are not paid. Furtb.er,
rates must not be excessive since exorbitant prices are not in the interest of the public.
Tbe third reguIatory requirement is, that rates must not be unfairly discrimmatory. For
example, if!wo bealthy males aged 30 buy the same type and amount of life insurance
from one company, they sbouId not be charged !wo different rates.'·
From the business point of view, rates must be simple to use and the system must be
easy to understand. Tbe sales units must be able to quote premiurns with a minimum
amount of time and expense. Ta maintain customer satisfaction, the rates should be
stable over sbort periods. Over time, the rate making of the insurance sector should
respond to changing 108S exposures and economic conditions. Loss control should be
encouraged because it can reduce loss frequency and loss severity. Fortber, it keeps
insurance affordahle for the clients and stabilises profits for the company.40
The total premium income of an insurer, regardless from the type of insurance,
must be sufficient to cover the lasses occurred and the business expenses. Claims and
expenses must be predicted and allocated among the various classes of policyholders.
Tbe underwriting income generated by the insurance company is calIed gross premium
and is based on a gross rate. 1bis groSS rate consists of two parts: The first part is
detennined to cover potenriaI los ses. If calcuIated in euros/dollars and cents, it is calIed
pure premium, when calculated as percentage, it is called expected loss ratio. Tbe
second part is the loading, determined to cover the expenses like commissions, other
acquisition expenses, general administrative expenses, premium taxes and aIlowances
for contingencies and profits,41
2.4.2 Reserves
In contrary to many other industries, the producti.on cyc1e of the insurance sector is
reversed, since the premium payment is m.ade by the customer before the service is
provided. The gross written premiums are used to pay commissions and administrative
expenses. Tbe ultimative service is provided as the claims payment by the insurance
company to compensate for a lass occurred. These payments are not nccessarily made
in the same year as the premium payment. Therefore, the insurance company estab-
lishes technical reserves, which represent the commitments of the insurance company
with respect to the insured party.
Non-life insurance companies have 10 maintain two principal types of reserves,
the loss reserves and the unearned premium reserves. Life insmance companies' main
3!1Yaughan and Vaughan [see 2003, p. 125]

39Rejda [see 1986, p. 547]
"'Rejda [... 1986, p. 548]
41Yaughan and Vaughan [see 2003. p. 125]
2.4. RISK AND RETURN 25
reserve position consists of policy reserves. If the reserve requirements are by law
fulfilled, the company may set up additional voluntary reserves. The voluntary reserves
are used to strengthen tbe financial structure or for the payment of future benefils to life
insurance policyholders.42
The classification of reserves is important for tbe types of assets an insurance com-
pany can take into tbeir books witb tbe surplus of cash infIow in order to cover future
claims and to generate additional investment incom.e. Th.e surplus returns of the invest-
ment activities are allocated to tbe capital of tbe company.
Figure 2.6 illustrates tbe earnings stream of an insurance company. The net pre-
mium stream, after payments for claims and expenses, is used to increase the reserves
necessary 10 cover future obligations. The reserves form the m.ain liabilities of an in-
surance company. Reserves should not be defined as surplus as it is understood in the
common accounting terminology. They are ratber debt to policyholders in !hat respect,
tbat they form obligations to them to meet their future claims. In almost all countries
the supervisory authorities OI even laws specify the requirements OI recommendations
regarding the reserves. 43
Insurance companies apply two principal reserving techniques: Capitalisation COD-
sists in holding a portion of the premiums in reserve to be able to meet future obli-
gations. This is the case in life insurance and annuities. The capitalisation technique
generates medium and long term reserves which can be invested in capital market in-
struments of maturity equivalent to the contract. Compensation consists in using the
premiums collected during a budgetary year to cover immediately tbe claims in !hat
year. This system generates mainly short tenn reserves and is used for non-life insur-
ance like car-insuranee and also for reinsuranee.44
The business written by property and casualty insurers requires mainly loss reserves
and uneamed premium reserves:
Since insurers eollect premiums in advance for their proteetion eovering an ex-
tended time period, they are required to make provisions for the unfulfilled and con-
tingent obligations tbeir contracls represent. Insurers are ouly permitted to include pre-
miums as income as the premiums become eamed. This is the ease when the time
for which protection is provided has passed. Further, they are obliged to establish a
deferred ineome account, ealled unearned premium reserve in order to p1ace a claim
against assels !hat will probably be used to compensate for claims in the future. 45
Loss reserves are established to cover all known and unknown future claims to be
faced by the insurance company caused by their underwriting activities. The first type,
tbe reserves for losses reported but not yet paid, can be established by tbe examiuation
of each claim and approximation of the severity. The second type, the reserves for losses
incurred but not reported due to a potential time lag in claim reporting, are usually
42Rejda [see 1986. p. 575]

43 ÜUtreville [see 1998, pp. 233-241]
44 ÜUb'eville [see 1998, pp. 221-223]
4SYaughan and Yaughan [see 1995, p. 119]
estimatOO on the basis cf past experiencc.46

The major liability item. for llfe iDsurera are policy reserves being obligations to
pay futnre policy benefits to the policy ownc:rs and therefore can be regardc:d as Iiabil-
ity item.s on the company's balance sheet. They are often callc:d legal resaves sincc
supervisory bodies and insurance laws speci:fy the minimum basis for their calculati.on.
Thc policy reserve plus interest earnings on the assets acqujrcd with the cash ßow of
the premium most be sufficient to pay aIl future benefits to the policy holder. It is the
formal mcognition ofthc company's obligation to pay contractual bcnefits. The rescrvc
further fonns the legal test of the company's solvency since the company must hold as-
sets equal 10 its legal reserves. It should not be viewod as a fund but rather as a Iiability
item. that must be offset by assets.
-
I I ~ " Ir 5
- ~ - - I1
E
~
Assc!s
( ,rem'' ' j
Reserves •
.~
~
u
,
U "l'p, , ", _ Surpll.ls

",d I
ln,,~:~
[ncomc
Assc!s & Liabilitics Statement of Incomc
113.<00 on: Qu",,, ilk kan·F"...cois. Throf) ond I'"",,;cc of Insurance

"I"wer ",,,..k mio I'ubli>h<rs. I)ortln:<hl. 1998. I'- 223
Figure 2.6: Flow of funds of an insurance company
Figure 2.7 shows an example of an ordinary US Iife insurance policy covering an

amount of USD 1,000. Closed at the agc of 35, it is supposed to stay in full forcc:
and e:ffect for the life of the insured with periodical premium payments for the same
period. At the starting point of the contract, the present value of thc oet single premium
ofUSD 421.21 is equal to the present value ofthe future payment to the poIicy holder.
Howcvc:r, when thc first premium installmcnt has been paid, this is no langer thc case -
the present value of future benefits and the present value of future net premiums are not
equal anymore. The present value of thc future benefits will increase over time when thc
46YIIIlghan md Yaugbm [_ 2003, p. 143]
date cf death is drawing closer. Sincc lower premiums are to be paid. the present value
of future net premium stream will decrease. The difference between the two forms the
policy IeSCIVC. If the insurcd is still alivc at the age of 100. the face amount of the
insurance is paid 10 the owner of the policy. At this point, the reserve is equal 10 the
policy face amount. 47
USIlI (J(l(l
~""ngI< ~"""""''''
l'<m lU'"
,m""""[;;~=~::::~J
(J5D 0
Pr<S<nt V.ru.: ,,r r.. w, ..... p«m,wo>
" .,~
" 9~ 100
I.""""",
fJ.ao<d '" Ou,.. " lIo. f'... ·F' Io'IOOo~ Th«oo) and Pr",·" ,,, of
r..:1"~<t Aca.Icrn>< Publo>h<f>. flot<h<h'. 1_. P 1""1
Hgurc 2.7: Prospccti.vc reserve of an ordinary 1ife insurance
Regarding the time of valuation, the Iife inmrance policy reserve shown in figure 2.7
can be cla:ssified as prospecti"ve reserve since it is ca1culatcd as the difference between
the present value of the future benefits of the policy holder and the future net premiums
he is obliged 10 pay for the insurance cover.
The second classification by the time of valuation, the retrospective reserve, repre-
sents the net premiums paid 10 the insurer fur a particular block of insurance policies,
plus interest eamings at market rates, minus the amounts paid out as death claims. It is
the excess of the net premiums collected at interest over the death claims paid out 10 the
polioyholde<.
Classified by the timing, when reserves are valued, the policy year begins with the
initial reserve. This rescrvc 1cvel is commonly used by the companies 10 detcn:ninc
dividends. The terminal reserve is the reserve level at the end of a given policy year,
while the mean reserve is defined as the average cf the terminal and the initial reserves.
41Rejda [see 1986, p. 57Sj

It is used to indicate the company's reserve liabilities for the annual accounting.48
2.4.3 Investments of the insurance sector

Together with pension funds, insurance companies are main investors in the capital
markets and io real estate. The returns on these investments are, together with the
premium income from policyholders. an important source of income for the insurance
sector. The ability of insurance companies 10 meet their future payments due, is vital at
any time time and for the long term survivaI of the company. The iovestment iocome
must therefore be sufficient to maintain the capital and surplus.<' The legal reserves
and other liabilities of an iosurance company must be offset by liquid funds and asset
iovestments. Approxirnately 80% of the assets of a life iosurer are needed to offset its
reserve liabilities. 50
In addition to the investment of the reserves as its provisions for claims, insurance
companies reiovest the substantial turnover and returns from their asset portfolios. Con-
tinuously irnproviog asset-Iability-management infiuences the iovestment philosophy of
the iosurance iodustry today. This ioc1udes a co-ordination of the assets se1ected for the
portfolio iovestments io that respect, !hat they represent the nature of the liabilities of
the companies. The efforts are on the matching of durations, delined as the average
life of the cash flows from both sides of the balance sheet. In addition, companies try
to immunize themselves against adverse interest rate developments by hedging therr
positions with derivative financial structures.
Most iosurance companies give ptime irnportance to the priocipal of security of their
capital invested. Second, their managers are concerned about earning the highest retum
possible for their iovestments chosen. Third, it is irnportant to secore the liquidity of
the iovestment portfolio io order to be able to pay claims timely or to meet unexpected
obligations.51
The investment income is also important for reducing the cast of insurance, the pre-
miums to be paid by policy holders. Most pTOperty and casualty insurers, especially the
US iosorers, were not able to write combioed ratios below 100 percent for most of the
annual reporting periuds of the past decades. This means that their expenses and claims
cost were higher than the premium iocome and their iosurance underwriting produced
lasses. Tbe investment incorne was necessary for them to overcome the difficult years
facing a competitive environment.52
Ufe insumnce companies have to assume a guaranteed minimum rate of return in
the calculation of the premiums. Tbe investment income in excess of the minimum rate
is used to pay benefits on the contracts. Competing for clients with similar products,
48Rejda [see 1986, p. 577]

490utreville [see 1998, pp. 221-223]
"'Rejda [see 1986, p. 575]
51 ÜUtreville [see 1998, pp. XX]
S2Cohen et aI. [see 2007. p. 25]
profits generated from investment income is an imporllmt eriterion for eustomers to

evaluate the finaneial strength and finally deeide whieh company to contract."
Assels-structnre or insorance companies
Fixed income investments are weIl suited to match the objectives of most insurance
eompanies globally in order to maintain sufficient assets to offset their liabilities. Only
the investment types listed as "admitted assets" by the supervisory authorities and reg-
ul.tory boards are allowed to be shown on the stalutory balance sbeet. Admitted assets
inelude cash, bonds, common and preferred stocks, mortg.ges, real estate, and other
legal investments.54
Investments in fixed income securities issued by governments, federa1 states and
municipals are generally regarded .s risk-free investments, sinee they h.ve historieally
not been endangered from def.ult or insolveney. Insuranee eompanies may usually hold
an unrestrleted arnount of bonds elassified .s "risk-free".
The qua1ity of corporate bonds, • forther investment elass for insurers can, in eon-
trary, be affeeted by eredit deterioration or def.ult of the issuer. They therefore p.y •
higher return. Rating .geneies estimate the quality of borrowers and single bond issues
and their likelihood of • def.ult. Appendis A sbows the mting definitions of the main
rating agencies.
An alternative to fixed income investments are mortgages and private loans. These
are usually non-liquid, and the insurer demands • higher mte to eompens.te for the
higher liquidity risk involved. At the diseretion of the policy holder,life insurers provide
poliey loans resulting from provisions in life insuranee eontracts. The polieyholder
borrows the cash value of the policy.
Due to the long term nature of the oblig.tions of life insurers, they are traditional
investors in the real-estate ownership whieh gener.tes stable returns .t. high level.
Investments in common and preferrcd shares have been limited duc to negative ex-
perienees during the crisis of the main stock markets in the late 199Oies. These invest-
ments are eharacterised by non-guaranteed periodie p.yments of dividends. Further, the
insurance company carries the rist of a deterioration of the market value of the shares. 55
In recent years, other legal investments of the insuranee sector in struetured credit
products have inere.sed. Inuov.tion has been the main driver of Ibis market Changes in
credit markets, like the strong involvement of hedge funds providing liquidity and eco-
nomie leverage inere.sing the demand for innovative products, have also been pl.ying
• fundamental role of its development. Insurance companies in all regions particip.te
actively in the whole range of products across the several tranches from super-senior
down to equity. Regarding the different produets launched by the market participants,
insurance eompanies participate in all produets explained in table 2.4.
53Goecke and Will [see 2001, p. 75-79]

"Rejda [... 1986, pp. 585-586]
550utreville [see 1998, p. 249]
Insuranee companies are strong cash generators. Due to high liquidity, they were
important partieipants in the synthetie struetured finance markets. In the peak year
2rxn, the purchase of risk assets represented 80% of their transaction volume. How-
ever, they also seil risks to the market to diversify their exposures. These transactions
represented 20% of the volume tomed over.'6
Regardless of the relevant legislation and the nationality of an insuranee company,
a1l have in common that they have to follow certain investment guidelines. Even when
these regulations may not be striet, they have to respect their own intra-eompany stato-
tory investment guidelines providing qualitative requirements and quantitative limits.
ln addition, insurance business is rating sensitive. The customer of an insurance COID-
pany is eoncemed about the ability of the insurer to pay the claim when due. Sinee the
ratings refleet the ability of the company to pay its obligations, the rating ageneies are
also monitoring the investment behavior of the companies in their regular evaluation
processes.
The EU will harmonise its supervisory regulations in line with the Solvency 2
framework. In November 2007, the member states bad to implement the Markets in
Financial Instrnments Directive (MlFID) of the European Union number 2004/39/EG
into locallaw. The directive is regarded as a big step towards Solvency 2 sinee it har-
monises the existing regulations of the different EU member states. In Germany, the
most important investment limitation elements are based on the supervisory 1egislation
ealled "Anlageverordnung" as deseribed in figure 2.8.
In the USA, the supervisory authorities are based at federal state level. The state in-
surance commissioners belang to the National Association ofInsurance Commissioners
(NAIC), founded in 1871. AIthough the NAIC has no legal authority, most states have
accepted the NAIC model1aws in mous areas. 57 US insurance companies must file
their investments with the Secorities' Valuation Offiee (SVO) of the NAIC. The SVO
rates the credit quality of the secorities and establishes rules for their valuation.58
The main regulations described below are based on the actnal insurance 1egislation
of the State of New York. There is an ongoing diseussion supported by the supervisory
harmonisation in Europe about the formation of a regulatory authority at federallevel."
Figure 2.8 gives an overview of the percentages of investments allowed in the dif-
ferent investment eategories in the USA and the EU, each based on the admitted eapital.
Bonds are the main type of investment followed by the mortgages'"
As per end of 2006, the maiority of the investments in new produets were transacted
in CLOs, CDOs and ABS. Depending on the region, insurance eompanies have a share
of 5% to 20% in the new investment products. The other market partieipants together
with hedge funds are mainly banks and investment managers. 61
56King et a1. [see 20.06.2007, pp. 3-7]
"Rejda [see 1986, pp. 584-592]
S!lYaughan and Vaughan [see 2003, p. 104]
59Miani and Dreassi [see 30.04.2007. p. 8]
600ECD [see 2006, p. 505];CEA [see 01.08.2007, p. 63]
61King et 81. [see 20.06.2007. pp. 4-6]
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Sourccs: Bundesanstalt ftIr FinanzdicnstlcistungsaufsirJrt, An1agcvcrordmmg:
AnlV, BOBL I S. 1373 22.05.200S; CEA, European insurance in figures, ~
Europccn des Assuranccs, Bruxcll.es, 2008, p.44; GDV, Insurancc Ycmbook 2006,
Gesamtverband Deutscher Vcrsichenmgswirbchaft, Bcrlin, 2008, p.44; m, Invest-
IIICIIts Property/Casualty and Life WUImI 2003-2007, InSUDIICC Infonnation lns-
titute, www.ili.orgIfactbookl1hJinancia1investand .. Jpc....:financial invest; last
checked: 21.07.2009; New York State Insurance Department, Inaurance - authorized
investments: ANYCCCH.IV.-Art.14.01-14.14
Ft.gUre 2.8: Asset classes: Limitations and reported figures - USA I EU

Supervisory authorities have been allowing insurance companies to invest into struc-
tured credit like Collateralised Loan Obligations (CDOs), Asset Backed Secorities (ABS)
and Collateralised Debt Obligations (CDOs). The investments into hedge funds are in-
c1uded in the position: other investments. The EU plans to increase the allowed share
in other investments from 5% to 10%.62
Furtber limitations exist in the quality of assets. The minimum Standard & Poor's
(or equivalent) rating of investment into corporate debt for the USA is "A", and real
mortgage loans must be secnred with prime property titles. The investments into non-
domestic assets are also Iimited to 10% for non-life insurers and 4% for life insurers
in the USA. 6' European insurers are allowed to invest up to 10% in debt issued by
borrowers which are not based in the European Economic Area. 64
Due to the experiences doring the stock market crisis of the 1ate 199Oies, the global
insurance sector is hesitating to invest heavily into high yielding assets or stocks. For
exan3ple, investments in shares have decreased in Germany from 8.0% at the end of the
stock exchange boom year 1999 to 2.0% in 2007.6 '
In the VI{, where insurance companies traditionally invest strongly in stocks, in-
vestments in this assel type fell from 61.0% in 1999 to 45.8% in 2007. 66
It has to be stated that the regu1atory framework infiuences the insurance companies
in the selection of seniority and product diversification.
Tbe valuation of assets is usnally regulated by law in all countrles. Cash is valued
at its face value. Since the market value of a bond usually differs from the face value
because of the changes in interest rates, it is recommended that bonds shall be listed at
their an30rtized values (bonds in default are valued at market prices). Tbe usnal practice
to value common stocks at market value results in adjustments in the surplus account.
Since a reduced surplus account limits the possibility to pay dividends to the own share-
holders, the position of the insmance company in the competitive environment may be
weakened. Mortgages are valued based on the an30unt of outstanding debt Real es-
tate assets are listed at book value (original cost minus depreciation) or market value,
whichever is lower. However, in many cases it is difficult to estimate the real martet
value of a real estate asset.67
62promme [see 18.06.2007]

63New York State Insurance Department [see 30.06.2007]
"Bafin [see 22.05.2007, § 2 Art. 2 d]
MODV [sec 2008, p. 44]
66 ABI [see 2009]
"Outreville [see 1998, p. 253];Rejda [see 1986. p. 585]
Type Product Characteristics Sector

Involve-
ment
CDO Securitised interests in pools of generaIly Moderate
non-mortgage assets called collateral usu-
alIy comprising loan or debt instruments.
If structured as casb-CDOs, investors bear
the credit risk of the collateral. They can
invest in several tranches with different
quality reßected in the tranche rating. Syn-
thetic CDOs expose investors to credit risk
in the form of Credit Default Swaps
CLO I CBO If CDOs inc1ude loans as collateral, they High
are called Collatoralised Loan Obligations
- if they inc1ude bonds as collatera1, they
are called Collatoralised Bond Obligations
ABSCDO Assel Bac1red Securities are pooled and High
placed into a trust vehic1e. Investors bear
the credit risk of the underlying risks. As-
set bac1red securities may inc1ude a vatiety
of debt auto loans, credit card debt, student
loans, private with floating or fixed rates
CRECDO Conunercial real estate related debt is Low
pooled and placed into a trust vehicle
which issues tradeab1e securities
CDO Squared CDO bonds resulting from cash or syn- Low
thetic CDOs are p1aced into a trust vehic1e
issuing tradeable securities. Investors carry
the credit risk of the issues
MVCDO' Assels with an embedded value are pooled Low
an placed into a trust vehic1e which issues
tradeable secutities
EMCDO Emerging market sovereign or corporate Low
debt is pooled and p1aced into a trust vehi-
c1e which issues securities. Altematively,
Credit Default Swaps may be used to cre-
ate a synthetic portfolio. The investors take
the credit risk of the underlying debt
Synthetic CDO Sq. The bonds of synthetic CDOs are pooled Low
and placed into a trust vehic1e issuing
tradeable secutities
Market Value Collateralised Debt Obligation
Table 2.4: Product innovations of the capital markets

Chapter3
The Insurance Industry
Tbe insurance sector is a very diversified industry. Table 3.1 summarises the main types
of primary and reinsurance available with their produet !ines. Basieally, there are two
!ines of primary insurance:
Tbe first !ine eonsists of the life insurance eontracts paying at the death of the in-
sured or alternatively earlier, when the insured is still a1ive, together with the health
insurance, covering for the 10S8 caused by illness or injury of individuals.
Tbe second group of insuranee 1ines are non-life insurance, also ca1led property
and casualty insurance or general insurance. It covers far damage to or lass of the
polieyholder' property and takes legalIiability for darnages eaused to other people or
their property.'
Credit insurance is rather specified and protects from monetary losses resulting
from the non-payment of a trading counterparty. The growth of exports and the increas-
ing use of internet for retail and wholesale Irades is increasing the demand for this type
of insurance. Further, surety, the insurance against contract frustration is classified as
credit insurance.2
In the USA, a special type of insuranee, ca1led the monoline insurance sector was
established in 197Oies. Tbe previously bighly rated eompanies are specialised in the
enhaneement of credit by ensuring the repayment of debt. Tbe result is a bigher rat-
ing of the obligation insured and therefore a reduction of the refinaneing costs for the
borrower. Monoliners insure munieipal bonds, projeet finanee and structured finanee
bonds. The insurance companies are called monoliners since they are limited to this
1ine of business by the underlying Artic1e 69 of the relevant law of the State of New
York.3
Reinsurance is agiobaI industry providing backup for primary insurers. Reinsur-
ILife Office Management Association [see 20.07.2007]

2SwissRe [see 2000, p. 3]
'Rasul [see 2005, p. 11

36 CHAPTER. 3. 11lE INSURANCE INDUSlRY
ancc companies, in their rolc as seoondary iDsurers, do not dircctl.y pay claims to
policyholders. Instead. they reimburse the insurers far claims paid. The reinsurer cov-
ers part of the ri.sk and part of thc premium. originally taken by thc insurer. Rcinsurance
etIectively increases an inmrer's capital and therefore its capacity to seil more coverage.
Reinsurers do have their own reinsurers, called retrocessionaires.4
3.1 Primary insurance

Primary insmance companies either deal directly with clients through their distribu-
tion netwoIks or act tbrough brokcrs. The c1icnts can be individuals or cmporations.
Supported by the new information technologies, brokers have gained more and more
importance. Customers like 10 choosc between several insurance compames to get
tailor-made solutions far the best price available. 1he distribution networks are under
constant ro-organisation in order to keep up with thc competitive environment.
• "0". ,\... ri<a

o "N.I:. ",pt
• J ..... .
• 0« ....
•
o C I~ 1:. .. 1"
o t .. , .. .. ...,;..
o ..........,.
,
• Ar,;. •
···iL········································
,
• '®
~ 1> 1 .~~..,<Id
, ,, . ).1IJ..,,,,,
t.,.".« .... _'•• pO' t.,.. ,Ho 'S"I ....... 'n.I~<d .\ , ..
[)01a Sourec: S"issRc. sigma No. 412007: World lnsuran", in 2006:

Premiums cam" bae~ '0 ..Iire·', S";ss Re. Zurkh. 2007. p. 31
Figure 3.1: Insurance penetration in the global economic regions
According to the latest survey covering 147 countries, the total direct premiums written
were USD 4.1 trillion. dividod by non Iife insurance USD 2.4 trillion and Iife insurance
4SwislRe [aee OU19.2005, pp. 4-14]
3.1. PRlMARY INSURANCE 37
Insurance Line Typ.. Insurance Producls

Life Term life (deatll indemnity)
(in 1he US: Savings produels and
Life and healtll savings insurance products
insmance) Produets witll guaranteed interest
(policy holder hears no inveslment risk)
Unit (index)-linked products
(policy holder hears tlle investment risk)
Lump-sum retirem.ent
Annuities
Pensions-related products (savings or
annuitics)
Healtll Disability
(InEurope: Critieal illness
Life- is often separate Healtll
from healtll insurance
Non-Life Motor physieal damage
Property & Casualty motor tllird-party liability
Persona! & Commercial Property
Aeeident healtll
Employer's liability/worker's eompensation
Third party and otller labilities
Credit insurance
Legal expenses
Credit Trade receivablcs and politieal risk
Surety and eontract frustration
Monoline Repayment of tllird-party debt in publie and
structured finance
Reinsurance Wholesale insuranee providing reinsuranec
protecti.on for the above primary insurance
types
Source: Batchvarov, Alexander and Dinesen, Christian, Securitisation

and Insurance: Marriage of Convenienee, Merri1l Lynch,
London,2006,p.3
Tablc 3.1: 'IYJ>cs of insuranec eompanics and tllcir products

38 CHAPTER 3. TIlE INSURANCE INDUSJRY
USD 1.7 trillion. Table 3.2 below gives an overview about the ten biggest markets in
tenns of US dollar premiums volumes before reinsurance transactions:5
Rank Country Non-life Lire AmouDt % change year % total

1 United States~ 651.311 578,357 1,229,668 +4.7 30.28
2 United Kingdom 113,946 349,740 463,686 +28.2 11.42
3 Japan' 94,182 330,651 424,833 -3.3 10.46
4 F= 81,907 186,993 268,900 +7.5 6.63
5 Gennany 120,407 102,419 222,826 +10.1 5.49
6 ltaly 54,112 88,215 142,327 +1.3 3.50
7 South Korea" 35,692 81,298 116,990 +16.3 2.88
8 Netherlands 66,834 35,998 102,832 +11.9 2.53
9 Canads 54,805 45,593 100,398 +14.7 2.47
10 PRCIrina 33,810 58,677 92,487 +30.8 2.28
Thp 10Thtal 1,307,006 1,857,941 3,164,947 +8.4 77.94
Gnmd Thtal 1,667,780 2,393,089 4,060,869 +10.50 100.00
1 non-life premiums incL accident and health insurance

2 non-life premium! incL state funds; life premium! and
an estimate of group pension business
, 01.04.2007 - 31.03.2008
4 Iife business expressed in net pre.miums
5 nominal change in USD without inßation-adjustment
Sourco: SwissRc., sigma No. 3flOO8: World insurance report, Swiss Reinsurance
Company, Zurich. 2008
Table 3.2: Top 10 eountries by life I non-life direet premiums 2007
Figure 3.1 gives an indieation about the importanee of the regional markets for the insur-
ance industry. It can elearly be seen, that the USN Canada, Western Europe and Japan
plus the newly industrialised Asian countries are the most important insurance mark.ets.
Tbe stronger the output of anation measured by the Gross Domestie Product (GDP) per
eapita is, the higber is the demand for insurance t.o secure the wealth of the nation and
its inbabitants measured by the insurance premiums per eapita This strengthens the
argument, that the development of the insuranee markets is ciosely linked t.o the growth
of the relevant economies. Tbe strongly growing economies of Centra! and Eastem
Europe and Asia are eurrently attracting the attention of the global insuranee eonglom-
erates. China and India are especially on the agenda of the insurers and reinsurers. 6
3.1.1 Non-Iife insurance

In the USA and the live biggest markets in Europe the non-life insuranee sector has,
measured by premium income, a market share of 60.0% and 36.4% respectively as
5Insurance Information Institute [see 2009];SwissRe [see 2008, pp. 36-39]
6Suess [see 11.09.2007]
3.1. PRIMARY INSURANCB 3.
shown in tablc 3.2. The recent natural. catastrophes have shown that, cspecially in the
USA. the insurance companies are not free in their rate making. When it comes down
10 insurance covcrage for individuals. US :fcdcral statc rcgulators are rcluctant 10 allow
premium increases in order 10 cover lasses caused by major catastrophes.7
This let 10 thc dcvclopment that scvcra1. cspccially smaller companics, arc consid-
cring 10 discontinuc the writing of covcrage in the cndangercd stares. Examples arc
Califomia. with a high likelihood of earthquakes and wildfires. Louisiana. tbreatened
by Humcanes and New York City as target for terrorist attacks with a high density of
valuable real-estate. 8 In the ease of Florida, the state authorities decided 10 set up a
state fund in order 10 compensate their citizens for losses caused by natural catastro-
phes. This was done to stop thc high rate increases announced by the property and
casualty insurance companies.'
O l ',i,'." C.. Uobili'J U1% )
• 110",.0" nc. "ulli I'"il ( I } % )
O Comn ..«i.1 C.. U.bi li ., ,6% )
. O,"'r (j.""i', ( ~%)
aComm«<i.1 " .lIi ,-..i I (1% )
o Inl.nd " ..i ... ,1 % )

• " cdi,,1 " . Ip"",'i« (1 % )
• Fi .. (2%,
• •\Ui'd,l %,
Cl Ot ..... .,. I %
., ~(. So urc~, lI "rt ... i~. l( o brrt and Ih rl (.II . SI.n. Fin" ncial S~" i c " Fact !look.
Propt.I)' and Casually " •• mi . ml W r illen b,. L.in t . InSU<3nef Inror mation
l"stiI UI., N..., Yorl<, 2008
Figure 3,2: Distribution cf non lifc pmniums in the USA 2006
Figure 3.2 shows the split among product Iines of the biggest market, the USA. The
statistics difIerentiate regarding muIti-peril and ear-msurance between penonallines,
rcpresenting private customers and c:ommercial Iines. rcpresenting corporate po1icy-
'Research [seeOl.09.2007, P. 9]
'Ward [see 16.10.2006]
'P1even md McDo:JWd [see 08.02.2007]
holder. lO
Car insurance is a highly competitive and standardised business with little variation
across international borders. Rates have been under pressure for severa1 years now and
the cost-efficient and price-transparent online distribution has been very successful. l1
3.1.2 Life insurance

Life and health insurance are related industries coveting individuals against the risk
of death, illness or accident. In the recent years the sector has gone through a pe-
riod of change. The strongest catalyst for life insurance was the stock market crisis in
combination with a low interest environment end of the 1990ies. In many countries,
life insurance companies are committed to pay the holders of endowment policies a
minimum re!um on their savings. Further, some regulations oblige them to share the
majorlty, in many countries up to 90%, of their annual profits with them. The insurers
had to pay out their profits to the customers and got under severe pressure when the
value of their stock portfolios deteriorated and they could, due to the low interest en-
vironment, not earn enough interest income to compensate the los ses. In the EU it is
being discussed whether with the introduction of Solvency 2, the fixed quotas should
be canceled to enable the insurers to strengthen their capital basis, when necessary. In
the USA, supervisors are of the opinion that the competitive market ensures attra.ctive
terms of the products and the participation of the policyholder in the profits. As a result
of Ibis, there is no regulation about profit sharing. '2
Further, the withdrawal of the state pensions schemes in the industrial countries
favours private solutions. It is expected !hat the growth of retirement products will ex-
ceed the GDP growth rates of the years ahead. The high growth economies of Central
Europe will most probably gain irnportance. While insurers active in the asset manage-
ment have bad difficulties to compete with the high retums offered by investment funds,
their traditional strength is the term life insurance and the accumulation of annuities. 13
The health insurance sector is faced with rapid medical advances causing high in-
creases in costs due to the involvement of u!'-to-date technology. Further, the with-
drawal of public support by the states increases the demand for private coverage. An
important innovation of the sector has been the insurance against critica1 illness. It pro-
vides the payment of usually one lump sum in the case !hat one of a list of weil defined
diseases may be diagnosed. Pandemics and new scientific developments like the nano-
technology or genetically modified food can potentially lead to rising health costs in the
future beyand the current reserve calculation of the insurance indUStry.14
Both !ines, the health and the life insurance, are challenged by inereasing longevity
of the population covered. The average age of the population in the industrialised na-
"'Frank and Shanker [see 2005, p. 3]
lICEA [see 01.12.2007, p. 7]
12Lang [see 2QOS]
13Quack Grobecker [see 29.01.2005]
14SwissRe [see 01.09.2005. p. 16]
3.2. CREDlT INSURANCE AND SURETY 41
tions was 29 years in the year 1950, 39 years in 2005 and is estimated with 46 years in
the year 2050.
Longer life means rising health cost for older people and longer payment period of
their annuities. 1S
Product innovations like the variable annuity products, granting the policy holder
wide ranging guarantees are challenging the reserve ca1cuIations of the life insurance
industry. Customers are protected against the fall of their investments in underlying
mutual funds and are given the full rights to participate in value increases. They may
also bave the contractual right to partly or fully withdraw the amounts invested at any
time. The products are regarded as being diflicuit to bedge against the fall in value of
equity investments. Further, the volatility of the investments may stress the necessary
equity basis of the insurance companies. 16
3.2 Credit insurance and surety

Credit insurance is used to secure the trading streams of the global economy. The in-
surance protects the seiler of a good from the risk of non-payment by the buyer, which
can occur from commercial or, in the case of exports, also political risk. The commer-
cial risks covered are insolvency of the buyer or extended late payment. Political risk
is usually caused by government action like the prevention of the payment transfer, the
cancelation of a license or the enactment of laws, war or civil conflict
Surety compensates the beneficiary for the case that a contractual, legal or regulatory
obligation is not met. It is closely tied to regulation; in the largest market for surety, the
USA, companies undertaking projects for govemment or semi-public institutions must
guaranty their work with surety bonds.
Both forms of insurance are closely linked to the real economy and the premium growth
can be expected to be more or less in !ine with the growth of the GOPs. However,
stronger growth than the GOP increase was experienced, for instance, after the opening
of the former commuuist states for free trade and in pbases of extraordinary growth of
the world trade volume, like in times of strong growth of the Asian economies, espe-
cially ChinaP
Tecbnological cbanges like the increasing anonymous online-trading accelerated the
demand for credit insurance. The total premium volume of credit insurance was esti-
mated to be USO 6.2 bn covering more than USO 2 trillion of sales for the year 2fXY1. 18
The latest figures available estimate the volume of surety premiurns as USO 7.9 bn,
covering notional amounts of USO 1,000 bn for the year 2005. Figure 3.3 shows the
geographie distribution of credit insurance and surety. The coverage provided by pri-
vate credit insurers usual1y taking shorter terms of 60 - 120 days into their books, whi1e
15Wiesemann [see 29.06.2007]

16Spehar et al. [see 2007, pp. 119-143]
17SwissRe [see 2006, pp. 3-37]
18EuIer Hermes [see 2009. p. 13]
the export credit agencies cover for longer terms up to five years. Surety is provided by
so caUed surety companieS.19
Wo.Ib ,%
II J.f"'" ,% IJ \I ,,~ '%

• er., ... I I I:" " .. I:.",... , % O J ..... m
. <h... ,-, . ()tbt, 1' %
[)ala so,,«.: S" ; .. " o. signo R No. 6n OO6. Cr. di! I ",uran<~. S"i .. R•• Z(irk~ Z006. PI', ZZ. 37
Figure 3.3: CIcdit insurancc and surcty premiums by regions
Crcdit insurancc and SUIety compctc wi.th othcr products:

Stand-by Letten 0/ Credit and Guarantees provided by banks oblige the issuer to pay
irrevocably and unconditionally for a customers draft or obligation within a specified
period up to a certain amount.
Assel Bar:1ced Commercial Papers are short-term discount instruments issued by COß-
duits to rcfinancc liquidity requirements from ovemight up tu a period of 270 da}'!
through the capital markets. Conduits are special purpose vehicles (SPV) - special enti-
ties establishod to deaI with tbe asscts - formed by big companies trading merchandise
intemationally. The SPV usually gets a credit enhancement resulting in an improved
ra1ing qualifying it far a cheaper funding through the issuance of commercial paper into
the capital markets.
Credit Defawt Swaps are also used as a substitute for credit inmrance. They provide
coverage against the impact of a negative credit cvent by a reference party. Tbis could
be a faUme to pay, debt restructuring, default, bankruptcy or other problems.
Factoring, a financia1 service in wbich a firm sells its rcceivablcs tu a company callcd
19SwislRe [aee 2006. pp. 3-37]
3.3. MONOLINE INSURANCE 43
factor for immediate eash payment at discount is on the one hand a eompeting produet
with credit insuranee. On the other hand, the factors often demand credit insoranee
to protect themselves against the risk of not collecting their Irade receivable. Credit
insurance therefore complements factoring. 20
The market for eredit insurance has gone through a strong phase of eonsolidation
during the past 15 years. While in 1990, the top live eredit insurers bad a combined
market share of 40%, the remaining top foor players Euler Hermes, Coface, Atradius
and Credito y Caution held 85.4% ofthe global marke! in 2007.21 Credit Insoranee has
a lang tradition in Western Europe, where the main markets Germany, the UK, France,
the Netherlands and Spain, account for an aggregated volume of approximately 60%.22
The US surety providers faced eataslrophie losses with the default of large eorpora-
tions like Enron, Modem Continental, Dillingham and J.A. Jones. The losses showed
the weaknesses of the underwriting and risk management of the industry. As a result, six
of the ten largest eompanies of 1998 have merged, became insolvent or exited business.
The ten biggest underwriters today belong to international insoranee conglomerates
whieh should be strong enough to withstand ehallenging market eonditions. 23
3.3 Monoline insurance

Monoline insurance companies have, until the credit crisis, usually been AAA rated and
offer credit protection to holders of insored credits. Policyholder ean be banks, pension
funds structured investment vehic1es, conduits or similar institutions. The financial
guarantee insorance provided is unconditional and irrevoeable. To demand payment, it
is sufficient !hat the bond holder verifies the failure to pay prineipal or interest by the
issuer of the debt.
Bond insorers provide credit enhancement for a lower rated issuer of an obligation. This
results in a eheaper funding due to the enhaneed rating. The insored bond, however,
needs to be at least rated investment-grade. The business bas been inereasing sinee
the early starts in 1971 substantially, when the USD 650.000 obligation bond for the
Greater Juneau Boorough Medieal Arts Building in Alaska was insored by the monoline
insorer Ambac. Today, the eompanies do not only insore several types of bonds but also
structored credit. Insuranee ean be provided on a primary basis when the Iransactions
are struetured and the bonds to be placed on the market are rated, or on a secondary
basis. This is often the case, when a bank. or investor asks a monoline insurer to enhance
an existing portfolio in order to free up regu1atory eapital or to protect hirnself against
market volatility or ratings migration.
While the bulk of the business is done in the USA, the monoline insurance eompanies
started to enter the European market providing protection for bonds issued to linanee
21Eulcr Henncs [see 2009, p. 13]
toll roads, sehools, rall projeets, tunnels, and publie buildings.24 Table 3.3 gives an
overview of the latest available transaction volumes in the different types of monoline
insurance.
Net par outstandiDg 31.12.06 Net par outstanding 31.12.06

(USDrolo) (USDrolo)
Public FiDance Structured FiDance
General obligation 463,564 Mortgage-backed USA 154,889
Tax backed revenue 200,426 O1her aaset·baclred USA 379,828
Utility revenue 202,481 Mortgage-baclred intern. 46,646
Health care revenue 95,337 Other asset-baclred intern. 154,673
Transportation revenue 109,862 Utility obligation 49,609
University revenue 67,871 O1hcrUSA 27,584
Housing revenue 38,337 Other international 10,505
Student loans 27,697 Total structured finance 2,171,518
International 84,643
O1her 57,564
Thtal public financc 1,347,782
Tota1 Net Financial Guarantees in Fo.... (P&I) 3,259,189
Somce: AFGI, Annual Report 2006, Association of Financial Guarantor

lnaurers, New York, 14.05.2007
Table 3.3: Volume of financial guarantors insured business in 2006
In 2007, tbe financial erisis in tbe overheated US real estate sector worsened as higbly
leveraged homeowners inereasingiy defaulted on tbeir mortg.ge p.yments. Monoline
insurers as • result may be expused to p.y billions of dollars in def.ulted mortg.ge
related securities and CDOs. The eornpanies took tbe following steps to stahilise tbeir
finaneial situation:
• Most monoliners discontinued to write insurance for structured finance concen-

!rating on the less e.pital intensive and less volatile municipal finauce sector. 2S
• They are establishing new, weil capitalised monoline insurers either as subsidiaries
or by e.pitalising an alre.dy existing entity, ideally witb extemal funds. Berk-
shire Hathaway, in addition, entered the market by founding • new monoline
insurer for publie finance. 26
• They started to work on commutations meaning that they unwind their insurance
policies .gainst • fee p.yment to the beneficiary.27
"Rasul [see 2005. pp. 5-8]
2S.Alaander [see 01.12.2008]
26Kaufmann [see 09.03.2009]
27 van Duyn [see n.p., 22.06.2008]
3.4. REINSURANCE 45
• Tbey are working on split-ups of their operations. MBIA, for instance, split its
business into a public finance insurer and a structured finance insurer.28
Unfortunately, in most of the eases, the e!forts were not fruitful and most of the for-
mer higbly rated finaneial guarantors were downgraded to low investment-grade, sub-
investment-grade, or even default levels. Under the current circumstances, the business
model based on eredit enbancement does not work for the lowly raled monoline insur-
ers anymore. Further, future bosiness prospects are rather bleak sinee eustomers lost
eonfidence in the value of the wrap for longer-terms. Due to the insecure prospects,
capital from new investors is difficult to attract and rating agencies are hesitating to
grant newly established monoline insurers excellent ratings. 29 30
3.4 Reinsurance
Reinsurance provides insurance for insurance companies. Tbe sector is a global in-
dustry with 250 companies operating in 50 eountries. In accordance with the primary
insurance, it can be divided into non-life reinsurance and life/health reinsurance.
Non-life reinsuranee dominales the market with a total volume of USD 123.1 bn
as per year end 2007. Life reinsurance with a total volume of USD 66.7 bn accounts
for proportionally less than non-life reinsurance because life products mainly consist-
ing of savings have a small insurance risk. component and therefore are, in general, not
reinsured. Tbe geographical breakdown of figure 3.4 shows the dominanee of North
Ameriea and Western Europe. Tbe benefits of reinsuranee are redueed volatility of
underwriting resuits, capital reliefs, and flexible refinancing. Reinsurers provide, in ad-
dition, access to expertise and services, especially in the fields of produet development,
the prieing of underwriting, and claims management.3 '
The regulation of the reinsurance sector in Europe is currently undergoing an har-
monisation process launched by the EU Reinsurance Directive. It was published in the
EU Official Journal end of 2005 and due to be irnplemenled in all 27 member stales by
year end 2007. Up to its introduction, some countries have not regulated reinsurers at
all. Others, like the UK, regulaled them on the same basis as the primary insurers. Tbe
EU Reinsurance Directive aIlows EU-based reinsurers to do their business in aIl mem-
her stales, as long as they bave the license from the responsible supervisory authority
of their horne state ("single-passport regulation"). Non-EU-based reinsurers will have
to get an authorisation from eaeh single state they like to underwrite business in. All
supervisors will work on the same EU-wide standards, bnt will not be either allowed to
demand any eollateral, nor to regulate any terms or conditions. The Solvency 2 regula-
tions with their risk-based capital approach will be introdueed for the primary and the
28 van Duyn [see n.p., 13.05.2009]
29Kaufmann [see 09.03.2009]
30The effects of the monoline downgrades will be further discussed in chapters 6 and 7
31IAIS [see 17.12.2008, p. 2]
5' %
J6 °1.
O."oclh ,\mtd ••
• L.,;" Am";"
Sou .. t: lAIS. Global rtin,uran .. m.r~. t ""pOr1 . I not,n . lionol """"i"i.n or

In, u... n.. 5"1'<"';...... H.,.I. 2008. p. 31
Figure 3.4: Cessions to global reinsurance companies 2007
reinsurance sector aIite. 32

In the USo the regulation cf reinsurance claseIy follows that of primary insurance
companies. That means, that there is no federal system of control. However, most fed-
end rcgulators havc adoptcd thc NAIC capital models. On thc condi.tion, that a rcinsurc:r
licensed in one federal stare provides a guarantee to honor its technical provision, it can
do business in another state. Foreign insurers, not registered in the USA. have to pro-
viele guarantees, normally in the form of bank. Iett:ers cf credit or trust funds. 33 There
bad been several efforts to reform the US regulation or to create a federal regulator
which faiWd in the past.304-
In the recent years. the market has gone through a concentration process especiaIly
in the US wbere foreign companies havc taken over a number of the bigger players. The
marltet today can be divided into three groups:
FlISt, the Buropcan reinsurancc compani.cs Munich Re, Swiss Re anti Hannover Re
with their US mbsidiaries, the insurance market Lloyds and SCOR.
Second. the US reinsurers Iike Berkshire Hathaway (owning General Re), Everest
Re, Transatlantic Re, Nationallndemnity, Employers Re, Odyssey Am Re, and Berkley
Insurance Co.
Third, the ofJshore compani.es in Bermuda sparked by the Iiability insurance crisis
J2Earopem Commisaion [see 21.04.2004]

"KPMG [see 2002, pp 64-66]
MIntmnationalTradeAdminiatraoo [see 2001]
3.4. REINSURANCE 47
in the USA of the mid 1980ies, hurricane Andrew (1992), and the terrorist attack against
the World Trade Center in New York (2001) causing high damage to the industry.
The offshore reinsurers were founded in three W8ves as new companies: In the first
wave ACE Limited and XL Capital, in the second wave Partner Re and Renaissance
Re, and in the third wave AXIS Specialty and Arch Capital. Most offshore reinsurers
are registered on Bermuda which offers them a benign regnlatory envimnment and the
absence of corporation taxes - ideal conditions for sustained growth.35
After the Hurricanes Katrina, W11ma and Rita (all in 2005), the offshore industry
was able to attract a total of USD 18 bn of additional capital in just a few weeks. This
was required to re-establish their reserves after historically high total insured losses of
USD 71 bn the insurance marke! had to absorb. Capital investors, mainly private eq-
uity and hedge funds, generally expect to benefit from attractive income after premium
increases in the years after natura1 and man-made catastrophes.'6
3.4.1 Non-Iife reinsurance

The non-life reinsurance sector is a cyclical industry (see table 3.4 far the major com-
panies by net premiums written 2007). In times with low damages, the rates get under
heavy pressure and in times of catastropbes, the mies increase heavily - new capital is
attracted.
llaDk Compauy Country Net Premioms % Share

1 Lloyds UK 26,621 22.8
2 MunichRe Gennany 18,486 15.8
3 SwissRe Switzcrland 15,622 13.4
4 Berkslrlre Hathaway Re USA 13,316 11.4
5 Hannover Re Gennany 5,'J:73 5.4
7 Transatlantic Holdings USA 3,953 3.4
8 Partner Re Bermuda 3,185 2.7
8 EverestRe Barbados 3,122 2.7
9 S"" France 2,994 2.6
10 XLCoptial Bermuda 2,111 1.8
Thp 10Thtal 94,683 81.1
Top 30 Total 116,741 100.0
Source: Rouele, Mark et al" 2008-2009 Global Reinsurance Review & Outlook.
Fitch Ratings, New York, 02.09.2008, p. 12
Table 3.4: Global top 10 non-Life reinsurance companies
One of the dominant reasons to buy reinsurance is to protect the capital base against
large deviation of losses. The cession of risks helps to avoid serious financial distress
and potential defaults in tim.. of severe natural catastrophes like windstorms, floods or
3!lPrank and Shanker [see 2005, p. 10]
36Lansch [see n.p., 29.12.2OO5];SwissRe [see 2009. p. 37]
earthquakcs. In!lUlCl'!l also benefit from cconomies of sca1e. sincc due to the rcinsurance
cover, they are able to underwrite !arger amounts of business. Reinsurance compa-
nies play an important role in thc dcvcl.opmcnt of thc professional ri.sk assessment and
underwriting. Further, they detennine the wording cf legal contracts and the efficient
mitigation and adjustment of claims, to the benefit cf the primary insurers and their
policyholder. Relnsurers are able 10 diversify geograpbica1ly, and, if not specialised,
within the different business lines available.
,.
", ,. f\
-",, ,.,.
0
/\.1", l'
•
0 .~
~~
z•
• ~~
_ , , , ...1"' •• ,........ ' (ra'.': J.~J ['-' . "1

-O-\lOD-... <I< ~~ .. "" n·... ,' uw 1;.·• • "1
Soure.: $" iss~. _ sigma 212009. Natural ,otastrophc_, and man·made disaSlcrs in 200K
I.Urich. 2009. p. S
Figure 3.5: Frequency of catastrophes 1970-2008
Ta operate dficiently, rcinsuren need legal security: The originally agrced claims must
be legally valid and they must be able to be exercised in the future. International oper-
ations need a free ftow cf:funds and the ability cf global. risk transfer. Capital requjre-
ments of the market participants must refiect thc diversification of risks by reinsurance
in a fair way."
The statistics of non-life insurance distinguish between natural catastrophes and
man-made disast:ers. Both types are being weil reported in the media. Appendix B
shows the most costl.y events since 1970.
r1SwislRe [aee 01.11.2004, p. 16]
3.4. REINSURANCE 49
Natural catastrophes are caused by natural forces. One can see, that the tropical stonns
affecting the Gulf of Mexico during the typical hurricane season from Jone 1st to
November 30th cause heavy damage to the industry. Figure 3.5 gives an overview of
increasing trend of the natural catastrophes and man-made disasters sinee 1970 adding
up to 8.483 events with substantiallosses of human life. 38
All events have in common that their frequency and severity are diflicult to predict.
Tbe insurance sector therefore is supported by risk modeling companies to estimate the
severity of lasses caused by catastrophe scenarios using the most recent computer soft-
ware and statistical methods available. In the case of hurricane Katrina, however, a1l
estimates of the damages were 100 low since they took into consideration the damages
caused by the wind, but not by the floods. Tbe models are onder constant develop-
m.ents. 39
Figure 3.6, shows !hat natural catastrophes cause the highest amount oflosses, followed
by man-made disasters. Earthqualres are rare, but can cause heavy damage to the region
affected. Tbe most endangered mega-eities are Tokio, Mexico OF, Los Angeles and San
Francisco. After a study done by the modeling company Risk Management Solution
together with Stanford University, a repeat of an earthquake in San Francisco with the
intensity of the one experienced in 1906, would cause damages of USO 150-200 bn,
while the insured part is estimated at USO 75-95 bn.40
Tbe high concentration of the petrochemical industry and offshore oll riggs in Louis-
iana and Texas is vulnerable to hurricanes. Alone the two storms Katrina and Wt1ma in
2005 have caused losses to the oll sector of an estimated USO 11.6 bn of which USO
5.0 bn were insured.41
Beneath the increase in intensity of weather related natural catastrophes, the increase of
population and wealth in coastal regions is one of the main reasons for higher damage
in the USA. In 2003, 53% of the population, or 153 million people lived in the 673 US
coastal coonties which cover 17% of the land area. This is an increase of 33 million
people sinee 1980.42 But also in Europe, a higher frequency and severity of winter
storms is expected. MunichRe regards a heavy storm like "Kyrill" in 2007, but with
higher damages up to EUR 60 bu as likely.43 Heavy floods regularly cause damages
in Germany, Franee, Switzerland, the United Kingdom, the Czech Republic and other
coontries. In contrary to !bis, Europe experiences longer periods of drought. Summers
willlikely become hot and dry, causing withering crops and water shortages.44
Wtldfires in the Mediterranean region and California can be a natural phenomenon
or man-made by real estate speculators. Due to the climate change, the warmer regions
are increasingly threatened.
38SwissRe [see 2JXJ7, p. 4]
39Pe1sted [see 16.10.2006]
4OGrossi and Muir Wood [see 2006, p. 2]
41Hartwig [see 22.07.2006. p. 20]
42lnsurance Information Institllte [see 2007]
43promme and Hagen [see 21.02.2007]
44Burnett [see 04.08.2006]
so CHAPTER. 3. 11lE INSURANCE INDUSlRY
110_000
100.000
~
" 30.000 -1-
] MI.ooII
]
.E 40.000 f-- -- I
• .,~~-~I:i6~.~
,~'\.. ,...'1'" ....'1"-,. ,...'\'" ,,,,,.. ,<t'" ,~'" ,.$ ,<t'o ,.i,b't, ,,,f' ,<J!' ,<f'-" ,*, ,<f'' '..,# ...,f>......",,-" ...~'o ...<1>"
-0- \, ulh<r· ",,,.d ~"",,,I "''''",[>10 .. (f.,.,: I SU ~8J.j "'"
__ 110 . "",,<1< dj,",,,,, ( 1"... 1: I sn 105.3 boo)
- t:. ......... kt> (1'0101: I SIJ ~U t>o)
Sou", S" 'ssll.<. S1gm. 112009. Nat"'" """"<:>pO<> ond ",,,,,·made d.;asl'" on 2008.
ZO""h. 1009. ~ 7
Figure 3.6: Severity of catastrophcs 1970-2008
Examples for further disasters caused by human activity are blasts of industrial
plant!. Ieaking oll-pipelines, railway- or shipping accidents likc.. far instance., leaking
oll tanken or burning femes.
The ever increasing mega-cities are main targets of terrorists. It is impossible to
mjnimize the risk cf a terror attack to zero without giving up the personal freedom of
the inhabitants. Large-scaJ.e terror acts are not insurable in the private sect:or. A nuclear
orbiological attack in higbrisk areas withdense population would cxceed theindus1:ry's
entire capacity.4S
In contrary to other politi.cal risks. terror risk was, before the attacb against the
World Trade Center in New York on September 11th, 2001, in most ofthe states in-
surable without limitation. In Europe, only the states threatenod by terror, the UK and
Spain, bad govemment rcinsurance of last resmt solutions to cover lasses cf terror at-
tacks in place. Others, like Germany. France and Austna. implemented solutions shortly
alter the attacks.-46
The US indumy was, after the events, protected by the Terrorism Insurance Act
4!lWard [see 16.10.2006]

46Schaad [see2OO2, pp. 27-28]
3.4. REINSURANCE 51
whieh was due for porential prolongation by end of 2007.47 The act was not only
prolonged for another 15 years, but expanded to cover group life insuranee and rerror-
ist attacks by Amerieans as weil as by foreigners. Cornmercial property and easualty
insurance lines are required to cover lasses from terrorist attacks involving nuelear,
biologieal, ehemical or radiologieal weapons. Before the prolongation, such policies
exeluded that coverage.4' Most fonns of stare partieipation have in eommon !hat they
are temporary regulations covering the acute shortage of coverage until the private in-
surance sector is able to provide sufficient capacity.49
3.4.2 Life reinsurance

There are three types of risk that can be transferred to reinsurers: mortality risk (also
eatastrophie claims), surrender risk (early rermination by the c1ient) and investment
risk (a rather small market eovering the risk of guaranrees given in eomhination with
annuities).50
Life reinsurance was in the past regarded as a stable and low risk bosiness eompared to
the highly cyelieal property and casualty sector. However, two trends have ehanged the
pieture: First, the higher life expectancy of the ageing population in the industrialised
nations requires higher reserves to cover future annuity payments to the policyholder.
Figure 3.7 shows that the life expectancy in all eountries shown is prediered to eontinue
to increase substantially in the decades abead. 51
Second, pandemies like the bird-flu or drug-resistant tuberculosis strains are diffi-
cult to forecast and can, due to today's travel streams, porentially eause high fata1ity in
a very short time. The los ses for the life and health insurers for this scenarios would be
substantiaI."
Table 3.5 gives an overview of the globallife reinsurance groups. In the recent
years, there has been a strong concentration process. Several US groups have been
taken over by European reinsurers like Transamerlea Re by Aegon (1999), Caledon Re
by Hannover Re (1999), Ameriean Re (1995) and CNA Re (2000) by Muuieh Re and
Life Re (Life & Health business 1998), Lincoln Re (2001), and GE Insuranee Solutions
(2005) by Swiss Re.53
The leader of the US market, Seottish Re based on Bermuda, has laken over the eom-
pany ERC Life Re (2003) and the life reinsurance business of ING Group (2004). Af-
Ier liquidity problems it has itself been taken over by a eonsortium of the investment
subsidiary of the US insuranee Group Mass Mutual with the privare equity company
41Dalton et al. [see 2006. p. 1]

48Labaton [sec 20.09.2007]
49Bertram [see 17.04.2007, p. 4]
50Spehar et al. [see 2007. p. 262]
51 Jobnson [sec 14.05.2007, p. 1]
52Reich [see 24.04.2007];Finn [see 04.05.2007, p. 8]
53Spehar et al. [see 2007. p. 251]
-'~
" - /"
,ff?"
" /~ -
" Jij'
...ß!f
"
"
~
",,$ ,<t." ,#,Of>" ,~.. ,4!0" ,~'" ,4>" ,#',.E- ",#",# "-",,.. ",,,,,0, "'f~ "'s-" ",$' ,,<»" ",..t .'f"
-;>-1 S,\ _F",,,,,.
Sourcc: S";,,Rc, sigma No. 312007. Annuilics:. pri"alc sol ution 10 longe';l) risk.
S\\;SS Rcin$urancc Compan}. Zürich. 2007. p. 6
Hgure 3.7: Life-expectancy at birth in differentcountries
eemeru. (2006)."
After it has recovered from difficulti.es, the French seDR Group has integrated
Revios (the farmer Iife reinsurance operations of the German Gerling Group) in 2006
and the Swiss reinsurer Converium. in 2007 with substantial positions in continental
Europe and improved scale in the UK and the USA. SCOR is at current the only global
rcinsurer with more Iife than non-Iifc business.55
The main benefit cf life reinsurance is the possibility for primary insurance COIn-
pani.es 10 cede the mortality risk which ean vary over time and the risk caused by pan-
demics to the market. Further, they can reduce concentration risks caused by group
insurance contracts offerod by employers 10 their staff. Through Iife reinsurance coo-
tracts, the primary insurec gains acccss to the know how cf the globally operating rein-
surers. Those normaIly have a deep understanding of the markets and their products and
provide statisticaJ. data of the population insured. In addition, they support thc primary
inS\lre1'8 in the development of new products and their pricing. Through the transfer of
a great part of the highcr risk c1emcnts like mortality and disability risk. the primary
SlHmdeliblatt [_ 27.11.2006]
"ClarkandPetlmv [_2006.p. 1]
3.4. REINSURANCE 53
RaDI< Compay CODDtry Ne! premiums % Share

1 SwissRe Switzer1and 10,615 26.4
2 MunichRc Gemumy 9,512 23.6
3 Reinsurance Group of America USA 4,909 12.2
4 HannoverRc Gemumy 3,785 9.4
5 Sc", France 2,967 7.4
6 Berkshire Hathaway Re USA 2,462 6.1
7 Aegon NL 2,173 5.4
8 Scottish Re Group Bormuda 1,890 4.7
9 XL Re Bermuda 701 1.7
10 p"""", Re Bennuda 571 1.4
11 Ace Bennuda 368 0.9
12 MaxCapitai Bormuda 302 0.8
Thp 12 ThtaI 40,255 100.0
Source: Rouck. Mark: et al., 2008-2009 Global Reinsurance Review & Outlook,
Fitch Ratings, New York, 02.09.2008, p. 13
Table 3.5: Global top 12life reinsurance companies
insurer can concentrate on the savings and investment business. In general, life insur-
en with higher risk elements !end to cede more tban those with a high percentage of
savings products io !heir underwriting portfolios. S.
S6SwissRe [see 01.11.2004, pp. 5-7]

Chapter4
Methods of Risk Transfer
4.1 Traditional methods

4.1.1 Reinsurance and retrocession
Tbe traditional way to transfer underwritten risk by primary insurers was to buy reinsur-
ance and for reinsurers to buy retrocession. The insmance company transferring the risk.
is called cedent and the reinsurance company taking the risk is called cessionaire. If a
reinsurer is transferring risk to anather reinsurer. the risk transfer is called retrocession,
while the reinsurer is the retrocedent and the risk-taking company the retrocessiolUlire
(see figure 4.1). Tbe outward risk transfer is ealled cession, and the taking up of in-
smance risk assumption. The main reason to transfer risk is the creation of additional
eapacity. This may be necessary to write large risks, e.g. in the insuranee of natural
eatastrophes or to increase the premium eapaeity, e.g. the ability to write large volumes
of policies in the same business 1ine. Another reason for the cession of risk is diversi-
fieation. 1f the diversifieation of risks in a portfolio is low, the inOuence of single !arge
losses can be strong. This effect ean be reduced through diversifieation. Tbe volatility
of earnings after the diversifieation of risk is lower.'
Reinsurance products are under continuous development Tbc following explana-
tions concentrate on the main types and techniques of reinsurance and retrocession.
Tbe fonns of the risk transfer, eharacterised by the reinsurance methodology, are oblig-
atory,facultative and semi-obligatory reinsurance, as described in table 4.1.2 The basis
for transfer is a contractual agreement voluntatily entered into by the cedent and the the
cessionaire, while the two companies are the sole parties to the agreement.3
ICUlp [see 2002, pp. 333-334]

2Liebwein [see 2000, p. 52]
'Schwepcke and.1 01. [see 2004, pp. 97-102]

56 CHAPI'ER 4. METIlODS OF RlSK 1HANSFER.
By contractual terms. only two types cf coverage can be distinguished: Proportional

and non-proportional coverage.4
C.,.ion _________________ .. ,\»"mp';Qn
C.d.. , 11.".<.....",
I"·r
1Po; ... ,), la'''nla« C ... ) (lI,in," ran • • Co. l
- A,,,,mpt'Oß
i! c _
,j ...,-
1I.,m.... ;on .....

(lI.in, . ", n.. CO.)
F1gure 4.1: Reinsurance and retrocession
Primary insurcr and reinsurer agree to a contract called treaty, 1lIlda which the former is
obliged to rede to the latter a share of rist he has insured. The reinsurer is also obliged
10 takc the risk by accepting cach cession. The treaty is a fairly Iengthy document and
includes the kind cf risk. defined by the business line, the region. and the time-frame
covercd. In addition. the amounts and the furthcr tcrms and conditi.ons undcl" which
the risk is ceded are agreed. The primary inmrer can be sure that he will automatically
get reinsurance for every risk written which moets the speci:fied rcquirements. The sum
of all ri!!ks covered is callcd the reinsured portfolio. Widlln the reinsured portfolio.
the amount payable by the reinsurer can be limited by the agreement of a maximum
underwriting limit, a cover limit, a cession limit andIor an annual aggregate limit. The
risb reinsured can be specified in positive terms by Iisting the risks to be included or in
negative terms by listing the risks to be excluded. Once the parti.es have gone through
the careful documentation process, the advantage of the obligatory reinmrance is simple
and cf low-co!lt administration, since the direct insurer does not have to provide details
4Ki1D. andKi1D. [_ 2001, pp. 1-2]
4.1. TRADlTIONAL METHODS 57
on every risk he wishes to cede. Tbe rein,urer, however, takes blind particip.tion in
Ibe business and can potentially accumulate risk or get vulnerable 10 Ibe impact from
specific, highly expo,ed ri,k. S
Oblig.tory reinsurance requires • high amounl of trusl belween Ibe counterparties
involved and is often used for insurance products wilb • high frequency and low sever-
ity of claims. 1YPicai insurance products ceded by Ibe w.y of oblig.tory Ire.ties are
personal accident, fire insurance, or car insurance.6
Form. or reinsurance 'IYPes or reinsurance

(contractual relationsbip) (possI'bilities ror covering risk)
Obligalory reinsurance Proportional reinsurance

Formal agreement whereby the in- Baseline:
surer undertakes to cede all risks sum insured I probable max. lass
matching specific description. The Premium calcu1ation:
reinsurer is obliged to accept al1 pro-rata (proportional) splitting of
cessions offered by the insurer UD- original premium
der the treaty.
Main treaty types:
Facultative Reinsurance quota share, surplus
The insmer has the option of ceding Non-proportional reinsurance
specific, usually larger risks. The
Baseline:
reinsurer can choose whether to ac-
the 10ss
cept or decline each cession.
Premium calcu1ation:
SemI-obligalory reinsurance not re1ated to original premium
Combination of option to cede cou- (non-proportional)
pled with obligation to aceept (fac- Main treaty types:
ultativelobligatory), or obligation to excess of loss, stop loss
cede coupled with option 10 accept
(obligatorylfacultative).
Source: Schwepcke. Andreas, Reinsurance. Verlag Versicherungswirtschaft.

Karlsruhe, 2004. p. 102
Table 4.1: Tbe varlous forms and types of reinsurance
.5Schwepcke and et al. [see 2004, pp. 99-101]

'Kiln and Kiln [see 2001, pp. 33-511
58 CHAPTER 4. METHODS OF RISK TRANSFER
Facultative reinsunmce
Tbe primary insurer decides facultatively, on a case-by-case basis, wbether he likes to
cede a risk to the reinsurer. This means that he will assess each single risk: individ-
ually. Tbe reinsurer is also free to aceept, to dec!ine, or to negotiate the term of the
reinsorance contract. The primary insorer will offer the risk by providing the reinsurer
information about the cover, the reinsored risk, and technical details. Having agreed to
do the transaction, the counterparties will draw up an agreement on the individual risk
covered. Very often the basis for facultative reinsurance is an a1ready existing relation-
sbip in form of a obligatory reinsurance for other business !ines.
Examples for risk transfer by facultative reinsorance are: Cover for objects like depart-
ment stores, manufacturing plants, oll refineries, steel works, but also for exhibitions,
erection risks, or product liability policies. 7
Tbe insured risks vary widely and are normally !arge, unusual, or hazardous. In con-
trast to the obligatory reinsurance, the reinsurer can freely aceept to cover the risk after
analysis of the perlls. Tbe primary insurer has the advantage that he can benefit from
the experience of the globally acting reinsurer and is able to cede large and hazardous
risk. Getting advice from a person engaged in sharing the risk with him will be more
rellable. However, since each risk has to be considered individually, facuitative rein-
surance is time-consuming and expensive for both parties. The direct insurer has 10
arrange the coverage before be commits to take the original risk. If he does not find a
reinsurer in time in a competitive environment, the situation may get disadvantageous
forhim. s
Semi-obligatory reiDsurance
While one party is under contractual obligation, the second party of a semi-obligatory
reinsurance agreement is free 10 choose the risks it wants to cede or accept.
Tbe first form, the facultative-obligatory reinsurance (also known as open-cover), gives
the primary insurer the freedom to decide which risks from a portfolio be likes to cede
within the terms of the treaty. Tbe reinsurer is obliged to take all risks offered.' While
the primary insurer gets an automatie mark.et for its cessions, the reinsurer ensures its
exc1usivity and is able to underwrite bigger, more diversified volumes compared to the
pore facuitative reinsurance at lower costs due to standardised legal documentation and
administration. Tbe reinsurer, however, has to live with the risk that the primary insurer
cedes the less attractive high-risk business, while keeping the profitable, low-risk busi-
ness. Since the reinsurer is in a very weak. position, facultative-obligatory reinsurance
contracts are very rare. They may be useful in a situation when the direct insurer writes
increasing amounts of facultative reinsurance and both parties like to lower their costs.
7Schwepckc and et al. [see 2004, p. 99]

'Kiln and Kiln ["",2001, pp. 11-16]
9Schwepcke and et al. [see 2004, pp. 99-100]
4.1. TRADlTIONAL METHODS 59
Tbe basis must be a long-term relationship of special trust between both parties. 1O
The second form, obligatory-facultative reinsurance (also known as compulsory ces-
sion reinsuranee), obliges the primary insurer to eede all risks within the terms of the
treaty, but gives the reinsurer the right 10 accept the cession in part, in full, or to decline
it. This form of reinsurance is in practice nearly non-existent, sinee it olfers the cedent
DO reliable reinsurance cover. ll
Proportional reinsuranee
lbrough proportional reinsurance (also known as pro rata reinsurance or size-based

reinsuranee), the primary insurer passes a certain pro-rata-share of its portfolio to the
reinsurer who is getting the similar share of the original insurance premium for the
risk. Tbe obligation to pay is divided between the primary insurer and the reinsurer
on the basis of the sum insured (size) defined in the primary contracl whieh defines
the probable maximum lass. If claims arise, the reinsurer will reimburse the primary
insurer to the same proportion. 12
Tbe main treaty types of propurtional reinsurance are quota reinsurance and surplus
reinsurance:
A reinsmer signing a quota reinsurance treaty is participating in the primary COD-
tracl. Tbe seope of the cover is seI down in the original policy of the primary insuranee
eompany with its elienl. Tbe reinsurer participates with a fixed percentage in the losses
of the specified eontracts on a silent basis. This quota ean be ehanged through mutual
agreemenlomy. Figure 4.2 shows how a 25% quota reinsuranec eontract works. Tbc
reinsurer will normally agree to a limitation of capacity in terms of sums insured or
indemnified whieh limils the primary insurer in ils underwriting eapacity, the probable
maximum loss (PML) taken. Further, the reinsurer ean agree limitations, ealled sub-
limits: obligations in claims for certain causes or specific events ean be limited. Tbe
cedent is able to underwrite more risk andJor bigger volumes by automatically trans-
ferting a part of every risk to the reinsurer. Each risk is shared irrespective of ils size,
severity, or c1ass as long as it is within the tenns of the treaty. The primary insurer needs
10 allocate a lower amount of capital 10 the business written, when part of it is ceded 10
areinsurer. In some countries, the reinsurer has 10 secure its ability in order 10 meet the
obligations from the contracts by providing guarantee funds or baok letters of credil. 13
Quota reinsuranee provides a limitation in the absolute obligation aod reduces the
eapital usage of the eedent. In times of a markeI entry or introduction of a new produel
!ine, this is an advantage for a primary insurer. Since the company ean write more bosi-
ness, the financing of the start-up is easier and the administration of the quota reinsur-
ance contract is simple and inexpensive. Further, the reinsurance company can provide
IOUebwein [see 2000, pp. 56-57]

IlLiebwein [see 2000, p. 57]
12Uebwein [see 2000, p. 101]
I= =:---"m,
Portel.... lII. Porter,.llIe . !'ter Q.oto • Tre.ty
_ Pnmary InsurerQuota _ ReiosurerQuota
Sou",c: Lid",,,in. l'c\cr.l<lassisd>c und ~ l oocmc !'(lm><:" der I\Ocl1crsich.:",ns.

Verlag Versichcru ngs\\insch,n. Ka.I,ruhe. p. M
Figure 4.2: Quota reinsurance
statistical infonnation to be used for the calculation of premiums. 14

In case of a big loS8, however. the remaining absolute Ioss for the primary insurer
can be high iIrespect.i.ve of an existing quota reinsurance contract. The reinsurer is
interested to participate in profitable, stable smaIl sized business - the primary insmer
in this esse shares relati.ve1y stable profits. Quota reinsurance is used in insurance lines
covering relatively similar rists such as third party liability, automotive, transportation
or hail and storm insurance. OOt also in life insurance. Further. it is usod in the coverage
for nuclear energy and aireraft full hull. 15
In Iife insurance business, a special form of quota reinsmance is common: Pm-
:linancing quota share agrcements he1p to offset the expensive acquisition costs through
the pre-financing of the amounts by the reinsurer in anticipation of future profits. The
ccdcnt can factor-in the start-up losscs far a markct entry er product innovation which
he expec1'8 to fully recoup at a later stage, but may not be ahle to bear the costs in the
short term without outside help.16
In several. cases it may be useful to agrce on variable quotas in orda to increase
14SchwqK:b andet 11. [see 2004.pp. 125-126]

l!!Liebwein [_ 2000, pp. 62-66]
16SchwqK:b andet al. [see 2004.pp. 125-126]
4.1. TRADffiONAL METHODS 61
:Ilexiliili.ty. Whilc the obligation of the reinsurer rcmains constant, thc eedent's retention
is variable among different risk classes reßecting the probability of claims to arise. 17
The primary insurer, when ceding business to thc reinsurance company, has to take
into considerati.on that, in the eyes of elients, investors. and competitors the image of
the company ean suffer. One of the criteria for the rati.ng of the primary inmrer is how
much premium ean bc gcnerated in order to build thc basis for a profitable operation
over the long_run. 11
,.,..."'.....,....
_ l'rimal) Insurer l.oss _ I" R"in,urer Los< c::J 2nd RC'in,"rer Los.
lIascd (In ; Lieb"ein. Po'e'. "lassische ",Id M<xkrne Furmcn der ROcb~rsichenJllS.
Verlag Versicherung'" insch"tl. ,,",Isruhe. p. 69
Figme 4.3: Surplus reinsmance
Surplus reinslUtl1lCe is anothertype of proportional reinsurance based on fixed sums.

The ccdent's intention is to pass on sums that are "surplus" to what he is abIe to keep
as retention on to the reinsurer. In other languages like in German the term "Exzedent"
and in French the tcrm "exc6dent", derivcd straight from the Latin "excedere", refer
to the intended limitation of the primary insurer's obligation. In form of obIigatory or
semi-obligatory contracts, the primary inmrer will pass on only that part of a risk 00-
derwrittcn which excccds thc defincd retention limit. This can bc regarded as the fint
dimension of the treaty. Normally. these are rists which exceed the primary insurer's
ability to carry in teIms of magnitude in the event of a total1oss (or expected maximum
l1Liebwcin [see 2IXX), pp. 62-66]

11Schwepcb md et al. [see 2004, pp. 115-116]
loss). Tbe reinsurer will take a much higher participation in bigger risks than in minor
risks which do not exceed the retention limit. Tbe system enables the primary insurer
to transfer only those risks which he actually needs to reinsure. Tbe insurer's total
obligatory capacity can be increased by adding successive surplus layers with different
reinsurers. Tbe layers are defined as multiples of the primary insurer's retained line.
Tbe .teOM dimension of the treaty defines the capacity in terms of the number of lines
or units covered.
The primary insurer, next 10 the increase of capacity, benefits from the homogeni-
sation of its portfolio since he will always participate in the losses up to the retention
limit only. This is, however, subject to the fact thaI, in case of a totalloss or probable
maximum lass, the capacity of coverage from the different layers is sufficient. 19
Surplus treaties are usua1ly employed in sectors where the potential for major or
partial non-uniform claims rises in line with the amounts underwritten. This is the case
in fire, theft, accident, and life insorance. Surplus treaties, measored by premiums, are
the most employed form of reinsurance treaties.20
Non-proportional reinsurance
In non-proportional reinsorance, the /0.. amount forms the baseline which triggers the
reinsurer's cover. The primary insurer and the reinsurer agree in their treaty the 1088
and the cause which trigger a compeusation. This is done independently from the pri-
m.ary insurance contract, since not a1l perils insured originally may need reinsurance
cover. Further, the scope of the cover has to be defined precisely; the contract partners
stipulate which risks, persons or property are inc1uded or excluded. Tbe contract can
relate to just one peril, like a horricane or an earthquake, or severa1 risks. In addition,
it may bc defined whcther the events may happen simultaneously or within a certain
time frame. Tbe reinsurer gets a premium for the commitruent which is calculated in-
dependently from the premium agreed in the primary insorance contract. In case of a
lass, the reinsurer indemnifies the primary insurer in excess of a specified deductible 10
bc cartied by the primary insurer and up to a specified limit. Tbe deductible plus the
reinsorance cover form the ceiling of the treaty. No reinsorance company will bc able
to agree on an un1imited cover. Tbe limit can bc a fixed amount or alternatively defined
as a percentage of the gross net premium income of the reinsurer or a per mille amount
of the aggregate sums reinsored.
Tbe purpose of non-proportional reinsorance is to limit the borden on the primary
insurer from losses caused by the defined cause. The advantage is that the primary
insurer can agree 10 a tailor-made solution for its needs and does not have 10 give away a
fixed proportion of the premium. However, it has to be remembcred that the range of the
cover is much smaller. Non-proportional reinsurance is used for natural and man-made
catastrophe cover, but also in the insorance of liahility or professional indemnity. In

2Or..iebwein [see 2000, p. 67]
4.1. TRADffiONAL METHODS 63
case of cxcess of less reinsurancc, cach individual settlement of the primary insurance
has to be monitored, while the stop less cover is directly geared to the primary insurer's
de.m.onstrablc claims IiabiliticS.21
Thc forms and typcs of non-proportional trcatics diffcr with respect to thc defini-
tion of the reinsured loss, while the main types used are excess of loss and stop loss
conttacts:
The exce;r" of loor;r contract male! thc reinsurer's cover conditional upon a clearly
defined loss cvent. The reinsurer will compensate the primary insurer minus the pre-
defined deductible, also callcd excess point The example in figme 4.4 shows that the
reinsurer has to pay if the loss excced.s the amount ofUSD 1 mln. Having predefined an
objective relationship betwcen thc losses, it figures the aggregate number of individual
lesses covercd into a single 1000s evcnt. Howcver, thc problem is to cxactly dcfine thc
objective rclationship.
[ 'CO" I'"in!: I S IJ I min -----1-1----------
lass 1 lass 2 lass 3

_ Prima!) In$Uf'" I..o ss (Dcd uclible ) _ Rein,""" l.o~<
Based on: Schwerd.e. And",as. Reinsurance. Bi ldungsnd/,lIerl.: Ve",icherung~.

wirtschaft Vc,lag Vcrsichcrongswirtsch;lfl. Karlsruhc. 200~. p, 09
Figure 4.4: Excess of lass reinsurancc far losses > USD 1 m1n
With cxcess of loss reinsurancc, the primary insurec is ablc to kcep the complete pre-
mium within the dcductib1c for himself. A great amount of insurance business is regu-
lated with fixed tari:ffs wbich reinsurcrs may find unattractive. Since thc cxcess of less
llSchwepcb md et al. [u:e 2004, pp. 136-171]
reinsurance does not follow Ihe primary contract., it may be More .ttIactive for 1he rein-
surer to take special element. of Ihe risks only. Tbi. can ••ve time, .ince 1hey are only
concerned wilh Ihose exposures which penelr.te 1heir speciallayer. That means, lhat
Ihey need limited underwriting inform.tion only. While it may be able to reinsure risks
which olher. consider nnknown, unsound or underrated, Ihe market for Ihe f.coltative
excess of 108S reinsurance may be limited, since many direct or pro-rata reinsurers may
not be willing to provide • market.22 If a primary insurer is looking for • coverage for
windstorm damage, he will agree an excess of 1088 coverage to get compensation for
• single windstorm. Exce.. of loss policies are typically stroctured in order to involve
More than one reinsurer or reinsurance treaty.23
Tbe primary insurer will take an additional stop loss cover if he likes to be allowed
to add up alilosses within • specified time period.24 Tbe stop loss reinsurance contract
provides cover against the aggregation of individua11osses, for instance, measured by a
percentage amount of Ihe net eamed premium., wilhin • pre-defined time period, usu-
ally 12 monlhs. Tbis means lhat 1he cover is not related to • single risk, but provides
protection .gainst • deterioration of Ihe profit and 10.. calco1ation of Ihe primary in-
surer. Stop loss is normally an additional cover to olher forms of reinsurance already in
place. Tbe contracts are relatively expensive and bear Ihe risk of moral hazard for Ihe
reinsurer. Tbe time-frame between Ihe loss event and Ihe reirnbursement by Ihe rein-
SUTer is relatively lang compared to other reinsurance types, since the overall results of
1he financial year have to be known. 25
Stop 1088 cover is aften established to cover primary insurers against extreme events,
e.g. hail in agricu1ture or fire in forestry, extreme mortality developments in life insur-
ance and potential hazardous part. of an underwriting account like war, confisc.tion or
riots.26
"Kiln and Kiln [see 2001, pp. 19-22]

23Schwepcke and et al. [see 2004, p. 141]
2ASchwepckc and et al. [see 2004, p. 141]
4.2. .AL1ERNATIVE RISK TRANSFER. 65
4.2 Alternative risk transfer

No clear definition of alternative-risk-transfer (ART) has been crystallised in the eco-
nomic literature. 27 All fOl'lDS of ART bave, however, in common that the insurance-
economical risk transfer is not being effected within the insurance and reinsurance sec-
tor, but tbrough the global financial markets. 2S
ART products Me important for the risk transfer by large. multinational corpora-
tions. Fi.gure 4.5 shows an estimation of the global volume of ART products compared
to traditionaI insurance in terms of global insurance premiums paid to oommercial car-
riers and alternative carriers in 2007.
Traditional
Carriers
US I) 287,5 bn
(69.8~.)
[)al. 5ou,«s (;""·c-s. JOMlhan Cl.[, ~o~l (;ell<,.""n C.p"w~, Ma"h, No" YOfk, 200&, P. 3,
111, Cap"'-<' and olhe, R.. k·Fmanomg Opuon" In,uf1U>C<.' Inrom,.uon In'Utule,
Nc,. Y"r\(. 2009. MMC ScCU'I1IC'. lhc Cal.SIr"!''''' Ilood Mar~cl aI Year End 2006.
Gu)' Ca"",nl« 11:: Comp"nh No,. Y o,k. 2007, "on Cap"a] Mar~,-"". In'uron«·L,nkeJ
Sc"'" ' "'O' 2008, AON, O.oago 2008
Figure 4.5: Global market for large corporation risk transfer products
Following the methodology of Swiss Re, it will be differentiated in the description of

the varions ART type! bclow whether the reIevant form inc1udes the transfer andIor the
ftnancing of rist. Further, it will be included in the relevant description whether the
form is an aItemative carrier taking the risk or an alternative product solution.29 The
subsections below will then go through the characteristics of each form, followed by
Z'lBanb [see2OO4, p. 49];SwilllRe [see 1999.p. 3]
ZlAlbed:Jt andSc:hndin [see OI.OS.l998,p. 2]
ZIISwUsRe [see 2003. P. 16]
cxamples how they are used and which pros and cons they include. Figurc 4.6 gives a
mmmarised overview cf the different forms of ART.
Rh;k Carriers Muhi-risk l'rod"cI'
• C.pl"CS • los! ""nfolio 1mnSre, • nlU lli_peril

• pools • 'lo(hcr'SC dCI-clopmcm • n\ul(i_(r ; ~cr
• ris~ retontion • sprc.d lu>S • blcndcd
groups • finite qoota share
/----
gmups
\ ---------------
'\!tern. ti,-t Ris k Tnlnder
,\RT
SidcCar.;
C""lingonl Capiwl
("s ur.nrt ••;" k.d S.~ uri(if$
• futures
• agr':"n1cn!s • rorwards
• pUl options • ,·.Iut_in_forct
• (triions
- <alaSlroph. ri Sk
• swaps
- fu nding
Sou,,,,- o..n Dal.
Figure 4.6: Alternative forms of rist transfer
4.2.1 Risk carriers

Captives
The captive insurance industry originatcd from the formation of mutual and co-insurance
companies in the 192Oies. The market grew rapidly. when 1arge US corporations with a
strong capital base in thc 19SOics startcd 10 crcatc captives in offshOIe tu. havens. Thc
main driver of the development was the fact that the corporations st:arred to question
thc efficiency of the risk: transfer via traditional CQIDDlC:rCialline insurance. The socond
boost for the creation of captives started with the liability crisis of the late 1980ies in
response to limited availability of liability coverage.
.According to the most rccent cstimation available, the volume of insurance busi-
ness written by captives in 2007 was USD 57.5 bn for ]arge corporations representing
14% of global risk. trans:fers cffectcd. The 5.422 captivcs retroceded a total. volwne of
approximately USO 8 bn to the global reinsurance market and hold USD 138 bn in
assct investments. 57% of the captives are owned by US corporations. followed by the
UK 10%, Sweden 6%, France 5%, and other nationalities with a share cf 22%, each
writing 2% or less of the total volume. While thc traditional COIIIIIlCIcialIines business
stagnated, the captive market grew by 10% per year since 1998. Figure 4.7 gives an
overview cf the leading locations by the number cf captives incorporated.30
i
..,,
"
Figure 4.7: Number of captives in the different locations
A captive is an insurance or reinsurance carrier owned by a company or a group of

companies whi.ch are not active in the insurance busmess themse1ves. It mainly insurcs
the risks cf its parents, also called sponsors. Single-parent captives of multinational
corporations. having the biggest share cf the market with about 70% cf premi.ums. only
underwrite the rists of their parents.
Multi-parent captil!es. regu1arly founded by mcdium-sizcd corporations. underwrite the
remaining 30% cf the premiums. Association captives are multi-parent captives whi.ch
serve the needs of members of industry or trade associations. They are often used 10
covec liability risks like medical malpract.i.ce. In case that a cOIpOllltion is too small or
not willing 10 set up an own captive. ~nt-a-captives can be used. The corporation pars
a fec for the use of the captive and has 10 provide some form of collateral to protect the
3OGroves andHusbmds [see 2008.p. 1-20]

captive from any underwriting risk. Diversified captives are a variety which, in addition,
underwrite business which is unrelated to their parents.
Captives are efficiently used for the transfer of high-frequencyllow-severity perlls.
Tbe corporation, through the foundation of a captive, is able to efficiently self-insure
risks. TraditionaI insurance premiums are calculated to cover the present value of ex-
pected claims, the insurer's acquisition costs and overhead expenses, plus a profit 10
compensate their shareholders' cast of capital. The non-claims portion of a captive's
premium income represenls as much as 30% to 40%. By establishing a captive, the
corporation can comparatively save the cosls of the highly predictable cash-flows, es-
pecially when their operation has a better-than-average risk profile which may not ade-
quately be recognised by the insurancelreinsurance marke!. Since insurance premiurns
have to be met in advance, but claims are normally paid with the lag of time nnill the
damage is recognised, the cash flows to the captive are held within the corporation.
This is especia1ly beneficia1 for companies with higher financing cosls. In addition, the
investment income generated by the captive's reserves may be taxed lower in offshore
places than in the home country.
Further, specific low-frequencylhigh-severity risk, for which no reinsurance may be
avai1ahle on the marke!, can be insured by a captive. The instrument is very ftexible,
there are many forms of captives available.
Hincorporated as an insurance company, captives have access to the global reinsur-
ance market. Due to regulatory issnes, it may be easier for captives, instead of acting
as a direct-writing company, 10 act as reinsurance captive as shown in figure 4.8. The
loeal subsidiarles of the multinational corporations cede their risks to fronting insur-
ance companies. This saves the establishment of a local insurer in each country having
different legislative requiremenls. Tbe fronting insurance company then passes the risk
10 the captive through a reinsurance agreement
Reinsurance captives are subject 10 their horne country control, but can be involved in
cross-border activities. This means that they can retrocede their risk into the interna-
tional reinsurance markets.
In the early years, premium payments to captives were tax-deductible. However,
this has been massively reduced in the industrialised countries. In the US, ouly pre-
mium payments to captivcs with a substantial third-party business are Iax-deductiblc.
In Europe, a substantia1 risk transfer must be proved - premiurns have to compensate
the underwriting risk.
Supporte<! by favorable lax and accounting regulations in offshore p1aces like Ber-
muda, captives, despite the unfavorable home-conntry lax treatment, have increasingly
been used further as financing instruments. Special reinsurance companies were estab-
lished with little or no risk transfer.3l This practise has, however, been heavily opposed
by the home-regu1ators.
Risk retention groups were introduced in 1986 as an alternative mechanism for US
corporations to access professiona11iability insurance. Tbey are a special type of captive
31SwissRe [see 1999. pp. 14-18];SwissRe [see 2003. pp. 16-17]
,\ luUin.!inn.l Co rp OU lion
Cap!i,·c of!~ Multinational Corporation
Profcs<ional R~i nsuran"" ,\Iarkel
Sou""': S\\ issRe. Sigma No. 211999: Altemali"e ri,k !ran,fer,ART) for corpor-.uions:
a passin~ fashion or rhk ma''''gcmcnt for t1le 21.1 cerotul). S"issRc. 1999. p. 14
Figure 4.8: Structure of a single solution
restrictcd 10 writing liability cover only. The spccialiscd mutual insurancc compamcs
need to be capitalised by their members. The business is dominated by the insurance
of liabilities for professional services and health care. A foderal charter allows the risk
retention group to write business in any US state without becoming licensed in each
single state or using a fronting insurer. Alternatively, the oompany can have a state
cbarteronly.32
Pools are risk transfor arrangements between corporations or insurers in order to creatc
sufficient capacity for very 1arge risks. They are organised in a similar way to mutual
insurers with tbe participating corporations as po1icyholder. Tbe first form of pools
is Ihe co-msurance pool, where the pool itself is organised as a risk carrier. In this
case, the members act as intermediaries. They write the business on behalf of tbe pool.
which itself operates as an insurer in thc form of a legal cntity. The pool cedes a ccrta.in
percentage of each rist to the pool members. Examples are the co-insurancc pools to
cover nuclear risk and tecrorlsm risk in Gmnany.
Through the second form, reinsurance-pool rnembers close the insurance contract
bi-laterally with the original policy holder and in most cases cede 100% of the risk
into the pool, while the other pool mernbers are acting as reinsurers. Examples are the
reinsurance pools for natural perils in France and Spain, as weIl as for terror in the
UK. 33
Self iDsurance
Self insurance is a special phenornenon of the US market and covers mainly worm's
compensation, generalIiability, product liability, automobile liability and property risk
as a substitution of traditional reinsurance. 111e biggest share of the volume is worm's
compensation, which, like auto liability, can only be self-insured as a state-regnlated
programme. The ernployer acting as insurer must qualify by means of an application
process and meet financial requirements to receive the self-insured status. The 10S8 re-
serves must be covered by cash, bank letters of credit and/or high-quality bonds. Within
non-regnlated self-insurance programmes, the corporation is allowed to determine the
lass reserves. The benefits are cast effectiveness and increased control of lasses and
moral hazard. Self insurance, by definition is a solution !hat does not include any risk
transfer. The volume, which is self-insured and financed, however, is substantial. 34
4.2.2 Finite solutions

Finite solutions are also known as financial insmance/reinsurance. They are a com-
bination of risk transfer and riskfinancing, while the emphasis is on risk finance. 3S
111e primary insurer acting as cedent closes with the reinsurer, in contrast to traditionaI
reinsurance, mnlti-year contracts which re-arrange the timing of losses. The premium
incom.e transferred from the primary insurer to the reinsurer is used to purchase assets.
111e expected returns of these assets are taken into account when calcnlating the price
for the reinsurance. The cedent can count on lang-tenn coverage at stahle terms and
conditions, the reinsurer on a continuous flow of premiums. Although the cessionaire
takes investment risl<, the fact that the cedent bears the ultimate risk out of the original
underwriting is not changed. The cedent, however, is able to smaath the lasses aver
time in order to reduce the year-to-year eamings voIatility.36
Finite contracts can be constructed as prospective (pre-funded) or retruspective
(post-funded) agreements. Prospective agreements refer to losses which have not yet
occurred at the time of the closing of the contract. They oblige the client to pay aonnal
or single premiums into an experience account. 111e funds plus the contractually agreed
returns are used to pay far lasses or fiaw back to the customer. Retrospective trans-
actions refer to losses which have aiready occurred and oblige the client to pay back
:33Schwepcke and et al. [see 2004, pp. 15-17]
34SwissRe [see2003,p. 17]
"Culp [... 2002, pp. 380-382]
finil ~ Soh,l ions
Pro;pec/;'..,
I. OSS I.... rtfolio

Irand ...
Time
Sp ru cllo..
an" di51an«
Acl'·.... c
d.... lopn' . n'
Source: Own Graph
F"1gure 4.9: Finite solutions
the claims payments by the reinsurer over time. While the credit risk: of a prospective
transaction is bom by the cedent. the reinsurer has to take the risk when a retrospective
transaction is agreed. The ratings of the contractuaJ. partners therefore mainly detennine
the economics of the transactions.
Apart from their smoothing function. finite solutions can be used in many different
circumstances. Be1ow, the main types of finite reinsurance are explained:
um portfolio transfers are contracts to cede losses which have already been in-
curred and reported to the insurance er reinsurance company. The cedent pays an up
front amount to the reinsurer who is obligcd to settle the claims in the defined time
period. The up front payment is the equivalent of the discounted value of the claims
plus the costs to compensate the reinsurcr fer the administration and a profit margin.
'lbe discowrted value ca1culation is critica1 for the reinsurer, since the timing of the
payments is unknown. NOIIDally, the reserve calculation of the cedent's actuaries is
taken as a reference. Further, the reinsurer takes the investment risk fer the placement
of funds in the capital markets during the li:fetime of the transaction. Since profitabil-
ity is based on the time value of money, loss portfolio t:ransfers are used in business
with leng-tail risks like third party liability. Loss portfolio transfers are mainly used by
primary insurers which decided to stop the underwriting in certain regions er business
segments. Alternatively, it may be the case that the insurer decided to seil parts of its
activities and the interested buyer is not willing to take over long tail risk underwritten.
It has to be taken into consideration by the buyer that incnrted but not reported claims
are not part of the contracts. Tbe cedent or the acquiring company still runs the risk!hat
unexpected claims may atise from the remaining portfolio. To solve this problem, in
recent years reinsurers offered a variation of loss portfolio transfers called retrospective
aggregate loss covers. These contracts. in addition to the timing risk, also take over the
underwriting risks covering lasses incurred but not reported. Reinsurers, however, nor-
mally set maximum 10S8 covers in these type of structures. The 1088 portfolio transfer
contract improves the financial condition of the cedent in the year of the closing, sinee
future investment income is converted into "underwriting profit". Further, the solvency
ratio and the combined-ratio of the insurer can be improved. The benefits are, however,
temporary since the insurer, anee he has ceded tb.e business, cannat realise the invest-
ment income of the following years. In many countries, lass portfolio transfers are not
possible since the regulators da not allow any discount of the lass reserves while in
same countries they are allowed on a very restrictive basis.37
Tune anti distance transactions were designed as an instrument to discount the time
value of money of loss reserves of predictable risi<. They are very similar to loss port-
folio transfers, except for the fact that the reinsurer agrees to pay a certain schedule of
losses, while the ceding company agrees to pay a certain premium in return, represent-
ing the net present value of the future loss payments. This means !hat the payment of
the reinsurer is unlikely to correspond with the time and value of the claims payments of
the primary insurers. Tbe reinsurer is not obliged to pay in addition to the agreed fixed
schedule, even if substantial irregular losses may occur. He neither takes the timing
nor the underwriting risk, but only the investment risk. This may result in a substantial
mismatch of payments for the cedent, even leading to liquidity shortages.
Because of the limited risk transfer involved in these transactions, the contracts in
many legislations are not recognised as insurance contracts but rather as financing COD-
tracts, and the expected balanee sbeet effects like the capital relief cannot be provided.38
Adverse development covers include the incurred but not reported losses - they lock
in the maximum liability resulting from existing insuranee contracts. The reinsurer
covers the risk of realised losses on an existing liahility being higher than the terminal
value of the reserves. Unlike lass portfolio transfers or time and distance contracts,
there is no transfer of claims reserves needed. Tbe policy holder pays a premium for the
transfer of the lasses exceeding the reserves. This facilitates mergers and acquisition,
sinee the insured can oftload the timing and the reserves development risk. 3•
Finite quota share agreements are similar to quota reinsurance explained in sub-
chapter 4.1.1. Tbe main differenee, however is !hat the obligation of the reinsnrer is in
any case limited by the policy. If the underlying primary contract does not include a
37Hess [see 1998, pp. 47-53]

38SwissRe [see 2003, p. 25];Hess [see 1998, pp. 61-63]
39SwissRe [see 2003. p. 25]
4.2. ALTERNATIVE RISK TRANSFER 73
policy limit, the obligation of the traditionaI reinsurer may be unlimited. Finite quota
reinsurance is often used to finance start-np operations with high acquisition costs. Tbe
primary insurer, together with the relevant liabilities, cedes part of its unearned pre-
mium income to the reinsurer. In retum, the cedent receives a ceding commission in
order to finance the start-up. The unearned premium, through the finite quota share
agreement, is converted into current income. In the early years of the operation, the
reinsurer may pay to the primary insurer a higher premium to avoid a lass in its earn-
ings schedule. Th.e ceding commission, together with the investment income resulting
from the unearned premium reserves, is expected to cover claims out of the new busi-
ness line. In later years, the primary insurer may get a lower compensation than usual
to balance out the start-up support.40
Spread loss covers are long-term contracts designed to provide risk financing. The
cedent pays a one-off or annual premium minus expenses, capital costs and a profit mar-
gin for the reinsurer into an experience account. Tbe investment income of the reserves
is credited, and eventuallosses are debited to the account. The reinsurer has the obli-
gation to pay timely far the lasses, even if the experience account runs into a negative
balance. The losses are cumulated and then redistributed over the remaining term of the
agreement. If the fund goes into deficit, the primary insurer is obliged to pay a bigher
premium into the account to compensate for the lasses. The cedent basically gets a
secure pre-funding ofthe losses from the reinsurer - he is able to spread the losses over
a very long time and therefore secures bis liqnidity. The reinsurer takes the contingent
credit risk and some underwriting risk wbich, however, is normally reduced through an
annnal or aggregate policy limit. Spread loss contracts are particularly popular for cap-
tives, since their parents/sponsors are interested 10 smooth the volatility of the captive's
claims payments and hence their earnings.41
4.2.3 Multi-risk products

Integrated multi-risk products are used to combine various exposures into a single
product. resulting in a efficient and cost-effective risk transfer solution. They are a more
recent development used in the ART for corporations and can be regarded as a subelass
of their enterprise risk management. Traditional insurance often provides coverage
on a per peril basis. That means that each element of coverage has to be negotiated,
documented and managed separarely. Multi-risk solutions, in comparison, provide the
advantage that all designated exposures within a firm's portfolio can be combined into a
single, multi-year policy. Subelasses of multi-risk products are multi-peril programmes
and multi-trigger programmes .•2 .3
"'Culp [see 2002, pp. 395-396];Hes, [see 1998. pp. 68-73]

41CUlp [see 2002, pp. 396-397];SwissRe [see 2003, p. 26]
42Banks [see 2004, pp. 103-105]
,\ 1uUi . ri Sk (>rodu<!!
Mul,;" I. ~ril M ulril"t lriggu
Multilin.
p<>lk)"
Cono"'tr<i.1
Unob .. lI. I"'lky
fiH d. ,- ~ri .bI ••
•" il rhing trigger
Souree: Bank <;. Erik Ahernal;,e Itisk rransfer

John \\'ik)' & Sons Limilcd. ChichcSI~r. 2004. p. 104
Flgure 4.10: Multi-risk products
Mulü-peri! programmes
Coverage on a per peril basis of traditional reinsurance with verticallayers, e.g. in

natural catastrophe reinsurance severaJ. reinsmers may take excess-of-Ioss sequences of
a rist. Multi-peril programmes are used to consolidate the designated exposures within
a firm's portfolio and combine them into a single, multi-year policy. The codent can
choose betwcen the atbtched. method where severaJ. polieies are grouped together under
a new master agreement. Alternatively, the single teIl method redrafts existing covers
into an complere new single agrc:ement. The result of both methods is a horizontal
diversification cf the rist; the insurers may participate alongside one another within a
risk silo. The lifetime of the treaty usually is between tlm:e and seven years. It defines
an aggregate premium, deductible and is capped. The cedent ge15 a package for all
exposure covers in unison. rather than getting each exposure individually reinsurcd.
The markct has developed several sub-forms of multi-peri1 programmes:
Multi-liDe (also known as commercial package policies) provide to the cedent spe-
cific coverage with Ihm own declarations, coverage forms and causes of 1055 forms.
A typical package may e.g. cover commercial property, business inrenuption, geneml
liability, equipment, inIand marine and automobile. The cedent is covered up to the
net amount which is calcul.ted .s the amount of the c.p minus the .greed deductible.
Commercial generaI liability progranunes cover exposures related to li.bilities of •
company. inc1uding premises, products, contracts, contingencies, environmental dam-
.ge or directors and officer's fiduciary breaches. Commercial umbrella programmes
provide to the cedent protection for very large amounts which lie weil in excess of the
commercial property or commercialli.bility policies. UmbreIl. progranunes cover a
wide variety of insurable risks, but are designated to pay out the ultimate net loss after
certain minimum liability covers which have to be paid out by other reinsurers involved
before the umbrella finally gets drawn.
The benefits of multi-peril agreements are lower transaction costs - the eedeut nor-
ma1ly can negotiate the cover with a lower nurnber of insurers with a standardised legal
documentation with lower premium rates since the risks covered are usnally low or
even non-correlated. Further, there is a lower probability !hat the codent gets expen-
sively overinsured.
However, on the other hand, the cedent must take care that he does not get underin-
sured, especially when his financial condition may have changed after the contract has
been effective same time, and that he gets coverage far the severa1lines from a few or
even one insurer ouly. This means !hat, if claims arising, he runs a credit risk. 44
In times of hard markets, the availability of multi-peril programmes is norma1ly in-
sufficient. In the past, corporate risk. management in many insmance companies has
been divided into dislinet areas of responsibility. While the finance deparnnent may
be responsible for covering interest rate, exchange rate and price ftuctoation risk, the
risk management department was responsible for the underwriting risk. Holistic risk
management as the pre-condition to use multi-peril programmes was not in p1ace. 4S
Supporte<! by the introduction of the risk based capital approach in the US and Sol-
veney 2 with the European embedded value in the EU, the insurance industry is working
on changes in the w.y of reporting their .ccounts and results. Further, .t an intem.-
tionallevel, the IASB has defined within its initiative IFRS Phase II as a key objective
to pursue convergence with national standards, especially with US GAAP. The bigger
conglomerates in view of these changes ahead, are reviewing their underlying systems
and management information processes. The key strategie decision is how to integrate
the various forms of reporting in risk management, c.pital management and liahility
management into one integrated model.46 When a1l three areas are established on a
consistent basis, it will be easier to implement multi-peril programmes.
Multi-trigger programmes
In order to get claims payments out of a multi-trigger programme, a second event or

risk must be triggered. This reduces the probability of a loss event under the agreement
44Banks [see 2004, pp. 103-112]

4.5SwissRe [see 1999, pp. 24-25]
46pate! et al. [see 2007. pp. 4247];EIlenbue<g.,. [see 20.08.2007. pp. 56-61]
and 1herefore the insuranee rate. The insurer/reinsurer providing coverage reduees the
risk of moral hazard, sinee normally a parametrie or index whieh is outside 1he inOu-
ence of the poliey holder is used to deline the triggera for the loss event. Multi trigger
programmes are attractive for corporations whieh have eaming struetures depending
heavily on the developrnent of interest rates, eommodity prices, or eurrency exchange
rates. 47 The programmes experieneed a sharp rise in demand after the Northridge earth
quake in Califomia 1994. In that year, direct insuranee companies suffered from losses
eaused by the quake and a sharp dee1ine of the bond market values in 1he same quarter.
So the foeus of the earIy variations was to combine the cover of a natural catastro-
phe (non-life event) and the cover of a fall in the values of the investments (linancia1
event).48
Today, dual, tripie OI even multiple trigger solutions are possib1e. The reduetion of
the likelihood of payment enables the cessionaires to take risks whieh have not been
regarded as insurable before. There are severa1 types of triggers whieh ean be agreed
between the parties: While fixed triggers simply determine whether an event bas oc-
curred or not, variable triggers deline the value of the payment related to an event.
Switching triggers vary on 1he basis of how individual risk exposures in the eedent's
portfolio are performing. Per occnrrence triggers are reset after each event, and ag-
gregate triggers allow the accnmulation over multiple events.4'
Blended-cover programmes
Blended-cover is the eombined use of multi-line and multi-trigger programmes together

with finite reinsurance. Th.e result is a solution which combines risk transfer with risk.
jinancing. On their own, they ean be regarded as synthetie equity. If eombined with
finite reinsurance, they help firms to pre-fund their losses. The result is a synthetie
hybrid security or mezzanine-like stmcture. The term blended-cover is also used to
describe traditional reinsurance solutions used in combination with finite reinsurance.50
4.2.4 Derivatives
Financial derivatives
Figure 4.11 shows the variety of the main linancia1 derivative instruments developed by
1he eapital markets. The derivatives ean ei1her be exchange traded, or elosed as individ-
ual over-the-counter eontracts. Further, 1hey can be uneonditional with an obligatory
execution or conditional, in which case the counterparts can decide whether to execute
1he contracts or not. All derivatives derive their value from a market reference.
47SwissRe [see 2003. p. 28]

48Culp [see 2002, pp. 423-4251
"Banb [... 2004,pp. 107-109]
soCulp [see 2002, pp. 423-425]
Financial Mar1c:et
.~---- '-.
Money Mar1c:et • ~Pltal Ma~
~vatives M0
/ Cash Mar1c:et
Commodities Denvatives
"--
Financial Derivatives
I
== .-----:::I
uncondibona l conditional
IFowards I I
Futures I ISwaps
'-.
I loptions l :Caps, Floors, Collars
Soure,,: Liebll"in . Pele,. Klassische und Modeme rOm"," de, ROcherskh"ru"g.

Verlag V"rsichcrungs\\irtschat\. Ka,lsruhc. 2000. p. 379
Figure 4.11: Derivative instruments used in the financial market
The focus cf tbis subchapter will be on the main derivative products wbich were de-
veloped by the capital markets, but are sometimes aItematively used 10 place insurance
risks:
Futures are contract:& wbich represent an obligation 10 buy or sell a specific quan-
tity of an underlying reference asset. The prk:c is agrced OOt not exchanged at the trade
date for settlement at a future time. Futures, like all Iisted contract:&, are traded through
physical er electronic exchanges and cleared through centralised clearing houses. The
buyers and seIlers have 10 post an initi.al margin 10 the clearing hause; the positions are
evaluatod daily. In case of a deficit, the clearing house will send a margin call wbich
must be met by the OOyer er seller if thc position is 10 be preserved. The contract may
feature financial settlement (i.e. cash exchange) er physical settlement (i.e. commod-
ity/assct cxchange). The contracthas a fixed maturity from. one day to ninety days. The
leng future position purchased, or owned, rises in value when the price cf the reference
entity rises, and loses in vaIue when it falls. S1
Forwards are traded over-the-counter as customised, bi-lateral, single-period con-
tracts referencing a specific assel. They were developed by the producing industry 10
hedge deliveries of natural rcsources like oil, gold, agricultural products, but also spc-
'lBanb [see2OO4, pp. 151-152]

cilic payment obligations in foreign currencies.S1 Like a future contract. a forward

defines that a specified volume cf the underlying will be sold or bought at a fixed price
for scttkmcnt on a future date. In contrast 10 thc:futwe, howevcr. 00 initial margin has
to be posted, and there is 00 daily evaluation of the position. 'Ibis exposes seilers and
buyers 10 a potential credit risk. The profit and loss re1ationships of forwards are similar
to tbose offutures.n
/
Profil I.ong Co ll I'runl I.ong PUl
'/
x
s, '" " x
S,
'"" . ",,' .
P",fol Short Cl.1I I'mnl Sh ort PUl
/
,
x
"~ V X
I.,<)ss
. S, lASS S,
Soure,: Ku« . ""nelle. Abgre nzung traditioneller Rßcherskhcrung ,on Kat.,trophcn.

nsil"n Zu ausg.:wähltcn Konzepten des ART. VVW. Karlsn,h<:. 2000. p. 68
Figure 4.12: The four basic positions in options
Options include the right, but not the obligation to buy (call option) or sell (put
option) a specified volume of the underlying reference asset at a level known as the
strike price spcci.fied in the contract American option! allow to execute the right at any
time until an agreed expiry date. while EuropMtl options are executable on the exact
expiry date only. The seller of the option.. by accepting the premium payment, agroes
to the obligation to buy er seil the underlying asset at the strike price when the option is
exereised. Reference assets can be stocks, bonds, currencies, but also indices.54 Flgure
4.12 shows the four basic option positions a participant in the market can takc. Being
32Kuck [&Ce 2lXXI, P. 83]

"BIIIJb [_ 2004, pp. 151]
SlBIIIJb [_ 2004, pp. 151-155]
/ong in • call option means th.t one h.s purchased the right to buy the underlying for the
strike price marked "X". In c.se of falling prices, the maximum the holder can lose is
the option premium. In case of rising prices, the holder of the call h.s unlimited upside
- the value of the option is the differenee between the market price of the underlying
ST and the strike price "X" .t the time of maturity.
Tbe seiler of the call is short in the call and holds the opposite position. He has
limited upside to win the premium if the share falls in priee, bot unlimited downside if
the value of the share rises. lf a market participant expoots rising prices, he will boy a
call option. He will seil • call option when he expects fa11ing prices.
Tbe buyer of a put expects falling prices. Being long in the put oprion, he is inter-
ested in limiting the loss, when holding the underlying, to the premium of the option.
Tbe profit is limited to the strike price of the option, sinee the value is the difference
hetween the strike priee and the lower actua1 price of the underlying .t the time the
option is executed.
Tbe seiler of a put, heing long in the option, expects rising prices. lf the actual
priee at execution is higher than the strike price, there is DO reason for the buyer to
execute, and the option will expire. Tbe seiler will then get the premium which marks
the maximum profit for him, while the maximum loss would he the difference between
the strike priee and an eventually lower actual priee.S5
Swapo are bi-I.tera1 agreements ca11ing for periodie (e.g. annual, semi-annual,
quarterly) exchanges of cash-ftows which are based on • defined asset, • referenee rate
or an index. Tbey can also he regarded as • package of forward contracts for e.ch inter-
est and principal p.yment date. Sw.ps are denominated in notioual terms and can h.ve
long maturities of up to 30 years. Tbey can expose the counterparties to credit risk,
unless collateralised. [nteTest rate swaps and currency swaps are the most widely used
forms. Interest rate sw.p .greements can regul.te the exchange of fixed rate p.yments
(i.e. of. fixed bond coupon) .gainst variable rate p.yments (i.e. Euribor plus a margin
for the underlying risk), but also variable rate payments (Le. floating bond coupon)
against variable rate payments (i.e. Euribor plus a margin). CUTrency swap agreements
regul.te the exchange of currency payments .t fixed exchange rates agreed .t the trade
d.te. Imagine \hat • German corporation likes to expand its business in Japan and needs
to borrow money in Yen. Since the corporation is unknown in the Japanese market, it
may be cheaper to borrow in Euro and to elose a currency swap with a Japanese bank,
fixing the interest and principal payments of the loan at • pre-defined EuroIYen rate.
At the heginning of the contract, the German corporation exchanges the notioual Euro
arnount into the foreign currency Yen and pays interest in the currency of the operation
abroad. When the contract is due, the Yen amount is exchanged at the fixed currency
exchange rate into Euros.
55Kuck [see 2000. pp. 68-69]

Insurance derivatives
Insurance derivatives are special products of the financial derivative market and can,
like a1l derivatives, be divided into exchange ttaded and over-the-couoter products. Ta-
ble 4.2. sbows the development of the notional amouots in USD of global weather
risk derivatives 2003-2008. Cbicago Mercantile Exchange (CME) trades accounted for
95.6% of the notional value and 99.96% of the contract numbers for the season 04/2007
to 03/200856 :
Season
2003104
2004105
OIc
.m-
ume
2,842
4,169
CME
Vol-
um.
1,868
9,696
Total
Vol-
ume
4,710
13,865
=
-
294.4
Volume
Share
CME
39.7%
69.9%
eon.......
CME
traus-
acted
109,839
227,196
Number
Share
CME
97.12%
98.21%
2005/06 2,347 45,244 47,591 343.2 95.1% 1,043,619 99.79%
71J06/07 1,869 19,193 21,062 44.3 91.1% 730,057 99.89%
2007/08 1,472 32,008 33,480 159.0 95.6% 984,750 99.96%
Source: Hartwig, Robert and Bartlett, Steve, Fmancia1 Services Fact Boot. 2009, Insurance
Information Institute. New York. 2008. pp. 93-94
Table 4.2: Global weather risk derivatives
Excbange-traded insurance derivatives are characterised by standard terms, mean-

ing that a1l participants trade the same underlying instruments. Tbe standardised mar-
ket helps to generate a greater critical mass and higher liquidity with tighter bid-offer
spreads. Tbe market for insurance-related risk is still small compared to the total deriva-
tive mark.ets.57 Exchange-traded insurance derivatives bad a slow start after their intro-
duction in the ruid-1990ies. Few insurers, reinsurers or policyholder were willing to
shift from traditional insurancelreinsurance markets to the new products; the liquidity
was therefore modest. Capacity in the traditionaI reinsurance sector was at !hat time
available and cbeap. It was regarded as being difficu1t to exactly hedge an existing
insurance contract with a standardised derivative product.
Tbe newly establisbed Bermuda Cornmodity Exchange did not take off and had to
be c10sed after two years oflittle activity in 1999. 58
Tbe trading of weather future contracts of the London International Financial Fu-
tures and Options Exchange (LIFFE) which started in November 2001 was stopped,
just one year after its introduction, because of low demand - despite the fact !hat Eu-
rope is regtt1arly affected by droughts, tloods and windstorms. At that time, the Euro-
pean energy market where the highest demand for the products was estimated was too
fragmented, and a harmonisation of cross-border regtt1ations was far away. Further, the
56Hartwig and Bartlett [sec 2008, pp. 93-94]

"Banb [.oe 2004, p. 156]
SIISouter [see 20.03.2000]
costs for weather derivatives was not recognised as deductible by the lax regimes.59
Tbe only remaining exchange trading weather derivatives today is the Chicago Mer-
cantile Excbange (CME). In recent years, some instruments like catastrophe-related
non-life risk and non-<:atastrophe-related weather risk have been increasingly accepted
by end-users and intermediaries for risk management purposes.60
A second company regularly mentioned in this context, the New York based Catas-
trophe Risk Exchange (CATEX), is not a regulated excbange. It has, however, in the
years after its foundation 1995, changed into a web-based platform for insurers and
reinsurers 10 exchange catastrophe risk covers. This is done in an organised fashion,
but not on the basis of standardised terms. 61 Tbe volumes traded at CATEX with cus-
tomers on five continents have experienced strong growth rates in recent years. Over
120 customers, mainly brokers, insurers, and reinsurers have concluded transactions in
excess ofUSD 4 bn in 2008.62
Tbe first exchange-traded product, the index-based C8tastrophe futures exist
since 1992. They were launched by the Chicago Mercantile Exchange in a revised form
in February 2fXJl. Tbe new one year contracts start and end on the last day of March.
Tbe settlement of the contract is done against the Re-Ex index, being based on data
supplied by a company called Property Claim Services (PeS). Tbe data contains prop-
erty damage estimates for a range of natural perils. Tbe index is posted and revalued
on a daily basis, when the losses observed increase by USD 25 mln or more after a
catastrophe event.63 Several regions traditionally affected by natural catastrophes are
included, like the geographical band between the US federal States Texas and Maine,
or the States of Florida and Ca1iforoia. Alternatively, contracts can be traded on the
USA as a whole. Tbe final settlement of the value of the forward contract is calculated
based on the data for the relevant region, dates and perils covered. Tbe index is valued
as insured losses divided by USD 10 mln. Tbe individual contract value is 10 times the
index (with a minimum tick of 1.00 index point or USD 10 contract value).64
As areaction to the strong 200S hurricane season, the CME has, in addition, started
to cover pure hurricane risk in February 2007. Tbey have developed three types of
contracts for hurricane futures and options on futures: for numbered events, seasonal
accumulated events and seasoual maximum (related to the strongest event). Geograph-
ically, they cover events in the most affected regions of the south-eastern coasta1 areas
of the USA. All products are based on the group of Carvill Hurricane Indexes, using
publicly available data generated by the US National Hurricane Center. The maximum
wind velocity and size in terms of the radius of each official storm is used to calculate
the potential for damage.65
"Rao [see 23.04.2004]

60Banks [see 2004, pp. 156]
61Banks [see 2004, pp. 157]
62CATEX [see 10.03.2009]
63Ellenbuerger [see 20.08.2007]
64Commodities Now [see 12.02.2007]
6SCommodities Now [see 14.02.2007]
Tbe second exchange-traded products are weather derivative•. The most com-
mon form of these products are temperature-based index futures and options that are
geared to seasonal, or alternatively, monthly weather in eighteen US, nine European
and !wo eities in the Asia-Pacific region. Weather is quantified in terms of degrees be-
low or above monthly or seasonal average temperatures. Based on a specific index, a
dollar amount is attached to the number of degrees the month's or season'. temperature
deviates from the average.
Weather contracts for the winter months in the US and a lintited nomber of European
eities are based on an index of Heating Degree Day (HDD) valnes. These are days in
which energy is used for heating. In summer, the basis are Cooling Degree Day (CDD)
values.
Both values are calculated according to how many degrees an average c1aily tempera-
ture varies from a baseline of 65 degrees Fahrenheit (18 degrees Celsius in Eorope or
Japan). This temperature is laken from the moment, when lower heating or when higher
air conditioning is norrna1ly starting to be used. It has to be mentioned !hat the average
daily temperature is calculated as the average of the maximum and the minimum on a
24h basis from ntithtight to ntithtight. Further, frost day products for Amsterdam are
offered as futures and options on the number of days that frost is recorded on weekdays
from November to March.66
There are m.ain differences between weather derivatives and weather insurancel
reinsurance: Derivatives norrna1ly cover low-risklhigh-probability events. 67 The strong-
est users of the products have been utilities with 70% of the volume, followed by the
agricultora1 sector with 7%, and consumer retail chains as weil as construction compa-
nies with low and le.. constant pereenlages. According to an esrimation of CME about
20% of the US economy is som.ehow weather related.68 In contrast, weather insurance
covers the low-probabilitylhigh-severity events defined in custontised polieies cover-
ing damages caused by a flood or a hurticane.69 In times of high hurticane activities,
the insurance marke! tends to go through a lack of capacity and high prentiums, ca11ed
hard market. Provided!hat there is enough capacity in the exchange traded derivative
market, transparency regarding prices and risk should be higher. This should lead to
a quicker recovery of the market after a calastrophe event. Insursnce derivatives are
regarded as an effieient way for non-insursnce related entities to participate in the risk
market. Thcy norrna1ly see an opportunity to enter the marke! at attractive prices after
a catastrophe. It does not m.ake a difference in the use of the derivatives whether the
partieipant likes to hedge a risk or to mske a bet. Since natural developments can be
regarded as uncorrelated to the financial markets in general, portfolio managers, hedge
funds, and other sophisticated investors have been increasingly interested in investing
in weather derivatives in order to diversify their portfolio correlations.
"CME [see 2005. pp. 2-51

67CME [sec 2005, pp. 2-5]
68Billich [see 30.06.2006]
"CME [see 2005, pp. 2-51
Insurers and reinsurers can diversify their geographic concentration and, unlike
reinsurancelretrocession do not have the risk of finaneial recovery if claims arise. 70
However, there are some obstac1es regarding insmance derivatives: The basis risk th.at
the contract may he very different from the loss suffered remains. It has to be taken into
consideration that the derivative is based on an index, not on the detailed risk insured.
Regulators and rating agencies may not give credit for the protection bought, and trans-
actions therefore may not be capital-effective. The market llquidity hence is low with
high hidloffer spreads, or it may even be impossible to unwind a position if necessary.
Regarding the accounting, the reinsurance premium is treated as an expense, while a
catastrophe futore, for instance, is a derivative instrument, requiring mark-to-market
accounting. 71
Non-exchange traded weather derivatives are over-the-counter products - their
main strength is flexibility. Itmovative products are heing continuously developed to
meet the requirements of market participants and regulators. Main products are pure
catastrophe swaps, temperatore derivatives and other weather derivatives.
Contingent reinsurance swaps are synthetic financial transactions exchanging a
commitrnent fee to be paid by the primary insurer for a contingent payment by the rein-
smance company in case of a catastrophic event. The transaction is tied to a parametric
even!, an index or a level of indemuity. The reinsurer compensates the cedent in case of
a loss event and assumes the claim rigbts through subrogation.
Pure catastrophe swaps are synthetic financial transactions allowing the exchange
of non-correlated catastrophe exposnres. Transactions are c10sed in order to diversify
the insurance and reinsurance companies' portfolios. They can exchange different types
of cat risks as weil as regional exposures. Also referred to as industry loss warranties
(ILWs), they are the most common form cf insurance derivatives used for reinsurance
and retrocession of natural catastrophe risk among globally active counterparties. In
addition to insurerslreinsurers, the market for ILWs is open to a1l types of investors like
hedge funds, insurance brokers, or banks. Over-the-counter swaps are also used in life
insurance business in order to cover catastrophe mortality risk and to hedge adverse
mortality developments. While catastrophe mortality cover runs for terms up to three
years adverse mortality hedges run up to 30 years. The long maturities usually need
collateraIisation.
Temperature derivatives are conceptua11y sirnilar to the standardised products of
the CME. The over-the-counter transactions are c10sed mainly in the USA and Europe
in form of forwards, swaps, calls, and put-options as weIl as multiple options strategies
to cover special needs of energy companies. They have also been used by insurers,
banks and special investment funds for arbitrage reasons. Since a rellable long-term
temperatore record for about 50 years is required, their usage in the Asia-Pacific region
is stilllirnited. The over-the-counter market allows the usage of alternative temperatore,
humidity or heat indexes.
70Ellenbuerger [see 20.08.2007]

71EI1enbuerger [see 20.08.2007]
Further, non-standard reference cities and longer tenors can be agreed between the
counterparts.
As a rule it can be stated that, the IDOre specialised the derivative products are, the
less liquid they are. This is also the case for other weather derivatives like precipita-
tion derivatives providing proteetion against, or exposure, to rain or snowfall. Further,
stream-flow derivatives are used by hydro-electric power producers to protect thern-
selves against falling water levels which lower their energy production and therefore
their returns. Wind derivatives pay an economic compensation against lower than ex-
pected wind activity, necessary for the operation of their wind generator facilities. 72
4.2.5 Contingent capital

Contingent capital solutions are contracts enabling an organisation to raise cash by is-
suing debt or selling stock at pre-arranged terms. Tbe different structures are shown in
figure 4.13. Tbe solutions are usually provided by insurance or reinsurance companies,
as an option on paid-in capital. Since the facility is arranged in advance, the COlpura-
tion has the benefit !hat costs can be materially lower compared to an eventual fioancial
distress situation after a 1088 event lbis makes contingent capital a cost-efficient so-
lution across a range of financial scenarios. Contingent capital is a way to finance
low-frequency/high-severity losses at pre-defioed terms, especially, when other ways
of reinsurance are difficuit to realise in hard marke! phases. Tbe corporation identifies
an amount and specification of the capital and agrees with the reinsurer the event 10
trigger the debt issuance. In return to firm commitment received, the organisation pays
a non-refundable regular or up-front fee. Tbe solutions are used by many industries.
A bank may arrange a facility against unexpectedly !arge credit losses. An insurer or
reinsurer may cover high lasses resulting out of a catastrophe event. A corporation may
securc the miuimum capital necessary to stay investment-grade rated for the case!hat
financial distress may occur. However, contingent capital is not an insurance but rather
a balance sheet and cash flow arrangement"
Contingent debt structures

A committed capital facility is a funded capital arrangement with a fixed maturity prior
to a loss. Tbe contract typically defioes two trigger events: Tbe first trigger is usually
irnplicit - the option to receive the debt will not be exercised unless it has value, i.e.
when the loss event has occurred and the organisation is not able to get funding from
another source. The second 10ss event depends on the organisation's exposure, but is
unlikely to be under its control in order to minimize the risk of moral hazard. Tbe con-
tingent capital facility may contain additional covenants in order to protect both parties
involved, like material adverse change clauses, change of control clauses or fioancial
72Banks [see 2004. pp. 163-165]
73Banks [see 2004. pp. 135-147]
~ CO"I;ng~nl [)~bl I
("on"n;l1r d ("api l al ra. il il'"
,
("onlin~,,"1 S ur~l u. '01<>
-I Su'plu, NOlCS
---i f inonri. 1G.....nl. .. I

L R.... ,du.1 Val"" Gua,"n~
Sou"..::; Banks. Erik. Ahcrn~ti,c Risk Transr, r. lohn Wik~. ChichcSlcr 200t. p. 136
Figure 4.13: Contingent capital. solutions
strength ratios to ensure that the reinsurcr docs not become financia11y subordinated to
other lenders.'4 Contingent mrpha 1Wks are pre-arranged solutions enabling an in-
sure:r, at its option, to obtain funds by issuing notes at prearrangcd terrns. The funds
enable the insurer to bolster its surplus (another apression used in the US for equity),
since according to US regulations. insurance companies are allowed to treat surplus
notes mther as policy holder's surplus than as liability under an insurer's statutory bal-
ance sheet. The notes are:made available to the insurer via a "contingent surplus nol:e8
trw;:t" cstablished by a financial. intermediate. The trust recci.ves the funds from. in-
vestors and places them into liquid investments like US Treasury Notes. In case of a
los5 event, the trust liquidates the assets and delivers the cash to the insurer. The trust
then holds the surplus notes at the pre-defined terms. The insurer before the loss event
has to pay the investors a higher yield than that achievable from. other investments with
comparable maturities, since the investor takes the credit risk of the insurer, whi.ch can
deteriorate substantially after a loss. The insurer. however. gets a contingent re:financ-
ing at pre-defined costs which may prove advantageous compared to a hanl reinsurancc
marltet after a substantialloss event7S
74Banb [see2OO4, pp. 139-140]

1'ElIiott[see2001,pp.1_2]
Contingency loans are bank lines of credit arranged at pre-defined tenns for the
occurrence of a trigger event. The loan is provided to cover lasses resulting from the
specified eveot and can therefore only be drawn wben the event has occurred. Since
the probability of a draw-down and the flexibility of ils use are lower, it pays less than
a standard bank line for corporate purposes. It protecls the organisation from higher
fioancing cosls after an eventual rating-downgrade or in the case of fioancial dislress.""
Tbe main role of jinancial guarantees is to transfer risk. Tbe capital provider aod
the COIporate customer simply agree on a trigger event aod the terms of the underly-
ing paid-in capital to be provided. When the trigger is activated, the curporate can
access the capital - the guarantor theo pays all the default-related losses up to the pol-
icy amount Tbe documentation for a guarantee is short and to the point. It contains
very few covenants and restrictions.77 Guarantees can also be used to create a form of
contingent financing when an organisation agrees with a reinsurer the access to funds
if a pre-defined trigger is breached. Financial guarantees are commonly used to protect
special purpose entities against credit losses or residual value claims. This may be the
case in the sector of collateralised-debt-obligations or assel-bac1red-structures. Before
the financial crisis, weil rated mono1ine insurers e.g. committed in exchange for a fee
to the special pnrpose entity a capital infusion in case !hat credit losses out of an un-
derlying portfolio are greater than expected. The support, also called monoline wrap,
helps the senior tranches of the transactions to achieve a higher rating. Tbe monoline
insurers da not wrap lower tranches ofthe structures.78
Residual value guarantees were developed by the leasing sector for capital-intensive
industries 10 weather the cyclical sales and income developments caused by the economy-
related volatility for the prices of capital goods. Especially the aircraft industry has been
interested to secure the value of their long-life assels against technical developmeots and
rapidly changing environmental standards. A residual value guarantee secures a mini-
mum value for the leased assets, and the corporation can calculate a minimum capital
infIow if a shortfall may occur.79
Contingeot equity structures

Lo.. equity puts, if related to a natural disaster even!, represent the right to issue new
shares at a predetermined price wben the pre-defined trigger is breached. Tbe shares are
normally issued on a private placement basis. In other terms, the purchaser, by paying
a premium, buys a put option from an intermediary !hat gives the right to seil a fixed
arnount of the newly issued shares. Loss equity puls are strongly standardised agree-
ments including terms and conditions like the exercise event, the form of securities,
the time period of coverage and issuance, the strik.e price, and certain covenants like
financiaI ratios and change of control. The most important covenant is the minimum
76Banks [see 2004, p. 141]
nCUlp [see 2002, pp. 433-434]
78Banks [see 2004, p. 142]
"Culp [see 2002, pp. 439-4411
net worth in order to protect the policy writer to be forced to invest into the company at
a time period when it may experience severe financial distress. However, in contrast to
the quite simi1ar contingent debt structures, contingent equity structures normally do not
inc1ude material adverse change c1auses. Further, compared to reinsurance contra.cts,
where the cedent can go into default and the obligation of the reinsurer is unaffected,
the purchaser of an equity put has to stay solvent in order to be able to issue the equity.
The risk of Moral hazard is reduced by the agreement of !wo triggers: First, a trigger
level of the company's stock price, and second, a specific lass event which has to occur
to enable the company to pul Ta avoid dilution issues resulting from the issuance of
new shares, the company will normally agree to issue preferred rather than common
equity. Alternatively, the equity can be issued as convertible preferred shares which can
or must be repurchased by the corporation prior to any conversion. 80
Pul prolecled equity enables a company to put its own stock in the aftermath of a
loss event which normally results in a decline of the stock price. This exactly forms the
eredit event, the company likes to protect itself. The company is able to generate an
economic gain against the seiler of the pul The put is bought by an intermediary at pre-
defined conditions usual for put options incl. the number of shares, the strike price and
the maturity. Shares can either be purchased in the open marke! or newly issued. Put
protected equities, however, can be viewed negatively by the market, since the investor
community, if they gain information that a company buys puts on its own stocks, will
natorally expect negative news to follow. 81
As an alternative to loss equity puts or put protected equity, the company may issue
reverse convertible bonds. These are not regarded as ART, but allow the company to
swilch debt into equity. In contrast to the convertible bond where the holder decides
when the swilch tskes place, the issuer of the reverse convertible decides the tinting of
the switch. The company will exercise the conversion when the issuance of debt is more
expensive than the value of the equity offered. This helps to offset or fund the costs of
the adverse loss forming the trigger event for the conversion (often, a second trigger
event must occur 10 enab1e the company 10 convert). Conversion improves the debt-1o-
equity ratio, and the reduction of the leverage increases the effective debt capacity.82
4.2.6 Reinsurance side-cars

After the insurance and reinsurance sector was confronted by severe and frequent catas-
trophe losses for several years, the industry sought an alternative solution to stabilise the
availability of reinsurance capital as weil as to reduce the volatility of their eamings and
capital positions. After the record hurricane season 2005, the first reinsurance sidecars
transactions were created. They typically have a lifetime of less than !wo years.
80Banks [see 2004, pp. 142-147]

SIBanks [see 2004, pp. 142-147]
"Culp [see 2002, pp. 448449]
Si.decars are special-purpose reinsurance vehicles (SPRVs) set up to takc underwrit-

ing risk from ceding insurers or reinsurers. F1gure 4.14 shows the typical structure of a
side car solution. A newly creatcd holding company issues cquity and dcbt. Thc pro-
ceeds from the securities are transferred to a collateral trust. The risk transfer from the
coding insurerlreinsurer is effectod by a standard quota reinsurance contract with the
SPRV. The trust pays the claims to the cedent in case of a 1058 event. If no cvent occurs,
the trust pays to the SPRV the debt interest and profits. The SPRV collects the premium
income from. the cedent and the investment income from the collateral trust and paytl a
dividend to the holding company. The holding company pays the interest on theil bonds
10 the investors and a dividend to the share holden.
'-,pi'"
'-s-;,-,-c-, ,---; :::d lr 1- ,
••~;~---;
---',~
c-: ~
SPRV
Il oiding -==:::::; I 11ot>,
l- ,i
Sl'o " ,or 1~'id''''l Ic.pi'" ,'&1
. r.....;•.::,
O" .'.llti.~
Sid. Car
SPRV
Bascd on: ~IUrrd}. All ." CI.1.. Rein,um"", Si<k·Ca,,;: Going IIlong tor lh..: Ri<!..',
~ 'ood) ·s. N.\I York.2006.p. 2
Ft.gure 4.14: Hypothetica.l side car structure
Reinsurance side-car structures include traditional reinsurance components: The under-

lying quota-sharc agreement is reinsurance standard. Thc legal structure is a special-
purpose holding with a licensed and regulated reinsurance subsidiary. The capital fund-
ing includes debt and equity, with the ability 10 add additional capitaL The performance
of the side-car is closely linkcd to \1IlIk%wri.ting and claim-setIling capability cf the
cedenl
The diffi:rcnces to traditiona1. reinsurance is private ownenhip potentially provided
by non-insurance-related investors. Further, the structures are set up with a defined risk
period and finire lifetime. The nature of the transactions is highly complex and with
a limired, ciearly defined purpose to serve the needs of a single cedent. They provide
significant flexibility for a high degree of customised structuring. Sidecars normally do
not have an active, independent management. Risk models (loss simulations, premium
rare levels, investment retoros) derermine the capital needs of the side car and serve as
the basis for calculating the probability of default and expecred loss given default for
the debt investors.
Side cars serve cedents as capped quota-share agreements on their underwriting
portfolios in force. They provide the benefit to customise the terms and conditions and
to creare a capital structure which uniquely suits their needs. Since the funds are already
placed into the collareral account, the cedent does not have to care about the solvency
risk of areinsurer in times of stress.
Equity investors get the opportunity to invest in a cyclical sector which, during the
time of sharp price recovery after a natural catastrophe had occurred, can deliver high
reloms. This is especially the case in the absence of major loss reloms like in the
hurricane season 2006, the year after Katrina.
Debt holders invest in higher-yielding debt instruments linked to clearly defined risk
caregories and pararnerers. They provide funding to cover losses ceded to the sideear
in excess of the equity up to the total limit of the sideear facility. The debt layers
normally have their attaclunent point at or above the once-in-l00-years relom period
(roughly equivalent to a BB+ rating frorn Standard & Poor's). Since they are not linked
to the general credit profile of the cedent, they are exclusive of legacy or litigation
issues, management disruptions or credit deterioration. The flexibility to customise
terms and conditions allows the parties involved to creare a tranching structure which
meets the investors' requirements to get engaged in the same structure at various levels.
These have, however, to be aware that the shareholders are not likely to be willing to
recapitalise the side-car after sustaining sigoificant losses. Traditional reinsurers are in
contrast willing to manage risk. and capital in order to maintain a going-concem status.
Side car structures attracred substantial capital arnounts from privare equity in-
vestors like hedge funds and institutional investors. In the peak year 2006, 15 sideear
transactions were complered for 12 sponsors with a total volume of USD 4.2 bn. For
the details of the transaction see Appendix C.83
4.2.7 Insurance-related securitisation
Insurance-related securitisation includes a wide range of products which will be anal-

ysed in detail in chaprer 5.
113Murray et a1. [see 2006. pp. 1-5] ;Securities [see 2007. pp. 36-38]
90 CHAPI'ER 4. METIlODS OF RlSK 1HANSFER
4.2.8 Summary and evaluation of ART instruments

Rist carriers such as captives, risk retention groups, and se1f-insurance were introduced
by 1mge US corporati.ons to overcome capacity shortages. Captives developed in10 a
global business with a growing number cf locations, among them the offshore finan-
cial centers competing with each other to provide al1Iactive business environments and
taxation benefits.
_ AU ......... .
O·T..... _'_
,..... _u ......
_.ri'''''
I........" Il<ri,.,;'.,
" .. dirio. .lllri.,..... d

IIM_ ..,; ••
Figure4.15: Spcctrum ofrisk transfer instruments
Pools have been used by several industries 10 cover liability risk but also for !Ita1:es
and multinational organisations to cover natural or man-made catastrophe rist.
FInite solutions are a bespoke form of ART for prospective ar retrospective cover.
Multi-risk products reduce the oumber of reinsurance COUDterparties. since they com.-
bine a oumber cf perils for several non-Iife insurance lines.
Derivatives are bi-lateral, standardised products and rather inexpensive. Only a
sma1l oumber cf counterparties are today qua.lified far and interested in exchango-traded
products. Therefore, Iiquidity is still mther low, and secondary market pricing is dif-
ficult. orc products lik:e n..Ws are more liquid and. if traded as derivatives, based on
ISDA standard terms and conditions.
n..Ws formed as derivatives are a bridge bctween rein!lUlllDCC and capital mark:ets
since, if an investor signs an n..W, this is not treated as insurance business. Altmnati.vely,
\LWs can be traded as reinsurance contracls and are comparab1e to traditionaI single-
or double-trigger cover.
Contingent capital is a rather limited resource, since it may hit the investor at a time
when he may run into own diffico1ties due to a low probability, high severity event.
Reinsurance side-cars are another product bridging the traditional reinsurance sector
and capital markets. Investors are able to participate in the reinsurance market for a
liutited time frarne and follow the fortunes of the sponsor. Tbe investor can chose
between perils and further between tranches with different risk profiles.
Figure 4.15 gives a categorised overview of the instruments available differenti-
ating between risk transfer versus risk financing and between the market for reinsur-
ancelretrocession and the general capital market Table 4.3 further summarises the main
cbaracteristics of the different products.
_ carriers
Type Finite Solutions Multl-_ Derivath.. CootiDgent Cop!- SIde-ears LS
produets taI
Produd captives. pools. prospective/retrospec °:vMulti_peril/ multi- options/futures! contingent debt rcinsurance siele-
self-insurance ag=ments trigger programmes n.Ws/swaps lequity c","
_Types non-life (liability life and non-life nOß-life (corn- non- life I non-life non-life
risks: modicaI (tIrlrd party liability, mercial propcrty, W'eIlife(=ging)
malpractice. autD, run-off portfolios) business inter-
warm's com- ruption, geneml
pensation, also: liability, equipment,
nuc1ear, terror) inland marine,
autD)
ObJective risk management: portfolio mnnage- portfolio mnnage- risk management: capital manoge- capital
ttansfer of high frc- mcnt: ment: hodge against nat- meD1: ment:
quencyllow severity smooth lasses over consolidate the des- ural catastropbes. finance low- reduction - 01
risk also low frc.- time- funding of ignatcd also longevity freqococyl earnings and cap-
qococylhigb sever- losses: prospective
""P"'''''''
and the number of high-severity losses ital volatility;
ity (insurance pools or retrospecti.ve; remslll'8llCc coon- at pre-defined tmns coverage for low-
to transfer other- capital mnnage- terparts; inclusion freqococylhigb-
wise non-insurablc ment: increase of of ot:herwi.ae not severityrisk
risk) retum-on-capital insurable rist ~
Strocture singIo- or mu1ti- bi-1ateral ag=ment com.bination of sev- oxcbange bi-lateral or syn- quotn-share agree- ~
porent to pay purchase 88- eml peri1s/seveml tradedlover-the- dicated agreement ment with a special
sets with the premi- biggers (can be counter, mainly with trigger event purpose reinsurance ~
ums paid from the commercial and standardisod prod- definition; stan- company
cedent to the rein- financial) ncts dardised loss equity ~
",re.- pUß
Enbpncement not relevant collateral none collateral for long- none I trust collat- collateral ~
tcrm life insurance cral (surplus note ~
structure) I mono-
1ine gwmmtee,
(wrap against credit
~~
lasses or residual
value claims)
TrIggers indemnity indemnitylindex indemnitylindex indemnityfmdex indemnity/index index bued
based based bued based
~
~
Type Risk carriers Finite SoIutions MUltI-_ Derivat!... Contiogmt Capi- Side-<ars ~
produets taI t->
Regulatory subject to home- significant no credit far protec- 00 credit for protec- amount issued af· res""", deductioo
country contral reductions
'"""".
(m.- tionbought tion bought ter trigger event is (similar to collater-
counting of lass treatcd as equity alisod reinsurance)
reserves}
AceountiDg reduction of liabil- reductioo of li- lack of clarity on DO credit for protec- treated os po1icy reduction of liabili-
ities, predictabl. abilities and accounting regulation bought holder's surplus lies
~
cost ftows are i.mproved solvency- tions rather thao as
kept within the lcombined-ratio in liability (US)
mganisation the lass ycar
~
Ratlog eIfect improvement of rat- avoidancc of rating improvement of rat- not recogniscd capital credit based full reinsurancc
~~
ing stability downgrades in the ingstability on evaluation of credit if adequate
year of a lass; trans- investment trost collateralisation is
fer of investment (AAA quality = provided
risk 100% credit) ~
Pridng premiums paid to 1-3% reinsurance reinsurancc pro- premium depending regular payment premium depending
the captivc reflcct premium depending mium is low'" on risk and term of non-rcfundablc on risk and term ~
the present values on risk and term thao with single upfront fee; cheaper
of the oxpected cootracts thao post-loss
claims to be paid finnocing
Investors parent or group of reinsurers reinsurers, hedge reinsurers, banks hedge funds, port-
companies """'""'" funds, portfolio folio managers,
managers IOinsurers
Term lang-term medium-term. medium to lang non-life 1-3years; multi-year finite risk period up
life up to 30 years to 3 years
""'"
Table 4.4: Summary and evaluation of ART instruments
~
Chapter5
5.1 Securitisation
Securitisation is the process of removing assets, liabilities or cash fiows from the COI-
porate balance sheet and transferring them to third parties through the creation of trade-
able securities. Tbe market started in the banking sector in the late 1980ies and early
199Oies, when Wall Street banks commenced to pool assets and to p1ace them into trust
vehicles which issued tradeable securities with severa1 risk and retnm characteristics.
The pooling of assets in a portfolio results in a lower risk in terms of the variance
of retnms for investors. Tbe development started with pools of residential mortgages
called Mortgage Backed Securities (MBS) and was followed by Collatera1ised Mort-
gage Obligations (CMO) which are pools of MBS. Shortly after the introduction of
MBS, commercial MBS followed inc1uding commercial real estate. The next step were
Assel Backed Securities (ABS) including pools of receivables, leases and any kind of
assets which can be securitised.
Beginning in the early and mid 1990ies, global investment banks started to cxtend
the technology to credit markets by pooling loans into Collatera1ised Loan Obligations
(CLO) and bonds into Collatera1ised Bond Obligations (CBO) which together formed
the asset class Collateralised Debt Obligations (COO). Figure 5.1 shows the structural
cash flows of a CLO. Tbe same principal is used for the other types of securitisation.
Tbe SPY is crealed with the purpose to manage the cash ftows, Le. to administer
the payables and receivables. Fnrther, it arranges the necessary hedges (e.g. the fixed
rate mortgages are for some securities hedged into floating rates). Different tranches
involve severa1 risk profiles for investors: The most secure tranche is called "super
senior" and raled AAA. In terms of ranking it is followed by the high-quality AAA
raled tranche, the mezzanine BBB and BB raled tranches, down to the residual tranche
carrying the "equity" risk. Tbe SPY redirects cash ftows from the underlying assets to
pay the interest and to repay the principle (P&I) in the order of the contraclual seniority.

96 CHAP1ER. 5. INSURANCE LINKED SECURlTlBS
This process is also called waterfalJ. principlc, sincc the most senior (securc tranches
with the lowest retum) will be paid first, followed by the next lower tranche and finally
the lowcst tranchc. thc cquity likc.. bigbly subordinatcd sccurity wbich pays thc higbcst
return reftecting the credit risk involved in its investment. It is common that arrangers
improve thc crcdit quality of Ihe senior tranches by the way of crcdit enhancement
through over-collatera1isation, reinsurance er monoline wraps, financial. guarantees ar
bank letters of credit. In case of a defanlt, the investors in the equity tranche will
lose their investment first, followcd by the next trancbe upwards until the super senior
tnmche.
I.... o, .. ilh 1'& 1
B " "~ B
Ihnk C
I P& '.
'---,J---'
I
So""..::; Banks. Erik. Ahcrnat;,c Risk Transf,r. lohn Wik~. Chi~hc Slcr 200.t. p. 116
Figure 5.1: Structural cash fiows of a Collateralised Loan Obligation
ltullTtmCe linked securiti3ation follows the same principle, but it is based on msu-
rance-Iinked events. Through securitisation, life or non-life insurance risks are struc-
tured into bonds which are financed and transfeIrcd to the market. After SOIIW carly
efforts to securitise earthquake and hurricane-related rists. the first insurance-Iinked
socuritisations were closed. in 1993. In the meantime. the insurance 1inkcd sccurities
were refined and customised. The basic principles, however, remained unchangcd. The
insurance or reinsurance company baues sccurities through a SPV, and the payment of
principle and interest is based on the lasses caused by a pre-detcrmined insurance event
If the losses exceed the agreed threshold, the SPV is not obliged to pay the agreed in-
5.1. SECURlTISATION 97
terest, and if the structure involves a non-principal protccted tranche. all er part ofthe
principal can be deferred or even e1iminaftod,1
Three main types of securitisations have becn developed by the international cap-
ital markets: First, various types of ure iosurance securitiaatioDs including true risk
transfers ar the monetisation of future profits associated with existing business, which
can be closed or ongoing operations, into securities. Second, 1lOIl-life iosurance sec:u-
ritisatioDs mainly covering catastrophe rim. Third, securiti&ations are being arranged
tI8 CDOs in order to cover the funding needs of the insurance sector. This can be done
to gain capital for new business strains or to enable smaller insuren to get access to the
capital markcts. CDOs are also arranged to finance reinsurance recovcrablcs.2
eS",,",,,,, .. n oHI< I... .....,. Ro' (foul USD .'6.J bo)

• s..:.........nofSO""* I .........,' R5.(f .... USD.'6 I bo) •
"
"
•
,. "
,,,, ,_ , .. , , ... ,__ 100' '" ' __ , ... _ ,.., _
1),0, Soon, M.'IC s.c ..".... -n.. c~ IIooo,! Mß<l" V... _Eod :>006. Go)' C"""_ I!o C _.. LI.C.
N", Yoo\. 1001, Sc~O~4 ~oul <l .1 . 1--.·Len' oo:I Sec"", ... 200t:. "ON C", 'tal MßIC', ClI",.,..1OOS
Figure 5.2: ILS capital issued and outstanding since 1994
Figure 5.2 gives an overview of the lIlIll'ket dcvelopment of the risk capital issued
through insurance-linked securiti&ation transactions. It can be seen that the volumes
issuod and outstanding experiencod a steady growth in mcent years which showcd a
small decrease after the markct turbulence after the world trade center attacks in 200l.
In 2008. only pre-arranged shelf-transactions were used far ILS issues. In line with the
negative developments on the financial. markets, the volumes slowcd down due to the
IBanb [see2OO4, pp. 115-1111]
lDinesm and BaIcllvarov Alexmder [see May 2006, pp. 11-9]
98 CHAP1ER 5. INSURANCE LINKED SECURITIES
general lack of investor appetite. 111e total volume issued through 1he 214 capital market
transactions until year end 2008 was USD 52.4 bn wilb half of 1he volume each life-
related and non-life related ILS. 111e non-life related volume includes 1he catastrophe-
risk mos Fremantle (USD 200 m), Garmut (USD 240 m), and Newton Re (USD 125
m).
5.2 Lire insurance securitisation

The k.ey attraction of life insurance securitisations is the enhancement o[ lhe return 0/
equity combined wilb a lower cost 0/ capital. 111e freed-up capital can be reallocated for
new business !ines wilb futore growth potential. Furtber, seeoritisation can be used for
risk mitigation. In contrast to other types of securitisation which wrap assets, life insur-
anee transactions involve the seeoritisation of liabilities. This makes the whole process
More complicated. Debts of the credit card business, for example, may be packed au-
tornatically by 1he card issuing bank into an asset-backed transaction. The customer
Iberefore no longer depends on Ibe credit of Ibe bank. If an annuity contract with a life
insurance company is seeoritised, the link with the customer cannot be broken, because
1he promise to pay Ibe insored Ibe annuity needs Ibis relationship to be fulfilled. Fur-
1her, regulators do not allow to transfer Ibe obligation from a weil rated life insuranee
company into a special purpose vehicle in form of an outright sale. 3
5.2.1 Reserve funding securitisation

Reserve funding seeoritisations were developed by Ibe US insurance industry afrer a
review of Ibe reserve regulations introduced by 1he NAIC called Triple-X (XXX), ef-
fective 2000.
The statutoIy reserve regulations affect the reserves of insurance companies writ-
ing individual multi-year term life contracts. The contracts have been very successful,
sinee customers were attracted by the guaranteed multi-year premium rates with flexi-
ble terms. However, US regulators are concerued about 1he varying, if not inadequate,
reserving practices of primary insurers. Insurance compauies in the US are obliged
to deliver stalotory results to Ibe regulators. Further, US GAAP based accoonts are
delivered to the US Seeorities Exchange Commission (SEC) and the compauies' share-
holders. 111e new NAIC stalotory reserve rules are demanding siguificantly higher cap-
ital requirements reflecting the maximum risk. The calculations are based on mortality
tables and averages. 111ey impose rapidly increasing stalolory reserve requirements.
111e GAAP ca1culations are much lower, since they are determined by Ibe most
likely outcome based on actuary caIculation. Until 2005, insurance companies were
able to successfully reinsure the redundant component offsbore, since they could get
hold cf lower levels cf reserves. In order to receive the desirable statutory reserve
3Devine et al. [see 12.04.2004. pp. 3-6]
5.2. LIFB INSURANCE SECURlTlSATlON 99
"'sc"'" ",quircn>cnts ro,

"2(1 )'car tcrm lire pol ic)
ro, a male non·,mole,
" Stal uto!) XXX ",sc", '.'

20 Yea"
GAAI' bcndit "'sc"'c (cconomic rcsc",'c)
Souree: I.e,it"'. J,..,I, Riegel. Roben . Ilidden Crcdit Rbl s orRegulation XXX I
Guidclin.: AXXX Rcinsur~n,'C I'rogram ,ncs. Moo.Jj-· s Ne" Yort. OII2O(1.t. p. J
Ft.gUre 5.3: The effect ofXXX on long term reserves cf life insuren
treatment by the US regulators, transactions were typically secured by either a bank

lcttcr of crcdit or a reinsunmce truSt. holding thc sccurities to collatcralisc thc rescrvc
credit. The capacity for letters of credit by banks, however, is expected to reach its limit,
especiaIly :regarding the fact that estimatcs for futurc :rescrve rcquirements reach up 10
USD 200 bn due 10 the high growth rates for term lifc insurance and their extraordinary
high reserving. Figurc 5.3 shows the difference betwecn statutory and GAAP rcserves
for a standard policy."
A similar regulation came into cffuct in 2003 for no-lapse guaranteu in umver-
sallifc insurance contracts with the Actuarial GuideIine 38, also rcfcrred to as AG38
or AXXX. No-lapsc guanmtccs arc commitmcnts by thc insurancc industry within long
term life insurance poIicies with contmctual tenns up 10 60 years. They allow the policy
holder 10 pay a certain amount into a contract, then just stop or docide 10 pay morc. Thc
futurc development cf the contracts, and as a result their rcserve rcqujrements are diffi-
cult 10 forccast. The first AXXX n..s was placed by Protective Life in 2007, followed
by Aegon in 2008 (sec Appendix D for the hlstory cf transactions).
Variable Annuities arc also being discussed as potentially being securitised. They
4Levine md Riegel [_ 2004, pp. 1-6]

were sold in Ihree main forms: Guaranteed minimum withdrawal benefils allow the
policy holder to withdraw up to about 7% of the principal per year, regardless of the in-
vestment performance. Guaranteed minimum income benefits convert the savings into
an anuuity after seven to ten years. Guaranteed minimum accumulation benefils period-
ieally reset the principal to an agreed level after a predeterutined period and at matutity
pay an agreed lump sumo Since their downside risk can be substantiaI, regulators and
ratings agencies became increasingly concerned about the various farms of living ben-
efils. The lack of predictability of casb fiows, however, makes it difficult to securitise
any of the vatiable anuuity forms. 5
The introduction of the XXX guideliue sparked the creation of reserve fuudiug se-
cutitisations, ma1ring this type of secutitisation to provide the biggest volume to the
capital markeIs.
Figure 5.4 shows the simplified structore ofaXXX securitisation: First, the insur-
ance company pays the capital plus an initial economic reserve into a special purpose
vehic1e being a captive reinsurance company.
Second, the soourities are issued by the SPV, and assels get purchased into a Regula-
tion 114 collateral trust with the proceeds. The term Regulation 114 is detived from
insurance regulations of the State of New York. Under the trust agreement, the grantor
delivers to a US-regulated bank securities with a market value of not less than the full
arnount of the grantor's obligations due under the reinsurance agreement. The types of
securities are liruited to good quality asseIs; no equities or debt rated lower than "A"
are allowed. 6
Third, during the lifctime of the transaction, the SPRV pays regular interest and the
principle back to the security holders at maturity. Further, the SPRV pays experience
refuuds and dividends back to the insurer who is interested to get the capital injected
back as soon as possible.
The financial guarantor's role is to secure the timely payment of the captive's obliga-
tions. In contrast to the insurer, the financial guarantor is interested in keeping the fuuds
with the captive to reduce its credit risk: tak.en. As in other types of securitisations, the
guarantor, due to his own underwriting standards, is ahle to enhance the senior tranches,
only.7
Like the guarantors, investors in the transaction face several risks8 :
lnsurance Risks: Secutitisation includes a distinct block of business. The block
of business must be clearly defined and the ability to separate, touch and measure the
included policies must be secored. lt must be transparent how the business was priced
and under which underwriting standards it was acquired. The policy holders must,
from the beginuing, be properly slotted into risk categories in order to avoid higher than
expected mortality or lapse rates which can lead to cash fiow shortages.
5Devine et al. [see 12.04.2004, pp. 18·19]

6Ellia [see 31.10.2007]
7Devine et al. [see 12.04.2004, pp. 43]
8Devine et al. [see 12.04.2004. pp. 11-14]
5.2. LIFB INSURANCE SECURlTlSATlON 10\
L " ina nd.1 J

I
I I
I
Spo nsor Gua r.nlor
n
w ,,""[
fund"
di,id,nd.
I '"I·i .. 1
,.in,"non"
, .. h·l\o" "m.'""
1'&1
,
I .-- I I .--
p,<><•• d, prOf..d,
I Capit~1 Mar~.t In'Hton

fo, thr SI' RV
", •• fit "",,'ili;, T ruots """' iti ••
"'
Collolrral Tru>! Reg. 11 4
"- [ «>norn;' 11 b,..,
,\>.. 1> .h .. t>
lJascd on: [k,·inc. Colin cl al .. Tho: Sccuriti!a1ion Solut"'n. Ci1igroup Inc.

No" Vor\:. 06.072006. p. 44
Pigurc 5.4: Hypothctical XXX sccuritisation
Inv~sl1Mnt porifolio risk: The quaIity of the investment assets supporting the re-
secves must be adequate, since the level of cash ßows is not necessarily guaranteed
over a 30-year horizon.
Structural and regulatory mies: Structures have been developed wbich have suc-
cessfully separated (ring-fenced) the cash flow of the securitised business from other
activities of the sponsor. Regulators will not allow the sale of a life insurance policy
and thad"ore true sales treatment is mther unlikcl.y. The target of the effo.rts of the
st:ructurer!l is to get bankruprey rem.oteness status for the investors.
MOtkling Risk: Determ.inistic sensitivity testing is a key for the predictability of
cash ßows. It has to be made sure that the transaction will perform. under various
scenarios. XXX securitisations rcquire reserve modeling of tmn life insurance wbich
is rather straightforward. Mortality rates., Japse rates, interest rates and the change of
the sponsor'! financial. strength rating are usually simulated for this transaction types.
Since its start in 2003, a total volume of USD 11.1 bn was issued in 16 t.mnsactions
as shown in figure 5.5. All issues are characterised by very long terms ofusually 20 or
30 years. Further details about the transactions can be found in Appendix D. Duo to the
negative effects of the capital. market crisis on the monoline insuren, life securitisation
came to a standstill.. No transacti.ons could be arranged in 2008 and 2009.
•
S KI,!
•
P,,'nm"<
• o • 1.I1C\ll ol din ~ ,
'"'" 2003 2004 2005 2006 2007 2008 2009
Dola Soor«: [b In<. Co l,". <1 .1. Tbc Sc<ur",,"' ,,) n Solu""'" EmcrBmgOptlO11S f ... L,f< Io;ucr$,
C"'IIfflI'P 'I><. No"' Yf)f\,. 06012006. p IO / Carc). lan and Jan~. Tim, Lu""",,,,, I.•fe
&<""" ..,,"". FIIC"II) &. I.,.",u'.o( Aetuar,C'<. 1. _ _ l00~ . II'o"~rp(,,nl Sild< 51
Figure 5.5: XXX Issues ofthe US life in5U1'llIlCC industry
5.2.2 VaIue-in-force securitisation

Value-in-force securitisation is the monetisation 0/ the future profits associated with 9:-
isting businesses of an insurance company. Transactions have bc:en exercisod for closed
books (also refencd to as blocks of policies) where the underwriting cf business has
been stopped. Further, open-end books where the underwriting of business continues
during the Iifetime cf the transaction werc securitised.9
The changes of the globallife iwurance market have put life insurers lJ11der pressure
10 incrcasc their:retums on equity. 10 rcducc thcir risk profiles and to maintain an appro-
priate credit rating. There are several driven of the change: Insurers, until a decade ago,
have operated in a capital market environment where sufficient retums were available 10
meet the retum requirements cf the po1icyholder. Further, rcinsurance was plentifully
available on- and offshore.
In recent years many Iife insurers. cspccia1ly in the US and the UK, have changed
their company profile from a mutoal organisation into a stock company in order to be
able to increase their fiexibility to grow by acquisitions or intemationally.
9Dinesm md Ba1chvarov ~ [see May 2006, p. 11]

5.2. LIFE INSURANCE SECURITISATION 103
This means, they need to be more transparent to their sbareholders and are chal-
lenged to rneet formal return-on-equity targets.
Regnlators and rating compauies brought new, More sophisticated requirements to
the capital and risk models. The intemationalisation of the capital markets resulted in
higher liquidity and lower returns. The risks, however, increased - the stock crisis of
the late 1990ies and the current capital market crisis wiped out a substantial part of the
insurers' reserves. Further, pandemics like the hird f1u are threateuing the calculation
of reserves.
After the consolidation of the sector, the top ten life remsurance groups increasingly
use their power to put upward-pressure on premiurns. Although growth opportuuities
exist in emerging markets, today's major markets North America, Western Europe, and
Japan are characterised by an ageing population involving longevity risk. 1O
These developments have caused a number of insurance companies to securitise
the embedded value of their business. Securitisation allows the insurer to monetise the
value of traditional term life insurance with lower return-on-equity. Capital is created
through aceeleration of the recoguition of the underlying eamings stream. This means
that a company can through securitisation immediately reduce its capital invested in a
business !ine. The freed-up capital can be used for higher-retuming activities." Figure
5.6 shows the history of the marke! since the first transaction LI was closed by Han-
nover Re in 1998. For a list of the 16 transactions with a total volume of USD 9.2 bn
placed see Appeudix E.
Embedded value refleets as closely as possible the total value of the company. It
is the sum of the adjusted net asset value plus the present value of the shareholders'
share of the future income stream expected from the policies in force written by a life
insurer. The adjusted net asset value essentially consists of the free assets as stated in
the cornpany's balance sheet minus any included goodwill and other intangibles (like
for instance deferred-acquisition-costs) plus any unrealised gains not aceounted for on
the balance sheet. '2
In Europe, the CFO forum, a working group of CFOs of 19largest European insur-
ance cornpauies, has been working on guide!ines on European Embedded Value (BEV)
disclosures. The!arget is to create a realistic and comparable reporting of the EEV."
The BEV calculation methodology further tskes financial options and guarantees, non-
market risk (operational and insurance risks), and the cost of capital into considera-
tion. 14
The shareholders' share of the future income is referted to as the value-in-force.
It arises as profit margins held in the insurer's reserves are released over the lifetime
of the policy." Value-in-force is a rneasurement of the expected present value of the
IOLa.thuil1eri.e [see 20.06.2006, pp. 2-3]
l1Devine et al. [see 12.04.2004, p. 9]
12Carpenter et al. [see 27JJ2.'1JXJ7, pp. 2-51
13La.thuilkrie [sec 20.06.2006, pp. 3-4]
I-4Carpenter et al. [see 27 .02.'1JXJ7, pp. 2-5]
15Carpenter et al. [see 27 .02.'1JXJ7, pp. 2-51
•
Mund.1<
l ·r"~<nli.1
'Orlh~ ' ind
u
• 'lu'".'
o
1"6 1'1')7 Pl9g 1~'19 2000 1001 1002 l OOJ lOUJ 2005 10006 W07 2003 2009
l)al. Soor", IXI"n<. Colon. 0' .1 . Th Sc<""l".l! 'on SoMIOO t""'fj;'ng üpt""" fO< I.,fo In,,,,,...
Ci"gr<>up In<. N<'I Yor\;. 06.07.2006. p. 25 I ClrO)'. lan anti ;""""'. Tim. Eu"'l'<"" Lof.
&\:U""""IOO. ~""ull) '" In>l"",,,of A<tuan",. 1.0.,,100. 2008, jl"''''0fJ><llnl Sh<k 5)
11.,,,,,1>'.'.
1I'.lh •. UI,oeh. Insuran« - L,"~ed So<... ,,,,os. I1.MO''-'' Re, :N 07.2007
1 1""'~rpo l nt SluJe 7)
Figw'c 5.6: Value-in-force securitisati.ons since 1998
policies an ins1.ttal1Ce company currently has in its books. It forms the intangible part
of the cmbedded value of the policies and is nonnally not incorpomted in the primary
financial statement&.16
The cal.culation of the value-in-force is a result of the actuarial forecast of the future
profit and loss items of the company discounted at a rid: discount rate. The evaluation
on a best-efforts basis is dune in three steps: First, the discounted statutory cash ßow
emerging from the relevant block: of policies is calculated as the residual value of the
life insurance policies at the end of each year after subtracting the benefit payments, the
cxpenses and the dividends to the policyholder. Second, the cash flows are summed.
'Ibird. the company cash ßow ia calculated by summing the value-in-furce of each pol-
ier aeroS! the lines ofbusiness.17
Although no one vaIue-in-force securitisation structure which has been closed by
now is similar to a second, Flgure 5.7 gives an overview of the cash ftows of a typical
structure. The issuer gets the proceeds of the securities from the investor and grants a
loan to the special purpose reinsurance vehicle. The sponsoring insurer closes a rein-
surance treaty with the SPRV far the relevant block. of policies. He is obliged to pay
16La11mil1me [_ 20.06.2006, pp. 3-4]

17La11mil1me [Re 20.06.2006, pp. 3-4]
.r ."inand.1
Guar. n.or
1,-" <,,<!i' .nhon"n,.n. (upb"n,')
,,,
pr<>«.d,
from "<1I'i'"
SI'R V .--.
i"tI.
11 11· :::. I Iss" er

I I" ,-slors
II
R.,....,'. ~U"d
1'&1
r<in,u,"nco rdn,ur... «
• .,h n"" . <"lIIrni"i,,"
·········· l Spo"><Ir
( R i,~ C":orrit<) J
lIa.wd On ' Lal"illc';" . FranI . ({""Iing in the Years' VIF Sceu';.sation . F;leh Ratings.
tondon. 20.06.2007. p. 6
Figure 5.7: Simplified value-in-forcc: securitisation
a premium. while the reinsmer pays back a commission to compensate the primary in-
sure:r Cer its acquisition costs. It is common practi.ce that the existing actuarial reserve8
remain with the risk carrier as a deposit (modified co-insurance). Altematively, the re-
scrves cou1d be transferrcd 10 the SPRY. During the li:fetime of the transaction, the SPRV
pays the isSW7 the principal and :int.erest agrced, which is passed on 10 the investors of
the different tranches. TM issuer may buy a wrap form a reinsurer er monoline insurer
10 enhance the ratings of the securities issued. This is cspecially useful far these kinds
of sccuritisations, since it is nearly impoS81ble 10 get a higher rating far the structure
than the isSW7:financial strength rating of the insurance company itself. Regulators will
not pennit the company 10 serve the prineipal and interest when the company is not able
10 moet the minimum solvency rcquirements. 18
In order to protect the interests of the investors and the potential provider of the
wrap, further cn:dit enhancement mecbgnjsms may be agreed: The SPRV may hold a
reserve fund to protect the note holders agRinst the general uncertainty of the profits
(i.e. unexpected fall in market values of the assets affecting the profits). Furthec, the
insurance eompany eRD add same protection 10 the note holdas by securitising a sma1ler
liLathuilli:rie [_ 20.06.2006. pp. 3-10]

amount than the calculated present value of the future cash flows. Liquidity facilities
can be put in pIace to secure the payments of interest and principal.
Tbe risks for the investors can be sumrnarised as folIows: Tbe amount of Ibe value-
in-force is volatile and is depending on Ibe actuarial experience of the underlying poli-
eies such as investment risk and surrender rates. Mortality, morbidity and longevity
are difficult to estimate. Embedded options and guarantees are common in life insur-
ance policies but can inc1ude severe downside risk. An unexpected increase in expenses
or lax rates may affect the cash flow projections assurned. Tbe correlation of risks is
difficult to model and may result in asset-liability ruismatches. Finally, it has to be
mentioned that the investors bear the risk that the sponsor is able to administer the
underlying contracts correctiy.19
5.2.3 Residual commission securitisation

Residual commission securitisation is a rather small market. The first transactions were
closed by American Skandia and Hannover Re in the late 1990ies. Until the !atest issue
in 2006, USD 2.3 bn of securitisations were finalised. For the market development see
figure 5.8 and details of the transactions Appendix F.
Tbe target for Haunover Re was to balance the necessary write-off of the acquisition
costs for life, health and personal accident insurance in the year of acquisiti.on. The
costs were transferred into the capital markets with the effect that Hannover Re gained
immediate liquidity for further growth. This enabled Haunover Re to continue its strong
growth in the segments without having to show a negative result 20 Clark-Bardes e.g.
securitised the agent's trail commissions to raise funds for future acquisitions.21
Ta give an overview of a typical structure, the transaction Li issued by Hannover Re
shall be explained as shown in figure 5.9. The SPRV closes a retrocession reinsurance
treaty precisely defiuing the block of business concemed with the insurer. For balance
sheet, solvency and tax reasons, the vehic1e is frequently established in certain countries
or national territories like Bermuda or Guernsey and not coDsolidated with the insurer.
Tbe agreement is treated as normal retrocession regarding the ceden!'s balance sheet
and statement of income. Tbe relationship between the investors providing Ibe capital
can tak.e many forms. It can be a loan or several types of securities with different layers
reflecting the risk. Tbe liquidity gained is immediately transferred to Ibe insurance
company.22
Tbe benefit of Ibe structure is an improved liquidity situation of the sponsor. How-
ever, Ibe liquidity strain has to flow back through Ibe payment of Ibe reinsurance pre-
ruiurn from the second year on already. In strong growth phases, Ibe company through
the securitisation is able to show a more constant profit and loss development. Tbe
"Lathuillerie [see 20.06.2006, pp. 3-10]

2OBuetow [see 01.12.2001, pp. 6-7]
21Devine et al. [see 06.07.2006, p. 27]
22Buetow [see 01.12.2001, pp. 6-7]
,_.
I~~O 1'1\17 I~~H 1~9\I 101141 1001 1001 100J 10 0~ !1141_~ !1141 ~
[lau Soo"" [)", 'rI<. Colln. 06.07 2006, P 26 / 1I':olIIß, Uhieh. In'Uf""",,·L In~<d &w"II<>
lI.nno' ... Ik lI.nno"o,. 29.07.2007 11'0>001»0'''' 51 ,<1< 71
Flgure 5.8: Residual commission sccuritisation sincc 1997
efIects of the securitisation for cx:ist:ing business on the balance sheet cf Hannover Re,
following the German regulations, are comparab1e to a normal retrocession. In case of
new business securitised. the 1iquidity inßow provides re1ief for the msurer'! b!bnical
result and equity capital. The asset investment volume increases. 23
5.2A Risk transfer securitisation

Risk transfer securitisation in life insurance is used to secure extreme mortality risk:
which may be caused by pandemics. The market started to develop the st:ructures
in 2003, when Swiss Re used its SPRV named Vita Capital to issue USO 400 mln
mortality-indexed-bonds. Vita 11 fo11owed in 2005 with a volume cf USO 364 mln.
Scottish Re structored USO 155 mln cf mortality-linked bonds in 2006.
AXA unvciled its debut mortallty risk securitisation Osiris in Octobcr 2006 with
a volume cf EUR 345 mln. The retums on the notes depend on the development of
mortality in Fnmce with a share of 60%, Japan with 25% and the US with 15%. The
calculation is based on the parametric, age and gender weighted, combined mortality
:DBamJw [see 01.12.2001, pp. 11-23]

'um • • ou.
Kr;n, uno.« T".,; ..
III <>pi.. ,
."" •.' I,
Slk,n'Q' .
I prrm,um ,
SPIH'
I 1'&1
InHItO'S
~ .. in,"",.« ,hk
<"... rtd I" •
7~% quol.
, h.rt 1..... 1)'
nase<! on: IlOto\\. SteITe". $ecur;.;''''l;<)n in Ure. IIcallh ..,cl Personal Acddcnl hinsurnn<•.
Ihmno,cr. 2001. p. 7
Figure 5.9: The L1 transaclion ofHannoverRe
index (CMI). The lifetime ofthe transaction is fromJanuary 2006 until December 2009.
Thc CMI is a two year rolling index. The data from 2004 and 2005 was taken as a
starting reference.24-
Flgure 5.10 explains the structure ofAXA's Gsiris transaction which is done within
a USD 1 bn shelf programme called "AXA Cessions ft
•
The issuer Dsiris Pie, a special pmpose vehicle based in Ireland. issued bonds of
the classes B, C and D (class A was not used fer Osllis). The bond class BI was
wrapped by a monoIine guarantee issued by CIFG. The proceeds of the issues were
he1d in a collateral trust In case of the trigger event. tbe capital of the relevant tranches
is transferred from the collateral to AXA Cessions. For the attachment I detachment
points and the terms of the notes, see table 5.1. If no event occurs, the collateral is used
10 repay the bonds at maturity.25
The model was provided by Milliman, an actuarial company based in the USA
which supported the evaluation of the ratings provided by Standard & Poor's and Moo-
dy's. A basis mortality component, a disease component, and a teIrorism. component
were included in the ca1culation mode1. It was criticised by the investor community that
24Farmw [see 2006]

l!ICmvcayet al. [see 17.11.2006.pp 1-4]
~",n« I'Olir::.j
r-
!!! Io,;·;,. ISt rit' 21·__
IClo" ,\1- .
-.--
rl.im,
= 1
'-- ,~
AX \ (',,,iQn, Ol i.i\ Pie
4S 4 ' ~ \ ' o"n,d I» ,\X.\)
pr,mium.
(I>Suing SI'\')
I',~ I -Ino" 1I1C1." 111
-
1- ICI." cln." ('1- - -
10o" IIICII" ])1- -
('\ 11
Ind"
I CO ll att .... 1
I
-
Soure.: Cer,,<n),. l'raJ1k. ,\ ,scd B"d,cd """Icher. AB S - in tödlicocr Mission. 1)/. Bank
~rn "Hun.I?11.2006. p. 3
Flgurc 5.10: AXA shelf programme 105iriS transactWn structure
France bad a 60% share in the index, but only 13% of the underlying population.
1 3mE+O.209Io meant 3-1DODIh EURIBOR plllS 0.2 pcrecDf.
DZ Bmk, AlMt Bacbd watchm: - ABS iD tödlichez: Miaion

F'rInkfurt, 17.11.2006
Thble 5.1: Osiris Pl.c - tranche structure

The risk for the investor is a higher than expected increase in mortality wbich can
be caused by epidemics, pandemies or man-made catastrophes like nuclear attacks. 26
F1gUle 5.11 shows the bistory of risk transfer securitisations. The activity has becn
slow since its start in 2003. USO 2.2 bn were issued in six securitisations. Further
transaction details can be found in Appendix G.
•
Vi•• I
2002 2003 200-1
D,,,. Soure< Schu l". Poulets'" In,ur",,«

2005
Lln~.J
•
2006 2007 2008 2009
Secu""",_ AON Capt ,al M,TI<m. Ch,cll8o. 2008 . P 48
Figure 5.11: Risk transfer securitisations since 2003
5.2.5 Life settlement securitisatiOD

life settlement is a business where policies are sold ror a lump sum payment by the
policy owner to a licensed cntity for an amount greater than the surrender value cf the
policy, bot lower than the face amount of the policy. TM purchaser of the policy be-
comes the new owner and continues to pay the prcmiums to the life insurance company.
When the insured individual dies, the purehaser gets the death benefits. The earlier the
insured person dies. the higher therefore is the yield Cor the investor.'n
The business is an outgrowth cf the viatica1 settlement marltet which started in the
times cf the AIDS crisis during the latc 1980i.cs. Terminal ill AIDS pati.cnts in thc US
2(iFarmw [see 2006]
17Moda [ee24.03.2OO11, p. 1]
sold their policies because they needed money for medical trcatments or wished to live
their time Ieft without financial problems. The market with AIDS victims stopped when
thc medical advantages thankfully allowcd thc paticnts to live longer with thc discasc.
Looking for growth opportunities, the markct for seniors holding life insurance con-
t:ract:8 became target for the life settlements industry. Wbile the volume of the life set-
tlement market was cstimated at USO 16 bn for thc year 2006, rccent cstimatcs forecast
a potential market for US life settlements at USD 21 bn by 2012. The economic value
of approx. 20% of the life insurance policies of holders over the age of 65 exceeded the
surrender value.2B
The life settlement bu&incss bears the opportunity to form portfOli08 of policics
which can be securitised and placed to the market. Figurc 5.12 shows the proccss of a
life settlement securitisation:
0 ",
0 --8 _. ,..... "", -
R ",~"
/ 1'T........
"" n..... ~ 1
o 1.."'·..1-·1,·....·..,,1-
/ """
.e.p;,.1 IS! uu
·1 T·oct.!!! " e 1
0 -- So ..... ( 8~,,< r"I'Ir)"-
o - /' 1 -
1'01;';'" rtn"Uo SPV)
I R ",~" I _I r.., .... I ~~;" I
0 /
M•.io<.1
~.,
I'-....
I"''''...''''' "'~"-:
...,- I
~~,
C.";,,I
\L
1'&'
"'1"""'0<1")
Pn,. Pb«_
' rO<'''.rl
,opoOOl'lOi)
J
u..,,,buofOO "", ..
-
~ ~di<al C(lun~ ~ ln-cslnrs
I
~gUlalOry COU"~
Figure 5.12: Simplified life-settlement securitisation
The process starts with the purchase of the individual policies by brokers acting as inter-
mediaries for the licensed entities. The entities (providers) can aItematively purehase
the policies dllectly from. their holders. The insurance compani.cs that issued the life
insurance policies most be informed ahout the transfer. They are critica1 to the process,
ZIICroIsonet 11 [see 12.l19.2OO1.p. l];Hodson [_ OS.02.2OO9];Pitzb: [see 3(UI9.2OO6]

sinee their solvency is the basis for the payment of the death benefits. The intennedi-
aries must malre sure that the transfer-related and sale documeutation delivered by the
attorneys is conform with the relevant regulations.
The policies are then assigned to the bankruptcy-remote SPV. The vebicle is set
up for the only purpose of purchasing life settlements, issuing securities and holding
other assets in the interest of the investors. In order to co-ordinate the process, reg-
ulatory counsels are used. Tbe medical examiners provide a two-fold comprehensive
review of the medical files of the poliey holders. They provide an estimated mortality
profile for the portfolio including a summary of the pertinent medical conditions and a
determination of the life expectancy. The proeess is supervised by a medical counsel.
During the lifetime of the transaction, the tracking agent contacts the insured or
their representatives to verify the corrent life/death status of the insured. Actuaries
help to provide the mortality tahles for the transaction. Tax advisors provide opinions
on the tax implications involved in the transaction and accountants provide OpiniODS
about the recognition of expenses and income regarding the bankruptcy remote entity's
country of domicile. The collateral manager supervises the choiee of policies for the
portfolio. He malres sure !hat eligibility criteria for the securitisation are fulfilled. The
focus is further on optimising the portfolio in !hat respec! that the premium payments
are minimised and the death benefits are maximised. He delivers the doeumentation of
the purchase of the policies to the trustee.
The trustee acts for the benefit of the note holders holding the security granted by
the issuer aver its assets, the life insurance policies. All documents referring to the
single life policy settlements are held by the trustee.'"
The benefit of life settlement securitisation is the attractive retorn for investors com-
pared to other capital marke! investments availahle. Further, the risk involved has been
regarded as rather uncorrelated to the capital market developments. 30 Policyholders are
able to get out of their contracts if the coverage is not needed anymore. This may be
caused for instance by a divorce, bankruptcy or sale of a curporation owned, but also by
financial distresS.31
However, the industry has been critieised for improper practices sinee the beginuing.
First, it is argued !hat the practiees of viatical settlement were immoral, sinee the fatal-
ill policy owners do not have many options to get hold of liquidity to pay for their
medical treatments. The result was a mis-pticing of the transactions.
Although the providers have to be regulated companies, the practiees of the life-
settlement marke! are non-transparent Reports were published !hat policies are sold to
elderly people who do not fully understand or appreciate the agreements. Life insuranee
is offered for "free" with an immediate cash payout: The insurer buys a policy with the
intention to seil it after a contestahility period of two years and gets the cash payout
immediately after siguing the contract in the form of a loan. If the insured dies within
29Crosson et al. [see 12.09.2007, p. 3]

3ORhode [... 01.10.20091
31Pitzke [see 30.09.2006]
the first two years. the heirs get the po1icy amount alter repayment of the loan amount
plus interest and fees involved. After the two years, the investor decides whether to buy
thc po1icy 01 nol If the hcal.th situatioo of the insuzcd has improvcd, thc invcstor may
decide not to buy, and the poIicy holder remains with the obligation out of the loan plus
thc future premium payment schedule due for the life insurance protection.
l ' ort'} ' o~n l,,~
•
•
I' .. ,~". !.<\lU, 64
I'.. ,~". I.<\lot, OJ
•
'\(>0110 S I."
0
• 1. <1:><) Ikn,r.1
2002 2003 2004 2005 2006 2007
lJata Sm!«· c"",). I.. ""~ Jatn<">. T,m. E"'opcM1 1.'[0 &0"""""011 . ~ac"I') &: In,,,,"!< "r "CI"3f'<">.
LOIIdon. 200&.11'0"·<""'101 SllIle Sl l !'......,. M",h3ocl. &."""""011 ofL,k &ulcmc"'
C ..... Ho" •. Fasan<> ""'''''al<>. \\ ..
hm&,011. 31.10.200& 1 11""."" .. \\ " 0," ~ I Bo..
""'li"'''' Tnd,o""'. R"" 'lll<> llonds Iss...d bj "(>0110 SIS Fund S'\. AM Iksl. Old" ,o~.
02092(1(1.1
Figure 5.13: Li:fo..settIement securitisations
In August 'lOO7. the NAIC has passed an amendment of the relevant regulation called
"VJ.atical Settlement Act" prohibiting the settlement of a policy during the first five
years alter issuance. 'Ibis is expected to end the iIIegimate practi.ces described above
and re.fcrrcd to as straDgcr-owned.-lifc-insUIllDCC. Thc lcgisl.a1ion is being ratificd in the
US federal states. 32
Apart from the reputational and litigation risk, the investor in a Iife sett:lement se-
cnritisation bean direct financiaJ risk. The assumption of Iife expectancy is difficult.
Although AM Best has publi!!hed its methodology far the rating of life settIement &eCU-
ritisation, rating agencies have not achieved a sufficient comfort level with the predic-
tions. As per September 2006. ooIy ODe transactioo was grantcd an indicative rating by
AM Best.33
~etll [see 12.09.2OO1.pp. 2-3]
"ZiIer[ee2007]
Securitisations placed on the capital markets therefore have been limired. The total
volume of the five public transactions was USD 1.4 bn <see figure 5.13 for the bistory
and Appendis H for the transaction details).
5.2.6 Summary and evaluation of life ILS

Apart from traditionaI reinsurance, a variety of securitisation types are available for the
life insurance industry:
Reserve funding is a special product for US companies to finance their increased
reserve requirements instructed by the statutory rules XXX and AXXX. Due to the
complexity of the reserve calculations and the very long terms requesred, the products in
the past depended on additional guarantees provided by bigbly rared monoline insurers
in order to malre them attractive for investors.
Value-in-force securitisations pre-finance expecred profits for closed or open life
insurance blocks of policies. Companies are enabled to generate cash wbich can be used
for further growth or to protect themselves against adverse developments of portfolios
acquired they may not like to continue.
Residual commission securitisations were introduced by companies to overcome
phases of slrong growth when entering new markets in terms of geography or products.
The sponsor pre-finances acquisition costs and in favour of investors collateralises its
mortality and expense fee income or deferred sales charges on unit-linked products.
Risk transfer securitisations protect against adverse mortality developments wbich
can be caused by pandemies or man-made cataslrophes. The products provide medium-
term coverage for a fixed price. By purchasing this protection, insurers get a stable basis
for calculating their premiums for the policyholder.
Most life settlement transactions are being closed as private placements sold to pen-
sion funds, asset managers, or retail investors. Pew transactions wore publicly placed
in 2003 and 2004. Despite legal issues and concerns from regulators, the market expe-
rienced steady growth, but shifted from public transactions to private placements.
Table 5.2 shows the main characteristics of the severallife insurance securitisation
types with total USD volumes and transaction numbers.
Type ReserveFund.{XXXIAXXX) Rlsk Trlmsfer Value-in-Force IJfe Settlement Residual Commtsslon ~
USD m 8,686.1J2,43O.0 2,210.2 9,239.5 1,466.2 2,330.0 t->
Os.... (1J/l) (7) (16) (4pub6e) (10)
(transactlOIIS)
Objecti.. capital management: is- risk management: pro- capital management: funding: raise liquid- !unding: Re-finance ac- ~
suance of nOD-rccourse debt tertion against adverse raise regulatory capitaI; ity foe acquisitions or quisition cest and future
to fund "excess" statutory re- mortality developments funding: raise liquidity in the phase of demu- profi" (e.g. in times
~
serves fot term life and uni- (e.g. pandemies, man- tualisation, tuming in- of fast growth), provide
versallife contracts made catastrophes) tangible assets into cash liquidity based on a per-
fundIDg: plUChase oflife centage of defer:red ac-
inaurance policies quisition cast oe salcs ~
charges
Strodure SPRV reinsures a block: of sponsor transfers assets protcction either fot a provide liquidity based provide capital block 01 ~
life insurance business equa1 to the economic closedlopen-end block on percentage of business is ceded to a
reserves 10 the SPRV of policies or using a
•
value in force term life SPRV providing reinsur-
procccds of the debt is- parametric DWrtality insurance or annuities; ance - the reinsurer re-
sue are used to purchase index trigger the trusts issuing the imburses the sponsor for
assets far the trust ac- notes are collatoralised the origination
~
count by a portion of future
~
fees, expense charges ~
and contingent deferred
saIes charges
Enbancement collatcral + guarantoe co1lateraJ. + guarantee collateral + guarantee collateral collatcral + guarantee
1iiggera indemnity indemnitylindex based indemnity not relevant not relevant
Regolatory credit for reinsurance on credit Iike with tradi- DO restrictions, relief in viatical settlement set 00 restrictions ar relief
il8 statu10ry reserve require- tional reinsurance, if in- combination with rein- (US); increasing COD-
mcnts (closed gap between dcmnity based, othcrs surance possible if truly cems of regul.ators due
regulatory and cconomic re- not qualified far a reduc- on a limitcd recourse 00- lo malpractice
"""ea) tiOD (US) sis and repayments are
contmgent on the emeI-
gence of suflicient sur-
plus; loan from SPRV is
considered as long-term
business funding
-'"
~
Type ReserveFund.(XXXIAXXX) Risk Transfer Valne-in-Force IJfe SettIemeDt Residual Commtsslon ~
USD m 8,686.lJ2,43O.0 2,210.2 9,239.5 1,466.2 2,330.0

issued (13/2) (T) (16) (4pub6c) (10) '"
(tnmsactions)
Accounting increase in assets and liabili- credit like with tradi- increase in assets and li- no accounting effect on improve leverage posi-
lies (reserve relief) tional reinsurance., if in- abilities equal to net pro- life insurance co tion, treated similar to
demnity based. others ceeds of the issue (EV retrocession - relief on
not qualified far a reduc- shown in the accounts technical result and eq-
tion (US) ist rc:duccd accordingl.y) uity captial
off-balance
Rating far the sponsor indirect1y rating capped by the rat- hnproving liquidity and Da rating effect far life all capital raised >50%
positive, if freed up capital is ing of the sponsor due to in same eases the capital insurance company of VIF will improve rat-
used for operations with pos- the re1iance as premium position (max. 50-75% ing conditions
itive and stable performance p0Y'" capital recognition); if
- not guaranteed capped
at the sponsors ratings
CmU guarantor fee, legal fees, rat- guarantor fee, legal fees, guarantor foe, Iogal fee" legal fces, rating agency arrangers, legal fees, rat-
ing agency fees. third party rating agency fees. third rating agency fees. third fees. third party advi- ing agency fees. third
advisors, arrangers party advisors, arrangers party advisors sors, 2-3% margin for party advisors
~
Investor Libor + 0.2% • 1.25% de-
around 1.5%;
Libor + 0.2% • 3%, Libor + 0.7% - 3%
arrangers
Libor + 1.5% • 2% Libor + 0.7% ·1.5%
i
yielcI p," pending on the rating of the function of duration and ~
relevant tranche rating of the nates
..... rat- AAA down to BBB- AAA down to BBB- AAA down to BBB if rated AAA down to usually not ratcd
mgs BBB
Investors insurancc companies, pen- pension furuh, ..set insurance companics, pension fund" os- banks, asset managers,
sion funds, asset managers numagers, insurance osset set managen, private private investors
(lang·term), banks companies, bedge
pension fund"
managers Oong·term) I investors
~
funds, institutional loan Banks (.hort term)
andCLOs
Term lang-term (up to 30 years) medium-term (3-5 lang-tenn (5-40 years) long term (7-10 ycars) medium- and lang-term
years) (3·20 years)
~
Table 5.3: Life insurance securitisation types: Summary and evaluation of characteristics
I
5.3. NON-LIFB INSURANCE SECURlTlSATlON 117
5.3 Non-Iife insurance securitlsation

5.3.1 Catastrophe bonds
Catastrophe bonds cover low-frequencyJhigh-severity risks and emerged in the hard
reinsurance m.arkct conditions of the mi.d 1990ies as a product to transform insurance
related risks to the capital markets. After significant lasses caused by Hurricane An-
drew and the Nortbridge Earthquake. the :reinsurance capacity available was limited and
expensive. The first catastrophe bond with a vo1ume of USO 85 mln called Kover was
placed by Hannover Re to transfer catastrophe risk in 1994. The second issue called Kl
with a volume ofUSO 100 mln followed 1996 to cover catastrophe and aviation risk. In
the meantime, transactions to cover natural catastrophes caused by wind-storms, earth-
quakcs, but also cvent canccllation of industriaI risk were placed into the capital.market.
..
..-
,------------------------------,"
.~.--, .
-
"
... ... ...

, , ,...., , ,- -,.., ,
•",'bi•• ••" )'" I'........, *' "'t .... The C~ 'Iood ~ b-I. ", .. v<* ...... 2OOIi. v,,). C..p'"'''' & c _ LI.!;.
,.«!
" ... yoo;. 2\10'. S<hultJ. 1'ao,. 00"";<0. 2\IOIl
Figure5.14: Catbond issues since 1994
Figure 5.14 gives an overview of the n.s vo1umes and transacti.on numbers issued since
1994. After a phase of steady growth, the volume reached im peak in 2007. A total of
159 transacti.ons were placed into the capital markct with a volume of USO 26.1 bn.
Appendix I contains transaction details of the several issues.
Similar to other securities, a cat bond is structured to pay a regular coupon, usuaIly
a :Iixed spread over the interbank offered rates as compensation ror the risk taken. The
documentation specifies catastrophe trigger events which, if occurred, allow the insur-
ance company tu use thc procccds cf thc band issuc tu cover losscs rcsulting from thc
exposures with poIicyholder a:ffected by the camst.rophe.34
I
p,.",I.m
r--------,
~---' . p ... ..,i"", ,"j
p"",<T<I, pi.,
S PK \' I "0''''
!.."
"0'
_I."......" ' 01"~.
!,Ibo,
'0" ~ <0"'"' i
11")"'<"' ...,,,,<nl 1'&1
c. ", .. ,
\I",~<!
In....'I<...
So"=: Culp. Chri'topl>c,. The ART of Ri" Mon.genlen!. Wilc) . Ne" Vor,. 2001 p. ~68
Figure 5.15: Simplified structure ofacatbond
The typical cat bond structure is describcd in figure 5.15. A SPRV is created for the
only purpose to reinsure the exactly defined risk and to isme the securities. The SPRV
closes a reinsurance agrcement with thc sponsoring insurer/reinsurer. The prococ:ds
from the issue are paid inm a collateral trust or cash account. The interest payment of
the coUateral can be fixed or floating with several interest payment dates. The proceeds
arc swapped with an extemal counterpart: into the ftoating rate! necessary tu meet the
timely interest payment of the investors holding the different classes ofbonds. The total
rctum 5W8p counterpart, usually a higbly ratcd bank, 5CCUIeS thc paymcnt of principal
and interest to investms and the payment to the sponsor in case of a catastrophe trigger-
ing the structure. Payments are &eeured no matter what the value of the securities in the
collateral tru!rt may be. If no trigger event occurs, the note holdeLs get the sprcad and
the principal at the repayment date. If a Ioss event occurs, the SPRV covers the losse8
MShahand I'icoDI= [see 09.02.2007, p. 7]

5.3. NON-LIFE INSURANCE SECURIITSATION 119
of the sponsor, and the investors get the remaining balance of the collateral account in
accordance to the seniority of their bonds. 35
Tbe basis for the loss ratings of the agencies is the modeling of los ses. Tbey are
supported by modeling firm estimates, principally AIR Worldwide, EQECAT and Risk
Management Solutions. Tbe probability of a first dollar loss, the probability of a full
exhaustion of the principal, and the expected 10s8 are taken into consideration. The
probability of the events is referred to as once-in-IOO-years or once-in-250-years events,
meaning they have a 0.01 %, or respectively 0.004% chance to occur during a calendar
year. Tbe pay-off triggers of the catastrophe bonds are normally set sufficiently bigh to
limit the probability of a bond being triggered. 36
Regarding the loss triggers, four types can be distinguished: 37
Indemnity triggers have been used since the emergence of n...s transactions and are
1in1red to the insurance cornpany's portfolio. Tbe catastrophe bonds are stroctured to
benefit from an excess-of-loss coverage comparable to a standard reinsurance contract.
When the los ses exceed a certain volume, the proceeds of the cat bonds are used to
cover the claims payments. Tbe rating agencies take the modeled default probabilities
of the attachment point and the exhaustion point into consideration. Forther, the ex-
pected loss for the policy holder is estimated. Tbe result is the basis for the ratings to
be assigned for the several tranches. Tbe insurer does not depend on the solvability
of the reinsurer, since the proceeds of the bond issue are kept in the collateral. From
bis point of view it has to be taken into consideration, however, !hat, like in traditionaI
reinsurance, between the occurrence of the event and the payment of the claims it can
tske months for the darnage to be evaluated. From the investor's perspective, indemrtity
triggers give rise to moral hazard risks. Since they depend on the insurer's book ofbusi-
ness, he may loosen the underwtiting standards and loss control features. To avoid the
negative developm.ents, the underwriting standards are usually disc10sed to the investor,
and the insurer takes a portion of the lasses as retention.
Industry loss triggers were an important step to open the transfer of reinsurance risk
to the capital markets. Tbe cat bond losses are determined with reference to a loss index
and are not based on the company's loss experience. For the US hurricane related issues,
the US Property Claims Services Index (PCS Index) is often used as a reference. Tbe
structures determine a series of index levels, representing the losses occurred as trigger
events for the several tranches. The loss development is transparent, and investors are
able to calcuiate the correlation of the bonds with other financial products. Tbe sponsor,
however, has to take some basis risk: While indemrtity triggers are closely related to bis
portfollo, indices can be influenced by losses which occur in areas where he is not even
writing business.
Parametrie index triggers use measured parameters lik.e wind speeds or the earth-
quake intensity of the relevant catastrophe event to trigger the payments. Tbey are used
3SCUlp [see 2002, pp. 470-471]

36Shah andPicone [see 09.02.2007, p. 8]
37Shah andPicone [see 09.02.2007, p. 9-15]
e.g. for European windstonn coverage and Japanese earthquake related bonds. In both
areas, industry loss indices do not yel exist. The benefit for the sponsor is !hat he does
not have to diselose his portfolio. For the investor the risk is easier to quantify, and the
securities get More liquid and tradeahle.
Modeled /oss triggers are used for synthetic portfolios of asseIs exposed to different
hazardous events, such as earthquakes and windstorms in different regions of the world.
Tbe synthetic portfolio is a virtual pool reflecting the existing portfolio of the sponsor.
It can stay static, or the sponsor may have the discretion to reset the portfolio during the
lifetime of the securitisation. 38
Catastrophe bonds have experienced a slow, but steady growth during recent years.
From the sponsor's perspective, they affer similar risk. mitigation features as reinsur-
ance. The exposure to peak risk is reduced similar to an excess-of-Ioss cover. Unlike
reinsurance, they are set up for a multi-year period and provide known cost during
the reinsuranee cycles. Tbe exposure is backed by collatera1, and therefore the trigger
events are elearly defined. Payment has to be provided without any objections. Tbe in-
vestor base can be diversified - cat bonds today are bougbt by a variety of investors who
get increasingly interested in the non-correlated diversification of their investments.
Tbe challenges are the relatively higb costs of the structores and the quantification for
catastrophe bonds with non-indemuity triggers. Althougb insurers and reinsurers have
suffered substantial los ses, only one catastrophe bond issue, Kamp Re, was triggered
after hurricane Katrina 39
Appendix J shows statistics with reference to the ILS market: As per end of 2008,
the outstanding volume of ILS was at USD 11.8 bn. Tbe higb share of ILS with indem-
nity triggers compared to total volumes issued, changed in !ine with the needs of the
sponsors and investors' appetite. In the past three years, the trend seems to move back
to indemuity triggers. Further, mnltiple-trigger structures were placed. Wind and earth-
quake risk dominated the market in the early years. Tbe market subsequently has been
moving into multi-peril structures and a variety ofnew perils and geographie loeations.
Two thirds of the capacity have been provided by US and Bermudan investors. Tbe
strongest year in tenns of capacity since the introduction of ILS was 2007 with a share
of 30% of total volurne provided, followed by 2006 with 18% and 2008 with 10%.
5.3.2 Non-catastrophic insurance securitisation
Tbe !wo types of non-catastruphic insuranee securitisation described below emerged

in late 2005 with underlying portfolios characterised by higb-frequencyllow-severity
risks.
38 see also chapter 5.4.2 about catastrophe bond CDOs

39Lathuillerie et al. [see 06.12.2006. p. 9-15]
Motor inmrance securitisation

AXA securitised through the FCC Spare transaction the risk of three million primary
auto insurance contracts underwritten in France. The motor book. is covered by a senior
deposit of EUR 200 mln paid to AXA, under a 85% quota share agreement with the
SPRV Nexgen Re Lid. The FCC Spare structure supports the losses above a pre-defined
yearly loss ratio trigger threshold, while the loss ratio is defined as eligible claims over
eamed premiums. Losses are covered up 10 the USD 200 mln deposit. The cover has
bcen agrecd for four consecutive. but independent years - Fitch annually sets out the
trigger level based on the loss expectations ofthe years befure (see figure 5.16).
Quola Sh.rt Tr~' I )· Sal. of Rt<ti.·. bl. "'01. Pla •• n'tnl

,~ _ _ A_ _ ~V~_~A~ _ _ ,~
_. ,
r-
f.1 M 100 ..I. d< po-i'
Fec SPA RC ,,
E
....
AA,\ "'01••
A ...... ~
RRR_ "'61tS npil.1
Bascd on: I-"Ihuillori<. Frnnz. Insurnnce Securilisalion _ Co",ing nf Ag<.

Fileh !lalings. I.o ndon. 06.06.2006. p. 7
Figurc 5.16: Simplified structurc ofthe AXA securitisation SPARe
The transaction has the following features: AB a Frencb. legal structurc "Fonds Com-
mun de Cr6ance", Fee Spare is not allowed to write reinsurance cover - the reinsurance
therefore was provided by thc reinsurance company Nexgen Re Ltd. The natural catas-
trophe components like hall, snow, wind, and also war were excluded. The maximum
individualloss was capped at BUR 5 mln to ßatten thc loss deviation expoctation.
The transaction locks in the reinsurance costs for a number of years and prot.ects
AXA from an unexpocted rise of claims. The cost of capital benefits depend on the
transaction cxpenses and the amount of capital the regulators allow 10 release. The
structure needs a sophisticated management reporting and budgeting process of the
eeding insurance eompany. It depends on effeetive claims processing, reserving, and

the availability of sufficient bistorica1 data. The risk of moral hazard is inherent.40
Credit risk securitisation

Through their transactioo Crystal Credit, Swiss Re securitised BUR 252 mIn of rein-
sured trade receivables. The holders of the notes listed in Table 5.3 are exposed to
losses if claims within the three underwriting years reach the attachment level of BUR
666 mIn, a figure wbieh takes bistorically experieneed losses sinee 1984 into eonsider-
ation. Swiss Re covered the risk of an unexpected increase of c1aims-frequency due 10
an economie downtum. Credit insurance provides the seiler with protection if the buyer
of bis goods or services defaults or fails to pay. It usually covers a short period of time,
and the seiler retains a share of 10-20% of the losses as retention. Swiss Re provides
reinsurance for the portfolios of credit insurance companies and in retum gets premium
income. The diversified portfolio in terms of geography (mainly eustomers based in
different countries of the BU) and industry sectors is constantly revolving.
Class Volume Maturity Attach I n _ Legal S&Ps

ment FlDaI
PoInt
A EURI08mln 12f2008 810 3m1l+nwgin 0612012 BBB-
B EUR81mln 12f2008 729 3m1l+nwgin 0612012 BB
C EUR63mln 12f2008 666 3mE+margin 0612012 B
1 3mE+2Obp means 3 month European Interbank offered rate;

the margin will reduce if the transaction cxtends beyond expcctcd maturity
Source: Josefs, MaIen ct al., Presa1e: Crystal Credit, Standard &Poor's,

London, 19.12.2005
Table 5.4: Crystal Credit - tranche structore
The structure ofthe transactioo is shown in figure 5.17. Swiss Re seeures a portfolio of
reinsurance receivables through an excess-of-Ioss retrocession agreement with Crystal
Credit Lid, arestricted Class-B insurer registered on the Cayman Islaods. Swiss Re
obtains an exeess-of-loss protection of BUR 252 mIn and is obliged to retain a mini-
mum of 10% of the aggregated losses retroceded under the agreement. The retention
will inerease with future premium growth. The note holders are exposed to a reduced
eapital repayment if the underwriting losses during the three years of the lifetime of the
transaction exeeed BUR 666 m1n. The reduction would effeet the junior C notes first.
The notes are seheduled to mature in December 2008, but Swiss Re has reserved the
option to extend the maturity to June 2012 in the ease!hat losses may be expected to ex-
eeed the BUR 666 m1n. This regulation allows Swiss Re to exc1ude existing reinsurance
treaties still on risk for the underwriting year 2008 and to determine the los ses. During
""Lathuillerie et 01. [,ee 06.12.2006, p. 6-7[;Jo,efs et a1. [see 18.01.2006]
the extension period, Swiss Re will not be covercd for the underwriting of the year 2009
and beyond. The investors will get a reduced coupon if the facility is extended. Swiss
Re will, howevcr. not gct any msUIllllCC premium for the ycars 2006 to 2008 whcn the
coupon payment is not continued.
When the facility was st:ructured, 96 cremt reinsurance t.reaties were collateralised
consisting of EUR 7.8 mln assigned single credit limits resulting in a total protected
pool amountofEUR 113.5 bnofwhich44% werenamedand 65% were unnamed. The
majority of the treaties with a share of 95% were proportional and the rema;n;ng 5%
excess-of-loss.
CoU" ", • •
",I. and
rttl t mphnn
.." "". dttl p,O<<<d. ·
I in<om.
r~
c-, >-
"c.,ccc,-
,"c;,c,.-,"c.---, not<.
SPII.V
~~ r=l.".,"'"
Capilal
"' ork"
Imn'ors
of,"
S",,, 11.. geTS 0110<.. 00 , .. ,""" sl"", nl sa"" ond ,".;",,'" collato,al.""
rompenSOIOS for onH'<lmenlTo$$<'< aod Eu ,ibo.- mmuS 11 bp
.. II.OTroccded losses ",,"alTOlallos..,. m"llI~hod b) 'Clrocedcd q""'a m,""' l~fC,hold o,,,.,,.nI (I'UII. 666 ml
Source: Culp. Chrislopher. 1l>c AKT ofRisk Management. Wile}. Ne" Yor'. p. 468
Figure 5.17: Crystal cremt risk securitisation
Crystal Credit issued DOIes of three cat.cgories and invested the proceed in10 eligible
securities under a total :retum swapo The swap agreement, closed with Swiss Re Fi-
nancial Products Corp as swap counterparty. results in a constant payment of Euribor
minus 11 bp at each interest payment date. This payment, 10gether with the retroces-
sion premium. enables Crystal Crcdit 10 pay the coupons of the notes. Each time an
invesbnent has to be sold or matures, the swap counterparty pays the positive difference
between the purchase price and the redemption or liquidation proceeds. Crystal C:redit
will thus dispose of enough funds 10 redeem the notes at maturity or 10 pay claims of
Swiss Re under the retroccssion agrement, if necessary. The swap counterparty receives
the income out of the investmeots and an eveotual redemptioo or liquidation boous.
The notes were placed to a variety of investors in the capital market. They are
exposed to a reduced prineipal repayment in case that aggregate losses of a diversified
purtfolio of trade receivables exceed the attachment level for the relevant tranche. They
were enab1ed to invest in a reinsurance risk they normally cannot get access to.
Swiss Re achieved economic, regulatory, and rating capital relief for the securitised
ris!<. Compared to traditional retrocession, they do not have to be concemed about the
solvability of the retrocessionaire in times of stress. 41
5.4 Insurance related CDOs

5.4.1 Funding eno pools
The first insurance-related funding CDO pool in Europe, called Dekania Europe I, was
lanncbed in September 2005. The issue followed the concept used for trust-preferred
securities issued by small insurance companies in the USo Dekania was the first trans-
aetion to primarily pool subordinated debt issued by small and medium sized insurers
and reinsurers based in Europe.42 The transaction structure of the most recent similar
transaction Dekania TI which was closed in August 2007 is described in figure 5.18. In
contrast to Dekania I, the second transaetion allows to include debt issued by baoks or
real estate companies.
Dekania Europe CDO TI, incorporated in Ireland with limited liability, issued the
various notes. The subordinared securities purchased are transferred to the collateral
manager. The 33 securities, issued by mainly Eoropean insurance holding or banking
institutions, constitute the USD 300 mIn purtfolio. HSBC was engaged to protect the
note holder's interest by monitoring the performance triggers and collatetal guidelines
and to maintain the accounting database. All bonds issued are due in September 2037.43
The structure was highly appreciated by the market, since it opened up an avenue
for smaller and mutual insorers to issue subordinated debt. 44 They normally do not have
the volume or the credit quality to issue hybrid securities in the capital markets. These
issues are debt which, due to its subordination structure, is qualified to be treated as
equity by the regulators and the rating ageneies. Further, it would not he economically
viable to issue single transactions for the following reasons: Raising of debt through
a eno was less time consuming far the management, since they are not required 10
spend time on road shows or to deal with a leogthy due diligence process.45 The costs
involved, however, were at the time of the closing of the transaetion higher than for a
41 losers et al. [see 18.01.2006]~osefs et al. [see 19.12.2005, pp. 1-12]

42Josefs ct al. [see 18.01.2006]
43Morlok. [see 02.10.2006]
44see subchapter 6.2.4 for an explanation ofthe subordinated debt structures
45Josefs ct al. [see 18.01.2006]
5.4. INSURANCE RELA1ED CDOS 125
IlSIJC T ,u" •• C I. LId

(l'ru,lCe)
Target Portfolio
.[~I
[) .~.ni
C[)O II 1'I,u;lo:I~)
r
Il .~."i. Copi,.1
EUR 300 mln \Ioß. ~.m. n ' U .C
Subordinated Ihn~rul >I'y R.m~;. Collalcral Man
Hybrid Bonds SI' V ~
- - - .•- - .• .....
j j j j j j j j j
CI... <., IM. <·N IM. <.>1 , ' .... e (IM. D·' <IM, D·l <IM ••
.- .- .-
'IM, •
.~ .~ .~ .~
..
.u~ 165", 'u~ 15., fuR 5", 'u~ U .. .u~ 11 .. 'Ul '1.510 ' uR 1", .u~ 11 .. 'u R 1'.510
" " 5.0'It CI , 35.0'It (I , l5.0'It n, '~ . l'" CI, I>-O'It (I, 11.l'Io (I,1l.l'Io (I ' ....... CI, O'J!o
'.,.ong ' '.ong '.' ~ ~ ~
Sou,e.: Morlok Markus cl aL. [)e~nnia Europe CDO IIPIc. Fileh Ralin gs. I.ondon.
02.10.2006. p. 2
Figurc 5.18: Simplified structure ofthe Dekania Europe 11 CDO
comparable bank financing tbrough a subordinated loan or a schuldschein. 46
5.4.2 Cataslrophe bond CDOs

Thc transacti.ons cover multiple catastrophc pcrils. Thc qualifying risk cvcnts are dc-
fined parametric or index-based, and a loss of the principal occms after multiple loss
cvents wcrc expericnccd.
In Iune 2007, Brit Insurance covered several catastrophic periIs by the arrangement
of a USD 200 mln CDO with a threc-ycar tenor callcd Fremantle limitcd. Thc loss of
principle occurs aftec the fourIh qualifying event. The qualifying events, for European
rim dcfincd parametric and for the US rim industry-based, are describcd in 'fable 5.4,
wbile the same peril can cause more than ODe trigger cvcnt:
Fremant1e, a SPV bascd on the Cayman Islands was formcd 10 issuc the notes. H
during the threc ycan after closing of the structure the defined natural catastrophes
happen, it will pay to Brit Insurance the relevant amounts of the notes. Thc payment
is based on a catastrophe swap contract closed by the two compani.es. The capital
collected from the investors is kept in a collateral trust with The Bank: ofNew York: until
46Gohü [see 09.10.2001]

Region Zone PeriI

I.UK UK windstorm
2. Europe cxcluding UK European windstorm
3. Japan Japanese typhoon
4. Japan Japanese typhoon
5. USA California Califomia earthquake
6. USA NcwMadrid New Madrid cartbquake
7. USA Florida only Florida hurricane
8. USA Gulf FI.ori.da hurricane
9. USA EastCoast Bast Coast hurricane
10. USA Bypassing Bypassing hurricane
Source: Thorpe. Donald; Jcbjerg, Lars, Fromantlc Limited

Fitch Ratings, London 21.06.2007, p. 1
Table 5.5: Basket of perils covered by Fremantle
a trigger event occurs or the tranches are due for repayment. The risk of the security
investments kept in the custodian is secured via a total return swap with ABN Amro
as counterpart. HSBC Financial Services (Cayman) Limited acts as administrator for
the payments, being Fremantle's principal representative in the Cayman IsIands. The
modeling for the transaction was done by Risk Management Solutions.47
Each note c1ass issued covers two lass events. When the industry lasses are sub-
sequently revised downward, note holders will bave the possibility to c1aw back the
protection payments.
If qualified losses occur, Fremantle will make a digital payout of half of the amount
ofthe effected notes perevent (see figure 5.19 for the cash flow and 5.20 for the tranch-
ing Structure).48
The sponsor of the cat bond structure benefits from the multi-year protection pro-
vided. He is not involved in any credit risk of areinsurer. Catastrophe risks are relatively
simple to calculate with established models. Non-indemnity triggers are transparent and
can be quickly and accurately determined in terms of losses to the investor. The struc-
ture, however, can take much longer for the set-up compared 10 traditionaI reinsurance
contracts, and is more costly in times of soft markets. The basis risk remains with the
ceding insurer.
The structure allows capital market investors, which are comfortable with the CDO
structures, to invesl in insurance related risk being geographically and loss-event di-
versified. Further, the risks are regarded as totally uncorrelated to other capital market
products. The transaction is non-binary since the relevant tranches will be liquidated if
losses start to accurnulate.49
47Thorpe and Jebjerg [see 21.06.2007]

481borpe and Jebjerg [see 21.06.2007]
49Gohil [see 09.10.2007]
5.4. INSURANCE RELA1ED CDOS 127
I.ibo' _lU bp Tmal

I
1I.~lurn
, - -_ S.... p
L_--,-_ _,---_-' cu,l""i.1 Counl.rPllr. o
I I
><roun'
. opi .. 1 • i"rom. . . ,h 1\0.."
"" <><,drtl
I",,,,"
r----:c::-----,
SPV not<>
Fr.manllrl.l d.
I
,<I, <><.."io" '---'-----'-'---'---,--'
""m,"", ~~.",,,, no",
I'& I~ F"--'"
Capi,.1
~ br~ ••
• ABN Am,o hc~g«I ,hc ",ue,'s .'f'OOutO ,othc asSe." ap a&r<C""'nI
Bas.cd on : Toorpr. Donald cl aL F.. mal1llc Limilcd. Fileh Rat ings, London, 2 1,(16,2007, p, 2
Figure 5.19: Simplified structurc cf the Frmnant1e enD
5.4.3 Relnsurance recelvable CDO.

The receivables of an insurance company. resulting from contracts with its rcinsurers.
can form a significant part cf its assets. The insurer is exposed to extensive credit risk
from the reinsurer's potential failure 10 pay claims. The credit risk can be removed
through securitisation.
In January 2007, Hannover Re came to the market with the enD sbucture McrIin,
a EUR 95 mIn issue cf credit-Iinked ßoating rate notes. The transaction was the first
synthetic CDO cf insurance entities rated by Standard & Poor's. The noteholders sold
protecti.on on a portfolio of 100 reference entities wholly or partly operating in the
insurance and reinsurance sector. Reinsurance companies bad a participation cf 48.4%
cf the initial. portfolio, fo11owed by non-Iife insurance companies with 38.1% and life
insurance companies with 13.5%. The majority cfthe companies are based in the USA
(66%), followcd by Germany and the UK with 10% cach, and Bermuda with 7%. The
remaining 7% are split among Japan and West European locations. The companies
ratcd AA- or hettcr bad a share of 55%, whilc furthcr 43% are ratcd A- upwards. and
the remaining 2% are rat.ed investment grade.
The transaction is shownin figure 5.21 and was st:ructurcd as follows: Malin issued
notes which are credit-linked 10 the performance of the EUR 1 bn portfolio of reference
- CI." B
I~)" hent 7
1.0" hcm6
I SI> 30 ",In
l SI) 30 mln
" rotee,cd
E\"CIII
Loss hem 5 LS n JO mln
Un l,rotected
I.M" [ wn! 2 [>,cut
Lo<s EWnl I
So uree: lhorpe . [)onald 01 al .. F",manlle Limit"cl. rilch Ratings. London. 21.06.2007. p. 2
Figure 5.20: Tranching struct\n'c cf the Frcmant1e enD
entities reßecting Hannover Re's credit exposure 10 insurance and reinsurance coun-
teIparties. At closing, the note proceeds were investcd into a guarantred-investment-
contract. This contract with a highly rated bank: secured the timely payment of interest
and principal of the notcs, wbile the note holders are insulated from the risk of the
bank's default.
Hannover Re then closed a credit-default-swap with Merlin. Merlin sold to Han-
nover Re protoctiOll on the portfolio fur lasses exceoding the tbreshold amount of BUR
60 mln and up 10 BUR 155 mln. The CDS premium is paid quanerly by Hannover Re
to Merlin. A credit event occmred has to be confirmed by an independent verification
agent and is linked to the bankruptcy, insolvency, or inabili.ty of a reference entity tu
pay its reinsurance obligations. The loss would then immediately be calculated as 65%
of the notionat amount of exposure.so
Through Merlin. Hannover Re was able 10 transfer its crodit risk exposure 10 wur-
ance and reinsurance compames into the capital markets. The product is very flexible.
Since reinsurance cont:racts nm for a period of 364 days only. Hannover Re has agreed
the right to replcnish names once a year. Therc are certain criteria tu be met, e.g. the
maximum national amount per reference enti:ty er group cf 5% of the portfolio and a
3Oo-iagnuolo etaL [see29.01.2007]

5.4. INSURANCE RELA1ED CDOS 12.
~ ,f",ntt "o. lf.. I."
j j j 1'·,.. 0." " 1·-

,bi..,
sr\'
...i .. ,
1'·'. . n ." H 1·_·
,., I , .,.. no .. , I· . ,
~
H.. nO'.r~ . ,\ I.rlin C OO 1
(S''''p
L _ __ 'oun"'I""~·1
_ _ _ --l p.... i ..., II.\'.
i".... ' I<>.i,,' I'·'. . n ... u 1·-·
Base<! on: Guadagnuolo. Lapo. Cl aL. ~Icrlin CDO I ILV .. Sla,ldartl &. I'oor' s.
tondon. 29.01.2007. p. 3
FlgUlC 5.21: Structureofthe Merlin COO
minimum Standard & Paar's insurer financial strength rating ofBBB-.
1 Legal maturity 6 yemI wilh fint call1bte Ifter 3 yeIIB
Guadapuolo, Lapo, et al., Merlin CDO I B.Y., Stmdan!. and Pom's,

LondoD, 29.01.2007
'fable 5.6: 'Ihmche structure er the Merlin CDO
The structure further has to pass the Standard & Paar's evaluation test in order to
maintain the original ratings.
The investors were offered a rare opporbmity to invest in a reference portfulio of
insurance and reinsurance assets. Most of the debt was owed by small counterparties,
in most cases not publicly traded. 111ere was no CDS protection for the names available
in the capital marke!. Hannover Re agreed to take tbe first loss part on tbe portfolio. 111e
credit events were clearly defined as failure to pay and !berefore narrower as tbe usual
ISDA tanguage. 111e interest payments on tbe notes are generated by tbe investment
income and tbe up-front premium payment by Hannover Re.
5.4.4 Summary and evaluation of non-life ILS

Non-life n...S offcr non-insurance related investors alternatives to diversify into new
areas.
Cataslrophe bonds offer collatera1ised multi-year protection for adverse loss devel-
opments.
Non-cataslrophe ILS are a further mutation. AIthough volumes have not been pick-
ing up yet due to the high administrative burdens and cost, the products are being recog-
nised. and their attractiveness may increase after the introduction of Solvency 2.
CDOs use structured linance techniques. Funding CDOs enable investors to partici-
pate in capital-like investments into the insurancelreinsurance sector. Catastrophe bond
CDOs combine exposures to several perils aud geographic regions. 111e traucbing of
the transactions offers the potential to choose between a participation in higher or lower
risks in terms of attachments points and exhaustion probabilities. Reinsurance receiv-
able CDOs offer avenues for investors who otberwise would not be able to participate
in the markets, and sponsors may secure medium term linancing.
Table 5.6 shows the main characteristics ofthe several non-life insurance securitisa-
tion types. Total USD volumes and number of trausactions until end of 2008 are listed
in tbe headlines.
Type Catastrophe Bonds Non-catastropbic FuDdlngCDO Catastrophe Bond ReinsIll'JUlCe Reeeiv- ~
USDm 25,434.8 (156) 1,128.6 (4) 688.2 (2) CIlO ableCDO ~
(_008) 665.2 (3) 122.7 (1)
PeriI natural catastrophes motor/credit Risk diverse lifeInon-life multi-peril re;",unmce ~
Objectlve risk management: risk management: subordinated functing: risk management: risk management:
protection against low protecti.on agajnst easier access to capi- protection agamst protection against
frequeny/high sever- unexpected rise of tat markets especiaIly """"aJ catastrophic rem.ure.: default;
ity risks; increase of high-frequencyllow- for mutual and small perlIs funding: transfonna-
capacity severity risk:; increase ;",..." tion of illiquid into
of capacity liquid assets
~
Structure SPRV far exact1y de- SPRV for a defined banhuptcy remote catastrophe swap with credit-linkcd floating
finedrisks block: of businesss SPV SPRV Dotes
Enbpncem ent collatcral collateral possib1e collateral and perfor- coIlatcral guaranteed invest-
Triggers indemnity, industry Hulemnity

mance triggers
not relevant parametric, industry
ment contract
Hulemnity portfolio
;
lass, modeled los8, lass 10S8 ~
parametric
Regu1ato'Y credit like with tradi- nrinhna1 release of investors do get DO regulatory credit no regulatory credit
tional reinsurance, if regulatory capital More favourablc risk:
indemnity based, ath- (may change with weigbting compared
ers not qualified for a Solvency2) to investments in
mluction (US) single issues due to
1rBnching
AcoountiDg risk. transfer risk: transfer funding risk.-transfer; rn-t-rn off-balance risk: trans-
gain if sponsor swap f",
liability decIines
RatiDg depends on the level like normal rein- lang-term subor- improved stability stability of
e/fect of basis risk (para- s=e protection: dinated capital far profit&1oss devcl-
metric: Iike nonna1 full credit u indem- ;",uren opmeots
reinsurance protection nity b..oo, othen
I parametric: modeI not qualified fot a
ootputs) mluction (US)
w
--
~
Type Catastrophe Bonds Non-catastrophic FuDdlngCDO Catastrophe lIcmd Reinsnrance Reeeiv-
USDm 25,434.8 (156) 1,128.6 (4) 688.2 (2) CDO ableCDO ld
(_0") 665.2 (3) 122.7 (1)
c- <eimunmce pm- <eimunmce pre- interest on subordi- rctrocession premium premium foc CDS
mium. legal fces, mium, legal fee" nated issues protection
rating agency fees, rating agency fees,
third party advisors, third party advisors.
arrangen ammg...
Investor Libor +3.0% - 11.5% Ubor -Kl.15% - 3.4% Libor +0.2% - 1.5% Ubor -Kl.7% - 7.0% Ubor -Kl.5% - 2.5%
Yre1dp.a. depending 00 tranche c1cpencling 00 tranche depending on tranchc depending on tranche depending 00 tranche
ruk risk risk ruk risk
Issoe rat- BB+toB- AAAtoBBB- AAAtoBBB AAAtoBB- BBB- toB
lDgs
Investon hedge funds, money hedge !und" banks. money man- hedge funds. money bankst money man-
manag""', dedi- money managers, ag"'" uumag"'" ag=
c&red ca! funds, re-insurance, banks
re-inSlll'8llCC, banks
Term short/medium (1.5-4 medium tenn (4 long term (30 years) medium-term (3 medium-term (5
yems) y""") yems) yems)
~
Counterparty none
risk mo_ nooe not relevant nooe nooe
i
C....,miaotim high modenlte high high ~
Cmnplexity low high modenlte high modenIte
PartIes single cedent single cedent multiple bond issuers multiple cendents sing1c cedent
/single contract {single contract I multiple contracts lsingle cootracts
~
Table 5.8: Non-Life insurance securitisation types: summary and evaluation of characteristics
~
I
Chapter6
The Perspectives of the

Stakeholders
6.1 Accountants and regulators

6.1.1 The global approach to standardisation
Driven by the globalisation of the insurance sector and the eapital markets, there bas
been a significant effort to improve and harmonise insurance regulation among the var-
iDUS continents and countries. Standardisation helps to reduce barriers of trade and es-
tablisb eertain international aecounting and regulatory frameworks that eould inerease
the confidence in accounting and supervision. 1
Mter a series of restatements of eamings, reva1uations of accounting fraud, and
other corporate seandals in 2002/03 - both in the US (e.g. Worldcom and Enron) and
Europe (e.g. Parmalat) - the trust of the publie eonfidence in financial reporting was
undermined. Investors, rating ageneies, analysts and regulators were pressing for ac-
counting standards which more accurately re:H.ect the economic nature of the business,
smeter eorporate govemance and greater transparency.'
The increasing amount and heigbtened complexity of risks whieh became obvious
through the scandals and natura1 eatastrophes has eaused a necessary transformation
in the environment of the insurance seetor. In respect of insurance accounting, the
responsible International Aecounting Standards Board (IASB) started areform of the
International Financial and Reporting Standards (IFRS) in two pbases. The first phase
in the adaptation of the accounting rules bas been operational since 2005, and the second
phase is expected to be implemented around 2012. Figure 6.1 shows the time frame of
the combined reforms IFRS and Solveney 2. The IFRS reform has the objective to offer
lIAA [see 2004, p. iv]
2SwissRe [see 02.11.2004, p. iv]

134 CHAPI'ER 6. THE PERSPECTIVES OF THE STAKEHOLDERS
a better view of all compani.es, parti.cularly with regard to the rillks they run. Whilc IFRS
in principle lock at the contracts an insurer writes, Solvency 2 delivers the principles far
an intcgra1cd risk approach taking into account thc mies an insumr is facing. Security
for the rists taten has to be held in the form of solvency capital.3
Although the scope of the twin framework differs and both reforms serve funda-
mentally different purposes, they have in common that they move the market to a more
economic basis of eval.uation and disclosure. Extensive disclosure cf risk and capital
management will expose insurance to ever-greater market scrutiny. The implications
include fundamental changes to the measurement of insurance liabilities.4
•
I'- RS I'hase 11
I"s"",ncc
sl.ndanl
publishcd
2007 20118
"'" 2010 2011 2012
QI S 4 \10'" QI S?
Dr.n frnmcwor'
din:cl;"c publishcd
•
Soh'cnc}' 2
•
Figure 6.1: T':uneframe of the IFRS accounting I EU supervisory refonns
6.1.2 International Financial ReporIiDg Standards

Since the insurance business by its nature is highly complex, it has been a challeng-
ing task far the many parties involved to establish a specific framework far insurance-
relatod accounting (see figure 6.2 fOt' the main organisations involvod).
'EDHEC [_ 2006, p. 11]

4McLarmand etal. [_ 2006, P. 13]
6.1. ACCOUNTANTS AND REGUlATORS 135
IFRS Phase I laid down Ihe revised accounting rules for insurance companies wilh
the main changes as follows: 5
• Disclosure of a substantial amount of additional information on their insurance

contracts in Iheir annual reports, e.g. sensitivity of profits to changes in underly-
ing assumptions; the definition of the insurance contract was altered
• Equalisation anti catastrophe reserves, previously used in certainjurisdictions in

order to absorb exceptionallosses, were prohibited
• Embedded options and guarantees, often used as attachments in life insurance,

have to be carried at fair value
• Investments hold-to-maturity and fixed income investments are exempted from

1he measurement to fair value
Phase n is concentrating on the remaining issues of insurance accounting. Tbe

objective is to transfer the accounting of results of an insurance company to the asset-
liability approach instead of 1he present cost-based profit and loss approach. Assets and
liabilities will have to be accounted for on a discounted fair value basis every quarter.
The revenue recoguition is expected to change to a value-in-force approach: Future
discounted net present value of the insurance contract issued is accounted for instead of
Ihe premium collected and Ihe cost incurred. While in Ihe traditional model premium
income and claims are recoguised in Ihe year Ihey occur, 1he new IFRS accounting
introduces Ihe fair value (expected present value) of premiurns, claims and costs for
new business written.
Acquisition cast is recognised in full in the year the business is written - based on
the experienced variations on the fair value assumptions, the business in previous years
is adjusted.
The most irnportant challenge is 1he fair-value treatment of liabilities (includiug Ihe
value of options and guarantees). Since Ihere is a very limited market for insurance
liabilities at present, as a provision it is proposed to add a market-value-margin on top
of its estimated fair value.6
The IFRS framework is obligatory for all EU-listed companies, and beyond Ihe EU,
Canada and Australia have switched Iheir local GAAPs to IFRS. Furlher, Ihe FASB of
Ihe US has eotered into an agreement wilh Ihe IASB to hannonise Ihe US accounting
standards wilh IFRS.7
.5SwissRe [see 02.11.2004, p. 3]

'Walhofet 01. [see 01.11.2005. pp. 13-14]
1SwissRe [see 02.11.2004, p. 7]
lAIS [ C[ SR
"PRA [IOSCO
,
CFO Forum
G~nc'a ASS<Kialion
Non-EU Insurance
associalioo. (ACLI. PCI.
GN /\ IE. LlAJ)
Sou,«;; "CU Ame""an Cooncll or LIre Insurers. "CSB ACOO\Inllng Standards Ik>ard (Canada), "PR,\ AuS-
nah." 1'11.1<1<01001 Rcgul'l<>l) /lud.o",). CFlOrs Comn1l11cr ofEurop lnsurane< aod Oceup.lIonal Pens","
SUf'C,,'isors. CESR Con"nu,,,, of Lu'"",,"" SecuntIeS Regulators. EBr [urpoc.n Ban, ing Federal l"" . •:FRAG
[u,,,,,,,an l'on""c,.1 Rcporllng Ad" I>Or) Groop. FEE '-.""rallon.Je s hpcnsComplablcs Luropc<ns. GNAIE
(;''''' 1' ofNMh A,n<rleon Insulan"" "n,<'1'''$CS, LA,\ Inlern.llooa] ,,"'uanal AsS/"".lIon, lAIS Int<m.1I()1' "'
Asjl<)C;""on ofln\u"",,,,, SUPC"'S<~. IA~U Int,rn'hO." ""ooun H"g Standards II<>ard. IQSCO InlcmiUoQnal
Orga"'sauoo or Sccurn.<s Co.m"""0II5, LI"! LIre InSurance A'SOCi"IIOO cf Japan. !'CI I'rop<ny Cau,"alt)
In,"ron"" A"'><I.ti""
Sou",< S" "sR<. sigma NQ 7flQO.l.·11><; lmpacl of I FRS On thc ,nlu"",",,< ,ndu,,'). SntS;R~. ZUrtch. 2QO.1
Figure 6.2: Organisations involved in the IFRS accounting reforms
6.1.3 Snpervlslon - the <hanges duo to Solvency 2

The reguIatory system delivers the framework: within which the insurance sector can
operate. Solvency 2, the cunmt harmonisation proce8s in Europe will change the su-
pervision cf the insurance sector. The following secti.ons will explain the key elements
of the new regulatory system in Europe and the basic mgtbematics involved. Since the
reguIatory system will not be in place before 2012, the current stare of the discussions
and the reasoning behind the reforms will be analysed and described.
Solvency 2 is the newly proposed regulation that will govem the capital. require-
ments of insunmce compani.es. The cunent system. cal1ed Solvency 1 was introduced
in the early 1970ies and harmonised for the member states of the EU in 2002. It defines
capital requirements by specifying simple. blanket solvency margins. In certain cases,
the framework rulcs are risk. insensitive and can conflict with good risk. management
since it focuses on underwriting risk. and not market risk. In sorne states like the UK,
Demnark/Sweden, Germany and the Nether1ands, reforms of the old Solvency 1 sys-
tem have already led to more sophisticated solvency models for supervision. Further,
stress tests similar to the Swiss model were introduccd in order to lest the solvability of
Ihe insurance sector in respect of disastrous developments.' Solvency 2 will hannonise

Ihe supervisory systems of Ihe 27 EU member states. Benealh Ihe capital requirement,
it will set a three pillar framework for Ihe quantitative reqnirement, 1he qualitative re-
quirements and the market discipline of the insurance and reinsurance sector.9
EU regulators are in constant dialogue wilh Ihe stakeholders of Ihe process. These
are Ihe supervisory bodies of Ihe EU membership states and 1heir industry and actuary
associations.
The EU comntission launched four quantitative impact studies (QIS) which resulted
in a permanent discussion between Ihe stakeholders: After QIS 3, Ihe proposal for EU
regulatory directive for Solvency was published on July 12th, 2007. Solvency 2 will
harmonise 13 existing regulations for the life, non-life insurance, and the reinsurance
sector of Ihe EUlO
The main regulatory objective, protecting the consumers, means preventing exces-
sive high pricing and opportunistic behaviour. Policyholders face 1he problem of asym-
metrie information and are therefore vulnerable 10 moral hazard or adverse selection of
an opportunistic or incompetent insurer. 11 The regulator has to secure the continuing
ability of Ihe insurance or reinsurance company to meet its contractual and financial
obligations towards its policy holders. '2
The second objective is 10 ensure the stability 0/ the system. The system must
be prepared to resist shocks like an econontic crisis or natural catastrophe which may
unIeash systentic risk affecting a !arge part of Ihe financial system.
The 1hird objective is to ensure the competitive efficiency of the sector. The regula-
tor in charge should ensure and strenglhen efficient comperitive structures, particularly
in Ihe areas of public trust and Ihe quality of information. This can be done Ihrough Ihe
definition and monitoring of codes of ethics, Ihe stimulation of intemal control mech-
artisms, and 1he intrnduction of transparency and disclosure rules for fair and stable
markets. Pillar 3 of Solvency 2 is airned at reinforcing Ihe market discipline and self-
regulation of Ihe market,13
6.1.4 Quantitative assessment by means of PiUar 1

Pillar I of 1he proposed Solvency 2 regirne will regulate Ihe quantitative assessment of
Ihe insurers' regulatory capital requirements. The ntinimum capital requirement (MCR)
will depend on Ihe size and activities of Ihe insurer and act as Ihe trigger for manda-
tory supervisory action. The higher solvency capital requirement (SCR) will be Ihe
key quantitative assessmenl. It is reqnired to ensure wilh a high degree of confidence,
that the insurer is ahle 10 meet bis obligations in case of adverse developments in the
8CEA [see 01.02.2007, p. 4]
9The main elements ofthe framework are described in chapter 2.3.3
IOCommission [see 10.07.2007, p. 4-5]
11Moral hazard and advcrse seloction are dcscribed in chaptcr 6.4.47
12IAA [see 2004, p. 1]
13Bäte et al. [see 2006, p. 59-60]
138 CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
12 monfus following the assessment. The basis for the calculation will be a 99.5%
confidence level over the one year timeframe for the onderwriting, markel, credit, and
operational risks tsken by the insurer. '4
Tbe SCR sball be calculated as to insure that all quantifiable risks to which an
insurance or reinsurance company is exposed, are taken into account. It shall cover
onexpected losses and at least the following risks:"
• Underwriting risk from non-life, life andlar health insurance operations meaning
the risk of loss or of adverse change in the value of insurance liabilities due to
inadequate pricing and provisioning assumptions
• Market risk meaning the risk of 108s or of adverse change in the financial situ-
ation, resulting directly or indirectly from ßuctuations in level and volatility of
market prices of assets, liabilities and financial instruments
• Credit risk meaning the risk. of lass or of averse change in the financial situa-
tion, resu1ting from fluctuations in the credit standing of issuers of securities,
counterparties and any debtors to which insurance and reinsurance undertskings
are exposed in the form of coonterparty default risl<, spread risk, or market risk
concentrations
• Operationa/ risk meaning the risk of loss arising from inadequate or failed in-
terna! processes, or from personnel and systems, from external events (including
legal risk, and exc1uding risks arising from strategie decisions as well as reputa-
tion risks)
• Liquidity risk meaning the risk that the insurance or reinsurance undertaking is
onable to rea1ise investments and other assets in order to settle their financial
obligations when they fall due
Table 6.1 summarises the key factors of the corrent proposal. Tbe following seetion
exp1ains the value at risk method in detail.
6.1.5 Digression: Value at Risk and Expected Shortfall

Challenged by increasing volatilities within the financial markets, the value at risk con-
cept (VaR) was developed in the early 199Oies. It was intended to measure the market
risks caused by price vo1atility, but can also be used for credit-, insurance- underwriting-
, and operational-risk. Tbe concept was first introduced by the investment bank JP
Morgan in their internal model Risk Metrics. The banking supervisory authorities in
14CEA and Towers Perrin Tillinghast [see 01.06.2006, p. 3]

15Commission [see 10.07.2007. p. 48]
Faetor: Currenl Pl'Opo8Ill:

(1) Confidence level This is proposed to be 99.5% (i.e. a once-in-200-years
risk of insolvency)
(2) TIme horizon This is proposcd to be one year (Le. over a one-year
time horizon assets should be suflicient to cover lia-
bilities up 10 the confidence level. including technical
provisions for aIl future losses from business written
up 10 the end of the year)
(3) Kcy risks ofl08. Exposure to insurance-underwriting riBk.,:market riBk.,
credit risk. and operational risk
(4) Risk measure Value at Risk: (VaR), which measures the amount of
capital to avoid insolvency at a defined confidcnce
level over a defined time horizon
Source: Cantle, Nei1 et al., Implications for Insurers of Solvency II, Milliman,
London. 2007. p. 5
Table 6.1: Proposed key capital calculation factors of Solvency 2
many conntties have beeo acknowledging inrental, VaR-based risk management sys-
tems as proper standard for Ibe measurement of Ibe overall risk position of financial
institutions. 16
Tbe risk of a financial instrument of a portfolio of assets is infIuenced by Ibe fluc-
tuation of its nnderlyings, called risk factars. Examples of risk faetors are single stock
prlces, the DAX 1ndex, Ibe 3-monlb LIBOR rate or Ibe USDlEuro exchange rate. Tbe
value of a portfolio is a function of Ibe changes of Ibe risk factors over time which
cao be described as stochastic processes, which change Ibemselves within stochastic
processes.
VaR is defined as a quantile of a disttibution desctibing Ibe upper bonnd for the
loss incurred by a portfolio of assets (or liabilities). In econontics and finance, VaR is
defined as " "The 11UlXimum lass not exceeded within a given probability defined as the
confidence level, over a set time period". The time period t5t analysed can either refer to
Ibe maximum holding period of an asset or, alternatively, Ibe time period Ibe financial
institution requires to liquidate Ibe position. Typical time periods are I day, 10 days, or
1 year. Tbe confidence level C of a statistical variable x is Ibe interval estimate in which
Ibe VaR would not be expected to exceed Ibe maximum 10ssP
As explained in table 2.5, Ibe SCR nnder Solvency 2 retlecting Ibe VaR for Ibe
business of insurance compauies is proposed to be calculated wilb a 99.5% confidence
level over a one year time period. VaR is given as a unit of the relevant currency.
Assunting an investment portfolio is analysed, Ibe uuit describes a threshold level of
lasses not expected to be exceeded within one year, given the defined confidence level.
Anolber important factor is the shape of the distribution. Earlier models of risk
management which were developed when computers were slow and sophistication was
16Schulte andHorsch [see 2004, p. 214 - 215]
17Schulte andHorsch [see 2004. p. 214 - 215]
10w as!llllIled that asset returns and loss evcnts were normally distributed. The distribu-
tion mathematically is the scenario for a portfolio being defined by speci:fying a value
for cach cf its ri.sk:factors. Espc:cially mgarding investment portfolios, howcvcr. history
shows that the assumption of a normal distribution is rather not realistic. There is Iim-
ited upside. and the downside can be the experience of severe losses with 10w frequency.
The result are skewed distributions with low-frequency, high-severity losses. la
The following cxp1anations are bucd on the publications. both IlIIIIICd "Value at
Rist", by D-fine19 andPhilippeJorion. 20
The confidence intervaJ cf the stochasti.c variable x is the subset of the variable's
range. the intervaJ. attained with a confidence c. The ~mmetrir: confidence interval of
the function with the probability density p( x) around the mean Il is defined as follows.
while Pisthe distribution function (see figure 6.3):
)'-(1 )1+(1
s urfacc c,
surfar e c,
,,
-00 JI
x
Source: Own C,raph
Figure 6.3: Confidencc intcrval cf a stochasti.c variable x
ct=P(ts-a<x<l'+a)=
I 1"+·
"-.
p(x)da:
~-----~
llMartin [see 29.10.2004, p. 214 - 215]

19Jorion [see 2007, p. 114-108]
20Daitlch [see2OO4, p. 6 -11]
6.1. ACCOUNTANTS AND REGULATORS 141
Sincc the VaR conccntratcs on the loss potential only, the ODe sided confidence
interval has to be used:
C:! ~ P(x > a) = 1 - P(x ~ a) = 1- i~ p(x)dx
Value Qc is associated with the quantile or percentile Q with a probability Co The

quantile is defined as a cutoff value - the surface to its left represents the given proba-
bility c. Therd'ore, the probability that a random. value x is less than, or equal to, Qc is
equal to surface c (see figure 6.4):
(a.
P(x ~ Qc) = c {:} Loo p(x)dx = c
p(x)
"al~~_.t_ri,k
Q, .., Qu.ntil~ "ith .unfiMnc~ • • Q<
,
.. i>«trd ,hUrTf.1I (.... ndition.1 , ' ~Iu. - .t - ri,k)
x
So urce: 0"" Grap h
Ft.gUI'e 6.4: Value-at-risk surface of the l08S distribution function
Thus the pen:entile is the "inverted" cumulative distribution function P

and the boundary a of a one-sided confidence inrerval is the (I-c) percentile:
c'!" P(x > a) = I - P(x ~ a)

P(x ~ a) = 1- c
Q,-c = P- 1 (1_ c)
TbeVaR of the value V caused by a financial instrument or portfolio is the upper

bound for the loss which will not be exceeded within a given probability defined above
as the confidence level C, over a set tinle period ot:
I
C = cp!w(W > -VaR(c))
Tbe change of V is denoted by OV. Inslead of P, cp!.V denotes the cumulative
probability function of the random variable OV - more explicitly:
j
-V"R(C)
c'!" 1- cp!w(oV ~ -VaR(c)) = 1- _~ pdJ.v(x)dx
Where Pd/w(x) denotes the probability density function of the random variable
W.
Tbe negative VaR is therefore the (1 - c) percentile ofthe distribution of OV:
VaR(c) = _Q~~~v = -cp!w -1(1_ c)
Tbe VaR is defined by the probability distribution of OV and not by the probabil-
ity distribution of the relevant risk factors. If this distribution is standard nOmull, its
quantiles can be taken from statistical tables which report:
j
Qo
c = prob(x ~ -00) = _~ iI?(x)dx
One of the main weaknesses of the VaR is !hat, even if the institution can calculate
the maximum level of lass, this does not give any information how severe in tenns of
the relevant currency amount the loss may be.
Not only the cutoff loss !hat will happen c percent of the tinle, but also the average
size of the 10s8 when it exceeds the cut off value has to be known. In order to answer
this question "how bad is bad", the expected shortfall (ES) confidence inrerval, also
referred to as "conditional value at risk (CVaR) " • "conditionalloss". or "expccted tail
loss", was developed. Not only the cut-offloss that will happen within the time frame
at the given confidence level, but also the average size of the 1088 when it exceeds the
cutoff value has to be found. This gives an es!imate how much the institution could lose
ifit is hit beyond the VaR. Tbe expected shortfall ES(X I X < Qc) can be calculated
wifu fue following formula:

Qo
ES(X I X < Qe) = f xp(x)dx
~-:ii~c-:-:-
f,!~p(x)dx
For a standard normal variable, fue integration of fue equation for 1he expected
shortfallieads to fue following formula:
-<Pa
ES(X I X < -al = F(-a)
Table 6.2 shows fue lower quantiles of fue standardised normal distribution which
will be used in fue examp1e below.
CODf. Ievel % '19.'19 '19.50 '19.00 97.50 95.00 75.00 SO.OO

QuaDtiIe ( a) -3.719 -2.576 -2.326 -1.960 -1.654 .{).674 -0.000
ES(X< a) -3.959 -2.891 -2.667 -2.338 -2.062 -1.272 -0.798
Source: Jorion, Phlippe, Value at Risk, McGraw-Hill, 2007,p. 92
Table 6.2: Lower quantiles if 1he standard normal distribution
The lower 1ine of fue table shows fue expected shortfall. The tail of 1he normal
distribution decreases at a very fast rate fue higher one gets wifu fue confidence level;
fue ratio between fue CVaR and fue VaR approaches I as fue confidence level inereases.
The following example is based on fue mefuod described by Jorion: The VaR and
ES of a portfolio of 1000 Allianz SE common stocks for a ten day holding period and
a 99% confidence level is calculated wifuin fue steps explained in figure 6.5. The data
of fue sampie is based on 1he elosing price levels reported by fue information system
Bloomberg. The distribution is assumed to be standard normal as shown in figure 6.6: 21
First, fue position has to be valued at market prices (as per 02.01.2008).
Opening Value EUR 147.97 x 1.000 shares = EUR 147,970
Second, 1he variahility of fue risk factor (fue stock price volatility) has to be calcu-
lated. The mean and fue standard deviation have to be evaluated. The Allianz SE stock
was EUR 157.66, and fue standard deviation for fue 225 trading days of1he year 2007
was EUR 10.92.
u= VL (I-' - x)2 In = EU R 10.92 == 6.92%
Third, fue time horizon for fue holding period has to be set: 10 trading days (time is
measured in terms of trading days), since volatility arises More unifonnly over trading
21Jorion [see 2007,p. 107-108]

I Mari; 2 Moas"", , ~, 4Sct

,,,,,ruk,,,,<
S 11.."""
""''' 'on ,-,,,"M I') UnI< pol<"""
or ",I. (""IOn
10m"",,., ""n"", 10,-01
"'"
Val"" '1.1"" ~" O<I""I\C) '1.1""
I",
~
• ~
..... ~ ...
"hI
~
--- --- ----
TI"'"
IOd"~s
1101''''''
J
-.
\ Ilo"m.
Soutee: Jorion.I'~;I;ppc. Valu<: a, Kisl. ~kGr'." I!ill. Ne\\' Vor\:. 2007. p. 107
Figure 6.5: Steps to evaluate the YaR I ES
days than calender days. The adju!llment for time is cxpressed in tenns of the square
root of the number of days; 10 days for 2 trading weeks. divided by 252, which is
usually the number of trading days per tuIIlUIIl.
Fourth, the worst loss by processing all the prcceding information is reported as the
VaR (for the quantile factor see table 6.2).
Value x st.deviation x time x quantile factor = VaR

EUR 147,970 x 6.92% x JlO/252 x -2,326 = BUR 4,727
Ftfth. the ES. the expected 1085 in case of the 1085 event, is estimatcd (for the ex-
pected shortfall value see table 2.6):
VaIue x st.deviation x time x ES factor = ES (CVaR)

BUR 147,970 x 6.92% x y'lO/252 x -2.667 = BUR 5.443
p(x)
"al~~ _. t _ ri,k - _ .:U R ~.73
,,
t
o , x
11 = EUR 10.92
.... nditi .. n. 1 '·alu ..... t_ris k - _ EUR S.44
SO~rce: 0" n Graph
Figure 6.6: VaR and ES per Allianz SE stock
Value of risk types
Depending on the usage, different types of VaR can be categorised: The 1IIIlTh!t VaR
measures the price changes of a financial instrument (as explained with the share price
example above), wbile the credit VaR measures the default risk cf an investment. In
contra!lt to the market VaR. cremt VaR focuses on langer time horizons, mch as the one
year proposed by Solvency 2. This is important if the insurance company mvem in
illiquid assets.
When the risks are regarded on an enterprise level, it is not sufficient to know the
aggregated VaR or ES figures of the assets and Iiabilitics. In order to get thc shape
cf the risk profile, the contribution of the individual instrument to the overall VaR has
to be quantified. A portfolio manager, far instance, might like to know how much the
removement of a single exposure may change the VaR of bis portfolio. 22
UFe1~et aL [see 2005, pp. 372-373]

Value of risk concepts
Jorion suggests three re1ated concepts: The marginal VaR quantifies the change in the
portfolio VaR driven by a small change (one USD) in the exposure to a given uoderly-
ing. The meTernental VaR quantifies how the portfolio VaR changes due to a specific
position - it takes the non-linear change of the VaR into account. The component VaR
is the result of the marginal VaRs multiplied by the real exposures in the portfolio. The
component VaRs sum up to the portfolio VaR.23
Value of risk models
Among the several stochastic modeling concepts to calculate the VaR available, three
main types can be cIassified: 24
Analytical models use theoretically fouoded distributions. As expIained in the ex-
ample above, they ideally use the standard normal distribution which enahles the user
to define the standard deviation u and the expected value fJ, for the relevant risk factors.
The calculation leads to the expected value of the assel infiuenced by the risk factors.
Historical simulation models can either be based on the actual development of the
value of assets or compute a simulation of the relevant risk factors. The model is based
on the opinion !hat risk factors and correlations e.g. for a stock price are included in
the price development. In order to evaluate the VaR of a stock position, the positive and
negative changes of the daily prices of the recent 1.000 days are plotted on a graph. To
see the VaR of a 95% confidenee level, the value ofEUR 2.81 at position 950 offigure
6.7 showing the historic stock prices is laken as an estimate.
Mante Carlo simulation models assume a functional dependence between the asset
values and the risk factors. For the conceivable developments of the risk factors, a ran-
dom generator estahlishes distributions. The structure of the distributions may neither
be normal nor based on historical data. The generated x random values for the risk
factors lead through the basic cohesion to x conceivable values of the assets. The gen-
erated values are sotted by size, and the VaR for the relevant confidence level can be
determined in accordanee to the historical simulation by taking the value at the relevant
confidence position.
Strengths and weaknesses of VaR and ES
VaRlES are among the most popular risk measures. The strength of the VaRlES method
is that it can be used for a variety of risk types financial institutions have to take. It is
easy to communicate extemally and intemally.
The danger using VaRIES is !hat they may give a false impression of accuracy, sinee
the models depend primarily on the calibration of the risk measure with respeet to the
!wo parameters time horiwn and confidence level. They give approximations of risk.
23Jorion [see 2007, pp. 166-179]
24 Schulte and Horsch [see 2004. pp. 216-227]
,
<
•
,•
. ___J
J.,i~ ~7 olM S2J ~I 6.l9 ~9'l ,~_\ 5U 571 929 987
.,
Thc 95% VaR ist dl'fincd a~ the loss valul' 31 da!.1 ooint 50 or LOOO
Source: O, ... n Graph bascd on data providcd by ßloombcrg Financc LI' .
Figure 6.7: Historical simulation of the Allianz SE stock
Traders may try to arbitrage the VaR system by moving into markets or securi.ties that
appear to have low risk for the wrang reasons.
The statistica1 accmacy of the risk estimate of historical simulation depends on the
available observation points. Historical simulation my create the problem that, if the
window is very short, 9:treme price changes within days can create a VaR measure
of risk that is predictably lower or higher than the true or implied risk.25 In order
to achieve the same statistical significance, the length of the sample pcriod and thus
the amount of historical observation points needed must increase in proportion with
the time horizon. To compute a l-day VaR for a stock price with a 99% confidencc
level 250 observations points are necessary. Ifthe time horizon is changed to 10 days,
2,500 observations are nccessary in order to get the same level of significance. Thus,
l-year VaR calculation already needs parametrie models like Monte Carlo in order to
get around the data problem (especially regarding the fact that no historical data may
be available to measure the relationship between several risk factars).
The VaR measure is non-coherent. Coherence enmres that, the greater the risk, the
greater the risk measure must be. A central characteristic is mb-additivity, which does
1!IJorion [see2007, pp. SS2-5S3j

not hold for VaR: It is possible Ihat VaRA+B > VaRA + VaRB. This violates Ihe
principle of diversification staring lhat risk decreases wilh diversification.
The ES, in contrast, is a coherent risk. measure - it gives an estimate about the
significance aflasses if they arise within the time period and confidence level. However,
Ihe most severe problem may be 1he implementation in practice.
To acbieve Ihe applicable level of sigrtificance, ES requires a much larger data sam-
pie 1han VaR. 26
6.1.6 EU-hannonisation effects in respect or ILS

Oue to Ihe 1ack ofharmonisation wilhin Ihe regulatory framework, differences regarding
Ihe development of insurance linked securitisation among Ihe single EU member states
can be observed. The supportive regulatory, accoontiog, and lax environments of Ihe
UK, Ireland, and Ihe Nelherlaods have helped Iheir fioancial centers to dominste Ihe
innovation process. '2:l
While Ihe foll specification and final implementation of Solvency 2 is not expected
to take place before 2012, Ihe EU Parliament on JOlle 71h, 2005 approved Ihe Rein-
surance Directive as a first step to harmonise Ihe locallegislations of 1he membersbip
states. The directive is an interim measure in order 10 harmonise the regulation of the
reinsurance industry, and Ihe states were obliged to implement Ihe appropriate regu-
lations into Iheir nationallaw before Oecember lOIh, 2007. Prior to Ihe Reinsurance
Directive, Ihe regulation of reinsurance in 1he EU could at best be desctibed as a patch-
work of inconsistent regimes. While in some states like Ihe UK, Finland, Oenmark,
Luxembourg, and Portugal, reinsurers were regulated in the same way as direct insurers,
Ihere was no supervision of reinsurance at all in Belgium and Greece. The management
of primary insurers was viewed as having sufficient expertise to adequately evaluate
1he financial strenglh of Iheir reinsurance coonterparties. In most of Ihe states, Ihere
was DO solvency requirement far reinsurers. In certain EU member states, collateral
requirements were in p1ace, wbich obviously Made it obligatory for foreigu reinsurers
to provide assets as a collaterai for Iheir liabilities from onderwritiog activities. Oue to
1he lack of simple transformer structures combining lax efficiency, flexible regulatory
and prodential reqnirements, insurance structured finance products have been difficult
to establish. 28
The key improvement regarding securitisations was lhat Ihe Reinsurance Directive
allows member states to establish Insurance Special Purpose Vebicles (ISPY). The di-
rective recognises that the ISPV can "... assume risks from insurance or reinsurance
undertakings and wbich folly funds its exposure to such risks Ihrough Ihe proceeds of
a debt issuance or some o1her financing mechanisms where Ihe repayment rights of Ihe
26Bäte et al. [see 2006, pp. 66-73]

27Klein and Wang [see 2007, p. 53]
28Prebble [see 01.06.2007, pp. 1-29]
providers of such debt or ofuer financing mechanisms are subordinated to fue reinsur-
ance obligations of such a vehicle."[Commission, 15.11.2005, p. L323.7]
ISPVs have to fund fueir liabilities completely furough fue issuance of an appropri-
ate financial instrornent, e.g. debt. Once 1he funding is in place, fuey have to maintain
sufficient assets to cover their liabilities. Regarding the selection of assel investments,
fue Reinsurance Directive sets out a "prodent person approach" consisting of a set of
principles which firms must apply.
Further, the "single passport regime" allows the reinsurers to operate without limi-
tations in the common mark.et, while the responsibility for supervision remains with the
horne state. Portfollo transfers among insurance companies and reinsurers were permit-
ted as long as fuey are in !ine wifu fue aufuorisation of fue horne country. Tbe regulation
is regarded as 1he basis for fue transfer of run-off bonks between EU jurisdictions.
The Reinsurance Directive provides the member states with a framework to be used
to establish additional reinsurance capacity. Tbe EU capitaI markets expect a rise in
embedded value securitisations, reserves financing, and non-catastrophe risk transfer
securitisations.
EU member states have some flexibility in designing fue jurisdiction for fue local
ISPVs. Some efforts have been made by 1he member states, especially by fue UK,
Ireland, and Germany in order to position fuemselves as fue ideal horne state for 1he
ISPVs 29
Since most of fue transactions have been done in fue UK, fue regulation of fue ISPVs
shall be explained by fue approach of fue local supervisor FSA having taken fue role as
lead counsellor for fue introduction of fue Reinsurance Directive. Wifu 1he introduction
of fue Reinsurance Directive, fue FSA has a1ready specified fue regulatory treatment of
securitisations:
Tbe FSA aufuorises and supervises ISPVsand, subject to fue receipt of a waiver,
amounts recoverable from ISPVs may be considered as reinsurance or retrocession in
calculating the cedent's solvency margin requirements. Amounts outstanding from an
ISPV may be treated as reducing, or inc1uded as assets covering technical provisions.
Subject to actoarial principles, fue regulations fuerefore allow fue recognition of an
EU-based ISPV for 1he reductions of fue solvency requirements on fue same basis as
for reinsurance or retrocession wifu an aufuorised reinsurer. The ISPV further has to be
taxed and is obliged to hold a regulatory surplus level as would be required of an insur-
ance company. Tbe supervision is taking place furough fue oversight of fue ceding corn-
pany, while fue ISPV is treated as reinsurer wifu minimal reporting requirements. On a
case-by-case basis, fue FSA examines to what extent risks are mitigated or transferred
from 1he cedent to 1he ISPV. Based on fue principle of senior management responsibil-
ity, fue FSA checks how risk is managed and whe1her fue risk transfer is genuine and
sufficient. Tbe case-by-case approach could, however, create some uncertainty among
fue insurers as to how a specific transaction may be treated by fue regulators. 30
29Prebble [see 01.06.2007, pp. 1-29]
30Klein and Wang [see 2007, pp. 4649]
ISO CHAPTER 6. 1HE PERSPECTIVES OF 1HE STAKEHOWERS
Tbe UK lax aufuorities "Her Majesty's Revenue aud Customs" have introduced a
new lax regime for securitisation wifu 1he effect fuat fue ISPV is laxed on fue actual
profit it retains under 1he terms of fue arrangement, normally a minimal amount, and
not on its profit as determined for accounting purposes. The new regime was modified
for ISPVs and took effect for accounting periods begiuning on or after January Ist,
2007. Before fue implementation of 1he new UK lax regime for securltisations, fuere
was uncertainty for a number of years about the treatment of interest on nOD-recourse
debt SPV issuers of ILS were fuerefore established in More favonrab1e jurisdictions
such as Ireland or fue Nefuerlands, even if fuey held UK assets. 31
Example
Tbe following example shows fue effects on fue regulatory capital for fue different alter-
natives an insurance company can choose to raise BUR 500 mln of additional capital.
Walhof et al. have shown 1he effects wifu a model balance sheet wifu total assets of
EUR40 bn (table 6.3) and a model regulatory capital statement (table 6.4) offue insnr-
ance group Friends Provident, one of fue leading life insnrers in Europe. Tbe company
at fue time offue calculation was rated A+ by Standard & Poor'S.32
The model compares fom different alternatives: First, the insurer decides to issue
additional debt. Second, fue company may issue additional stocks. Third, fue value-in-
force securitisation (VIF) aims to strengfuen fue regulatory capital to potentially finance
new business !ines. Fourth, fue Deferred Acquisition Cost (DAC) securitisation can be
arranged in order to fiuance 1he take-over of anofuer insnrer.
Tbe first altemative, issuing perpetua1 subordinated debt, is fully treated by fue
regulators as equity. Under normal market conditions, fue costs can be estimated at
250-300 basis points per annum plus additional 25 basis points of commission costs
for fue arrangen3ent of1he debt.33 In stressed markets, fue costs can rise to 700-1,000
basis points or even higher. Tbe debt issue has to be subordinated and to fulfiI certain
requirements in order to be recognised as regulatory capital.34
Tbe second alternative, issuing equity, is ra1her costly for fue insnrer. Tbe costs for
raising EUR 500 m1n equity are estimated at 500 basis points. 3S In times of difficult
markets like fue cnrrent capital market crisis, fue costs were estimated at 1500 basis
points. Tbe capital raised is treated as regulatory capital.
Through fue securitisation of a AAA Floating Rate Note of EUR 500 m1n of fue
value-in-force (Alternative ill) or fue deferred acquisition costs (Alternative IV) in form
of a AAA 10 year floating rate note, fue costs in times of favourable market conditions
like fue period 2003-2007 can be estimated at around 25 basis points plus 125 basis
points of ioitial costs including fue mono!ine insurance guarantee and fue interest swap
31Davis [see 2006, pp. 1-4];HMRC [see 2007, pp. 1-6]
"Walhofetal. [seeOl.l1.2005,pp. 16-17]
33Data Source: Bloombcrg Fmance L.P.
341be different types of subordinated debt are described in chapter 6.2.4
35erean et al. [see 20,CJ7,2007. p. 18]
Bcfom Afta'
.......
Inv<o_ 36.700
Alternative I
DebtIssue
36.700
Al.ternativell
EqwtylMuo
36.700
Alternative m
VIF Sec.
36.700
Alternative IV
DACSec.
36.700
Deferrcd acquillition costa 2.000 2.000 2.000 2.000 2.000
Other intangib1e assets 100 100 100 100 100
c..h 1.000 l.S00 1.500 1.500 1.500
Other tangible assets 200 200 200 200 200
1bta1 ....... 40.000 40.500 40.500 40.500 40.500
Befme Afta'
Alternative I Alternative II Alternative m Alternative IV
Llablli... DebtIssue Equity Issue VIF Sec. DACSec.
Capital and rescrves 2.000 2.000 2.500 2.000 2.000
Subordinated liabilities 1.000 1.500 1.000 1.000 1.000
TechnicaJ. provisions 34.000 34.000 34.000 34.000 34.000
SPVloans - - 500 500
Other crediton 3.000 3.000 3.000 3.000 3.000
1bta1 LIabIIIIHo 40.000 40.500 40.500 40.500 40.500
Source: WaIhof, Pictcr cl al., llic Insurancc Sccuritisation in Europc, Nycmodc R.cscarch Group.
Breukclcn, 2005, p. 16
Table 6.3: Example: Alternatives to raise EUR 500 mln capital
agreement. Due to the transferred risk of future cash fiows, the regulator recognises the
amount as 11er-1 regulatory capital, while the accounts under lFRS will recognise the
financing as loan.
Table 6.4 shows the effects on the capital requirement from the perspective of the
regulator:
B .... Afta'
Alternative I Alternative 11 Alternative m Alternative IV
Capital requirement DebtIssue Equity Issue VIFSc:c. DACSec.
Shareho"""""""
Other rcgulatOIy capital
2.000
300
2.000
300
2.500
300
2.000
800
2.000
300
Thtal available c:apital 2.300 2.300 2.800 2.800 2.300
Capital rcquirement 700 700 700 700 700

Overall surp].UI capital 1.600 1.600 2.100 2.100 1.600
In=uc 500 500
in .. 31 .. 31 ..
Somce: Walhof, Pi.et:er et al., Life Insurance Securitisation in Europe, Nyemode Resean:h Group,
Breuke1en, 2005, p. 16
Table 6.4: Example: Regulatory capital requirement !able
Tbe example shows !hat, through the VIF secutitisation alternative, the capital available
was increased from EUR 1.6 bn to EUR 2.1 bn (+31 %). Subject to favourable market
conditions and the availability of monolioe-wraps, the costs compared to an equity ur
subordinated debt issue are lower. Further, Ihe sbareholders do not need to be involved
in Ihe process. The insurer may increase its future profitability and is able to compete
at lower margins. 36
6.1.7 Accounting and supervision in the US

Insurance regulation in Ihe US historically lies wilhin Ihe responsibility of Ihe Federal
States. Reinsurers are treated similarly to primary insurance companies. The approach
regarding Ihe regulation of Ihe financial condition of insurers has been prescriptive or
roles-based, and Ihe market practices are heavily infIuenced by an accounting perspec-
tive. A voluminous set of laws, regulations, roIes, and other measures govem insurer's
acti.ons. The regulators tend to concentrate on insmers' compliance with the prescrip-
tions. The companies have to deliver two sets of accounts: Th.e statutory accounts
are based on Ihe Statntory Accounting Principles (SAP) which are determined by Ihe
insurance regulators at state level. Tbe second set of accounts is based on Ihe Gener-
ally Accepted Accounting Principles (GAAP) determined by Ihe Federal Accounting
Standards Board (FASB). Tbe!wo sets of accounts are ra1her similar, but have some
important differences. SAP is intended to determine the liquidation value 0/ an insurer
whereas GAAP is intended 10 measure lhe value of a firm as a gomg cancern.
Therefore, SAP does not recognise certain assets, for instance goodwill or franchise
values which are recognised by GAAP. As to life insurance contracts SAP requires to
bnok all acquisition expenses in Ihe year a policy is written ralher 1han to arnortise Ihese
expenses over 1he lifetime of 1he policy.
Currently, US insurers are not subject to any requirements to perform intemal risk
modeliug - Ihey are not allowed to use it as an optional approach to demonstrate Ihe
adequacy of Iheir capital and financial risk management. In 1heir interaction, Ihe regu-
lators have not embraced an enterprise risk management perspective. Tbe full range of
risks insurers face in Iheir action is not evaluated - Ihe system classifies underwriting
risk, pure marke! risk, asset-liability risk, credit risk, and operational risk only. Tbe
regulatory aulhorities do not provide any incentives to evaluate interna! risk modeling,
e.g. for Ihe belter management of catastrophe risk.
Regarding risk mitigation, regulators grant "credit" for reinsurance and olher forms
of risk transfer. Tbe company may Ihen count Ihe payments owed by Ihe reinsurer on
claims it has paid as an asset or as a deduction from its liability and decrease estimates
for potentiallosses. In doing so, Ihe insurance company can increase Ihe reported earn-
ings on its financial statements. Tbe credited accounting values are reflected in Ihe
calculation of 1he surplus and 1he risk based capital requirement The amount of capital
needed to meet the risk based capital requirements is lowered. The reinsurer must be
authorised; foreign reinsurers are considered to be authorised when they collateralise
1heir liabilities resulting from activities in Ihe USo
36The difficu1ties monoliners insures are facing at cur:rent are described in chapter 3.3
Tbe authorities also credit for 1LS issued through US-regulated entities. Tbe regu-
lators tend to be cautious in accepting cr approving new approaches to risk financing
by insnrers of their participation in alternative 1inancing mecbanisms for !he insnred.
Transactions involving the traosfer or hedging of risk are not prohibited, but nei-
ther do insurers gain any credit for such transactions. Tbe use of derivatives is c10sely
watched and ra!her 1imited by the regulators. 37 38
Regulators impose two types of capita! on insuraoce companies: The fixed min-
imum capita! requirement is an amount raoging from USO 0.5 mln to USO 6 mln,
depending on the individual state regulations, while the mean requirement is USO 2
mln. Apart from this amount, insurers are subject to risk based capita! requirements
calculated with a formula developed by !he NAlC. Tbe capita! has to exceed the higher
cf the two standards. Tbe application of chosen factors to various accounting values
results in the charges for the five components. Tbe charges are summed into seveta!
baskets, subject to a covariance adjustment to refiect the independence of certain risks.
Tbe formula to calculate the RBC is shown below: 39
• RO: Investments in Affiliates
• Rl: Fixed Income Assets (interes! rate and credi! risk)
• R2: Equity Assets ("marke! value" risk)
• R3: Credit (risk associated with reinsuraoce recoverables)
• R4: Loss Reserves (higher charge for adverse loss development)
• R5: Premiums (higher charge for high loss ratios and rapid growth)
• RBC = 0.5[RO+ VR,' +R?+R?+R.' +R.']
If the ratio of the Total Adjusted Capita! of an insnrer available to the RBC require-
ment falls under certain 1imits, the company or regulatory actions shown in table 6.5
are authorised.40
Action Level: TAC/RBC: Requirement:
Company Action 200% Company must file plan
RegulortO')' Action 150% Regulator must examine insurer
Authoriaed Control 100% Regulator authorised to seize insurer
Mandatory Control 50% Regulator requirc:d to seize insurer
Table 6.5: Risk Based Capita! action levels

31K1ein and Wang [see 2007. pp. 6-11]
38GAO [see 2002, p. 23]
39Klein and Wang [see 2007, pp. 6-11]
40Klein and Wang [see 2007. pp. 6-11]
After the industry faced big losses caused by the Nortbridge Earthquake, Hurricane
Andrewand the terror attacks on September 11th, 2001, several efforts have heen made
to inerease the capacity of the non-life sector througb securitisations. The US Congress
and the US Interna! Revenue Service have identified the problems of capacity sbortages
in states exposed to natural cataslrophes like Flotida and Califoroia. A hearing took
place before the responsible subcommittee 00 oversigbt and investigations to discuss
the following solutions proposed by the supervisory authorities and industry represen-
tatives: 41
NAIC has proposed !wo key accoootiog legislations in order to enable onshore
transactions in the USo Protected cell structures allow domestic insurers to segregate
certain assets and liabilities. Protected cells could he used by an insurer to hold funds,
e.g. raised by issuing catastrophe bonds. The investors back ooly predefined risks under
certain contractually-specified circumstances. The protected cell is a subsidiary of the
primary insurer and for purposes of state law classified as areinsurer. Similar to rein-
surance, where the creditors of an insurer in default have Da claim against the reinsurer
(ooless a indernnity-based trigger event happened), the general creditors of a bankrupt
insurer are not able to claim against assets of the protected cello Creditors of the pro-
tected cell do not have access to the insurer's general account. According to the SAP
accountiog rules related to the protected cell, proposal insurers are allowed to reduce
their written and earned premiums by the amount paid to the protected cell to under-
write the risk that has been securitised. The payments would therefore be treated like
premiums ceded in authorised reinsmance transactions - the reduction of the net premi-
ums is a proxy measure for its potentialliabilities. Any recoverables from the protected
cell are, similar to reinsurance, recognised as a reduction ofthe insurer's gross incurred
lasses and 1088 adjustm.ent expense incurred.
Until the end of 2006, a number of federal states, among them Vermont, South Car-
olina, lllinois, Kentucky, and Rhode !sland, adopted the NAIC Protected Cell Model
Act. 42 Apart from the administrative hurdles to set up the structure, investors are still
concemed that the protected cell's assets may be vulnerable to seizure 10 cover an in-
surer's general account, despite the intention to prevent this.
A forther hurdle for onshore protected cells is that the sponsor, when settiog up a
segregated unit, is not allowed to deduct paymcnts to the protected cell in calculating
its tax liability. Interest paymcnt to investors would be deductible, wbile profits earned
by the protected cell would have to he fully taxed.
The protected cell model depends on a certain tax treatment wbich may require
amendments to the tax code. The segregated unit needs to be recognized as part of
the insurance company. The insurer would then be able to increase its reserves with-
out paying taxes on their reserve contribution and accumulations, or on the equivalent
transfer of risk to the protected cello Reinsurance paymcnts Made to protected cells for
contingencies would also be tax deductible. The provisions would minimise taxes on
41 House of Representatives Committee on Financial Services [see 2002, p. 1]
42David [see 03.11.2006]
profits for the protected cell.43

The well intended Protected Cell Model Act and its accounting treatment unfor-
tunately have failed to produce any realised benefits regarding ILS - no insorer has
actoally used the model to issue a cat bond.
As the second proposed model, the Special Purpose Reinsurance Vehiele (SPRV)
gives investors a greater comfort that creditors or regulators of aceding insorer cannot
access the funds in a SPRV (unless a trigger event has occorred). The structore is
similar to the protected cell with the difference that the SPRV is a separate company
set up for the holding of the assets pledged to support obligations of the sponsor if a
triggering event occors. The Special Purpose Reinsurance Model Act desires changes to
the federal lax code: Premium paid to the SPRV would be lax deductible for the insurer.
The regulation would be beneficial to the SPRY, since the difference of investment
income and interest paid to investors would be taxable, only. Since this would result
in a profit of more or less zero, no corporate lax would be charged to the SPRV. The
sponsor and investors would gain a retum of principal rather than an cquity dividend
and would therefore not be subject to the double taxation of profits. The bond holder's
investment income, however, is taxable.44
At current, the use of a SPRV in a catastrophe bond securitisation involves a number
of complex financial accounting issues in the USo Unless all of the following criteria
are Met, the sponsor of a SPRV has to report all assets and liabilities in its financial
statements: 45
• At least 3% of the investment in the SPRV's total debt and equity or total assets
must be owned by an independent third party
• The independent third-party owner has a controlling financial interest in the SPRV
(Le. the owner holds more than 50% of the voting rights)
• The independent third-party owner must possess the substantive risk and rewards
of its investment in the SPRV (e.g. the owner's investment and potential retoro is
"at risk" and not guaranteed by a another party)
Due to this set of regulations, many US insurers have continued to issue cat bonds
through offsbore SPRVS. The trost funds associated with these instroments hold their
deposits with US certified institotions acting as trostees. This effecrively provides the
collateral required for the SPRY acting as areinsurer to be treated as authorised under
US regulations. 46
Onshore SPRVs until now have not been established due to the following reasons:
First, there has been a lack of an accepted regulatory framework that could govern
and provide insurers accounting credit for insurance securitisations. Second, onshore
44Klein and Wang [see 2fnl, pp. 41-42]
45GAO [see 2002, p. 24]
46K1ein and Wang [see 2007. p. 38]
SPRVs have been subject to US corporare taxation while US insurers have been allowed
to deduct payments to offsbore SPRVs in calculating their tax liability. Regardless of the
eventual outcom.e of the coverage, premiums paid to an offshore reinsurer are subject 10
an excise tax based on the gross premiurns paid - profits earned by offsbore reinsurance
affiliates of the US insurer (and by implication offsbore SPRVs) are not taxed in the
calculation of the consolidated profits of the US insurer.47 Third, current accounting
guidance requires that reinsurance agreements must indemnify the company against 1088
or liability associated with insurance risk in order to qua1ify for reinsurance accounting.
The credit for reinsmance is designed to ensure that a true transfer of risk has occurred,
and that any recoveries from reinsurance are collectible. By the way of traditional
indemnity-based reinsurance, an insurer gets credit for reinsurance on its balance sheet
in the form of adeduction from liability for the risk transferred to the reinsurer, and
can teduce the arnount of regulatory risk-based capital required. Tbe ca1culation of the
credit with indenmity-based coverage is fairly straigbtforward. In contrast, it is a very
complicated challenge for the regulators to value the true arnount of risk transferred to
determine credit for reinsurance with non indemnity-based coverage.48
Until the end of 200S, a number of federal states adopted the NAIC SPRV Model
Act, arnong them Vermont, South Caro1ina, and Delaware. Tbe model bas not been suc-
cessful, since the federal government has been hesitating to grant this so-called "pass-
througb tax treatment". Further, there has been continuing opposition against the model
from the reinsurance industry, claiming that the NAIC model act creates a new class of
reinsurers !hat will opemte under regulatory and tax advantages not available to existing
US-licensed and -taxed reinsurance companies. Tbe SPRV will act as a reinsurer, bnt
will not be subject 10 insurance regulation. This is criticised for endangering solvency
regulation and creating an uneven playing field for reinsurers. 49
As a third approach, NAIC is currently reconsidering the appropriate statutory ac-
counting treatment fOT non-indemnity-based insuTance, which would include insurance
linked securities.50
Regulaturs in general do not allow the fuH outrigbt sale of life insurance liabilities.
As such, the life insurer must ultimately retain the guarantee to the individual policy-
holder. Althougb, due to the changes in the reserve regulations called XXX and AXXX,
the industry moved towards a securitization model, the transactions will most probably
not get true sale treatment because regulaturs will not allow the sale of a life insurance
policy. Policyholders rely on the financial solvability of the life insurer when signing a
contract to secure their financial wea1th.
Tberefore, from a legal standpoint, creating bankruptcy remoleness without having
a true sale is important to find investurs, since they need to be protected from the in-
surers' liability to policyholders. Structures have been developed !hat have successfully

480AO [sec 2002, p. 23]
"GAO [.... 2002, p. 28]
soGAO [.... 2002, p. 23]
defined and separated, so-ca1led "ring feneed", the ceded block of polieies from cash
flows in ather areas of the sponsor's business.
This was partieularly important to financial goarantors because they do not want to
take corporate eredit risl<, as it eould bave strained their own AAA finaneial strength
rating. Fnrther, guarantors of life insurance securitisations are eoncerned that the reg-
ulatory uncertainty may be used by a rebabilitator in the event of an insolvency for
seizing the assets within a seeurltis.tion trust in order to equally support the p.yment
of all policy li.bilities,sl
Bcyond the regulatory environment of the SPRY, the regul.tory environment of the
sponsoring insuranee company has to be taken into consideration. It is important to
b.ve an ide. of how the transaction is going to perform if the regul.tor w.s ever to get
involved as the result of. eeding eompany's insolvency. Althougb the parties involved
will never get absolute eertainty with respect to Ibis, they ean, through due diligence,
get. very good ide. ofhow the situation may develop overtime.52
As per July 2006, ouly South Carolina bad the statutory .uthority to allow secu-
ritisation, while most other federal states have • regulatory order in p1ace th.t earties
the remote but potential risk !hat • decision eould be reversed by • future director of
insurance. The New York State Insuranee Departrnent h.s publicly stated it views secu-
ritisations as appropriate. However, other state regulators could intervene. As • result,
almost all US ILS have been exeeuted in South Carolin•. 53
Example
The implications of a securitisation are comparable to those of reinsurance contracts

(as per today, Ibis is the ease for indemnity-b.sed, risk-linked securlties issued by an
SPRV). The NAiC SAPs allow an insurance eompany obtaining reinsurance to refleet
the transfer of risk on the statutory finaneial statements. Many reinsurance contracts
include a commission to be paid by the reinsurer to the ceding company in order to
compensate for the acquisition cast, premium taxes and fees, assessment and general
overhead. The example in table 6.6 shows a reinsurance contract where an insurer
receives reinsurance for USD 10 mln, having negotiated a 20% ceding commission of
USD 2 mln. The reinsurer p.ys the primary insurer USD 8 mln net. The transaction
reduces the eeding eompany's .ssets by the USD 8 mln paid for reinsurance, while the
eompany's liability for unearued premiurns is tedueed by the USD 10 mln transferred.
The USD 2 mln are recorded by the primary insurer as eommission ineome. Since the
eommission ineorne inere.ses the equity (also defined as policybolder's surplus), the
eeding company gains an economic benefit. The reinsurer has assumed • USD 10 mln
5l Devineetal. [sec 06.07.2006, pp. 3-14]

52Devine et al. [see 06.07.2006, p. 66]
53Devine et al. [see 06.07.2006. p. 3]
liability and reports a mirror entty having the opposire effects on the aecount."
cam 25.000
""""" 17.000
Afuz
'oupI.. ~ ~
""""" ""'"
=
.,... 3U.UUO ".UUO
Tobol 30.000 38.000 ~

Source: GAO, Catastrophe insurance risks - The role of risk-linked securities
and factors afIocting their use, Wasbington OC, 2006, p. 42
Table 6.6: Effeet of reiosurance on the eapital positions
Reiosurance eontracts, however, do not relieve the eeding iosurer from bis obligation
towards policyholders. Failore of the reiosurer to honour bis obligations eould therefore
result in lasses to the cedent.5S
6.1.8 Outlook to further reforms

The "Working Group on Supervision and Regulation of The Group of Thirty"56, has
identified several caveats regarding the securitisation of insurance risks arising from the
current supervision and aceounting frameworks. They have suggesred solutions to work
on wbieh would help to overcome constraints and to develop agiobaI reiosuranee mar-
ke! where securitisation eould playa key role regarding the risk transfer to the eapital
markets:
Intemationally harmooised oversight framework
Harmooisation bears the porential to iocrease transpareocy, facilitare a better under-

standing of risks, and enable comparisons across the insurance and reinsurance sector.
The harmonisation of the EU framework will eoable a eompany lieensed io one eountty
to operare io any other membership eountty of the eommon market. No sueh sysrem
currently exists between regulatory regieres elsewhere, notably between the USA and
"GAO [see 2002, pp. 41-43]

"GAO [see 2002, p.43]
S61be Group of 1birty is a private, non-profit consultation group of international economic and moncy
affairs consisting of a body of senior representatives of the private and public sectors and academics
Ihe EU. Global hannonisation would reduee Ihe harmful regulatory arbitrage, Ihe trend
to ehoose Ihe jurisdiction wilh Ihe lightest regulation. 51
Supervision on a consolidated basis
The raison d'@treoftheinsuranceJreinsuranceindustryisrisk.diversification. 58 There-

fore, reinsurance is almost necessarily a global business. Due to the consolidation of the
sector, Ihe bigger reinsurance units spread Iheir portfolios globally and view Ihemselves
as multinational enterprises. They are interested in consistent standards for supervision
across jurisdictions and in elose cooperation when implementing them. Nationa11aws,
directives, and insolvency mIes are inefficient and complicate the achievement of this
objective. Consolidated supervision would gain Ihe potential for Ihe supervisors to fo-
cus 1heir often lirnited regulatory resoorces where Ihey are most needed. A eonsolidated
supervisor would playa key role and would be relied upon by olher reinsuranee super-
visors. The risk-based eapital requirements could be ealculated on a eonsolidated basis
and securitisation of insurance risk. as a result would be much easier.59
Enhance the role of the IAIS
Tbe mutual recognition of olher jurisdictions would lirnit Ihe number of distinet regula-
tory frameworks aglobaI insuranee firm needs to address -Ihe overa1l regulatory burden
would be reduced, and duplieative regulation would be e!iminated. Tbe level of mutual
reliance irnplied would require higher supervisory standards in some jurisdictions and
a strong frarnework for intemational cooperation. IAIS offers Ihe necessary framework
and is a1ready warking on severa1 issues. It is being suggested that the organisation
should become a more signifieant polieymsking body. The eight major reinsuranee
jurisdictions, the US, the UK, France, Germany, Switzerland, Ireland, Bermuda, and
Japan should mske a strong eommitment to 1he IAIS in terms of resources and by lead-
ing 1he way in adopting its intematioual standards. Furlher, different regulators should
work toge1her more closely nationally and promote intemationa1ly within Ihe IAIS or-
ganisation. Tbe interaction between 1he IAIS and 1he industry should be earefully eon-
sideted - Ihe IAIS has to get input from Ihe industry, bot must be able to tske diffieult
decisions. Tbe ties to olher international bodies like Ihe IMF, Ihe World Bank, Ihe FSF,
and 1he Basle Committee for Banking Supervision need to be strenglhened. Overall,
Ihe reputation, international standing and funding should be irnproved in order to fulfil
its task. 60
57prenkcl et al. [see 2006, p.69]

58prenkcl et al. [see 2006, p. 9]
s9Prenkel et al. [see 2006, pp. 70-75]
60prenkcl et al. [see 2006, pp. 70-77]
CoUateral requirements
Collateral requirements have been used in the past 10 overcome concems about reinsur-
ance regulations and accounting differences across countries and continents. However,
the practice has a number of disadvantages: By immobilising assets that cannot be used
elsewhere, Le. because of collateraIisation requirements in one jurisdiction. it may not
be able 10 use these assets to overcome challenges in another jurisdiction. An efficient
use of capital resources is undermined, due to the fragmenled capital base of the rein-
surer split among several jurisdictions. Tbe company has to bear the cost to provide the
coUateral. Higher raled and lower raled companies have to deliver the same amount of
coUateral, Le. the rules are not correlaled with the credit risk of the reinsurer. FinaUy,
banking institutions in their function as intennediaries between insurers and reinsur-
ers are put in a position to take credit risk by providing the collateral in the form of
letters of credit. Prom a financial system perspective, the likelihood of systemic COD-
tagion inereases. Wbile the EU jurisdiction has raised the bar by e1iminating collateral
requirements,61 the announcement of the chief supervisor of the New York Insurance
Department to cancei the collateralisation requirements in the State of New York62 is
facing the opposition of other regulators. Tbe proposed new framework is likely to
be vigorously debated by the industry and will be revisiled by regulators at the NAIC
and at the individual state level before it is enacted by state legislatures. There bas
been Da consensus among either regulators or the industry on how to proceed, and the
supervisors are a long way from changing current practice."
Risk management practices
Tbe introduction of a "risk based capital measure" within the supervisory framework
helps to ensure that the calculation is taken seriously. Companies whose financial con-
dition is deteriorating will use the powerful device for spurring necessary action. Tbe
market needs to develop tools for understanding, parsing, and pricing risk. Tbe su-
pervisors need to set the foeus on the broader risk measurement and risk management
processes that are being used by the sector in order to assess and control risk on a
firm-wide basis. This approach is consistent with the broader financial sector trend in
favor of increased resources and attention to enterprise-wide risk: management. Since
the companies may be interested not to disc10se their approach to risk management 10
the general public, direct regulatory reporting may be required. Tbe supervisor needs
to get a fuH picture of the porent companies and their supported subsidiaries. Disclo-
sures therefore need to reflect the consolidaled financial condition of the increasingly
complex finaneial institutions.64
61Frenkel et al. [see 2006. p. 71]

62promme [see 19.10.2007]
63F1eckenstein et w. [see 2007]
"_etal. [see2006,pp. 73-74]
6.1.9 Results or the interviews regarding accountants and regula-

tors
General
111e interest of any supervisor is the interest of the policyholders. ILS are usually pur-
chased as an alternative to traditional reinsurance. Regulators are indifferent to the
form of that insmance or reinsurance. While traditional catastrophe reinsurance is al-
most always based on indemnilication and therefore follows the fortunes, ILS can be
paramettic or model-based which introduces elements of basic risk the supervisor has
to take into consideration. ILS have been adding capacity into the markets for catastro-
phe cover and, due to the collatera1isation of the majority of the products, are seen as a
stable source of reinsurance.65
By all supervisors, it is regarded as positive that the insurance sector is able to tap
the capital markets through the issuance of ILS. By piacing cat bonds, insurers and
reinsurers are able to get multi-year protection in contrast to the mostly annual renewal
of their reinsurance contracts. Supervisors analyse the whole reinsurance structure of
a company. ILS in the non-life sector should cover the higher attachment points for
low frequency risks. 111e basis risk for these structures is rather !intited, sinee either a
storm triggers the transaction or not Same sponsors, however, try to use cat bonds as
a working layer of reinsurance for frequent sma11 claims - this causes same concern,
sinee it bears the potential for moral hazard.66
Regarding ttiggers, the regulators are flexible. 111ey are as concemed as the spon-
sors of a transaction about the underlying models and ttiggers heing appropriate for the
risk covered. It was stated !hat innovative ttigger structures bave not pushed them to
their !intits yet 67 In general, it is irnportant !hat the sponsor is transferring real eco-
nomic risk. The structures have to pass the supervisors' test far real economic risk
transfer. If!bis test is passed, the accounting rules ought to work. Where the involved
parties got into trouble in the past were those cases when sponsors were trying to get
accounting treatment as if they were transferring risk but effective1y did not transfer it
economically. lbis was not allowed. 68
Regarding the decision process about the loeation of the SPRV, sponsors operate in
their basic econontic model whicb normally requires a low-tax treatment. 111e biggest
obstaele for onshore SPRVs in the US, the UK, or Germany remains the corporate tax
problem. In order to get them as attractive as offshore loeations (incl. Iteland), work
has to be done on the corporate tax issues. Whether a transaction is done onshore or
offshore depends on the specific nature of a structure and the sponsor's organisatinnai
setup. Most regulators and organisations would welcome a registration onshore because
"INT-I4-SUP [19.09.20081
"INT-I4-SUP [19.09.20081
67INT-I4-SUP [19.09.20081
"INT-24-INS [28.10.2008]
of the familiarity, reliability, and transpareney.69

International supervisory standards are being worlred on. In North Ameriea and
Europe, committees among the supervisors and insurancelreinsurance associations are
in eonstant dialogue. Regulators of both areas are aware about the developments of the
other supervisory systems.1°
USA
In the early days of the ILS markets, US regulators hesitated to cede authority to the
eapital markets and thereby ereate vebieles that undermine their authority. Tbey irtitially
used their authority to sign off on every eatastrophe ILS to certify that the transaction
either m.et the requirements of the insurance regulations or perhaps was not subject 10
them. 71 Today, NAIC operates througb the Securities Valuarion Office defining wbat is
an acceptable investment for all regulators of the 50 states.72 US regulators are willing
to accept ILS struetures and usnally grant equal eapital relief for them as for reinsur-
ance sinee, due to the lintited counterparty risl<, they regard them as more secore than
traditional reinsurance.73
US insuren and reinsurers underlie the same regulations and corporation standards.74
Tbey are not allowed to hold eatastrophe equalisation reserves, and they also do not
ebarge any eredit risk eapital for reinsuranee that is not a1ready receivable. This means
that, from a solvency point of view, it is almost irrelevant whether a company issues
a catastrophe bond or buys reinsurance.75 The US may revise their collateralisation
regime. New York and Florida are reporred to work on an at least part-eliurination of
the collatera1 requirements and there are discussions at NAIC level whether a federa1 re-
form may be implemented. However, there have been coneerns for decades that foreigu
reinsorers benefit from low taxes offshore and eompete with lower pricing than US in-
surers. At the time of the interview, there were discussions and hearings to lintit the tax
deduction for premiums paid by US subsidiaries to affiliated non-US reinsuranee hold-
ing companies. Tbe basis for tax deduetion is planned to be set at 10-20% of premiums
paid, reflecting the industry-average of risk-transfer ceded to reinsorers. Tbe argument
that US jobs are exported as a result does not seem to hold, since BemlUdan reinsurers,
for instance, employ 10.000 penple in the US. If this business went to the US insorers,
they eould not be expected to employ the same amount of people, since they would
simply have the economies of seale there they would take the business without employ-
ing extra slaff. Tbe eapacity brougbt by non-US insorers into the natural-eatastrophe
exposed US market improved the stability of the system. Althougb the outcome was
"INT-20-LAW [20.IO.2008];INT-28-ASO [03.11.2008]

7<)INT-14-SUP [19.09.2008]
71INT_12_INV [14.09.2008]
72INT-19-ASO [26.09.2008]
"INT-I-MOD [19.08.2008];INT-14-SUP [19.09.2008]
74INT-14-SUP [19.09.2008]
"INT-5-BNK [04.09.2008]
still unclear at the time of the interviews, there was some cerlllinty that at least pick-
ing single offshore centers or geographica1 regions would be against international trade
agreements.76
Ufe ILS have to meet a number of regulations which are pretty specific about the
type of risk transferred and the structure of the transaction. Since the sponsor is not
allowed to true-sale the policies, it tries to have a non-consolidation treatment of the
ISPY. This is then not a sale of the underlying policies, bnt a reinsnrance of the risk.
The ISPV is a licensed insurance company, and as such it can sell reinsurance. It has
a license in its state, countty, or domicile, bnt generalIy does not have a license in the
state where the ceding cornpany is domiciled. Because it has no license in that state, it is
obliged to fund a trust for the full amount of the reinsnrance of the reserves recoverable.
The formation of the trust is the pre-condition that the sponsor is able to get the capital
relief. The transaction is therefore fully collateralised. The ceding insurer is stililiable
for the risk, but gets indemnification for il The ISPY has to be adequately capitalised.
There must be real equity capital7'
The location of choice for ISPYs are the Cayman Is1ands, since they require low
capital and do not charge any corporate lax. The infrastructure is weil established -
there are sufficient lawyers, trustees and accountant offices available.78
Most ILS in the US fall under SEC Regulation 144A (Reg-I44A) in order to be
eligib1e for US investors. Ouly a few are regulated by REG-S and thus cannot be sold
to US investors. The regulations require striet filings of the infornuuion about the trans-
action and the financials of the sponsor.79 Further, the transaction needs a trust bank
in order to get the reinsurance credit. While reinsurers are required to co11ateralise
claims which have been submitred but are unpaid, SPRYs have to collateralise the trust
in full from day one.'o For Reg-I44A secnrities, the offering memorandum is key, and
everything which is not defined as available information must not be disclosed to the
markel As a result, not much infornuuion about the consistence of the collatetal was
disclosed in past ILS transactions. After the information memorandum was handed out,
there norma11y were no regular updates - the transparency to investors was therefore
limited. 'I Another set of important regulations for the US market are the ERISA mies.
They are valid for US pension funds which are important investors in ILS. The mies do
not allow the trading of the collateral. Thus, oncc the investments are done, the trust
has no chance to react to adverse developments by selling or exchanging the bonds. It
has to be kept in mind that, even if this may be allowed, the collatetai banks at cnrrent
da not have the resources or systems 10 manage margin ca1ls or exchange collateral on
a frequent basis.82
76INT-6-ASO [05.09.20081
nINT_8_LAW [1O.09.2OO81;INT-IO-RAT [12.09.20081
"INT4BNK [04.09.2008]
"INT4BNK [04.09.2OO8];INT-I4-SUP [19.09.2008]
"'INT-7-RE1 [OS.09.2OO81;INT-14-SUP [19.09.20081
81INT-29-INV [14.11.2008]
"INT-25-BNK [29.10.2008]
A refonn of the fractural stare-regulation sysrem, porential1y from the risk-b.sed

c.pital to • principle-based .pproach, is constantly beiog discussed. Regul.tors are
aware of Solvency 2 and see some need for harmonisation. 83 Sponsors are following the
regul.tory regimes regarding the mioimom requiremenls. For iostance, the regul.tory
reinsorance credit is b.sed on the coll.teral of the transaction: if ils value falls, the
sponsor gels less credit. 84 In .ddition, they have to follow the requiremenls of the
rating agencies putting on extra layers of security. The discussions with them therefore
infiuence Ibe final structore of. transaction. 85
Especially io the US, the govermnent has • particu1ar iorerest io Ibe coverage of
extreme catastropbe risk, sioce they are recognised as so large th.t Ibe effects can get
sysremic to the financial sector. The privare sector prob.bly did not do • good job io
man.giog these risks io the p.st. There are concerns th.t the regul.tors regard this nei-
ther as • market failore nor as • success, but may finally decide to srep io and elimio.re
the market mechanisms. Effectively, as with the Florid. funds mentioned .bove, this
wou1d mean !hat laxp.yers may need to srep io for the c.tastropbe los ses. Insread of.
direct involvement as insurer, the government could, for instance, provide an infrastruc-
tore which eases the market mechanisms, establisb • network of wind-speed merers, or
provide • regisrer of real estare qua1ity. The easing of Ibe the lax status for c.tastrophe
bonds, .s it was done for mortg.ge secoritis.tion, wou1d accelerare the development
of Ibe ILS market.86 US supervisors wou1d be ioreresred in an efficient w.y to cover
rerrorism risk. Every time the TRlA is due for prolong.tion, there is • lot of concern
.bout wh.t will happen if it is not renewed. 87
Europe
In Eorope, solvency and c.pital considerations do not pl.y • role io Solvency I, but
they will come into effect with the Solvency 2 world.88 Reinsorance is expecred to be
charged with. hair-cut for Ibe coun1erparly risk depeudiug on Ibe credit rating, wbile
ILS, especia11y catastrophe bonds, may be accepred wilb its full coll.teral and wilbout
any deduction.89 Solvency 2 does not seem to become an obstaele; it will help to
develop the ILS market. It is more difficu1t to buy • stop-Ioss reinsurance than to place
• stop-Ioss ILS ioto Ibe market.90 Companies will be .ble to employ freed up c.pital,
for instance as a result of a life-securitisation to be used for unit-linked or even non-life
business.91
"INT-5-BNK [04.09.2008];INT-I4-SUP [19.09.2008]
84INT-17-MON [24.09.2008]
"INT-19-ASO [26.09.2008]
"INT-18-INV [24.09.2008]
87INT-14-SUP [19.09.2008]
"INT-I-MOn [19.08.2008]
"INT-4-BNK [04.09.2008]
"INT-I-MOn [19.08.2008]
"INT-23-BNK [28.10.2008]
At the time of the interviews, an increasing number of eountries in Europe were get-
ting worried about the introduetion of the Solvency 2, since, due to the financial erisis, a
number of insurance eompanies ean be expected to be under the p1anned solvency eap-
ital requirement standards. However, it is common sense that Solvency 1 is too emde,
allowing too mueh arbitrage. The process hit a roadblock but certainly will not stop.92
The uneertainties are not being seen by the ILS market as an obstacle for further
growth. Sponsors have been looking for opportunities to diversify their capital and
reinsurance sources. They search for possibilities to transfer the real economic risk.
when deciding to issue ILS for their protection. 93 Regarding the natural eatastrophe
bonds, Solvency 2 does have a limited impact only. Sponsors do not issue eatastrophe
bonds for eapital relief, but for risk protection. In life seeuritisation, the uncertainty is
overcome through the usual agreement of a regulatory capital eall: If, after Solvency 2
has been introdueed, the eapital relief would fall away, the protection buyer ean eall the
transaction. 94 In conversations between arranging banks and sponsors, the uncertainties
around Solvency 2 have not come up as a reason not 10 da an ll...S structure. 95
As a result of the erisis, EU regulators together with the rating ageneies and, in
order to avoid moral hazard, are eonsidering an up to 10% vertieal sliee of risk the
sponsors will have to take in a securitisation. The sponsor then will have to bring in
eapital for the slice. Since Europe has a weil funetioning reinsuranee market in the
natural catastrophe business, only the top layers were securitised, and the lower layers
reinsured"· The frarnework established with the reinsuranee direetive elearly favours
onshore solutions - the regulatory wish to minirnise tax leakage. 97 Although Europe is
not as exposed as the US regarding natural eatastrophe, a transparent and independent
eatastrophe index would be appreciated by the regulators."
The loeation of ehoiee for ISPVs is Ireland, while, after the introduction of the
Reinsurance Directive, there is a trend to unifomtity in the UK and other EU states.
The main obstaele, however, remains to be eorporate taxation and the non-existence of
pass-through regulation."
Bermuda
The main ehallenge for the independent regulatory authority of Bermuda is to meet
an equivalent level of the rules that the international standard setters are proposing.
While Europe is working on Solvency 2, the US are beading towards a moderuisation
of the reinsurance collatera1 regulations. Bermuda is willing to create a great degree
of eompliance with the international standards. The regulators are actively involved in
"INr-22-BNK [27.10.2008]
"INr-24-INS [28.10.2008]
"INr-26-INV [29.10.2008]
"INr-27-BNK [29.10.2008]
96INr-26-INV [29.10.2008]
"INr-28-ASO [03.11.2008]
"INr-29-INV [14.11.2008]
"INr-24-INS [28.1O.2OO8];INr-25-BNK [29.10.2008]
the IAIS working groups and interested to enter memorandums of understanding with
o!her insuranee regulators. One benchmark to be aehieved in the years abead will be the
implementation of Solveney 2 in Enrope. A1J a result of its implementation, Bermuda
expects greater transparency and a group regulatory regime for the international mar-
kets. Transpareney would mean published annual financial statement issues and, in
addition, more risk and eorporate governance diselosures. Currently, the transparency
is based on the SEC regulatory regime, sinee 18 of!he 20 rnembers ofthe loeal associa-
tion are publiely traded in !he USo Bermuda is cnrrently evaluating the SEC, the Swiss,
the UK and Solveney 2 proposals in order to figure out whieh transparency rules are
appropriate for their insuranee sector. Lean regulation and highly qualified slaff offers
a high speed to markets. Tbe island has reached eapacity - a fnrther wave of reinsnrance
foundation is regarded as ra!her un1ikely. However, the system is leading the side-ear
business whieh can be done with few personnel ouly.lOO Some Bermudan reinsnrers
bave been volatile in their earnings; they are not able to show the track record and the
eapital resoorces of the well-establisbed and diversified European narnes. Tbe correla-
tion of their results with those of the cedents is ra!her high - in terms of high eatastrophe
losses both, the cedents and the Bermudan reinsnrers, suffered substantially in phases
of high hnrrleane activity. Bermuda is eharacterised by higher eapital requirements, but
lower lax, the eorrent net benefit eompared to the US bas been approximately 4-5% in
the past years. 101
lOOINT_6-ASO [05.09.2008]
101INT_5_BNK [04.09.2008];INT-22-BNK [27.10.2008]
6.2. INSURERS AND REINSURERS AS SPONSORS 167
6.2 Insurers and reinsurers as sponsors

6.2.1 The Integrated management of risk and capital
'The management of capitaI focuses on delivering the optimal balance sheet, being com-
posed of assets, equity, and debt. The intemal capitaI models of thc company deliver
information about the usage of capitaI by the different activities. The target should be
the minimisation of the cost of capitaI. The calculation of the solvency capitaI by using
stochastic models is part of today's enterprise risk management, the holistic manage-
ment of the assets and liabilities of an insurance company.l02
Traditionally, risk management in insmance was referred to the roles of the risk
manager, being respansible for the operational risk of the underwriting, and the trea-
surer, being responsible for the refinancing to cover the operational risk and the in-
vestments in the capital markets. Some years ago. most insurance business models
were based on the warehousing of risk. Risk was underwritten, pooled, and borne by
thc insurance sector, while part of it was transferred within traditional reinsurance pro-
granunes. The result was a concentration on diversification and underwriting standards.
Products with high retoms were favoured without measuring the risk and vo1atility in-
volved. Insnrance cornpanies required a relatively large amount of capitaI which was
not always efficiently used. The management of assets was independent from the man-
agement of liabilities. Most companies were not raled, and the assets and liabilities
were not marked-to-market. Due to the lock of ratings and transparency, institutionaI
investors were not involved in insurance underwriting. 103
The emcIgencc of enterprise risk management has been motivated through the recog-
nition that the separation cf risk. management from treasury is not consistent with the
shareholder's demand to maximise profits. Intra-firm opportunities for the diversifica-
tion of risk were not recognised. It became clear that failing to realise existing natural
hedges and adverse correlations among risks, can lead to high hedge expenditures or
high risk exposures. 104
Although thc Solvency 2 regulatory framework is not likely to be introduced be-
fare 2012, some of the kcy elements of the reform are already aJIecting the strategic
decisions of thc companies: First, insurance companies are getting capitaI models in
place in order to enable their operating units an effieient usage of capitaI. Together with
thc regulators and rating ageneies, up to date techniques like VaR and ES are imple-
mented to calculate risk measures for underwriting and investment activities. Second,
the management of assets and liabilities is being constantly improved, partly as a result
of the stock market crisis of the late 199Oies. Third, a wave of hybrid bond issues with
long maturities or perpetual structures was placed into thc capitaI markets. Although
thc bonds can nonnally be ealled after 5-10 years, they count as regulatory capitaI and
1tr20ctenga and GroBpietsch [see 2006, p. 1-3]

l03Robinet rlee 27.05.07, p. 3]
104Cumm.ins [lee 2005. p. 190-191]
improve the solvency basis. The former practice to issue senior bonds at holding level
and to transfer it to the subsilliaries as subordinated capital will not be possible un-
der Solvency 2 any more. ILS are getting inereasingly attractive as tools to free up
eapital. Fourth, diversifieation of the insuranee groups is strongly incentivised by the
regulations. Beneath the economies of seale, one of the key drivers of the acquisition
of Revios, a German life reinsurance company, and Converium, a Swiss reinsurer by
the French reinsurance group Seor, for instance, was to get a lower solvency capital
requirement because of diversification benefi:ts. 105
6.2.2 Capital management

Adequate risk-bearing capital is an essential prerequisite for the underwriting of in-
surance risk. It acts as a buffer against unexpected losses. Also called economic net
warth of a company, it is calculated as the difference of the market value of its assets
and the present value of its liabilities. As already explained in previous ehaplers, the
insuraneeJreinsuranee eompany pools sufficiently independent and halanced risks into
its portfolio in order to reduce the volatility of the aggregate claims to a manageable
level. Premium income is invested in the capital mark.ets to generate the cash fiow
for future claims. The surplus generated is held as economic net worth. The market
capita1isation, measured for a public1y listed company by the total value of stocks out-
standing, is generally higher than the economic net worth of the company. This is due
to the fact !hat investors value the insurer's ability to generate economic profits through
future business done by its human capital with the clients. The difference between the
market capita1isation and the economic net worth is called franchise value. To keep up
the franchise value, especially for times of stress, insurers tend to hold more capital
rather than less. However, they do not hold arbitrarily !arge amounts of capital, since
the higher the capital base, the higher are the capital costs in terms of dividends to be
paid. These are passed on as eharges to the insurance policyholder as loading to their
insurance premium. However, there is a 1irnit the policyholders are willing to pay for
additional security. The insurer needs to find the optimal balance between adequate
security and appropriate premium levels in order to maximise the franchise value. '06
6.2.3 Asset-Liability-Management
Asset-Uability-Management (ALM) is defined as the practice of managing a business
so !hat decisions and actions taken with respec! to assets and liabilities are coordinated.
It inc1udes the ongoing process of formulating, implementing, monitoring, and revis-
ing strategies which concern assets and liabilities to achieve an organisation's financial
objectives. Risk. tolerances and other constraints influence the process. ALM is critical
l05Raymond [see 12.03.2007]

' ' ' ' _ et a1. [see 2006. pp. 95-100]
for any organisation managing its investments in the capital markets in order to meet its
futore cash ßow needs and capital requirements.
ALM focuses on economic value. Th.e value of future cash tlows is derived in
such a way as to be consistent with market prices or using market consistent principles
methodologies and parameters. The distribution of futore asset and liability cash ßows
is taken into consideration to determine the exposnre to ALM risk. Where available,
values are derived by direct observation or by considering replicating portfolios, i.e. if
values are not avai1able, models are used. The models are calibrated to observable and
appropriate market prices. They recognise the cbanges of cash ßows and the change
of the economic value of cash fiows arising from a range of possible scenarios. In
addition, the ALM framework needs to consider accounting and regolatory values !hat
may involve non-economic considerations and conventions. 107
The m.ain traditionaI metries used 10 m.easure the exposure of economic surplus to
cbanges in the financial variables are the following: 108
Insnrers monitor their liquidity ratio. They estimate the normal expected amount
of liqnidity that is requined to meet the demands of their underlying liability portfolios
for various time horizons. By taking this amount plus a margin to cover unexpected
liquidity requirements on top, a ratio can be defined which is inc1uded in the insnrer's
investment portfolio.
The airn of cash flow management is to compare the cash ßows of liabilities with
the cash ßow of assets. Changes of interest rates, including parallel curve shifts, twists,
and bends have to be tsken into consideration. The size and timing of the cash ßows
may be difficult to forecast. The insnrance company further may be challenged to find
assets matching with the cash ftow stream of its long-term liabilities, especially to find
appropriate assets to meet the investment standards in terms of qua1ity. Insnrers with
a higher risk tolerance may be in a position to accept a lower precision in cash ftow
matching standards in order to achieve their rate of retnrn goal.
Insnrers use risk models which help to calcuiate the adequate amount of capital
to maintain the given level of security. Deterministic scenario testing models project
business results into the futore. They are appropriate for eaiculating a small nomher
of sets of cash ftows, aod the results obtained are valid for these specific scenarios.
Deterministic modeling is justified in stable, long term businesses like the projection of
mortality in life insurance. If cash flows depend on future economic conditions, more
complex models such as stochastic scenario testing are used. 109
Risk is grouped into categories, mainly according to how they are managed. Similar
to supervision, they are normally categorised into financial marke!, underwriting, credit,
and operational risk. l1O
All risk categories affect the economic value of hoth assets and liabilities: The eco-
lO7IAIS [see 2006, pp. 3-4]

l08IAIS [see 01.10.2006, pp. 3-13]
l09IAIS [see 01.10.2006, p. 11]
lloIAIS [see 01.10.2006, p. 11]
nomic value is exposed to mterest rate risk, sinee it is the present value of future claims
payments. Conversely, interest rate risk affeets the mar1ret value of bonds in the in-
vestment portfolio. At the same time, these bonds are exposed 10 credit default risk.
Additional credit risk may result out of proteetion written by the insurer on credit risk
in favour of its clients. Exposure 10 man-made or natural catastrophes bears insurance
undeTWriting risk. Operational risk cannot be quantified, but may not be underesti-
mated, since it has often been the ultimate cause of company faHures. Tbe company's
capital acts as protection against operational risk related los ses. One source of risk can
possibly affect several other positions of the economic balance sheet.
The potential interdependencies among the various sources of risk require an in-
tegrated approach 10 risk and capital modeling (see figure 6.8). The combined effeet
of all relevant individnal risk exposures and their dependencies needs 10 be quantified;
figures like underwriting liabilities or asset investments are balanced and carried for-
ward. ALM takes internal and extemal assumptions into consideration. ALM models
generally are run in six steps: First, the setting of capital market assumptions includes
the general economic environment such as changes in interest rates, foreign exchange
rates, liquidity conditions, economic shifts, and possible market events. Related 10 the
business, premium levels and the stated dividendlbonus philosophy, in addition, have
10 be determined. Assumptions need 10 be relevant and reliable. Second, a stochas-
tie scenario generatoT is needed 10 develop scenarios based on the assumptions. The
stochastic processes are applied sirnultaneously for assets and liabilities. The process
is performed under 100 10 10,000 independent scenarios. The insorer gets information
about the impact on its financial position of asset allocation strategies considered and
of various new products under simulated mark.et conditions. Third, scenarios are trans-
formed by a projection model, basically acting as a financial calculator into financial
results. Fourth, these are selected and assessed by the optimizer before fifth, a series
of output data is produced. As the sixth step, a risk adjusted and market value based
analysis is following.
As a result of the process, the probability of the company's profit and loss can be
derived. The distribution of data contains all the ex-ante information on how the random
behaviour of the performance of the insurance business and investments may affect the
economic net worth of the company. Based on so-called summary risk measures, the
entire probability distribution can be condensed into a single figure. The report contains
risk measures like the mean, standard deviations, VaR quantiles, ES, all describing a
performance corridor resulting from the scenarios. 11l
As described in chapter 6.1, VaR and ES are widely-used sununary risk measores,
since they allow 10 specify the amount of capital required to ensure a desired level of
security. Hence, 10 express its risk tolerance, the required capital could be defined as
being equal 10 a multiple of, for instance, 1% VaR or I % ES of the overall portfolio. If
the insurer holds the defined amount of VaR equivalent capital, it will be able 10 with-
stand a loss ofthe size ofthe once-in-1OO-years loss. With the ES equivalent capital, it
llIZwies1er [see 2005. pp. 122-127]
6.2. INSURERS AND RElNSURERS AS SPONSORS 171
.J1:1-rc;\
'-_'_"_"_·C
"'_'"_"'---.JI Li I'rojr<liun \ludtl
_ rOCt~n ",h.n~t .alt>

_ 'nn.tion
_ <,,,,,"1 n... ~" <ondi,ion,
- d""tIQ~m"l "r,.lori"
- .m"onl ud ,...,"tri'l oftbin"
'nl". , 1ibo,int" 1"'1'<))

. ~"miom I.. d,
_ nt~ bo,int" d,,-.. ,II,m,n' Sr.;<> 01
- . ... in,"<>lmt."
_ di,id,ndll>o no, , o.~ l u, ,h.nn~
-"""o •• n«
L-'"--'- " ---,I
""-'-- ~ _ h. lon« ,ht."
- pmrol .nd 1.-." ,1.I,n"nl,
. ,um,,," n,~ m.. ,o...
Bascd on: Zwiesle •. lIan ... luachim. A,scI-Liabilil)-.\ bnagcmcm. in: Sp",mann an<! Bamlx·rg.
Vorsicherungen im Umbruch. Sp.inger Verlag. Berlin 2005_ p. 121
Figure 6.8: Basic ALM model for insurancc companies
will be able to absorb a loss of the siz.e of the average loss occurring with a frequency
of less than once-in-lOO-years. By comparing the available amount cf capital (being
the economic net worth) with the requircd amount cf capital (VAR or respectively ES),
the adequacy of the insurer's capitalisation can be established.
YaK and ES measures an: bascd on extrapolation of past cxpcrience, which is not
necessarily representative of systemic risk. They have limited ability to accurately cap-
ture what may happen in exceptional circumstances ar extreme events.
The main challenges far insurers an: the COII'CCt choice of the assumptions and exact
interpretation cf the results. Internal assumptions bear the risk. that decisions cf the
management, e.g. surplus sharing policy, are anticipated, which may finally be taken
under different conditions in the future. ll 2.
Therefore, the implementation cf tkcision mies is cf tey importance: The company
must have a clear concept how it intends to behave under the different market condi-
tions, since the quantitative risk model cannot be a surrogate for management decisions
and common sense. Back testing is necessary in order to compare the assumptions and
projections with the results ex post
Stress km can also be used by insurers to identify and quantify the impact cf dif-
lUzwiesler [see 2005, pp_ 122-123]

ferent stress scenarios on the financial condition of the company. They are used to
cross-check the plausibility of the model used. Based on simulations, future expected
cash ftows under various scenarios are calculated. By constructing many possible sce-
narios, the outcomes result in statistical distributions. They reflect the risk exposure
in the portfolio of an insurer who, by studying the results, can evaluate different ALM
strategies. While sensitivity tesling examines the effect of changing just one or a few
variables, scenario testing may go beyand deterministic scenarios, e.g. inc1uding the
modeling with reference to severe bistorical events and to risk databases. The test must
be appropriate 10 the activities of the insurer, taking the c1asses of risk underwritten, the
level of risl<, the distribution systems, the investment policy, operational systems, and
controls into consideratioD. Stress tests cannat predict what will happen, but are useful
to examine what may happen in the future. With the results, insurers are able to manage
risks and maintain adequate financial resources to dea1 with them. 113 114
The tesling of ALM therefore includes risks arising from assets and liabilities. Apart
from liability risks these consisl of markeI risks and liquidity risks. Market risk is
the impact of the financial condition of an insurance c0n3pany due to the following
reasons: 115
• a severe economic or market downtum leading 10 interest rate movements

o price shifts within assel classes of the entire portfolio
o inadequate valuation of assels such as real estate and bespoke derivatives
o currency devaluation effeets on the portfolio
• any mismatch of assets and liabilities, also reinvestment risks

o a dran3atic change in the spread between a markeI index of rates and the risk free
rates
• non-linear market moves between sectors resulting in non-linear effects on values

o effeets of downgrades and changing credil spreads on assel values
o the impacl of interesl rate changes on the potential exercise of options embedded
in insurance policies
Liquidity risk, defined as the possibility that the insurer will be unable to meel bis
obligations when due, has to be examined. It may resulI from: 110
o thc mismatch of assel and liability cash flows

113IAIS [see 01.10.2006, pp. 12-13]
114Zwieslcr [see 2005, pp. 125-126]
115IAIS [see 01.10.2006, pp. 12-13]
116IAIS [see 01.10.2006, p. 12]
• ehe inability to quicldy liquidate assets al fair and reasonable prices
• a liquidity shortage because assets cannol be sold, since !hey bave been pledged
• the insurcr having to withstand sbaIp, unexpected outllows caused by high claim
payments, or an unexpected drop in cash inllow from premium,
• Ibe in.urer not being ,uccessful to reduce large asset position, in time and prob-
ably al high costs because of difficoll markeI condition, wilb an environmenl of
low liquidity
Duration and convexity are important measures of interesl rate risk for fixed incorne
securities and interest bearing liabilities. Duration is a measure of sensitivity of an asset
to changes in inte:rest rates, while convexity measmes the rate cf change of the duration
wilb respect to Ibe interest rate. To meel Ibe objective of immunisation of a portfolio,
Ibe presenI value of the asseIs musl equal Ibe presenl vaJue of Ibe liabililies. Furthet, Ibe
duralion of the assets and liabilities must be equa!. FinaJIy, Ibe convexity of Ibe assets
must be greater than !hat of the liabilities. 117 11.
DIgressIon: DuratIon and convexlty

Tbe duration concepl developed by Frederick R. Macaulay in the 193Oie, explains the
inftuence of the changes of interesl rates on the value of fixed incnme securities: 119
First, the Macaulay Duration formula provides Ibe weighted average maturity of
the discounted cash j/ows of abond:
D = ~ time to ooshflow x pruent valuc: 01 ca." ffow
M L..J pr'ce 01 the band
,,!& ~ !1n±!!
DM=1"X~+2X (lV) + ... +nx~
""'
L.J
txG +~
... xM
=
(1+0)1
DM &_1 V
DM = f: (PV~CF.
t=l
X
V -- f: ..!m..-
t=l ll+iJ-
where:
DM = Macaolay Duration
G = coupon vaJue
M = maturity par value
t = time to maturity
1171AlS [see 01.10.2006, pp. 9-10]

lUIpreokcl Cl aJ. [lee 2006, pp. 95-100]
1I9Schulte and Horscb [sce 2004. pp. 203-208]
n = number of cash flows

V = bond price
i = required market (discount rate)
CF = cash flow
Tbe following example (see lable 6.7 and figure 6.9) explains the methodology in
practice and the terms used in the formula ahove. Suppose we are dea1ing with a EUR
_:
100 mln bond that carries a coupon of 8% having a remaining life of 5 years. Tbe mar-
ke! rate (discount factor is 10%). Tbe Macaulay Duration ofthe bond is 4,28 years:
Term: Paymenl: PV PV PV Duration

Paymenl: IPrice: yoars:
(1 + i)' .&.v
y (1+!)1
CtandMt mar~et tla!ue
... x t
1 8.00 0.90909 7.27 0.07866 0.07866
2 8.00 0.82644 6.61 0.07152 0.14304
3 8.00 0.75131 6.01 0.06503 0.19509
4 8.00 0.68300 5.46 0.05908 0.23631
5 108.00 0.62090 67.06 0.72572 3.62854
Sum MarIret Value - 92.42 1.00000 4.28165
Table 6.7: Calcu1ation ofthe duration of a straight bond
Tbe Macaulay Duration of the bond is shown in figure 6.9. It is determined by the
following factors:
• the remaining lifetime of the bond (the lower the remaining life, the higher the
duration)
• the coupon (the higher the coupon, the lower the duration)
• the market rate to discount the payments (a higher market rate leads to a lower
duration)
Portfolio durations DM P are calculated by the weighted average of the Macaulay

Durations of the single positions DMa. It has to be taken into consideration that the
concept assurnes one discount yield for the fixed incorne investments, regardless of their
tenn:
n n
DMP"" L: DMa x G. with L: G. = I
a=l a=l
where:
DM P = Macaulay Duration of the portfolio
G. = Share of marke! value of the single asset a of the portfolio
D Ma = Macaulay Duration cf the single asset a

0= oumber cf single assets a
Second, the Macaulay Dnration can be used to show the price elasticity of a band, i.e.
the percental change in the price of a bond in relation to the percental change of the
discount factor i.
w X (\t~) and V = L.J

D M = 6(H~) ~ (I+i~'
CF
t=1
_ w (1+i) _ ~ ~ (1+i)
D M - 6{1+i) X v -
,-,
L.J - t (1+i}t+1 X v
D M -- ~ -tx (C~~.
L.. l+i x \1-Fij
(Ho) XlV
t=1
n (0'..
DM=E-tx~
t -t
t=1
{P~CF.
DM =
,-, X
Cash Flow and Duration Balance

loo F======t'lR
5 0 ~----------~
O ~1~~2~~3--~4~
, ~5~O';"~"~"'~"'~'"~'1
a . Nom illal I
Flgure 6.9: Duration of the sample BUR 100 Jxmd
The formula above results in a negative value: As the market rate (yield) decreases, the
duration increases, since the factor gets tower. The duration is not constant, it docreases
during the lifetime of the Jxmd and changes due to cxternal factors. Thc calculation is
linear and does not tae the conye;rity cf the bond yietds into consideration. Therefore,
the Macaulay Duration overstates the price sensitivity (see figure 6.10). Yield changes
abow 1.5% and calcu1ations for bonds with lang lifetimes result in improper values.
Furthcr. thc duration is not fcasiblc for bonds with implicd options since thcir sensitivity
to interest changes is not calculated.
oi <0 Si = 0 oi > 0
Figure 6.10: Approximation error ofthc Macaulay Duration
Modißed Duration was introduced by John R. Hicks in 1939 as a method to refine

the cak:ulation of the price sensitivity of a bond for a one basis point change in yield as
follows: 120
(1) Sensitivity fonnula:
5V = -~ X DM X V x 6i
(2) Modified Duration is defined as:
MoD = (li.) x D
W = -MoD x V x öi
120Sclmlte andHorso:h [IR2OO4, pp. 209-214]
Supposed we are dealing with the bond in the .bove example with • market value
ofEUR 92.42 and. M.caul.y Dur.tion of 4.285. The bond will lose EUR 1.98 ofits
value when the interest rate rises by 0.5%:
8V= -MoD x Vx 8i
8V = -4.285 x EU R 92.42 x 0.5% = -EUR 1.98
When 8i = +0.5%, the value of the bond will be EUR 90.44; when 8i = -0.5%,
the value of the bond will be EUR 94.40. There is • positive coherence between the
dur.tion and the risk of rate changes, i.e. the higher the dur.tion, the higher the risk.
Characteristics and usage of the Duration Concept

Duration can be categorised as a tool to measure sensitivity rather than risk. The risk.
is determined by the sensitivity of the Modified Duration and the change of the market
yield, the risk factor. Knowing the sensitivity of the assets and liabilities enables •
financial institution to manage them.
A 30 year tenn life insurance contract with a guaranteed minimum return is com-
parable with • zero bond. Since there are no interest payments over the lifetime, the
duration is 30 years. The insurance company may further have obligations and loans
with • variety of different durations. The portfolio dur.tion of the liabilities forms the
benchmark for the strategie investment decisions of the company. The assets principally
consist of bonds and real estate assets, again, with different durations. The m.easure-
ment of the durations helps to get. matched asset-I.bility structure.
The insurance company may furtber hold positions with market risk depending on
the development of short term interest rates. The calculation of the duration of the
assets enables the company 10 set up tactical hedge positions with derivatives to seeure
the value of the assets.
Duration h.s • clear focus on the yield changes. It is rel.tively e.sy to calcul.te
and can be used to assess portfolios of assets and liabilities. The deviation between
real yield changes and duration based yield changes exists, but is rather marginal for
trade.ble bonds (especia1ly if the problems c.used by the complete registration of all
assets and liabilities are tsken into account).121
6.2.4 Hybrid bonds and risk securitisation

Hybrid issues
Hybrid bonds are designed with characteristics of both: debt and equity. They are
intended to provide protection to the issuer's senior note holders. According to the
l2ISpremann andBamberg [see 2005. pp. 133-160]
definition of the NAIC, they are securities whose proceeds are .ccorded some degree
of equity treatment by one or more of the nationa1ly recognized statistica1 rating or-
ganizations and/or which are recoguized as regul.tory c.pital by the issuer's primary
regul.tory .uthority. [22
Tbe regul.tors differenti.1e between two types of c.pital: TIer-l capital has no
maturity and is typically .ble to .bsorb losses. It h.s no fixed costs and ranks for
rep.yment upon winding-up after all other debts and liabilities. 11er-1 capital includes
share capital and shareholder's reserves. Further, it includes perpetual non-cumulative
preference shares and innovative Tier-I c.pital (deeply subordinated instruments with
a potential conversion into non-cumulative preference shares).
According to EU rules, innovative Tier-I c.pital is limited to 15% of total 11er-1
capital. TIer 2 capital includes forms of c.pital which are perpetual but cumul.tive,
where inlerest p.yments can be deferted but not waived (Upper Tier 2). It also includes
d.ted debt where fixed service costs cannot be waived or deferred (Lower Tier 2). Ac-
cording to EU rules, an insurance company must not cover its capital requirements with
more than 50% of 11er 2 debt, including no more than 25% of Lower 11er 2 debt. [23
In the USA, hybrid bonds emerged in 1996 when the US Federal Reserve Bank al-
lowed trust preferred securities (TRUPS) issued by US bank holding cornpanies to be
included in Tier-l capital. TRUPS are cumulative preferted instruments issued by bank
holding companies through. wholly-owned SPV, usually. trust. Tbe TRUPS are sold
to investors, and the proceeds are used to buy subordinated bonds issued by the bank
holding. The favorable treatment of TRUPS was based on the deeply subordinated sta-
tus of the underlying securities, the ability of the issuer to skip coupon payments, and
the long final maturity of the securities, miuimum 30 years. Tbe products are attractive
for issuers, since they get equity credit by regulators and rating agencies while min-
imising the cast of capital. Issuers get a debt-like refinancing at lower cast compared
to a share issue. Furiher, the issues get debt-treatment by lax authurities (Le. inler-
est payment is Iax-deductible business expense in contrast to dividends on preferred
shares which are non-lax-deductible). Hybrid proceeds are used for different activi-
ties like acquisitions, stock buy-backs, capital expenditures, and for pension liability
offsets. From the year 2000 on, several institutions issued TRUPS which were pooled
into CDOs. As a result, the market volume has grown dramatically and has become
• siguificant souree of c.pital for stuall and medium sized US banks. According to
US regulations, up to 25% of a bank holding companies 11er-1 capital may comprise
TRUPS or direct1y-issued preferted stock. TRUPS have also been issued by insurance
holding companies. l24 125
Tbe hybrid market has experienced strong growth globally in recent years. Differ-
ent lax rules and regulations enabled a wide vatiety of issue types. The pricing of the
122Regent [see 15.09.2006. pp. 133-160]

123Regent [see 25.11.2004, pp. 4-5]
124Regent et al. [see 05.04.2006, p. 3]
llSHolton [see 2008]
relevant security is affected by a number of features related to the subordination lan-

guage of the underlying bond documentation. 126 The more senior an instrument is in
the capital structure of a corporate, the more protection is there for the bondholders,
sinee the high ranking may lead to a lower loss severity when the issning company is
liquidated: Senior debt is repaid first, leaving subordinated bondholders with higher
losses. Even for bonds issued by high quality companies, this justifies differenees in
the pricing of bonds. Tbe maturity of the debt instrument and call features a!so has a
noticeable infiuenee on the level of risk tsken by the investor.
Dated bonds are less risky than perpelußl bonds, since they offen rank senior in
liquidation. Usually, the issues have call options, with margin step-ups if they may not
be called after the agreed non-call period (5 to 10 years). Call options give the issuer
the right, but not the obligation, to repay the debt. Tbe step-up is a strong incentive
for the issuer to call. If the bond is not ca!led, the interest coupon increases. If interest
payments are suspended, bondholders may at least be able to claim accumulated interest
at maturity, even if this may be 10 to 15 years away. The situation could be less clear
with perpetual issues without a fixed maturity date. The market prices most issues to
the call date. Tbere is a strong expectation that they will be called at time. l27
Tbe level of structural subordination is important for the risk tsken by the investor
and therefore infiuenees the pricing of the debt. Tbe creditors in a pure holding company
issue are subordinated to creditors in operating subsidiaries, since for the service of debt
they rely mostly on dividends upstreamed from subsidiaries. Since the subsidiary's debt
is closer to the operating cash flows and assets, the holding company debt is structurally
subordinated. 128
Nearly all bonds issued include an interest deferra! provision, enab!ing the issuer to
defer interest payments without triggering adefault in times of stress. This is in !ine
with EU directives that proceeds of a subordinated debt issue are admissible in the sol-
vency margin and that the insuranee undertaking must be enabled to defer the payment
of interesl. Darnien Regent has introduced an eight step ranking of the deferrailan-
guage of subordinated bonds, ranging from debt-like and cash cumulative instruments
to instruments where unpaid coupons may be cancelled (see table 6.8).
In a stress scenario, the weak interest deferra! wording is more likely to result in
spread volatility and falling bond prices. Bondholders could rapidly question whether
the issuer is able and willing to pay interest in a timely maoner. Further, regulators may
press the insurance company to suspeod payments, at least temporarily.l29
Duriug favourable market conditions, for instanee in the beginning of 2007, insur-
anee companies issued deeply subordinated debt, includiug mandatory coupon deferrai
provisions based on accounting tests. In stressed market conditions, the sponsor's COD-
solidated eamings are related to its capital position, and issuers may be forced to defer
12'Regent [see 04.01.2007, p. 121

127Rcgent [see 09.01.2006, p. 12]
1"Regent [see 04.01.2007, p. 151
12'Regent [see 04.01.2007, p. 141
Category: Hybrid ])pe, 1)picaI defernd strocture:

A No interaIt deferrallanguage TheIe is no intcrcst defenal provision. Not
payiDg coupons on time therefore leads to a
defanlt The instrument is as close as it gets to
a senior bond, but in thc cvent of a liquidation.
ia subordinated to senior debt.
B DeferraJ. liDked to a breach aI. Intcrest dcferral is only possiblc - er manda-
the miDimum solYmCJ ratio tmy - if thc issucr or thc guarantor of the in-
strument has breached minimwn capital re-
quirements. Since insurance compaoies C8n-
not operate when they are in breach of sol-
vency minima, thc risk of interest deferral ap-
pears 10 bc low.
C De:ferral Unked to • breach of • Interest deferral is possible - or mandatory
scivenc:y threshold bigher tban - if the company is in breach of a solvency
the regulatory minimum, or 10 threshold higher than tbc regulatory mini-
an IICCOUIltiDg _
pa- tho""'''''''''_
ID.D.JD, which is a morc likcly !ICCIllIrio than
B. AIrears of intercst llCCIlIIl1llatc and are re-
......,
payable in cash as soon 118 solvency rcaches
D OptiODal 1be issuer has 1he option to suspend coupon

liDked to the paymmt aI. a payments until shareholder dividend is paid
_
..- pa-
lIIum!bolder divideDd. Arre111'5 again. Arrean; of interest accumuIate and arc
01 interest are 1ett1ed in cash. repayable in cash. Investonl are given Iittlc
These instrameDU are CIIDlD- protection, since dividend payments Ire likcly
.. -
latiTe and the lauer does not to be suspended at early stages in die case of
need 10 iuoe equlty to Idde stress.
E """'"
0pti0DaI ~, Dcferral language similar to D, bot instru-
liDked to the payment 01. a ments are not cumu1ative in cash. AIrears of
""""""- interest are settled wi1b. an additional. equity
settled wlth eqaity issuaDce issue, and not with cash resources. Tbere may
bc cxecution riJks regarding tbe capital issue.
and the oompany may bc unable In reise addi-
......
tional capital in times of stress. Coupons may
F ....,.-~ ...
accotIIlting tesII, bat mo.dly CD-
then be lost.
~. ~ OI coupons is Iinked to eaming
andIor to changes in capital position. Tbc is-
malative for Investors suer is foroed to dd'er coupons er to raise ad-
"""'" .......
w_ ditional cquity er alternative capital.
-
G CouPImII paymcnts are lost and th=fon: do
coupoDS are lost iD smne or aB not accumnlate. Instruments O18y or O18y not
""'" contain mandatmy defmal provisions based
on camings and change! to capital position.
H MaDda....,. tri..... The instruments are non-cumuIativc; missed
AND non-eumulative Ceature!l coupoIlll are canccUcd er lost. Mandatory Be-
counting triggen put thc issum: into a position
that it may not be able to prevent 1he loss of
the coupon, if breached.
Sourcc: Regent, Dmnien, Credit Research: European Insurance, UBS Investment

Bank, London, 05.02.2007, p. 6
Table 6.8: UBS's eight caregories of coupon deferrallanguage

coupon payments or to raise additional capital in order to be enabled to pay Ihe coupons.
The key drivers for sub-debt market growth have not been Ihe regulators, bot 1he rating
agency models granting higher equity credit in 1he calculation of geating ratios to Ihese
types of bonds,!30
Issuers, in consultation wilh investment banks, stmclure hybrid debt in a way lhat
Ihe rating ageneies will view Ihem as significantly equity-like. The ageneies judge 1hree
general characteristics: 131
• Maturity: The longer the better. The issues are compared wilh equity which has
no stated maturity. The equity consideration for a ca11ab1e bond will be higher,
if it includes a rep1acement language in Ihe documentation specifying Ihe tenns
of replacement or even a1ready inc1uding a contractual obligation, (hybrid issues
can run up to 60 years).
• Non-payment: Slwuld not constitute adefault. Dividends on equity are not guar-
anteed. Mandatory deferra1 provision is Iherefore granted higher equity credit.
• Subordination: Needs to be below senior debt. Hybrids should ideally be subor-

dinated to all existing creditors similar to Ihe loss-absorbing featore of common
equity.
The five-scale c1assification of hybrid bonds by Moody's and Standard & Pool's
wilh Ihe relevant corresponding equity credits is shown in figure 6.11:
Insurance linked securitisation

The introduction of integrated risk and capital management, especially wilh Ihe imple-
mentation of Solvency 2, is expected to increase Ihe demand of reinsurance cover. The
most important changes in terms of the risk. environment of the insurance company as
cedent of risk are 1he following: '32
• the integrated monitoring of business lines
• the inc1usion of non-actuarial risk. components (e.g. financial risk on the asset
side)
• Ihe inc1usion of off-Ihe-balance-sheet risk (e.g. political risk)
• 1he standardised valuation of assets (hidden reserves will partially disappear)

• Ihe standardised valuation of reserves (loss equalisation funds will become equity
and will disappear)
'30Rogettt [see 04.01.2007, p. 16]
131Regentet al. [see 05.04.2006, p. 16]
132Renggli [see 09.11.2005. pp. 8-9]
_ LI -----'S_&e''--------'
-
.....,
.,.._..,l"..,.,,_
c_~
C.... ... n._....-.. .

....,,,. ........
~_
h • ..-........, . . .- _ _
""".,..-.
"-
" , _ , - " , , , '0, __ .. _
... _ _ 'b .....
.'.........
,_ ' ~""~
T' .... _ _
... p<t"'--
'F.qU>'Y<r<d" d ...,f",.. "", .nl< r", Mooo.,I) • ..J S&r.

.- ""... _-~ ...
J"""'" ..""'", ...... _ >«<1<,"" ~ I1h ,m<=O <l<f"",1 ""'."".
' c ..... , NOO .... 40 y"" (0 bO )'eor
_--
Soo,,,,, Regen •. [)aol1lcn. Credu Rcscar<h 11) bJ1d I',,,ner. UIlS In'csun<m Il",,~.
1.00don. OH'-I2006. p 7
Figure 6.11: Classification ofhybrid securiti.es by Moody's and S&p's
The process is expocted 10 result in an increase of the volatility of some ba1ance shoet
positions. Otherwise, the integrative approach will havc a smoodllng dfect, intcma-
tionally diversified multi-line companies will be in advantage of national companies
and monoline msurers. Ccdents will be interestcd in risk transfer products with the
following specifications: 133
• products with multi-line or even holistic cover
• multi-year products to be able to withstand cycles
• products wbich do not completely Dse up the reservc lines held by the rcinsurcr
_ou=
• bcspokc products. improving the "follow the fortuncs" among the ccdcnt and the
Insurance soclttitisation seerns 10 be the ideal product according with the noeds of
the cedent. In addition, the cover providcd through securitisation lowers the sponsor's
tnRmsgli [see09.11.200S, pp. 11-9]

cxposure to counteIparty risk. againlrt its rcinsurance providcrs. Thc different types of
securitisatien havc alrcady been described in chapter 5. Figure 6.12 summarises thc
critcria rcgarding ILS from. thc cedcnt's pcrspcctivc.
T )'p~s of I nSur" not l. inkf1l S ~Curi!its
P''',n,i •• \I",i, .,ion eh ....... i;'i., ,\pp'i,.'ion

Ilolanc< Sl>t<l Manag<m<n, • [m,I<O' ,o.","n g ofhqu,dllJ • [mbolldtd ,a lO< S«u"'ISO"",,
• !."IU,Ulil • OfT·bo '.n",,-!ihe<, '''\Ic'u 'e (hfe In,,,ra,,,,,,)
• rran,f""".",," of ,Ihqu,d • S"e of tc-IIISur."". "'''''" .... k:s
,mo liqu,d .. "-~.
C.pllot Man~emc"l ' • ') 1""" )'"~ be,"",," ",~. ar;j • r"plc·X SC<,,"'' ' ' ' '
Mb 11f"S<.c ""wie",,,,," , <ap"'11 oo>ode,."",,,
• A,blt",ge be1\lCO" ",~.
8<lcqu.'. '''P"al "", .... g< ar;j
re&u l"'O<) ''''lU ,ren"",!>
• Rorogn""'" as",k ,,,,,,,fo'!»'
."" ',&ul"'O<)' ......... ,,""'
Ri,l Manag<m<n' • Cos' "" '"&' • C.... lfopho ><ouflti""i""
• I""",OS<: of '..,a<:IlJ'
• l.<>ngcr l<:m" ,bon «'ns"","cc
I'onr~l i o Man.ge..,.." • l'h J"':'"," aga in" an adwrso • Se<u"""",",,, orhigh.
...., dc".klpn",o, f,,,,,,,,,oO)" """""011') mk
Sou""': S'ahlmann . Ben. Te ll er. Niool." Weid", .\IOgliohlei'en biN<" die Ve rsicherungs.
,erbriefung rut die beleiligten I'an~icn'·. in: Krcdilwcscn. FranLfun 2007. p. J I
Figurc 6.12: Sponsors' criteria regarding ILS
The business models of insurers are evolving towards thc management and intcnncdia-
tien of risks: Risks are taken from. the policyholder. poolc:d, structurcd, and cxtemaliscd
through :reinsurance programmes or transferred to thc financial markets via securitisa-
tion. Pre-conditions for this process are an cffective diversification supported by thc
risk managcment and a moderate amount of capital. Further. a well functioning ALM
most be in place in order to handle thc cash fiow Streams. l34
Securitisation is further used by the insurance sector as an effective tool to achieve
a grcater diversi:lication in assct sources or to tap ncw investor groups. The liquidity
attracted through thc creation of tradeab1e securities may be employed to finance future
new business generation or co-finance acquisitions.13S In a demutualisation process the
nced for funding is acute, and in many cases securitisation solutions were favoured.
The increasing importance of capital management, especially in the EU, may be an ad-
134-~ [see 27.05.07, p. 4]

I"Wa!bof etal [eeOl.ll.200S, p. 7]
ditional driver for securitisation. 136 Securitisation can help to res1ructore and manage
the balance sheet and to sustain solvency relief benefits. Even if regulatory capital re-
lief is not granted, the economic capital of insnrers may be released, and they further
benefit from the process, since they want to be seen as heing active in a market which
is perceived to be innovative. Tbey like to ensure that the company is able to build an
alternative to traditional reinsurance. 137 138 Tbe products may be used further as risk
management tools to manage the matority mismatch between assets and liabilities. Al-
though costs for securitisations are high, they can increase the underwriting capacity at
lower cost compated to the issue of additional equity. Traditional reinsurance premi-
ums lIuctuate cyclically. Since securitisations are structured as multi-year transactions,
the cedent is able to fix the cost for a number of years instead of closing reinsurance
contracts for one-year periods only. In the context of portfolio management, existing
risks in a specific sector can be reduced via the transfer of risk - securitisation provides
protection against adverse developments. 139 140
Securitisation creates the possibility of separating the insurance policy origination
function from the investment management and risk beating functions. Tbe instrument
is cleaner and quicker than traditional reinsurance, since the trigger event is usually wen
defined and the payment in case of the loss event is due on first demand. Compated to
traditional reinsurance, there is no timing risk because of a potential delay in payment
in case of any objections by the obligor.'4'
6.2.5 Results of the interviews regarding sponsors

Regarding the acceptance of ILS products, one has to differentiate between reinsurance
companies, bigger insurance conglomerates, and smaller insurance companies. Further,
one has to differentiate between strategie issuers coming permanently to the markets
and opportwristic issuers which temporarily take advantage of attractive marke! envi-
ronments. 142
Drivers
Leading reinsurance cornpauies usually have their ILS programmes in place. Due to
their sophisticated internal models, they feel comfortable to bear the basis risk and
therefore are able to s1ructure transactions with indemuity, modeled loss, or paramet-
rie triggers. 143 The intention is to increase capacity as weIl as to transfer risk to the
136FSA [see 01.05.2002, p. 51]

137Stahlmann and Teller [see 2007, 17]
138FSA [sec 01.05.2002, p. 50]
139Walhofetal. [see 01.11.2005, p. 7]
'''''FsA [see 01.05.2002, p. 49]
141FSA [sec 01.05.2002, p. 50]
142INT_I_MOD [19.08.2008]
143INT_I_MOD [19.08.2008]
markets. Reinsurers normally lever 1heir capital base 4-6 times. 111erefore they are
interested in diversifying their portfolios internationa1ly and among perils in order to
protect themselves against concentration of risk. 144
The bigger insurance conglomerates also use ILS transactions in order to diversify
their capital source.'45 In Europe, the activity of primary insurers depends on their
business: Allianz, for instance, was acti.ve in catastrophe bonds, while AXA introduced
the transferted of motor risk to the markets. 111e life insurers Aviva and Royal & Sun
Alliance further announced !hat they will use lLS as part of their capital strategy.l46
While smaller European insurers and mutual players are rarely seen on 1he market
as sponsors yet, their US peers regularly plaee n..S. 111e reason for 1he evolving of US
transactions was the lack of capacity in 1he years 2004 and 2005, causing 1he insur-
ance compaoies to search for alternative capacity and lower, stable pricing which they
found on the lLS market. 111e PeS index helped to establish parametric n..S in the USo
European primary insurers rather favour indemnity structures, since there is almost DO
difference to the reinsurance protection they are used to. 147 There have been phases
of hard mark.ets, when primary insurers were dominating the issuance activity because
reinsurers were writing their business restrictive at high rates, and weak market phases,
when reinsurance sponsors dominated the issuance activity.l48
In Europe. mutual insurance companies are expected to become interested after the
introduction of Solvency 2, since 1hey will have to intensify their ALM.14.
Sponsors have been attracted to lLS for several reasons, and several drivers of the
market today were mentioned:
Pricing: Wben lLS started after 1he Northridge Earthquake in 1994, 1he market
needed a jump-start pricing for the first issue by USAA. I50 Today, sponsors will be
interested in 1LS, when the costs of the structures are lower than the yield they have to
pay to equity holders. 111e return-on-equity after the p1acernent of a transaction should
improve by a minimum of 0.5% to m.ak.e the issue attractive. 151
Diversification of reinsurance source: Sponsors are interested in a broad capital ba-
sis to prntect themselves for times when capacity is short. I '2 It was stated !hat. regarding
non-life, compaoies purchasing coverage of more than USD 400 m1n should consider
lLS as an alternative, especially for 1he higher layers and remote risk. 1S3 Primary in-
surers, through ILS, get the possibility to sponsor risk transfer transactions without the
144INI'-4-BNK [04.09.2008]
14SINI'_1_MOD [19.08.2008]
146JNT_23_BNK [28.10.2008]
147INI'_1_MOD [19.08.2008]
148INI'_20-BNK [20.10.2008]
149INI'_1_MOD [19.08.2008]
150INI'_12-INV [14.09.2008]
lSIINI'_26-INV [29.10.2008]
152JNT4-BNK [04.09.2008];1NT-7-REI [08.09.2008];JNT-I4-SUP [19.09.2008I;JNT-15-RAT
[22.09.2008]
lS3INI'-4-BNK [04.09.2008]
involvement of reinsurers at all. ILS as an alternative may enable them to put pressure
on reinsurance when negotiating the terms and pricing for their cover. 1S4
Multi-year prieing: Closely linlred to the diversifieation argnment is!hat sponsors
bave the ability to lock in multi-year prieing. Especially in traditionallife reinsuranee,
the market for long-term eoverage up to 40 years is rather limited. 155
Througb the issuanee of 1LS, sponsors get independent from the vagaries of the
fast-ehanging reinsuranee prieing cycle. 1So
Collatoralised natnre of the product: Sponsors do not bave to he coneerned about
the eredit risk of the eounterparty.157
Clean payout mechanism: From day one, every party in the process has agreed to
the method for triggering the bond, no matter wbether it is indemnity-, modeled-, or
index-based. This means that there is no time delay and limited litigation risk. 158
Rating and repotational effects: Tbe sponsor, through the involveroent of the ratiog
agencies in the process, ean prove to the market !hat he has a functioning enterprise risk
management His eompetitors are getting aware of the ability of the sponsor to struetnre
an ILS transaction. 159
Regulatory enviroornent: Sponsors in the US life sector got attracted to ILS through
the introduction of XXXIAXXX regulations. Tbe eapital reqnirements suddenly were
so bigh !hat there is an exeess that ean be securitised and arnortised. Solvency 2 may
favour already establisbed structures like mortality catastrophe bonds, the monetisation
of future premiums, or struetnres wbieb eash out expected futnre profits. l60
Ob.tael..
In many cases, especially in the life sector, the management is rather reinsurance -
oriented. Wbile CFOs usual1y are in permanent dialogue with banks and some of them
worked in banks hefore, CEOs usually have their rools in insuranee and maintain close
eontacts to reinsurers. The person promoting ILS internally may run a career risk by
introducing new reinsurance structures. Tbe organisations' mindset may have to be
ehanged, people have to bave some vision and strategie perspective to buy into the
ideas of ILS. 161 There is a certain amount of insecurity of sponsors putting too much
stake into ILS, sinee they need to maintain long-term relationsbips with reinsurers as
weil.
Not evetybody in the insurance sector has been convinced that it is in the best inter-
est to invite the broader capital markets into their tetritory.l62
"'INT-22-BNK [27.1O.2008]:JNT-23-BNK [28.10.2008]
15SINT_2-BNK [02.09.2008]
"'INT-4-BNK [04.09.2008];INT-15-RAT [22.09.2008]
157INT-16-REI [23.09.2008];INT-2-BNK [02.09.2008]
'''INT-2-BNK [02.09.2008];INT-4-BNK [04.09.2008]
"'INT-2-BNK [02.09.2008]
160INT_28_ASO [03.11.2008]
161INT_27_BNK [29.10.2008]
1O'INT-19-ASO [26.09.2008]
Hard markets may be the right timing to start with multi-year ILS. However, de-
spite the benefits an ILS structure offers, there remains a tension between reinsurance
protection and 1LS in terms of pricing.'63
Although it is not necessary !hat the sponsor is a public1y listed company, they need
to prepare the offering circular in aceordance to the strict 144A standards. Smaller
companies may not have the data necessary for the periodie reports avai1able. They
may not have the expertise and the IT systems avai1able in order to generate the his-
toricaI pool information which is necessary for the rating agencies and investors. New
reguiations corrently being discussed can be expected to require a significant amount of
due diligence procedures by investors, and they need to have aceess to sufficient data. 164
Especially regording smaller sponsors, there is a hurdle to get around the structoring
complexity of 1LS products compared to wriring traditional reinsurance which they
are familiar with. The lack of supply is holding back the ILS market from growing.
The creation of new perils and structures at attractive retums is important for keeping
the interest of the investors alive. Tune, cost and expenses have to be invested by
the sponsors in order to reward investors for deploying the resoorces and the time to
evaluate the sector. '65
Even for ILS with indenmity triggers, raring agencies do not give full equity credit
if there is basis risk involved. Sponsors therefore face higher rating agency capital
requirements than for reinsurance cover. l66
They further demand the reguiatory aceeptance of products and would appreciate a
capital relief similar to reinsurance. Tbc market is influenced by regulators concentrat-
ing on the controlling of prices inslead of allowing a competitive market. Govermnents
stepping in and e1iminaring private marke! mechanisms are seen as an obstaele. For
instance, Florida taxpayers not only pay for supercat risk which is defined as once-in-
lOO-years events, but also for cat events, which are defined as once-in-lO-years. Gov-
ermnents should be involved in a constructive way: they could, for instance, establish a
census bureau for cat damages, get uniform wind speed recording stations installed. or
create tax pass-through regulatioDs. 161 Sponsors are not ahle to reinsure terrorism risk
through ILS, since there is no model for it - the availahility of models in generailimits
the growth of the business. l68
Life 1LS in EU take time to develop - but signs are encouraging. Insurers' enterprise
risk management regording valuation of life book versus annuity book is pretty unso-
phisticated. Some insurers have a poor grasp of morta1ity risk in general, and only a
few actuaries within the organisations are familiar with the problems. In general, spon-
sors need more education. New prnducts for longevity risk transfer with indexed swaps
163INf_S_BNK [04.09.2008[:INf-ll-CON [l2.09.2008[

16'INf4BNK [04.09.2008[:INf-28-ASO [03.11.20081
l"INf-2-BNK [02.09.2008[;INf-II-CON [12.09.2008[
16'INf-I-MOD [19.08.2OO81:INf-ll.coN [12.09.20081
167INf-<;_ASO [05.09.2OO81;INf-II.coN [12.09.2OO81;INf-18-INV [24.09.20081
168INT_16-REI [23.09.2008]
versus mortality risk coverage are emerging.'69
PeriIs
Non-life products cover US regions exposed to wind risk by almost 100%, and there is
a liquid market. Califomia earthquake cover is weil establisbed, but less dernand for the
bunds is recorded. ILS covering floods have emerged after hurrlcane Katrlna. A sub-
stantial nornber of market participants regard the current discussions in the US congress
to establisb a federal flood insurance programme by the state as counterproductive. Tbe
govemment should leave as much as possib1e with the competitive private sector. Th.ere
have been ILS to cover potential earthquakes in Mexico and the Caribbean elosed by
Swiss Re. Additional European wind and earthquake exposures, also for Turkey, are
being discussed. Japan traditionally has a weil established marke! for earthquake aod
typhoon risk, and ILS have been placed for catastrophe risk in Australia Tbe market
expects substantial growth for the Asian markets, especially China.'70
Life secnrltisation offers a wide spectrurn of peri1s which can be covered. Emhedded
value curves out part of the risk for a better pricing and is the elosest product to the
c1assical securitisation of banks. 171
XXX is financing the lack of reserve capacity. Due to the deterioration of the
monoline insurance sector, alternative products to ILS are being developed. Tbey p1ace
the life insurance tail-risk to the capital market for long terms ranging from 10 to 30
years. 172 Arrangers are offering customised hedging with arc mortality swaps. Tbe
contracts are closed between the hedger. usually a life insurer or a pension plan provider,
and the end-investor. In order to limit the credit risl<, an investment bank is in between as
intermediary. Transactions effected anoong pension plans and banks can be fu11y p1aced
to end-investors. Tbese transactions are regulated by the ISDA or CSA standsrd and do
not require a SPRV. Cash flows are exchanged every month, after a new mortality report
about the portfolio is delivered. Tbe cash flows are calcuIated by adding the discounted
net value of each swap-Ieg. Tbe investor then pays the hedger the pension obligation,
while the hedger pays the bank a fixed payment including a risk premium. Tbe bank is
backed by its swaps with the end-investors. Tbe investor takes the risk !hat mortality is
less than expected. Tbe long term up to 40 years is certaiuIy a cha11enge, but is identical
to reinsurance with the benefit that it is col1ateralised - the transaction requires a daily
collatera1 exchange managed by the bank who does stochastic calcuIations about the
risk taken. Tbc transaction can be carried out without the involvement of areinsurer or
a monoline insurer. arc mortality swaps got fu11 capital release by UK regulators aod
the rating agencies. They were treated simi1ar to reinsurance. Simi1ar relief is expected
under Solvency 2. A potential delay of Solvency 2 is no reason for sponsors not to enler
'''INT-27-BNK [29.10.2008]
17<)INT-4-BNK [04.09.2008];INT-19-ASO [26.09.2008]
171INT_7_REI [08.09.2008]
172INT-6-ASO [05.09.2008]
long-term transactions, since investors get the contractual commitment \hat they may
unwind the transaction if an unexpected change of the legislation may occur. 173
Another alternative are oIc morta1ity swap structures based on indices taking for
reference a national population index rather than a block of life insurance policies. 174
Due to the uncertainties involved, longevity transactions are much harder to model
than mortality catastrophe risk. Further, a block of deferred annuities still open for new
business and starti.ng to pay out in one or !wo decades in the future, is harder to model
than a block of life insurance policies for a1ready retired people. [75
Life products are a method to recycle business. Cornpanies are enabled to write
more or acquire longevity businesses by using them. More standardisation would ease
the risk transfer in this market and would allow trading of packages. Investment banks
are interested in putting in p1ace infrastructure with more dealers if demand picks up. [76
173INf_27_BNK [29.10.2008]
1741NI'_27_BNK [29.10.2008]
17.5INI'_27_BNK [29.10.2008]
176INT_27_BNK [29.10.2008]
6.3 Rating agencies and risk modelers

6.3.1 Rating agencies' services
Rating agencies are service providers giving c.pital market participants an independent
view of the general creditworthiness of • borrower or of tbe creditwortbiness of • bor-
rower witb respect to its .bility to meet • debt security or specified financial oblig.tion,
b.sed on certain risk factors. Tbey oper.te witbout • government mandate and are in-
depeodent of any regnl.tory body. Further, tbey are independeot of any corporation,
bank, or similar bOdy.177
Tbe .geocies genera11y provide tbree types of insurance ratings: Debt ratings .s-
sess tbe ability of tbe company to repay a specific issue. Counterparty credit ratings
assess the company's creditworthiness from a general creditor's perspective. Financial
strength ratings judge the company's general .bility to meets its policyholder's claims
and its oblig.tions in time. Ratings help to address tbe information asymmetries be-
tweeo differeot groups of market participants. Tbey are .ble to compare tbe ratings
of different companies active in tbe market. High ratings play an important role, es-
pecially when buying insurance or reinsurance for longer terms. Customers buying a
life insurance contract get more comfort witb • higher r.ted company. Primary insurers
judge tbe robustoess of tbeir reinsurance "hedge" by tbe rating of tbeir couoterparty.
Regnlators justify tbe capital relief for tbe primary insurers for reinsurance purch.sed
on tbe b.sis of the reinsurer's financialstrengtb ratings. Tbe majority of tbe r.tings are
interactive, meaning !bat • r.ted company requests • rating providing tbe .gency witb
uopublished intemal information. Altematively, tbe r.ting .geocy may use publicly
.vailable information about tbe rated eotity onlyP'
Especially regarding reinsurance, rating .geocies are coromonly viewed by tbe in-
surance sector, investors, and otber market participants as tbe "de f.cto" regnlators. In
some jorisdictions, rating ageocies h.ve developed a much closer relationship to tbe
reinsorers tban tbe regnl.tors and therefore have • greater knowledge tban tbe super-
visors. Further, the agencies analyse the entire groups on a global basis, while many
regnl.tors take • local approach only. Altbough tbe rating process cannot replace an
effective prudential supervision, tbe tbre.t of neg.tive rating change may sometimes be
more effective tban supervisory analysis. Ratings enable marke! participants to quickly
obtain an overview of the financial strength of the insurerlreinsurer. 179
Due to the adverse development in many asset c1asses they were involved in, the
further need of rating .gencies was questioned by the general market. Regarding ILS,
tbey were accused for not having recognised tbe ruismatch between .ssets and liabil-
ities. FortIIer, tbey did not grant full transparency of tbeir metbodology and included
too many soft facts in their rating analysis. However, there is a common understand-
lnStandard and Poor's [see 27.09.2004, p. 9]

178Prenkel et aL [see 2006, p. 27]
179Frenkel et aL [see 2006, p. 72]
6.3. RATING AGENCIES AND RISK MODELERS 191
ing among stakeholders Ihat, on Ihe condition lhat 1heir melhodology is fully disclosed
in Ihe future, Ihey will be able to provide a valuable Ihird-party view on transactions,
knowing Ihe sponsors very weil and having detailed legal and insurance know-how.'80
6.3.2 Importance of enterprise risk management and capital for in-

surer's ratiogs
Caused by 1he catasttophe events in recent years, Ihe risk management tools and prac-
tices of 1he insurance seetor have advanced significantly. Tbe trend to holistic "enter-
prise risk management" (ERM) including eeonomic capital models, more sophisticated
catasttophe management, and dynamic hedging programmes, has increasingly been im-
pacting Ihe overall rating process of Ihe agencies. l81
AM Best has published its melhodology regarding Ihe assessment of risk manage-
ment and Ihe rating process for insurance companies. It outlines Ihe importance of
the development of enterprise-wide risk management systems in the insurance sector,
stating Ihat it is not Ihe objective of risk management to eliminate risk, but to under-
stand and manage it. 182 ERM is characterised by adding value in Ihree areas: First,
it inftuences corporate culture, since Ihere need to be clear directives established by
senior management and Ihe board. Tbe directives have to be followed up by a sttong
risk-aware cu1ture among officers and directors working on a common language and
understanding of risk. Tbere needs to be a common set of rules governing account-
ability and incentive compensation. Second, Ihe corporation needs to identify Ihe key
risks for Ihe organisation and to establish detailed conttols and procedures to manage
Ihe impact of Ihose risks on its value. Beside 1he wide variety of risk identification
and management provided by traditional risk management, ERM adds a more compre-
hensive approach. It includes Ihe deve10pment of a consistent, corporation-wide set of
guidelines forma1ising Ihe risk management activities and Ihe shating of information
across business lines and functions. Third, individual risks are managed wilh respect to
Iheir correlation. Tbe ability to consistently quantify 1he risks wilh sophisticated tools
and data-collection procedures is key to ensure Ihe data's integrity. The impact of risk
correlations on the corporation enables natural hedges across business lines. A.M. Best
is evaluating Ihe ERM wilh a detailed catalogue of sttong and weak criteria. l83
Benea1h ERM, Ihe final ratings judgement is based on Ihe company's balance sheet
strenglh, operating performance, and business profile. Tbe rating approach by AM
Best concentrates on balance sheet streng1h. Tbe "Best Capital Adequacy Rating" score
(BCAR), defined as Ihe ratio of adjusted statulory capital to required capital, is one of
Ihe most important factors in determining a company's rating. 18' Tbe adjusted capital
180Lathuillerie et W. [27.10.2008]
l!1lEasop et al. [see 25.01.2008. pp. 1-2]
182Easop et al. [see 25.01.2008, pp. 1-4]
183Shimpi [see 2007, p. 2]
1ll4Easop et al. [see 25.01.2008. pp. 3-7]
is a company's reported surplus afrer adjustments reflecting the after-tax impact Of: '85
• adding equity in uneamed premium reserves
o adding equity (discouot amouot) in 10ss reserves
o adding redundancy or deducting deficiency in 10ss reserves
o adding or deducting market value versus book value of fixed income portfolio
o deducting one oet catastrophe 10ss (the higher of a once-in-l00-years windstorm

or a once-in-250-years earthquake)
Tbe required capital is the amouot of capital !hat AM Best estimates the company
needs 10 support its risk profile. Asset, credi!, uoderwriting, and reserve risks are takeu
into consideration, while catastrophe risk is a1ready inc1uded in the adjustment of the
statutory capital. Tbe Minimum BCAR scores for the AM Best rating categories are
shown in table 6.9. 186
MlnImmn BCAR
17>
-.
A++
160 A+
145 A
130 A-
115 B++
100 B+
Source: Fleckcnstein, Micheie; et al., Rating Agency Update

Guy Carpenter, New York, 01.11.2006, p. 29
Table 6.9: AM Best: Miuimum BCAR and rating
Althougb BCAR is an assessment of capital adequacy at a point in time only, it helps 10

differentiate between compaoies and indicate whether a company's capitalisation is ap-
proptiBte for its rating level. Tbe operating performance evaluation includes the vatious
financial management practices and operating elements dictating the company's perfor-
mance and its exposnre 10 capital volatility. Tbe hosiness profile enables the analyst
10 estimate a company's ability 10 generate fotnre profits 10 optintise stakeholder value
and to strengthen its capital basis. Strong performers are companies with consistent,
sustainable earnings. 187
Fitch Ratings introduced PRISM, a methodology and model for the capital assess-
ment of insurauce corupaoies, in 2006. Fitch changed its approach by incorporating the
results of iusurers' "in-house" capital models into its ratings analysis. PRISM deter-
mines the capital adequacy of the rated company using a stochastic measnre of required
capital across sectors and counmes of operation on a CODsistent basis. The eore of the
185Fleckenstcin et al. [see 2006, p. 29]
186F1eckenstein et W. [see 2006, p. 29]
lB7Easop ct al. [see 25.01.2008, pp. 3-7]
6.3. RATING AGPNClES AND RlSK MODELERS 193
model ja an integrated economic scenario generator providing results based on 5.000

scenarios of the primary sources of risk found &cross the global insurance industry as
sbown in figurc 6.13. The system can be lUD solely on public data. Divenification
cremt is generated directly by the system. PRISM enables the user to compare the
capital adequacy of companies. for instance those of an UK automobile insurer. with
a life insurance company in France. Fitch decided to build tbe model because insuras
in Europe increasingly start to use "in-house" models which differ substantially :from.
com.pany to company. their outputs being difficu1t to compare with one-another. The
risk is primarily measmed by ES and secondarily by VaR.
,\ ggr~g~ l ~ Risk Profil.

1 1
1
,\, ., 1 1
Liabi li ly 11 ns" ranr~)
1
.' I ", ~<1 1

Ri,k
,\ 1..\1 ertd;1 1 b .d. .... ';I ; ,,~ 1I R t>"';"~
Iltt:.I.,,,,,ph.t
" 01" ..1
Ri>k
11 R i ,~ Ri, ~ Ri, ~
I~II-AI 11\- II~IIA-

- _-
1
-,..'............n'........_,.' ..................
..._, ...........
............. _...., .........
_.-, ,A_.' .-...... _...... ,......,
-_
.....,.....,
_"
_, .... " .. "'-'-
.................
....... 10 .... ' ''.
...........
" ,.,_ . ...
..... -.,.
- ".... _..,.." ..........." .........
"
......
1 .... 10';,.,10
..,..........,_. ,...,"", .. "..-, ........ .......'~ ......

.... ...;,.,'f_
. . , ",~
_ ... n .... '

,...,,. .....""
..., .."t ........... , ........ _'_M ur"
. _"-, .
_ . - . ...... b .
'· . ...... r_ _ ....
Sou ..:" I\-Iohft""."'''. lofT. <I aI. hposu'o Drall

In,u ' '''''''' CIIP.I" "",es""""1 MOlllOOolog) ."d
Model ((,"'rn). fll<h R.lI"gI. N<" York, 06.06_2006. p. 7
Ft.gUre 6.13: Rist types modeled by Fitchrating's PRISM
Fitch ca1ibratcs the simulated losses to rating standards within the fo11owing steps: First,
historical bond default rates are used u a starting point Capital requirements are allo-
cated by rating category bued on historical ratings experlence. Second. YaR tbresholds
are calculated by rating category. The target pereentile is calculated by subtracting 1 -
default rate. e.g. for a 100year horizon, if the cumulative default rate at level "BBB" is
5%, the targeted VAR to define ~BBB~ risk capital would be the 95th pereentile. Third,
the YaR thresholds are converted into ES thresholds. Fourth. the insurer's liability du-
ration is considercd. Fifth, the required capital is determined bll8ed on a comhination
of liability time horizons. The focus of PRISM is to measure risk &cross the entire CQ-
terprise. It ensures Ih.t adequate consideralion is provided to risk factors potenlially

offsetting one another. 188
Moody's .pproach, ra1her 1hao building its own model, is b.sed on "interrog.lion,
not replic.tion". The ratiog company performs an in-deplh qnantitative and qualita-
tive analysis of Ihe company's risk man.gement and econontic c.pital framework. '89
Risk management is viewed as • core competency and • critical dtiver for Ihe insur-
ance companies. Moody's publisbed 1heir detailed rating melhodology for global and
regionallife and non-life insurance companies.'90'9' Furlher, detailed guidelines in-
c1uding questionnaires exist far the assessment of risk management of life and non-life
insurers. '92'93 The output of Ihe company's econontic capital calculations is included
in Moody's overall risk management view. The c.pital strenglh ratiug is • result of
Moody's confidence in the economic capital m.ethodology used and the agency's own
view of Ihe insurer's c.pital streoglh. Important factors of Ihe analysis are listed be-
low: l94
• extent of integration of the model into the regular business and risk management
processes
• us.ge of Ihe results of Ihe model by Ihe senior management for decision processes
• future sustain.bility and extendability of Ihe model

• comprehensiveness of the risk: identification process
• exposure to extemal checking by .uditors or consultants
• c.p.bility to perform sceuarlo testiog on short notice

• whe1her Ihere is any public diselosure of Ihe results
• us.ge of prudent melhodologies, especially regarding areas of greater uncertainty
• us.ge of sophislic.ted and recoguised software packages
• availability and usage of extensive experience analysis
• evidence of consider.tions of stress-tests (hypolhetical scenarios)
• re1iance on recoguised external data or model providers where required and .p-
propriate (especially for economic scenario generation or natural catastrophe
modeling)
18!1Mohrenweiser et al. [see 06.06.2006. pp. 1-4]
189Hunisett et al. [see 01.06.2006, pp. 1-2]
190Collins et al. [see 01.09.2006]
191Perry et al. [see 01.09.2006]
151 2Geny ot al. [see 01.03.2007]
1513Bergetal. [see 01.03.2007]
1945hhnpi [see 2007, pp. 1-2]
Tbe insurer's balance sheet is regarded as a mix of sold complex loog-dated op-
tioos on both the asset and liability side. Variable annuities on the liabilities side and
mortgages or mortgage-backed securities on the asset side are examples which are sus-
ceptible to prepayments triggered by finaocial (interest rates) and non-finaocial (per-
sonal) drivers. Tbe companies just started to include the complex products into their
models. A wide range of regulatory, accounting, aod taxation regimes add to the com-
plexity of issues. In Moody's opinion, these differences are such that building aglobaI
or even pan-Europeao model would result in significaot loss of specificity and over-
simplification of the particular business being considered. Tberefore, the optimal ap-
proach in their opinion is to concentrate on thorough interrogation of the companies'
interual models.'·'
Although they decided not to develop a general insuraoce capital model, Moody's
uses maoy quantitative models for the rating process.
One model framework used by Moody's helps to understand the methodology re-
garding reinsuraoce exposure and the underwriting of natoral catastrophe risk: In order
to quaotify the various sourees of risk within a US noo-life insuraoce group aod to
gauge the adequacy of a group's resourees for covering those risks, "Moody's Property
& Casualty Risk Adjusted Capital Model" (MRAC) was developed.'·6
MRAC is a ooe-year timeframe model which employs Monte Carlo simulations,
typically 60,000 iterations, to develop the estimated probability distributioo for the ag-
gregate future performaoce of the group. Certain adjustments are made to discount cash
f1ows, e.g. for claims payments !hat are expected to stretch out over a longer period.
Tbe NAiC Annual Statements are the main souree of basic data input. For compa-
nies outside the USA, features of the model may be adapted to refleet different data
sets available and appropriate. To cstimate the required capital, MRAC simulates the
exposures in the four key areas: investments, reinsurance, reserves, and underwriting.
Tbe results of the simulations are combined, allowing for correlation effects to get ao
aggregate probability distributioo of the expected performaoce of the compaoy.'97
Tbe informatioo gained is used in different ways within Moody's rating process:
Tbe quantitative data produced about the discrete sourees of risk within a non-life in-
suraoce group is used by aoalysts to focus their inquiry and investigatioo of certain
business risk areas. Further, the information is used to establish an estimated rank or-
dering of creditworthiness among non-life insuraoce groups hased on a fairly extensive
and consistent examination of their different risks. The MRAC ratio is computed by
dividing the available capital by the required capital estimated by the model. Tbe ratio
as well as its estimatcs of default risk and expected loss for ao insuraoce group arc used
to compare the existing rating to other independent indicators of creditworthiness such
as option-adjusted trading spreads or CDS spreads.'·8
195Hunisettetal. [see 01.06.2006, pp. 1-2]

196Barker et al. [see 01.08.2006, pp. 1-2]
197Barkeret al. [see 01.08.2006, pp. 1-2]
198Heerde and Martin [see 01.09.2007. p. 6]
By ceding risk to areinsurer, the company is exposed to the risk of a shortfall in col-
lection of reinsurance assets. This is the case for both on-balance sheet and off-balance
sheet if contingent reinsurance assets were agreed. The reason may be a deterioration
in the creditworthiness of the reinsurer or his unwi1lingness to pay due to legal dis-
putes. Tbe sampie in table 6.10 shows that MRAC applies higher charges and staodard
deviations to reinsurance recoverables from companies with lower ratings.
""""" ......... s_ _
Aoa
..... ' 1%
S
1%
Aa 2% 2%
A ,% ,%
Bu 10% 10%
All othcr ratings 25% 25%
Source: BaIkcr, Thomas; Cl al., Moody's Risk. Adjusted Capital Model for US
Property & Casualty Insureu, Moody's Investor Sernce, New YOIk. 01.08.2006, p. 9
Table 6.10: Moody's MRAC: Charge for reinsurers' IFRS ratings
The charges are determined stochasticaIly, so that each simulation results in a different
reinsurance recoverable charge although the reinsurers may be in the same rating cate-
gory. MRAC first e1iminates all recoverahles from affiliates of the insurer (intra-group).
Fnrther, the model distingnishes between reinsurance risk from four different sourees:
I) paid loss recoverables, 2) ceded reserve development, 3) ceded underwriting, or 4)
ceded catastrophes. Within the simulation, Moody's assurnes a 50% correlation be-
tween the several reinsurance rating buckets. Funds withheld, letters of credit, and other
farms of collateral serve to reduce risk of non-collection and are given credit in the ca1-
culation of the adjusted and required capital. Tbe US staodard information provided in
Schedule F, Part 5 of the statutory statements, e.g. is used to reduce the recoverahle be-
fore applying the reinsurance charge. Tbe model gives 100% credit for funds withheld
and 95% for letters of credit provided. Tbe net recoverables are mapped as shown in the
sampie of table 6.11 to the corresponding reinsurer, and a rating is identified. For the
USD 300 mlo of net reinsurance recoverables reported by the company in the example
below, MRAC charges USD 25 mlo to the capital. l99
Tbe underwriting risk calculation is intended to captore the profitability of an in-
surer's uneamed premium and one half year's worth of new business to incorporate one
full year of business. Tbe profitahility for the new business is estimated with the loss
ratio and staodsrd deviation generated by the reserve risk module of the model. Loss ra-
tios of each business !ine are simulated using a lognormal distribution, and correlations
between business !ines are estimated using industry aggregate data subject 10 Moody's
judgement
Tbe expense ratio and the "unallocated loss adjustment expenses" are constaot across
all business !ines and for the most recent accident year in order to simplify the process
(unaIlocated 10ss adjustment expenses are those claim settlement costs which either
199Barkeret al. [see 01.08.2006. pp. 9-10]

Source: Barker, Thomas; et al.• Moody's Risk Adjusted Capital Model for US
Pmperty 01: Casualty Insurers, Moody's Investor Service, New YOlk: 01.08.2006. p. 9
Table 6.11: Moody's MRAC: Sampie reinsurance recoverable chart
cannot or for practical reasons are not directly allocated by an individual claim. For
instance, claim department salaries, travel, postage, rent, and equipment would be clas-
sified as unallocated lass adjustment expenses, since under typical insurance company
record keeping systems these costs would not be associated with individual claims.
However, attomey fees, independent adjuster fees, doctor fees, court costs, and police
report costs are classified as "aIloca1ed loss expenses" because these costs are typically
assigned to specific claimS).200
Catastrophe /osses from underwriting risk are simulated separately from general
underwriting above. Moody's has estimated industry loss curves for the seven major
catsstrophes in the US: South Atlantic Wind, Gulf Wind, Mid Atlantic Wind, North
Atlantic Wind, New Madtid Earthquske (I and 2), California Earthquske, and Pacific
North West Earthquske. Table 6.12 shows an exarnple of the catastrophe charge for
one simulation. Tbe company is supposed to have exposure to South Atlantic Wmd and
Pacific North West Earthquske only. The values shown in the table form the theoreti-
ca! exceedence curve far the company for each catastrophe. The random numbers are
drawn uncorrelatedly for each catastrophe and the losses are aIl added up to form the
total catastrophe charge for the single simulation.201
MRAC uses a market share approach to calculate the estimated losses of a company.
Bach company analysed has an own exceedence curve based on its market share of
gross wtitten underwriting premium for the relevant perils in the regions listed. For
each individual catastrophe, the total of its state aIlocations will sum up to 100%. Tbe
inputs for the model are the gross wtitten premiurns wtitren by the company within each
state, by business !ine, and as a share of the total marke!. Tbe individual exceedence
curve ofthe company can be derived from the overall industry curve (see Appendix K).
The single simulation picks a random point from each exceedence curve, corresponding
to the estimated loss of the company caused by each catastrophe.202
Table 6.13 shows the effect of the single simulations (in Ibis case, simulation num-
her I, 2, 3, 4 and 60,000) on the change of the relevant reserves either as deficiency
2{)2Barker et a1. [see 01.08.2006. pp. 13-14]
Source: Barker. Themas; et al., Moody's Rist Adjusted Capital Model fot US Property
& Casualty Insurers, Moody's Investor SCrvice. New York 01.08.2006. p. 14
Table 6.12: Moody's MRAC: Company one-simulation exceedence curve
(figure shown in brackets) or as redundancy (no brackets). Tbe model assnmes that
most risks are uncorrelated, while some positive correlations among the individual asset
c1asses and lines of bosiness may be considered. After adding risk charges and offset-
ting for taxes, the model rnns 60,000 simulations in order to ensure robust results. Tbe
required capital at the 99.9% confidence level necessary for the category, e.g. under-
writing, can be taken as the 60th highest loss corresponding to the once-in-l,OOO-years
level capital.
=- -
->
....
"
)
-
- ...-......
- ... -..
",-...)
- ......,.... ..-
......
""
-)
::::; ::::;
(U_,c..-
)
::- ,-
,, ,,
,, "'"
0) ,,. ,,
,
,
• •, "'"
"" "" "" "
"""_,.
•'" .,
'"'"
(113)
• "" 'u •..

..... , (11-4)
"
" 0) ,'"
Source: Barker, Themas; et al., Moody's Risk: Adjusted Capital Model fot US Property
& Casualty Insurers, Moody's Investor SCrvi.ce. New York 01.08.2006. p. 14
Table 6.13: Moody's MRAC: Overa1l required capital simulation
Figure 6.14 is an example of a distribution resulting out of a ca! risk simulation. Tbe
once-in-l,OOO-years value USD 300 mln after correcting the correlation benefit results
in required capital of USD 171 mln for the cat risk exposnre of the company.
By observing the results of the simulation, a breakdown of the company's risks
at the stressed levels can be recognised. Tbe sampie of figure 6.15 shows the typical
drivers oflosses at stress levels. Catastrophe risk and reserve risk. are the major risks for
the company at the 99.9%, respectively the once-in-l,OOO-years confidence level. Tbe
shares reflect the contribotion of each risk to total required capital.203
Fina1ly, Moody's considers the ratio of actual capital to required capital in order to
203Barkeretal. [see01.08.2006,pp. 15]

Zero Loss
J in 1000 after rorrdali"n ewnl
I in 1000 (60th "",,1)
=' - v -==
'
Requi",d capila)
(dcnomialor) om
Soure.: lJarkcr. "rhomas: cl aJ.. Mood)'s Kisl AdjuSlcd Capital Model ror US I'rupcn}
& Ca'Uall} In$u",,,. Mood)'s In"estor Sen'ie". Ne" Yor~, 01.0&.2006. p. 18
Figure 6.14: Cat risk distribution graph
make judgements about tbe capital adequacy of the company. The numerator of tbe
ratio is the company's book adju!lt.ed capital and the denominator is the company's total
MRAC charge at 99.9% 1eve1. It is important to remind that certain adjustments are
made to the nominator in order to yield an amount morc refiecti.ve of the com.pany's
true, or book: adjusted, capital ODe year in tbe future. The denominator is adjusted with
the same amount because it represents the amount of capital necessary to cover the
difference between the expected result and the 99.9% 10ss result. If the model did not
adjust the denominator as well, the ratio could potentially penalize a company in both
the numerator and the denominator for the same deficiency.204-
Far the actual rating det:ennination, the analyst will consider the MRAC model for
US insurers ar the rather basic ratios listed in table 6.14. The gross underwriting 1ever-
age as predictive ratio for capital adequacy is calculated as the gross written premiums
dividcd by thc sbareholder's cquity.20S
It is interesting to note that the weigbting of capital adequacy is only 15% among
Moody's seven scoring factors far the financial strength ratings of non-life insurance
com.panies. Bach ofthe seven contributing factors rcceives a rating, either qualitativc1y
2I)4.Barmet 11. [see OI.08.2OO6,pp. 18-20]

2O!I~etal. [see2006,pp. 34-36]
Und .r"riti " g

Rcin ~ura"fe Ri st
H is!<
OpHHling Rc s tnt
Hi sk Hi sk
Assu
1" "Ulmen t
Ri ,k
Cal3st rophe
Risk
Sooft< B.,~c,. Thoo,,,, 01 01. Moo.l)'> R,,~ ,\dJuSICd c""t.1 Mode l r", US l'ropcn\
&Casuall) I",u",rs. Moody" •. Ne" V<:>r\;. 2006. p 1$
Flgure 6.15: Non-life insurance: drivers oflasses
through ratios or quantitatively by the analyst. Business profile factors Iike market
positioning and brand. product risk and diversification weight one third of the scores.
Financial. profile factors like asset quality. capital adequacy. profitability. rcserve adc-
quacy, and financial flexibility weight two thirds. 206
.'"'"
3,,- :r
...""
"-
A
••
u
,'"
_ ..... MJcl>olo; .01....... . . . . . . , , _
Gur Cupcmc!r, New Yad: 01.11.2006,.p. 34
Table 6.14: Moody's: Gross underwriting1everage andrating
Standard and Poar's. in their process to evaluate an insurance company. have al-
ways analysed the company's risk factors and how these are managcd. After consulta-
tion with the insurance sector, Standard & Poor's in 2006 published their formal. eval-
uation criteria fur ERM. Tbe evaluation of an insurer's ERM includes the assessment
of risk management cultnre, risk controls, emerging risk management, risk and capital
models, and strategie risk management. '1ff1 The evaluation of risk management cu1ture
concentrates on the company's risk tolerance, Le. their numerica1 expression of maxi-
mum acceptable losses at a defined confidence interval of frequency. Ibe risk toleraoce
depends on the compaoy's risk appetire - a starement of the broad raoge of loss out-
comes or consequences that would be acceptable to management Standard & Poor's
sees the importance for insurers to have articulated their ideas and communicated them
inrernally and exrernally. Further, the iosurer's general quality of governaoce is evalu-
ated. Rist controIs inc1ude the wide range of practices to identify, measure, monitor,
aod manage risk. The compaoy is expecred to leam from the ongoing risk management
process and lass experiences. Standard & Paor's works with extensive examples and
crirerla catalogues to be used for Ibe assessment of the relevaot risk types and as guide-
lines far the rating process. Emerging risk management is relevant for the occurrence
of extreme risks. The focus is on assessing the processes insurers use to imagine, track,
prepare for, aod leam from new risks that could emerge. Risk models are evaluared on
Ibe qnality of Ibe processes supportiog the models aod used to provide risk information.
Timely, accnrare aod compiere data has to be used to ensure Ibe robustness of the mod-
els. Ibe methodologies aod assumptions have to be adequare aod updared if necessary.
Principles aod controls have to be in place in order to run, maintain, validare, and check
Ibe models. 20'
To emphasise Ibe importance ofERM, Standard & Poor's have introduced a separare
rating caregory for the qnality of the compaoy's ERM programme. Ibe published rating
categories are as follows: 209
• Weak: lack of or incomplere control sysrems for one or more important risks.
• Adequate: comperent, traditionaI, silo-type risk management programme for

controlling most important risks; may not have a fully developed process to opti-
mise risk adjusred retnrns.
• Slrong: all characrerlstics of adequate risk management, but also risk control
practices that exceed the adequare level for the major risks. A weil developed
overall view of risks, wilb view of making risklreward tradeoffs arnong Ibe risks,
aod a process for aoticipating emerging risks.
• Excellent: all characrerlstics of strong risk management aod more advanced in

the developing of new processes, in implementation or in effectiveness of execu-
tion. Consequently, optimisation of risk adjusred retnrns throughout the organi-
sation.
2071ngram ct al. [see 02.06.2006]
2{)8Ingram et W. [see 02.06.2006]
2ü9F1eckenstein ct al. [see 2006, pp. 34-36]
s_ RatiDgEqui.....t
-
""""""'t CARin%
-yottoDg AAA 175 and higber
Very stroDg AA 1 -174
A 125 -149
Good BBB 100-124
BB lells than 100
Source: Fleckenstein, Michele; et 81., Rating agency update

Guy Carpeltter, New York 01.11.2006, p. 33
Table 6.15: S&P's: Capital Adequacy Ratio ranges
For each raled entity, Standard & Poor's ca1culares a Capital Adequacy Ratio (CAR).
Tbe CAR ratio is defined as the ratio of (total adjusled capital minus asset risk charges
minus credit relaled risk charges) divided by (underwriting risk plus reserve risk plus
other bosiness risk). Adjustments are made for loss-reserve/redundancy and time value
of money. The CAR model is static, not stochastic:
Standard & PoOl's evaluation is based on eight crireria: In addition to ERM, eco-
nomie eapital, capitalisation in !enns of capital adequacy, liquidity position, operating
performance, managementlcorporate strategy, competitive position, investments, and
financial ftexibility are taken into consideration when rating an insurer. 210
21Üf1eckenstein et al. [see 2006. p. 13]

6.3.3 The rating agencies' rating methodologies for ILS

Catastropbe risk ILS
AM Best's rating of catastropbe bonds relies primarily on data and information from the
risk modeling companies AIR, EQE, and RMS. The models are reviewed, and the rating
methodology further takes into consideration the risk characreristics of the perils cov-
ered, as reflected in the attachment probabilities. AM Best runs stress-tests on the key
modeling factors. The items reviewed, evalnated or monitored inc1ude the following:
• complete strnctural, legal and third party related documentation
• specific natural catastrophe perils inc1uded in the transactions
• granularity of exposure data put into the risk model
• outputs of the model
• results of the stress-tests

• eventual basis risk assoeiated with the trigger-type mechanism
• existence of multi-triggers
• credit risk of the SPRV and credit risk of swap counterparties
• other factors such as the risk period of the transaction, annual re-setting of attach-
ment points, extension options, and the model archiving policy
Prior to 2006, nearly an catastrophe bonds were rated bb-t or lower. In the past few
years, however, new catastrophe bonds were structored with very low attachment prob-
abilities. Weather re!ated catastrophe bonds may be triggered by aseries of catastrophic
events minimising the risk of an inunediate downgrade after one event Further, CDO
strnctures have emerged with investment-grade !ayers.
The analysts follow a methodology in order to deterntine whether the strncture's
stated objective will strengthen, weaken, or has no cffect on thc finaneial strength rating
of the sponsor.
The criteria for a single catastrophe bond, index-triggered with single-peril, are as
follows: The amount of credit in the cedent's (sponsor's) BCAR is based on an overall
basis risk score and/or on the capital effectiveness ratios. Each of the metrics in the
basis risk scoring table 6.16 below is rated, and the corresponding weight is applied
to get the total score.211 The basis risk score is then relevant for the calcu1ation of the
reinsurance credit. The highest basis risk score I results in a reinsurance credit of 90%,
2 in 75%, 3 in 50%, 4 in 30%, and 5 in 10%. However, this reinsurance credit has to be
valued for a single peril bond with one tranche against the capital effectiveness ratio:
211Modu [see 22.01.2008, pp. 1-2]
Tbe ratio is equal to 90% of the difference between the probable maximum loss before
adding the bond and the probable maximum loss after adding the bond, divided by the
principle amount of the issue. 212
The lower of the two amounts is then calculated as reinsurance credit. For multi-
tranche bonds, the reinsuranee credit ascribed is determined by the aggregate eapital ef-
feetiveness ratio (90% of the difference between the comhined aggregate annual PMLs
before and after the eatastropbe bond issue, divided by the principal amounts of all
bonds).213
Fitch rates all catastrophe bonds against a probability of loss eriterion. In eontrast to
the eommon usage of probabilities of default for Fitch ratings, they use the probability
0/ /oss, sinee a failure of a catastrophe bond to pay principal and interest is eaused by
a eatastropbe event, not the default of a eompaoy. Fitch eompares the probability of
loss on each tranehe of a transaction with its historieal default grid, defining how the
various loss probabilities transiate to ratings. Tbe global default grid for ILS ean be
found in Appendix L. Fitch's global insurance eriteria do not have an upper limit on the
rating !hat eao be assigned to ao n..S. However, it is rather unlikely that a eatastrophe
bond will be assigned a "AA+" or "AAA" rating if, regardless afits probability, a single
-
eatastrophe event ean trigger a loss of the principal. Ratings above "A+" require a high
level of eredit enhancernent.
"""" Saolo
w.....t
Probability cf > 50% shortfall (amount by which index loss [to 5 35%
falls mort of modelcd company loss expressed as % of principal
"..
~t)
Exhaustion probability [to 5
PeriJ. (e.g. F1.orida more aedit than New Madrid ) [to 5 [
-
Independent modclcr's involvement in basis risk analysis [to 5 [0'<
Data quality [to 5 [0'<
Ccrtainty of business compollition [to 5 [0'<
Thbl [to 5 [00%
Iwcd=
Source: F1cckenstein, Miche1e; et a1.. Rating agency update

Guy Cmpenter, New York 01.11.2006, p. 21
Table 6.16: AM Best: Basis risk scoring table
Fitch has not developed its own models to estimate eatastrophe risk. Tbey rely on mod-
eled loss statisties ealeulated by third party modelers like AIR, EQE, RMS, and Pater-
son Martin. Tbey tend to have greatest confidenee in the latest versions of models for
perils and geographies that have served the longest in the insurance industry including:
US horricane, US earthquake, Japanese typhoon, Japanese earthquake, and European
windstorm.
Tbe initial transaction rating process inelndes the analysis of the sponsor's back-
ground and motivation for the transaction. Other koy parties like sponsors, banks, and
212F1eckenstein et W. [see 2006, p. 21]
213F1eckenstein et al. [see 2006. p. 21]
modelers are checked. As second step, Fiwh is reviewing data provided by Ihe parties in
order to get a detailed picture about how Ihe transaction works, Ihe ßow of funds, under
what circumstances the investors would lose principal, and how lasses are determined.
Third, Fiwh studies 1he modeled loss probability and adjusts Ihe data, if necessary.
Adjustments are necessary for modeling uncertainty, exposure growlh, currency risk,
unmodeled perils / territories, and olher risks. The estirnated adjusted loss probability
is 1hen compared to Fiwh's default rate grid to detennine 1he implied rating. The risk of
Ihe sponsor is analysed. The sponsor is a key counterparty to 1he transaction, analogous
to Ihe seller/servicer of an ABS transaction. Important factors are Ihe insurer linan-
cial strenglh rating and Ihe bistory of Ihe company wilh regard to Ihe general business
and ILS. For indemnity risk structures, Ihe underwriting, reserving and claims-handling
abilities are important. The ratings are reviewed at least annually, 1hey can be upgraded,
put on "rating watch", or downgraded.214
Moody '. ratings of cat bonds are based on Ihe expected loss estimations and address
Ihe ultimate receipt of all interest and principal payments owed to Ihe investor as pro-
vided by Ihe governing documents of a transaction. The analysts focus on Ihe likelihood
of a catastrophe to occur and Ihe severity of losses to investors as a result from such
events. ForIher, Ihe analysis concentrates on Ihe credit strenglh of Ihe parties involved
and Ihe effectiveness of Ihe documentation regarding 1he risk transfer. Moody's rating
approach entails Ihe following steps: First, Ihe promise to investors to pay principal and
interest when due is assessed. The terms, conditions, and legal structure of Ihe transac-
tiOll are analysed. Second, Ihe poteutialloss sceuarios and Iheir associated probabilities
are assessed. This includes 1he independent review and testing of Ihe underlying mod-
els provided by Ihe external servicers. The results of Ihe models are usually expressed
as Ihe probability of loss exceedance corresponding to Ihe particular peril considered.
Third, Ihe los ses are calculated. The expected loss, delined as Ihe weighted average of
the losses, is adjusted for the relevant stresses across a1l possible scenarios considered in
the analysis. It is expressed as apercentage of the amount promised to the investors. To
get the average, a probability is assigned to the occurrence of each scenario considered.
The expected loss is Ihe sum of Ihe losses to investors for each scenatio weighted by
Ihe probability of lhat scenatio occurrlng. Foorlh, 1he expected losses for Ihe bonds are
compared to benchmark notes (conventional bullet bonds wilh 1he same duration). 21S
Standard & Poor'. use a four-step process to evaluate and rate catastrnphe bonds:
First, Ihey evaluate Ihe structure of Ihe transaction, taking into consideration Ihe legal
structure, Ihe control of funds, and 1he process of evaluation of valid claims. Second, Ihe
model provided by modeling companies is evaluated in detail, identifying its parameters
and making sure lhat no parameter was overlooked. Third, Ihe model is stress-tested in
order to find out how weil it incorporates each risk. Since the investor is often not an
informed party, Standard & Poor's skews Ihe model slightly in Ihe investor's favour. For
instance, if the model estimates a 15% surge of demand for reconstruction services after
2J.4Thorpeetw. [see 11.03.2008,pp. 3-12]
215 Araya et w. [see 23.01.2004, pp. 5-12]
• c.tastrophe, Standard & Poor's may run the model .gain with. 20% iocrease. Further,
if the modeliog firm m.y use • 90% confidence level, Standard & Poor's may .sk to run
the calcuIations .t • 99% conlidence level. Fourth, the def.ult risk is evaluated. After
recalibration of the model 10 be appropriate with the risks involved in the transaction,
the output will be • prob.bility !hat the covered event will re.cb the .ttacbment poiot
of the tre.ty with the special purpose reiosurance vebicle. If the prob.bility comes out
e.g .•t 1.6%, it is correspondiog with. security carrying • BB Standard & Poor's raring
carryiog • def.ult prob.bility withio the one year horizon.21 6 The most conserv.tive
version of the catastrophe models available, e.g. for hurricanes at current those of AIR,
RMS, and EQE, are used to evaluate the bonds. Due to the risk exposure concenu.tion,
Standard & Poor's use. rating ceiliog ofBB+ for c.tastrophe bonds from. siogle-event,
iocludiog those lioked to multiple perils and A+ for third-event bonds. For bonds with •
suffieiently large numher of n.tural perilloss evenls, the mioimum is live and they must
be less correl.ted, Standard & Poor's m.y assign • maximum rating of AA. However,
the presence of • fifth-event p.yout trigger is not. gnarantee for an AA r.ting. The
occurrence cf any trigger event cannat result in a downgrade of more than one rating
c.tegory, based on the prob.bility of .ttacbment.217
Special coosiderations regarding Iife-insurance-related ILS

Reserve funding transactions, the so-ca11ed XXX securitisations, are Iong term transac-
tions runniog up to 30 years. Their r.tings are b.sed on the review of the methodology
and models of the actuarial model firm iovolved. Cash flows are stress-tested - effecls
of changes io Japse r.tes and mortality rates are addressed. The rating company runs
deterministic sensitivity tesring and stochastic modeliog resulting io estimated percent-
.ges for the failure-to-p.y of several tranches of the transaction. The ratings are further
b.sed on the quality of coll.tera1 and the strength of the sponsor. The checkiog of the
structure iocludes the legal terms and the terms of the note gnarantee iosurance policies
provided by the external gnarantors.218
The ratings of risk transfer securitisations are usua1ly iodex-based. They strongly
rely on the results of the actuary models and the quality of the gnarantees provided by
the externa1 gnarantors. The raring agency analyses frequency and severity of an event
reachiog the iodex attachment poiols. Collatera1 asseIs and ioterest obligations are taken
ioto account. The total return and ioterest swap counterparties must be of high quality.
The diversification of the exposure io terms of geographical location, age and gender
are evaluated in line with the rating agency's catastrophe bond ctiteria.219
The analysis of an embedded value life iosurance securitisation by the 1eadiog rat-
iog ageneies would be similar and expected to focus on the follow key aspects of the
transaction:
216Levin et al. [see 22.03.1999. pp. 3-5]
217Fleckenstcin et al. [see 2006, p. 20]
2181borpeetal. [see 17.05.2006,pp. 1-11]
219parrow [see 2006]
6.3. RATING AGENCIES AND RISK MODELERS 2m
• legal structure
• exposure on the financial strength and operational risk of the sponsor and the
impact of the transaction on the insurer itself
• assel coverage ratio (embedded value vs. debt outstanding) aud debt payment
ratio (ernerging surplus vs. debt service obligations)
• actuarial models used
• other features such as guarantees, derivatives, and swaps
Without an external guarantee from a suitably higbly rated counterparty or other

suitable credit enbancement features, the rating of the bond issue is likely to be capped
at the claims payiug ability of the sponsor reflected by its financial strength ratings.
The sponsor is key to the development of the transaction going forward. If the financial
strength or condition starts to weaken, healthier policyholders may start to leave. All
things eqnal, the securltised block of business may behave very differently from what
has been projected.
The agency will further stress-test the transaction regarding the parameters: invest-
ment returns, interest rates, expenses, termination rates, and mortality.220 221
Life settlement securitisation complicates risk management for life insurers, since
they require a whole new area of focus due to the risks of all parties involved. Fraud and
criminal activity are key concerns - the original investors have the legal right, and often
the intention to seil the policy acquired immediately to third parties (e.g. investors in
securitisations). Fitch's analysis e.g., given the importance of ordinary life insurance to
the industry as a whole, concentrates on the product risk and its pricing. The key pricing
assumptions are mortality, lapse rates, investment spreads, and expenses. The actual
experience is compared to pricing expectations. Tbe understanding and management of
risk by insurers and their reinsurers are assessed.222
Ratings for Residual Commission securitisation transactiODS rely on actuarial mod-
els representing the block of business. While historically similar policies were mapped
into cells, models have become more granular, moving into a seriatim or policy-by-
policy calculation. Rating agencies test the model fit with a static validation testing the
reserve and face amounts at some point of time, usually the validation date of the issue.
They further perform adynamie validation testing the soundness of the projecrions over
different periods of time. 223
22OGemmelletal. [see 1O.1O.2000,pp. 17-18]

22IDevineetal. [sec 06.07.2006, pp. 73-84]
222Crossonetal. [see 12.09.2007,pp. 1-6]
223Devine et al. [sec 06.07.2006, p. 4O];Karapiperis [see 01.05.2005, p. 2]
6.3A Risk. modeling compames' services

Overview of probabilistic natural catastrophe risk modeIs
Probabilistic models developed to assess insurance losses wen: designed to help the
insurance sector quantify im profile and set business strategies to effectively manage
and transfer risk to optimise its finqncial perfmmance. Further. they he1p rating agencies
and investors to evaluate the risk of an n..s.
Ifutmy "'" been longeot fm tIw development of """'tropbo riok, "'!"'cially oorth-
quake risk in Japan and the US, and windstonn risk in Japan, the US, and Europe. The
approach 10 catastrophe modeling of the tbree main firms AIR, RMS. and EQE :is ralber
similar. They consin of thrc:e modules, the hazard module, the damage module and the
financial module as shown in figure 6.16:22.4
historie dal.
sdcnlifkl.oo" lcdgo _
I II .u,ci M o d u l . _
I SilC charM!'-';'ti<,
~='"=',";"=',~;,;"J,;(";"";,;~;~;,~,~
J;mu"d mOlioo (canhquaLcs)
-
""1Ul1) damagc
.~""rience.
C'PO~U'"
engineering e~pc"ise n .",agt Mod .. lt
dal.
Fin.nci.I ,\ I Odul.
- CUlllr.>C1
"""eilieal;un.
( _ _ '_
O~'_)
So"",.; ,\"de'so". Ri~hard. cl aL. Ana luing InsuI1lncc-LinLcd Sccuriti.s.
Risk \bn~cmcnl Solmions. NcwarL. 1998. p. 7
Figure 6.16: IDustrative framework for cat risk modeling
The inputs of the hazard module consist cf historical data from stonn catalogues or
earthquake history, being replenished by expert opinions and scientific tnowledge. Side
characteristics. such as terrain roughness and soil conditions. further are taken into
account. The outputs of the hazard module consist of a set of stochastic events with
determinant characteristics, such as wind speeds and earth motion.
:z:MAnden!m etal. [_1998. pp. 5-7]
Tbe damage module determines the damage c.used by • natural c.tastrophe to the
infrastructure, such as hauses or industrial installations. Tbe modeling firms use struc-
tural engineering expertise in combination with claims experienced by their customers,
the insurance companies.
The finaneial module applies the damages against the insurance or reinsurance con-
tract specific.tions in order to determine the impact of the estim.ted event and to ca1-
culate the ultim.te financiallosses which can be expected.
Apart from hurricanes and earthquakes, models h.ve been developed for other perils
like tornadoes, straight-1ine windstorms, winterstorms, wildfires, earthquake, worker's
compensation, flood, hall, ground liquefaction and landside potential.22S 226
Tbe outcome of the models can vary quite substantially among the different model-
ing firms. Tbe differences are • result of the density of data .vailable and the variety of
simul.tion methods used. Further, the estim.tions of loss severities c.used by n.tural
catastrophes vary.
Hurricane risk is the major contributor to lasses of non-life insurance in the USo
Tberefore, the characteristics of. typical model shall be exp1ained in more detail:
Tbe historical insurance loss data .vall.ble has to be collected and .djusted for the
effects of inflation, popo1ation growth and changed property values, huilding materials,
and construction designs. Contract changeslike the details of coverage, co-insurance,
deductibles and maximorn insured loss h.ve to be amended. In some are.s, the model-
ing firm faces small sampies only. To overcome these problems, the risk modeler makes
parametrlc assornptions .bout the prob.bility distribution of the characteristics of the
hurricane.
Tbe first step, the hazard module of the modeling process, is therefore the simul.tion
of. hurricane database for • discrete coastal are. by estimating r.te of occorrence and
prob.bility distribution of the clim.tological characteristics (centra! pressure difference,
forward velocity, track angle, landfall location, and radius of maximum wind). Tbe
hurricane characteristics in coastal areas are simulated by selecting a series of joint
values of the above mentioned key storm parameters. Tbe storm behaviour is then
simul.ted, since tracks change as the storms move inland.
As second step, the damage module is developed. Horricane systems can bting •
varlety of associ.ted perUs such as storm surge and w.ves, local flooding, ruissiles, and
tornadoes or very localised highly torbulent wind conditions. As experienced in horri-
cane Katrina, these perils can cause far more damage than the storm itself. Wind hazard
is generally represented by maximum wind speed, influenced by terrain fe.tures, and
dur.tion. Sorge hazard is characterised by its hydrostatic effeet called surge level, and
hydrodynarnic consequences due to w.ve actions. Topographic conditions, tide level,
and ftood protection structures are taken into consider.tion. In. validation process to
follow, the results of the hazard module are compared with historical data.
Third, the financial module estimates • mean dam.ge r.tio (MDR) which is defined
"'EQE [... 2007]

226RMS [see 2007]
as the ratio of the infrastructure's repair cast divided by its rcp1acement costs. FOI'
each location, tbree MORs are calculated: st:ructure, contents, and time element losses
(e.g. business interruption or additionalliving cxpcnscs). Buildings are classificd by
construction material, usage, heigbt, and unit (e.g. single-familylmulti-family). MDR
damage tab1es typically consist cf a matrix ofhazard leve1s (wind speed or ßood leve1)
by construction class.
Sponsors use the models in summary first to determine a hurricane hazard level, then
10 look up the corresponding MDRs ror the classified (insmed) buildings and their COD-
tents in order to determine the damage leveI. while the creati.on of the damage function
is based on several enginoering disciplines. In addition to tbese studios. a substantial
nwnber cf insurance companies provide their actual financialloss data which is updated
after catastrophic events. m
0,10
,.
~
0, 19
,.m
~
,•
0, 18
0. 17
,.
~
,.
,.,.
m
O. I ~
-\
O. I ~
- -
]
O. U
,.
O.IJ
-" ••"
0, 11
IEH
.,.
0. 1'
0, 10 •
" • ..•,.........
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g ",~ ~ ~ ,~
•, -\-=
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-
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0 0.01
-\
O.O~
0
0.0.
.,.
O.Oj -
0.0!
0,0'
..,. ..,.
"'~
.''"
",' ;1" ;1"
• '" ""
;I' ",...f' ;I'
" , ,~' , .f'
.;'-t nl Lon Soor<:" (ND Graph
F1gure 6.17: Sample of a 1088 exceedance curve
Models finally deliver calculated loss distributions by convoluting losses calculated for
each simuJatei! storm (L.) with the probability of occurrence (T(L.» ofthe storm. The
result is shown as a graph called loss excc:edance curve, where Ll+l > Li, A sample
1088 cxceedance curve including a frequency distribution is shown in figure 6.17. The
curve shows the probability that in a year ODe or more 1011& events will occur that are
:z:l1BnilSfllJlWle and Ulrich [_1995, pp. 182-190]
.t le.st as great as • given loss amount. For example, if TUSD125mln = 1% (ex.ctly:

0.009950 as shown in the sampie of lable 6.17), there is • 99% chance th.t the largest
event occurring in • single year will c.use • loss of Jess th.t USD 125 mln.
Tbe lass exceedance curve is usually consistent with a collective risk model of event
frequency and severity; the the number of events follow • Poisson distribntion. The
sum of independent Poisson distribnted randorn vari.bles is also • Poisson distribnted
randorn vari.ble itself - and Poisson distribnted randorn vari.bles can be decornposed
into single Poisson distributcd random variables. Each point of the curve can therefore
be thought of as an independent randorn variable, • single event independent of all
ather events. The probability of at least one occurrence for a Poisson distribution with
mean A is calculated as 1 - e-~. Tbc mean annual frequency of events at least as
gre.t.s Li, is A(L;) = -Ln(l- T(L i )). The annual frequency ofthe specific event
>.(Li) = A(Li) - A(LH1). Ifthe total frequency of all evenls is A(O), the size ofthe
loss distribntion or individual evenls is F(Li ) = I - A(Li )/ A(O). The retum perind
of a 10S8 event is the inverse of the mean annual frequency of losses at least as great,
R(Li ) = 1/ A(L;). Theretumperiodis also referred to as the inverse ofthe prob.bility
of cxceedancc, R(Li ) = I/T(L i ). This definition is nornerically vcry clo," to thc
inverse of the annual frequency for low frequency events. However, it can become
fairly meaningless for very high frequency evenls. 228 Table 6.17 shows an example of
the components of a 10s8 exceedance curvc.
Calculati.on based on: Evans, Jonathan, Simple practical estimati.on

of sub-portfolio catastrophe loss exceedance curves with limited
information, Casualty Actuarial Society, Arlington. 2005, p. 54
T.ble 6.17: Loss exceedance curve data lable
Loss exceedance prob.bility curves also provide • visualisation of loss probabilities for
the different tranches of. securitis.tion. Figore 6.18 shows the loss exceedance curve
for the Residential Re transaction sigued in 2001. The curve shows !hat the prob.bility
otlosses increases, peaking in the range between USD 450 and 500 mln and then fa11ing
with • long tail to USD 1.6 bn and higher losses with • very low prob.bility.
Figore 6.19 shows the layers where the transaction is included as C.t bond. Mondy's,
using the catastrophe rnndel provided by AIR, estimated the prob.bility of an annual
228Evans [see 2005. pp. 53-54]

1... , Il<r,ull Pr.bobili')· in ~.
"
1'-'1..: _
,.,
S06lba $ 1.lb. S1.Ob.
"C, (.,'rop~. I...... , in ,'sn Im

lJascd ,m: Shah. I'ri)'a and 1';COne. Du"",n;<:<). (;W;lSlrophc Honds..
Drcdsncr Kkin\\on. London. 09.02.2007. p. 9
Figure 6.18: Rcsidential Re - los5 exceedance curve
Ioss cxcecding USO 1.1 bn 10 be 1.12% and exceeding USO 1.6 bn to be 0.41% with
an expected annualloss of 0.68%.
This resulted in a Ba2 rating for the catastrophe bond exposing its holders to hurri-
cane risk. in US rcgi.ons defined as high risk.
Life insurance securitisations use the services of independent actuaries to develop the
model and the projections for the sponsor. In addition. an independent actuary, on
behalf of the rating agency. gets involvod in order to review the projoctions and as-
sumptions and how they intemct in the transaction model.
The actuarial model of a nserve junding securitisation is a representation of the
socuritised block of business. They bc:came increasingly granular with the improved
computer technology and moved to a seriatim OI' poIicy-by-poIicy calculation.
Setting the actuarial assumptions is key, while mortality and tapse rate are the most
important factors driving the value of the life insurance securitisation transaction. Fur-
ther, investment income, apenses (also rcinsurance costs), and premium patterns are
taken into consideration. The experience of the sponsor is important. especially regard-
It&" r-.....1nIIIIIIIIII
.."' _O.• '·'" * ____ _ -
.......
L ....
"f,."~
..
r 110;\11
~'I"<,nl c., S ••d C ,\
1 SI) 150 m
lro~ilionol
"in,.ro""
L... _ Il.ISI'o
~.,~ 1 !>I) .100 ", ~
r-o.......
',Ib. I'WI.lb.) .,~ '" ," Ib.
" 1,.""... "' _ 1.11% ~ -
'ro"i,ion".tin,", .."
--
1 SI) ~ O~ mln
' " ' ' ' ' of l SI) 6~ .""
............
.1nIIIIIIIIII i I
Souttt; Shah. I',iya and Pico"". Ikm><:"i'"<:I. Ca"astrophc Illmds.

n",dsncr Klc;nwon. I.ondon. 09,02,2007. p. 8
Figure 6.19: Residential Re - catastrophe-Iinked notes structurc
ing the quality of data.

The poIicy counts and face amounts, together with the assumptions, are ran through
the actuarial model 10 calculate premiums, investment incomes, death benefits, ex-
penses in order 10 derive income statements and balance sheets. Econo.mic reserves and
tax reserves represent a key number, since they basically help 10 determine what the
1evel of redundancy, defined as the difference betwcen the statutory and best estimated
reserve, is, This amount is being raised from the capital markets through securitisation.
The outputs are cash Dows which are fed into a deal. model, and the terms of the
transaction can be wrapped around them.
Fmally, the actuary rans sensitivity tests for each of the assumptions, i.e, an addi-
tionallevel of mortality experience. reduced lapse rates, or a pandemie hit are performcd
(also in combination with each other). Financial guarantors check. the transaction struc-
!ure far weak points.22!I
Risk transfer .recllriti!ations have occmred to transfer catastrophe mortality risk
10 the capital IIWkets. Thereforc.. they are also referred 10 as catastrophe mortality
bonds, While other cat bonds ar derivatives usually depend on underlying loss indices,
catastrophe mortality bonds are triggered by a catastrophic evolution of death rates of
lZIIDevine etal [see06.07.2006, pp. 3S43]

a certain population. Rating agencies base their decisions on the data cf risk modeling
companies. 1he approaches of the two leading companies in this sector, Milliman and
RMS. diffcr considerably. Whilc Milliman bases its analysis on an actuarial model,
RMS use an epidemical approach. 230
MilUman uses actuarial and statistical models ror the future evolution of mortallty
based on historical data. The base1ine component models random ftuctuations within
annual mortality rates if no catastrophic event occurs. Millim.an uses time serie! mod-
els 10 develop stochastic forecasts for mortality evolution in the countries covered by
the mortaIity index. The results are simulations of the weighted combined death rares.
Thc discase componcnt captures the cxccss mortality duc to a pandemie outbrcak - thc
data relies on past pandemie outbreaks. The terrorism component is used far mortal.ity
shocks. For each component, 250,000 simulations are producod and combinod to esti-
mate annualised as well as cumulative expccted lasses. Further, the probability of loss
triggers of a certain tranche is calcu1ated (see figure 6.20).2.'U
11>"",ooC"",,,,,,,,,o'
-----1 .~~=-1
I
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- <kl.,m,,,,,,
cornbll>c< ...,.",,><:
-1 ':'~;:"~
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mQ<1.hl)'. pantlcmoc
du< In "",""". 1 Ioss prob.1b,hl)
amI ,crro",m ocntnarios
Je",asc .,'an",) ond k)s. ntend
In' O an Index , -.,""
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-- I ..!~~I I
Soure<; LinfOOI. I\ndn:\\. Finanein/; (;au1>slrophc Risk - ~I"rtalil: Hond Cas.: SlUdy_
Scoui;.h 1\0. Bc""uda. 1~.02 .2007. p. 18
Pigure 6.20: Scottish Re I 'Thrtan - mortality risk model structure
RMS's mode1 is based on epidemiologica1 data and research rather than historical
data. The company has bcen supportcd by world-wide cxpcrts for influenza research
:DOBaum: and Krama: [see2007, pp. 9-12]
D1Baum: and Krama: [see2007, pp. 9-12]
in order to develop their methodologies. Event tree techniques are .pplied to produee
1,890 probability-weighted scenarios. RMS states that there h.s been an .verage of
three pandemies each eentury and therefore .ssurnes an outbreak prob.bility of 3 to
4%. Taking industrialised livestock husbandry and other eonditions fostering mutations
of viruses into consider.tion, levels of 5% to 6.7% are used for stress-testing. Parame-
ters regarding infectiousness and lethality are based on influenza research. Tbe loe.tion
of outhreak is important with regard to its demogr.phie structure and government reac-
tion.232
Li!e settlements modeling is rather ehallenging. Therefore, life settlement transac-
tions are significantly stress-tested. Scenarios are nm in order to find out, how solutioDs
for some decrements like eancer will effect the underlying portfolio of life insoranee
policies. Viatical transactions experienced an overhaul oftheir estimates when a break-
through in AIDS medicines was achieved.'33
6.3.5 Results of the interviews regarding rating agencies, risk mod-

elers, and monoliners
Rating Agencies
Rating agencies' scores give an idea of the relative risk. of a capital mark.et transacti.on.
Investors tend to rely on the .geneies' due diligence to vaIidate the mostly external mod-
els underlying the relevant structure. Tbey further provide transparency to the markets
by ehecking the offering memorandum and publishing • pre-sales report before • trans-
action is placed. Based on their methodology to evaluate the reinsurance risl<, they rate
the prob.bility of the investor faiIing to receive interest and prineipal.234 During the
structoring phase, their guidelines ensure • proper eonsideration of legal aspects, also
for offshore transactions. Tbe focus is on ehecking the SPV ring-feneing, Le. the mech-
anisms for • full funding and eollateralis.tion of an 1LS. After elosing, they publish •
final rating report to their subscribers and monitor the operating .greements. If neces-
sary, the ratings of the structure are up- or downgraded.235 Although often referted to
as quasi-regolators, they are not regolators, bot being regulated themselves. Whi1e they
h.ve their own models for life insoranee in place, they usually take for non-life lLS
third-party modeling into consider.tion.236
The agencies calculate the necessary capital for the insurer to mect bis obligations.
Tbey have been giving fuH c.pital release for XXX structures, while the relief for ea!
bonds was ealco1.ted by taking into eonsideratioo the prob.bility of the underlying
event happeniog. Rating .gencies distinguish between pararoetrie, index or indemnity
232Bauer and Kramer [see 2007, pp. 10-12]
233Devine et al. [see 06.07.2006, pp. 82-83]
"'INr-10-RXr [12.09.2008];INr-15-RAT [22.09.2008];INr-18-INV [24.09.2008];INr-19-ASO
[26.09.2008]
"'INr-10-RXr [12.09.2008];INr-18-INV [24.09.2008];INr-2O-LAW [20.10.2008]
236INr-3-BNK [03.09.2008];INr-10-RXr [12.09.2008];INr-20-LAW [20.10.2008]
based transactions. Parametric ILS can be structured as up-front transactions paying for
losses before the damage is verified. Sponsors arranging indemnity coverage must be
able to properly process their data about the perus, their track record in underwriting
and claims processing in terms of speed and accuracy is iruportant. Indemnity cat bonds
highly depend on the sponsors rating, since they are highly correlated to the underwrit-
ing and claims handling skills - a sponsor with excenent skil1s tends to be rated higber
than one with poor skills. Commercial-line insurance tends to bear greater risk than
personal-1ine insurance. Tbe agency evaluates how the relevant ILS issue fils into the
corporate strategy of the sponsor. Tbe overall funding alternatives are tsken into con-
sideration in order to identify tactical issuers who may have difficulties to get traditional
reinsurance in p1ace. 237
Most rated non-life ILS are ca! bonds for evenls in the probahility range between
once-in-50-years up to once-in-250-years events and usually rated up to BB+ (follow-
ing Standard & Poor's rating methodology). Tbe charge for those events is in accor-
dance with the outcorne of the models. Once in 250 years events, also referred to as 40
bp evenls, have been rated BBB-. Some rare once-in-500-years evenls have been rated
BBB+. Tbere is no capital charge above once-in-500-years events and therefore no cap-
ital relief for a sponsor placing an ILS issue. Th.e reason to issue a bond against a very
rernote once-in-l,OOO-years or even once-in-lO,OOO-years event is rather economica1-
than capital-driven. However, mortality cat bonds for those remote risks can get ratings
up to AA or even AAA.238
While Standard & Poor's is of the opinion that it is highly unlikely that a once-in-
200-years event does not trigger when it is supposed to, AM Best has a limitation of
credit they grant for non-indemnity or non-modeled loss triggers: Indemnity is granted
100% credit while pararnetric 80% only.239
Wrapped transactions are used to get the higber of the !wo ratings, those of the un-
derlying risk or the wrapping monoline insurer. Both ratings can iruprove or deteriorate.
If the agency withdraws a rating of a monoline insurer, the rating of the issue is also
withdrawn. 24O
For life ILS, the ageneies use in-bouse actuaries to model the past underwriting
experience, for instance the mortality over years. Tbe fiuancial strength ratings of the
sponsor are iruportant for investment-grade reserve funding XXXlAXXX transactions
where proceeds are segregated into a collatera1 trust and initially not available for the
sponsor. Tbe investor depends on the underwriting and reserving of the company which
is rellected by its own ratings: If the best estimate reserves are adequate to pay all the
claims, the trust will remsin intact, and the money will be available to be repaid to the
noteholders a! the end of the transaction. If the best estimate is not suffieient, those
reserves could be depleted. Ufe reserve transactions further depend on the quality
23'INT-IO-RAT [12.09.2008];INT-13-MOD [16.09.2008];INT-15-RAT [22.09.2008]

23'INT-15-RAT [22.09.2008]
23'INT_7_REI [OS.09.2OO8];INT-15-RAT [22.09.2008]
24<lINT-IO-RAT [12.09.2008]
of the investment book collateralised. The SPRV has to hold mark-to-market valued
assets equal to the credit taken far reinsurance in a collateral trust. The investment
portfolio essentially is a credit to the sponsor. The cedent has the right to liquidate the
assets to pay claims under the polieies first, over and above the right for the investors to
receive money. However, the co11ateral trost does not have any recourse back on another
company - it stands for itself. 241
For a value-in-force transaction, the use of the proceeds is important After having
sold its share of the profits from a book of underwritten bnsiness, its ability to repay debt
relies on the sponsor's futore financial strength. Since the company will no longer have
the right to receive those futore cash flows, it is very important for the rating ageneies
to evaluate the usage of the funds, since it may weaken or strengthen the credit profile
of the company. If, for instance, the company took the proceeds and repurchased stocks
or paid very !arge dividend, those proceeds will no longer be an available repay sort
of unsecured debt of the company to other creditors. Conversely, if the company took
those proceeds and invested them in another part of the business !hat perhaps generates
a higher margin than the part !hat was securitised, Ibis could be positive. Since those
funds have been invested at a higher rate, there is a larger strcam of futore cash flows
that can be assumed to get generated by the company.242
Rating agencies would not lik.e to see a sponsor getting al1 its reinsurance coverage
as catastrophe bonds or XXX structures. since ILS investors may not be a reliable source
of refinancing in difficult market environments.243
They are reluctant to update default tables in short frequency, since existing issues
on the market as a result may have to be downgraded, and More defaults may lead to
a looseuing of standards. Catastrophe bonds are not placed on wateh before an event
occurs, e.g. a hurricane made landfall and any loss estimates are published. In general,
rating ageneies are reluctant to downgrade n..S quicldy, since it may cause forced se11-
ing by some market partieipants and deteriorate secondary market prices and liquidity.
The agency may decide to upgrade, downgrade, or withdraw its ratings at any time.
The intent is to review the ratings annually, bnt it could also occur more frequently, de-
pending upon whether something is happening with a transaction. This could be either
on the asset side (co11ateral trost) or on the liability or insurance side (a trigger event
happeuing). Their ability to change ratings every day causes marke! participants to pay
attention to the evaluations.244
The credibility of rating ageneies received a blow with the ongoing crisis of the
stroctored finance markets since 2007. Before the collapse of Lehman Brothers, they
did not look at the asseIs in the co11ateral trosts themselves, since they did not view them
as a risk. They always expected !hat if the company were to go down in credit quality,
co11ateral could be posted. Their definition of an "A" rated bank like Lehman further
241INT_7_REI [08.09.2008];INT-IO-RAT [12.09.2008];INT-15-RAT [22.09.2008]

2A21NI'_10-RAT [12.09.2008]
243INT_15_RAT [22.09.2008]
""INT-10-RAT [12.09.2OO8];INT-15-RAT [22.09.2008];INT-19-ASO [26.09.2008]
was not to go into default in two days as the company finally did in September 2008.
As a result of the default, the ageneies bad to downgrade the ILS transactions called
Willow, Newton, Ajax, and Carillon where Lehman was acting as total return swap
counterparty. The mark-to-market values of their collatetaltrust could not be regarded
as sufficient to repay the face value of the bonds.245
Solutions for the Lebman transactions were heavily discussed at the time of the
interviews.246 However, they did not materialise. Although market participants wanted
to avoid the negative effects on the reputation of the ILS products, it was not possible
to find a new TRS counterparty to replace Lebman due to the severe detoxication of the
portfolio and the difficu1t market conditions.247
Tbe tremendous amounts of RMBS securities in collateral trusts are anather cause
for concern. While some collatetaltrusts for long-term XXX ILS have invested in
RMBS, some have avoided to take positions in this market at all. Tbe sponsor of an
ILS further has the right to call the transaction in part or as a whole. The sponsor of
the transaction Ballantyne Re, whose investment portfollo consisted to a considerable
amount oflow performing mortgage-backed securities, decided to take back about 35%
of the face value of reiusurance provided by the SPRV through retrocession, and to
replace the coverage with LoCs issued by banks. The transaction was continued at a
lower face value.248
Rather than for risk modeling, rating agencies are acknowledged by the ILS com-
munity for their work on validating the structure in detail, in particular the collateral
safety. They provide a lot of "watch dog" functions behind the scenes, making sure !hat
the deal is properly structured and has been discussed accurately. They even ensure !hat
it doesn't violate any lax exemptions which require !hat the deal needs to be formed,
discussed, conducted, and structured offshore. If representations and warranties are
laler found to have been violated, there could be an unwinding of the structure. The rat-
ing agencies are further monitoring numerous operating agreements and documents to
keep the SPV structure going even in the most challenging events and enviromnents.249
It will probably take some time for them to expand their mind-setting to include
innovative structures more again. At current, they are reluctant 10 rate new products
and are expected to be even more restrictive in giving high ratings for ILS issues in the
nem future. 250
Tbe crisis is being regarded as a learning experience. The foeus in the future will
be on improvements regarding transparency and monitoring. The intention is not to
change their analytic methodologies but to add to them. Regarding XXX, the focus will
be on asset risk and mortality developments. 251
24'INT-2-BNK [02.09.2008];INT-15-RAT [22.09.2008];INT-26-INV [29.10.2008]
246INT-15-RAT [22.09.2008]
247Evans [see 14.05.2009]
"'INT-15-RAT [22.09.2008]
"'INT-18-INV [24.09.2008]
2SOINT-2-BNK [02.09.2008];INT-5-BNK [04.09.2008]
2S1 INT-15-RAT [22.09.2008];INT-28-ASO [03.11.2008];INT-IO-RAT [12.09.2008]
Kisk Modelers
The function of risk. modelers for the overall insurance and reinsurance market is to
provide lass estimates for catastrophic occurrences such as earthquak.es, hurricanes,
winterstonns, wildfires, and !loods. Essentially, they estimate any type of catastrophic
activity for which the insnrance sector does not have enough information just by looking
at past claims, while the post-perspective can be misleadin.g because these events are
infrequent So what !hey da is simulating the cnrrent exposure or !he potential risk to
the current exposure from these catastrophic events. Risk modelers provide the science
delivered by their software also to rating agencies. For some ILS types like catastrophe
bonds, their models are a pre-condition to get a rating. Tbe lack of use of extemal
models was one of!he reasons why !he mortgage-backed-securities market in !he US
went into difficulties. For some risks like terror no models at all have been deve10ped
- securitisations therefore are not possible for these types of risk. Tbe avai1ability of
models enablea or limits growth in the ILS market.252
Except in the hnrricane season 2005, when they underestimated the losses cauaed
by Katrina by not including the !lood damages in New Orleans into !heir calculations,
modelers were not as challenged as rating agencies recently. Their models are rather
sophisticated and difficult to verify for third parties, since the data is rather young. 253
Life natnral catastrophe mortality risk is better understood than standard life-related
risk. Models for bird !lu or terror are regarded as rather intransparent. Critical i1lness
modeling is in its early stages.2S4
Indemnity triggers are used to maximise reguiatory capital while parametric triggers
to attract investors. Sponsors use models to calculate expected losses for indemnity
transactions, for instance by combining data about the material of buildings like roofs
and walling. Modeling software is also used for parametric transactions in order to
limit !he basis risk. Tbe risk modeler performs • very detai1ed analysis of the insurer's
portfolio, just as detai1ed as for an indemnity deal. But then its analysis is uaed to
minimize discrepancies between the individual portfolio losses and those ca1culated by
the index company, e.g. PeS for the US.2S5
Investors pnrchase the very same software that they use to estimate the interplay
in a correlation between the various bonds, ILWs, and any types ofILS th.t they may
hold in their portfolio. Tbey aggregate their perus from !he different sonrces, run !hem
together, and are enabled to get their own sort of customized view of the risk. Risk
modelers provide the basis for ratings and help to grow the pool of potential investors.
Tbey also provide the basis for liquid secondary market capacity.25.
For life and non-life transactions, inveators like to h.ve. third party modeling in or-
der to verify the in-house calcul.tions of the sponsors. Models are fixed for the lifetime
"'INr-13-MOD [16.09.2OO8];INr-16-REI [23.09.2008]
"'INr-l-MOD [19.08.2008];INr-2O-BNK [20.10.2008]
"'Carey ct al. [27.10.2008b]
"'INr-13-MOD [16.09.2OO8];Carey el al. [27.1O.2008b]
""INr-13-MOD [16.09.2008]
of the relevant transaction, but the discovery of compurer errors may lead to the use of
a newer model. The change, however, is at the discretion of the parties involved. Risk
modelers constantly develop new models for emerging perils. Tbey provide the basis
for futore ILS market growth, sinee they make sure !hat investors feel comfortable with
innovative transactions. Tbe World Bank has engaged modelers for projects in order
to find solutions for perils threatening the developing world. In 2006, the World Bank
underwrote a transaction covering Caribbean catastrophe risk. 257
Post-event, risk models deliver important estimations of damages. In case of a hur-
ricane, the process already starts with a first loss estimation 48 hours before a hurricane
makes landfall. 24 hours before landfall, a more detailed estimation folIows. After
landfall, another estimation of damage is provided following the track of the hurricane.
Risk modeler's estimations got more importanee after the experiences with the transac-
tion KampRe. Tbe indemnity transaction was triggered by hurricane Katrina in 2005.
Investors decided to seIl the bonds at values elose to zero. However, their values Iater
recovered, since the payout was indemnity-linked and the losses were not as severe as
expected. In general, the residual value of a catastrophe bond can be estimated at 20%
and for an earthquake bond at 15% of the face value, depending on the peril. Risk
modelers are able to provide transparency of the evaluation of the bonds after a trigger
event.258
However, it has to be taken into consideration !hat models simplify reality - the
more they are introduced, the greater is the risk of error. Tbe aggregate exceedenee
probability curve is an important element of the analysis. It helps to quantify how many
triggers may add up to the relevant attachment point.25'
If storm activity increases in the years to come, risk models for Europe are expected
to face recalibrations, especially for wind risk, and especially in the UK. 260
RMS further introduced its own catastrophe European windstorm index called PARA-
MEX in 2008. In order to bring more confidence into transaction with parametrie trig-
gers, Renaissance Re in cooperation with RMS instalied wind speed meters in exposed
regions. Tbe modeled loss is calculated using RMS technology. Some marke! partici-
pants, however, give the project a rather limited chance for general aceeptanee due to
the dependence on RMS' models and the lack oftransparency provided.261
Risk models are important for providing the basis for priee calculation of the rel-
evant risk by the market.262 Pricing of transactions for similar risk like, for instance,
wind in Florida may vary. This may be based on variations of outcome of the different
models used. Modelers use different methodologies and the information provided by
sponsors.
"'INT-I-MOD [19.08.2OO81;INT-2-BNK [02.09.2008];lNT-13-MOD [16.09.20081

'''INT-I-MOD [19.08.2OO81;INT-13-MOD [16.09.2008]
"'INT-15-RAT [22.09.2008]
""INT-I-MOD [19.08.20081
'61 INT-6-ASO [05.09.2OO8];INT-29-INV [14.11.2008]
26'INT-13-MOD [16.09.2008]
Further, 10ss payment periods and the pricing for reconstruction of the damages are
calculated in a different manner.263
Monoliners
Mono1iners regard the insurance sector as a diversifier to the rest of their portfolios,
main1y consisting of gnarantees for municipal bond and structured finance issnes. 264
In lLS, most of their activity consisted in providing wraps for US reserve financing,
funding-CDOs and reinsurance-receivable-CDOs. Before their rating downgrades, their
AAA qnality gnarantees substantially reduced the funding costs of XXX issnes carrled
by the sponsors down to approximately 25-30 bp p.a. for a 30 year term. 26S
The monoliner's due diligence for XXXlAXXX transactions takes approximately
two months and concentrates on the following criteria: The monoliner is exposed to
the management of the portfolio, the insurance portfolio as weil as the assets. So they
are looking for credit-worthy and competent partners. Their ideal c1ient would be an
insurance company with high investment grade ratings in the A or AA range. They
would go through all the normal kind of dne diligence and underwriting to make sure
that it is a stable block of business they have underwritten. As for tenn life, the history
should include 5 to 10 years of experience. They expect a sirnilar approach in the
underwriting for the future in terms of qnality. So underwriting is key to the product
because the monoliner takes real out of the money underwriting as weil as pandemic
risk. Further, they ensure that the investment portfolio and the underlying guidelines
are not too aggressive and that they were fairly constrained. The portfolio does not
need to be the major source of profit or was not anticipated to be very aggressive when
built. Mono1iners use third party actuaries in order to understand the levels and slope
of the morta1ity of the book. They check the credibility of the historlcal information
provided and project the cash t10ws and financials of the Iransaction. Further, the credit
worthiness of the sponsor in terms of its ability to manage the portfolio of assets and
the investment policy guidelines is irnpurtant.
The monoliner sets reporting guide1ines for the lifetime of the transaction asking
for regular monthly, quarterly, or annual updates and financia1 statements of the SPRV.
Reports about the pool of life insurance policies and the mark-to-market value of col-
lateral trust have to be delivered. Stricter reporting guidelines and stress-testing of the
asset portfolio can be expected after the past negative experiences.266
Longevity and morta1ity are being regarded as a marke! with high volume potential.
While in the US the longevity market is dominated by life settlement structures, EU
pension funds are looking for support to irnprove their management of morta1ity risk -
they are inlerested in securing stable, long-term pricing for their hedging against risk
263Couey et 01. [27.10.20080]; ILS-pricing will be exp1ainod m Chapte< 6.5.5

"'1Nf-17-MON [24.09.2008]
"'1Nf-17-MON [24.09.2008]
""'1Nf-17-MON [24.09.2008]
caused by negative mortality developments. 267

Tbe way monoline insurers evaluate a transaction is that they need to be comfortable
!hat they are not exposed to a confidence level above the 99% thresbold level. Tbey look
at scenarios as weil as the stochastic models that result in a risk being above this level.
Tbey hesitate to wrap structures where they can experienee a sudden 100% loss, which
is the case with catastrophe bonds, but rather take out the tail risk of the distribution.
Tberefore, they have limited exposure in cat mortality transactions.268
In CDOs, monoliners usually take the senior part of the risk. If there is a credit
event or adefault of the underlying single CDS, monoliners anticipate that there will be
a recovery they can get after a work-out of the structore. Although some loss potential
in transactions exist, a !arge recovery can still be assumed after a credit event of an
underlying CDS referenced on a single name occorred. However, due to the multi-
event trigger structore, catastrophe bond CDOs are diflicult to insure sinee a 100% loss
of a wrapped tranche can happen.269
Further, monoline insurers do not like to wrap life settlements, since there is not
enough experience with their portfolios. Even if medical underwriters, sponsors, orig-
inators, actuaries have been involved in the discussions, the experience was that the
actoal results were coming in well below their prognoses. Tbe number of the block of
policies is rather limited consisting of 100, 200, 500 policies of individuals in smaller
life settlement transactions compared to 100,000+ policies in a life insurer's portfolio
with at least 10 years of experience.270
Investors in the past have been relying on the due diligence provided by mono-
liners. However, the franchise of the monoline industry suffered severely during the
crisis. Tbeir business model in ILS, enbancing long term mortality structores, is basi-
cally against the principle of risk pooling. Even if the portfolios differ in location and
population, monoliners basically cover longevity risk ouly.
The future use of monoline insurance far ILS depends on regulatory environments.
If the environment stays unchanged and the companies manage to restore their capital
and ratings, they can continue to be capable of providing credit enbancement in the
future. 27l
267INT_17_MON [24.09.2008]
268INT-17-MON [24.09.2008];INT-18-1NV [24.09.2008]
""INT-17-MON [24.09.2008]
270INT_17_MON [24.09.2008]
271INT_8_LAW [1O.09.2OO81;INT-22-BNK [27.10.20081
6.4. lNVESWRS 223
6A Investors
6.4.1 General market environment
Since the introduction of ILS 10 the capital markets, the share of the different investor
types bas changed. While in the cady years the insurancelrein!lUlllIlCC sec10r dominated
the investor landscape, the wider range of opportunities has attracted different types of
investors as shown in figure 6.21. While primary insure:rs and reinsurers, with a share
of 30% and 25% in issues outstanding respectively, were int.erested in supporting the
development of the market with investments, their share has fell to 3% and 6% at the
end of 2008. Dedicated funds and hedge funds have gained in market share. 272
1999 2008
"' ... ~.
Markel S izc US O 1.4 hn Market Sill,' USO 11.8 bn
Soo,,,,,, !""''''''''I:< Shares 0",,,,,,. I Ge ..,.! M.. ~o' 0.01"'''. S"",Ro. Zo"ch, !5 03 2<lIYiI
l)l<1
Wo",."""n, S!id< 51. 1 l<:"ufmann. More<!. Cop ".1 m"""8<""n, >r>d "'"u,""''','''' '" thc "t'u,,","" ..duSI!}'.
S'\I"lI.c. ZOrrch. 29 11.2007. (I'Q"OIII",n' S!id< 81 " T",aI ,·Qlu"...· M~ I C S«u""cs. 'Ibo c.'''''''fIh< bQnd
"" .. . '1 .1 )~.,..,"" lOO6. GU) ("arpon,., 8: com~."~ 1.1.(". N,,, yoo.. 2007 I SchulII. r.ul ., 11 .
InStiI ..", L," ~ od S«u""cs 2008. Aon C.., .. aI Ma,k... Ch,cago. 2008
Figure 6.21: Market share of n.s investor types
Banks continue 10 be involved in the arranging of the transactions, taking smallcc par-
ticipations in their deals.:173 Their share has remained 10 be low, rising from 4% in 1999
10 7% in 2008. 274
l'nKmfmann [_29.11.2007, pp. 8]

l'7'Klugman [IR 2004, pp. 11-9]
lUKmfmann [_ 29.11.2007, p. 1I]:Ozizmir [_15.03.2009, p. 4]
6.4.2 Convergence of investor's and sponsor's interest

Sponsors and investors of ILS can be expected to act rationally. They will complete
any transaction only if the marginal benefits exceed the marginal costs for both parties.
Sponsors need ILS to distribute hard-to-place risks and are interested to fix the terms
and conditions of their cover long-term. ILS can help investors to effectively diver-
sify existing portfolio allocations (including stocks, bonds, property, commodities, and
cash). Most investor types should have in common to be interested in managing their
portfolios with respec! to !beir risk and retorn preferences. They shift between assets in
order to achieve higher returns with /ess risk. AB a result, they are constantly searching
for assets defined by the efficient frontier, enhancing the portfolio's risklretorn trade-off.
Further, they should be interested in lowering the risk of the portfolio of asset invest-
ments by reducing lhe correlation among the assets they invest in. ILS are instruments
which bring a relatively high yield bearing a low correlation with any other asset type,
and should therefore be attra.ctive far investors.275 276
While asset managers and hedge fund investors are constantly looking for yield en-
hancement, insurance companies in their role as investors are interested in diversifying
!beir underwriting portfolio into ILS, taking those types of risk they may otherwise,
due to regulatory reasons, not be allowed to take. Further, through ILS they may aceess
markets in which they would otherwise only be able to participate at much higher cost.
In addition, through ILS they can diversify regionally. For instance, by taking natural
catastrophe risk in regions they normally do not underwrite. 277
6.4.3 ILS as zero-beta assets

Enhanced portfolio management systems in combination with regu1atory reforms are
expected to refine the risk selection of reinsurers and investors. Risks which are not
in line with the extemal and intemai guidelines will not be placeable to the reinsur-
ance and retrocession mark.ets. A possible substitute for traditional reinsurance is ART,
which bears the chance far capacity increases with new investor types which can be
approached. 278
Investors following modem portfolio theory evaluate their expected retorn versus
the risk of the investments available on the capital markets. Risk diversification is avail-
able in those cases when the development of asset values is not fully positively corre-
lated.279 The beta of an asset compares its spread to the development of a reference
portfolio universe. A beta greater (or smaller) than 1 means!hat the asset's spread will
increase by 1 basis point (or less) on average ifthe reference index increases by 1 bp.
275Müller and Schaefer [see 2000]

276Cole [see 1999]
2nMUller and Schacfer [see 2000]
278 SV [see 2005]
279MUller and Schaefer [see 2000]
6.4. INVESTORS 225
Zero-beta assets are tharefore uncorrelated.280

Studies of the early days of the ILS market have already shown that ILS and other
capital market investments show an extremely low correlation over time. Tbe correla-
tion of annual percentage changes of the S&P 500 equity index and catastropbe losses
was elose to zero between 1949 and 1996. 281 There is a very limited probability !hat
developments on interesl, currency or stock rnarkets correlate with ILS. 282 It could be
the case that natural or man-made catastrophes affect certain financial eentres and the
ILS markets as a result. However, Ibis relationship cannot be proved historically. Due
to the increasing size of the markets split between the main regional financial centers,
Ibis risk bas been regarded as negligible.283
The academic and business literature has therefore permanently been stating !hat
the risks involved in ILS are not or at least lowly correlated with the general economic
developments and other investments available.284 However, the current financial crisis
and the default of Lebman Brothers puts the non-correlation assumption into question.
The adverse developments resulted, at least temporarily, in a general lack of investor
interest. Sponsors were forced to hold back new transactions for some months, and sec-
ondary market values for existing transactions deteriorated. Further, ILS with Lebman
Brothers as total retoro swap counterparty are endangered to default.
6.4.4 Pricing and returns

One of the main obstaeles sinee the early days of the market has been that structoring
costs have been regarded as rather high in relation to traditional reinsuranee and that
investors' return assumption was high in order to be compensated for the borne risk,
novation, and low liquidity. The market for ILS tharefore faced an essential conundrom:
Both, seilers and buyers of the instruments, feit to be mispriced. While in the early days
the ILS market was bedeviled by the fact that there was no demand but supply, investor's
demand, unti1tha current financial crisis, bas outweighed the availability of assets by
far. 28'
Pricing sources for n..S are rare, and quotations have to be taken with some scepti-
cisrn due to the low liquidity of the bonds. The history of the market is sbort, especially
if one takes newer products into consideration. Cat bonds yields are often compared
with corporate bonds with similar ratings in the "BB range", since the loss character-
istics of an ILS are very similar: 286 A pre-defined event triggers a loss that results in
a partial or even totalloss of the capital invested. Only the canse of the event and the
determination rnechanics of how rnucb capital is lost are different. Tbe actual monetary
280Pe1senheimer ct al. [see 2005. p. 470]
28 ICanteret al. [see 1997, pp. 69-83]
282Hanft and Struve [see 1999]
283Müller and Schaefer [see 2000]
284Cole [see 1999]
28SZolkos [see Ol.04.2002];Schultz et al. [see 2008, p. 13]
286Tnwdetal. [see2007,pp. 35-391
losses of the sponsor may be ;ndemnjfied defined by the pre-speci:lied formula. Alter-
natively, the ammmt may be compensated based on the modeled size of the event and
its location. In the lattcr casc, loss profiles arc cstimatcd by ODe of the main catastrophc
modeling firms using sophisticated models and detailed policy level exposure data. The
majority cf catastrophe n.S, far instance. have estimated annual default probabilities of
around 1% (oncc-in-lOO-years) and cxhausti.on (totalloss) probabilities cf around 0.4%
(once-in-25O-years). These cha:racteristics place them at the high non-investment-grade
ratinJ: I'8IUtC cf corporatc bonds (Standard & Poor's: BBlMoody's: Ba).287
..
,
,.
,; '"'"
•
~,
.,· '00
"
- S"'ssR. Cat Sm,ci , ndr_, - Hr dgr " ulld Rrsur<h , nd • .• FO r

--M u r ill l ..)n<h US Hond I nd .. RI! _ S&P's~OO Indn
- J P,\ ' US GO\1llond I ndn
Sou=: 0"" Gmph bascd on <Iota from Illooml)erg r inan" L.I'. / SoHdum Partners
Figure 6.22: Comparison of index performances
Figure 6.22 shows a historical comparison between the performance of the Swiss Re
Cat Bond Index ver8US several other indexes since 2002. n..s investments experienced
a stcady and positive performance. In the phase of extraordinary market turbulence
since the middle cf 2008, the performance was still acceptable. while other investments
like those into the US BB rated corporate debt, hedge funds. or stocks lost in value.
Although the iIlIiaes are quite broad and difficult to compare, it can be !IUIIIlllIlri.sed
that there was an overall positive trend compared with other investment types. Flgure
6.23 further shows a comparison cf the performance of several ILS fund investments
since July 2005. Details ofthe indexes and funds are explained in Appendix M.
Zl7Chrlatophides [see 14.05.2004. pp. 2-4]

6.4. lNVESWRS 227
The yie1d enhancement of ILS against ccuporate bonds is based on the novation
premium and as a eompensation for information asymmetry between sponsors and in-
vestors. Anothcr:reason may be the 10w liquidity of the uscts. Further. investors nor-
mally are eharacterised by their myopie loss aversion. This leads tD a stronger mental
rccognition of losses than of generated profits. The modeling for ILS quic1dy reaches
its 1i.mits, since e.g. catastrophe events are not characterised by the normal distribution
being the core assumption of modem portfolio theory.2BB
'"
:",~
::~ -
. ~r
~
-- - ~:
'(
I \~ _7
" t",;~::.;;::;;-=
- ""
w +-----------------------------~
m +-~~~--~~~~--~~~~--~~~~
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
\~ o~ \",<> ~~< \~ o~ \",<> ~~< \~ d"''' \",<> ~~< \~ 0...... \",<>
--- Solidum I · ~rln.r . S,\C ."und 1/2 __ CS,\ ILS r und

-+-Ci. <id.n L ru C.t Kond F,md - A I G CAT Kond t"und
_A I G I LS Fund
Sou"",: O"n Graph hascd on data rrom Illoomb<:rg Finan« LI'_ I Solidum f'an'>e1'S
Figure 6.23: Performance of ILS funds since July 2005
Capltal Auet Pridng M_
Modem portfolio management is strongly influenced by the theory of Harry Markowitz:

The risk of a portfolio consists of systematic risk which is non-diversifiable and unsys-
tematic risk, also known as idiosyncratic risk wbieh is related to the individual asset.
Markowitz hall proven that unsystematie risk ean be reduced or eljmjnated by the diver-
silication of assets. Investors reach an optimised uset allocation by using their funds
for the purchase of the highest yielding assets at a given risk level or the lowest rist at a
21ITraudet al. [see 2OO1.pp. 35-39]

prc-defined pcrformancc level. 289 Building on the work of Markowitz, the Capital As-
set Pricing Model (CAPM) was independently introduced by Treynor, Sharpe, Lindner.
and Mossin. CAPM is a thoory about thc way asscts arc priccd in re1ation tu thcir risk.
It worts under the condition that asset retums are normally distributed and investors in
a fully transparent market are foI1owing a profit maximisation approach.290
Tbe major result of the model is that the expocted retum of each aaset is solely <Je..
tennined by its systmlati.c risk which is measured by the asset's sensitivity towards the
market portfolio defined as the portfolio containing every risky asset in the international
economic system (stocks, bonds. but also real estate., commoditics, etc.).:l5Il
'"
IM
••
.. IGJ
- •••
-
0
, .,"
-
• "
"
" . " ". '"
., 21,0
Sou",<. (Nn Graph
Figure 6.24: Comparison cf dlicient fronti.ers
Fm the detailcd explanation cf the following example please refer to Appendix N: Fig-
ure 6.24 shows the portfolio lines of two portfolio combinations. Combination lines
plot the cxpcctcd retum E(r) against the risk in tcn:ns of tbe standard deviation O"(r)
with the given portfolio weigbts. Bach point of the line represents a different set of
portfolio weights in the relevant socurities. Tbe portfolio combinalion line shows how
the cxpected return and risk of the portfolio change with the variation of their wcights.
ZlllMarkawitz [_1'JS2. pp. 71-92];SIoettneI: [see 1994.pp. 322-32S]
ZIIOSharpe [see 1964]:Treynor,I..intnm" [see 1965]:Mouin [see 1966]
ZII1Gisdakis and et aL [see 11.03.200S, p. 20]
6.4. INVESTORS 229
Tbe blue !ine consists of the risklreturn coordinates of a combination of stock and bond
investments. Point A of the graph inclodes a 100% share of stocks measored by the
Standard & Poor's 500 index. Tbe share of the stocks falls from point A to point B
until the total portfolio consists of govemment bonds only. Tbe risk return profile of
the govemment bonds is calcolated with data from January 1931 until November 2008.
Tbe historical correlation between the stocks and bonds was 0.077.
Point C of the graph consists of a portfolio of 75% stocks and 25% catastrophe
bonds. As a reference to calculate the risklreturn profile of catastrophe bonds, the av-
erage yield of 7.32% and the volatility of 2.1 % of the "Swiss Re BB Cat bond lodex"
in the timeframe since its introduction in January 2002 until November 2008 has been
laken. While the 25% share of the cat bonds remains stable, the 75% share of the stocks
reduces down to zero, being replaced by government bonds until point D. Tbe correla-
tion between the catastrophe bonds and stock or government bond investments, based
on the results of an earlier research done by Canter et al., was defined as zero.292 293
It can be summarlsed !hat 1LS offer investors an attractive way to diversify existing
investment allocations generating relatively high expected re!ums above the risk-free
rate.
ILS diversification henefit measured hy the Sharpe Ratio

Based on the CAPM the Sharpe Ratio (SR) was developed as a risk-adjusted perfor-
mance measure. Tbe diversification benefit of an asset is calculated as the ratio of
excess return above the risk free rate to the standard deviation of an asset. SR works as
an indicator for the investment risk.294
where:
Sp = SR of the portfolio
E(Tp ) = expected return ofthe portfolio
T F = risk free rate
"(Tp) = standard deviation ofthe portfolio
Investors norma11y take an asset purchase into their portfolios into consideration if the
SR of the investment in question is equal or bigher than the correlation coefficient of
!bis asset, multiplied by the SR of the portfolio.
292Canteret al. [see 1997, pp. 69-83]

293Litzenberger et al. [see 1996, pp. 76-86]
294Cole [see 1999]
where:
Si = SR of single asset i
Pi,p = correlation coefficient between i and the portfolio
Sp = SR of the portfolio retum
Therefore, under the condition that ILS are uncorrelated with the other asset c1asses
available, the right hand side of the equation reduees to zero, and investors will enhance
the portfolio perfonnance as long as their expected retum exeeeds the risk free rate. 29'
6.4.5 ILS triggers

Digression: Asymmetrie information, adverse selection and moral hazard
Before George A. Akerlof published bis article "Tbe Market of Lemons", the common
premise of econornie theory was that all market participants act on the basis of full or at
least homogenous information. It was assumed !hat the seilers and boyers of goods are
able to exactly price, for instance each automobile on the mark.et, since they know its
quality. At the time it was eommonly assumed !hat, for instance, insuranee eompanies
evaluated the risk in the same manner as the insured and banks bad the same information
regarding default risk as their borrowers. 296
Akerlof first analysed the problem of asymmetrie information. He descrlbed the
market for used cars where the seIler, having used the vehic1e for same time, knows the
quality of the ear better than the boyer. Tbe buyer then assumes an average quality he
may be informed about through the press aud is willing to pay an average priee only.
Tbe seiler of a good car then is not able any More to realise a fair price, sinee the boyer
eannot evaluate the qoa1ity. Sinee the average priee may be regarded by the seiler as
too low, he will not offer bis ear on the market any more with the resolt !hat low quality
ears will drive out the good ears. Sinee the boyers then start to assume low qoa1ity ears
(ealled "Iemons") on the market only, priees will fall further until the market comes to
a point that Da cars may be traded anymore. 11ris process is called adverse selection.
Adverse selection is the process of an individual to make a deduetion for uncertainty
when purchasing a merchandise on the secondary market.297
In literature about insurance economies today, it is common to assume that the in-
sured has More information ahout bis risk type and futore behaviour than the insurance
eompany. Tberefore, the information is asymmetrie in favour of the insured. 298
Since the phenomenon of adverse se1ection is disastrous for any economy, the fol-
lowing methods to avoid the deerease of its wealth by stimnlating the information flow
were developed:
29SCole and Sandor, pp. 207-208

296Emons [see 2001, p. 664]
297 Alerlof [see 1970, p. 488-492];Decker [see 2OOO];StoeUner [see 1994, pp. 322-325]
298Zweifel and Eisen [see 2000, p. 292]
6.4. INVESTORS 231
Sigoolling is the initiative of the iofonned party to avoid adverse selection. Michael
Spence has written about signalling on the job market. Signals are defined as observ-
able, variable features which can be iniIuenced by the job applicant. An example for a
signal is qualification. Through signalliug the employer is able to evaluate the produc-
tivity by analysing the signals and to fix the salary.299
Joseph Stiglitz has developed screening as a method for the low infonned party to
minimise adverse selection. Screening is used by banks in the credit application pro-
cess. Individual and corporate customers as weIl as projects are evaluated by screening
systems within the credit application process. The result is a so-called pass-grade, the
credit being approved, or a fail-grade, resulting in a decline. 300 Further, screening is
used by insuranee companies. Customers who know that they face large risks are more
likely to buy insurance than customers who face small risks. Through the screening of
their clientele, insuranee companies are able to distingnish between risk groups, trying
to minimise the problem that ouly people facing !arge risks are buying their insuranee.
The result is a variety of contract types, for instanee, customers with low risk profiles
can be offered a low premium but have to accept a lower compensation in case of a
claim. In contrast, customers with high risk profiles have to pay high premiums but will
get full compensation for claims. Thus, life and health insurance companies require
medical examinations and will refuse coverage to persons with terminal illnesses. Au-
tomobile insurance companies charge higher rates to people having been involved in a
number of accidents or with a conviction for drunk driving.301
Credit rationing is another method used by banks due to the following reasons:
Banks are not honoured for taking high risks. Their revenue is the margin on top of
their refinancing costs, this means that the expected return decreases with the riskiness
of their outstanding volumes due to higher los ses expected. The expected return of a
bank depends on two contrary effects: The interest effect results in higher returns with
higher interest rates, but the selection effect results in lower returns due to higher lasses
as a consequenee of higher default risks tsken. The two effects result in an optimized
interest rate for the individual hank at maxirnum returns, meaning that credit is auto-
matically rationised. 302 Credit rationing is supported by regulatory frameworks like
Basle 2: Financings to customers involving higher risk, for instance reflected by lower
ratings, are charged with higher capital costs and therefore require a higher interest
rate than credits to customers with lower risk. The regulatory framework automatically
rations the financing volumes available on the market."l3
An insuranee company offers a pooling contracl with a general premium level for
the average risk type, sinee it has incomplete ioformation about the individual risk to
cover. lbis average premium, however, is too expensive for the higher quality risk types
299Spence [see 1973]

300Stiglitz and Wcis, [see 1981, pp. 393-4091
30IStiglitz and RothschildMichael [sec 1976, pp. 648-649]
302Stiglitz and Weiss [see 1981, pp. 393-409]
303Pioretti [see 19.04.2005, p. 1];Slwpe [see 1990]
so !hat the customer will be acquired by other competing insuraoce compaoies offering
bespok.e tariffs at lower levels. The first insurance company will run into the situation
!hat it has to increase the premiums because of its taking bigher risks only, will lose
even more customers and finally run into insolvency. The bigher risk types will bave to
cbaoge to aoother company aod the whole process starts again. 304
Moral hazard is the second form of asymmetrie information defined as the result
of maximising human behaviour. Insurers, for instance, are not able to write a camplete
contract specifying the exact level of precaution effort the insured bas to employ in ev-
ery contingency. The insured's behaviour is not observable, or it is observable but not
verifiable. The insured is assumed to be risk averse. Therefore the insurance bought has
a positive effeet on bis expected utility. But at the same time, the utility function is neg-
atively impacted by the bigher premium to be paid in order to compensale for the more
severe moral hazard problem. The right mix between risk shating aod incentives has to
be found.'05 Costs aod benefits of an action are weighted by the insured, and the ac-
tion is taken when benefits exceed costs. When the insurance contract has been c1osed,
loss frequency aod loss severity cao be dependent on the bebaviour of the insured. It
is under bis contral to protect himself in order to prevent damage or to limit its conse-
quences. Hence, the insurance company charges an excess premium in order to cover
its additional risk. The threat of Moral hazard malres insurance More expensive. '06 307
There are two forms of Moral hazard: ex-ant. moral hazard if the chaoge in be-
haviour of the insured tskes place before the occurrence of the event insured, aod ex-
post moral hazard if the cbaoge in behaviour tskes place after the event. Ex-post moral
hazard is mostly relevant for health insurance, for instance when insured persons de-
mand too much treatment. The unqualified term "moral hazard" therefore usually refers
to ex-aole moral hazard. '08
There are severa1 methods for insurance companies to avoid moral hazard: Loss
prevention, also referred to as self-protection, keeps the insured value of any misfortune
less thao the value to the insured person, for instaoce buildings or automobiles are
insured for less than their true worth. Altematively, both parties may agree a deductible
- the insured then receives an indemnification that is smaller than bis 10ss by the amount
of the deductible. The partial insurance is ao incentive for the insured to avoid damage.
Loss reduction, also referred to as self-insurance, leads to a situation where the insured's
effort inlIuences the distribution of the loss occurted but not its probability. For instaoce,
precautionary measures against the damages of tornadoes or ftoods are loss-reducing,
but the insured does not have any inftuence on its occurrence. Exclusive contracts
avoid the situation that the insured buys protection from severa1 insurance companies
to compensate loss reduction.
304Zweifel and Eisen [see 2000, p. 293];Stiglitz and Rothschild Michael [see 1976, p. 293];Pauly [see
1968]
305Sonnenholzner and Wambach [see 2005, p. 1134]
306Zweifel and Eisen [see 2000, pp. 292-293]
307Sonnenholzner and Wambach [see 2005, pp. 1133-1134]
308Sonnenholzner and Wambach [see 2005, p. 1133]
6.4. INVESTORS 233
Many period contracts with bonus-malus sehemes allow the insurer to rate the expe-
rience aver time and renegotiation contracts include the right for the insured to change
the contract to full-insurance in case that the risk. of moral-hazard ceases 10 exist. 309
Moral hazard and ILS

Securitisation of insurance risk depends on detailed knowledge about the developments
and effects of natural and man-made catastrophes, mortality, aod other risks insured.
Since there are no underlying .ssets being traded in ao ILS structure, the specific desigo
of ao appropriate trigger is of significant relevaoce for investors 31O The market bas
developed • variety of different trigger types: 311
• indemnity triggers are activated through actua1losses within the sponsor's port-
folio
• index triggers are tied to an iodex usually established by ao independent tbird

party
• parametrie triggers activate when a certain level of losses is reached
• modeled loss triggers activate when expected losses re.ch a certain level
There are trade-offs between the trigger types. Indemnity triggers entail moral hazard
bec.use the size of the claims p.yout remains within the control of the issuer. Index,
parametric, aod modeled loss triggers do not entail moral hazard but give rise to b.-
sis risk because the p.yoff released by the trigger may differ from the actual claims
experience.312
Indemnity-based structures are attractive to issuers because they avoid basis risk.
wbich they would be exposed to io • pararnetric or iodustry-iodex-based transaction.
However, this raises various issues related to asymmetrie information, such as advene
selection and Moral hazard: Adverse selection reflects the problem th.t the sponsor
might try to securitise the most unattractive parts of bis portfolio keeping the more
profitable ones. Moral hazard refers to the possibility th.t cedents might no longer try
to limit their losses, since they have traosferred the risk to investors. Further, the ini-
tially estimated level of risk may increase if the cedent relaxes its underwriting policies
(ex-aote) or its claims settlement in case of a c.tastrophe (ex-post). Even if the under-
writing policy is not relaxed, the risk io the covered portfolio could grow aod chaoge io
composition because of the underwriting of new policies. Th.e insurer gets compensated
for this portfolio growth by collecting more premium iocome. The risk for the secn-
rity holders may iocre.se without compensation, however, if the loss on the security is
309S0nnenh0lzner and Wambach [see 2005, pp. 1136-1139]
31°Erdönmez [see 01.09.2005]
311 please find a detai1ed explanation of trigger types in chapter 5.3.1
312Csiszar [see 2007]
defined in terms of fixed attachmeot and exh.ustion points. Another issue rel.ted to
.symmetric information arises out of the proprietary nature of the exposure data - the
investor typically does not have full access to this inform.tion. In this respect, ILS are
different from CLOs where the investor might dig down and analyse each of the loans
in the portfolio securitised on bis OWD. 313
Tbe market has developed several tools to control these issues: 3l4
• adverse selection potential can he addressed by establishing in advance clear and

non-negotiable rules for the selection of qua1ifying business (. forther tool may
he to include the cedent's full portfolio or. complete line ofbusiness).
• the cedent keeps • portion of alliosses: Tbe goals of the cedeot and the security
holder can be aligned by making sure th.t first, in an excess of loss contract, the
cedent could be required to retain • certain percentage of losses in the reinsured
I.yer. Second, regarding losses helow or .bove the layer, there can he limits .s to
how much additional reinsurance the cedent may obtain.
• changes and growth of • portfolio can be controlled by defining • specific portfo-

lio consisting only of pre-.greed contracts and exposures. Altem.tively, through
periodie trigger resets or limits on the inc1usion or impact of new policies in the
.greemeot. Short risk periods, or indexing the contract to the combined ratio
(paid losses divided by premiums received) for the relevant lines of business may
also be considered.
• Catastrophe modeling firms, and to • lesser extent the rating .gencies, play an
important role in controlling the problem of .symmetric information. H.ving
access to details of the exposure and policy data, thcy can provide the investor
with relevant information through the loss prob.bility distribution. Modeling
firrns also pl.y an important role in evaluating the quality of the data provided in
terms of completeness and consistency.
6.4.6 Results of the interviews regarding investors

Before the c.pital market crisis, investors Made significant allocation to the sector and
were looking to deploy assets - there w.s • healthy demand for ILS. However, the
demand has heen too low to bring the ILS market to • macro level in terms of volumes.
On condition !hat enough supply will be .vail.ble, the traditional money managers and
investment man.gers are needed to bring the market to • bigher level.3l5
313 Andcrson et al. [see 1998, pp. 11-12]

314Anderson et W. [see 1998, pp. 11-12]
31'INT_2-BNK [02.09.2008];INT-4-BNK [04.09.20081
6.4. INVESTORS 235
Investors are the last in the "food-ehain". They continue to be very sceptieal about
the ILS market. While some still !end to rely on the information of the offering cir-
culars and ratings rather than on the orulerlying documentation, an increasing nomher
of market participants follows a More sophistieated approach. Newly established funds
with insurance specialists employed have heen eoming to the market.31•
The sector continues to be dominated by experts. The maiority of investors today are
institutionaI rather stieking with the risk purehased following a buy-and-hold approach.
There has been limited secondary trading, mostly in natural eatastrophe ILS. 317
A lot of investors, especially hedge fonds, have the ability to cross the produet
spectrom into high yield eorporate bonds or structured finance. A side-effect of the
current crisis is that ILS are getting eompetition from other high-yielding asset classes
trading at high discounts. ILS, however, stay to be attractive due to their low correlation
to other produets.318
Investor Types
Ranked by their volomes invested as shown in figure 6.21, the following types of in-
vestors can be summarised:
Dedicatedfunds: At the time of the interviews, there were about 14 funds spe-
cialised in ILS investments, among them funds managed by Clariden Leu, Fermat,
Pimeo, and Zurieh. Two of the funds with asset volumes above USD I bu and the
remaining with asset volurnes between USD 350 to 600 mln. These have been the main
investors for eatastrophe bonds attracted by higher returns eompared to other eredit mar-
kets - during recent years the yie1ds generated by the funds are reported to be around
12-13% p.a.. Usually funds are prepared to accept a 1% loss risl<, meaning!hat they are
prepared to invest up to 1% into eatastrophe bonds with a once-in-lOO-years event risk.
At the time of the interviews, dedieated funds remained to be the only liquid souree in
the secondary markets. An inerease of eorrelation between the ILS and general market
developments was reported in !hat respect !hat the investors in the dedicated funds ean
pull out their liquidity and put it to work on alternative produets.319
Dedieated funds for individuals: ILS funds for individuals are mainly traded in
Switzerland. For individnals, an allocation of 2 to 3% of the total arnounts invested is
regarded as an appropriate diversifieation into a lowly eorrelated, high yielding asset
class. At the time of the interviews the products experieneed a strong track record
in terms of performance. They were among the few asset classes which were still in
positive territory. Investments into private funds are available for small arnounts from
CHF ISO whieh are allocated to investments in eatastrophe bonds only. ILS funds for
3l6INf_l_MOD [19.08.2008I;INf-5-BNK [04.09.2008];lNT-ll-CON [12.09.2008]
3I7INf_7_REl [08.09.2008I;INf-ll-CON [12.09.20081;INf-25-BNK [29.10.2008]
3l'INf-l-MOD [19.08.2008I;INf-5-BNK [04.09.2008]
3l'INf-4-BNK [04.09.2008];INf-20-BNK [20.IO.2008];INf-22-BNK [27.1O.2008];INf-25-BNK
[29.10.2008]
individuals do not invest into life insuranee related ILS because of their long tenn, low
yields and diverging cash flow mechanisms in comparison to catastropbe ILS. Tbe fund
admistration is supported by up to date risk mode!ing tools.32•
Tbe products rarely exist in the US, but may be introduced sinee there definitely is
a market for them. In general, the sector is experienced to grow in !ine with the growth
ofILS, and reinsuranee is finding its way into collateralised products.321
Hedge funds: In their search for high yields, hedge funds were attracted to the high-
yielding catastropbe bond space during low margin environments. Especially the boom
year 2fXY1 brought a lot of opportunistic cash rich investors looking for attractive yields
in BB rated issues. ILS were regarded as a belter investment than the usuallong-short
equity funds, since they are a diversifier to the portfolio with low correlation. Tbe
funds have been getting increasingly professional and employ speciaiistS. 322 Compared
to dedicated funds, hedge funds are prepated to take higher risk - some of them are
prepated to dedicate 10% of the volume into once-in-lOO-years, or even 20% into once-
in-lOOO-years perils. Tbey have been regulated by their investors only323
Hedge funds usually act professionally and do not appear to the market as forced-
seilers. However, due to redemptions by their investors caused by the deteriorating
capital markets, they started to seil massively in ntid-2oo8. Although they have been
professionally refocussing and re-balancing their portfolios, the market reached a point
when there was just too much US wind ILS for sale in the market doring the hurricane
season 2008 and priees started to fall.'24
Although hedge funds are facing adverse developments and are forced to move out
of the space currently they are expected to retorn to the markets when the situation
will get back to normal. C0n3petition from investment opportmtities into high yielding
subordinated baok debt or CDOs is regarded as temporary, and the low correlation to
the general market is still a slrong argument tu invest into the ILS space. 325
Hedge funds usnally are levered, meaning !hat they borrow money to invest. This
means !hat they have to generate yields .bove 5% plus their funding cos!. Tberefore
they can be expected to continue to be interested in high-yielding, low-rated risk like
catastrophe bonds.'26
Money managers are interested in the lowly correl.ted asset class. Tbey see it as
• long-tenn investment and stick to their allocations over disaster and pricing cycles.
Tbey are prepared to accept about 1% loss in the portfolio due to a catastropbe even!.
While ratings are almost irrelevant to them, they appreciate the agencies certifying the
legal issues and rather look at modeled investment risks, comparing them with third
320INT4-BNK [04.09.2008];INT-3()'BNK [14.11.2008]

'" INT-ll-CON [12.09.2OO8];INT-I9-ASO [26.09.2008]
"2INT-I-MOD [19.08.2008I;INT-5-BNK [04.09.2008] ;INT-I()'RAT [12.09.2OO81;INT-24-INS
[28.1O.2OO8];INT-25-BNK [29.10.2008]
"'INT-ll-CON [12.09.2OO8];INT-2().BNK [20.10.2008]
'''INT-26-1NV [29.1O.2OO81;INT-30-BNK [14.11.20081
"'INT-I-MOD [19.08.2008I;INT-3-BNK [03.09.2008];INT-4-BNK [04.09.2008]
"6INT-12-1NV [14.09.20081
6.4. INVESTORS 237
sourees. Sinee they work without leverage, they are prepared to take long-term, low-
yielding investments in life reiated n..S.'27
InsuTers anti reinsurers: In the early phases of the marke!:, insurers were main in-
vestors. Life insurers are interested to diversify into the eatastrophe n..S space, sinee
they understand the risk and actuarial models. Today there is no signifieant trend of
insurers investing directly into ll..S, either for hedging or diversifieation. Insurers rather
tend to invest through dedieated funds in order to get more diversifieation and expertise.
Life insurers a1ike pension funds are interested in a negative correlation with longevity
and therefore also invest in indexed products through funds. Selectively they also in-
vest in lowly-eorreiated eatastrophe risk. Pension funds eompare the products with
indemnity-based reinsurance and appreciate that the produets do have limited basis risk
only.
Reinsurers have the ability to cross the speetrurn. They are able to seil reinsuranee
and hedge the risk with the issuanee of ll..S. This ereates a eircnlar market Ibe risk
flows among the participants, like between the Bermudan reinsurance carriers who tend
to retrocede their risks taken to eaeh other. Finally, the same risk may be sitting in
several companies' books. 328
Banks helped to develop the markets in its initial stages through their participations,
but were less present as investors in recent years. Caused by the crisis, they were forced
to take participations in recent issues arranged due to a 1ack of investor interest in recent
months. However, !heir balance sheets are eonstrained, and !herefore !hey are not able
to warehouse risk on large seale at present. Banks do not sponsor n..S to hedge their
own books yet but the active trailers of n..S seasonally use n..Ws for the hedging of peak
risks,329
Investors for funded XXX transactions will be difficult to find, since the eost for
leverage is getting higher. Banks may be the only participants who are willing to take
long-term risks on their books."o
Drivers
Non-life ll..S started in 1992, eaused by horricane Andrew followed by the North Ridge
earth quake when investors were attracted by collateralised deals and spreads whieh
were higher than !he modeled price and !herefore any premium to be paid for reinsur-
ance.331
Investors follow !he supply and demand mechanisms - !hey are constantly looking
"'INT-5-BNK [04.09.2OO8[;INT-6-ASO [05.09.2008];INT-I2-INV [14.09.2008]

"'INT-5-BNK [04.09.2008];INT-6-ASO [05.09.2008];INT-23-BNK [28.1O.2008];INT-24-INS
[28.10.2008]
"'INT-I-MOD [19.08.2008];INT-2-BNK [02.09.2OO8];INT-4-BNK [04.09.2008];INT-5-BNK
[04.09.2008]
''''Carey et 01. [27.10.20080]
"'INT-3-BNK [03.09.2008];INT-9-EXC [l1.09.2008];INT-ll-CON [l2.09.2OO8];INT-I2-INV
[14.09.2008]
for alternatives to established markets and over-returns. Tbeir benchmark is the so-
called "multiple" which is calculated by plotting the yield of an issue against expected
loss. Usually the multiple is higher for a high expected loss probability, like once-in-
lOO-years or once-in-50-years. Investors correct deficiencies for indemnity or pararnet-
ric triggers and take into consideration limited ttansparency, callablility, and granularity
of an issue. Seasonality has to be corrected since hurricane seasons, for instance, do not
run over the whole year. Finally, care has to be taken that foreign exchange f1uctuation
does not interfere the ca1cu1ation. lbis is the case when lasses are paid in Euros, but
the ILS pays out triggered amounts in US Dollars. ILS multiples have been attractive
relative to corporate bonds. However, while catastrophe issues offer a relatively high
BB type pricing, and the investment-grade life ILS offer a rather low yield. Investors
like efficient market pricing mechanisms.332 Tbe low correlation 10 other asset c1asses
like credit markets, OIe products, commodities, or foreign-exchange is attracti.ve. But
correlation shows up where investors usually do not expect it. While Kattina could be
regarded as system-inunanent, the results of the credit crisis bring some doubts about
the non-correlation thesis. 333
Especially cat bonds are diversifying investors portfolios into new areas. Tbe prod-
ucts offer the benefit to be fully collateralised although the Lehman default raised some
concerns about the strocture of the collateral funds. '34
Ob.tael..
Capital market investors usually are not used to insurance, especially weather risk. The
majority or the big investors are not involved in the business, since they regard the
market as too small to build capacities and know-how.'35
Tbere are concerns about adverse selecrion. Tbe ILS sponsor therefore has to keep
a good share in the transaction. Investors usually do not have a close contact to the
sponsors and are afraid that they only place risk into the capital markets they are not
willing to keep then3Selves. 33•
Transparency was low in cat bonds, but in3proved after hurricane Katrina. Tbe
transactions were not very transparent when investors wanted to verify damages after
catastrophe events. Apart from reinsurance premium to be paid to the SPRY, the cost
s1ructures of the transaction were not disc1osed. The investor was not ahle to evaluate
how the promised yield will be generated - in case of the Lehman ttansactions, much of
the yield was based on risky investments. Tbe information f10w post-event was beller
regnlated and in3proved in the issues after hurricane Katrina.'37
"'INT-4-BNK [04.09.2008[;INT-IO-RAT [12.09.2008];INT-I2-1NV [14.09.2008];INT-20-BNK

[20.10.2008]
'33INT-4-BNK [04.09.2008];INT-20-BNK [20.10.2008]
334INT_7_REl [08.09.2OO8];INT-12-1NV [14.09.2OO8];INT-13-MOD [16.09.2008]
335INT-4-BNK [04.09.2008]
'''INT-6-ASO [05.09.2OO8];INT-12-1NV [14.09.2008]
"'INT-7-REl [08.09.2OO8];INT-20-BNK [20.10.2008]
6.4. INVESTORS 239
After the depart of the monoliners, complexity is becoming an issue in life ILS.
Risks involved in XXXlAXXX transactions are rather difficult to quantify, while mor-
tality and non-life related catastrophe risk is a lot easier to model. 338 There is a psycho-
logical hurdle to invest in ILS: approximately 90% of the capital market participants are
educated economists, journalists, accountants, or psychologists hut only a few of them
are physical scientists specialised in meteorology or seismology. It is easier for them to
predict the acts of humans than of nature and the management of the investors in many
cases has to overcome its lack of familiarity. Peop1e are afraid of natural catastrophes,
and insuring their risk is rather frightening to thern339
Triggers
There is a permanent tension between indemnity and parametric structures. In a hard
market phase, investors are in control and they like parametric or modeled loss deals.
In a soft marke!, the sponsors are in control and they like indemnity deala. 340
Indemnity ILS are very similar to reinsurance, which insurance companies are used
to. The mostly conservative managements of primary insmers lik.e indemnity triggers,
since they are not prepared to take the basis risk. Indemnity from primary insurers
seems to he More acceptahle than from reinsurers. Catastrophe bonds have indemnity
perlods of 12 to IS months. 341
Indemnity bonds need a rigorous filing in the US similar to standardised IOK an-
nual reports, heing cornbined with rather high costs. Since only one indemnity based
bond, Kamp Re, has heen triggered following Katrina, there has not heen areal test to
the market Investors buying an indemnity bond prefer high quality established names
with a successfnl franchise to ensure the necessary underwriting and claims handling
quality.342
Investors lik.e parametrie transactions due to their transparency. It is referred to
as the purest risk, since parametric ILS carry less risk of Moral hazard and adverse
selection. The loss can be evaluated pretty early after an event within a perlod of less
than six months. Parametric ILS mainly cover catastrophe liability and catastrophe
mortality. Investors like a diversity of loss triggers and new perils as long as the models
are understandable - new structures with multi-triggers were placed in 2OOS. Further,
an innovative ILS which disaggregates the PCS Index to county level was placed to the
market 343
Index based transactions are also favoured by investors due to their transparency.
338INT_7_REI [08.09.20081;INT-12-INV [14.09.20081

339INI'_12-INV [14.09.2008]
""INT-I2-INV [14.09.2008];INT-13-MOn [16.09.2008]
'''INT-I-MOn [19.08.2008];INT-4-BNK [04.09.2OO81;INT-12-INV [14.09.2008];INT-13-MOn
[16.09.2008]
'''INT-I-MOn [19.08.2OO81;INT-2-BNK [02.09.2008];INT-4-BNK [04.09.20081
'''INT-2-BNK [02.09.2OO81;INT-4-BNK [04.09.2008];INT-I2-INV [14.09.2008];INT-25-BNK
[29.10.2008]
A third party agency surveys the market place in order to come up with a value that
represents insured lasses associated with the event. Investors da not take basis risk
associated with one particular company but the broader industry's exposure to the event.
After the strength of a stonn or the magnitude of an earthquake has heen announeed,
the investor knows whether or not bis prineipal is at risk. Sponsors and supervisors
are monitoring the market discipline regarding triggers. Tbe parameters should ideally
be metries wbieh are relatively easy to quantify by scientists like meteorologists or
seismologists.344
Sponsors have to keep a 10-15% retention in order to stroeture out the moral hazard
risk.. The crisis increasingly m.akes investors demand the same information than reinsur-
ers. The creation of an independent, PCS-like eatastrophe index is planned for Europe
and would benefit the market by lowering the basis risk. Tbe approach is appreciated by
the rating ageneies. However, there are coneems about the indemnity aspeets involved,
since even if lasses are aggregated across the insurance companies, it still stays to be an
indemnity-based risk. While the aggregated indemnity risk reduces the likelihood of an
individual company having a moral hazard aspect to their behaviour, it does not reduce
the moral hazard at an aggregate leve!.'45
Apart from natural eatastrophe indices, life indices inciuding a limited number of
lives were developed. Data about approximately 50,000 life insurance polieies are eOffi-
bined by a servieer, and a daily mark-to-market valuation is provided by an investment
bank. Index-based derivatives ean be traded as an investment or to hedge longevity
risk. 346
Modeled loss ILS follow the ealeulations of the interna1 model by the sponsor, in
general verified by one or more risk modelers. Tbey are bespoke transactions with
limited basis risk taken by the sponsor.'47
Portfolio Models
Market partieipants entertain the whole speetrum of portfolio models: some investors
are very sophisticated, while others are rather naive in their approach to portfolio man-
agement. Mathematica1 rigour is irnportant, since catastrophe models are bighly eOffi-
plex. Therefore, investors nonnaIly license neutral and conservative cat models but
then aggregate the outcomes of the models by transforming and reworking the data.
The data have to be adjusted for the purposes of investment management, since most of
the modelers' customers are primary insurers who do not trade eat risk. Modelers have
their strengths in natural eatastrophe and life risk. Casualty, nuelear, aviatioo, marine,
or catastrophe mortality still need to be ca1eulated manually by the investors. 348
"'INT-2-BNK [02.09.2008]:INT-I2-INV [14.09.2008];INT-I4-SUP [19.09.2008]

3"INT-I-MOn [19.08.2OO8]:INT-IO-RAT [12.09.2OO8]:INT-I2-INV [14.09.2008]
346INT-3-BNK [03.09.2008]
347INT_2-BNK [02.09.2008]
348INT-ll-CON [12.09.2OO8];INT-I8-INV [24.09.2OO8]:INT-26-INV [29.10.2008]
6.4. INVESTORS 241
Investors need systems which are e.sy to use on • daily basis, they must be stable
without constant adjustments of the parameters. ldeally, investors get • daily informa-
tion .bout thell: portfolio. The total, aggreg.ted notional .t risk is important to them.
The systems help to be exposed in • diversified risk spectrnm.349
The retum of the portfolio is calculated frequently. Investors get • monthly eval-
u.tion with priee sheets of market makers - usually the weighted mid-bids or bids are
taken .s • reference. The retum from ILS is calculated .s the discounted .sset value.
Pure cash flow calcu1ations da not work because of the seasonality of same business.
Reinsuranee and ILW premium is calculated .s accrued income, sinee it is paid up-
front. 3SO
Traditioual portfolio optimis.tion works among all .sset c1asses .vail.ble. Covari-
anee models should therefore be sufficient for investment management. Copul.s work
with estimation which are provided by the risk modelers. However, today they still
rather complicate the process without e1ear benefits. 351
Secondary market
In the early days of the ILS market, the pioneer investors had to follow • buy-and-hold
strategy, sinee • secondary market for the bonds was non-existent. In the meantime,
several investment banks and brokers initi.ted secondary market trading desks provid-
ing regular pricing quotations. The pricing of ILS is the biggest challenge for investors.
Insurers and reinsurers have a c1ear competitive advantage, since they have a far bet-
ter know-how than the remaining investor groups. These investors are challenged to
evaluate the insurance related risk and more or less have to rely on the evaluations of
the rating agencies and modeling firms. Transparency and comprehensiveness are the
preconditions for • liquid secondary market.
Unill the capital market crisis, ILS markets were domin.ted by buy-and-hold in-
vestors doing • substantial arnount of research before they decided to invest Secondary
markets have therefore been in • developing stage with low volumes. Some market
participants regard thern .s rather weak, while others report sufficient liquidity to find
buyers. 3S2
Regarding the fact th.t most catastrophe issues are BB or B raled, the limited liquid-
ity, however, can be assumed to be normal. Trading ofhigh risk tranches of ABS issues,
for instance, is also limited. In general, the markets should be liquid enough and pretty
Mature. For small investors liquidity is sufficient .s long .s they trade professionally,
i.e. they h.ve to know what risk they trade and where the price needs to be to get an
offer. Secondary markets certainly are .t current not large enough to shift investor's
34'INf-5-BNK [04.09.2008[;INf-26-INV [29.1O.2008[

35oINf_29-INV [14.11.2008]
35IINf_l_MOD [19.08.2008]
35'INf-2-BNK [02.09.2008];INf-4-BNK [04.09.2008];lNf-5-BNK [04.09.2008];INf-20-BNK
[20.10.2008]
appetite to a macro-Ievel. 353

US catastrophe bonds are by far the most liquid product with 10-20% of the out-
standing volume traded annually. However, since most of the activity of US hurricanes
is in the three months August, September, and October, spreads use to increase prior to
the season and come down thereafter. Trading usually drops off wben a disaster appears
and only forced seilers trade. 354
In Europe, the only liquidly traded risk is windstorm at rather small volumes. Lüe
ILS show a very limited liquidity with 5-6 active trading parties in the US market
only.35'
In same cases, funds seil positions, since they like to participate in new opportuui-
ties wbich overlap with existing exposure. In the past, participants mosUy exchanged
positions far diversification. The effect was that until June 2008, each trade counted
double due to the fact !hat, far instance, an investor wanted to swilch wind risk against
earthquake risk. Tbese kinds of trades accounted for approximately 80% of the sec-
ondary market, and participants without having something to offer had to pay bigher
bid-offer spreads.356
Values were still stable in September 2008 with a limited correlation to the general
downtorn, even at bigher volumes than before. Most of the trading in 2008 carne from
hedge funds wbich needed to liquidate catastrophe ILS positions, either sinee they faced
redemptions or since they needed to deleverage because of lasses in other areas. In
addition, same investors just saw other attractive opportunities. The mark.et was then
extremely liquid in 2008 with prices between 97% and 102% of par.
Market participants started to seil below bid in autumn 2008. Tbe trades as a result
showed lower and lower prices down 3 to 3.5% in the two weeks beginuing of October,
ending at approximately 5% down in November. In comparison to the deterioration
of the stock markets during the same period, Ibis was regarded as still acceptable, but
negatively infiuenced the performance of dedicated funds. Overall, 2008 was a record
year in trading but also in negative pricing developments.3S7
A strang and active secondary market helps sponsors to place the products. It brings
down price volarility, also through standardisation, and saves time to figure out what is
in the deal in terms of risk.'''
"'INT-7-REI [08.09.2OO8];INT-12-INV [14.09.2OO8];INT-18-INV [24.09.2008]

"'INT4-BNK [04.09.2008];INT-S-BNK [04.09.2008];INT-ll-CON [12.09.2008];INT-I2-INV
[14.09.2008]
'''INT-3-BNK [03.09.2008];INT-I6-REI [23.09.2OO8];INT-22-BNK [27.10.2008]
'''INT-S-BNK [04.09.2008];INT-I2-INV [14.09.2008];INT-26-INV [29.10.2008]
"'INT-S-BNK [04.09.2OO8];INT-26-INV [29.1O.2008];INT-23-BNK [28.1O.2008];INT-29-INV
[14.11.2008]
"'INT-19-ASO [26.09.2008]
6.4. INVESTORS 243
111e US regulatory framework is bloclring transparency in secondary markets since,

following Reg-l44A, investors need to buy the bond in order to get the full documen-
tation. Otherwise they are not allowed to get the information disclosed. Further, the
ERlSA rules relevant for US pension funds do not allow the exchange of assets in
certain fund types. Especially after the Lebman default, investors want to have full
information ahout the collatera1 truSt.359
35'INT-25-BNK [29.1O.2008];INT-26-INV [29.10.2008]

6.5 Arrangers of ILS

ILS need arrangers who combine the interests of the involved parties and co-ordinate
the process from the structuring to the final distribution of the product. Tbe transactions
may be arranged by banks, brokers, or the insurance/reinsurance sectur itself.
Innovation in a number of assets c1asses of the capital market has been about find-
ing risks that are incidentaIly attached to each other, separating them and making them
transferable. Arrangers are putting each of the risk in the best holders' bands by dis-
tributing them to the capital markets.360
ILS arrangers are not necessarily tearning up unIess the cIient asks them to. In
many cases, sponsors chose the arranger according to bis ability to successfully pIace
ILS structures. Transactional lawyers pIay an impurtsnt role in arranging ILS. Tbeyact
as intermediaries representing sponsors, investors, and arrangers. Therefore. they have
a good insight into the ILS market 361
Tbe arranger has some infIuence regarding triggers. Arrangers tend to Iike pararnet-
ric triggers, since these are easier to distribute. Tbere is no single story: In some cases
the trigger depends on the reinsured business, in others the sponsor is restricted by the
rating agencies or the supervisor. 362
Tbe procedure of formation of the SPRV of a rwn-life ILS is defined by the regnIa-
tors (in the US at state level), even when the entity is located offshore. It is an orpban of
the sponsor and therefore has to pass the test for effective risk transfer with established
procedures. Tbe SPRY, formed as a reinsurance company, needs to be adequately cap-
itaIised, and there must be areal first loss piece taken by the sponsor. Otherwise lbere
is a lot of fiexibility regarding the 00- or offshore status. Since the SPRV is located
in another state than the sponsor's domicile, it has to collatetaIise its obligations with
funds to get the reinsurance credit similar to a collatoraIised reinsurance obligation. 363
Some sponsors of catastrophe ILS do not care ahnut reinsurance credit Examples
are the ILS Studio Re covering the earthquake risk of the Universal Studios in Los An-
geles in favour of Vivendi in 2002 and the ILS Pararnetric Re covering the earthquake
risk of Disneyland in Tokyo in favour of Tokyo Marine & Fire in 1997. Tbese transac-
tions were structured as derivatives in order to get market-to-market credit They do not
result in a regnIatory or rating capital relief due to the low probability of the underlying
events.364
Ufe reIated ILS can be structured as a cash transaction, or alternatively, as an actuaI-
to-expected swap, also referred to as "synthetic transactions". Synthetics in general are
not regarded as a threat to the cash markets, since in many areas they have helped to
develop markets for new asset types by bringing in More liquidity. Established capital
market players are able to quickly understand synthetic structures. Life related ILS
'60INT-3-BNK [03.09.2008]
36' INT-7-REI [08.09.2OO81;INT-8-LAW [10.09.2OO81;INT-II-CON [12.09.20081
36'INT_7_REI [08.09.20081
'''INT-8-LAW [1O.09.2OO81;INT-IO-RAT [12.09.2008]
364INT_8_LAW [1O.09.2OO81;INT-IO-RAT [12.09.2008]
6.5. ARRANGERS OF ILS 245
are recognised by arrangers as having a big potential in tenns of volumes to hedge

annuities, pensions, reverse mortgages, and life settlements.3M
Regulators do not allow a true sale of policies, bot economically hankruptcy non-
consolidation treatment of the SPRV issuing the securities can he achieved: The SPRV
takes the obligation for the reinsurance contract, and assets securing the obligations
are put into a collateral trust (usually based in the UK). The result of the structure is
reinsurance and not a sale of the policies - uulike MBS or Credit Card ABS where
the obligations are truly sold. The sponsor remains liable for the insurance claims
payment.'""
US reserve transactions have very long terms, AXXX ILS run up to 40 years while
XXX ILS have lifetimes with a range of 12 to 45 years. LoC solutions have also heen
available with similar tenns. Arrangers usually hire external actuaries to monitor de-
viations from the base case, any extra contractual obligations, or regulatory changes
during the long tenn of the transaction. Since the reinsured block changes over time,
open blocks have to update and refresh the SPRV's capital on a regular basis. 367
The following statements by the interviewees highlight the strengths and weak-
nesses of the relevant stakeholder groups:
6.5.1 Ranks
Banks bring players together as market makers providing mark-to-market valuations
and flexibility regarding the investors' and sponsors' needs. They are able to act as a
one-stup shop and can take a role as neuttal advisor. They divide riaks up, warehouse
basis risl<, and create transaction forms suitable for the risk-transfer into the capital
markets. Banks also act as total-return and interest-swap counterparties. In their role
as trustee, they further liaise with service providers, risk modelers, and rating agencies.
They act as broker-dealers by handling the sale, verifying qua1ifications, and applying
for legal requirements.368
Banks understand the needs of their investors in an out. The global distribution
networks olfer high placement capabilities. Further, although the products themselves
enable no operating leverage, they can provide financialleverage and short term liquid-
ity to funds. Their broad custorner basis brings primary and secondary marke! liquidity
and alternative risk-takers into the sector.369
The products olfered by banks are usually rather asset-management-like with a rein-
surance component. ILS are different from other capital market products - the investor
is olfered an event ris!<, not a credit ris!<, e.g. with a corporate bond. Banks are the risk-
'''INT-3-BNK [03.09.2008[
'''INT-8-LAW [1O.09.20081;INT-24-INS [28.10.2008]
367INI'_8_LAW [10.09.2008]
'''INT-2-BNK [02.09.2008];INT-3-BNK [03.09.2008];INT-5-BNK [04.09.2008];INT-22-BNK
[27.10.2008]
36'INT-2-BNK [02.09.2008];INT-4-BNK [04.09.20081;INT-23-BNK [28.10.2008]
taking entities but are not an insuranee entity per se. Pricing volatility or underwriting
risk is on their focus and monitored. 370
Due to their involvem.ent in mergers and acquisition or even owning insurance com-
panies, they have a detailed insight into sponsors' business models. In contrast 10 rein-
surers, they are able to act with less eonHicts of interesl, since their ILS desks do not
face in1emal eompetition with reinsuranee underwriters. It bas been reported !hat it
may be easier to convinee a customer of a produet without baving to eonsider tradi-
tional reinsurance alternatives. Products offered by banks tend to foeus on the elients'
eapital.371
The decision to da a life transaction in reinsurance form, in capital markets form,
or as an ILS depends on the sponsors' needs and the investors' ability to take the risks
involved.372
Banks bave helped to find and establish life relaled ILS by creating innovative so-
lutions for the seetor, supported by modelers and actuaries. Since banks are not able, or
in some jurisdictions, not allowed to warehouse indemnity risk, they pass it on direetiy
10 the investors. 373
Banks were able to use their franchise by embedding auetion rate notes into XXX
struetures: Tranehes of some transactions were prieed by using auction rate mecha-
nisms at very low yields like Libor+5 basis points or even Libor Hal Due to the crisis,
however, investors currently are not willing to participate in auction rates. The illiquid
market environment caused heavy price increases. 374
Value-in-force transactions as weIl as catastrophe bonds need to be structured, sold,
and potentially underwritten by banks. Tbey act as intermediaries between the insur-
ance companies, pension funds, or other eapital market investors. After a long pause,
the value-in-force market was reopened in Europe with the Portofinos transaction in
2fXY7. 375
While a single trigger eatastrophe bond is rather straight-forward, banks involved in
multi-trigger, indemnity, and life-relaled ILS need a longer track record. Tbe arranging
bank needs to understand the reqnirements of sponsors, investors, rating ageneies, and
regulatory authorities. 376
Aecountants and CFOs, often having a banking background, like to take the secu-
ritisation route instead of reinsurance. Being in charge of the general refinancing of
the insurance eonglomerate, they maintain close eontact to bankers who are demanding
compensation for providing cheap LoCs with securitisations. 377
370INT_3_BNK [03.09.2008];INT-4-BNK [04.09.2008];INT-5-BNK [04.09.2008];INT-2O-LAW

[20.10.2008]
371INT_7_REI [08.09.2OO8];INT-22-BNK [27.1O.2OO8];INT-26-INV [29.10.2008]
372 INT_3_BNK [03.09.2008]
3"INT-8-LAW [1O.09.2OO8];INT-12-INV [14.09.2OO8];INT-26-INV [29.10.2008]
374INT_17_MON [24.09.2008]
"'INT-22-BNK [27.1O.2008];lNT-23-BNK [28.10.2008]
376INT_23_BNK [28.10.2008]
"'INT-25-BNK [29.1O.2008];lNT-26-INV [29.10.2008]
Arranging banks in the past have mainly been the big international invesbnent
banks. That means that they were not able to use !beir balance sbeet to take any basis
risk or to guarantee the execution of the transaction with a substantial underwriting.378
Sorne of the banks unfortunately did not act as if having the long-run growth of the
market for !beir target. Negative examples were repnrted wben arrangers seern to have
manipulated deals to let the produets look good but failed to do enough investigation
about the spnnsors' motives. Sorne arranging banks undermined the usual fees by half
in order to get mandates, especially in the eatastrophe ILS market whieh is regarded
as too small to have short-sighted participants of this kind. ILS were regarded as one
more asset class and the sales force, although globally present on a !arge seale, was not
used enough to the produet or not very rnotivated to distribute the produets, sinee others
brought More volumes and higher internal sales credits. 379
6.5.2 Reinsurance brokers

Brokers are mainly involved in natural eatastrophe ILS and regard !bem as an additional
product in their range. Apart frorn ILS, they are particu1arly strong in the trading of
ILWs and do not need banks acting as broker-dealer for these products.380
Brokers tend to be extremely strong in understanding the structure of insuranee
business, analysing portfolios, and warking out basis risks. This is the business they
have historieally been doing, and they understand the insoranee/reinsuranee business in
and out. Basieally, they enter the eore competenees of!be banks by acting as intermedi-
aries and, due to their insurance know-how, are able to act as arranging intermediaries
between sponsors and investors. 381 Brokers maintain elose relationships with reinsur-
ers providing proteetion, but less with primary insurers. They have strong analyties
teams in place, especially for the natura1 eatastrophe business. Intemally, however,
they face eornpetition among ILS and reinsuranee brokersge. Spnnsors launehing ILS
naturally da not demand reinsurance brok.erage services for the underlying business se-
curitised.382 They certainly are well-positioned knowing the business and customers'
needs, but are laeking the ability to manage the eollatera1 as a trustee or to provide inlef-
est rate and tota1 re!um swaps. Forther, they do not bave a !arge balance sbeet volume
to use and therefore are not in a position to take basis risk or to underwrite a transac-
tion. Therefore, they usually pair with an investment bank to use its services. Brokers
in recent years just started to arrange ILS transactions, and most of them do not have a
sales force of the size of an international invesbnent bank. Over time eapital markets
activities ean be expected to be established in the future in order to reaeb full placement
eapability for any kind of ILS.383
37'INf-I6-REI [23.09.2OO8[
"'INf-18-INV [24.09.2008]
'80INf-5-BNK [04.09.2008]
3811NI'_8_LAW [10.09.2008]
"2INf-22-BNK [27.1O.2008];INT-23-BNK [28.1O.2008];INT-26-INV [29.10.2008]
"'INf-8-LAW [1O.09.2008];INf-16-REI [23.09.2008];INf-22-BNK [27.1O.2OO8];INf-26-INV
6.5.3 Reinsurance companies

Reinsurers through their underwriting activities collect a lot of rather uncapped risk.
They hold a very diversified portfolio of income in terms of geographie regions and
perils. The focus is 00 buildiog a portfolio with low correlation. It is un1ikely, for
instance, that an earthquake in Califomia will happen at the same time as a hurricane in
Florida. Life reinsurance is a different risk with its own characteristics.384
In recent yeus, reinsurers turned into intennediaries, meaning they place risk taken
from primary insurers with ILS into the capital markets. Risk is the core competence of
the sector. Companies are focussed to understand it and maintain strong actuarial and
risk teams. Their know-how enables them to keep the basis risk after repackaging and
issuance of ILS with paramettic or modeled loss triggers. Apart form third-party risi<,
they actively manage their own balance sheets by using ILS 38S
While understanding their clients' business and needs inside-out, they have the goal
to find the best solution available. Especially in the catastrophe risk sector, ILS is
an additional product in the range. Reinsurers need the primary insurers to get the
ctitical mass for ILS. They take the role as service providers for risk evaluation and
distribution.386
The primary insurer finally decides which product, traditional reinsurance or alter-
natively which type of ILS is chosen. In the early days of the market the capital-market
teams faced interua1 competition from the reinsurance underwriting teams. This has
been less the case, since after hurricane Katrina capacity limits for traditional reinsur-
ance were reached in 200S and it was acknowledged !hat ILS can provide additional
capacity. 387
Reinsurers today follow an integrated approach, the management tries to avoid any
confiict of interest between traditiooa1 reinsurance and ILS. However, they cannot do
transactions for their competitors. Further, customers having a difficult relationship
with the reinsurance side will not give a mandate to the capital markets team of the
same company.388
Reinsurers, due to their business relationships in some cases lasting for 100 years
or even more, usually have a lang track record with the primary insurance underwriters.
The contact to the CFO office and the accounting side of the insurance companies who
rather like to take the securitisation route instead of buying reinsurance, is of rather
shorter term."·
Reinsurers are very strong in lougevity risk - some market participants are of the
[29.10.2008]
"'INT-5-BNK [04.09.2008]
'''INT-7 -RE! [08.09.20081;INT-8-LAW [10.09.2008] ;INT-I2-INV [14.09.2008] ;INT-13-MOD
[16.09.2008];INT-I6-REI [23.09.2008]
"'INT-4-BNK [04.09.2008];INT-20-BNK [20.10.2008]
'''INT-26-INV [29.10.20081
'''INT-16-REI [23.09.2008];INT-26-INV [29.10.2008]
389INT_26_INV [29.10.2008]
opinion Ih.t banks are far less competitive.'90

Tbe leading global reinsurers h.ve established full p1acement c.p.bilities for ILS.
In some cases, however, they use the sales network of broker-dealers 10 seeure the
placement of the risk. 391
Reinsurers are leading regarding product innovations. Tbey provide Ihe classical
risk ttansfer using c.pital market techniques. Munich Re managed to arrange all sorta
of non-life ILS; even • mortality-sw.p in 2008, while Swiss Re arranged all sorts of
ttansactions from XXX, EV, c.tastrophe ILS to morality and side-cars. '92
6.5.4 Market
Its • joke in Ihe industry that in terms of growlh ILS h.ve been Ihe nexi mortg.ge backed
securities for 15 years. Allhough 1here were disruptions in 1998 and 2001, 1he markei
has seen upticks in growth. However, it is still growing from a very sma11 base.393
Tbe recognition of Ihe catastrophe ILS marke! .s an assel class, supported by press
articles and academic research, is happening slowly but surely. Catastrophe bonds oul-
standing were.l. volume of USD 14.5 bn.1 1he time of 1he interviews plus an addi-
tional ILW volume of .pproximately USD 7.5 bn. Compared 1001her assel classes this
was a rather small market. 394
Life insurance ILS bad. big stake in volumes (USD 10-15 bn), but dropped drarn.l-
ically and carne to • standstill after Ihe rating deterior.tions of Ihe monoline industry.
Tbere were!wo US reserve securitis.tions wilh. total volume ofUSD 1.7 bnplaced in
early 2008 oniy.'95
ILS h.ve not been part of Ihe general securitis.tion boom now coll.psing. Tbey
are not grounded in human behaviour, bul in real physical, natural phenomenons of
earthquakes, hurricanes or c.tastrophes. Bonds sponsored by ptimary insurance com-
panies give Ihem protection back to back to Iheir uriginal business. Bonds sponsored by
reinsurance companies are not necessarily a means of protecting th.emselves. Th.ey are
More of • means of acquiring additional capacity. Bul at Ihe end of Ihe d.y, Iheir spon-
sors have to find reinsurance contracts to securitise. And Ih.t is coming from primary
insurance companies. Tbe grounding in reality has been preventing Ihe market from
growiug 100 much. 396 Growlh of ILS is in line wilh 1he growlh in insored values which
can roughly be me.sored by • nation's grow1h of GDP. Emerging economies like 1he
r.pidly growing BRIe states (Brazi1, Russi., India, and China) are regarded as h.ving
Ihe largesl growlh potential.'97
390INr_22-BNK [27.10.2008]
391INr_8_LAW [1O.09.2008];INr-16-REI [23.09.2008]
3"INr-20-LAW [20.IO.2008];INr-23-BNK [28.10.2008]
393INI'_19-ASO [26.09.2008]
3"INr-4-BNK [04.09.2OO8];INr-5-BNK [04.09.2008]
3951NI'_S_BNK [04.09.2008]
39'INr-5-BNK [04.09.2OO8];INr-13-MOD [16.09.2008]
"'INr-11-CON [12.09.2008]
The ILS volume is correlated with the reinsurooce prieing eyele, meaoing that the
volume of ILS increases or decreases with the demand in reinsurance. Issuance of n..S
grows when reinsurance gets expensive and slows down when reinsurance gets cheap.
Volumes naturally decline wheo the market experienees a lack of investor interest 398
Amistake people often malre wheo aoalysing the ILS market is to foeus solelyon
the total dollars notiooal amount of securitisations inslead of looking at the eapacities
heing added to the industry's eapital base to provide risk beariog eapacity for e1ieots and
whieh continues to grow quite rapidly. Volumes eoo he misleading - until early 2008,
wheo the effects of the erisis started to spill over ood trading activity pieked up, eaeh
secondary market Irade eounted double, since market partieipants mostly exehanged
risk when they lraded. These Irades aceounted for approximately 80% of the volume
traded secondary. Further, market volume may fall away when reinsurers enter into
quota share agreements. For instance, Swiss Re entered into a quota share agreement
with Berkshire Hathaway, ood as a result of this, less issuaoce was done for them in
2008.'99
ILS is promoted by market associations as a natural extension of the product credit
securitisation into the eapital markets. It is expected to experieoce its break-through
when popular consciousness increases and more institutional funds with large amounts
will start to invest400
Natural disaster risk is relatively easy to understaod, while liability risk or terror is
rather eomplieated. The market needs to he educated in order to understaod ood feel
comfortable with insurance risk.401
Katrina was a large eveot ood lragie, but not the real lest the market needed in order
to find out whether the market functions as expeeted ood investors are prepared to return
afterwards. This would prove !hat the market is deep enough to provide real insurooce
eapacity. Further, the market eould prove whether claims management is funetioning
properly.402
6.5.5 Pricing or ILS

Pricing of ILS is not different from that of other seeurities. It is determined by supply
and demand, meaning that arrangers agree with the sponsors to go irrto the market for
the price and then reach a market clearing level for a new issue. Similar recent issues
are taken as a benchmark for pricing. Secondary markets also follow the supply ood de-
mand mechanisms. Theoretical research has been done to explain pricing mechanisms
by different perils. Up to now, however, it has been very diffieult to explain the prieing
mechanisms taking pricing cyc1es into consideration.403
'''INT-20-BNK [20.IO.2008];INT-24-INS [28.1O.2008];INT-26-INV [29.10.2008]
'''INT-7-REI [OS.09.2OO8];INT-23-BNK [28.1O.2OO8];INT-26-INV [29.10.2008]
4OOINT-5-BNK [04.09.2008];INT-18-INV [24.09.2008]
401INT_6-ASO [05.09.2OO8];INT-19-ASO [26.09.2008]
402INT-2-BNK [02.09.2008];INT-7-REI [08.09.2008]
403INT-7-REI [OS.09.2OO8];INT-ll-CON [12.09.2OO8];INT-16-REI [23.09.2008]
In a conference, 1LS pricing was delined as a result of different components like

the risk modelers' loss probability estimations, the rating of a total return swap cooo-
terparty, the secondary market liquidity, and the trigger mecbauisms. In addition, the
timing of the placement in a hurricane season or in a hard or soft reinsurance market
phase, which also depends on the general capital markets, bas an infIuence.404
The average cost of an USD 100 m1n BB+ raled catastrophe bond issue was esti-
maled in September 2008 as follows: 405
CosIType: Per cent p.a.: USDp.a.:

Riskpremium 6.00% 6,000,000
SPRV OO8t 1.00% 1,000,000
Rating agencies fess 1.50% 1,500,000
Legal counsel fees 0.75% 750,000
Agent. trustee fees 0.30% 6,000,000
Total cost 9.55% 9,550,000
Table 6.18: Price estimation for a catastrophe bond
Pricing has often been mentioned as a hmdle far sponsors. However, it has to be com-
pared by talting the counterparty risk of reinsurers, and the fact !hat approximately
10% of the coverage has to be paid upfront to reinsurance brokers bas to be taken into
consideration. Costs can be reduced by sbelf-offerings with finalised documentation
and process set-up abead of a catastrophe, and further, more competition among the
involved parties.406
Traditional reinsurance offers sloping yield curves, since they rather avoid writing
multi-year coverage. The longer the protection gets, the more expensive is the cost far
protection. Further, some catastrophe bonds are ca11able.4U7
1LS pricing follows cycles. Taking into consideration the pure prentium without
the additional benefits of an n..S issue, there have been only very btief petiods when
the pricing for catastrophe bonds was in a more advantageous position than traditional
reinsurance or even retrocession. In the extreme period after Katrina, it was experienced
that the pricing development far ILS was not as volatile as reinsurance prices.408
Pricing basically depends on the perils and the market's fantiliarity to them. In non-
life, indemuity-based issues tend to be higher priced than parametric, modeled-loss or
index-based bonds paying the lowest spreads. The expecled loss plays an important role
in pricing: Single-peril bonds tend to pay a higher spread than multi-petil issnes. The
reputation of the sponsor and the fantiliarity of the market to the structure is another
""'Carey et 01. [27.10.2008.]

""'1Nf-2-BNK [02.09.2OO8];1Nf-4-BNK [04.09.2008]
....1Nf-4-BNK [04.09.2OO8];McMmrougb et 01. [27.10.2008]
""'1Nf-2-BNK [02.09.2OO8];!NT-3-BNK [03.09.2OO8];!NT-4-BNK [04.09.2OO8];!NT-5-BNK
[04.09.2008] ;!NT-13-Mon [16.09.2008]
"""1Nf-5-BNK [04.09.2008]
pricing factor. Permanent issuers with a good uoderwriting track record can achieve
lower prices than new names.409
Tbe quality of the Intal return swap couorerparty further infIuences the pricing of the
issue. Tbe expecred revenues of the collatera1 trusts, basically the difference between
the nore coupon to be paid to investors for the risk and the cash income of the collareral
trust, can inftuence pricing. If high retums are achieved, the spreads of the issue can
be subsidised. Before the crisis, the coupon for risk was higher than the spreads gained
through the investment of the collatera1. The difference, also called negative carry,
will increase further now at the cost of the sponsor, since investors will accept high-
quality collatera1 investments only. Low quality sponsors may even be forced In pay
the difference upfront.410
6.5.6 EtTects of the crisis and expected measurements

All parties involved demand more transparency. Tbe information pruvided by the offer-
ing circulars is regarded as non-sufficient. Transparency is needed regarding the uoder-
lying contracts, the rerms of the reinsurance agreements, and detailed swap confirma-
tions including swap receipt definitions. Until2007, the parties involved did demand In
inc1ude the investment gnidelines of the collareral trust inln the offering circular. Reg-
ular, at least annual updares of the uoderlying risk covered and the collareral trust are
necessary. Monthly srep-up conditions in the Intal return swap contracts would enable
investors In react if the asset value fell below the required pre-defined amount. Ar-
rangers would avoid reputational issues, since they were enabled 10 react in time being
able In recognise how bad a transaction got when difficulties arosen 411
Total return swap spreads were at 5bp before the crisis and were estimared at 15bp
at the time of the inrerviews. It can be expecred !hat inveslnrs will demand higher
quality AAA Intal return swap couorerparties insread of the usual AA rared entities (on
condition that the collatera1 trust is invesred in stable, high quality assets). As alrema-
tive collateral solutions to bonds, guaranteed investment contracts or bank. accounts are
being discussed. 412
Custodians of issues pre-2007 are currently under pressure In provide more col-
lateral information and third-party valuations to investors. One solution discussed 10
impruve the transparency regarding collatera1 trusts would be an online portal for each
issue with regularly updared information about the assets invesred. Frequent mark-In-
market evaluations must include stress rests for the asset portfolio. This may lead In the
inc1usion of more cash products and govemment securities.413
409INT-lI-CON [12.09.2008]
4loINT_17_MON [24.09.2008];lNT-28-ASO [03.11.2008]
411 INT-23-BNK [28.IO.2008];lNT-26-INV [29.1O.2008];INT-29-INV [14.11.2008]
412INT_16_REI [23.09.2008]
413INT_17-MON [24.09.2008] ;lNT-24-INS [28.1O.2008];INT-26-INV [29.10.2008] ;INT-29-INV
[14.11.2008]
It is expected !hat in the future the proprietor holding the coll.teral must be indepen-
dent from other parties involved. Further, no p.per issued by any of the parties involved
as total return sw.p counterparty in the transaction may be accepted as collateral asset
any more.414
In order to .void the problems faced by collateral portfolios he.vily invested in
mortg.ge-backed-securities, sector and regionallimitations are recommended to be de-
fined in the collateral trust investroent guidelines. The total amount of collateral pro-
vided should be incre.sed from 90-95% for past issues to 100% or even .bove.4!'
As • result, ILS structures can be expected to become more expensive. This will
especially be the case if the market participants .ccept to use the less vol.tile on-the-
run rates for !re.sury bills .s • reference instead of the currently used USD-Ubor. Tbey
would then .gree to skip the so-called 1ED spread, defined as the difference between
the rate of government securities and USD-Ubor which was regarded .s • risk-free
income for them in the past. Risk free, bec.use the marke! assumed th.t banks rated
in the AA c.tegory are as risk-free .s government oblig.tions. Tbe 1ED-spread used
to be 50 bp, hut went up to 300bp during the crisis. At the rlme of the interviews in
November 2008, it w.s back down .t .pproximately 150bp 4!6
Taking the rates of US 3-month treasury bills as • benchmark would mean !hat
the returns of the collateral trusts will fall by 1-1.5% on .verage. It is assumed !hat
it will be an upbill-b.ttle to get the reduction of performance sold to investors. Soroe
market participants therefore suggest to increase transparency and to concentrate on
informing investors .bout the risk involved. Comparing with w.tcbes, an interview
partoer reported !hat some market participants propose to define structures as "w.ter
resistant" instead of "waterproof' .417
It seems to be common sense that until the market finds anather acceptable solution,
Uhur will continue to be the reference rate. Funds are paid their performance fees with
Libor as a benchmark - their performance is measured as net income minus the hurdle
r.te (Libor). However, in order to p.y Ubor out to investors, the coll.teral trusts need
to invest in Ubor assets. Generally these are bank obligations wbose values h.ve been
higbly correlated with the general market and which are .t risk in the current crisis.418
Regarding the opinions .bout future developments stated .bove, one has to decide
between structurers/arrangers of n...s acting as intennediaries who are interested 10 sup-
port increased transparency, and step-ups. Tbey seem to!hink!hat investors will then
be h.ppy and continue to invest.
Investors and sponsors, however, definitely demand more transparency and would
like to invest rather based on the 3-month treasury rate .s b.sis than .t Ubor. Tbeyask
for • coll.teral solution with • matching return and duration profile.419
414INf_23_BNK [28.1O.2008];INf-26-INV [29.1O.2OO8];INf-29-INV [14.11.2008]
4!'INf-I6-REI [23.09.2OO8];INf-23-BNK [28.10.2OO8];INf-26-INV [29.10.2008]
41'INf-24-INS [28.1O.2OO8];INf-29-INV [14.11.2008]
4171NI'_29-INV [14.11.2008]
41'INf-25-BNK [29.1O.2008];INf-26-INV [29.10.2008]
419INT_29-INV [14.11.2008]
Chapter7
ILS Online Survey
7.1 Methodology
The questionnaire attachod as Appendix 0 was on-line through a professional survey
secvicec from October 12th, 2008 until Ianurary 12th, 2009. A total cf 225 ILS cx-
perts seross the stakeholder groups were invited. 46 expert8 answered the inquiry rep-
resenting 20.4% of the invited specialists. The distribution of rcspondecs among the
staeholder groups and nationalities is shown in figure 7.1:
-"'" -
..-."'''.-
I .... ~ '''''~
•••
' %/1
1%/1
''' J)
,"
.,-_.
I ~ . , .~
~"
.
".,."
.......
",,,,.,, - ,.••. "
" %1"
,..." ........ : .. -.""".,,"p.

Hgure 7.1: Smvey respondees by sponsor type and geographie

256 CHAPI'ER 7. ILS ONLINE SURVEY
The strongcst stakeholder groups werc investors (15), followed by banb (9), rcinsurers
(5), and primary insurers (5). The answers of lawyers (4), rating agencies (3), risk
modclcrs (2), a monoline insurcr (1), and an associ.ation (1) 8IC for thc purposc of thc
analysis, when appropriate, summarised asjrameworking stakeholtkn. By nationality,
thc stakeholders can be split into USAJBermuda (17), the UK (11), and Continental
Ewupe(18).
The survey was executed in line with current data privacy regulations. The par-
ticipants were assured that the survey was anonymous and all data would be trcatcd
confidentially. All information would be canceled after the dissertation project was
~
Figurcs listed in brackets in the following analysis are cither refeIring tD number of
responses, scores responded. or shares of total:responses of the relevant question.
7.1.1 Basic questions

The average number of people within the organisations working on n..s are 12, while
the biggest entities are employcd by reinsurers with 35 peop1e on average, followod by
lawyas (22), banks (12), risk modelers (12), insurance companics (9), investors (5),
associations (5), and the monoIiners (2).
9%
61 % ( 18%
So ....,., 0,," C",ph
Figure 7.2: Organisat.i.onal status of n..s acti.vitiClil
The status of the ILS activities within the organisations has mostly been definod as a
team (27), followed by aformal group (8), a division (5), and a department (4) as shown
in figure 7.2.
Fi.gure 7.3 shows the number of lIIlSWClS rcferring to the importance and commu-
nieation with the general management measured by the scale from 100 (very close) to
7.1. METIlOOOLOOY 257
o (very far). ILS activities are rather c10se 10 the management, cspecially within insur-
ance and reinsurance companies where the average score reported was 82 and investors
with 76. Btmks reported 61 and the framcworking stakcholdcrs an average of 51.
The regional focus is shown in figure 7.4. It is interesting that the majority is active
in Western Europe (48.8%), foI1owed by the US (48.6%) and Asia/deve1oping coun-
tries (20%). Furtber, 33,3% of the rcspondecs (15) answacd that they follow a global
approach. Tbc majority of the companies with global approach are reinsurers (4) and
investors (7).
'"
90 JU
80
'" SoU l'«: O~n C ... ph
F1gure 7.3: Distance of ILS activitics 10 gcneral management
The majority of the rcspondecs, 82.2%, answercd that they are involved in non-1ife I
reinsurance ILS, while 64.4% among those are also involved in lifc insurancc ILS.
Regarding the products (:Iigure 7.5), the majority of the intcrviewccs are activc in lifc
and non-Iife risk transfer products, followed by embedded value and US reserve funding
products (XXXIAXXX). Thc involvcmcnt in catastrophc bond CDOs is strong, while
other COOs are of rather limired att.racti.veness er availability 10 the broader market.
Life settlements gained interest among banks and invcstors. The frameworking entitics
naturaIly follow the other stakeholders.
7.1.2 Market enviromnent

On a scale ranging from 0% stating "strongly disagree" 10 100% stating "strongly
agree", the majority of the interviewees answered that they expect an :increase in capital
rcquirements for the reinsurance sector (see figurc 7.6).
Figurc 7.7 further shows that, despitc the current crisis, the majority of the intervie-
wees expect an increase of the demand for ILS in the future.
,-"" ,,'<',,<
". •·e .'
""
0-
~
"
,~
"
Figure 7.4: Regional focllS
.. ,
,
",. , , , ,
• , ,
" •
• N,;...",. , "
. I...... "I ~I
[] ,."'" ..<\",
c o,,,,,,'
.;.,.-".......,....... ,,,
,......... ",
'_ '_""~"'R'"
Sou,,<: O~n GNVh
Flgure 7.5: ILS products covercd
The majority of the interviewees is of the opinion that innovation will not stop and
therefore new product types can be expectcd to arise on the markcts (see figure 7.8).
The ILS markcts are mosdy st:andardiJJed in the life and non-life risk transfer prod-
uct:s, while the remaining products are regarded as rather bespoke currently. Life settle-
ments show a ccrtain degrcc of standardisation although a limitcd numbcr of transaction
60%
Total"'n.~ ...: H So",,<: 0,," Croph
Pigure 7.6: Increasc of insurance soctor capital rcquirements
10%
60%
Total "'n.~ · . ... : U
Figure 7.7: The demandfor n..s will increase
were dune as public ILS only. The majority does not agree 10 the statement that the ILS
market is currently standardised sufficiently (see figure 7.9).
Although trading picked up dllring the crisis, the secondary mar1ret for ILS seems
10 be far from the standardisation of other secondary financial market sec1ors. Pigure
7.10 shows that the majority of the participants regard the secondaIy market as rather
10%
30%
60%
So",«: 0,," G ... ph
Figure 7.8: New product types will arise
.....
M", T" .. f,,(I;fo' 11.1
I:........... ' ....

lU
"..
,,-,
" " " • Sou",.:

" • Graph
" O~n
Figure 7.9: Standardisation ofll..S
lowly standardised. The average value on a scale between 0 and 100 was rather low at
34.6.
"
" 30
80 40
60
Figure 7.10: Stare of the n.s secondary market standardisation
7.1.3 About 11.8

Asked to rank the driven for the n.s market, the interviewees responded with an av-
erage score of 1.57 that the market :i& mainly motivated by risl:: transfer, followed by
capital considerations (1.97), and divenification (2.46) as shown in figurc 7.11.
To .. l"'n.~ ...: ~ l
Figure 7.11: Ranking: Main n.s market driven

The 10w commitment cf the sponsors' management ia rankcd as the main obstaclc
for n..s market development (average score 2.5 in figure 7.12), c10sely followed by the
lad: cf investors' msUIlUlCC expertise (2.6). Further. tbe I.ack cf rcgulatory hannon-
isation (3.2), the rating agencies' requirements (4.0) and technical systems (4.0) are
confirmod as obstacles. Restrictions by the sponsors' owners (4.6) are less cf an issue.
", •• I" ,,,,, ~, ........ " .. "~< 1.
10, • • r ... ..... ~ .. _.~,,;..

I I J .l
Tot.t "n,~'''<: J8 s.~ r«; 0,," G",p~
Fig..:tte 7.12: Ranking: Main ILS market obstacles
Investment bank:s (average score 1.6 in figure 7.13) and the reinsurance sector (1.7)
arc regarded as the most capable ammgen cf ILS. The sponsors themselves arc less
convincing as potential arrangers (2.7).
"
Soure<: 0 ... C ... ph
Figure 7.13: Ranking: Most capable ILS mangen
7.lA Corporate lem

6.5 years ago to be involved in n.S, while the time
The institutions started on average
span ranges betwoen 1 year and 14 years.
The main motivation to do an ILS (figure 7.14) is pricing in comparison to other
reinsurance alternatives (43.5% of answen). Further, the value-added in terms of al-
ternative reinsurance sources plays a major role in decision-making (41.0%). The fuIl
acceptance by the capital markets (35.9%) is c1ose1y linked to the availability of sec-
ondary market trading which seems to be of less importance (25.4%). Tbe complexity
ofthe products is not a major issuc (15.4%).
Risk models are mo.re important than ratings (figure 7.15). Especially investors,
reinsurers, and banks answered that they give mo.re importance to risk moc:Iels.
7.1.5 The banks' roJe

Thc major anangcrs of ILS, reinsurcrs and banks, agICC to thc statement that thcrc are
enough banks able to mange n.s.
This is natural since every new bank as arranger brings competition into the market.
The remWning iIItervWwees are equally split of a neutral opinion or would appreciate
the number of mangen to rise.
The frameworking entities would be interestM. in new players. 'Ibis ja also un-
derstandable since new parti.es bring additional sources of revenuc to them (see figurc
7.16).
....... , . . ,..;.-. . . . " _ . . ." '. .

10........ ... . . ........ ""' •• ".·
,~' I . . . 1==========. '"
di,"'m,....
....... •• '••k •........
1"''''0''''''
_d .. '0''''''.
" .... ·, :~~~~~~~~~:J ".'
"" . . .. , .. _ "
...... '-"'."..
,., ... ., ","pI<d .., ....
1=====:1
l!_'
.- ..........., . r,,, . .... ,, ... <1..1>;" . ., l~'

"~'"
_. 1. . '11<'...... ,., .", ............ 10, I===~ I~ .'
.. " . .. po.,."
"Iof, ......, ~IIIIIIIIIIIIIIIIIIIIIIIIIIIIIIII'-:'.:..._

jU
" " " • "

So"IT<: 0 ,," G",p~
Figure7.14: Sponsor motivations
"
..Are ' ",mar t;"," ... inl!" in }our opinioo
more import.nt .ha" .;' k ".odd.?"
-"..
Figure 7.15: Importance oftransaction ratings
The biggest strength is the banks' capability 10 place II.S into the capital markets. fol-
lowed by innovation and structuring capabilities (figure 7.17).
The main weaknesses of banks are the lack of knowledge of the insurancelreinsur-
ance solutions and the market behaviours. followed by the low speed to markcl (figure
7.18).
_lI<> ).U Ih;"~ Ih... "."~h buk, .... bl. I •• "."~, 1I.s?-
Figure 7.16: ILS arrangingbanb
"ut)' ","," ..... (1<. .« ... I•..,".11.,

in.·.... o> in ..... , I. , ..... "full), pb« .11< 71.0
1I.s """, ... ~"
·,,\"\"j.-."I .. ·'m.....
" 11l< )' ''''''~b'''''''''o'''",lop
"""'d""'~-b ______....
~8./0
"'111<) ~ .. ~ bt" ... ~ ,. "N<lU" . ... I::::::~

...... "~. 11.s ' ......<.10..... 5'-'
• ,0 10 J(I 40 .so
" ...... ~' . .. ' . ,'",. ..... . 1"
60 le 80
1'01) ' .... ,
To .. ' An . ...... ' 41
Figure 7.17: Banks' strengths
7.1.6 FiDaI questions

Figure 7.19 shows the percentage of questi.onnaires agreeing to the cxpccted rcsults
of the current crisis. The majority agrees to the statement that a closer monitoring of
the bank counterparty risks and the collatecal trust investments will fo11ow the IIWket
turbulences. Banb are expected to be challenged as stable leng-term creditors.
. . _....,.. ,.... _...,...._...

.Wb.' . ... 'he ~ 01 'h. h.,,~. ift 'he P""«"~"
., , ..... ;. .. .... . .... ~ .

---------~
00,'
•..,.." ,.....
w, ....-_.
,....1.........
' -~-
... -'_ ..
' "
..,.... ,;.~
,,. .... I::::::::::l H ,t
. ............
', , ,._ " ", . ,-. ...
.......""..... "... ,.
- ~,
-
, ...... ~.o .. ,. ,,~ .. .. <_ IM 101) , . ... ,
Ftgure 7.18: Banks' weaknesses
Further, investors will ask: for a higher collateralisation. Wbile COOs will general.ly be
of less attractiveness. only a third of the participants expoct a gencra1 simplification of
st.ructurc:s in the future. Long-term products are expected to be difficult to place and
ra1ing agencies to imply &t:rict:er guidelines•
......" ,,_ . ,,"...,_..- ......., ",,,,

• Th. <O,«n' <r;,i. ~ l l1l<.d '0.
_
.. "'M' _ ,......., .......
,~
_. '::.".:.:=::::::;~,."::':~:"" , .,.
_,..".. '::,:::::::,=~.',,, .. f ,
_.'_,, __ " "I . ''','''~''

t.>." ...." .,
_..... ••" .......... ".... I_.
.._........,....... _.. .,,_...,.
, _~
,.~< _ ~
" , -,., "
- .t .... ,,' ...... ,"" . " .. '''''' "",,',. ,'

.,
_. ,' ....,....... ,'n.<,'~ " ... ,,~'_.' ,,.
o. " ......... ,. .... '"
"" ....... 01 ,,.,,,.....;,,,, "<''''")
So"IT<: 0,," G .. p~
Figure 7.19: Expected:result!l of the crisis
While 23% of the participants are of the opinion that the pricing of n.s for the 12
7.1. METIlOOOLOOY 'l1i7
months ahead cannot be cstimated. the majority cf the remaining respondees (69.2%)
expects a rising pricing development for n..s. For the sponsors. Ibis means higher cost:s
wbi1c fm the investors highcr retums (sec figure 7.20).
AB per 01.01.2009, the interview participants bad an average experience in the busi-
ness of 6.05 years. ranging from 1 year 10 15 years. All responded that they started 10
get involved into n..s within their professional career, wbi1c ODe professional was also
involved in n..s dllring bis academic careet.
_\\ hloh P';"'"R d"-.,",," ..", d~ lOU",>to' f~, ' ho ' LS p n:><lu<I,
===:":'=:--
)·0" ' '-' ,,,po.,lb'< for I. Ih< 12 mo.ln •• n"d~-
llJ
•• %., •••
l~ %
10"" lJ.O
'/·0 % _ 5.1
.JO% o,,..,. • 1.6
f"'''D''~' .rQut,'ioD.''''' .(".d

To .. 1 !lo,",,,,,, l~ Sou«<: 0". C .. ph
F1gure 7.20: Expected pricing development fm n..s

268 CHAPTER 7. ILS ONLINE SURVEY
7.1.7 Summary ofthe results ofthe ILS online survey

A broad range of stakeholders with a wide variety of functions and interests in the
process participated in the online snrvey. It was not possible to find any statistical
correlations between the stakeholder groups and answers given.
However, the following conc1usions can be drawn: n...s related activities are mostly
teams of specialists and rather elose 10 the general mangement of the companies.
Tbere is a high percentage of companies involved which are big enough to operate
on a global basis.
Most parties involved operate in standardised products which can be risk transfer
ILS (e.g. catastrophe bonds and catastrophe mortality issues), embedded value, and US
reserve financing. Structured products like CDOs or life settlements are less attractive
tothem.
Higher capital requirements are expected to increase the demand for ILS, and the
market is ready to develop new product types, while the main driver is risk transfer.
Main obsta.c1es on the sponsors' side is the low commitment of the management 10
the products, while on the investment side there is still a lack of expertise. - Regulation,
rating agencies' requirements, technical systems or restrictions by owners are less of an
issue.
Reinsurers and the banking sector are almost equally regarded to be capable to
arrange ILS, while arranging sponsors need support from one of them.
Price, diversification and product liquidity are the main reasons to attract market
participants.
Risk models are more important to the respondees than ratings.
Strengths of the banks involved are their structuring and placement capabilities.
Further they are able to provide innovative products to the capital market. However,
they seem to have a lack of understanding of the insurancelreinsurance products and its
business behavioms.
The survey participants, as a result of the crisis, expect stricter supervision of bank.
counterparty risk and the investments in collateral trusts. Further, investors will demand
a higher arnount of collateralisation and will be less prepared to participate in structured
products like CDOs. Long-term products are expected to be more difficult to place, and
banks may be challenged as long-term creditors. Rating agencies will strengthen their
guidelines.
Tbe majority of the participants expect a rise in pricing for ILS. However, due to the
market turbulences at the time of the interviews, 23% stated that they cannot estimate
the further pricing development.
Chapter8
Recent Developments
After Ibe eIosing of Ibe interview phase, ILS markets have gone through an extraor-
dinary period facing rapid changes. The !atest key developments until July 2009 are
summarised as follows:
There is a common understanding !hat state-of-Ibe-art principle-based solvency
regimes are imperative to maintain Ibe financial stability of Ibe insurauce industry glob-
ally. In Europe, Ibe last QIS 5 will be done in 2010 in order to test Ibe soundness of
Ibe aunounced Solvency 2 architecture (Level I of the process). The European Com-
mission started in 2009 with the design of the implementation measures necessary for
Ibe fina1isation until 2012 (Level 2).1 Further, a comprehensive reform of Ibe EU in-
surauce oversight is being discussed which may result in Ihree committees, each for Ibe
supervision ofinsuraoce, banking, and securities (Level 3).2
The new US administration, within its finaocial regulation reform proposals, called
for arevision of the insurance supervision. Tbc creation of a Federal Office of National
Insuraoce within Ibe Treasury Department was suggested to galber information, develop
expertise, negotiate international agreements and coordinate policy in the insurance
sector. 3
NAIC proposed in May to establish a Reinsuraoce Supervisury Board under federal
law. The authority will supervise US-domestic aod licensed foreign reinsurers operating
in the USo Tbc revision process is expected to address the reinsurance issues,4
The drive to revise accounting roles for finaocial instruments is gaining fresh mo-
mentum. A simplification of the standards for their valuation is being worked on. Cur-
rently, the valuation is regnlated by lAS 39 aod the US equivalent FAS 133. The ru1es
were challenged by difficult market environments which made a mark-to-market evalu-
'CEIOPS [see 2009, pp. 23-28]

2CEA [see 2009, p. 10]
'Treasury [,ee 17.06.2009, p. 4]
4GoSS [see 21.04.2009];III [see 2009a]

270 CHAPTER 8. RECENT DEVELOPMENTS
.tion of securities impossible due to • lack of pricing sourees. 5

Tbe crisis swept over from banking to insurance with • time lag. Especially life
insurers operating in the US face substantial capital sbortages.6 A Outch insurer and
severallarge US life insurers had to .pply for Government support.7
Non-life insurers are facing USO 22 bn of claims caused by the 2008 burricanes Ike
and Gustav. Further, the balance sbeets of insures are not immune .gainst the financial
crlsis - the sector reported to have 15-20% Jess economic capital .vail.ble compared to
2008.' In contrary to the 2005 burricane se.son, the markets are currently not prepared
to inject fresb c.pital. 9
Tbe reinsurance and retrocession mark.ets are hardening with rates for US Wind
coverage up 15-20% in the recent renewal roonds. Reinsurers started to hold back
c.pital on the sidelines amid investment losses and to be prepared for the 2009 burricane
season. lO
Bec.use of the removal of hedge funds and low secondary market liquidity, sec-
ondary market prices for c.tastrophe bonds are moving wider .t rather low liquidity."
Despite the difficu1t environment, the sponsors HannoverRe, Soor, Liberty Mutual,
USAA, and MuuichRe retumed to the market after an absence of six months while
Assurant joined as • new-comer with • total volume of USO 987 m1n of c.tastrophe
bonds.'2 However, a number of addirional sponsors bold back, facing a price increase
of 50% oompared to the previous year. Depending on peril and region, the transactions
were priced at 9-17% above Libor." Tbe total volume of non-life !LS for 2009 is
estintated at USO 3 bn.'4
For the !LW market, new ISOA standards were introduced to facilitate trading of
the products. Pricing for !LWs also increased with a preruium of 17.5% for a USO 50
bn industry loss oompared to II % the year before. 15
AIG has, in a private transaction securitised the value of USO 8.5 bn, a siguificant
amount of the embedded value of their US life business. As part of their ball-out strat-
egy, the securitisation Dotes were transferred to the US government. 16 Otherwise, DO
life related !LS bave materlalised.
Tbe financial situation of the monoline insurance sector deteriorated further, and the
lack of capacity will remain. This will need More specialist investment to support life
5CEA [see 2009, p. 15];Fromme [see 29.06.2009]

6Yickers [see 28.05.2009]
7Barr and Mamudi [see 15.05.2009]
8Bogg and Hipp [see 08.01.2009]
9Pelsted [see 17.04.2009]
IOyicken [see 28.05.2009];Reuten [see 15.05.2009];K1ein and Mowe'Y [see 01.07.2009]
lICora [see 28.05.2009]
12areen [see 09.06.2009];ZeUer [see 23.04.2009]
13Yickers [see 28.05.2009]
14Pelstcd [sec 17.04.2009]
15Reuters [see 15.05.2009]
16Green [see 09.06.2009]
271
related securitisations,17
Rating Agencies will be registered and supervised by the EU authorities from 2010
on. They are working on restoting investor's confidence by disclosing their methodolo-
gies. Any contlicts of interest are avoided through the striet separation of methodology
development processes and day-to-day rating operations. I'
Hedge funds facing losses continued to lose!heir investors' support. European higb
wealth individuals withdraw record sums from !he funds and are being replaced to a
lintited arnount by US pension funds. The EU launcbed a draft directive for bedge fund
regulation and faced lierce criticism from the industry. The US financia1 regulation
reform proposals also include a call for more regulation. I'
Dedicated investors still are attracted by low correlation assumption despite the fact
that ILS retumed mueb lower than corporate bonds in similar rating classes doring the
recent months.20
Arranging of ILS is challenging. The investors are reluctant to take credit risk,
meaning that the arrangers need to find innovative collateral structures to separate credit
risk from event risk. If necessary, this can be done by using derivatives. Some of
the transactions stayed with enhanced total retum swaps with top-up margining, while
others invested the collateral in AAA rated Dotes with matched durations or invested in
money-market funds. The collatera1 investroents are goverument guaranteed and fully
transparent.'1
While the avian flu virus (H5NI) has not developed into a form that would be eas-
ily transmitred in human-to-human contact, the declaration of the swine influenza A
(HINI), which is thougbt to have originated in Mexico as pandemic by the WHO on
June 12th, 2009, brougbt the topic back onto the agenda. 22
170'Connor [see 31.03.2009]

18Tait [see 23.04.2009]
19Sorkin [see 24.04.2009];Brewster [see 19.04.2009];Treasury [see 17.06.2009]
20Suess and Umack [see 19.01.2009];Suess and Umack [see 17.02.2009];Fields [see 04.06.2009];Reuters
[see 08.06.20091
21Dankwa [see 17.06.2009];McMurrough et al. [see 27.10.2008]
"Cheng and Jonlans [see 11.06.2009]
Chapter9
Summary and Conclusion
Convergence between the insuranee and banking sectors is already reality. There baa
been a strong tendency to follow the blucprint of thc banking supcrvisory framcwork
Basle 11 when creating Solvency 2 for the Eurnpean insuranee and reinsuranee indus-
try. Although the current crisis made evident the weaknesses of the regime and some
countries have concerns that their insurance sectors may not have sufficient capital to
keep up with the sehedule to introduee the new regime, it has been agreed to implement
Solvency 2 unti12012.
The current erisis bears the potential to leam many lessons and to create a stable
framcwork. Thc US and a number of important offshore regulators arc elosely fol-
lowing the process in Europe, and there is a common inrerest to harmonise the global
supervisory systems. As the regulators, all other stakeholders involved in the process
are interested in a constructive discussion.
Due to the exposure to natural eatastrophe, the US market has rather been risk trans-
fer driven, while the European market has rather been capital-driven. The ILS market
has shifted from indemnity triggers to investor-friendly parametrie and index-based trig-
gers. ILS would gain attractivcness among sponsors, if thc usc of indemnity triggers
increased. This process requires the availability of statistica1 data and eommon practiee
regarding the evaluation of risk. Banks ean take responsibility in their role as interme-
diaries between sponsors and investors.
The market was for years regarded as growing too slowly. However, there was a
misconeeption when eomparing 1LS with other eapital market products. The growth
rates of the MBS markets were taken as a benehmark for 1LS products. While MBS,
for instanec, built up a bubblc, thc insuranec market is grounded on reality. There must
be business written by primary insurers whieh baa to be ceded, otherwise ILS stroetures
da not malre sense. Further, in order to benefit from capital deduction, regulators and
rating ageneies demand a full eollateralisation of the products. This prevented the 1LS
market from over-Ieverage into a bubble.

274 CHAPTER 9. SUMMARY AND CONCLUSION
Further, investors needed to get eomfortable with writing protection against risk
they usually are afraid of. Sponsors needed to get over the hurdles of being rather used
to traditional reinsuraoee thao to the eapital market-like ILS.
Securitisation offers a vatiety of alternatives to traditional reinsuraoce. Although
some produets are not eompetitive to traditional reinsuraoee in terms of ptieing, they
offer some benefits whieh outweigh the higher eosts like eollateralisation or multi-year
eover at a fixed price. The produets have been providing additional eapacity aod at-
tracted a number of new investors who were not interested or not capable to participate
in the insuraoee-linked markeI.
Non-life n..S will continue to be atrractive due to their high yield aod the vatiety of
perils available. The eollateral trusts will go through areform aod experienee a strieter
regime - portfollos will inc1ude more secure investments than in the past The crisis will
further lead to arnended terms aod More traospareney for the investors. Monthlyevalua-
tions of the assets invested and step-up conditions for the case of a market deterioration
will enable the trusts to react quieker thao in the pasl.
Whether Libor remains as a reference or will be replaced by short-term treasury
rates depends on the flexibility of investors. At the time of the interviews, the majority
of the market partieipants eould not irnagine that investors will aceept lower yields by
approximately 150bp as a result of a switch to treasury-referenced prieing. The produets
wou1d then get less attra.ctive in comparison to alternative investments.
Sid. ears and eaptives are eompetitive products to non-life ILS. However, the ehar-
acteristics of reinsurance overweigh those of securities attracting the broader investor
space. Partieipaots in side ears provide reinsuraoce eapital for a elosely defined set of
eontracts aod perils for a lirnited time-frame. They have to nnderstaod the business in
order to be able to bear the risks. Regarding the location of eaptives, it eao be assumed
that they depend to a substaotial part on low-tax legislation. There is a lot of diseussion
regarding offshore finaocial centers. As a result of the erisis, governments eao be as-
sumed to improve the attractiveness of onshore solutions in order to stay in contro! of
the market aod to keep tax revenues in1aod. The US aod Europe are not far away from
finding solutions whieh may become eompetitive through pass-through taxation roles.
Li!e ILS are facing a strongly ehaoging environment: After the departore of the
monoline insurers and the 10S8 of confidence in ratings, investors have 10 evaluate the
traosactions on their owu. This meaos that the sector goes through a traosition phase.
Swap transactions between the sponsor and investors with banks as intermediaries may
bear a higher potential thao life n..S sinee they eao be done privately without the regu-
I.tory requirements of a REG-I44A transaction. The market, as a result, will be even
More dominated by specialists exactly nnderstaoding the risk aod the actnatial model-
ing; More education of investors will eertainly be necessary.
Some investors are very sophistieated regarding longevity risk traosfer. Dedieated
funds have been irnportant participants in this market sinee they see longevity assets
alongside other n..S products. Longevity is a slow buming, cumulative risk. Existing
models are rare aod econometrie - they are different from the usual models aod normally
275
outside the experience range of investors.

Embedded value transactions will continue to be attractive far demutualisations or
portfolios sent into run-off after take-overs. The loan-to-value of embedded value trans-
actions, however, as a result of the crisis, may come down from 80% to 50%, or even
40%. The risk of loss may therefore be reduced and the usnal monoline wraps can fall
away.
The future development regarding ILS volumes depends much on the liquidity of
the market. Primary markets were, until the current crisis, liquid enough to place ILS
of the different varieties exp1ained. However, hedge funds among the primary investors
currently lose a substantial part of their liquidity because of redemptions aod banks not
being willing or able to provide leverage. Further, they have to solve a number of issnes
with difficulties in their investments in mortgage-backed securities. Whether they are
able to return to the markets depends much on the further development of the crisis in
tenns of severity.
Dedicated funds and hopefully newly emerging retail funds may be able to fill the
gap and will be interested to further buy the products. Unless reformed, US Reg-I44A
aod ERISA rules will stay to be a hurdle for the liquidity of secondary markets .
Secondary marke!s are vital for the future gruwth potential regarding ILS. They
proved to be stable and able to absarb selling efforts at acceptable prices until end of
2008, much longer than other segments of the capital markets: stock exchanges aod
prices for high yield corporate debt were already in free fall at that time.
Life settlements have to same extend started as ILS, but the market has shifted to
private placement structures, some of thern are retail funds. They currently experience
sintilar difficulties as hedge funds. Liquidity unfortonately dried up at a time when pol-
ieyholder are willing or forced to cede their life insurance contract at attractive prices.
Overall, ILS, also in combination with other ART products, affer a wide range of
flexibility. There is room for further product inoovation, especia1ly regarding multi-
perillmulti-trigger securitisation structures. However, the marke! needs higher volumes
with attractive spreads to meet investors' demand far More diversification aod high
returns. Tbe premium compared to other capital market investment categories can be
expected to remain over a longer term and is justified by the lower liquidity and the
necessity to understand catastrophe risk mechanisms when investing in ILS. There is
some possibility that reinsurers may take the role as intermediaries writing reinsurance
cover aod p1acing it in a structored form into the capital markets.
Supranational institutions like the World Bank are interested in ILS to cover catas-
trophe risk aod bring stability into the system.
The ro/e of the banks has changed since the early days of the marke!. While in
the beginuing they were investors to support the start-up, they concentrated on provid-
ing leverage aod arraoging transactions before the crisis. They will continne to play
ao irnportaot role to provide liquidity for the primary marke! by finding investors, ar
far the secondary market through warehousing and trading. Their strength compared
to reinsurers and brokers is their international placement capability aod their savvy
276 CHAPTER 9. SUMMARY AND CONCLUSION
of the investor space. Reinsurers and brokers are eh.sing up, bot are yet not .ble to
provide • similar sales force. Banks' weakness is the lack of kuowledge of the insur-
ance/reinsurance space. Further. they are DO traditional investors in the BB range of
ILS investments. Tbey will eontinue to be needed in the future to provide services as
interest rate sw.p counterparties and trustees. Tbey will certainly stay to be .ecepted
.s total return sw.p providers for short or medium term transactions (up to 5 years).
However, it will take time to eonvince counterparties to accept lower quality banks for
longer terms.
The non-correlation assumption of the ILS market holds for the different insurance
perils, but not for the general effeets of • severe finaneial crisis. Tbe recent months
have proven that banks can default or run into state conservatorship and that investors
are reluctant to boy any kind of securities, .t least temporarily.
Tbe separation of credit risk and event risk is necessary and a1ready refiected in the
new ILS structures of vintage 2009.
ILS depend on the pricing cyele of reinsurance: Tbe produets are .ttractive when
reinsurance prices are high in hard markets and are less attractive when the prices are
low in soft markets. Tbe ILS market will pick up when traditional markets ealm down
and reinsurance rates harden. When comparing the prices, the full costs of the different
products h.ve to be taken into consideration.
Tbe future of the market depends • lot on the severity of the eurrent crisis. Tbere will
remain to be ups and downs in the capital market and the nature of insurance causes a
eertain vol.tility of loss ratios. Tbe eonfidenee in structured produets has to be restored
to • degree !hat sponsors further accept ILS as an alternative and !hat investors, aftaid
of the bank risk involved, .ecept them .s secure investments. Less eomplex struetures
with ciear documentation standards are needed.
This ean only be reached when alI parties involved act in • eonstructive w.y. At
current, the market is in a phase to overcome its weaknesses. The first hurdle has been
taken by the successful introduetion of new e.tastrophe ILS structures with more secure
standards. While .pproximately 50% of them continue to use modified total return
sw.ps, the remaining are seeured by eoll.tera1 trusts holding govemment-guaranteed
bonds. Supposed!hat the erisis will come to an end soon and no major disruption like
a mega-catastrophe cr a severe pandemie occurred, ILS have a good chance for further
sound development .ttracting more sponsors and investors willing to place and take
pure insuranee risk into their books. ILS produets certainly h.ve • chance to recover
earlier that other securitisation types.
Interesting topies to analyse in the future m.y be the potential usage of ILS for the
banks' hedging purposes. Another interesting subject would be to analyse the effeets
of the global barmonis.tion of the insuranee solvency regimes sinee the use of Basle II
opened the doors for global investment alIocation into the wrong direetion, resulting in
the current crisis. Further it may be interesting to analyse how the products eould be
used to prevent emerging eountries ftnm n.tural e.tastrophe damage.
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AppendixA
Insurer Financial Strength Rating Methodologies

2••
AppendixB
The 35 most costly insurance losses 1970-2008 1
ID8ta Source: Sigma.. Natural catastrophes and man made disasters in 2008.
SwissRc, Zurich, 21.01.2009
....., """""", Start Date: E_ eounttr.
71,300 1,836 25.08.200S Hnrricane Katrinaj tloods, damI hurst, damagc to oll rigs USA, Gulf of Mexico, Bahamas, N.At1anti.c 8
_ 24,552
22,855
43
2,982
23.08.1992
11.09.2001
Hurricane Andrewj f100ding
Terror attack on WTC, Pentagon and othcr buildings
USA, Bahamas
USA
20,337 61 17.01.1994- Northridgc Earthquakc (magnitude 6.6) USA
20,000 13. 20.09.2008 Hurrk:ane Ike; ßoods. olIshare damage USA, Caribbean, GuJf of Mexico cl a1.
14, 1 Hurrkane lvan; damage to oll USA, Caribbean: Barbados et .
13,847 19.10.2005 Hurricane WIlma.; torrential rain, floods USA, Mexico, Iamaica, Haiti ct al.
11,122 34
" 2O.09.200S Hurricane Ritaj floods. damage to oll rigs Hur. Charley USA, Gu1f of Mexico, Cuba
9,176 24 11.08.2004 Hurricane Charley USA Cuba, Jamaica et al.
8,926 51 27.09.1991 Typhoon MiIcilleINo. 19 I."",
7,940 71 15.09.1989 Hmricane Hugo USA, Puerto Rico et w.
7,695 ., 25.01.1990 Winter starm Dm France, UK, Belgium, NL ct al.
7, 11 .1 .1 99 Winte<.-Lotlw Switzerland, UK, France et al.
6,328 54 18.01.2007 Wmtcr storm Kyrill; floods Gcrmany, UK, Nethcrlands, Belgium ct al.
5,875 22 15.10.1987 Storm and f100ds in Europc Francc, UK, Netherlands cl al.
5,866 38 26.08.2004 Hurricane Fnmces USA Bahamas
5,255 64 25.02.1990 wmtcr stonn Vivian Europo
',222 26 22.09.1999 Typhoon Bart/No. 18 I."",
4,663 .09.1998 Hurrk:ane Gearges; ooding USA, Caribbean
' ,
4, 41 1 .- . heavy ralll, UA
4,334 3,034 13.09.2004 Hurricane Jeannc; floods, landslidcs USA, Caribbean, Haiti ct al.
4,087 ., 06.09.2004 Typhoon Songda!No. 18 Iapan, South Korea
4,000 l3S 26.08.2008 Hurricane Gustav; F1oods. Offshorc damage US, Caribbean, Gulf of Mcxico et 81.
3,752 45 02.05.2003 Thnndcrstorms, tomadocs, ball USA
3,648 70 10.09.1999 HmricllIlC Floyd; hcavy rain, floods USA, Bahamas. Colombia
3,642 1 .rJJ.1988 Explosion on pI Piper UK
3,'" ,. OLlO.1 ••' Hmricane Opal; fiooding USA, Mexi.co, Gulf ofMexi.co
3,493 6,425 17.01.1995 Great Hanshin carthquakc (magnitude 7.2) in Kobc
"'" I."",
3,102 ., 27.12.1999 Wmter storm Martin Spain, Francc. Switzedand
2,925 246 10.03.1993 Blizzard, tomadoes, flooding US, Canada. Mexico, Cuba
2,763 38 06.08.2002 Scvcrc floods UK, Spain. Gcrmany, Austria cl al.
2,688 20.10.1991 Fon:st fims which spmad to mban areas, drought USA
2,675 - ",042001 Hail, 1l00ds and wmadocs USA
4 25. -". UK
" .. 7.~' ~
-- --- " ""'"
lUSD m insured laISes indexed. to 2008 (inct. pmperty and buBinells inremIption, excl. liability and life insurancc 1000000s); 2dead and missing
Appendix C
Reinsurance Sidecar Issues 1
IData Sources: MMC Sccurities, The catastrophe bond marlet at year end 2006,
Guy Carpenter & Company, New York, 2007 and Aon Capital Markcts, Insurance-linkc:d
securities 2008. AON. Chicago 2008
2005 _SImre 90.9 [:3
2.005 Kait _S",",
_SIwe 370.0
2005 Helicon Re 146.0
_SIwe 525.0
Bluc Occan Re 300.0 Propcrty I
~71.9
_S","", 250.0 USj
_S",",
.Re _S",",
_SIwe 60.0
_SIwe 3IT.O Shart-tailed
2006 Bi_ _SIwe 360.0 40% I f'ot
200.0 Marine I Of
2006 _S","", ~ c energy and marine
2006 :ontingent a 300.0
2006 Sille by Sidc 70.0
",>,"""""""
nprotcction
2006 [HcIlooc Re
_SIwe 330.0
NortonRe ,ide by Sidc 107.7 Property I

Syruoro QunlaS","", 100.0 Property I
Nr:w Point Re Sille by Sidc 250.0 Property I
4,159.7
!1iXJ7
2007 lYnmcate 6104
MopücLtd
Bi_
QunlaSlwe
QunlaSlwe
78.6
69.0
Property I
,
1iXJ7 lyndicate 6105 Arl<U_ QunlaSlwe
40.0
400.0 """"""
_
1iXJ7 ACE Side by Silk:
2007 S",",Re Swis! Re QunIa SImre 220.0 Proper
2007 XOL 200.0 Proper
2007 XOL 550.0 Proper
ThIal1iXJ7 (9) 1,959.
Data source: Guy CaIJ?"'!ter, Ibe World Catastrophe Reinsurance Marlre~ Guy Carpeoter & Company, New York, 2008
Aon Capltal Markets, Insurance-Linked Securities 2008, AON, Chicago 2008
AppendixD
US Life Insurers:
xxx and AXXX Securitisations 1
I Data Sources: Devine, Colin, ci al., The Securitization Solution: Emerging Options
for Ufe Insurcrs, Citigroup Inc, New York, 06.07.2006, p. 10 I Carcy, !an and)amcs, Tim,
European Life Securitisation, Faculty & Institute of Actuaries, London, 2008,
[Powerpoint Slide 5]
Yoar N.... 0- USDm Urig. Ra~ Ad. Ra~ Type fum ........- ~
2003 Rivm: Lake Ins. Co. I-A GcnworthlFirst Colony Lifc 300.0 AA'
"'" A
"'" XXX 3. MBlA
2003 Rivm: Lake Ins. Co. I-B GcnworthlFirst Colony Lifc 300.0 AA' A XXX 3. MBlA
Tht.l2OO3 600.•
2004 Potomac Th1st C8pital I 04-1 Banner Life (ht BritishAmerican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac Th1st Capital I 04-2 Banner Life (1st BritishAmerican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac Th1st Capital I 04-3 Bumer Life (1st BritishAmerican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac nult Capital I 04-4 Banner Life (bt BritishAmerican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac Th1st Capital I 04-5 Banner Life (bt BritishAmerican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac 'IIust Capital I 04-6 BaDDet Life (bt BritishAmerican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac 'IIust Capital I 04-7 Banner Life (1st BritishAmerican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac 'IIust Capital I 04-8 Banner Life (1st BritishAmerican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac 'IIust Capital I 04-9 Banner Life (1st BritishAmcrican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac 'Ih1st Capital I 04-10 Banner Life (1st BritishAmcrican) 49.1 AAA AA- XXX 20 AMBAC
2004 Potomac Trust Capital I 04-11 Banner Life (1st BritishAmerican) 49.1 AA- AA- XXX 20 AMBAC
2004 River Lake Ins. Co II-A GenwortbJFirst Colony Life 300.0 AAA A XXX 3. MBIA
Toto! 2004 840.1
2005 River Lake Ins. Co. D-B GenworthIFirst Colony Life 300.0 AAA A XXX 3. MBIA
2005 River Lake Ins. Co. I-C GenworthlFirst Colony Life 200.• AA A XXX 3. MBIA
2005 Orkney Holdings _Re 850.0 AAA BBB+ XXX 3. MBlA
2005 Orl<ney Re rr _Re 383.0 AAA wo XXX 3.
2005 Orl<ney Re rr _Re 43.0 A- B.1 XXX 3. ""'''''''
2005 Orl<ney Re rr _Re 30.0 BBB+ B02 XXX 3. ""'''''''
2005 StiDgray Th1St _Re 325.0 - - XXX 10 ""'''''''
Tht.l2OO5 2,131.0
2006 River Lake Ins. Co. m GenworthlFirst Colony 500.0 AAA A XXX 3. FGIC
2006 Rivermont GenworthlFirst Colony 315.0 AAA A- AXXX 44 MBIA
2006 B_Re 500.0 AAA CC XXX 3. ""'....,.--.
2006
2006
2006
B_Re
B_Re
B_Re
_..
_Re
_Re
500.0
400.•
250.0
AAA
AAA
AA
CC
CC
ce
XXX
XXX
XXX
3.
3.
3.
""'....,.--.
""'....,.--.
""'....,.--.
2006 B_Re _Re 10.0 BBB+ ce XXX 3. ""'....,.--.
2006 B_Re _Re 40.• BBB+ ce XXX 3. ""'....,.--.
2006 B_Re _Re 50.0 - - XXX 3.
2006 Tunberlakc Financial RGA 850.0 AAA' A' XXX 3. Am"'"
2006 S""""""'" Banner Life TI (htBritishAmerican) 450.0 Aal' w, XXX 31
2006 River Lake Ins. Co. I-D GenworthlFirst Colony Life 300.0 AA' A' XXX 3. ""'''''''
MBlA
y~ N_ Spoouor Ra~ 1)pe 10nn M ........
USD m Orig. Rat-
I iDg Ad.
I iDg
Co. IV Genwortb. 500.0 Aaa 3 A XXX 21 MBIA
Co. IV Genwortb. 40.0 Baa33 DIa XXX 21 MBIA
~ Aeg= 550.0 AAA' AAA' I XXX I I
~~teIVDoubleOakC = Protective 1,::~ AAA I A- I AXXX 45 MBIA
I 2008 I SBLI Savings Banks Life Ins. Co. of I 175.0 I n/a I n/a I XXX I DIa I n/a
MASS
[ 2008 [ Pine Folio [ Aeg= [ 1,0400 [ A+' [ nI. [ AXXX [29 [-
2008 ToW 1,715.0
1 Standard &Poor's Rating;2 Fitch Rating; 3 Moody's Rating
51
AppendixE
Life Insurance:
Value-in-Force I Embedded Value Securitisations'
IData Sources: Devine, Colin, Cl al., The Securitization Solution: Emerging Options
far Ufe Insurers. Citigroup Inc. New York, 06.07.2006, p. 25/ Carey, !an and James. Tim,
European Life Securitisation, Faculty & Institute of Actuaries, London, 2008,
[Powerpoint Slide S1 I Wallin, Ulrich, Insurance-linked securities Hann.over Re, Hannover,
29.07.1JXJ7. [Powerpoint Slide 7]
V"" N.... S......' USDm Tonn Rating Rating Type Guanm
v.... Orig. Ac!. Loao- il\l
- (
. - ti..
-)
1998
1998
Mutual Securitisation Pk
Mutual Securitillation Pk
National. Provident
National. Provident
196.0
168.0
Bonds Class A
Bonds Class B
I'
25
A-
A-
BB+
CCC
Yalue-in-Force
Yalue-in-Force
- ...
EU
EU
-
-
'Ibtal. 1998 364.0
1999 12 _Re 184.0 Note. - Emboddod Vo1ue EU/USA
ThtalI999 184.0
2001 Prudcntial Holdings ll.C Prudcnti.al Financlal 175.0 SharcsO. B - Block Securitisation USA -
2001 Prudcntial Holdings ll.C Prudcnti.al Financlal 332.9 Notes Serie5 A 16 Aaa Ao3 Block SecuritisaUon USA FSA
2001 Prudcntial HoldinglllLC Prudcnti.al Financlal n6.7 Notes ScriC5 B 22 Aaa A>3 Block SecuritisaUon USA FSA
2001 Prudcntial HoldinglllLC Prudcnti.al Financlal 640.' Notes ScriC5 C 22 A2 A3 Block. SecuritisaUon USA -
Thtal2001 1,925.1
200l MonyHcl<tingaLLC MonyGroup 300.0 Note. I' AAA
, =oedBI..,. USA Amboe
Thtal2002 300.0
""""
2003 Gracechun:h llie New Barclays Life 559.9 Note. 10 Aaa Valuc-in-ForccICB EU Amboe
Thtal2003 559.9 """"
2004 Box Hili Life Friends Provident 391.9 Notes Al 12 Aaa Bul
, Value-in-Force EU Amboe
2004 Box Hili Life Friends Provident 140.0 NotesA2 I' Aaa Bul
, Valuc-in-Force EU Amboe
l'LAC _ . LU;
2UU4 W.ll """"'" '" Man. '0.0 NotesA 3 AAA
, """""""Vo1ue USA XLCA
2004 FLAC Holdings u.c Weil Gothshal & Man. 100.0 NotesB 7 AAA
,
"""" Emboddod Vo1ue USA XLCA
Thtal2004 681.9
""""
200S Qw=.... Swissh 175.0 NotesA 20 A+ A+ Emboddod Volue USA -
(3.0)
200S Qw=.... Swissh 45.0 NotesB 20 BBB
, BBB Emboddod Vo1ue USA -
(7.6)
2005 Qw=.... SwissRe 25.0 NotcsC 20(10.2) BB' BB' Emboddod Vo1ue USA -
2005 Alps Capital 11 SwissRe 220.0 NotesA 20 AAA
, AA-' Emboddod Vo1ue USA XLCA
(5.5)
2005 Alps Capital 11 SwissRe 90.0 NotesB 20 AAA
, A' Emboddod Vo1ue USA XLCA
(9.1)
200S Alps Capital n SwissRe 30.0 Notes C 20 BBB
, BBB Emboddod Volue USA -
(10.')
v_ N_ S.......' USDm Thnn Ra", Ra", 1Jpe G~
v.... Orig. Art. Loca-
(n- ""
2005 Alps Capital n SwissRe 30.0
-
NotcsD
-)
20 BB' BB' Emboddod Vo1De
-...
USA -
(12)
Thbl2005 615.0
2006 L6 _Re 143.0 Notes - Emboddod Vo1ue DIA
2006 Thilwind Holdings Unnum Provident 130.0 NotesA 3. AAA 01. Redundant Capital. USA MBIA
,
Thbl 7 .
2rxn Chwdion 171.5 Note. - Valuc-in-Forcc UK -
2rxn
2rxn
_.
Metlife Re Charleston
Northwind Holdings
Meilife
UnumGroup
2,500.0
800.0
Su""'"
"
35 AA
AAA
,
AA-
A
Emboddod Vo1De
Block Securitisation
USA
USA
-
MBIA
2rxn Avondale Securities Bank of IrcIand Lifc Ins. 490.• Notes Al 2> Am A3 Valuc-in-Forcc IRL AmbE
2CX17 Avondale Sccuritics Bank of Ircland Life Ins. 2>.1 NotcsA2 2> ,B..l Bu3
, Valuc-in-Forcc IRL AmbE
Thbl 3,986.
2008 Zeot Aegon (Scottish Equi- 350.0 NotesA 14.0 A' A' Yalue-in-Force UK -
tablc)
Thbl2008 350.0
C':I1'Bnd Total 9.239.~
I Standard & Poot's Rating; 2 Fitch Rating; 3 Moody"s Rating
fJ
AppendixF
Life Insurance:
Commission / Acquisition Cost Securitisations 1
IData Sources: Devinc, Colin. ct al., The Securitization Solution: EmerJrim!: Options
for Ufe Insurcrs, Citigroup Inc, New York, 06.07.2006, p. 26/ Wallin, OIrlch,
1nsurance-1in1red securities Hannover Re, Hannover, 29.00.2007. [Powerpoint Stide 7]
V... Name Spousor USDm Term V..... Type Region w
~
1997 American SkaDdia 1997-1 SkaDdia 54.4 7.7 Commission Fmancing USA LV
1997 American SkaDdia1997-2 SkaDdia 65.9 6.0 Commission Financing USA
1997 American SkaDdia 1997-3 SkaDdia 45.0 6.9 Commission Financing USA
Thbll1997 165.3
1998 LI Hannover Re 66.2 3.0 .Acquisition Cost Euro (DIA)
1998 AmericanSkaDdial998-1 SkaDdia 47.9 6.9 Commission Financing USA
1998 American Skandia 1998-3 SkaDdia 28.9 6.8 Commission Fmancing USA
Thbll1998 194.4
1999 L3 Hannover Re 65.0 3.0 Acquisition Costs ABia
1999 AmericanSkaDdial999-1 SkaDdia 97.4 7.8 Commission Financing USA
1999 American Skandia 1999-2 SkaDdia 113.9 7.7 Commission Financing USA
Thbll1999 276.3
2000 L4 HannoverRc 259,0 Acquisition costs Europe
2000 American Skandia 2000-2 SkaDdia 75.1 7.9 Commission Financing USA
2000 American Skandia 2000-3 SkaDdia 77.7 7.9 Commission Fmancing USA
Tota12000 616.0
2002 ClMkB.me. ClarkB.me. 403.0 20 Broker Commission USA
2002 L5 Hannover Re 388.3 3 Acquisition costs Europe
Thbll2002 791.3
2004 Anglia Funding Ltd ' Aviva 286.7 nla Premium & Commission UK
Thbll2004 286.7
Gtand Total 2,330.0
1 RatingA-1
Appendix G
Life Insurance:
Extreme Mortality Risk Transfer Securitisations 1
1D8ta Source: Schultz, Paul ct al, Insurance Linkod Securities 2008, Aon Capital
Marlrets. Chicago. 2008. p. 48
Date Name Sponsor USDm Class RatiDg Term TerrItorIes w
~
S&Ps ....
2003 VitaCapital SwissRe 400.0 No'" A+ 3.0 USA, UK. F, CH
Thtal2OO3 400.0
2005 Vita Capital TI SwissRe 62.0 B A 4.7 USA, UK. F,I, CH
2005 Vita Capital II SwissRe 200.0 C A- 4.7 USA, UK. F, ~ CH
2005 Vita Capital U SwissRe 100.0 D BBB 4.7 USA, UK. F, ~ CH
Thtal2005 362.0
2006 Tartao Capital Scottish Annuity & 75.0 A AAA 2.7 USA
Life
2006 Tartao Capital Scottish Annuity & 80.0 B BB 2.7 USA
Life
2006 Dsiris Capital AXA 129.0 B-I AAA 3.9 USA,F,J
2006 Dsiris Capital AXA 64.5 B-2 A- 3.9 USA,F,J
2006 Dsiris Capital AXA 150.0 C BBB 3.9 USA,F,J
2006 Dsiris Capital AXA 100.0 D BB+ 3.9 USA,F,J
2006 Vita Capital m SwissRe 90.0 BI A 4.0 USA, CAN, UK. J, D
2006 Vita Capital m SwissRe 50.0 BU A 5.0 USA, CAN, UK. J, D
2006 Vita Capital m SwissRe 38.7 Bm A 4.0 USA, CAN, UK. J, D
Total 2006 777.2
2007 Vita Capital m SwissRe 100.0 AIV AAA 4.0 USA, CAN, UK. J, D
2007 Vita Capital m SwissRe 100.0 AV AAA 5.0 USA, CAN, UK. J, D
2007 Vita Capital m SwissRe 71.0 AVI AAA 4.0 USA, CAN, UK. J, D
2007 Vita Capital m SwissRe 120.0 AVll AA- 5.0 USA, CAN, UK. J, D
2007 Vita Capital m SwissRe 90.0 BV AAA 4.0 USA, CAN, UK. J, D
2007 Vita Capital m SwissRe 90.0 BVI AAA 4.0 USA, CAN, UK. J, D
Total 2007 571.0
2008 NathanLtdI MunichRe 100.0 IA A- 4.9 USA, CAN, UK. D
Thtal2008 100.0
Grand Thtal 2,210.2
AppendixH
Life Settlement Securitisations

(Public Transactions only)!
I Data Sources: Carey, !an and Jamcs, TIm, Europcan Life Securitisation, Faculty &
Institute of Actuaries, Landon, 2008. [Powerpoint Stide 5] I Fasana. Michael. Securitisation
of Life Settlement Cash flows, Fasana Associates, Washington, 31.10.2008, [Powerpoint Stide 1] I
Business Wue, A.M. Best Assigns an Indicative Rating to Bonds Issued by Apollo SLS Fund SA,
AM Best. Oldwick, 02.09.2004
Year Name Spoosor USDm Issue RatIDg Current Term w
~
RatIDg Years
2003 Thrrytown Second UC Seabury 63.0 notrated not rated 8 '"
2003 Patrons Legacy 2003-1 AIG Life Insurance Co. 231.9 Aaa' Aa3' 15
2003 Patrons Legacy 2003-ll AIG International 170.5 As'l. Aa3 13
2003 Patrons Legacy 2003-rn AIG Life Insurance Co. 238.8 Aaa' Aa3' 15
2003 Patrons Legacy 2003-IV AIGID_anal 188.5 As'l.' Aa3' 15
Thtal2003 892.7
2004 Patrons Legacy 2004-1 OldMutual 171.0 A2' Baal l 14
2004 Patrons Legacy 2004-ll Protecti.ve Life 143.5 Aa3' A2' 21
2004 Apollo SLS Fund Leleux Associated Brokers 189.0 bbW not rated 10
2004 Legacy Benefits 2004-1A LLC Legacy Benefits Co 61.5 Al' Al' 35
2004 Legacy Benefits 2004-lB LLC Legacy Benefits Co 8.5 Baa2' Baa2' 35
Thtal2004 573.5
Grand Total 1,466.2
1 Moodyls Rating; 2 AM Best Rating (indicative)

Appendix I
Non Life Insurance:

Catastrophe Bonds!
IData Sources: MMC Securities, The catastrophe bond market at ycar end 2006,
Guy Carpenter & Company, New York., 2007, pp. 32-35 and Schultz, Paul et al., Insu:rance Linked
Securities 2008. AON Capital MaIkets. Chicago 2008, pp. 40-47
w
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AppendixJ
Non-Life Insurance:
Catastrophe Bond Statistics 1
IData Sources: MMC Securities, The catastrophe bond market at year end 2006,
Guy Carpentcr & Company, New York., 2007 and Schultz, Paul ot al.., Insurance-linked
securities 2008. AON Capital Markets. Chicago 2008
328
16000
,. 14000
12000
,; 10000
13. 79~
., 111100
i 11.8lJ
,----- 16•m
6000
~
4.040 ....,u..
4000
:i"
1.503
J.4 ~~ 11 043
"
2000
, 1.948 1 hTI:rl 2.001
2.688
!OO8
Volume of ca! bonds issued
-- 41,3 ....
Sl,7
~
i
-- ,i
,~ 42,9'1(0 5(1
,-
~ .0
•
~.
,•
-
] J(I~
i 20 ~
~
~ ,, '
,~
,~
• '00' '00' '00' '00. lOO~ ,- '00' ,- •
Percentage of indemnity-based ca! bonds

32.
,
,·, ..
IOO'Y.
'Xl"!.
~.
•, 70'Y.
1, W%
Sl)0,4
& 30%
~O ·I.
l :0°1.
·
:i
10 0;.
O'Y.
2001 201)2 2003 200~ 200S 2006 2007 2008
o I ...... n~ y • 10<l",.,,· Inol<, 1:1 P."'rn"';"
Volume of ca! bonds by trigger type
.,!
100%
,•,
80%
, 600;.
!1 ~O"l.
,
·••
20%
0%
2001 2002 2003 200~ 2005 2006 2007 200~
o ~luk~I' ..... D O'h<r • J .p.o. Qo u~. • b rup< Q • • I«

• " S,\Q ..... [l J'p.n\\'.d • [_ruf>< W,nd 11 1 S ,\ ,,,nd
Volume of ca! bonds by peril

330
Honnud.
tI UI>:
. S... iw,rbnd
CI .' nlO<~
.Cuad"
• t\u,trdli~
(;.n"~n )'
• h~ll'
Volume of ca! bonds by investor nationality
19'18 I 'W'J
J"Io 4% 2000
",. " '0.

IO '~
~OO 7
10'1.
Volume of ca! bonds per year

AppendixK
US Catastrophe Loss
w
US Catas....phes: Industrywide - G..... I Diroc:t A _ Annual Catas....phe Loss and Loss Rad.. (USD m)
ld
Return Return South Gulf Mid North Ne.. Ne.. Califor- Pacific
period probabilily Atlande Wmd Atlande Atlande Madrid Madrid maEQ North-
(years) (pereent) Wind Wind Wind (1) (2) WeslEQ
EQ EQ
10,000 0,0001% 225,292 149,428 92,722 95,787 41,067 123,200 101,200 23,613
1,000 0,0010% 187,743 124,523 77,268 79,823 24,444 73,333 63,250 14,758
500 0,0020% 104,886 80,290 42,912 44,643 13,399 40,198 47,633 11,114
250 0,0040% 73,340 61,144 35,874 28,557 7,282 21,847 39,824 9,292
100 0,0100% 64,333 53,635 26,583 18,333 3,870 11,611 30,556 7,130
10 0,1000% 13,403 11,174 5,538 3,819 255 764 5,093 1,188
1 1,0000% - - - - - - - -
New Madrid (2) is the outer centric region far New Madrid (1) which are assumed to be perfectly com:lated - all other catastrophes are uncom:lated.
Bach valuc in thc table represcnts the loss associatod with a discrete evcnt. The estimatcd retum pcriod of such an event (column 1) can also be cxpressed as
retum probabilily (oo1umn 2).
Source: Barmt Thomas; et al.• Moody's risk adjusted capital model for US
property & casualty insurers Moody's Investor Service, New York 01.08.2006, p. 14
AppendixL
Fitch Prism: 30-Year Cumulative Default Table (in %)1
ISource: Thorpe, Donald, Themas; Cl al., Insurance-Linked Ratings Criteria (Global)

Fitch Ratings, Chicago, 04.02.2008, p. 9
334
••• ••
••
" H±-H-:++H
!! ! ~ ~
'''I'""
AppendixM
DefiDition of Indices:
Swiss Re BB Cat Bond Total Return Index (Bloomberg Code: SRCATI'RR)
Tho "Swiss Re BB Cat Bond Total Return Index" calculated by SwissRc marIrets is an cqually-weightod
bastet ofUS Dollars denominated natural catastrophe re1ated bonds. It was constructed to track. the total rate
of retum far the USD denominated issues outstanding which are rated BB by Standard & Poor's,
Hedge Fund ofFunds Composite Index (Bloomberg Code: HFRlFOF)
The "Hcdgc Fund ofFunds Composite Index" includes over 800 constituent funds. It includes hath do-
mesti.c and offshore fund of funds having at least US 50 mln under management or have been actively trading
for at least twelve months. Ibe index is equally-weighted and a11 funds report assets in USD. Reported are
performances net of a1l fee returns on a monthly basis.
Merrill Lynch BB US High Yield Index (Bloomberg Code: HOAI)
The ''Merrill Lynch BB US High Yie1d Index" is a subset of the Menill Lynch US High Yie1d Index.
It is tracking the performance of USD denominated corporate debt including an securities rated in the range
BB+ through BB-, inclusivc. Qua1ifying securities must have a remaining lifetime of ODe year, a fixcd coupon
schedulc and a minimum amount outstanding ofUSD 100 mln. Index constituents are capitalisation-weighted
based on their current amount outstanding.
Standard cl: Poor's 500 Index (Bloomberg Code: SPX)
The "Standard & Poor's 500 Index" is a capitalisation-weighted index with each stock's weight in the
index proportionale to its market value. The 500 stocks are chosen fot market size, liquidity and industry
group representation. It iB designed to measure performance of the broad US economy. Tbe Standard &
Poor's 500 iB one of the most widely used benchmarks of US equity performance.
IP Morgan Global Government Bond Index (Bloomberg code: IPMX)
The "JP Morgan Global Govemment Bond Index" comprises 13 markcts: Australia., Belgium, Canada.,
Denmark, France, Gennany, ltaly, Japan, Netherlands, Spain, Sweden, Th.e UK and the USo Th.e Index in-
cludes Govmunent bonds only and the index iB weighted by market capitalisation (i.e. amount outstanding
times the dirty price). Th.e index iB rebalanced. 8t the close of the first business day each month in order to
336
accurate1y reftect the availab1e market supply of investable bonds.
Definition 01 ILS Funds
SoUdum Partners SAC Fund 1/2 (Bloomberg Code: SLDEVNr BH)
Solidum Partners AG is an indcpendent investment advisor and fund manager foundcd in 2004 and spc-
cialising in ILS. After a change in ownership, the former "Solidum Partners SAC Fund 1" was c10sed and a
new "Solidum Partners SAC Fund 2" was established within which the ongoing portfolio is managed. The
objective of the open-ended fund registered in Bermuda is to achieve long term capital appreciation and low
correlation to fixed income, oquity and non-traditional investments. The fund achieves those goals by invest-
ing in ILS. n.Ws sidecars and insurance derivatives.
Credit Suisse Anlagestifhmg ILS Fund (Bloomberg Code: CSAlDXL SW)
"Credit Suisse Anlagestiftung ILS Fund" is an open-ended investment fund denominated in Swiss Francs
and incorporated in Switzerland. The fund allocated 100% of its invests globally into rated ILS bonds cover-
ing natmal catastrophes in different geographical regions.
C/oriden Leu Car Bond Fund (Bloomberg CO<k: LEUPCBU SW)
"Clariden Leu Cat Bond Fund" is an USD denominatod open-end investment fund incorporatod in
Switzerland. The fund invests in a broadly diversified portfolio of catastrophe bonds. The fund's objec-
live is a stahle return that is ahove the money-market yie1d and has only a low correlation to other movements
on the financial markets.
AlG Diwmified CAT Bond Fwu1 (Bloomberg Code: ACATCHA SW)
"AlG Diversified CAT Bond Fund" is an open-ended investment fund incorporated in Switzerland. The
fund's objective is 10 achieve a money market retum and an appropriatc risk premium by invcsting at least
75% of its asscts in a global portfolio ofll.S of catastrophc bonds which are linked to insurcd cvents.
AlG Insurance-I.inked Strategy Fund (Bloomberg Code: AILSUSA SW)
"AIG Insurance-Linked Strategy Fund" is an open-ended invesbnent fund incorporated in Switzerland.

The fund's objective is to achieve an appropriatc risk-adjusted return over the mid-term. The fund invests in
open- and closed-end, non-traditional funds which focus on investment strategies related to insured cvents.
AppendixN
CaIculation of Ibe emcien! frontiers of the portfolios figure 6.24.
Tbe monthly valuation data of the time period bctween January 1931 and November 2008
far the S&p's 500 index and the long term interest rates of US treasury bonds was taken from the
web publication "Irrational Exuberance" of Robert Shiller, Princeton University. Tbe US 10 year
treasury bonds experienced an average yield of 5.34% p.a with a standard deviation of 4.5%.
The S%P's 500 stock index retum was 17.06% p.a. with a standard deviation of 24.5%.1 The risk
free rate was determined by th.e average of 3 month US Treasury Bills for the timeframe above
being 3.89%.'
Tbe yield for n..s was measured by the pedormance of catastrophe bonds as calculated by the
SwissRe BB Cat Bond index from its introduction in January 2002 until November 2008 being
7.32% p.a with a standard deviation of2.1%.3
I. Calculation of the security portfolios from point A to B:
Following the methodologies introduced by Henry Markowitz4 • the return of the two security
portfolio from Point A to B was calcu1ated with the following formula:
where:
E(T.) = expected return of the portfolio

Xi = share of tbe asset I of tbe total portfolio
E (Ti) = expected return of the asset I
As a measure of the risk of the relevant portfolio combinations, the risk was ca1culated as the
standard deviation of the historical portfolio valuations within the am. time frames. The
following formula was taten:
'Shille< [see 2000]
2Data Sourco: Wren Investment Advisors
3Data Source: Bloomberg Finance L.P.
'Marl<ovßtz [see 1952]
338
u(rp ) ~ [XA'. u'. (rA) + (1- XA)'. u'(rB) + 2XA(1- XA)

*UA,B * a(TA) * u(rB)]1/2
where:
O'(rp )
= standard deviation ofthe portfolio valuations
rl =historical returns ofthe asset I
u(n) = standard deviation ofthe returns ofth.e asset I
11. Calculation of the security portfolios from point C to D:
The return of the three security portfolio from Point C to D was calculated with the following
fonnula:
where:
E(rp ) ~ expectedreturn oftheportfolio

Xi = share of tbe asset I of the total portfolio
E( r,) ~ expected return of the asset I
111e risk was calcu1ated as the standard deviation of the historical portfolio valuations within the
a.m. time frames. Tbe following formula was taken:
u(rp ) ~ [XA'. u'(rA) + X1u'(rB) +Xc'.

u'(rc) + 2 ,XA' XB' PA,B' u(rA)' u(rB)]'/'
where:
O'(rp ) = standard deviation oftbe portfolio valuations

r i = historical returns of the asset i
a(n) = standard deviation ofthe returns ofth.e asset i
PA,B = correlation coefficient between assets A and B
Appendix 0
Overview of the stakeholder interviews:
Company Type: Abbreviation: Number ofInterviews:

Associations ASO 3
Banks BNK 10
ConsuItants CON 1
llxchange EXC 1
Investors 1NV 4
Lawyen LAW 2
Monoliner MON 1
Primary Insurers INS 2
Rating Agencies RAT 2
Rcinsurers RE! 2
Risk Modeler MOD 2
Supervisor SUP 1
list of interview participants (functions at the time of interviews):
[!NT-1-MOD] [19.08.2008] 111e interviewee is Senior Consultant specialised on life and

health insurance modeling and working in Europe for one of the leading global modeling com-
panies.
[!NT-2-BNK] [02.09.2008] 111e interviewee is working in the US office ofthe global insur-
ance capital markets team of aleading international private bank. His tasks are the structuring of
securitisations and side-car solutions and the hedging of catastrophe risb.
[!NT-3-BNK] [03.09.2008] 111e interviewee is working as Vice President in the US office

of the longevity reinsurance group of an international investment bank. He is looking after the
structuring of life contingent risk transactions.
[!NT4-BNK] [04.09.2008] The interviewee is Executive Director in the US office of the

insurance capital marlrets group of an international bank. He is covering property and casualty
insurance companies in the US and Bermuda for structured products.
340
[INT-5-BNK] [04.09.2008] Tbc interviewee is Associate in tbe US office of tbe insurance

products group of a leading international investment bank. The activities are focused on the
structuring of life and non-life capital markets solutions,letters of credit, and writing direct rein-
surance through a reinsurance subsidiary. Further the group is active in the ttading ofthe products.
[INT-6-ASO] [05.09.2008] Tbe interviewee is Executive Director for an association rcpre-

senting a group of insurers/reinsurers active in the non-life sector. Tbe main task is 10 represent
them on public policy issues working with foreign international regulators and policy makers on
regulatory issues.
[lNT-7-REI] [08.09.2008] The interviewee is Director in the US office of a leading global

reinsurance company. He is responsible far the origination and structuring of II.S and related
securities, primarily non-life.
[lNT-8-LAW] [10.09.2008] The interviewees are Partners for the US office of an international
law firm. One person is heading the business with life insurers, the other the business with non-
life insurers as weIl as reinsurers. Tbc responsibiliti.es include all kinds of alternative risk. transfer.
[lNT-9-EXC] [11.09.2008] The interviewee i, Director in Ibe deparbnent Research and Prod-
uct Development of an exchange. His main task is to identify possible new products that can be
traded at the exchange.
[lNT-I Q. RAT] [12.09.2008] The interviewee is Ibe Global Head of Ibe msuranc.,.linked ,e-
curities rating activities of a international rating agency. He is responsible for the development of
rating methodologies for life and non-life re1ated securities.
[lNT-ll-CON] [12.09.2008] The interviewee is Ibe President of a con,ulting company for

insurers and investors promoting a risk m.odel. The company occasionally acts as a broker for
n..S products.
[lNT-I2-INV] [14.09.2008] The interviewee is Managing Director of a hedge fund active in

ILS investments. He has worked before for a top international investment company and has bui1t
up their activities in ILS.
[lNT-13-MOD] [16.09.2008] The interviewee;, Senior Risk Consultant for an intemation-

ally active risk modeling company for non-life risk. His function is 10 supervise the capital
market activities including the risk analysis for new ILS issuances and 10 provide services 10 the
cus10mers in the role as intersection between the cus10mers and the product developers.
[lNT-I4-SUP] [19.09.2008] The interviewee is Supervising Risk Management Specialist for

an insurance and reinsurance supervisor. He is in c10se contact with numerous insurance and
reinsurance companies and domestic and international supervisory bodies as well as associations.
[lNT-15-RAT] [22.09.2008] The interviewee, are a Director and a Rating Specialist of an

international rating agency. They are responsible for financial services ratings and specialised for
insurance related issues on the life and non-life side.
341
[INT-I6-REI] [23.09.2008] The interviewee is Managing Director for the US operations of

an international reinsurance group. The is responsible far customer-related transaction and own
retrocession-issues on the capital markets.
[INT-17-MON] [24.09.2008] The interviewee is Director in the structured finance division

of a monoline insurer. He is looking after insurance-linked issues.
[INT-18-INV] [24.09.2008] Tbc interviewee is Founder of one of the largest investment man-
agement firms in catastrophe bonds globally.
[INT-19-ASO] [26.09.2008] The interviewee is Chief Econontist of non-profit organisation

funded by international insurance companies. He is responsible iar collecting information about
insurance activities, including ll.S, and identifying trends.
[INT-20-BNK] [20.10.2008] The interviewee is Analyst in the department econontic research

of a regional bank. He has analysed the ILS marlet in detail and published research about the
actua1. developments.
[INT-21-LAW] [20.10.2008] The interviewee is Partner of an internationallaw firm. He is

responsible for legal consulting of insurance companies regarding supervisory elements of ILS.
[INT-22-BNK] [27.10.2008] Tho interviewee is Head of 1LS Structuring of a global bank

group. He is concentrating on the structuring and the consulting of insurers regarding the rating
process of the securiti.es.
[INT-23-BNK] [28.10.2008] The interviewee is Analyst in the Fixed lncome Division of a

international bank: supporting the n..S team and their clients reviewing documentation, reviewing
modeling results and preparing presentations far rating agencies and investors.
[INT-24-INS] [28.10.2008] Tbe interviewee is Partner of a pension insurance and annuities

company. He has been involved in n.s since the early starts of the market and worlred before for
a global reinsurance company.
[INT-25-BNK] [29.10.2008] The interviewee is Director in the alternative risk rnarket activ-
ities of a global bank. He is responsible for the origination of catastrophe bonds.
[INT-26-INV] [29.10.2008] Tbe interviewee is Chief Executive of an asset management com-

pany specialised in the n..S investment. He has before worlred for a global reinsurance company.
[INT-27-BNK] [29.10.2008] The interviewee is Managing Director of a global bank respon-

sible for asset-liability advisory business in Europe. Tbe group further originales life related n.s
from insurers. reinsurers and other providers.
[INT-28-ASO] [03.11.2008] The interviewee is Managing Director of an Eoropean structored

products trade association. Tbe association promotes the use of risk transfer mechanisms across
342
capital markets instruments including ns. They are involved in the development of Solvency 2.
[lNT-29-INV] [14.11.2008] 11Ie interviewee is Managing Partner of an independent advisory

company specialised in insurance-linked securities. His background is natural science and eco-
nomics.
[INT-30-BNK] [l4. 11.2008] The interviewee is Investment Manager of a private bank. He is

specialised in the investment in insurance-linked securies ior retail and professional funds.
[lNT-31-INS] [14.11.2008] The interviewee is Manager working in Ibe insurance-linked se-

curities team of an international insurance conglomerate mainly active in th.e non-life insurance
business.
AppendixP
344
00Iine Survey .bout buurance-Linked-8eeuritiel
0_
L Buko
1. How many peopte in your institution arc working on ILS? <num.ber>
2. Ow- activity is a
Please dick the relevant box.
o Division
o G=p
° T"""
3. How close is your activity to the General Management (in terms of importancc end
COtnn]1m;cation)?
Please dick on scale.
very
w
0 50 100
4. What is your regional focus?

Please dick the relevanJ box{es)
0 North America
0 Western Europe
0 <othm>
5. Which ILS products Me covered by your entitiy?

Pkase dick the relevant box{u)
° Risk transfer for non-life:insunmce
° Risk tnmsfer for lifc...insurancc
°
0
Embedded w1ue
Reserve funding XXX
0 Reserve funding AXXX
0 Funding eno pools
° Ca! bond COOl
° Reinsunmce receivable CDOs
° Lire settlements
6. Which industry focus regarding ILS da you foUow?

Please dick the relevant box(es)
0 non-Iife insurance
° life-insurancc
°
0
reinsurance
otho<
345
n. Market Enviroament
Whkh effed:l do you expeet from the Belt' regulatory frameworkl IFRS ud Solveney2 ?
7. Capital requjrements for the insurance I reinsurance sectm will increasc.

Please cJick on scale.
.1rongly .1rongly
disagree .gree
0 50 100
8. The demand far ILS will increase.

.1rongly .troogly
disagree .grec
0 50 100
9. New n..S products will arise.

.troogly
disagree
0 50 100
.....
.troogly
Standardisation and SecoDdary Market
10. In wbich segments does in your opinion the market need lIlOI'C standardisation?
Please cJick the relevant box(u)
o Risk transfer far non-life insurance

o Risk transfer far life-insurance
o Embedded value
o Reserve funding XXX
o Reserve funding AXXX
o Funding CDO pools
o Cd bond. CDOs
o ReinsUIlUWe receivable CDOs
o Life settlements
o The ILS market is standardiaed enough aIready
11. In which stage is in your opinion the secondary market far n..S?
higbly
dovelopod
o 50 100
346
m. About IIWII1UlP:e LiDked Securitiel
12. What are the main drivers Car the ILS market sector you cover?
Pleasl! auign a value to em:h answer. &eh value can be usetl only once.
Risk transfer lease select

Capi1al lease select
Diversification lease select
14. Please rank the following sources of potential obstacles regarding ILS.
Please assign a value to each answer. Each value can be used only ollee.
Lack ofharmonisation of international rcgula1:ory [plcasc selcctll

and I or accounting standards
Lack: of insurance expertise of capital lplease selectl

market investors
Lack ofharmonisation of intemational regulatory lplease select]

and I or accounting standards
Low commitment of sponsors' DUIIUIgCIDeIlt (pleasc sclectl

(rather favouring reinsunmcc)
Rating agencies' requinnents t1)lease selectl

Restrictions by equity holders I owners ofinsurance fPleasc selcctll
companies
15. Which market participent:s do you tbink arc most capable to mange ILS?
Please assign a va/ue to each answeT. Bach value can be used only once.
Investment banks lease select

Rcinsurance lease sclcct
Sponsors on their own lease select
IV. Comorate Level
16. In which year has your institution started with ILS tranaact:ions?
PI_e we the format 0J/OIIXXXX.
~~~I (mm/ddIyyyy)
17. Pleasc complete the !fI:atemeut: "ILS get I get interesting for out institution ...
Plecue dick the relevant box(es)
o ... when the pricing was IIlOIC attractive than for reinsurancc or other alternatives."
o ... when there is a value-added in terms of diversification of reinsunmcc sources."
o ... when the complexity gets manageable far out company."
o ... when the products got fully accepted by the capital markets."
o ... when Iiquidi~ secondary marketa is not an issue."
o 0'I:hcr IClISOOS: ~
347
18. Are transaction ratings in YOUl opinion morc important than risk. models?
o ,...
o neuttal
o no
v. The bllllkl' role

19. Da you think that cnough banks 8IC able 10 ammgc IL8?
o "..
o neuttal
o no
Pleaae cvaluate the following aDtwen to the question: "What are the Itrengthl of the bllllb in
the proceu?"
19. They Imow beBt how 10 develop innovative capital market products. Please click on scale.
highly
devcloped
o 50 100
20. They Imow beBt how 10 structure and arrang n..s t:ran&actions.
highly
devcloped
o 50 100
21. They have a deeper access 10 potential investors in order to successfully place the IL8 products.
highly
developed
o 50 100
Pleaae cvaluate the followiDg IIIIIJWeI'S tu the qUestiOD: "What an the wealmesses of the bllllkl
in the protal?"
22. They do not Imow the insurancclrcinsurancc solutions good cnaugh.
highly
devcloped
o 50 100
23. They 8IC not used 10 the business behaviours ofthe insurancclrcinsurance sector good enougb..
highly
devcloped
o 50 100
24. They need 100 much time 10 structure and place IL8 transactions.
highly
devcloped
o 50 100
348
VI. Ftnal OuestioDl
25. Please click the boxes ifyou agree with the completion ofthe statement: "The current crisis
will lead In .•.
Please click the relevant box(es)
o ... a closer monitoring ofbank counteJparty risk in total retum end rate swaps."
o ... a challenged rote of the banks as stahle 1ong-teJm creditms."
o ... investors demanding a bigher level of co11ateralisation...
o ... a eloser monitoring of the quality of the investments ofthe SPV' 8 trusts."
o ... stricter gu.idelincs of the rating agcncics."
o ... a More difficult placement oflang-term. products."
o ... a lower acceptance of CDO st:ructures by investors."
o ... a simplification oflLS structures available."
com:ments: Irtextl
26. Which pricing developmcnt da you cxpcct far the ILS products you an: fCspons1ble for in the
12 months ahead?
Please click the relevant box(ea)
0 +30% ormore
0 +20%
0 +10%
0 0%
0 -10%
0 -20%
0 -30%ormore
0 cannot be estimated
,omm••'" ~
27. How da you cxpcct the volumc 10 dcvelop in 2009 rcgarding)'OlD" product(s)?
cotnments: ~
28. In which year havc yau pcmIOIlBlly started 10 work on ILS transactiOll8?
Pleose use theformat Ol!Ol!XXXX.
29. In which carreer have yau started 10 work on n..S topics?
o professional
o academic
30. Which improvcments da you whish :n::garding the ILS markct (plCIISC feel fu:c 10 lcave any
other comments)?
PI_e click the relevant box(es)
End of questionnalre.
Abbreviations
Abbreviation Explanatinn
A Austria
ARS Asset Backed Security
ACLI American Council of Life Insurers
ACSB Accounting Standards Board
AIDS Acquired Immunodeficiency Syndrome
ALM Asset Liability Management
APRA Australian Prudeotial Regnlatory Authotity
approx. approximately
ART Alternative Risk Transfer
AUS Australia
AVI Aviation
BCAR Best Capital Adequacy Ratio
BRIC Brazil Russia India China
bn billinn
bp basis point-s
CAN Canada
CAPM Capital Asset Pticiog Model
CATEX Catastropbe Risk Exchange
CBO Collatoralised Bond Obligation
CDD Cooliog Degree Day
CDO Collatoralised Debt Obligation
CDS Credit Default Swap
CE Credit Enhancement (through over-collatera1.isation)
CEEurope Centra! & Easlern Europe
CEIOPS Committee of European Insurers and Occupational Pension Supervisors
CEO Chief Executive Officer
CESR Committee of European Securities Regulators
CFO Chief Financial Officer
CH Switzerland
CHF Swiss Francs
CLO Collatoralised Loao Obligation
CME Chicago Mercantile Exchange

350
CMI Combined Morta1ity !odex

CMO Collatoralised Mortgage Obligation
Co. Compaoy
CRB Commercial Real Estate
CSA Canadian Securities Administrators
D Deutscblaod
DAC Deferred Acquisition Costs
DAX Deutscher Aktien Index
dev. developing
EBF Eoropeao Baokiug Federatiou
EEV Europeao Embedded Valoe
EFRAG European Financial Reporting Advisory Group
e.g. exempligrata
EQ EarthQuake
ERM Enterprise Risk Maoagement
ERISA Employee Retirement Iocome Security Act
ES Expecred Shortfall
EU Eoropeao Uniou
EURIBOR Europeao Ioterbaok Offered Rate
F France
FASB Federal Accouotiug Staodards Board
FEE Federation des Experts Comptables Europeens
FEIN Federal Employer ldenditication Number
FSA Financial Services Authority
FSF Financial Stability Forum
GAAF Generally Accepred Aeeooutiug Principles
GDP Gross Domestic Product
GNAIE Group of North American Insurance Enterprises
HDD Heatiug Degree Day
HMRC Her Majesty'''s Revenue and Customs
ffiJR Hurricane
I ltaly
IAA International Actuarial Association
IAIS International Association of Insurance Supervisors
IASB Iotemational Aeeooutiug Staodards Board
IFRS Iotematioual Financial Reportiug Staodards
ILS Insurance-Linked-Securiti.es
ILW Iodustry-Loss-Warranty
IMF Iotemational Mouetary Foud
Iov. Investment
IOSCO International Organisation of Securities Commissions
ISDA International Swaps and Derivatives Association
ISPV Iosurance Special Purpose Vehicle
IT Information Technology
J Japan
UM Life Insurance Association of Japan
351
LIFFE London International Financial Futures and Options Exchange

LoC Letter of Crecit
LId Umited
mln million
MASS Massachussets
max maximum
MBS Mortgage Backed Securities
MDR Mean Damagc Ratio
MIFID Markets in Financial Instruments Directive
MCR Minimum Capital Requirement
MRAC Moody's Property & Casualty Risk Adjusted Capital Model
MV Market Value
DIa not available
NAIC National Association of Insurance Commissioners
D.p. no page
OECD Organisation for Economic Co-Operation and Development
orc Over-the-Counter
PCI Property Casualty Insurance Associatinn
PCS Property Claims Services
p. page
pp. pages
P&I principal and Interest
PML Probable Maximum Loss
QIS Quantitative Impact Stody
RBC Risk Based Capital
Reins. Reinsurance
SAP Statutory Accounting Principles
SCR Solvency Capital Requirement
SEAsia South Bast Asia
SEC Securities Exchange Commission
SPV Speetal Purpose Vehicle
SPRV Special Purpose Reinsurance Vehicle
S&P's Standard and Poor's
sq. sqnated
SVO Securities' Valuation Office
sI. standard
TAC Total Adjusted Capital
TED Treasury Bill Eurodollar Difference
tkd. takedowns
TRIA Terror Risk Insurance Act
TRUPS Trust Preferred Securities
UBS United Banks of Switzerland
ULAE unallocated 108S adjustment expenses
UK United Kingdom
USD United States Dollars
US United States
352
USA United States of America

USGAAP United Stares General Accepted Accounting Principles
VaR Value at Risk
VIF Value in Force
Index
accidcnt bealth Ger.: kritische Erkrankung, 32

Ger.: Unfallversicherung, 32
asset ba.cked datcd bonds
Ger.: Vcmtögeruowert-besichert, 37 Ger.: eodfllllige Anleihen, 157
assumption determi.nistic scenarios
Ger.: Risikoaufnahme, 49 Ger.: Planszenarien, 149
disability insurance
Ger.: Invalidität, 32
captive
Ger.: koDZ<tDCigen, 60 discrete distribution
Ger.: UlIStetige Verteiluog, 8
cashßow
dispersion
Ger: KapitalIIuß, 149
Ger.: Streuung, 8
cedent
distribotinn sbape
Ger.: Zedent, 49
Ger.: Verteilungsschlefe, 123
centrallimit tbecrem
duratioo
Ger.: zentraler Grenzwertsatz, 13
Ger.: durchschnittliche Bestandadaucr, 152
central tendcncy
Ger.: Mittelwerte, 8 eamed premiums
cession Ger.: verdiente PrI!mieo, 107
Ger.: Risikoabgabe, 49 economic net worth
cessionaire Ger.: betriebswittscbaftlicher Nettowert,
Ger.: Risikooehmer, 49 148
claim eligible claims
Ger.: Scbadenforderung, 10 Ger.: berechtigte Schadcnsforderung, 107
collateral manager embcdded valuc
Ger.: Sicberbeitenverwalter. 100 Ger.: innerer Wert.. auch: Methode zur
confidence interval Ermittluog des Unternchrnenswertes
Ger.: Konfideozintervall, 123 einer Versicherung. 68
contingent capilal ernployer's liability
Ger.: 1>edinps Kapital, 76 Ger.: Arbeitgeber Ihftpfticht, 32
continuous distribution expectcd lass
Ger.: stetige Verteilung, 8 Ger.: erwarteter Schaden.umfang, 8
cmJit dcfau1t swap expectcd shortfall
Ger.: Kreditausfall Derivat, 38 Ger.: erwartete Verlust.schwere. 125
credit insurance
Ger.: Kreditversichenmg, 31 factoring
critical illness Ger.: Forderungsvcrkauf,38

354
facultative monoline insurance

Ger.: freigestellt, 49 Ger.: Bio-Produkt Versicherung, 38
finite solution mortgage-backed
Ger.: begrenzte Rückversicherung, 63 Ger.: hypothekarisch besich~ 85
franchise value motor physical damage
Ger.: Barwert künftiger Gewinne, 148 Ger.: Auto-Kaskoversicherung, 32
frequency motor thitd-party liability
Ger.: Häufigkci~ 10 Ger.: Auto-Haf1pflichtversicheruog, 32
full hull insurance
Ger.: Volldeckung aller versicherbarer RisikdlQD-life business
55 Ger.: Nicht1ebengeschäft, 34
hazard obligatoty
Ger.: Wagnis, 16 Ger.: =htsverbindlich, 49
health insurance
Ger.: Krankenversicherung, 32 peril
hybrid bond Ger.: Gefahr, 16
Ger.: Eigenkapita1äbnliche Anleihe, 156 pcrpctuallifetime
Ger.: oboe bestimmtes FäIliglreitsdatum,
indes linked 147
Ger.: index-basierend,32 policy reserves
insurance pool Ger.: Prämienreserve, 22
Ger.: Versicherungspool, 63 primary insurance
Ger.: Erstversicheruog, 33
legal expenses proportional reinsurance
Ger.: Rechtsschutzversicherung, 32 Ger.: anteilsmäßigeRückversicherung, 53
Iiability insurance
Ger.: Haftpflichtversicherung, 32 quota reinsurance
life cxpectancy Ger.: Kontingentrückversicherung, 54
Ger.: Lebeoserwartung, 46
life insurance reinsurance
Ger.: Lebensversicherung, 35 Ger.: Rückversicherung, 41
liquidity ratio retention
Ger.: Liquiditätsquote, 149 Ger.: Selbstbehalt, 19
reserves
1088 run-off
Ger.: Schadensreserve, 22 Ger.: Abwiclduog, 19
lump-sum
Ger.: Einrnalz.ahJung, 32 savings insurance
Ger.: Versicherung mit Sparanteil, 32
market capitalisation self insurance
Ger.: Börsenwert. 148 Ger.: Eigenversicherung, 63
mean severity
Ger.: arithmetisches Mittel, 8 Ger.: Schwere, 10
medical advisor sidecar
Ger.: ärztlicher Berater, 100 Ger.: wörtl. Beiwagen, sachl. abgegren-
medical examiners zter Versicherungsbestaod, 81
Ger.: Gesellschaftsarzt, 99 solvency
355
Ger.: Eigemnittelaustattung, 19
special purpose reinsurance vehicle
Ger.: Rückversicherungs ZweckgeseUscbaft,
136
sponsor
Ger.: Initiator, auch Förderer des Geschäftes
(i.d.R. ein Erst- od. Rückversicherer),
4
stand-by letter of credit
Ger.: Solawechsel, 37
standard deviation
Ger.: Standardabweichung, 9
statutoIy reserve
Ger.: satzungsmäßige Rücklagen, 88
stochastic scenarios
Ger.: zofaUsbediogte Szenarien, 149
surety
Ger.: Bürgschaft, 36
swplus reinsurance
Ger.: Summenexzendenten Rückversicherung,
55
tax advisors
Ger.: Steuerberater, 100
technical provisions
Ger.: technische Rückstellungen, 19
term life
Ger.: Risiko-Lebensversicherung, 32
tracking agent
Ger.: Außendieost Mitarbeiter, 100
trigger
Ger.: Deckungsauslösung, 16
trustee
Ger.: Treuhänder, 100
underwriting
Ger.: Risikoübernahme, 13
uneamed premium reserves
Ger.: unverbrauchter Beitragsübertrag, 22
unitlinked
Ger.: fondsgebunden, 32
variance
Ger.: ntittleres Fehlerquadra~ 9
worker's compensation
Ger.: Arbeitgeber Uofall, 32

Insurance Linked Securities

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Insurance Linked Securities

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Christoph Weber

Insurance Linked Securities

With a foreword by Prof. Dr. Rainer Stöttner

First Reviewer: Prof. Dr. Rainer Stöttner

Oral Examiners: Prof. Dr. Georg von Wangenheim

Disputation took place in Kassel on May 12th, 2011.

1st Edition 2011

All rights reserved

No part of this publication may be reproduced, stored in a retrieval system

Cover design: KünkelLopka Medienentwicklung, Heidelberg

Tbe broad criticism of financial markets leads to an underestimating of the doubtless

It is a well-known fact that without the availability of proteetion agaiost risks io

It is DO surprise that this sort of competition is not welcomed by insurance com-

Tbe pioneering work of Weber provides a convincing aud straightforward analysis

Kassel, in May 2011

After three years of eolleeting information I presented my project of a doctoral the-

After having refreshed my theoretical knowledge of modem investment manage-

Fortber, I would like to thank my employer Landesbank Baden-Würt1emberg and

Stuttgart, in M.y 2011

2 Insurance Business and its Risk S

3 Tb. Insurance Industry 3S

4 Methods of Risk TrBDSl'er SS

6.1.7 Accounting and supervision in the US . . . . . . . . . . . . . 152

7 ILS Ooline Survey 2SS

8 Recent Developments 269

2.1 Sampling distribution versus sampling size. . . . . . . . . 15

3.1 Insuranee penetration in the global economie regions . 36

4.1 Reinsurance and retrocession . . 56

4.15 Spectrum of risk transfer instruments . . . . . . . . . . . 90

6.1 Timeframe of the IFRS accounting I EU supervisory reforms 134

6.19 Residential Re - eatasuophe-1inked notes sttucture . · 213

7.1 Survey respondees by sponsor type and geographie · 255

2.1 Expected Loss Example I . . . . 9

3.1 Types ofinsurance companies and their products . 37

4.1 The vorlous forms and types of reinsurance 57

5.1 Osiris Plc - tranche structure . . . . . . . . . . 109

6.1 Proposed key capital calculation factors of Solvency 2 . 139

6.8 UBS's eight categories of coupon deferrallanguage . 180

1.1 Problem description and definition

C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_1,

1.2 Objective of the thesis

2Bogner [see 2005, pp. 113-130] far the sampling methodology

Insurance Business and its Risk

2.1 Risk and insurance

ILiebwein [see 2000, p. xxi]

C. Weber, Insurance Linked Securities, DOI 10.1007/978-3-8349-6788-6_2,

2.1.1 Classification of risk faced by insurers

Fundwnental and particular risk

Operating and financial risk

Speculative and pure risk

Uosystematic and systematic risk

2.1.2 CIassification of risk by insurance regulators

2.1.3 Peril and hazard

18Rejda [see 1986. pp. 5~1

Probability and statistic analysis

1-'= LXixPi (2.1)

Loos amount (Xi) Loos probability(Pi) Expected loss (Xi Pi)

Table 2.1: Expeeted Loss Example 1

19Rejda [see 1986. pp. 4046];Rejda [,ee 2008. pp. 17-20]

Table 2.2: Expected Loss Example 2

Frequency and severity of losses

Var(X) = (Var(Z) x E(Y)') + (Var(Y) x E(z)) (2.4)

To illustrate the calculation method, we assume as a simplified example, that 1,000

P(z) = p% X (1- p)'-%