Convergence of Insurance and Capital Markets

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1 Convergence of Insurance and Capital Markets COMMITTED TO IMPROVING THE STATE OF THE WORLD A World Economic Forum Report in collaboration with Allianz Barclays Capital Deloitte State Farm Swiss Re Thomson Reuters Zurich Financial Services World Economic Forum October 2008

2 The Convergence of Insurance and Capital Markets is published by the World Economic Forum. The Working Papers in this volume are the work of the authors and do not represent the views of the World Economic Forum. World Economic Forum USA Inc. 3 East 54th Street 17th Floor New York, NY Tel.: Fax: World Economic Forum route de la Capite CH-1223 Cologny/Geneva Switzerland Tel.: +41 (0) Fax: +41 (0) World Economic Forum USA Inc. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, including photocopying and recording, or by any information storage and retrieval system without explicit written permission from the World Economic Forum USA and the respective authors. REF:

3 Contents Foreword and Contributors 4 1 Executive Summary 6 2 The Existing Market for Insurance Risk Market development Market instruments P&C bonds Life bonds Weather derivatives Industry loss warranties Cat swaps Exchange traded cat risks Market participants 15 3 Impediments to Growth Impediments for sponsors Basis risk Accounting and regulatory treatment Inconsistent ratings treatment Pricing of traditional reinsurance Time and cost Data quality and transparency Limited types of risk Cultural factors Impediments for investors Lack of standardization Limited secondary market Long payout periods Valuation complexity 30 4 Conclusions and Recommendations 31 Appendices 33 Appendix A: Project Description 33 Appendix B: Findings 34 Appendix C: Current Initiatives 37 References 39 Acknowledgements 40 Footnotes 41 3

4 Foreword and Contributors We are pleased to present this report on the convergence of insurance and capital markets. It stems directly from an initiative of the Financial Services Governors launched at the World Economic Forum Annual Meeting 2007, when the assembled Governors agreed to carry the dialogue and work beyond Davos in line with the Forum s mission of being Committed to Improving the State of the World. Subsequently, working groups comprised of industry representatives, academics, experts and Forum staff took up work on several projects that Governors felt were of broad interest, not only to the financial services industry but also the public. This project, examining the convergence between capital markets and the insurance sector, focused in particular on the role new financial instruments could play to better address and syndicate particular types of risk. This report could not be more timely. While the credit crisis, now going into its second year, was triggered inter alia by faults associated with securitized mortgages, insurance-linked securities (ILS) turned out to be highly resilient at a time of extreme market turbulence. In fact, ever since the outbreak of the sub-prime crisis, prices of catastrophe bonds (perhaps the most prominent ILS example) have performed strongly, easily outperforming indices of credit instruments with similar debt ratings. However, this outperformance has hardly registered with nonspecialists in light of overall market challenges. In this environment, where the financial markets face such turmoil, this publication aims to shed light on a critical area in which the capital markets are showing signs of success. Its authors make a convincing case that insurance-linked securities are an important asset class, and that the ILS market is not only here to stay, but likely to grow at a strong pace in the future. Of course, there are and will continue to be obstacles to the growth and broad acceptance of ILS. This report identifies many such challenges. We believe that the benefits of insurance-linked securities will ultimately appeal to investors and issuers alike and have an important role to play for particular types of investment risks. The report should help to create an elevated baseline of understanding among a broader base of non-specialist investors, discussing the impediments and potential solutions to further the debate about the use of these products. A work of this caliber can only be written by many talented people pulling together towards one common goal. We thank our Governors, sponsors, workshop participants, experts and team members for their dedication to this report. The ball is now in the court of the market participants. They have it in their hands to unlock the full potential of insurancelinked securities, and we are confident therefore that the increasing convergence of insurance and capital markets will create value for all. James J. Schiro Group Chief Executive Officer and Chairman of the Group Management Board Zurich Financial Services Switzerland Kevin Steinberg Chief Operating Officer and Head of the Centre for Global Industries (New York) World Economic Forum USA 4

5 Contributors Co-authors Katharina Hartwig (part 3) Group Legal Services Allianz Kurt Karl (part 2) Senior Vice-President Head of Economic Research and Consulting Swiss Re Steven Strauss (Executive Summary) Senior Adviser World Economic Forum USA Tom Watson (parts 4 and 5) Project Manager World Economic Forum USA Operating Committee Daniel Brookman Head of Structured Insurance Barclays Capital Daniel Hofmann Chief Economist Zurich Financial Services Kurt Karl Senior Vice-President Swiss Re Ben Lewis Head of Strategy Thomson Reuters Stephan Theissing Head of Group Treasury and Corporate Finance Allianz Deborah Traskell Executive Vice-President State Farm Steering Committee Paul Achleitner Chief Financial Officer Allianz Jerry Del Missier President Barclays Capital Jim Rutrough Vice-Chair and Chief Operating Officer State Farm James J. Schiro Group Chief Executive Officer and Chairman of the Group Management Board Zurich Financial Services Devin Wenig Chief Executive Officer, Markets Division Thomson Reuters Key Knowledge Partners Jack Ribeiro Global Head of Financial Services Deloitte LLP Ed Hardy Insurance Partner Deloitte & Touche LLP From the World Economic Forum Kevin Steinberg Chief Operating Officer and Head of the Centre for Global Industries (New York) World Economic Forum USA Steven Strauss Senior Adviser World Economic Forum USA Tom Watson Project Manager World Economic Forum USA While not necessarily endorsing any of the specific conclusions reflected in this report, both the Steering Committee and Operating Committee provided detailed feedback and helped ensure the overall integrity of the work. Any opinions herewith are solely the views of the authors and do not reflect the opinions of the Steering Committee, the Operating Committee or the World Economic Forum. Jacques Aigrain Chief Executive Officer Swiss Re 5

6 1. Executive Summary Facilitating risk transfer and increasing transparency have been dominant themes in the financial markets since the end of World War II. Transferability and transparency are widely believed to promote better economic performance with important benefits not just to investors but also to consumers and other social stakeholders. In certain risk areas we see an increasing need for capacity. Weatherrelated insurance claims, for example, have increased fifteen-fold over the last 30 years. In this challenging situation, insurance-linked securities provide new fully collateralized and multi-year capacity for the risk-carrying industry, along with a high degree of risk diversification, which makes them attractive for investors as well. Paul Achleitner, Chief Financial Officer, Allianz, Germany Financial innovation has allowed many types of risk to become more tradable including credit, interest rate, equity and foreign-exchange risk, to name but a few. However, one important category still lacks a liquid, transparent and tradable market: insurance risk. The potential market is vast, with total premiums of all the world s insurers equalling approximately US$ 4.1 trillion. Insurance risk comes in many varieties and can be segmented into broad categories (e.g. life, property and casualty, etc.), as well as geographic markets. This is not unlike other types of risk widely traded in the capital markets. Credit risk, for example, can be divided into corporate, municipal, mortgage and consumer sectors, among others. However, it is necessary for investors and policymakers to recognize the distinctions between the securitization of assets (mortgages, car loans, etc.) and the securitization of liabilities. Most life insurance securitizations are similar to asset-backed securities (ABS) currently offered by banks and prone to many of the same issues associated with ABS. Some life insurance, securitizations, for example, are backed by the embedded value of future profit streams from a book of life insurance policies. In the case of property and casualty (P&C) securitization, however, the distinction between the transfer of assets and the transfer of liabilities is critical. Risks in bank assets tend to be correlated, as the recent sub-prime crisis has demonstrated. This creates a strong incentive for bankers to transfer risks to the markets in order to diversify their asset portfolios. P&C liabilities, on the other hand, are uncorrelated, or only weakly correlated. Hurricane Katrina, to cite one example, severely impacted a relatively small geographic region of the United States, but had little or no effect nationally or globally. The typical P&C portfolio, then, consists of a wide spectrum of uncorrelated risks. This creates diversification benefits, in that total risk in the portfolio is less than the sum of the individual risks reducing the incentive for P&C insurers to transfer these risks to the market. Yet, this diversification benefit is precisely what makes insurance-linked securities (ILS) potentially desirable to investors they are uncorrelated with their existing asset holdings. P&C insurers, meanwhile, have another incentive to transfer risk, as a means of obtaining additional capacity (mainly for catastrophic risk). Thus, liability securitization can be a tool for capital management for both buyers and sellers. Market development Although the market still lacks a clear, transparent and tradable platform, ILS issuance and trading activity has been growing at a rapid pace, albeit from a small base. The tradable insurance risk market currently has a notional value of only US$ 50 billion, but has been growing at 40-50% per year since The premium equivalent is now about US$ 3 billion, or 1.5%, of global reinsurance premiums, which were about US$ 192 billion in In more mature risk markets, the tradable portion is typically a multiple of the underlying notional value. Hence, there appears to be ample room for growth. 6

7 The development of the ILS market has increased the ability of insurers and reinsurers to accept peak natural catastrophe risks such as US hurricanes. David J. Blumer, Head of Financial Services Swiss Re, Switzerland The need for capital, liquidity and transparency has become even more urgent for the P&C industry as it faces the challenge of global climate change, which is increasing the risks of European windstorm damage and American coastal flooding, among other hazards. Accordingly, the industry would like to move to more flexible and efficient capital structures, which would be facilitated by greater development of the insurance risk market. Even if the increased access to capital were confined to reinsurers, this would still indirectly benefit policy-holders by increasing their capacity to absorb risk. Finally, transparent pricing would also reveal the cost of well-intentioned political solutions that increase the provision of insurance but fail to adequately fund those guarantees, by making it possible to mark public sector insurance schemes to market. Structural impediments to growth While there are reasons to be optimistic about the development of the insurance risk transfer market, there are also some fundamental dynamics that could slow its growth. Some of these factors are rooted in the distinctions between asset and liability securitization mentioned earlier. A simple comparison to the mortgage market may illuminate the point. The originator of a mortgage loan (particularly in the American market) can completely remove itself from the risk equation by executing a true sale of the note to a third party. In effect, it can elect to have no further risk exposure to the borrower going forward, even if it chooses to retain other elements of a customer relationship. This separation is feasible because the underlying contractual relationship is simple and relatively unambiguous. The borrower is not dependent on the credit quality of the lender and has no economic or legal interest in the identity or financial strength of the ultimate mortgage holder. The lender, on the other hand, does have an incentive to understand the borrower s creditworthiness although the incentives for due diligence clearly can be weakened by the originator s ability to transfer the mortgage quickly. In an insurance contract, the situation is quite different. As the ultimate risk holders, insurers must make significant investments in due diligence. To manage their exposures, they must be aware of and seek to control moral hazard. Policy-holders, meanwhile, have a very real interest in knowing the identity and understanding the business practices of their insurance providers. They want to be sure their claims will be met if losses are incurred. Obviously, the average policy-holder cannot check the creditworthiness and solvency of his/her carrier; he/she has to rely on the assessments of regulators and the rating agencies. Hence, the policy-holder will always want approval regarding any assignments of the insurance contract, while the primary insurer is unlikely to ever be completely removed from the value chain. While these interests may inhibit the growth of the risk transfer market, they also may provide some protection from the exuberance we have witnessed in sub-prime lending. Key findings Over the course of this project, certain themes emerged from our workshops and interviews with market participants. Sponsors (mostly reinsurers and some insurers) identified the following key issues that will need to be addressed in order to facilitate the development of the insurance risk transfer market: Lack of standardization: Insurance risk transfers can take a long time to complete, costs can be very high and the accounting treatment is uncertain. The latter problem often stems from the considerable uncertainty about regulatory and rating-agency treatment of the transaction. The result is a reluctance to engage in the market among institutions subject to the most uncertainty. 7

8 Insufficient cost/benefit analysis: Traditional reinsurance is of a limited term, the list of potential counterparties is small and the ceding insurer ends up with a credit risk from the reinsurer. Capital market transfer instruments provide longer terms and reduce counterparty risk, but increase complexity. The insurance industry also lacks a language and a methodology to evaluate the benefits of these instruments and make quantitative comparisons to conventional reinsurance. Poor data quality: In many markets, tradeable market indices do not exist. In the US, there is also a need for more granular data for parametric transactions that can potentially be used as market indices. 1 Basis Risk: Any market structure in which the insurer s reimbursement is based on a market index or formula creates basis risk, which is the difference between the actual claims paid out and what is received from the counterparty based on the index/formula. (Note that this can result in either a gain or a loss for the insurer). For some companies, basis risk may reduce the capital adequacy relief provided by such transactions thereby favouring transactions by other companies (such as reinsurers) that receive regulatory and/or rating-agency treatment that more closely matches the actual claims paid out. Uncertainty concerning the probability of catastrophic loss: This presents a bit of a Catch 22. One of the major reasons the insurance industry wants to promote liquid transfer markets is the uncertainty regarding risks such as climate change and global pandemics. However, this very uncertainty makes the capital markets price these risks conservatively, limiting the benefits of securitization. Our recommendations for addressing these and other issues are described in more detail in the following sections. Our key point is that these impediments will not be simple, fast or easy to overcome. In order to maintain the growth of the insurance risk market, concerted action will be required from market participants over a multi-year time horizon. Investors and risk assumers involved in the insurance convergence project identified the following key issues: Limited secondary market: While liquidity conditions in insurance risk markets typically equal or exceed markets for similar fixed income instruments (such as collateralized debt obligations, high-yield corporates and off the run ABS), investors still believe that many existing products trade by appointment particularly if the investor needs to trade in size. This presents a challenge for market participants who mark to market or who need liquidity on short notice, etc. As is the case in the collateralized fixed-income markets, these perceptions also impact pricing. Valuation requires specific knowledge, models and data: A wealth of material and tools exists for valuing most other risk categories. However, this store of intellectual capital does not yet exist to the same extent for the insurance risk market. 8

9 2. The Existing Market for Insurance Risk Since its infancy in the early 1990s, the market for insurance-linked securities has grown at high double-digit rates. This convergence is being driven by a number of major trends. First, financial innovation is playing a key role by developing new instruments for transferring insurance risks. Second, insurers need to efficiently manage their capital and these new products provide flexibility and access to a large pool of capital. This can be advantageous for P&C insurers who have a sudden need for extra capacity to write insurance following a major catastrophe, for example. Several trends are driving the convergence of insurance and the capital markets. At other times, the most efficient way to transfer a particular risk may be through a non-traditional instrument, such as a catastrophe bond (cat bond) or swap (cat swap). Even insurers that do not themselves use these instruments may benefit from the increased availability and affordability of reinsurance as reinsurers tap into the additional capacity made possible by market growth. For life and health (L&H) insurers, using ILS to access the capital markets is an effective way to finance growth and manage excess reserves. Life insurers may also desire protection against extreme events, such as pandemics. Finally, there is growing interest in ILS among investors, because in some cases they represent a diversifying asset class with robust yields. Additional growth drivers include: Attractive investment performance, despite major losses such as Hurricane Katrina, the largest insured loss in history Enterprise risk management benefits, with ILS making it possible for insurers and reinsurers to supplement traditional capacity, diversify their trading partners and reduce counterparty risk Efforts by the rating agencies to improve and document their methodologies for rating cat bonds, which especially benefits the tranched layers of multiple-peril cat bonds Other factors are also driving the growth of the risk transfer market. The increased visibility of catastrophe modelling firms in the capital markets, boosting the credibility of their models Dramatically improved distribution capacity, as more investment banks and reinsurers offer ILS products to investors The availability of senior financing, which is now obtainable at meaningful levels for ILS Increased price transparency with the launch of exchanges trading cat risks and brokered cat swaps Lower transaction costs made possible by document standardization and shelf financing 2.1 Market development ILS issuance and capacity both set records in Issuance of insurance-linked securities totalled US$ 14.4 billion in 2007, up 40% from US$ 10.3 billion in at the end of 2007, outstanding notional value stood at US$ 39 billion, up 50% from US$ 26 billion at the end of By May of 2008, the value of bonds outstanding had reached about US$ 40 billion, with life bonds accounting for 58% of market value of bonds outstanding. The market still has significant upside potential. P&C risks transferred to the capital markets represented only 12% of global catastrophe reinsurance limits in 2007 and under 1% of other non-life reinsurance limits. There appears to be no shortage of sellers of protection demand for this asset class from dedicated cat funds has been particularly strong. Issuance is expected to grow to US$ billion by 2011, while the notional value of bonds outstanding could reach US$ 150 billion. ILS issuance slowed in Although long-term prospects for the market are robust, ILS issuance slowed in the first half of 2008 due to the turmoil in the credit markets, which 9

10 particularly affected investment-grade life and nonlife bonds. Life insurance issuance in particular slowed to a standstill, due to the credit crisis as well as issues related to embedded value and US actuarial guidelines on valuation (commonly known as Regulations XXX/AXXX). These instruments are similar to asset-backed securities, which have been dramatically affected by the current market turmoil, increasing the price of life securitizations. However, with the exception of the small investment-grade sector, non-life issuance has not slowed as spreads have generally tightened in line with the softening reinsurance markets. As expected, tightening spreads and softening reinsurance markets have dampened sidecar activity. The market for insurance-linked instruments is developing rapidly. Other recent ILS developments include: The weather derivatives market has remained healthy, with the notional value of trades rising to US$ 32 billion in the period from less than US$ 10 billion in The use of industry loss warranties and cat swaps has grown at a strong pace and those instruments now have an outstanding notional value of about US$ 10 billion Investor interest in natural catastrophe risk has increased rapidly. Dedicated cat funds attracted substantial new capital after it was seen that the prices of cat bonds remained stable even as corporate bond prices plummeted Catastrophe risks are now traded on exchanges Many parties are developing tradable indices, with an initial focus on longevity, cat bonds and natural catastrophe risk Our experience with ILS-transactions has been positive and these are an important part of our capital market activities and a key strategic lever. Dieter Wemmer, Chief Financial Officer Zurich Financial Services, Switzerland 2.2 Market instruments P&C bonds Catastrophe bonds, the primary type of P&C bond, originated in the hard market of the early 1990s following Hurricane Andrew, when reinsurance capacity for catastrophes was limited and expensive. The earliest forms provided a simple mechanism to transfer catastrophic risks to capital markets. In a typical transaction, a fully collateralized special purpose vehicle (SPV) enters into a reinsurance contract with a protection buyer, or cedent, and simultaneously issues cat bonds to investors. The reinsurance is usually an excess-of-loss contract. If no loss event occurs, investors receive a return of principal and a stream of coupon payments that compensate them for the use of their funds and their risk exposure. If, however, a pre-defined catastrophic event defined by a trigger does occur, investors suffer a loss of interest, principal, or both. These funds are transferred to the cedent in fulfilment of the reinsurance contract. The first catastrophe bonds were issued after Hurricane Andrew. There are five basic types of loss triggers. There are five basic types of trigger, with varying degrees of transparency for investors and basis risk for the cedent: An indemnity trigger is based on the actual losses of the sponsor and has negligible basis risk An industry index trigger is based on an industry-wide index of losses, such as the estimates published by ISO s Property Claim Services (PCS) unit in the United States A pure parametric trigger is based on the actual reported physical event (i.e., magnitude of earthquake or wind speed of hurricane) and has the most transparency for the investor, but also a great deal of basis risk for the sponsor A parametric index trigger is a more refined version of the pure parametric trigger using more complicated formulas and more detailed measuring locations A modelled loss trigger determines estimated losses by entering actual physical parameters into an escrow model, which then calculates the loss 10

11 Figure 1: The different types of insurance convergence products Transparency for Investor Parametric Index Indemnity Source: Swiss Re Capital Markets Modelled Loss Basis Risk to Issuer Most P&C bonds transfer catastrophic risks. Pure Parametric Industry Index The overwhelming majority of P&C securitizations are for catastrophic risks, such as windstorms (hurricanes, typhoons) and earthquakes. These serve as collateralized protection for extreme event risk, which eliminates counterparty risk, at a multiyear fixed price. Additionally, however, bonds have also been issued that transfer liability, credit, motor and reinsurance recoverable risks. The largest proportion of bonds outstanding are for multiple perils. In 2007, almost half of total issuance covered multiple perils. Also, cover has now been Multiple peril bonds now constitute the largest proportion of outstanding cat bonds. Average issue size has grown as new sponsors have been attracted to the market and standardization has lowered the cost of issuance. extended to new perils beyond the peak Florida wind risk that was typical in the market following hurricanes Katrina, Rita and Wilma. One bond, for example, now covers European earthquake risk in Turkey, Greece, Israel, Cyprus and Portugal, while another covers Japanese typhoon risk. Also, the average lifespan of the bonds has lengthened, from two years in 2006 to three-and-a-half years in Some now have a lifespan of six years. The cat bond market continued to grow in 2007, even in a softening insurance market. The process of issuing cat bonds is increasingly standardized, lowering the cost of issuance and attracting new sponsors. The issuance of standardized programme or shelf-offering transactions accelerated in 2007, with shelf offerings accounting for 72% of total non-life issuance. At the same time, the size of the average bond increased Figure 2: Total P&C securitizations over time and split by peril US$ billion New issues Outstanding from previous years 3% 2% 5% 1% 19% Multi-peril 39% 31% Wind Liability Auto Earthquake Credit Other 21% 12% 6% Source: Swiss Re Capital Markets 11

12 from US$ 141 million in 2006 to US$ 271 million in Of the bonds issued in 2007, State Farm s Merna Re had a record value of US$ 1.2 billion, while the Emerson Re and Longpoint Re bonds were for US$ 500 million each. Sponsors and indemnity-based bonds increased last year. There was also a further widening of the pool of sponsors, which included large primary companies such as State Farm and Chubb, and corporations, such as East Japan Railway for the Midori bonds. In another sign of a maturing market, the use of indemnity triggers increased in 2007, as primary insurers sought to minimize basis risk and investors grew more comfortable with such triggers. In 2005 and 2006, growth was supported by catastrophe activity in 2004 (hurricanes Charley, Ivan, Frances and Jeanne) and 2005 (hurricanes Katrina, Rita and Wilma). However, underlining the market s growing maturity, cat bond issuance continued to grow robustly in 2007, even with softening insurance market conditions and despite the credit crisis Life bonds Life bonds can be used to monetize intangible assets, fund US regulatory capital requirements under Regulations XXX/AXXX, and transfer risks, such as extreme mortality events, to the bond market. These bonds, and the regulatory requirements for them, differ from existing P&C bonds in a very crucial respect: they are typically used as a financing tool. That is, asset-backed life bonds are secured by the flow of future profits from life insurance policies. Risk is not fully transferred in a legal sense, since the life insurance company will always retain the obligation of its policies. However, the burden of risks, such as mortality and lapse risk, are assumed by the investors. For these bonds, investors and protection buyers share the benefits and losses in the development of the underlying policies that have been securitized. Extreme mortality bonds are similar to P&C cat bonds in that they, too, are fully collateralized and have a specified trigger. Life bonds are typically a financing tool. Figure 3: Life bonds issued and outstanding in US$ billion US$ billion 9% 16 7% % 4 42% 0 3% New issues Outstanding from prev. years XXX AXXX Embedded Value Extreme Morality Other Source: Swiss Re Capital Markets 12

13 The flow of XXX/AXXX securitizations weakened in 2007 after the credit crunch hit the financial markets. five-year mortality cat bond (US$ 100 million) to protect against an exceptional rise in mortality in the US, Canada, England and Wales, and Germany Weather derivatives Funding of Regulation XXX/AXXX redundant reserves in the United States has been the primary focus of life securitizations in the past few years. These redundant reserves are for fixed-length term life (XXX) and universal life (AXXX) policies. In the second half of 2007, pressure on the asset-backed securities market and on the monoline insurers slowed issuance, but this is expected to be a temporary factor. In 2007, XXX transactions were executed publicly by Genworth (US$ 790 million) and Aegon (US$ 550 million). Protective Life completed a US$ 250 million AXXX securitization to fund universal life reserves. These figures understate the true transfer of risk as substantial private transaction activity coexists with the public market. Securitizations that monetize the embedded value (EV) of a defined block of business accelerated in The Bank of Ireland closed a US$ 573 million EV transaction for its life insurance subsidiary, New Ireland Assurance. UnumProvident issued a 30-year bond (US$ 800 million) to monetize the value of its closed block of individual income protection insurance. In December, MetLife issued a 35-year bond (US$ 2.5 billion) to provide statutory reserve support for a large closed block of liabilities. Securitizations of this type hold strong growth prospects since they provide an effective tool for life companies to improve capital efficiency and profitability. The issuance of mortality cat bonds was unaffected by credit market woes. Weather derivatives are primarily used by utility companies to hedge against extreme heat and cold. They are typically triggered by heating degree days (HDD) or cooling degree days (CDD) and serve to reduce the volatility of earnings by offsetting losses from higher variable costs at fixed prices when demand surges during extreme weather. HDD, for example, is the number of average degrees of temperature for a day below a reference value (usually 65 F or 18 C, which have been shown to require no heating inside buildings). Frequently, the derivative contracts are for cumulative HDDs over a season, depending on local weather patterns. Though HDDs are one of the most common types of weather derivative, derivatives have also been constructed with rainfall and other weather-related triggers. The weather derivatives market is likely to grow by 30% per year for the next several years. Demand for weather derivatives remains healthy, with the notional value of trades tripling in three years, to US$ 32 billion in from US$ 9.7 billion in (the intervening period was marked by some anomalous conditions, Figure 4: Weather derivative contracts (in US$ billion) The market for mortality risk transfer through securitization continues to expand, as these bonds were unaffected by the credit market s woes. So far, mortality cat bonds have been issued by Swiss Re, Scottish Re, AXA and Munich Re. Swiss Re issued a fourth mortality cat bond (US$ 521 million) in early In February 2008, Munich Re issued its first /01 01/02 02/03 03/04 04/05 05/06 06/07 07/08 Source: Weather Risk Management Association 13

14 including the rapid entry and exit of several hedge funds as well as increased trading after the Katrina/Rita/Wilma hurricanes). Growth of about 30% per year is expected for the next several years. Counterparties for weather derivatives are mostly utilities, construction companies and farmers. North America remains the main driver of the weather derivatives market, although Europe is increasingly significant. Counterparties are: 1) Mostly utilities hedging against a warm winter 2) Agribusinesses buying yield and revenue protection influenced by temperature and precipitation 3) Construction companies hedging against precipitation or cold that can disrupt construction schedules 4) Retailers hedging against the impact on buying habits of temperature and precipitation Industry loss warranties ILWs, cat bonds and cat swaps are all triggered by specified indexes. Industry loss warranties (ILW) provide protection against natural catastrophes. In their reinsurance form, they are based on two triggers an agreed upon industry-loss trigger and an indemnity-loss trigger based on the buyer s actual losses. In the United States, the industry loss data used is frequently taken from the PCS, which provides timely estimates of insured losses after a catastrophic event. In other countries, Swiss Re s sigma data, Munich Re s catastrophic loss data or other loss estimates are used. Single ILWs may provide anywhere from US$ 1 million to US$ 250 million of cover. By contrast, cat bonds typically need to provide at least US$ 100 million of cover to be economical Cat swaps Cat swaps are over-the-counter, customized derivative contracts similar to ILWs, in that they require less documentation and are often set at lower levels of payouts than bonds. Cat swaps are very flexible and have been issued for protection against US windstorms, US earthquakes, Japanese earthquakes, Japanese typhoons, Turkish earthquakes, aviation losses, terrorist attacks, mortality, longevity and multi-perils. It is difficult to establish the exact size of the ILW and cat swaps markets since these are private transactions. However, together the two instruments are estimated to have about US$ 10 billion in outstanding notional volume Exchange traded cat risks Exchanges have been established to trade insurance-linked derivatives. Recently, exchanges have been re-established to trade insurance-linked, index-based risks. Such risks were traded on exchanges in the 1990s, but these listings were discontinued due to a lack of interest. The New York Mercantile Exchange has partnered with Gallagher Re to create an exchange based on an index of aggregate insurance industry losses reported by the PCS excluding earthquake and terrorism losses. The Chicago Mercantile Exchange and Carvill & Company have set up an exchange to trade derivatives based on an index of wind speed and hurricane force radius at landfall. The Insurance Futures Exchange Services Ltd (IFEX) has initiated trading in catastrophe event-linked futures on the Chicago Climate Futures Exchange. IFEX derivatives are based on an index of PCS losses a named hurricane must breach the trigger. Each of these exchanges lists derivatives for various geographic regions (all US, Florida, North Atlantic coast, etc.) However, all three trading venues are relatively new and it is not yet clear if they will succeed. 14

15 2.3 Market participants Investor interest in insurance-linked securities continues to grow. Fixed-income investors are increasingly interested in ILS and related risk-taking instruments, for several reasons: These instruments often provide exposure to specific insurance risks, such as the risk of an earthquake in a specific area, resulting in a pure play investment Their funds are held in trust, so investors face no counterparty risk with the bond s sponsor, the insurer or reinsurer ILS investments often offer low correlation with equity and credit markets, making them a diversifying asset class Most investors tend to focus narrowly with relatively little overlap, for example, between investors in catastrophe bonds and investors in embedded-value life bonds. The comments below focus on investors in catastrophe bonds and related instruments. Creating loss indexes in Europe Dedicated cat funds are now the largest investors in cat bonds. Dedicated cat funds are now the largest buyers for cat bonds, making up 44% of the investor base. Last year, they continued to invest in higher yielding noninvestment grade bonds and often set the pace for market trends such as the growing acceptance of indemnity triggers. Dedicated cat funds continue to attract funds at a rapid rate. Interest among other investors, such as hedge funds and traditional pension plans and mutual funds, is also rising. Investors are attracted by the uncorrelated nature of cat bonds and thus their portfolio diversification value, as well as the increased liquidity of the secondary market. Spreads on cat bonds continued to narrow in the second half of 2007, even as investors in other types of bonds saw spreads widen. Since 2002, spreads on cat bonds have narrowed from about basis points to basis points over LIBOR. Spreads on US wind-peril instruments spiked after Katrina, but are now back down following two consecutive benign hurricane Although Europe does not have a recognized loss index, help is on the way. A recent European initiative aims to develop indexes capable of measuring the scale of natural catastrophes in Europe. The initiative was launched through the Chief Risk Officer Forum and is supported by numerous major insurers and reinsurers. The goal is to develop a data service capable of promptly providing estimates of insured European natural catastrophe losses. This information could be used to develop industry loss indexes for insurance-related instruments such as ILWs, cat bonds and cat swaps. Figure 5: Investors in cat bonds by type As of 31 Dec Hedge fund 14% Bank 13% Money manager 22% Reinsurer 4% Source: Swiss Re Capital Markets Insurer 3% Dedicated Fund 44% 15

16 seasons. This downward trend in spreads was strongly reinforced in the second half of 2007, despite the credit crunch. While yields on corporate bonds widened in the second half of the year, cat bond spreads, on average, continued to tighten. By contrast, the credit crunch and the accompanying uncertainty surrounding the major monoline insurers have had a dramatic impact on the market for life insurance bonds. These instruments became dramatically less liquid and new issuance slowed to a halt as transactions were reworked. Since traditional insurance and reinsurance leave gaps in customers cover needs, we support efforts to explore and develop innovative solutions, such as an effective transfer of insurance risk to the capital markets. Jim Rutrough, Vice-Chairman and Chief Administrative Officer, State Farm Insurance Group, USA Sidecars Sidecars provide capital when prices are high. Sidecar capacity shrank in Sidecars are special purpose vehicles that are temporary collateralized capital pools funded by a third party, such as a hedge fund. The pool is structured as a retrocession vehicle for a top flight reinsurer, which assumes a specific type of business on its highly rated paper, and then cedes it via a quota share or some other reinsurance agreement to the sidecar. Typically, sidecars are multi-year and created during hard insurance markets, when prices are high for catastrophic risks. Because the P&C industry is now well capitalized and returns are falling, sidecar capacity shrank in Last year, only nine new sidecars with US$ 1.9 billion in capital (mostly debt) were established or renewed, while about US$ 4 billion in sidecar capacity was retired. The remaining capacity is roughly US$ 4 billion. Sidecars may regain their popularity after future large catastrophic events. Figure 6: New sidecar capacity from 2001 to Capital Debt Value (US$ billion) Gap in issuance illustrating opportunistic sidecar use by insurers after major hurricanes (KRW)

17 3. Impediments to Growth Though growing rapidly, the insurance risk transfer market is still small in absolute size and slow in its development compared to some of the credit-linked ABS markets. 2 This section will describe factors that are impeding growth. Our findings are derived from interviews with investors, insurers, reinsurers, rating agencies, investment banks, modelling agencies and other stakeholders, as well as a review of the existing research literature. Except where noted, most of our analyses focus on catastrophe bonds, which represent the bulk of the P&C instruments currently outstanding. For sponsors, the transfer of insurance risk to the capital markets is an alternative or a complement to traditional reinsurance or retrocession. Accordingly, they will compare the costs and benefits of securitization to traditional reinsurance in terms of both the scope of the protection provided and the price. Relevant criteria are that an instrument provides tailored cover with minimal basis risk, low counterparty risk and favourable treatment with respect to regulatory capital and credit ratings. For sponsors, the key impediments to market growth are the potential for basis risk in transactions with parametric triggers (as well as the accounting, regulatory and rating consequences resulting from basis risk) and the pricing of capital market transactions compared to traditional reinsurance. Two key differences between the ABS and the ILS markets It is worth noting following two key differences between the ABS and the ILS markets: With ILS, the insurer retains a considerable amount of insurance risk. To date, ILS mostly have been used to protect insurers against peak risks. Accordingly, there is much less of a moral hazard problem, compared to the securitization of an entire credit portfolio. Secondly, there is no duration mismatch in cat bond or sidecar structures. Thus, the difficulties caused by the illiquidity of the market for short-term notes issued by structured investment vehicles in the ABS market will not be repeated in the ILS market. Investors, on the other hand, tend to value liquid markets, objective and transparent triggers, standardized documentation and short settlement periods. Key impediments for investors include the complexity of the underlying risks and the models used to evaluate them, the lack of standardization in the ILS market and the limited secondary market this heterogeneity produces. 3.1 Impediments for sponsors Basis risk Traditional reinsurance, whether proportional or excess of loss, provides indemnity-based protection without or with only limited basis risk. 3 However, some capital market instruments, if not indemnitybased, expose the primary insurer or reinsurer seeking protection to varying levels of basis risk. Traditional reinsurance or retrocession can be divided in two types, proportional and nonproportional. In proportional reinsurance, including both quota-share reinsurance and surplus reinsurance 4, insurer and reinsurer share premiums and losses proportionally. In non-proportional or excess-of-loss reinsurance, the reinsurance premium is not expressed as a specified share of the primary insurance losses and premiums but rather in absolute terms. The reinsurer assumes all losses of the primary insurer in a class of business that exceed a certain amount and up to a specified limit. However, all these types of reinsurance are indemnity-based, meaning the recovery from the reinsurer is based directly on the specified losses incurred by the primary insurer. Note, however, that a limited amount of basis risk for the ceding company may result from exclusions and other contractual terms such as the exclusion of postevent assessments that limit the extent to which the reinsurer follows the fortunes of the ceding company. In capital market transactions, indemnity-based cat bonds are structured similarly to excess-of-loss reinsurance. Within the limits, the sponsor also receives full protection, since the risk assumed by 17

18 the investors relates to the specific loss exposure of the sponsor s underlying portfolio. However, in any other transaction where the trigger is based on an index or is parametric, the insurer retains a basis risk (which may be positive or negative) arising from the imperfect match between the losses resulting from the portfolio for which protection is sought and the compensatory payment under the risk transfer instrument, which are not fully correlated. Basis risk will vary according to the granularity of the trigger used i.e. whether an index provides a geographic breakdown that allows sponsors to refine the trigger to geographic areas where their exposures are significant as well as the deviation of the specific portfolio from the industry-wide exposure or losses. The assessment of basis risk depends on the quality of the risk model used to estimate the impact of certain catastrophic events on the specific portfolio for which protection is sought, the quality of the data available with respect to such portfolio, and on the specific peril. For example, there are only a few recalibrating events for high severity perils such as earthquakes, which adds uncertainty to the models. For the sponsor, basis risk presents an impediment because the protection obtained from the risk transfer instrument is imperfect. This must be reflected in internal risk management. In addition, under the applicable accounting rules, as well as most regulatory regimes and rating-agency rules, basis risk may have negative impacts. This point is discussed in more detail in the next subsection. On the other hand, in indemnity-based transactions investors expect to receive a premium for moral hazard and adverse selection, the size of which is a function of the type of business covered and the associated modelling credibility, as well as the market's confidence in the sponsor's underwriting, risk management, loss and claims adjustment processes, among other factors. 5 Furthermore, investors will want to undertake more extensive due diligence of the sponsor and the securitized portfolio, increasing the cost and time spent to the sponsor. Catastrophe bond issuances in 2007 showed an increasing volume of indemnity-based transactions. This trend may reflect the surge in investors seeking opportunities in the cat bond market, leading to more favourable terms for sponsors. However, many investors still express concerns over the modelling integrity in indemnity-based deals, in particular with respect to complex commercial exposures, reinsurer portfolios (where portfolio information is less granular) and portfolios outside the US 6, where data quality is generally lower. Figure 7: Instruments with and without basis risks Instruments with basis risk Instruments without or with limited basis risk Non Life Cat bonds with modeled loss, industry loss or parametric triggers Cat swaps ILW Sidecars Cat bonds with indemnity based trigger Life Extreme mortality bonds Longevity ILS Embedded value securitization XXX and AXXX bonds 18

19 Further standardization of risk transfer instruments requires that sponsors become comfortable with retaining basis risk from a risk management, accounting and regulatory perspective. The standardization of risk transfer instruments can be driven much further if these instruments are not structured for an individual portfolio but instead relate to an objective index or parametric trigger. Thus, further standardization by means of standardized parametric or industry-loss triggers requires that insurers become comfortable with retaining basis risk, or have the means to cede basis risk to a third party for a price that will still make the overall transaction competitive with traditional reinsurance. In either case, it will be necessary to develop robust methodologies ones that are understood and accepted by the rating agencies and the regulators 7 in order to evaluate basis risk and determine the levels of regulatory and rating capital necessary to support it Accounting and regulatory treatment Accounting The accounting treatment of alternative risk transfer instruments under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (US GAAP) depends on whether such instruments are classified as reinsurance contracts, and thus accounted for in the technical provisions and the insurance result, or whether they are classified as financial derivatives, and thus have no impact on the insurance result. Under IFRS (IFRS 4), reinsurance accounting applies only to risk mitigation instruments that have an indemnity-based trigger. Under US GAAP, industry loss warranties documented as reinsurance contracts are treated as reinsurance since they have a dual trigger one relating to industry losses, such as those reported by the PCS; the other being an indemnity trigger, which relates to actual losses incurred by the protection buyer. If the risk transfer instrument is classified as a financial derivative, it will, under both IFRS and US GAAP, be measured at fair value and marked to market, with impact on profit and loss accounts. This can create considerable volatility in the insurer s income statement compared to a traditional reinsurance claim, which, subject to contract exclusions, is measured consistent with the treatment of underlying direct insurance liability. However, this difference in accounting treatment may be alleviated in the future with the move to fair value measurement of insurance liabilities under both IFRS and US GAAP. This would increase the volatility of insurance liabilities and, correspondingly, of reinsurance assets as well. Solvency capital In addition to creating volatility in the insurer s income statement, treatment as a financial derivative has the consequence at least in many jurisdictions that the risk transfer instrument will be disregarded with respect to solvency capital as long as no gain is realized. Insurance undertakings and (in the European Union since the Reinsurance Directive 8 ) reinsurance undertakings must maintain a minimum level of solvency capital as a risk buffer. This supplementary reserve over and above the technical reserves serves as protection against adverse business fluctuations and is an element of prudential supervision. In banking, the Basel I and Basel II accords have allowed credit institutions to release regulatory capital through the securitization of their credit portfolios. This opportunity has had a considerable impact on the development of credit securitization. On the other hand, the insurance solvency regimes in most jurisdictions do not yet award such favourable treatment to the transfer of insurance risks to the capital markets. In the European Union, under the current Solvency I 9 regime, capital adequacy and the determination of the required solvency capital is based on the liabilities side of the balance sheet and on insurance risk only. For non-life insurance undertakings, the 19

20 required solvency margin is defined as the higher of the premium index or the claims index. Under both indexes, reinsurance reduces the required solvency margin, but not by more than 50%, as shown in the following (simplified) formulas: Premium Index = (18% x the first 50m gross premiums + 16% x the remaining gross premiums) x the retention rate Claims Index = (26% x the first 35m gross claims and 23% x the remaining gross claims) x the retention rate Retention rate = net claims three-year average of gross claims (but not less than 50%) 10 For life insurance, the required solvency margin is calculated as a function of the actuarial provisions or the capital at risk, and is lowered within certain limits to the extent that business is ceded by way of reinsurance. Solvency capital release varies by jurisdiction and inter-alia depends on reinsurance accounting. Whether an alternative risk transfer instrument reduces the required solvency margin depends upon whether it is considered in the retention rate and, therefore, under the Solvency I regime as currently implemented in most EU member states, upon whether the instrument qualifies as reinsurance. Treatment as reinsurance under the applicable accounting rules is a necessary, though not sufficient, prerequisite for regulatory treatment as reinsurance. The reduction of the required solvency margin may further depend on the jurisdiction of the special purpose reinsurance vehicle used to transfer the risk to the capital market, and whether the sponsor's regulator accepts this jurisdiction as having sufficient reinsurance supervision. While currently it is often beneficial from a tax or capitalization perspective to locate special purpose vehicles in Bermuda or the Cayman Islands, jurisdictions outside the European Union will not always be seen as providing adequate reinsurance supervision. For the sponsor, this could have a negative impact on the regulatory treatment of the instrument. Using a transforming reinsurer may solve this problem but may create additional costs. This dependence of the regulatory treatment on the accounting treatment is similarly found in the United States: US insurers and reinsurers are required to report their financial results consistent with Statutory Accounting Principles (SAP), an insurance accounting system that is more conservative than US GAAP. Under US GAAP (FAS 113, sections 9a and b), the criteria for a risk transfer instrument to qualify for reinsurance treatment include the significance of the risk transferred and a certain probability of significant loss. A significant transfer of risk is only achieved if there is no positive basis risk for the insurer. Similar rules apply under SAP. Therefore, in many transactions with parametric or industry-loss triggers, sponsors will use a double-trigger reinsurance contract similar to an ILW, thus capping the payout to the sponsor at the sponsor s actual losses. This can also delay the payout until actual losses are assessed. The interest paid for this extension period can be an unintended benefit for investors. In order to achieve solvency capital release from alternative risk transfer mechanisms, sponsors must ensure these instruments receive accounting treatment as reinsurance. However, for the ceding companies this may add complexity to transactions in which solvency capital relief is an important objective. The solution should be to look at these instruments from an economic viewpoint and place the economic substance over the form of the relevant risk transfer instrument. In the European Union, progress in this direction has been made under the Solvency II regime, as rules detailing the Solvency II Directive Proposal 11 are being developed. Solvency II will be a principles-based regime designed to take into account all types of risk to which the insurer is exposed and to reflect developments in the capital markets in a timelier and more flexible way. New capital adequacy standards are expected to come into force from

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