Trading Risk Awards 2010

capacity

Large capacity is something that Tokio Millennium Re is known for. But we also believe that capacity is more than a financial measure. We have capacity in many additional ways: capacity to understand your business; capacity to anticipate your changing demands; capacity to provide intelligent, affordable solutions. These qualities ensure that your insurance needs are met and fulfilled, each and every time.

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Standard & Poor’s rating: AA A.M. Best rating: A+ (Superior)

TOKI16954 - A4 ADS_v2.indd 2 5/29/08 9:38:46 AM t r editor’s letter 03

Coming back stronger…

Dear Reader,

Like a knuckle-headed, brutish boxer raining blow after crunching blow on the face of an ill-matched opponent, the financial crisis pummelled the global economy in 2009. And, although the convergence sector caught a few glancing blows, it demonstrated its flexibility, strength and agility by rolling with the punches and coming back off the ropes to fight another round. Over the past year, the trading risk market has had to absorb the withdrawal of a swathe of investors, a benign natural catastrophe year which stalled cat futures trading, credit contagion and a slow return to new issuance as sponsors sheltered in a soft reinsurance market. But, by rallying as a market, tackling the problems highlighted by the collapse of Lehman Brothers, and continuing to demonstrate its limited-correlation to other financial markets, the convergence community has evolved into a yet stronger, more sophisticated and resilient sector. As Michael Millette says on page 8 of our second Annual Review, the convergence sector is equipped with the “requisite skills and discipline” to address the very different world which is emerging from the financial crisis Volatility is onmipresent – in macroeconomic trends such as interest rates, inflation and currency, but also in the future of litigation, climate change and life expectancy – and the trading risk sector can turn these uncertainties to its advantage. But – if you’ll allow me to stretch the metaphor yet further – the fight is far from over, as even the briefest of glances in this Annual Review will reveal. While there is a genuine admiration for the market’s progress in 2009, there are still uncertainties to resolve and breakthroughs to achieve if the trading risk sector is to stand as an equal to the traditional reinsurance market. These are discussed at length and over the next 50 pages. Has, for example, the convergence market proved itself as a worthy capital complement to reinsurance? How much growth potential is there in longevity risk? Will we ever see the tipping point reached in dynamically trading risk rather than the buy-and-hold approach that currently dominates? What steps are needed to achieve adequate transparency and disclosure in insurance-linked trades? And talking of progress, Trading Risk has also continued to evolve in 2009. Our annual New York conference in October was a huge success, with almost 200 market luminaries joining for lively debate on the convergence issues du jour – see page 18 for a reminder. By reading the highlights of our first roundtable (in a supplement available now), you will have as strong an understanding of the underlying trends that will shape the trading risk market in 2010 as anyone else. The success of our inaugural Trading Risk Awards in 2009 was a particular highlight – providing a platform to reward excellence and achievement in our market. I hope that you will continue to support the Awards in 2010 by submitting your entry and nominations before the 31 March deadline. So, as the bell rings to usher in a new year, it is impossible to predict exactly what 2010 will bring, but if the past is any indicator, it will be an exciting one for the sector. Here’s to a fruitful year ahead.

Rebecca Bole, Editor www.trading-risk.com 2009 Review; 2010 Preview 04 TR contents

2009 Review; 2010 Preview 03 Editor’s letter Risk 06 ILS analysis 08 Vie wpoint Editor Rebecca Bole Goldman Sachs’ Michael Millette looks at convergence opportunities out [email protected] of economic adversity Managing Editor 10 B ack to strength Jerry Frank [email protected] Swiss Re’s Martin Bisping analyses 2009 14 Life ILS analysis Art Director Paul Sargent 15 L ongevity swap case study [email protected] Towers Perrin Capital Market’s Ernest Eng walks us through the Sub-Editor Aviva-RBS longevity swap Peter Williams [email protected] 16 C raig Hupper interview Transatlantic Re’s director of risk management shares his perspective on Head of Events convergence Cathy Turner [email protected] 18 T rading Risk in New York Marketing Manager Market luminaries discuss pricing, transparency and more… Amber Bates 22 Industr y loss [email protected] PCS’ Gary Kerney explains that it takes time to get insured property loss Sales Director Spencer Halladey estimates right [email protected] 25 S aluting excellence Sales Executive Trading Risk Awards 2010 headline sponsor Credit Suisse Asset Rob Hughes [email protected] Management applauds the market on its resilience Business Development 28 D erivatives Director not out of puff yet… Tyrone Francis [email protected] 30 Industr y loss warranties The ILW market provides a pool of vital capacity, Willis Re’s Henry Marketing Executive, Subscriptions and Events Kingham argues Aimee Pitt 33 T ransparency [email protected] Elementum Advisor’s Tony Rettino outlines the benefits of disclosure Publishing Editor 34 C at bonds Peter Hastie [email protected] ILS structures have undergone a make-over since Lehman’s collapse. Sidley Austin’s Michael Pinsel and Michael Madigan scrutinise… Printing Buckley Deane Wakefield 38 R atings viewpoint S&P’s Cameron Heath shares the ratings agency view on recent Published by: Insider Publishing Ltd, innovations Asia House, 31-33 Lime St, 40 In vestors London EC3M 7HT, UK. Tel Main: +44 (0)20 7397 0615 A new breed of insurance-linked investor emerges from the Editorial: +44 (0)20 7397 0618 financial crisis Subscriptions: +44 (0)20 7397 0619 42 Lif e investments Fax: +44 (0)20 7397 0616 e-mail: [email protected] Credit Suisse’s Niklaus Hilti and Marcel Grandi check the vital signs of the 2009 Insider Publishing Ltd. life insurance investment market All rights reserved. 44 S idecars The post-Katrina sidecar structure is dead, but the vehicles continue to Trading Risk, the sister publication of tick over. Aon Benfield’s Des Potter looks under the hood… 48 Reinsur ance report Subscription enquiries Analysis on reinsurer capital strength and the 2009 loss year Annie Lightholder 50 D eal directory Tel +44 (0)20 7397 0619 Comprehensive list of 2009 ILS deals and 2010 maturities Fax +44 (0)20 7397 0616 [email protected]

2009 Review; 2010 Preview www.trading-risk.com t r contents 05

30 16

www.trading-risk.com 2009 Review; 2010 Preview 06 TR Ils An even keel

A late push took 2009 issuance to $3.5bn, but as our Annual Review Subsequently, tranches of two of highlights, this ship needs a fair wind for growth in 2010… those bonds – representing $350mn of Allstate’s Willow Re and Aspen’s 009 was an excellent year for However, Swiss Re noted that the Ajax Re – defaulted on their interest 2natural catastrophe ILS, riding anticipated $3.5bn of new issuance payments this year (see table right), out the squalls and riptides of the would merely offset the $3.7bn of sending the sector into its second financial crisis to emerge into the cat bonds maturing in 2009 – leaving ever quarterly loss, according to faint sunlight with rudder and sails the sector in a static net position in Lane Financial research. intact – ready to sail into a stronger terms of outstanding ILS capacity. This, combined with the higher 2010. And with an estimated $5.1bn cost of investor capital during the A combination of a strong and of maturities expected in 2010 credit crisis, meant that new cat liquid secondary market, limited (see page 50), the ILS market bonds were deeply scrutinised credit contagion and natural will need a steady flow of new by the market in 2009 for signals catastrophe losses, improved issuance – requiring the continued of fresh structural and pricing collateral structures and a core commitment of sponsors and benchmarks for the ILS sector. dedicated ILS investor base was investors alike – to return to Spreads widened considerably – sufficient to see the market emerge absolute market growth. by around 25 percent, according to from the crisis in robust shape, with industry experts – and a series of issuance exceeding 2008 levels. R unning repairs new collateral structures attempted New cat bond capacity was The year was kick-started in to reach the holy grail of a credit predicted to reach $3.5bn for the full February with the closure of SCOR’s risk-free cat bond (see table right). year, although two deals – with an $200mn Atlas V cat bond, marking Early in the year, transactions estimated notional value of $375mn the end of a six-month issuance including Atlas V took advantage – were not closed at time of going drought caused by the wider of the US government’s Temporary to press (see table right). And a record financial market turmoil. Liquidity Guarantee Program, breaking 10 of these transactions In late 2008 four cat bonds with supported by the Federal Deposit – those closed at mid-December collateral guaranteed by Lehman Insurance Corporation as a means – increased in size during the Brothers were downgraded of guaranteeing returns on cat marketing phase, evincing strong by Standard & Poor’s (S&P) bond collateral. However, due to investor demand for the product. following the bank’s bankruptcy. the finite nature of this programme,

2009 Review; 2010 Preview www.trading-risk.com t r ILS 07

2009 cat bond issuance and collateral features alternatives were needed. Although Date Transaction Sponsor Size (mn) TRS** AAA- MMF** Repo no front-runner has emerged, collateral subsequent collateral management Dec-09 Redwood XI* Swiss Re/CEA $150 X mechanisms include investing in Dec-09 Lakeside Re II* Zurich American $225 X US Treasury money market funds Dec-09 Longpoint Re II Travelers $500 X or AAA-rated puttable floating Dec-09 Atlas Capital VI SCOR EUR75 X rate notes from organisations that Nov-09 Successor X Swiss Re $150 X include the IBRD and German Nov-09 Montana Re Flagstone Re $175 X government agency KFW. Finally, Nov-09 Vita Capital IV Swiss Re $75 X a tri-party repo structure emerged, Oct-09 MultiCat Mexico 2009 Swiss Re/FONDEN $290 X with independent daily mark-to- market and over collateralisation of Jul-09 Eurus II Hannover Re EUR150 X cat bond investments, guaranteed Jul-09 Parkton Re NCJUA $200 X by a bank counterparty. For more Jun-09 Ianus Capital Munich Re EUR50 X analysis of these developments, Jun-09 Calabash Re III Swiss Re/ACE $100 X (see pages 34-37). May-09 Residential Re 2009 USAA $250 X May-09 Ibis Re Assurant Inc $150 X

I ke’s ill wind Apr-09 Successor II Swiss Re $60 X

In addition to the losses and Apr-09 Blue Fin II Allianz Argos 14 $180 X near-misses on the four cat bonds Mar-09 Mystic Re II-2009 Liberty Mutual $225 X affected by Lehman’s demise, 2008s Mar-09 East Lane Re III Chubb $150 X Hurricane Ike – the third-costliest Feb-09 Atlas V SCOR $200 X natural catastrophe in history – Total ($mn equiv) 3,500 threatened to trigger two more cat bonds. *not closed at time of going to press **TRS; Total return swap MMF; Money market funds Source: Trading Risk Most recently, a loss looks increasingly likely on the $67.5mn Secondary market responds Class G notes of Glacier Re’s 2008 Nelson Re, as claims from Hurricane Distress in the financial markets a healthy volume, boosted in part by Ike threaten to trigger the bond and in 2008 pushed secondary trading new investors entering the market Moody’s downgraded the notes. volumes to $7-9bn as credit and building portfolios, according to In April, S&P placed all three risk seeped into the sector and traders. tranches of Allianz’s 2008 $120mn de-leveraging hedge funds were Volumes were said to be in line with forced to sell cat bonds. “seasonal adjustment” during the Blue Coast transaction on negative Although at the beginning of 2009 hurricane season and the pricing gap watch due to fears that hurricanes some mainstream investors were still between ILS and reinsurance pricing Ike and Gustav would trigger a loss. selling small amounts of cat bonds – cited as a brake on the ILS market Finally, although not a nat cat – a testament to the liquidity in the in 2009 – appeared to shrink. bond, Swiss Re’s Crystal Credit was market and the relative value of cat During the 2009 wind season, US downgraded twice this year on the bond assets versus other structured multi-peril spreads tightened in the finance – activity slowed to “normal” secondary market by more than 30 back of recession-related credit levels later in the year. percent with US wind-only spreads reinsurance losses. Total secondary trading levels for and US quake spreads tightening by Then in November S&P affirmed 2009 were predicted to reach $4bn, more than 25 percent, traders said. its credit ratings on the EUR252mn notes, despite a further surge in recession-related credit losses on C at bond hits and near misses 2008/9 the bond. Losses at end-September Transaction Sponsor Loss event Affected Comment stood at EUR663mn, while capacity (mn) aggregate losses of EUR666mn Losses… would trigger a payout on the class Willow Re Allstate 2008 Lehman bankruptcy $250 Lehman was TRS counterparty. Defaulted in February C notes. Ajax Re Aspen Insurance 2008 Lehman bankruptcy $100 Lehman was TRS counterparty. The market is not disheartened Defaulted in May by the threat of losses on a small Near misses… number of bonds, however, as they Nelson Re Class G Glacier Re 2008 Hurricane Ike $67.5 $67.5mn of $180mn bond provide further evidence of cat downgraded.Rising Ike losses threaten indemnity bond bonds’ validity as a risk transfer Crystal Credit Swiss Re 2008-9 credit crunch EUR252 At end-Sept losses were EUR663mn. tool to complement reinsurance Class C notes trigger at EUR666mn capacity. Blue Coast Allianz Bermuda 2008 Hurricane Ike $120 Loss modelling delayed on first LAZR With a fair wind, the hard work bond. Notes on review for downgrade Carillon Ltd Munich Re 2008 Lehman bankruptcy $150 Downgraded to CC by S&P. Still paying and diligence of the ILS market in interest the past 12 months will provide Newton Re 2008-1 Catlin 2008 Lehman bankruptcy $150 Downgraded to CCC by S&P. Still additional impetus to growth in paying interest 2010. Source: Trading Risk www.trading-risk.com 2009 Review; 2010 Preview 08 TR Viewpoint Out of adversity… The views of Michael Millette, co-head of Americas securitisation, are always worth listening to. Here, he tells Trading Risk why he is looking forward to 2010….

TR: How would you sum-up 2009? important reason behind the disappointment in the market is Michael Millette: Following the that the housing bubble worked in catastrophe and financial events reverse this year. of Q3 2008, I believe that there was During the housing bubble, real live expectation – and not hype primary insurers were always – that we would have a hard market anxious about rapidly rising in June and July. aggregate exposure levels in But, come the summer, the property books. anticipated 25 percent hardening For example, during the four in the reinsurance market did not month process of getting an materialise and this began to affect ILS deal to market, the housing the convergence market. market would increase five The most obvious and most percent – inflating exposure levels commonly heard reason for this and making the modelling of ILS deviation from expectations was deals very difficult. Indeed, in the that Florida and Texas didn’t buy bubble, land value and property provides real opportunities for the as much protection as expected. replacement costs were rising at a convergence sector. In reality, these states never buy 12 percent clip every year. I believe that the possibility of tort much cover, but this year’s purchase But in 2009, that anxiety was liability expansion could make the was certainly disappointing to the much less, because housing prices capital markets useful to reinsurers. market and resulted in less demand were falling around 10 percent. In After a very rapid expansion for reinsurance – and subsequently addition, many companies felt that of tort liability in the 1960s and cat bond purchase. slack capacity in the construction 1970s – which bled out into the Another reason is offshore. There sector would greatly reduce 1980s – we believe that we’ve is an annual showdown between demand surge after a catastrophic experienced a relatively benign London and Houston, with the event. environment around the expansion former daring the latter to go So, rather than being approached of tort liability for the last 20 years. uncovered and Houston daring by companies seeking a new top There is no assurance that this is London not to raise its rates very layer of cover, in 2009 we saw them likely to persist in the future and much. considering whether to trim their this uncertainty also needs to be Our perception is that energy old top layer. managed. For example, the current companies took down their buying And as a result of these administration has not emphasised levels this year – walking away from dynamics, we saw massive pricing tort reform in its legislative a very concerted attempt to harden re-adjustment towards the end program. offshore. of 2009. Earlier in the year, the Liability is a complex risk to This outcome gets to the heart of reinsurance market hardened only transfer into the capital markets the problem with offshore – that 10-15 percent and the cat bond because it harbours an intrinsic energy companies feel they have market had got ahead of it. moral hazard. Liability is more adequate hedges in place based The ILS market began to trade interactive, less objective – subject on the moving oil price, without back into conformance with to more negotiation and litigation needing reinsurance cover. reinsurance in the latter months of than natural catastrophe risk – and The American International Group 2009, spurring issuance. there is a longer tail. (AIG) crash in Q4 of 2008 proved to (Re)insurers are more active be less significant than anticipated. TR: We have seen many changes in participants in the settlement of The crash was dramatic, but in the past year. How do you see the (re)insurance than capital markets reality not as many AIG customers convergence market turning those players. This activism is more moved from the company as had to its advantage in the future? Michael Millette is synergistic with the active nature been expected, mitigating the affect co-head of Americas of liability claim settlement, making on the market. MM: A greatly changed world is securitisation at Goldman traditional reinsurance a more However, the real subtle and emerging from the crisis; one which Sachs natural home than bonds for

2009 Review; 2010 Preview www.trading-risk.com t r Viewpoint 09

this risk. and the Euro had flown out of both a growth and diversification However, I think that the alignment, inflating the aggregate perspective. In particular, the possibility of tort liability expansion exposures of Japanese insurance Chinese and Indian markets are is poised to be an issue for the companies. This fed through to rapidly approaching the threshold (re)insurance industry and the overseas markets, which found that at which the risk management convergence sector needs to they were extending more limit needs of domestic companies show more dexterity than simply into Asia than previously thought – will require these industries to proposing a bond solution to every pushing pricing up. tap the global reinsurance and problem. Another set of issues are mortality, convergence markets. Goldman Sachs is now longevity and health, which I Finally, I predict that the shape considering the possibility of suspect will become a more central of the property and casualty creating long-term indices that part of our market. industry will change, moulded by would provide (re)insurers with a Mortality risk is traded today consolidation and run-off. And macro hedging tool for their as a consequence of the need to contingent opportunities will arise liability tail. come to grips with Regulation XXX from that. We suspect that (re)insurers liabilities. The excess reserves of We do not have a natural will find them useless at first and US insurers have become a big and reinsurance industry structure ultimately find them useful and very difficult to hedge problem. at the moment but one which – they’ll become a way to trade the And longevity is an issue being shaped by the events of 9/11 and expansion, or plateauing, of tort driven primarily by the out- Katrina and the restructuring of liability. placement of pensions in the UK. the Lloyd’s market – contains just a handful of large-cap reinsurers Macro-economics “Currency volatility and several dozen small to mid-cap Another pair of issues that the companies ILS sector will need to address will become a big We have already seen the are inflation and currency risk issue for (re)insurers” beginnings of consolidation in management. This sector has the market and I expect we will grown up in a benign inflation see more in the commercial, environment and a relatively stable reinsurance and – to some extent – currency environment and the Many dedicated ILS funds have in the life space. chances that both are true for the begun to participate – or to think History teaches us that next five years are close to zero. about participating – in mortality consolidation will lead some of The crazy thing is, it’s not at all and longevity risk. the larger companies to discover clear which direction they will go In addition, in recent years it that they have tail-hedging needs, in – we could have a deflationary has become more pressing for which can be transferred to the environment or a quite an healthcare companies to look at capital markets. inflationary environment. The ways to hedge high loss ratios. I As well as consolidation, trillions of dollars of stimulus which suspect that this is increasing in combined companies will shed have been pumped into the global importance as they become more books of business and therefore we economy in recent months will utility-like and feel the need to expect to see some pick-up in run- have to be extracted at some point, manage their tails better. off blocks on the life and non-life and this is already causing currency Climate change, renewables and side – and maybe some attempt to volatility, inflationary concerns, and energy are also going to feed into securitise those. spiking gold and commodity prices. the convergence market – with Now, we are not anywhere near These macro economic factors will carbon trading already one element – in any of these areas – a concrete all feed back into the convergence of that. deal, but these are the sorts of market. Some cat traders are also trading things that we think about. Referring back to liability, inflation carbon and weather derivatives, The ILS sector has been among will have an impact on the valuation which are fundamentally tied to the the best performers in structured of liabilities, which could create energy sector. finance over the course of the opportunities for this sector. As energy requirements grow, recent crisis. It got back on its Inflation will also affect being able to quantify and trade feet in 2009 and is functioning (re)insurers’ attitude towards the those risks will provide a great at pre-crisis levels, without any claim tail – in a highly inflationary opportunity to specialist cat government intervention at all. environment, the duration of a investors. If there is a market equipped with claim will become much more the requisite skills and discipline important. Globalisation benefit to address the issues that the Also, currency volatility will Globalisation will become more changing macro environment will become a big issue for of a factor in the market in throw at us, it is the convergence (re)insurers – we have already seen coming years, and this will be a market. an example of this with the Asian positive to reinsurers as well as For that reason, I am very much rate hardening this April. The Yen the convergence market from looking forward to 2010. www.trading-risk.com 2009 Review; 2010 Preview 10 TR 2009 analysis Back to strength Swiss Re’s ILS head, Martin Bisping, looks at the challenges faced by the convergence market in 2009 and how it has overcome them…

009 proved to be a year bankruptcy and poor quality are now down approximately 25 2of significant change and trust assets combined to result percent for cat bonds issued in development for the ILS sector. in mark-to-market losses for four the first half of 2009, with further Late in 2008, the Lehman Brothers ILS transactions, investors and tightening possible by the year-end. bankruptcy had critics predicting sponsors re-examined their view of Stabilisation should encourage its demise, but the slowdown in the credit risk in these structures. new and repeat sponsors to access primary activity at the end of 2008 The four transactions arranged the capital markets for capacity was short-lived. by Lehman were impacted for to complement their traditional The cat bond market rebounded a variety of reasons, including reinsurance programmes. Declining in 2009 with new issue levels for illiquid collateral account assets, spreads closed the gap with the year to 23 November reaching a lack of top-up provision and reinsurance pricing, which should $2.2bn. This activity reflects the concentration limits, long-dated further encourage new issuance. market’s acceptance of new assets (mismatched maturities), a Following low activity in the collateral account solutions, an lack of transparency and a lower- first half of 2009, trading volumes influx of cash into the sector rated swap counterparty. have rebounded significantly, with and stabilisation of the broader To address these issues, the ILS year-to-date volume at Swiss Re financial markets. The market has investor, sponsor and investment Capital Markets exceeding $665mn. continued to show strength through banking community developed While volume in Q1 was marked its ability to attract new sponsors several alternative solutions to the by increased activity in bonds, with and investors. traditional TRS structure used in Lehman as the TRS counterparty, previous deals (see table page 12). trading since Q1 has been Back on track While the new collateral account predominantly in non-distressed ILS issuance has resumed and solutions helped to fuel the market bonds across all perils. Although is again on a growth path. New after the Lehman losses, new issue selling interest vastly exceeded sponsors and investors are levels in the first half of 2009 did buying interest over the first few expanding the market. There has not approach growth levels seen months of 2009, there has been a been a robust deal pipeline in 2009, pre-Lehman. reversion to the norm as buying with total notional outstanding This was partially due to wide interest now dominates the market. issuance expected to exceed $14bn spread levels resulting from the cost In early 2009 the ILW market was by year-end 2009. of cash being re-priced, relative characterised by a sharp spike in Two new sponsors – Assurant value considerations and the prices (from the end of 2008 to and the North Carolina Joint abundance of bonds available in the January 2009) followed by a gradual Underwriting Association/ secondary market. drop to current levels – which are Insurance Underwriting Association This secondary market down about 10-20 percent from the – accessed the market for the first overhang was caused by forced peak. Volume was down compared time this year. Additionally, the liquidations by a few hedge funds to 2008 as supply of capacity greatly World Bank sponsored the MultiCat in the aftermath of the Lehman exceeded demand at indicative Program, allowing countries bankruptcy. By mid-June, as the levels. The low activity in the ILW worldwide to access the cat bond broader financial markets began market may have also contributed market for disaster relief funding. to settle, $2bn of outstanding to an increased demand for cat risk US hurricane and California cat bonds matured and fewer in bond format. earthquake perils continue to companies had accessed the The performance of the cat bond dominate issuance with Central industry loss warranty (ILW) market market in 2009 is well illustrated US, Pacific Northwest earthquake than originally anticipated. by the Swiss Re Cat Bond Indices and European windstorm following (see graph page 12). The cumulative close behind. S econdary squeeze annual growth rate for the All Martin Bisping is With the broader market stabilising, Cat Bond Performance Index C ollateral repairs head of non-life risk and inflows from bond maturities (ACBPI) was 10.58 percent at 20 Innovation of new collateral transformation at Swiss and new capital, the supply- November 2009, while the BB Re, having taken account structures was a key driver charge of insurance- demand dynamics shifted. An Performance Index and the US in resuming new issue activity in linked capital markets increase in demand for bonds Wind Performance Index were at the ILS market. After the Lehman solutions in April 2009. caused spreads to tighten – they 13.4 percent and Continued on page 12

2009 Review; 2010 Preview www.trading-risk.com Some think bank with tradition. We think more than 150 years of innovation.

Since 1856, we have focused on bringing new perspectives to our clients. Understanding the past, but shaped by the future. Always looking at opportunities and challenges from a visionary point of view. Con- sidering from the outset our clients’ goals. Because our sole ambition is to help maximize their potential. www.credit-suisse.com

Thinking New Perspectives.

15409_210x297_PLAZA_par_e.indd 1 5.10.2009 7:39:00 Uhr 12 TR 2009 analysis

Continued from page 10 14.8 percent respectively. Cat bonds deliver impressive returns… Throughout 2009, the composition High yield performance: 1 Jan 2007 – 20 Nov 2009 of the indices has changed somewhat, as the tougher issuance 1.40 10.58% environment resulted in more 1.30 bonds maturing than being issued. 1.20 6.27% At year-end the ACBPI had 86 1.10 bonds in the basket, down from 1.00 105 bonds in November 2008. 0.90 -8.51%* The following table captures the 0.80 total returns for the ACBPI since Index values ACBPI 0.70 Barclays BB US High Yield 2002. Twelve-month returns have 0.60 S&P 500 been positive since 2002, which 0.50 illustrates stable returns relative to 0.40 other sectors.

Few would have predicted Jul Jul Jul Sep Sep Sep Mar Mar Nov Nov Nov Mar May May May the Lehman collapse would

eventually strengthen the ILS Jan 2007 Jan 2008 Jan 2009 market by facilitating more *Compound annual growth rate Source: Swiss Re Swiss Re Cat Bond Index Total Return, calculated by Swiss Re Capital Markets, is a market value-weighted basket of natural transparent collateral structures, catastrophe bonds tracked by Swiss Re Capital Markets, calculated on a weekly basis; past performance is no guarantee of future results. The index is based on indicative prices and may not represent actual bids or oers on any of the underlying cat bonds by but the events that have unfolded Swiss Re or any of its aliates. Such indicative prices may vary signicantly from actual trade prices and from indicative prices through 2009 show this is indeed provided by other parties. The information may not be reproduced or be used in any way without prior written permission from Swiss Re. what occurred. The underlying T otalTotal cat cat bonds bonds outstandingoutstanding by year by year fundamentals of the ILS market 20,000 have been reinforced by the Issued 18,000 financial crisis and investors Remainder 2009 (Announced minus Maturing) Outstanding continue to be attracted to this 16,000 diversifying sector. 14,000 The financial crisis has also 8,801 reduced capital in the $mn 12,000 (re)insurance sector and resulted 10,000 11,884 in lower credit ratings and reduced 12,445 8,000 4,419 capacity. These factors in turn have helped facilitate increased 6,000 3,941 demand in the ILS market as an 4,000 8,462 2,206 alternative source of capacity for 3,502 5,696 685 1,812 2,000 1,412 2,980 reinsurers and insurers. 759 2,388 2,500 2,674 1,125 967 990 1,143 The ILS sector responded 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 quickly and definitively to Source: Swiss Re investor and sponsor concerns over credit exposure in the increase transparency and further this growing asset class. The ILS collateral account structures. minimise liquidity and credit risk sector continues to grow, innovate Newer transactions have been in the collateral. The activities and adapt to changing market structured more conservatively to during 2009 are representative of conditions. C ollateral solutions evolve in 2009…

Selected Solutions Characteristics Pros Cons Used by

TRS with government-guaranteed FDIC guarantees new senior unsecured debt of Government guarantee provides security while c Temporary Liquidity Guarantee Program sunsets Atlas Re V, East Lane III, Mystic Re bank debt financial issuers with the full faith and credit of the yields are higher than treasuries c High cost to sponsor II, Ibis Re FDIC. Expires 30 June 2012 c Mark-to-market volatility c Documentation complex c Exposes risk to swap counterparty

Customised notes by government- c Notes issued by government-backed entities c Highly-rated, stable assets structured to match Additional mechanisms may be required for Reg Calabash Re III, Blue Fin II, Ianus backed issuers (ie KFW, International c Notes generally can be maturity matched cash flows of respective transaction 114 compliance for some entities Bank for Reconstruction and c Investors receive a LIBOR or LIBOR-like c Reduces mark-to-market risk for investors Development) benchmark based return c Efficient execution

Treasury Money Market Funds c Underlying assets are typically government- c Documentation and execution relatively simple Successor II, Res Re, Parkton Re, guaranteed securities such as treasuries c Stable value and secure MultiCat Mexico c Investors receive spread over money market return

Third party daily repo structure c Long term repo with the SPV instead of TRS Assets adjusted regularly to provide accurate c Additional mechanisms may be required for Reg Eurus II c Counterparty repo agreement with SPV and valuation of assets in trust 114 compliance for some entities tri-party agreement with a third party agent c Documentation complex c Collateral replaced daily when schedule of c Relies heavily on secondary market trading and eligible collateral breached liquidity c Concentration limits c Correlation of assets and counterparty credit risk

Bank CDs with AAA/AA banks Simple and replicates TRS payments Unsecured and exposed to bank risk

Source: Swiss Re 2009 Review; 2010 Preview www.trading-risk.com Capital | aCCess | aDVOCaCY | innOVatiOn reDEFINING Capital The financial world is experiencing unprecedented change, and traditional sources of capital may no longer be optimal or even available. How do you know which form of capital is best for you?

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Redefining_Capital_Piggy_Bank_A4.indd 1 12/10/09 11:28 PM 14 TR life

A strengthening pulse…

12 months ago, the life ILS market was L7 was followed by a whopping life ILS sector as “one of the least flatlining. Since then, almost $1bn of life $650mn embedded value deal successful structured finance from Dutch life insurer AEGON markets in the world”. insurance risk has been securitised into and JPMorgan, creating regulatory Ratings agency actions based the capital markets… capital relief for the former’s US on mark-to-market losses in operations. investment portfolios, failed he life securitisation sector JPMorgan securitised $650mn auctions for non back-stopped Tis slowly returning to health of the insurer’s life exposures, commercial paper and the one year after suffering severe releasing future profits from uncertainty surrounding the fate contagion from the financial crisis, an existing portfolio of in-force of the monoline bond insurers which almost brought the market to policies, it announced in October. – which provided credit wraps a halt in 2008. The latest deal takes the value of for the majority of Regulation Although the transfer of life risk the ten-year transaction to $900mn XXX transactions – all led to a has continued mainly in derivative – the first portion having been retrenchment among investors. form – more than £4.3bn of completed in 2008. Among the worst hit bonds were longevity swaps were completed in The transaction comes one Scottish Re’s Ballantyne Re and 2009 (see opposite and pages 28-29) – year after AEGON closed Zest Orkney Re II, UNUM’s Northwind life insurance risks to the value of – a £250mn value in-force life and Tailwind transactions, $865mn were securitised in public insurance securitisation with Genworth’s River Lake and Bank of form in the capital markets in 2009. Barclays Capital that unlocked Ireland’s Avondale Securities. This is a huge leap from the cash tied up in its primary UK However, since then many $255mn securitised in 2008, but still subsidiary, Scottish Equitable. investors have shown increased well below volumes of almost $8bn Finally, Swiss Re closed a interest in the sector – with many in 2007 (see graph and chart below). $75mn extreme mortality cat established asset managers In January 2009, convergence bond in November, spurred by an investigating the class. stalwart Hannover Re proved that anticipated deepening of the H1N1 In June, Credit Suisse Asset the foundering life securitisation swine flu pandemic. Management (CSAM) launched market still has a pulse by closing Swiss Re forecasts a surge in the a $65mn dedicated life ILS fund, L7 – a EUR100mn embedded value transfer of extreme mortality risk demonstrating the resurgent transaction. to the capital markets, predicting popularity of life risk trading. Hannover Life Re’s CEO, Wolf market potential of $5bn-$20bn by The fund – called IRIS Life – Becke, noted that the success of 2019. It cites “significant untapped launched with $65mn of start-up L7 – which released future earnings opportunities” for the sector, capital from third party investors worth EUR100mn through the “supported by increasing pandemic and seed capital from Credit Suisse. transfer of a portfolio of European concerns”. It had targeted $200mn by the year- life and annuity reinsurance In a 2009 Sigma report, the end, according to Niklaus Hilti, business – demonstrates the reinsurer said that the $2.2bn of CSAM’s head of insurance-linked market is still open to “high-quality extreme mortality risk transferred strategies. business” despite the “difficult to date – of which $1.8bn is Meanwhile, Leadenhall Capital situation on capital markets”. outstanding – is “miniscule” Partners hired a specialist life compared to the face amount of actuary to research the fund’s Life bonds issued and mortality risk insured globally. possible expansion into life risks. Lifeoutstanding bonds issued and in outstanding $bn in US$ billion “When the markets re-open, a W aking the dead… life insurance-only fund could be $bn Last year, Goldman Sachs’ Michael palatable to investors,” the firm’s 16 New issues Millette famously described the CEO Luca Albertini predicted. Outstanding from prev. years 12

8 Life ILS transactions 2009 Date Transaction Sponsor Size (mn) Peril/type 4 Jan-09 L7 Hannover Re EUR100 Embedded Value

Oct-09 AEGON AEGON/JPM $650 Value-in-force 0 00 01 02 03 04 05 06 07 08 09 Nov-09 Vita Capital IV Swiss Re $75 Extreme mortality

Source: Swiss Re Capital Markets; Trading Risk Source: Trading Risk

2009 Review; 2010 Preview www.trading-risk.com t r life case study 15

Aviva-RBS longevity swap Towers Perrin Capital Markets’ senior on a monthly basis. basis to secure longevity protection consultant Ernest Eng sheds light on the Under the mirroring swap, RBS when prices are favourable, and syndicates the longevity exposure gives capital markets investors mechanics of the transaction… synthetically to investors by entering a signal that there are further rowing demand for longevity into a total return swap with each potential transactions to come. Grisk-bearing capital has led investor. The insurer is also able to use to longevity swaps being used to In common with many other its preferred legal format – a address the ever-growing concerns over-the-counter (OTC) derivatives, reinsurance agreement – with of insurers and pension funds. there are no provisions for investors the RBS-sponsored GICC, while In March 2009 UK insurer Aviva to terminate the swap. Given the investors are able to transact via transferred £475mn of longevity private nature of the transaction a swap format that they are more risk to the capital markets through and the small number of investors familiar with. The GICC structure a swap arranged and syndicated to involved, the secondary liquidity of also provides Aviva with a more investors by Royal Bank of Scotland this swap is expected to be limited. efficient platform to execute future (RBS). swap transactions if desired. The 10-year swap, which Planting the seeds references a fixed portfolio of The Aviva-RBS swap mitigates the A fair swap annuitants aged 80 and over, has insurer’s longevity risk exposure Aviva’s swap allows investors to advantages for Aviva, investors and by transferring the “at-the-money” gain exposure to a risk that should, RBS. Not least that in a swap there risk, thus allowing the firm to write in theory, exhibit lower correlation is no need to transfer assets to a more annuity business in the future. with market risk on a transaction- counterparty or the ultimate risk The use of an actual portfolio of by-transaction basis, in the investor- holder. annuities as opposed to an index- friendly format of an OTC swap. Instead, the original liabilities and based payout creates an indemnity Longevity swaps, as the name scheme administration remain with transaction, removing basis risk for suggests, have an element of built- Aviva, which reinsures the longevity Aviva. in leverage to enhance expected risk with an RBS-sponsored Although Aviva said achieving returns. This would be highly Guernsey Incorporated Cell capital benefits was not the main appealing to investors, particularly Company (GICC). The GICC then objective of its first longevity swap, in the current environment, where transforms Aviva’s original longevity it delivered improvements to its acquiring external leverage is exposure from reinsurance to a capital position and also had a difficult, if not impossible. swap format. small impact on reported IFRS and Given the current imbalance Aviva pays pre-defined fixed embedded value figures. between the supply and demand payments – based on expected In future, it is likely that longevity for longevity solutions, the yields annuity payments from the swaps will be executed specifically are likely to be attractive (on both reference portfolio – and receives to regulatory capital requirements. an absolute and relative basis) floating payments, which are As such, the motivation for to investors looking to maximise determined by Aviva’s actual transferring longevity risk via swaps the “alpha” component of their mortality experience. (and similar structures) can be investment returns. Compared to From a counterparty credit risk expected to increase, especially longevity bonds, longevity swaps perspective, the structure of the under Solvency II. do not need a formal rating and are swap allows Aviva to “look through” The swap also gave Aviva limited much more efficient to execute. to RBS as the ultimate counterparty, access to capital markets longevity For investors, referencing the swap using a mirroring swap between pricing levels, which it can choose on a fixed portfolio of annuitants the GICC and RBS. To mitigate the to factor into its primary annuity means that the longevity exposure credit risk exposure, collateral is prices. Aviva’s swap structure gives is known from the outset, while posted between the parties to the it the option to enter into repeat the longevity-only risk offers transaction and marked to model transactions on an opportunistic diversification without any asset or investment risk. T ransaction overview Given the relative illiquidity of the Fixed/oating Aviva longevity swap, it is likely that Mirroring swap swap payments the investors have adopted a “hold- Premiums Investor to-maturity” approach to their Guernsey Aviva Incorporated Cell RBS Investor investments. These investors may Claims also reap some additional benefits Investor Reinsurance to the extent that there are novelty Contract Longevity swaps (and illiquidity) premiums for Source: Towers Perrin Capital Markets bearing longevity risk this way.

www.trading-risk.com 2009 Review; 2010 Preview 16 TR interview

The reinsurer’s perspective

Craig Hupper, director of risk management at global reinsurer Transatlantic Reinsurance Company (TRC), explains how he views the convergence market…

I n your opinion, what has support. Reinsurance has provided evaluate risk transfer options, we been the most significant one of the safest harbours in the ask lots of questions; including development of 2009? financial storm. setting our appetite for basis risk The affirmation of traditional within our portfolio. We evaluate reinsurance as a vital risk financing How do you compare the counterparty credit quality. We tool. The industry has passed a various risk transfer options assess impacts on our risk-adjusted major stress test, to both sides of available to you? returns, compared with the value the balance sheet, over the last Our starting point is that of downside protection. year. Even after Hurricane Ike, the reinsurers come in at the end of We also question how rating global financial crisis, the subprime the exposure risk chain. Part of agencies, regulators, investors and meltdown and other “unthinkable” our value proposition is to exploit other constituents evaluate the events, reinsurers have come diversification and portfolio effects alternatives. through quite well. by pooling uncorrelated exposures Can we establish a long-term Reinsurers have continued to pay in ways that our clients and their commitment? Will capital markets claims and to provide customers customers often can’t do. be available after an event, to with critical capacity, expertise and But since we are already reload the balance sheet? diversified, it can be challenging to The answers to these questions find someone with a comparative aren’t always intuitive, and may advantage in assuming our point in different directions. exposures, especially after expenses and concerns about How has Trc accessed the information asymmetries. convergence markets to date? For diversified, financially strong We recognise both the companies, one alternative to opportunities and challenges transferring risk is to eat our posed by convergence and risk own cooking and retain the securitisation. So we keep our risk ourselves. As part of our fingers on the market pulse by enterprise risk management constantly talking to people, (ERM) process, we spend and monitoring deals and other a lot of resources on risk developments closely. We’ve optimisation. We try to find bought retrocession protection the best balance between from some of the capital markets assuming risk – across cat vehicles, while also buying different lines and different from traditional markets when regions – and transferring it makes sense. We have made it externally. Often, the most an investment in a dedicated cat attractive option is to adjust our fund, Juniperus Capital. We want assumed portfolio, and simply to to be leaders in the marketplace, retain exposures ourselves. This regardless of the form convergence also keeps us from becoming too takes. reliant on counterparties, in whatever form. W hich areas of the When we convergence market are most compelling to TRC at the moment, and why? Given our concerns about basis risk, we are particularly

2009 Review; 2010 Preview www.trading-risk.com t r interview 17

interested in true indemnity picked up again. modelled under a conventional approaches. By this I mean That said, in late 2008 and early framework. When I talk to traders, protections that effectively mirror 2009 the ILS market seemed to their focus is on the current market the risk of our assumed portfolio, freeze up for new issues. There price – regardless of whether that is even for non-natural perils or is still concern that the capital the correct price for the risk. perils no one may have considered, markets are fickle and look at Underwriters historically are but which are still covered under reinsurance as just another trade, more buy-and-hold oriented. our inward contracts. This type of while reinsurers are fundamentally Once they bind a deal, they risk transfer is most attractive to us committed to the business. usually hold the risk until at least on a worldwide basis, so we don’t Disruptions like this are one the next renewal, as part of an have to buy multiple silos for each reason why risk managers are ongoing relationship. They only region. leery of over-reliance on a single sell insurance and reinsurance We are interested in leveraging risk financing approach and want contracts. For the most part, they our underwriting expertise by multiple options, between focus on covering identifiable originating additional risk into the (re)insurance, self-insurance, goods and services. capital markets, while maintaining captives, ILS and other capital Even with all the data available our own net risk tolerances. market instruments. now, underwriting decisions often We have discussed “reserving” still come down to experience, capital with investors, so we can I s insurance just an annual judgement and even art. quickly put it to work after an renewal game, or can it really Underwriters are clearly attuned event. be traded dynamically? to market conditions and prices, As a leading casualty reinsurer, Some (re)insurance is already but tend to focus on what the we are also interested in traded dynamically, but moving correct price should be for a given approaches to hedging longer- to true real-time trading will exposure, even if the market price tail, non-cat risk. Transferring is different. portfolios of different lines – for “We recognise both the example bundles of cat, aviation, W hat poses the greatest threat marine and casualty risks – also opportunities and challenges to convergence in 2010? may be attractive if investors can Disintermediation is one of the gain a level of comfort with the posed by convergence and risk emerging risks we’ve identified in exposures. securitisation. So we keep our our ERM process, and we’re always thinking about threats where risk D espite significant softening fingers on the market pulse” could bypass reinsurers. throughout 2009, is the price While convergence could pose of capital markets capacity such a challenge, we think of it just too high? require several things. Exposure as an opportunity to leverage There is no single answer to that information and portfolio our expertise in originating and question. Spread or rate on line simulations need to improve, also pricing risk and assembling is obviously a critical part of the there would be more emphasis effective portfolios. We think these buying decision, but needs to be on collateral management, which are critical skills, with significant evaluated alongside credit quality, must be tracked effectively. In barriers to entry, and we welcome value-added services, basis risk order to dynamically trade risk, both the potential competition and other factors – including self- (re)insurers will need to improve from the convergence market and retention of the exposure. basis risk management, or get the options it provides to manage Reinsurance is also still a comfortable accepting more of it. our exposures more effectively. relationship business, with greater Much boils down to this: expectation of a long-term view Even with all the activity in the Craig Hupper – and a company’s reputation is convergence space, there are still a critical part of that. It is very real differences between trading Craig Hupper is vice president and director of risk difficult for the capital markets and underwriting cultures. management at TRC, where his responsibilities to replicate the expertise, insight As a gross generalisation, traders include development and implementation of and flexibility that a sophisticated are transaction oriented, and the comp any’s enterprise risk management reinsurer provides to its clients. move in and out of positions framework. Hupper joined TRC in 1998 and opportunistically. They may served in underwriting and ceded retrocession T hroughout the financial cri- trade synthetic assets, where the roles before establishing the risk management sis, has the ILS market proved instruments seem pretty removed group in 2005. itself a worthy capital from tangible exposures. They’re New York-based reinsurer TRC offers both complement to reinsurance? more immediately focused on treaty and facultative reinsurance – structuring Questions about ILS collateral opportunity costs, and how risks programmes for a full range of property and seem to have quietened down and rewards compare across lots casualty products, with an emphasis on specialty with recent adjustments to deal of asset classes. They’re reluctant risks. structures, and the market has to take risk if exposures can’t be www.trading-risk.com 2009 Review; 2010 Preview 18 TR nyc

Cat bond wizards defy storms The catastrophe bond market has faced down its fiercest challenge yet and the guild of alchemists who transform reinsurance risk into capital markets instruments are confident that growth will return in 2010…

his was the over-riding theme Goldman Sachs partner high pricing levels of early Tfrom Trading Risk’s annual and co-head of Americas 2009, we’re not falling back to a New York conference in October, securitisation, Michael Millette, soft market level, but to a very where nearly 200 investors, characteristically praised the respectable pricing level,” he said. advisers and sponsors gathered to industry for its resilience in Aon Benfield Securities compare techniques and gaze into weathering the financial storms president Paul Schultz observed the 2010 crystal ball after a year and for being the only segment of that secondary pricing on which began with the shockwaves the structured finance markets to 2009 cat bonds had tightened from Lehman Brothers and ended have “restructured itself without by approximately 25 percent with a credible $3bn+ of ILS any government intervention”. throughout the year, with bonds issuance. However, Millette noted at lower expected loss – around 1 percent – falling 32 percent by “So if we fall back from those high pricing early October (see graph on page 20). Swiss Re Capital Markets levels of early 2009, we’re not falling back managing director Judy Klugman to a soft market level, but to a very praised a successful year for the convergence market, which was respectable pricing level” an active and liquid environment for new issuance and secondary Michael Millette, Goldman Sachs trading, while attracting stable investors back to the sector. that the cat bond market “got She noted that at least 25 new ahead” of expected hardening investors have entered the space in the traditional catastrophe since 2007, adding to its depth and reinsurance sector, with prices breadth. for Q1 and Q2 ILS rising to “the Although dedicated ILS funds’ highest levels in the entire history share of 2009 issuance was of the market”. He warned that unmoved from its 2007 level of 46 the cat bond market “now has to percent, reinsurers increased their trade back into conformance with share of cat bond capacity from 5 reinsurance in order to bring on percent to 15 percent, and money issuance”. manager participation fell to 13 “So if we fall back from those percent from 23 percent over the

2009 Review; 2010 Preview www.trading-risk.com t r nyc 19

same period (see charts right). T he evolving ILS transactions,” Rettino said. Despite painting a rosy picture Nephila Capital principal Barney of the current ILS sector, the investor base Schauble described the $5-7bn audience and panel engaged in cat bond sector and the $6bn+ a lively debate over transparency 2007 industry loss warranty (ILW) 3% and disclosure in the convergence 5% market as small in the context of market. the approximately $160bn over- Ex-Stark Investments’ portfolio the-counter reinsurance market, manager, Tony Rettino – now noting that ILWs and cat bonds of Elementum Advisors – 14% suffered from “limited price commented that the lack of transparency, irregular issuance transparency in the ILS market 46% and limited liquidity”. was an “important contributor” to 9% “Access to all four markets allows the market dislocation of 2008-09. for best relative value portfolio Rettino said that Stark was construction and hedging among unable to fully review its collateral markets,” Schauble said. 23% investments and underlying ILS Lane Financial president Morton agreements in the aftermath Lane stated that the ILS market of the Lehman collapse, due to Continued on page 20 “the difficulty in obtaining the 2009 necessary information, which 4% in some cases was not even “[Price transparency]is one of the available”. great contributions of the ILS He said: “Better transparency 15% would have clearly reduced the market to traditional reinsurance” mark-to-market impact of the Lehman bankruptcy, enabling Morton Lane, Lane Financial 46% the ILS market to trade at tighter 17% and more differentiated spreads instead of cat bonds being indiscriminately marked down.” Rettino compared the ILS 13% market to the collateralised 5% reinsurance market, where “the range of permitted investments Dedicated fund is negotiated and investments are generally controlled by the Money manager investor and/or reinsurer”. Bank Highlighting another Hedge fund opaque corner of the ILS and collateralised reinsurance Reinsurer market, he called for more Insurer disclosure regarding the Source: Swiss Re underlying exposures in deals at inception and also during the life of a transaction. “This lack of transparency is most pronounced in indemnity and modelled loss www.trading-risk.com 2009 Review; 2010 Preview 20 TR nyc

Continued from page 19 had made significant elsewhere. At the same time, the ILS “Better transparency would have developments in transparency market seized up, Slade said, leaving during 2009, adding that it was the volatile ILW as the best option clearly reduced the gratifying to see the sector return to for protection. mark-to-market impact of its original message of “pure play, Slade added that the biggest secure play and fair play”. considerations for Flagstone Re in the Lehman bankruptcy” Lane called for capital markets assessing protection options were investors to have access to “the basis risk analysis and the rating Tony Rettino, Stark Investments same information as other agencies’ treatment of deals. reinsurers and at the same time”. Countering Rettino’s comments on Spreads tighten in the secondary market… price transparency, Lane asserted that it is vital to the liquidity of the 18 market and “is one of the great contributions of the ILS market to traditional reinsurance”. Representing the traditional 14 market at the event, Flagstone Re’s head of capital markets, Brent Slade, did not rate transparency as one of the key considerations when deciding whether to access the 10 Bid Spread US Multi Peril 9 October 2009 capital markets for protection. Questioning whether 2009 was an (%) Risk Spread Premium 2009 Spread at issue opportunity lost for the convergence market, Slade noted that retro 6 capacity was limited during the year 0.75 1.25 1.75 2.25 2.75 3.25 3.75 and pricing was volatile, sending reinsurers to search for capacity Expected Loss (%) Change is the Mother of Invention (and Profit) in Reinsurance IFEX US Tropical Wind Event Linked Futures

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A4 IFEX ad.indd 1 15/06/2009 18:26 22 TR industry loss

insurance carriers after Wilma, PCS counted another 77,000 losses. PCS attributed that significant increase It takes time to secondary homeowners, many of whom did not go to Florida until after the holiday season. When they arrived, they found damage to their to get it right residences that was not visible from the outside and had been overlooked by friends, relatives and real estate Property Claims Service (PCS) loss estimates form the definitive trigger on managers. $3bn of outstanding cat bond capacity and approximately 90 percent of the It is important for insurance $5bn industry loss warranty and cat futures market. Gary Kerney explains carriers to rely on completed the process of producing insured property loss estimates… inspections of damaged properties to better gauge the atastrophes involve millions of destruction caused by Hurricanes effect of a catastrophe on their Cclaims and billions of dollars in Katrina, Rita, and Wilma (KRW). All policyholders. As insurers fine-tune damage, with causes ranging from three storms struck the southern loss information, they are better hurricanes to earthquakes to hail US within two months – and the equipped to tally the extent of both storms. insured losses they inflicted now insured and uninsured damage, As such, estimating insured rank as the first, ninth and sixth such as household flooding. property losses from catastrophes costliest hurricane losses in history. Information obtained from is challenging. Identifying the While 2006 and 2007 were completed adjustments is valuable Gary Kerney is assistant geographic areas affected by an hurricane-free seasons, 2008 in setting loss reserves, and it also vice president at event and compiling an estimate of brought another round of events helps manage insurers’ catastrophe Property Claims Service the total insured property damage that challenged insurers and their response plans. After KRW in 2005, (PCS). Responsible is not an exercise to complete in adjusters to provide swift relief. PCS estimated the average personal for catastrophe haste. It takes time to get it right. Three hurricanes – including Ike and lines loss at nearly $12,000 – vastly identification, loss In recent years I have seen how Gustav – and two tropical storms different from the $1,800 average of estimating, and catastrophe response external issues influence the (PCS did not declare a third tropical the late 1990s. and mitigation activities, ultimate payments that carriers storm to be a catastrophe) struck In 2008, the average personal lines Kerney manages PCS’ make. Those influences include the US. loss – including hurricane losses divisional operations. loss amplification – or demand A second challenge is the huge – was nearly $6,000. In 2009, with surge – and political interference or numbers of claims from catastrophic no hurricane landfall to speak of, intervention. In addition, insurers events. In 2005, PCS estimated that the average personal lines loss was are subject to class action lawsuits insurance carriers received about nearly $5,000. All these figures are accusing them of not paying claims, 4.4mn claims. In 2008, the number still greater than the average losses even though that damage may not of catastrophe claims totalled nearly measured less than a decade ago. have been insured. 4.1mn and in 2009 to mid November The scope of property coverage PCS recognises – in a benign hurricane year – varies by insurance carrier, policy that those influences the number was type, line of insurance and claims can cause insurance payments to adjustment variations, and also increase. That’s why we instituted changes over time. PCS our resurvey process, which allows us to compile a reasonable estimate of total insurance payments following a catastrophe. To compile reliable 2.2mn. and reasonable Before the onslaught of estimates after Hurricane Wilma in south Florida, most insurers estimated that screened enclosures around pools catastrophes, and patios would add between wades through we must $6,000 and $8,000 to the value of insurer reports to compile overcome some a home. In the aftermath of that a useful and viable measure serious challenges. One hurricane, the replacement cost of insured damage. The PCS process is the effect of concurrent for these “lanais” balconies was does not lend itself to overnight catastrophes. For example, in 2005 generally in excess of $25,000 — calculations. But while it insurers, policyholders and other primarily due to material and may not be the quickest groups faced the installer shortages. process, it is the In the course of its best. second resurvey of

2009 Review; 2010 Preview www.trading-risk.com Know your risk. Know your exposure.

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Sector Re III-2 Limited Vega Capital Ltd. Sector Re II Limited $75mm Common Shares $150mm Principal $150mm Participating Notes At-Risk Floating Rate Notes Sole Bookrunner 2009 Sole Bookrunner 2008 Joint Bookrunner 2008

Trading_risk_Annual_Conf_Tombstone_EN_GBR_171209.indd 1 18.12.09 07:49 t r credit suisse 25 Saluting excellence Credit Suisse Asset – which will provide a number lead to increased volatility over the Management (CSAM) is the of boosts to the trading of (re) next decades. insurance risk, not least by bringing Population shifts to more exposed headline sponsor of the transaction structuring skills. areas such as coast-lines; high tech Trading Risk Awards 2010. Another boost will be derived and high value concentrations CSAM’s head of insurance- from a need for investors to seek in low sea level areas such as new markets – there is great Germany and the Netherlands; linked strategies, Niklaus pressure at the moment to generate concentration in earthquake Hilti explains why his firm new streams of transactions regions such as Japan, Taiwan and Niklaus Hilti is head is so keen to support the of insurance-linked and incomes. This will increase California or in flood defended sector’s achievements strategies at Credit Suisse competition among ILS-asset regions like London are building Asset Management managers. up enormous vulnerabilities in (CSAM), administering The current economic today’s society. The global use of a portfolio of Q: What attracted Credit Suisse to environment will prove to be technology such as GPS in the approximately $2bn of a seminal moment for the aviation sector makes our life very the convergence sector? insurance risk across life and non-life ILS, ILWs, development of the insurance- dependent on catastrophic events Insurance linked strategies offer an derivatives, collateralised linked market. impacting satellites, for example. attractive and low or un-correlated quota shares and We believe that over the next stream of returns to investors, collateralised reinsurance. Q: What factors are shaping decades, along with the growth of and offering true alternative the development of the sector emerging markets, the global need investments and innovative currently? for (re)insurance will increase products is key to CSAM. Credit On the non-life side, the market – helping to protect assets and Suisse group has been active in is being shaped by the pressures securing wealth and achievements. insurance-linked investments since within investment banks. The the early days, and has built-up a increased demand on the investor Q: What do the Trading Risk strong presence in the market. Awards mean to you? “The Awards are a platform to For a long time, the insurance- Q: Where do you see the linked investment sector was insurance-linked capital markets honour these people with whom lacking a platform for information in 12 months’ time? we have worked for a long time to exchange and press coverage. We believe there will be a There is a lot of talent, skill and tremendous growth of diversity develop this growing sector” innovation amongst ILS managers, in the markets. On the investor investment banks, reinsurers side we see a large number of and our competitors – the asset investors entering the market from side for true alternative investment managers – which deserves respect across the globe. As a result of with low correlation to financial and recognition. The Awards are a the recent global financial crises, markets will send investors to the platform to honour these people many institutional investors came insurance-linked sector. with whom we have worked for a to recognise the merits of a true On the life insurance side we long time to develop this growing alternative investment and hence will see a gap opening. On one sector. are entering the insurance-linked hand the investment returns are market. below expectations and required Increasingly on the (re)insurance levels over the long term. On the side, broad access to capital is other, longevity is improving at becoming a key differentiator for an an accelerated speed, leading to insurance franchise and hence we a potential long-term mismatch see more interest and demand from for our pension and life insurance (re)insurers to access alternative companies. risk capital through diversified Globalisation and climate channels. change will also have an impact We expect the cat bond market to on life insurers through the need grow by 20 percent, coupled with to mitigate the effect of – or strong growth in the life insurance raise additional capital due to capital markets. As a result of the losses from – diseases and global financial crisis, talent from the warming. investment banking sector spilled We believe that globalisation and out into the convergence arena improvements in technology will

www.trading-risk.com 2009 Review; 2010 Preview Welcome to Trading Judging panel Dan Ozizmir – Ozizmir spent almost a decade building Risk Awards 2010 Swiss Re Capital Markets (SRCM) – the firm’s market leading ILS investment banking operation. Trading Risk, the leading publication dedicated to the Under Ozizmir’s leadership from 2000-2009, SRCM was instrumental in the development and growth of the ILS convergence of the (re)insurance industry with the market and earned many industry awards – including capital markets, is proud to present its second annual Manager of the Year at the inaugural Trading Risk Awards 2009. awards celebrating excellence and innovation. Ozizmir left Swiss Re in June, having joined from Greenwich Capital Building on the success of the inaugural awards in in 2000, where he helped build its mortgage business and held senior 2009 – which gained huge market support, demonstrated positions in trading and management. by the high calibre and quantity of entries – I hope the Ozizmir graduated from Columbia College in 1985 with a BA in Trading Risk Awards 2010 will raise the benchmark of political science and economics. professionalism and achievement in this fast developing market. Morton N Lane, PhD – President Lane Financial LLC As the editor of Trading Risk, I am constantly A pioneer in the move to securitise insurance risk, Lane impressed by the determination of those in our sector provides consulting and risk management advice to investors in, and issuers of, insurance-linked securities. to develop the traded (re)insurance risk universe. He is president of Lane Financial LLC, a registered These awards – which will be decided by an independent broker-dealer. panel of industry figures – are a way of acknowledging Lane is an esteemed authority on the convergence sector, writing and rewarding the pioneering spirit that is driving the numerous papers and studies on securitisation, editing the Alternative sector’s development. Risk Strategies publication and co-authoring two books on the Indeed, Trading Risk has fast become the leading derivatives industry. publication dedicated to insurance-linked securities He has taught at the London Graduate School of Business, the (ILS), exchange and OTC-traded risk, loss warranties, University of Chicago and is currently a Visiting Professorial Fellow at sidecars and all non-traditional forms of risk the University of New South Wales. transfer. Dr Lane is a graduate of the University of Birmingham in England It provides the ideal and earned his PhD from the University of Texas. platform for our awards. Simon Cloney – Managing director, Beach & Associates. We look forward to your Managing director of Asia-Pacific operations at involvement. convergence intermediary Beach & Associates, Cloney has 25 years of (re)insurance experience, specialising Yours faithfully in treaty reinsurance prior to joining Beach in 2005 to develop a capital markets capability. Beach & Associates is a leader in working with hedge funds and other non-traditional sources, to provide unique reinsurance solutions for both retrocessional and non-retrocessional portfolios. The firm’s capital markets capability is fully integrated within its treaty Rebecca Bole, Editor reinsurance teams in London, Sydney. Toronto and New York. Cloney has worked on collateralised ILWs, collateralised sidecars and whole account retro indemnity excess of loss private placements.

Rebecca Bole – Editor, Trading Risk Andrew Martin – Director, Optex Group Ltd An insurance professional with more than 10 years Optex Group is an FSA-authorised convergence-focused underwriting experience in the London market, Bole advisory firm. Martin has almost 30 years of experience joined Insider Publishing in 2007 and launched Trading in trading (re)insurance risk. Martin was instrumental Risk in January 2008. in the creation of the first series of catastrophe bonds As a financial institutions underwriter – spending in the late 1990’s with joint venture Sedgwick Lane seven years with ACE Global Markets as a senior underwriter – Bole’s Financial. He established and headed London’s first (re)insurance clients included global investment banks, stock and commodity broker licensed to trade options on the Chicago Board of Trade exchanges, brokers, insurance companies and hedge funds. [CBOT] and acted as an adviser to the CBOT insurance derivatives She is an associate of the Chartered Insurance Institute. As editor team. of Trading Risk, Bole has a unique perspective on the convergence Martin was also a member of the Alternative Risk Transfer working landscape. group formed by Lloyd’s of London. Award categories

Young Meteor of the year (Re)insurer/Sponsor of the year Entry criteria: The candidate will be an individual, aged 35 or Entry criteria: Candidates will be (re)insurers who have either under on 31 December 2009, and working in the convergence demonstrated an ongoing commitment to the convergence sector sector. Although young, the winner would already have made through consistent ILS issuance and/or adoption of new trading risk a significant contribution to the sector, clearly demonstrating technology, or a newcomer to the market who has researched the playing a solid role in the future of the convergence market. sector and sponsored an innovative deal. Candidates must be nominated, or supported by their departmental manager. Transaction of the year Entry criteria: Nominations will be welcomed for a life or Derivative initiative of the year non-life peril insurance-linked securitisation which either breaks boundaries in ILS innovation, or cements the foundations of a core Entry criteria: Candidates will be derivatives intermediaries, ILS transaction. exchanges, (re)insurance companies, broking houses, capital The winner will be an efficiently structured, well priced and markets teams or risk modelling firms whose endeavours in the successfully executed transaction. The winner will be either an insurance-linked derivatives sector has significantly aided its individual, or a team, which has structured the transaction. development. The winner will be a corporation or a team which has made an outstanding contribution to improving transparency and liquidity in the trading of insurance-linked derivatives in the Manager of the year past year. Entry criteria: Candidates will be investment banks, capital markets divisions within broking houses or (re)insurance companies who provided an outstanding service to the ILS space in the past Outstanding contributor of the year year. The winner will be a company or a team which has either Entry criteria: The candidate will be an individual working in the demonstrated an ongoing commitment to the convergence convergence sector. The winner will have made an outstanding sector through consistently managing ILS transactions and/or the contribution to convergence in the past year, and consistently over successful launch of new trading risk technology, or a newcomer to the market’s development of this sector. the market who has enriched the sector through its involvement. Investor of the year Adviser of the year Entry criteria: Candidates will be institutions, individuals or Entry criteria: Candidates will be professional advisers to the investment teams who have made an outstanding contribution to convergence sector, including legal, professional services, actuarial the development of the ILS investor community in the previous and risk modelling firms who have helped to foster and structure year. The winner will have demonstrated either a continued, deep innovation to further the development of the space. The winner commitment to the ILS sector, success in attracting new investors will have been instrumental in developing either a new trading risk through a fund, an innovative or pioneering approach or a technology, bringing new perils to market or new instruments for commitment to research and understand the sector. trading risk.

Headline sponsor For further information… …about the Trading Risk Awards 2010 or if you need assistance with your entry please contact: Sponsored by In association with Aimee Pitt Insider Publishing Asia House 31-33 Lime Street London EC3M 7HT

Tel: +44 (0)207 397 0619 Email: [email protected] 28 TR derivatives

Out of puff? A benign 2009 wind season and low volumes did little to silence the doubters over the potential for cat derivatives trading. But the faithful remain optimistic… he trading of insurance-linked exchange to provide cat futures of CHI trades have been matched Tderivatives read as a tale of two clearing, offering contracts and posted on exchange”. This sectors this year. which mirror ILWs, triggered by contrasts with the near $100mn of While a benign US wind season catastrophe industry loss estimates net limit traded to the end of 2008, and adequate reinsurance capacity from industry data provider according to the CME – which dampened nat cat futures activity, Property Claims Services (PCS). acquired the instruments in March a desire for diversification from There has been no trading in the on the demise of reinsurance investors and a lack of traditional 2009 or 2010 Eurex contracts to broker Carvill which originally capacity drove the life market date, but Christian Baum, director launched the initiative in 2007. to new levels of innovation in of product strategy at Eurex, noted Prices on most CHI contracts – longevity swap trading. “high interest” in the products from wind futures with a parametric The more established industry firms seeking to open accounts trigger based on hurricane wind loss warranty (ILW) market traded with Eurex clearing members. speed and radius at landfall – strongly – after pricing was pushed On the flip side, disappointing plummeted during the course down from the almost peak 2007 over-the-counter (OTC) trading of the wind season. A first event levels early in the year – to close volumes pushed the world’s largest just behind 2008 volumes with interdealer broker ICAP plc and $5.5bn of capacity traded (see pages insurance intermediary JLT to close PERILS index boosts 30-31). their joint venture vehicle, ICAP- European ILW trading But trading in the Chicago JLT Ltd. Climate Futures Exchange’s (CCFE) ICAP-JLT cited “current market The newly-launched PERILS European windstorm industry loss index was first used as the trigger on two IFEX and Chicago Mercantile conditions” for the immediate ILW contracts in December, opening insurance-linked Exchange’s (CME) CHI instruments closure of the stand-alone cat swap derivatives to non-US perils in a meaningful way. suffered from high pricing, wide broking desk in September. The The much-anticipated initiative aims to replicate the bid-ask spreads, a lack of liquidity desk brokered more than $350mn success of the US Property Claims Service by becoming and a dearth of storms to provoke in OTC contract limits across a standard benchmark for the insurance-linked capital the live-cat trading needed for more than 70 transactions since markets. dynamic exchange trading. it started trading cat swaps, ILWs Swiss-based PERILS – which launched its windstorm Having burst out of the blocks and cat bonds in January 2008. index a month ahead of schedule in December – will provide an independent source of data to determine However – like other insurance- in late 2007 – the notional volume the property market loss arising from a large European of cat derivative trades exceeded linked derivatives ventures – it windstorm event. This information will be used to $500mn in the first 18 months reported a steep decline in volumes produce an index value to determine the payout of the of trading to April 2009 – a quiet throughout 2009. protection under the ILW contracts. 2009 did little to silence the Interdealer broker Tradition PERILS was established in February 2009, and has cynics. However, in the wake of – which brokers the CHI futures – received “tremendous support” from the industry, the global financial crisis – and noted that of the almost $500mn indicating a “true market need” for the product, according to CEO Luzi Hitz. the heightened sensitivities worth of bids and offers passing The firm will provide two products to subscribers such around counterparty credit risk – through the broker in 2009, “$40mn as (re)insurers, brokers, risk modellers and banks – exchange-trading of insurance risk aggregated industry-wide exposure data to CRESTAzone attracted (re)insurers’ attention. level and post-event loss data by risk type and CRESTA- Market participants highlighted zone. the credit protection provided The data will initially be provided for European by an exchange, acting as central windstorm focussing on Belgium, Denmark, France, counterparty and providing credit Germany, Holland, Ireland, Luxembourg, Switzerland and the UK, with a view to expand to other countries in 2010. mitigation, contract certainty and PERILS is currently supported by more than 50 potential payout right after the insurance companies across Europe, from small, local event. businesses to large, international insurance groups, who And the arrival of the leading are contractually bound to provide exposure and loss European derivatives exchange, data in a standardised format to PERILS. Eurex, in June this year The firm reached its threshold market share of 40 demonstrated a continued belief in percent of pre-and post-event industry loss data and 60 percent of European industry windstorm exposures in the exchange trading of insurance- October. linked risk. Eurex was the first European

2009 Review; 2010 Preview www.trading-risk.com t r derivatives 29

Eastern US contract with a strike Bursting with life asset class. value of 15 was quoted at a rate on In contrast to the natural Aon Benfield projects a £10bn line equivalent of 8.11 percent in catastrophe insurance derivatives market, which is set against October 2009, whereas the same market, the transfer of life studies suggesting that pension contract was priced at 31.5 percent insurance to the capital markets liabilities for private companies in May. took off in derivative form in 2009. within the UK exceed £1tn and Trading in the IFEX wind futures Commentators estimate that the that companies are more actively – which are ILWs in derivative longevity swap market is poised seeking ways to transfer longevity form – fell just short of $40mn this to grow to up to £10bn in several risk and reduce volatility of their year, with trading cited as being years, after the latest £1.9bn balance sheets caused by the “lumpy” over the wind season. transaction between UK insurer financial market disruption and Prices plummeted as the season RSA and Goldman Sachs took increased regulatory scrutiny. progressed, with the 2009 $10bn the value of longevity reserves To date, index-linked transactions first event IFEX US wind contract transferred to the capital markets have proved a successful capital priced at a 45 percent rate on line to more than £6bn since February management tool and a source of equivalent in June, falling to just 2008 (see table below). additional traditional (re)insurance four percent at the beginning of Meanwhile, SCOR added a new capacity. If the market continues in October. $75mn lower layer of protection this direction, a liquid, transparent The insurance-linked derivatives to its four-year mortality swap and active longevity risk market sector still struggles with a lack transaction with JP Morgan – the would enable those institutions of liquidity, oft-blamed for a lack first derivative transfer of extreme with substantial longevity risk of active trading. Traders can mortality risk. exposure to hedge this risk, while rarely agree on a contract price, The fully collateralised indexed allowing others to trade and invest with bid-ask spreads often in transaction – which was originally in it. multiples of a percent rather than signed in February 2008 – is The latest longevity swap closed the marginal basis point difference weighted against a combination in July 2009 between RSA, Rothesay seen in more mature markets. Even of US and European population Life and Goldman Sachs. It saw the presence of market makers, mortality and will see SCOR receive the UK insurer hedge £1.9bn – including Deutsche Bank on the up to $230mn once the index is or around one third – of its UK IFEX platform, has not spurred the triggered. pension schemes’ liabilities with traditional (re)insurance market Although the transfer of longevity Goldman Sachs. In May, Babcock – for whom the mind-step to and mortality exposures to the International Group was the first dynamic trading is a big one. capital markets via index-linked corporation to hedge its pension In the quest for higher trading risk transfer is still in its infancy, fund risk via a £500mn longevity volumes – and after two years it poses “significant untapped swap with Credit Swiss. of market consultation – the opportunities” for the convergence To aid liquidity and ease of International Swaps and sector, according to a September execution, various indices have Derivatives Association (ISDA) report from Swiss Re’s Sigma unit. been developed to aid the transfer launched a standard template for The report cites “increasing of life risk to the capital markets, trading US wind event futures in pandemic concerns and the with Credit Suisse starting in 2005, June. savings and retirement needs of followed by JPMorgan’s LifeMetrics The ISDA standards – from the an ageing global population” as in 2007, the QxX index by Goldman global trade association for OTC the main reasons for increased Sachs and Deutsche Börse’s Xpect derivatives – should allow cat demand from (re)insurers in the 2008. swaps, futures and options to be traded more transparently and L ongevity and mortality swap transactions efficiently. The template – which Date Peril Insurer/Issuer Lead investor Arranger Amount (mn) was based on a Swiss Re standard Jul-09 Longevity RSA Rothesay Life Goldman Sachs Goldman Sachs £1,900 created for industry loss warranties May-09 Longevity Babcock International Credit Suisse Credit Suisse £500 – provides standard definitions Mar-09 Longevity Norwich Union PartnerRe RBS £475 for key terms such as risk period, Feb-09 Longevity Abbey Life Pacific Life Re £1,500 extension threshold, termination Oct-08 Longevity AXA Reinsurance Group of America £1,000 date and a menu of standardised choices for US wind. Aug-08 Longevity Canada Life JPMorgan JPMorgan £500 Feb-08 Longevity Lucida JPMorgan JPMorgan EUR100

Feb-08 Mortality SCOR JPMorgan JPMorgan $230

Source: Trading Risk www.trading-risk.com 2009 Review; 2010 Preview 30 TR Ilws Quenching the market’s thirst The ILW market is still a small component of traditional reinsurance, but it provides a pool of vital capacity. Willis Re executive director Henry Kingham leads us to the water’s edge…

ore than $30bn of industry from $5bn to $70bn+, although – albeit to a much lesser extent – Mloss warranty (ILW) capacity – since 2005 the lowest entry for US Japanese wind and quake contracts, representing approximately $4.5bn nationwide wind has typically been UK wind and flood, tornado/hail, of premium – has been traded since $10bn. terrorism, marine and aviation 2003. For nationwide and regional US ILWs. Despite strong market growth wind and earthquake perils – which Notably, in 2009 Willis Re post-Hurricane Katrina, the sector account for more than 85 percent experienced a significant upswing is still small in comparison to the of limit traded (see pie charts) – the in non-US contracts (see pie charts). traditional catastrophe reinsurance accepted ILW loss trigger is the Non-US ILWs rose to 26 percent of market – with its estimated $200bn Property Claims Service (PCS) loss total capacity in 2009, due mainly in annual deployed capacity. But estimate. to the strength of the Japanese the ILW market punches above its European windstorm triggers yen against sterling. As a result weight in providing a vital reservoir account for the next highest trading of the latter, a large number of of capacity to fill gaps in traditional volume, but have historically reinsurers were unable to write the reinsurance programmes for peak suffered due to the lack of an same limits on Japanese risks as zones and perils. applicable index in Europe. In in previous years, and sought ILW ILWs are private reinsurance this instance, Swiss Re’s Sigma capacity to soak up limits written in or derivative transactions, most or Munich Re’s NatCAT Service excess of aggregate risk appetites. often from $5mn to $100mn+ in industry loss estimates have been We do not expect this to continue individual limits, traded on an adopted as triggers for non-US into 2010, and anticipate that the annual basis and triggered by an ILWs. However, with the launch of proportion of non-US ILW written index of the total industry loss the European industry loss index will fall back to 2007/08 levels. arising from a natural catastrophe PERILS, the proportion of European However, as stated above this could event. windstorm ILWs traded may change as PERILS is rolled out into Peak Zone industry loss increase considerably. the market. attachment levels typically range Market participants also trade

C apacity and ROL changes

8.0 20% 7.0 18% 16% 6.0 14% 5.0 12% 4.0 10% 3.0 8%

6% ROL Average

ILW Capacity (US$) ILW 2.0 4% 1.0 2% 0.0 0% 2003 2004 2005 2006 2007 2008 2009

Source: Willis Re

2009 Review; 2010 Preview www.trading-risk.com t r ilws 31

O pportunity knocks This was coupled with additional market opportunistically dependent This is a good time to emphasise the traditional reinsurance capacity upon territory and peril. speculative nature of ILW trading – becoming available, as balance The participants are a mixture of where protection buyers, typically sheets were partially restored by Lloyd’s syndicates, multi-national (re)insurers, will buy instruments to improved investment portfolios and (re)insurers, multi-strategy hedge plug gaps in traditional cover when retained earnings. funds and dedicated ILS investors, capacity is lacking, and protection This decrease in activity during with both the number and the sellers will typically sell capacity Q2 caused the US wind market proportion of non-traditional when rates are high enough to Henry Kingham is to soften by between 15 and markets having grown since 2005. prove compelling. executive director at 25 percent. Extreme cases saw Collateralised markets have the Willis Re. Average ILW rates on line are contracts with attachments greater ability to write larger deals, which generally high, ranging from just than $40bn softening by in excess of boosts their proportion of the over 10 percent in 2003 to a peak in 30 percent. market. 2007 of just under 18 percent (see As a result, overall ILW limit The rate decreases experienced in graph page 30). traded in 2009 is likely to be 10-15 2009 have also been partly driven The 2007 high reflected the top of percent less than the $6bn traded in by inflows of capacity from multi- the hard market after hurricanes the market during 2008. strategy hedge funds that suffered Katrina, Rita and Wilma (KRW) redemptions in late 2008, new start- in 2005. Ultimate Net Loss (UNL) Hard core? up collateralised markets entering retrocession capacity was under In the aftermath of the credit the ILW space and traditional pressure and several of the new crunch and Hurricane Ike, there are markets looking to fill territorial retro vehicles and sidecars that approximately 25 active participants buckets. formed post-KRW concentrated on in the ILW market – down 25 ILW trades. This combined with the percent on post-KRW levels, when 2010 reassessment of risk tolerance after almost 35 capacity providers were Around 80 percent of ILW capacity KRW to push volumes and rates active (see bar graph). is traded in the first half of the higher than historical levels. Roughly half of those capacity year, as (re)insurers’ traditional The softening traditional providers are core players that have programmes close and firms seek reinsurance market of 2008 and offered significant capacity over top-up cover elsewhere. 2009 shows falling rates and this, the years, with others accessing the The market is incredibly active combined with a rebounding once again, which could be financial market, has produced Changing shape of capacity providers* attributable to more attractive ILW healthy levels of capital. This is pricing levels at the end of 2009 or usually an ominous sign for the 25 uncertainty over available capacity Traditional ILW market, which is generally Non-traditional for 2010 programmes. overlooked in these market 20 We predict that existing capacity conditions. will remain relatively flat in 2010, Paradoxically, the ILW market 15 but this could quickly change, experienced a very active start dependent on loss levels and to 2009, due to increased buying 10 purchasing activity. resulting from the credit crisis that In terms of rating, we expect a came to a head in October 2008. NumberActiveof Markets 5 10-25 percent year-on-year fall in Prices for the instruments began rates for Q1 ILWs, dependent upon 0 rising immediately and then peaked Pre 2005 Post 2005 Post Credit Crunch/Ike territory, peril and attachment. during Q1 at levels similar to June The most recent RMS and AIR Source: Willis Re *based on Willis Re estimates 2007. This was due to a combination earthquake models resulted in a of concerns over the impact of the C hange in territorial distribution significant reduction in expected credit crisis on balance sheets: a of ILW capacity… loss levels for US earthquake, and large US primary insurer being for California in particular. This may unable to purchase adequate cat 2008 2009 produce downward pressure on bond capacity due to the paralysis pricing, with drops of more than 20 in the capital markets, and which 12% percent not unreasonable for these then sought huge volume from 2% 18% perils. the ILW market; and uncertainty The nimble nature of the ILW surrounding rating agency market, and the ability of capacity 26% pressures. 62% providers and sellers to negotiate The upturn in pricing drove 80% contracts when market conditions potential Q2 buyers to amend are conducive, will mean that this business plans for reducing corner of the convergence market aggregates rather than purchase should remain a significant addition US Ex-US US + territory cover at uneconomic prices, to the armoury of risk transfer therefore causing demand to drop. Source: Willis Re instruments. www.trading-risk.com 2009 Review; 2010 Preview THE POWER24 OF

CAYMAN ISLANDS CYPRUS DUBAI HOURS OF HALIFAX HAMILTON HYDERABAD SERVICE ISLE OF MAN JOHANNESBURG LONDON IN EVERY LUXEMBOURG MARTIGNY SAN JUAN CORNER.

With offices in twelve countries, Flagstone capitalizes on the unique strengths of industry leaders in distinct geographic locations. Operating from diverse locales and time zones around the world allows us to provide efficient service 24 hours a day, seven days a week.

A- by A.M. Best A- by Fitch Ratings WWW.FLAGSTONERE.COM A3 by Moody’s Investors Service SPECIALTY LINES, PROPERTY AND PROPERTY CATASTROPHE t r transparency 33 Promises (mostly) kept A lack of disclosure exaggerated the market impact of the Lehman bankruptcy. Elementum Advisors’ founding principal, Tony Rettino, reviews… THE POWER OF wo fundamental promises were Ex-Stark Investments Tmade at the inception of the portfolio manager Tony 24 insurance-linked trading market. Rettino launched independent investment Sponsors were told they would get manager Elementum an alternative source of capacity Advisors with John CAYMAN ISLANDS with minimal credit risk, while DeCaro and Mike France CYPRUS investors were pledged uncorrelated in December 2009. Elementum Advisors will DUBAI HOURS OF returns with minimal credit risk and adequate disclosure. focus on collateralised HALIFAX While the market has largely kept natural event reinsurer at maturity. matched an actual ILS – Cat Bond B HAMILTON reinsurance, managing its promises, 2008 fell short with Separately negotiated collateral – in all but one aspect. In Cat Bond HYDERABAD SERVICE assets across the full the collapse of Lehman Brothers spectrum of reinsurance arrangements are not practical A we utilised detailed exposure data ISLE OF MAN – highlighting the need for change risk transfer products, for ILS, given the breadth of that the real bond did not contain. JOHANNESBURG to protect this trust. The reach for including collateralised the placements, sponsors may We then added the bonds to a LONDON IN EVERY yield was not limited to the Lehman reinsurance and cat consider issuing separate tranches hypothetical portfolio comprised of bonds. LUXEMBOURG cat bonds, as certain market with varying credit risk levels to actual transactions, and measured MARTIGNY participants sacrificed diligence maximise capacity. the marginal impact on the portfolio SAN JUAN CORNER. and disclosure for lower cost and Other improvements include daily for required risk capital. Finally, we higher spreads. The impact of the access to investments, daily top-ups implied pricing by normalising the bankruptcy was also felt in the of collateral and disclosure during marginal return on risk capital. collateralised reinsurance market, the marketing phase of underlying The marginal cost of adding the With offices in twelve countries, where many counterparties were agreements and terms, including more transparent risk is lower Flagstone capitalizes on the unique forced to scramble for cover in the swap agreements and spreads. (see table). In the less transparent strengths of industry leaders in distinct midst of the hurricane season. The market would benefit from Cat Bond B, market participants geographic locations. Operating from After the Lehman collapse, market greater disclosure of underlying are forced to measure the impact diverse locales and time zones around the participants were unable to fully exposures – especially in indemnity of adding the risk to their portfolios review collateral investments and and modelled loss transactions. This with relatively crude proxies, such world allows us to provide efficient service underlying documentation because should include changing exposures as industry market share. 24 hours a day, seven days a week. the necessary information was during the life of the transaction. Proxies can be adjusted to mimic hard to obtain or in some cases, not Transparency is essential in any the overall and regional modelled A- by A.M. Best available at all. framework where pricing and risk expected losses disclosed in the A- by Fitch Ratings WWW.FLAGSTONERE.COM Better transparency would have management is performed at the offering documents, but this process A3 by Moody’s Investors Service SPECIALTY LINES, PROPERTY AND PROPERTY CATASTROPHE clearly reduced the mark-to-market portfolio level in addition to the will result in loss estimates that are impact of the bankruptcy – enabling specific transaction level. highly correlated with an investor’s the ILS market to trade at tighter existing portfolio of catastrophe and more differentiated spreads T he benefits of sharing risks. Investors will assign a instead of being indiscriminately To illustrate the benefits of greater amount of risk capital to marked down. transparency, we created a the transaction and demand a hypothetical Cat Bond A that correspondingly higher return. C ollateral lessons I t pays to be clear… The ILS and collateralised In order to maximise growth, the reinsurance markets are poised to Cat Bond A Cat Bond B market needs better transparency. grow positive returns in 2008 and In collateralised reinsurance Loss trigger Indemnity Indemnity an ever-increasing demand for transactions, the range of permitted Transparency in cat exposure data High Low reinsurance. To do this, participants investments is negotiated and Modelled expected loss 1.50% 1.50% need the necessary diligence and investments are then controlled by Correlation of deal’s modelled loss estimates to resources – including cat modelling, hypothetical portfolio Moderate High the investor/reinsurer, which seems reinsurance and fixed income Spread required to achieve equivalent return on appropriate, given that in most cases risk capital 10.50% 11.66% specialists. They also need the

the collateral returns to the investor/ Source: Elementum Advisors appropriate level of transparency.

www.trading-risk.com 2009 Review; 2010 Preview 34S TR iL mechanics

Collateral makeover Cat bonds have undergone significant restructuring since the collapse and credit risk of the underlying of Lehman Brothers. Sidley Austin partners Michael Pinsel and Michael collateral assets – was retained. However, investors and ceding Madigan discuss whether cat bonds are ready for their extreme close-up… companies generally agreed that improvements to the traditional he Lehman bankruptcy filing TRS arrangements were needed Tin September 2008 put a to address weaknesses identified temporary stop on new cat bond following the Lehman collapse. issuances in the last quarter of Accordingly, the traditional TRS that year and led the market provisions were modified to reduce to re-evaluate the collateral credit risk to the TRS counterparty. component of cat bonds. For example, the new arrangements Two issues had to be resolved included enhanced monitoring and before the cat bond new issuance reporting of collateral assets and market would ultimately revive in required TRS counterparties to post early 2009. First and most important collateral for any unrealised losses was to ascertain what collateral on a daily or weekly basis. arrangements would be acceptable Nonetheless a thornier TRS to investors and ceding companies. issue remained. Some cat bond Secondly, how would investors investors were frustrated to learn be provided with (a) greater – while trying to work out the transparency regarding the assets four Lehman-backed cat bond Michael Pinsel is a owned by the cat bond issuer and transactions – that the traditional partner in the Insurance (b) greater access to key transaction cat bond structure did not contain and Financial Services documents, the specifics of which a mechanism to unwind the deal if group in Sidley Austin’s Chicago office and heads were particularly relevant in times the TRS counterparty was no longer the firm’s property and of distress? able to fulfil its obligations and casualty alternative risk Regarding collateral no replacement TRS counterparty transfer practice. arrangements, much of the could be found. discussion focused on acceptable Long time participants in the cat Michael Madigan is types of underlying investments. bond market, however, recognise a partner in the firm’s insurance practice in Investors and ceding companies that a fundamental principle in New York, advising were generally in agreement on cat bond transactions has always principally on insurance this point – more conservative been that as long as the ceding securitisations, having underlying investments were company pays the premium due represented either issuers necessary. on the risk transfer agreement, the or their financial advisors Accordingly, the transactions ceding company should be entitled in more than 60 such transactions since 1997. executed during the first half of to receive loss payments should a 2009 generally limited the permitted triggering event occur. Or in other collateral to debt securities words, ceding companies have guaranteed by the US Federal traditionally maintained that they Deposit Insurance Corporation will not take any risk associated Temporary Liquidity Guarantee with the failure of third parties, Program and to securities issued such as TRS counterparties, to make by quasi-government bodies payments. that received the backing of In this regard, as disclosed in cat their respective governments bond offering documents, if the – for example, bonds issued by TRS counterparty fails to make a Kreditanstalt für Wiederaufbau, a payment under the TRS, the issuer public law institution serving the might default on its obligations by Federal Republic of Germany’s paying noteholders less than the public policy objectives. full required coupon. Consistent In early 2009 cat bond with typical debt securities, such a transactions, the traditional default by the issuer would allow structure – in which a total return noteholders to declare the debt swap (TRS) counterparty essentially immediately due and payable. agreed to absorb the investment

2009 Review; 2010 Preview www.trading-risk.com t cr ils me hanics 35

“Ceding companies and investors Beyond Trs During the second half of 2009, are generally satisfied with the revised many transactions did not involve collateral structures. However, investors have a TRS counterparty. The proceeds from several cat bond issuances largely split into two groups” were instead invested in US Treasury money market funds for the duration of the transaction. C ut your losses? replacement TRS counterparty. From a structural point of view, However, contrary to typical Accordingly, the ceding company this collateral arrangement is quite debt securities, in a cat bond could decide whether it wanted to simple. The indenture trustee transaction the indenture trustee keep the reinsurance cover in place, monitors the money market funds, and noteholders are specifically in which case its affiliate would and if they no longer meet the pre- prohibited from taking any action need to assume the obligations established investment criteria, to realise upon the collateral and under the TRS and make the the assets would be reinvested in a from taking any action inconsistent investors whole. Or, alternatively, it qualifying money market fund or, as with the ceding company’s rights could decide whether it wanted to a last resort, held in cash. to the collateral. Accordingly – terminate the transaction within a In these transactions, the coupon notwithstanding that noteholders short time period after the default paid to investors consists of the would not be receiving their full by the initial TRS counterparty. risk spread (which essentially agreed coupon – the bonds would Other structures gave the ceding compensates the investors for not be redeemed prior to the company the option to make the event risk) plus the investment scheduled maturity date, and the investors whole without having an earnings actually received by the risk period and the cover for the affiliate assume the obligations of issuer on the underlying assets. ceding company would stay in the TRS counterparty. If the ceding In other words, investors do not place until the expiration of the company did not elect to make receive the typical LIBOR portion original risk period. the investors whole, the investors of the coupon, but instead bear Observing this theoretical risk would have the right to terminate the investment risk of the assets become reality, many investors the transaction. traditionally borne by the TRS demanded that if an interest Continued on page 37 payment default or collateral deficiency default occurred, the cat bond transaction should unwind Typical TRS cat bond structure promptly. Ceding companies, on the other hand, held to the position that as long as they made the Catastrophe bond LIBOR + risk spread issuer premium payments under the risk Investors transfer contracts, the transactions should not unwind. Ceding Collateral account Outstanding principal companies believed it would not amount be fair to lose coverage through no fault of their own, and potentially Total LIBOR “Top up” for in the middle of hurricane season return (minus swap fee) investment losses when they needed the reinsurance swap cover the most. Several different solutions Swap counterparty emerged at the beginning of 2009, each reflecting a compromise between the two positions. In some transactions, the compromise was Beyond LIBOR: Money market fund structure that, if the initial TRS counterparty was downgraded or otherwise in Actual investment earnings default of its obligations under the Catastrophe bond + risk spread issuer TRS, the ceding company could Investors keep the cat bond transaction in Collateral account Outstanding principal place by causing its adequately amount rated affiliate to become the Source: Sidley Austin www.trading-risk.com 2009 Review; 2010 Preview Tri-party repo Global master LIBOR Repurchase Catastrophe bond +risk agreement issuer spread Repurchase Investors counterparty LIBOR Outstanding Collateral account principal amount Daily mark to market and transfer of eligible investments

Agent/ collateral trustee 09GCCO6531_InsiderQuarterly_M1_OTL.indd 1 7/14/09 10:19:25 AM Typical TRS cat bond structure

Catastrophe bond LIBOR + risk spread issuer Investors

Collateral account Outstanding principal amount

Total LIBOR “Top up” for return (minus swap fee) investment losses swap

Swap counterparty

Beyond LIBOR: Money market fund structure

Actual investment earnings Catastrophe bond + risk spread issuer Investors t cr ils me hanics 37 Collateral account Outstanding principal amount

Continued from page 35 Tri-party repo Global master LIBOR Repurchase Catastrophe bond +risk agreement issuer spread Repurchase Investors counterparty LIBOR Outstanding Collateral account principal amount Daily mark to market and transfer of eligible investments

Agent/ collateral trustee Source: Sidley Austin

counterparty. However, any L et there be light group prefers a collateral structure investment risk is mitigated by The other major development that includes a LIBOR-based requiring high credit quality assets in 2009 was the increased return – which essentially requires such as US Treasury money market transparency and access to collateral assets with higher funds. information afforded to investors. potential returns and accordingly Alternatively, several transactions Cat bond transactions now post higher credit risk – addressed by a included a tri-party repurchase collateral asset information on an TRS or repurchase arrangement. arrangement, in which a third easily accessible and easily updated This group includes pension funds party acts as the “repurchase internet site. and other investors that benchmark counterparty” that sells a pool of Information available on such their returns to LIBOR. eligible investments to the cat bond sites includes the Committee on The other group prefers a collateral issuer in return for cash. Uniform Securities Identification structure with reduced credit risk, The repurchase counterparty has Procedures (CUSIP) number, name which essentially requires more an obligation to repurchase the of issuer, face amount, purchase conservative collateral assets such eligible investments at maturity of price and the market value of each as US Treasury money market funds the cat bonds and to pay LIBOR asset held in the collateral account. and involves lower investment (or some similar return) to the For those transactions involving a returns. This group includes issuer on a quarterly basis. The TRS, there is also corresponding investors that prefer to invest more pool of eligible investments is information with respect to any purely in insurance-related event required to be over-collateralised collateral posted by the TRS risk. by the repurchase counterparty, counterparty. Information on If, as some market participants and the investments are marked money market funds includes the predict, investing in LIBOR- to market on a daily basis by an name of the fund, the market value yielding assets becomes the market independent agent/collateral per share, ratings and any accrued preference, the proportion of 2010 trustee. If the market value of dividends. In addition to collateral cat bond transactions involving the eligible investments drops information, the key transaction TRS or repurchase arrangements on any day, additional eligible documents such as the indenture, should increase. Additionally, investments are automatically the risk transfer agreement and, if with tightening secondary market transferred to maintain the required applicable, the TRS documentation, cat bond spreads – reducing over-collateralisation ratio. The are posted. the relative cost of protection to eligible investment criteria set forth By late 2009, the number of ceding companies and therefore permitted and prohibited certain successful cat bond issuances encouraging new issuances – the cat types of investments, along with suggests that ceding companies and bond new issuance market has been valuation “haircuts”, concentration investors generally have become gaining momentum. Barring new limits and other requirements. satisfied with the revised collateral major unanticipated capital markets structures. However, investors have events, this regained impetus largely split into two groups. One should continue throughout 2010. www.trading-risk.com 2009 Review; 2010 Preview 38 TR ratings

Perpetual motion After considerable market disruption in 2008, Carillon and Newton Re to CC and 2009 collateral solutions CCC respectively – reflecting our Repurchase agreement cat bonds are back with some innovative assessment of their collateral pools’ 10% Government guaranteed Total return swap solutions to address investors’ concerns. ability to meet their cash flow 17% 39% S&P’s Cameron Heath analyses… needs. Money market fund Four of the first five cat bonds that S&P rated in 2009 continued 35% s 2009 progressed, bond to employ TRS agreements, but Source: S&P Aissuers, arrangers and other sought to reduce their dependence explains our criteria for assessing market participants developed on the counterparty by: model, data and other insurance some innovative ILS solutions • tightening up their investment risks; how we stress the results of to address investors’ concerns eligibility criteria and improving the catastrophe models to analyse following the Lehman Brothers asset diversification; those risks; and how we assign a collapse. Modelling agencies • increasing transparency of the rating using all of that information. continued to develop their underlying investments; catastrophe models. And Standard • requiring more frequent T he weakest link Cameron Heath is a & Poor's Ratings Services (S&P) marking-to-market of The article also explains how director in Standard & enhanced and clarified its ILS investments; and/or in analysing timely payment of Poor’s insurance ratings rating criteria accordingly. • including provisions to top up the interest and ultimate repayment of group in London. He is Until 2008, cat bond issuers collateral pool should collateral principal for ILS securities we look lead analyst of insurance- typically used total return swap values fall. at what could affect these payments linked transactions in Europe, with particular (TRS) agreements to limit collateral The remainder of the 2009 – consistent with our criteria. emphasis on the non-life risk in ILS transactions. For a transactions rated by S&P Within that we focus on the sector. premium, counterparties match bypassed the TRS provider and likelihood of the catastrophic event the cash flows on the notes, used either AAA-rated putable happening; the creditworthiness irrespective of the actual cash notes specifically issued by a of the ceding company in making flows, mark-to-market valuations government-guaranteed agency, premium payments; and the and possible defaults of the money market funds (rated likelihood that the collateral underlying collateral. either AAAm-G or AAAm), or a assets will make their payment. The demise of Lehman – a TRS repurchase agreement (see pie chart). Where the collateral cash flows are counterparty on four cat bonds S&P published two major criteria guaranteed by a third party such – exposed those investors to articles during 2009. as a TRS counterparty, we focus on collateral risks. Subsequently, two The first in May expanded on an that party’s creditworthiness. of the four bonds – Ajax Re and earlier article, "Methodology and We typically base our rating on Willow Re – defaulted. S&P lowered assumptions for rating natural the weakest of these elements. its ratings on the other two bonds, catastrophe bonds". The article This method is common to other

2009 Review; 2010 Preview www.trading-risk.com t r ratings 39

structured finance ratings that use C at bonds – relative performance the weak-link approach, and has not changed in light of Lehman’s ITRAXX Crossover index 160 Lehman Swiss Re cat bond ‘BB’ rated index demise. However, our pre-and 150 post-sale reports, which detail any S&P500 Total Return Index 140 strengths and weaknesses of the KRW* 130 collateral structure, are available 120 free of charge. 110 We also published “Methodology for rating non-catastrophic 100 Deepening property/casualty insurance-linked (%) return Total 90 nancial disruption securities”. These securitisations are 80 typically highly individual, and as 70 such, this article aims to provide 60 the reader with a framework and some guidance to our likely Jul 07 Jan 09 Jun 09 Feb 06 Feb Sep 06 07 Feb Dec 07 08 Apr Aug 05 Aug Mar 05 Aug 05 Aug May 06 May 08 Aug analytic rating approach. In June 04 Source: S&P 2009, S&P twice downgraded the *KRW - Hurricanes Katrina, Rita and Wilma three classes of Swiss Re’s credit reinsurance securitisation, Crystal Supervisors has announced plans hurricane risks and had expected Credit Ltd, after reported losses to produce recommendations in losses of 4.11 percent and 4.17 deteriorated beyond expectations. 2011 to enhance consistency in percent respectively. Despite the the supervision of insurance and lower modelled risk, the class D C onstant change reinsurance securitisation. The notes were priced the same as the With so much focus on the globalisation of the market means class B and C notes. remedial measures undertaken that issuers of securities are often With around $800mn of bonds post-Lehman, it is easy to forget domiciled in one jurisdiction maturing in the final quarter that the ILS market is undergoing while sponsors are in another, of 2009 and more than $3bn constant change in many areas. increasing the need for consistent maturing in 2010, we expect S&P’s ratings analysis has to supervision. investor demand for cat bonds to keep track of considerable ILS continue. That said, if the market is developments in the course S ound recovery to flourish, we also believe that the of a typical year, with 2009 no Despite the market disruption investor base will need to broaden. exception. caused by the financial crisis, Growth could come from A new index provider, PERILS ILS continued to outperform enhanced capacity among existing AG, announced plans to collect, equivalent corporate securities on specialist investors or from the aggregate, and extrapolate data a relative basis (see graph). re-emergence of new investors, on European windstorms to We saw a recovery in issuance such as pension funds. ILS may estimate the market loss and create in 2009, starting with SCOR’s offer these investors a case for an industry loss index that will Atlas V Capital Ltd in February. diversification away from corporate become active in January 2010. And between then and the end of securities, but the risks of ILS This follows the introduction of October, 12 more bonds totalling securities are not in our view the RMS Paradex industry loss $2.1bn were issued, of which we uncorrelated with wider market index for European windstorm in rated $1.9bn. risks. 2008. During 2009, RMS extended Early in 2009, we observed that To better understand the Paradex's peril coverage to include spreads were large and issuance risks being offered to them, we US hurricane and it now competes focused on the most familiar expect that investors will seek to with Property Claims Service in ILS bonds – industry loss-based review the specialist information this market. bonds of US perils. Spreads contained in the offering The three major catastrophe began to narrow during the year documents, including the sections modelling agencies also continued as confidence returned, but in that relate to collateral and to develop their models in 2009 our view investor concern over catastrophic risk assessment. and we expect they will update concentration on US perils kept We expect that issuers will seek to them again in 2010. In particular, spreads relatively high. continue to accommodate existing they are incorporating the data The specifics behind the pricing investors and attract new ones released by the US Geological on any issuance are subject to by offering innovative structural Society into US earthquake models. debate. In MultiCat Mexico 2009 features and diversity in terms of We expect this may cause material Ltd's recent issuance, the class D perils. We therefore expect to see changes in the severity of modelled notes covered Atlantic hurricane more collateral solutions, new events in certain locations. risks and had a modelled expected structures and the securitisation of In addition, the International loss of 2.42 percent, while the class new classes of business in the ILS Association of Insurance B and C notes covered Pacific area. www.trading-risk.com 2009 Review; 2010 Preview 40n TR i vestors

Changing of the guard Opportunistic investors have withdrawn, making way for more stable capital…

hile chunks of capital Wretreated from the ILS sector in 2008/9 – to meet redemption calls or as multi-strategy investors eyed more lucrative opportunities in other asset classes – the sector’s fabled message of non-correlation with the capital markets proved a compelling story for many mainstream investors. There are now an estimated 300 investors in cat bonds, industry loss warranties (ILWs) and collateralised reinsurance, providing around $25-30bn in capacity. However, just 30-40 entities manage more than half of that capital, according to industry sources (see the Trading Risk directory, right) – and they are becoming a more dominant force in the convergence market as new investors seek sophisticated, dedicated managers for their alternative investment mandates. relative basis”. effective to these investors. The ILS market performed well Despite the reinforcement of This lack of leverage and the during the crisis (see right), largely the insurance message to “stable relative illiquidity of many immune to losses from 2008’s money” investors, opportunistic insurance-linked instruments – Hurricane Ike and only mildly players – including a number of such as sidecars and collateralised suffering from a bout of credit multi-strategy hedge funds – relied reinsurance – saw capital contagion as the financial crisis bit. on leverage in order to secure their available in these sectors shrink This performance proved targeted returns on investment. dramatically. attractive to “stable money”, which And when the cost of capital Although stalwarts such as flowed into the sector – mainly shot up to multiples of pre-crisis Nephila, DE Shaw, Aeolus and through mandates to dedicated levels in the credit crunch, $-for-$ Securis still wrote the majority of insurance-linked funds – in the collateralisation became less cost- collateralised reinsurance business form of pension funds, multi- national wealth managers such as Australia’s AMP and family offices. Marching higher… Swiss Re noted that at least 25 new investors have entered the It’s the shape of graph that every investor likes T otal value of $100 index sector since 2007, adding to its to see – ILS returns have pushed upwards for (see pie charts) eight consecutive years, meaning that $100 investment in cat bonds at Sep ‘09 depth and breadth . Total value of $100 index investment in cat bonds at Sep ‘09 Indeed, leading insurance- invested in January 2002 would have grown by 82 percent, to $182.57 at end September, $200 specialist hedge fund Nephila according to Lane Financial research (see Capital attracted mandates worth graph). $180 $800mn in Q2, which it deployed The Swiss Re cat bond total return index $160 $182.57* across the sector. continued to climb during the year and sat at an Total return (Insurance return + oating rate all-time high in December, having passed the i.e. LIBOR, EURIBOR and/or money rate) One mainstream investor – Peter- $140 Jan de Koning of Dutch asset 190 point mark. The index rose more than 13 percent during 2009. of Investment Value Dollar manager PGGM – commented that $120 The cat bond market has suffered only two loss he was looking for an investment quarters during their history – in 2005 and again $100 that “behaves differently from the in Q4 2008 – proving appetising to investors as a Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 rest of a pension fund”, adding solid, consistent investment. *Compound annual growth rate 8.08% Source: Lane Financial that “ILS has proven its worth on a

2009 Review; 2010 Preview www.trading-risk.com t nr i vestors 41

in 2009, the sector was believed ILS Investors by type to be operating with around half of the $5bn of capacity placed in 1999 2009 3% 2008. And only two traditional 5% Primary insurer sidecars were completed during the year, owing to a mis-match 23% 9% Reinsurer 30% 30% between equity investors’ high Bank return hurdles and falling rates in a Dedicated cat fund softening reinsurance market. 14% And the ILS market also suffered 46% 5% Hedge fund redemptions – mitigated, however, 25% thanks to a robust secondary 5% Money manager trading market which allowed 5% securities to be re-allocated swiftly Source: Swiss Re Economic Research & Consulting and efficiently. investors in searchPre-credit of appropriate crisis DedicatedPost-credit crisiscat fund investors D ivide and conquer investments to spend it on. Investor 5% Comment 9% 6% Redemptions soon calmed down, Acheron Capital Ltd UK-based hedgeU.S. fund Aeolus Re Bermudian collateralised reinsurer and ILW writer. and more dedicated cat funds S low pace 12% Approx $1-1.5bnBermuda emerged to take advantage of the However, ILS issuance was slow AIFAM14% NY-based hedge fund purported increased interest in the at the beginning of the year45% as a AlphaCat Fund 56% Validus Managers,Switzerland subsidiary of Validus Holdings, 13% launched late 2008 asset class. result of credit concerns following Anchor Risk Advisors Established in 2009 by former Magnetar manager Pete UK During 2009, a handful of new the Lehman Brothers’ collapse 19% Vloedman 21% Armored Wolf Fund managed by ILS investor heavyweight John dedicated asset managers were and due to the high cost of capital Brynjolfsson Other* launched, including private equity which was pushing capital markets AXA Investment Managers Dedicated investment vehicle for French insurer 2007 & 2008 BNP Paribas 2009 Subsidiary of major French bank firm Cartesian Capital Group’s investors’ prices above acceptable Cartesian Iris Re Cartesian and Aspen Re-funded $100mn ILW fund first foray into insurance-linked levels for sponsors. Challenger Financial Services Financial services company investments – Iris Reinsurance So, investors had to seek Clariden Leu Swiss ILS fund. $1.1bn under management Ltd – which is expected to offer an alternative assets – finding yield Coriolis Capital Insurance-specialised hedge fund Credit Suisse Asset Management Subsidiary of major Swiss bank with approx $1.3bn estimated $100mn in ILW capacity. in older cat bonds traded on under management Stark Investment’s insurance- the secondary market, or ILW Elementum Advisors New firm spun-out of Stark Eskatos Capital Management Luxembourg hedge fund. Advisor Swiss-based Katarsis linked team launched Elementum and collateralised reinsurance Capital Advisors Advisors in December, while programmes where pockets of Falcon Private Bank Ex-subsidiary of AIG Fermat Capital Management US hedge fund. $2.5-3bn under management ex-RBS banker Henry Kus potential high returns remained in Global Insurance Strategies $50-100mn seed capital from Aon. Not yet launched launched dedicated ILS vehicle the form of retro or whole account Goldman Sachs Asset Management Subsidiary of leading ILS investment bank Traymar Capital and ex-Magnetar protections. Guggenheim Capital Broker-dealer with portfolio management arm portfolio manager Pete Vloedman Pickings were slim, however, and Hannover Re $150mn in-house fund from German reinsurer HBK Capital Management Hedge fund established Anchor Risk Advisors. when ILS issuance returned to Highfields Capital Management Hedge fund Credit Suisse Asset Management full strength in the second half of Horizon21 Alternative Investments Swiss investment manager Horton Point: The Gallery QMS $100mn NY based multi-strat fund established Jan ‘08 launched a $65mn dedicated life 2009 – as pricing reduced towards Master fund vehicle – also called Iris – in June. traditional reinsurance levels – ILS Value Advisors AG Swiss portfolio manager for Partners Group. Approx $25mn fund. Bermudian insurance-linked demand from investors was strong Juniperus Investing mainly in UNL and collateralised reinsurance. investment manager Pentelia as they fought for yield for their Aon Benfield invested $50mn. Leadenhall Capital Partners $75mn seed capital from London-based insurer Amlin. Capital Management tapped portfolios. LGT Capital Management Swiss investment boutique with $300mn over 2 portfolios the Japanese investor market However, investors hoping to through a multi-manager approach in April to raise $132mn for a deploy otherwise idle capital Magnetar Investment Management US hedge fund with MVRe affiliate in UK MMA Finance (MMA ILS fund) Mutual fund new dedicated cat fund – Eolia in new ILS found themselves Munich Re $1bn dedicated investment fund part of risk trading unit Diamond Ltd. going hungry, as – despite ten Nephila Capital Bermuda-based. $3bn under management New Holland Capital New York fund invests exclusively for Dutch pension Meanwhile, global broker 2009 cat bonds increasing in size fund, APG Investments Aon Benfield suspended its during marketing – their desired Ontario Teachers Pension fund fundraising efforts for Aon’s participation in the deals was Oppenheimer Funds $250mn via dedicated ILS fund and multi-strat allocation investment management firm heavily marked down. PartnerRe Reinsurer Pentelia White Mountains-backed investment firm. First fund Global Insurance Strategies LLC, The growth of the insurance- raised $600mn to concentrate on Benfield-backed linked investor community PIMCO Pension fund Pioneer Investments Hedge fund/mutual fund cat fund manager Juniperus – and the changing focus of its Securis Investment Partners UK-based insurance-specialised hedge fund. Approx Capital Limited, launched in May participants – is an encouraging $750mn-$1bn Sequaero Advisors Hedge fund launched 2008 by Dirk Lohmann 2008. sign for continued growth in the Solidum Partners AG Swiss hedge fund, re-branded from ISPartners in 2006 Adding to the demand for convergence market. With pockets Stark Investments US hedge fund investing mainly in collateralised insurance-linked risk from capital full of cash, all that remains is to reinsurance and UNL covers. Approx $500mn in ILS Swiss Re Financial Markets Asset management division of reinsurer markets investors, $3.7bn of cat produce the volume of transactions Tiaa-cref Pension fund bond capacity matured in 2009 necessary to feed their appetite for Tokio Marine Asset Management Subsidiary of insurer – boosting coffers and sending this non-correlating asset class. Source: Trading Risk www.trading-risk.com 2009 Review; 2010 Preview 42 TR life investments

Finding the pulse… An increased demand for A pocket full of posies longevity, both of which centre on life risk transfer is spawning The outbreak of the influenza A/ the question of life expectancy. H1N1 virus – or swine flu – in April Longevity investments can investment opportunities for 2009 significantly raised public be further divided into macro- mortality and longevity risks. awareness of pandemics. longevity – relating to a whole Credit Suisse’s Niklaus Hilti In a 2006 report, Fitch Ratings population or a pool of tens of estimated that insurance claims thousands of lives – and micro- and Marcel Grandi check could reach as high as $53bn longevity, which typically relates to the market’s vital signs… following just 600,000 deaths in the a small pool of 50-500 older lives, US and Europe from a pandemic. with an average age of 79. ince 2000, approximately $25bn Limited reinsurance capacity Sin life ILS has been placed leaves life insurance companies U nder the microscope with capital market investors – virtually unprotected in the event Historically, micro-longevity has encompassing embedded value of a major pandemic. In the highly focused on the US life settlement securitisations, bonds that finance concentrated reinsurance market, market and the purchase of US regulatory excess mortality excess mortality risk is aggregated medically underwritten individual reserves (Regulation XXX) and pure in the books of the few reinsurers. life policies covering wealthy or excess mortality bonds. In addition, US life insurance health-impaired lives. Conversely, The emergence of asset and companies carry close to $150bn as macro-longevity is based on large credit risk during the financial of excess mortality risk – for which numbers and actuarial models, crisis brought life ILS issuance to a regulatory pressure requires them such medical underwriting has standstill – especially in embedded to employ risk transfer solutions. been, and continues to be, absent. value and Regulation XXX-related The same imbalance of exposures Unlike macro-longevity, micro- structures, which now trade at and capacity constraints also apply longevity does not reference large discounts. However, activity to longevity risk. It is estimated that base mortality tables, but instead appears to be recovering. In only a small percentage of the UK’s provides for a selection of autumn 2009, two excess mortality £1.5tn total longevity exposure has specific lives that might perform transactions – one bond and one been reinsured in the traditional differently from their age group. derivative – were completed at market. Similarly, in a survey of 76 This was clearly demonstrated in lower attachment levels, allowing corporate pension schemes in the autumn 2008 when assumed life sponsors a protection closer to the UK, 80 percent ranked longevity as expectancies in micro-longevity actual risk. the highest risk, ahead of interest portfolios were extended by around While principally life ILS has rate and inflation risk. two years. As such, micro-longevity transferred mortality risk to the Along with buyouts, longevity or life settlement requires a capital markets, investors have swaps based on a standardised different approach when assessing recently been able to access longevity index or on an individual underlying risk. longevity exposure. The 2008 portfolio of annuitants are seen Short positions in micro-longevity Canada Life swap with JP Morgan as a preferred tool to isolate and have recently been marketed, and RBS and Norwich Union’s hedge longevity risk. Banks have providing investors with mortality 2009 longevity swap were pioneer put forward proposals in this field exposure to a small pool of older transactions, followed by a small to a number of the 8,000 corporate lives. number of longevity swaps for pension schemes in the UK, While excess mortality is a corporate UK pension schemes. creating the potential for a wave of heavy-tailed event risk, longevity Niklaus Hilti is head So far, ILS investors have had transactions in 2010. is considered a long-dated, trend- of insurance-linked limited involvement in this market. Increased risk awareness, like risk with low volatility as life strategies at Credit Suisse In the past, many transactions were obvious capacity constraints and expectancy changes are slow to Asset Management, wrapped with a capital guarantee regulatory pressure all open up new emerge. managing a portfolio of from a monoline insurance opportunities for dedicated ILS In recent decades, life expectancy approximately $2bn. company – limiting the potential investors willing to take exposure has improved for all age groups Marcel Grandi is returns for ILS investors who target to pure life insurance risks. The in all developed countries. This a senior portfolio high yields. capital markets are likely to provide trend has already been factored manager in the division, The monoline alternative lost a useful insight into the efficient into actuarial assumptions and responsible for setting its relevance for the market due pricing of – and appropriate capital applicable models, so longevity risk up IRIS Life, the first to the financial crisis, although requirements for – longevity and should only materialise if mortality life insurance-linked investment fund the demand for life insurance mortality risk. improvements exceed the best launched by Credit Suisse risk transfer solutions has not The two main risks in life estimate assumptions of future life in June 2009. disappeared. insurance are excess mortality and expectancy.

2009 Review; 2010 Preview www.trading-risk.com t r life investments 43

excess mortality risk only. However, with a monthly swap of the actual transactions are tightly priced annuity payments (floating leg) and can only work for investors against conservatively modelled targeting a higher internal rate of best estimate annuity payments, return by using substantial leverage including a risk premium (fixed – an alternative that is not always leg). The investor pays the floating attractive. leg and receives the fixed leg. In addition to providing exposure To avoid idiosyncratic risk, the to excess mortality risk, embedded portfolio must be sufficiently large value transactions bring lapse risk – more than 70,000 lives – and and residual asset and credit risk. balanced with a broad range of In the aftermath of the financial similarly sized individual annuity markets turmoil, new structures values. Actual annuity payments coming to the market will need can be capped and the realised strict covenants in order to mortality can be floored in order eliminate non-insurance-related to limit the downside risk for risks as far as possible. investors. Additionally, involving Within macro-longevity, we need a professional life reinsurer as a to differentiate between index and cornerstone investor alongside portfolio transactions. capital market investors can The purest and most transparent An index transaction is based provide an extra level of comfort. way to access extreme mortality risk on the longevity/mortality Derivatives appear to be the is to invest in transactions based experience of a defined national most efficient risk transfer format, on an underlying mortality index population across certain age with return expectations ranging that has been constructed using groups. A mortality strike is set between 11 percent and 15 percent age-and gender-weighted mortality at the modelled best estimate of for the baseline scenario. In order rates gathered from publicly mortality at the final settlement of to turn longevity into a broader available data. the transaction. market, liquidity will have to These transactions can easily The profit/loss of the transaction be improved, in part by adding be executed in derivative format, is calculated by multiplying the bonds as an additional investment giving a cost-efficient alternative to difference between the realised instrument. a larger bond issue. Investors have mortality and the strike by the Credit Suisse has invested actively re-priced mortality risk, with senior notional value of the transaction. in the life ILS market throughout risk tranches not clearing below In addition, the investor receives its development and has made use 300 basis points (bps) and more regular cash flow via an annual of the diversification benefits of exposed junior tranches requiring or monthly risk premium. Due to life risks in some of its managed pricing above 500bps in order to their transparency and reduced ILS portfolios. With the expected attract broad investor interest. complexity, index trades may be growth of the life ILS segment, In Regulation XXX, sufficient pure seen as the easier way to access the investor preferences may expand mortality risk exposure can only longevity market. from commingled ILS funds to be generated for investors using A portfolio transaction is based dedicated strategies funds that give a non-recourse structure (bond), on an actual portfolio of annuitants investors the option of pursuing a which provides a better return than or pensioners. The transaction is considered asset allocation strategy a recourse structure – historically structured as a cash flow hedge, in an emerging risk class. the most common solution to satisfy and fund the regulated Distribution of life insurance-linked excess reserve requirement. investment opportunities Under new structures, a bank 30 letter of credit (LoC) can be used instead of the XXX bonds 25 as a replacement guarantee for 20 the excess reserves. The bank syndicates the LoC in derivative 15 format to capital market investors, with the payment contingent on 10 an excess mortality event causing (USD bn) Outstanding volume 5 actual claims (death benefit payments) to exceed the estimated 0 ones several times over. 2001 2002 2003 2004 2005 2006 2007 2008

Appropriate solutions remove any XXX Reserve financing Embedded Value Cat Mortality Life Settlement Longevity/Mortality derivatives residual credit risk and limit the Source: Credit Suisse transactional risk profile to pure www.trading-risk.com 2009 Review; 2010 Preview 44 TR sidecars Fine tuning The post-Katrina sidecar structure is dead, but the handy quota share vehicles continue to tick over. Aon Benfield’s Des Potter looks under the hood…

he key ingredients for a settle down investors will return to retrocession. Tsuccessful reinsurance sidecar this asset class. Originating in the mid-1990s, are four-fold: a short-term market In the past, sidecars have the sidecar became a mainstream dislocation that pushes reinsurance established themselves as a viable alternative source of temporary prices above risk-adjusted expected source of temporary capital during capital post 2005. The dislocation returns; a sponsor with a respected periods of market dislocation. The in the US property catastrophe underwriting track record who is structure of these vehicles will market that year – following prepared to participate in the risk continue to evolve to meet the needs Hurricane Katrina and a number ceded to the sidecar; a transparent Des Potter is European of both sponsors and investors, of other storms – created a unique structure providing comprehensive head of capital markets providing a valuable capital opportunity for sponsors and disclosure to potential investors and at Aon Benfield Securities management tool for the investors and was the catalyst for a a clear route of exit; and finally an (re)insurance cycle. new generation of sidecars. informed equity investor prepared A typical reinsurance sidecar The attraction of these vehicles for to accept the illiquid nature of the is a short-term special purpose a sponsor is the offer of short-term investment. vehicle – usually self-liquidating capital to maximise reinsurance The scarcity of equity capital after one or two years – that capacity in hard market conditions, and high required rates of return provides collateralised quota share providing a secure source of during the past 12 months have reinsurance. The majority of sidecars capacity at a time when traditional severely limited the classes of underwrite US property catastrophe retrocession may be limited or business amenable to supporting reinsurance, though some have expensive. Sidecars also provide a reinsurance sidecar structure. offered other classes of risk such as fee income for the sponsor to cover However, as the financial markets marine reinsurance and worldwide Continued on page 47

2009 Review; 2010 Preview www.trading-risk.com Save £245/$395 to attend*

the10 February Date 2010

2010 Capitalising on the vicissitudes of insurance… Navigating 2010: The Insurance Insider’s flagship annual London event In February 2009, The Insurance Insider the thoughts of senior industry figures, will fare in 2010. hosted a landmark event to discuss the including the former AIG CEO Maurice It promises to be a challenging year. opportunities and threats to the (re) “Hank” Greenberg. Rates under pressure, a bleak investment insurance industry in the aftermath of Wall Fortified by its success, The Insurance landscape and the prospect of losses Street’s effective collapse. Insider is making the event an annual emerging from the financial crises. But “Endless Risk, Prodigious Opportunities” fixture. Taking place after the 1/1 renewals capitalising on the vicissitudes of insurance was a roaring success. Almost four hundred season, InsiderScope will bring together is always a challenge. senior London market and international industry rainmakers and other prominent Join us and find out how you can… executives converged in Lime Street to hear thought-leaders to look at how the industry

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the New York regulator the clients’ advocate Sponsored by James Wrynn is a busy Joe Plumeri is an institution. In man. Since succeeding charge of Willis Group since Eric Dinallo as the New 2000, he has long been the York Superintendent of most consistent and eloquent Insurance in August 2009, spokesman for the industry’s a host of major issues clients. We’ll find out what is have been thrust into his in-tray. They preoccupying him in 2010 include a rethink on the so-called Spitzer agreements and the issue of commission transparency, the long-running debate of state vs federal regulation and, of course the king is dead, long live… and the response of global regulators to On the 1 January 2010, Tom the financial melt-down in 2008-09. Bolt will become only the As Superintendent, he is also the guardian second-ever Lloyd’s Franchise of the Lloyd’s American Trust funds which Performance Director when contain billions of dollars of Lloyd’s funds he succeeds Rolf Tolle. that are ring-fenced on behalf of its US In one of his first public customers. Yet another reason why the speaking roles following his coronation, we London market is eagerly awaiting his will find out just what he has planned for views…. Lime Street

Date: Wednesday 10 February 2010 | Timings: 10:00am - 1:00pm Venue: The Auditorium, The Willis Building, 51 Lime Street, London, EC3M *Subscribers can attend for FREE – non subscribers: £245/$395

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MR_Iceberg_CI_GB_210x297_IQ insider quarterly_RZ01_ICv2.indd 1 05.11.2009 11:32:52 Uhr t r sidecars 47

Continued from page 44 underwriting expenses with a R einsurance sidecar capital structure mainly hedge funds or private potential upside from a share of the equity funds – also experienced sidecar’s underwriting profits, and redemptions from their own Retained Risk T a il R is k provide increased franchise value, as investors and a loss of leverage the sponsor is able to deliver much across their own investments. C a t B o n d needed reinsurance capacity to its Many refocused on investment D e b t customers. ILW opportunities in other asset classes, Investors are attracted to these such as distressed debt, which were vehicles as they can be structured perceived to provide a more liquid to meet individual risk appetites, investment and an expected return S id e c a r usually focusing on classes of Traditional E q u ity significantly in excess of what could business and/or territories with Reinsurance be achieved in the reinsurance established and credible risk market. modelling. Sidecars also provide Only two traditional reinsurance investors with an asset whose N e t sidecars were launched during 2009. performance is broadly uncorrelated Retained Risk P re m iu m In June Renaissance Re – one of the with other financial asset classes and pioneers of the reinsurance sidecar – that offers an attractive risk-adjusted Source: Aon Benfield securitised a pre-selected and introduced Timicuan Re II to provide Securities yield and a relatively short-term exit diversified portfolio of US property reinstatement premium protection period. catastrophe insurance contracts. capacity for clients writing Florida Most sidecars are capitalised The sponsor’s alignment of interest property catastrophe insurance. This just with common equity, though with investors came from their was followed by the innovative Fac around one-third of the vehicles investment in the equity capital, Pool Re sidecar from Hannover Re launched for the 2006 season used assumption of the tail risk, and and Aon Benfield to provide capacity debt leverage of 25-60 percent to co-participation on the same layers for a prospective portfolio of large enhance potential returns to equity of the contracts ceded to the vehicle, complex property and catastrophe investors. This debt was, in most rather than the traditional retention facultative risks. cases, rated and placed with banks, percentage of the quota share. The pension funds and collateralised highly structured nature of this L ondon calling loan obligation vehicles. transaction enabled debt leverage to In contrast, one market that More than $8bn of sidecar capital be 75 percent of the capital structure. has thrived during the current was raised to support underwriting The crisis in the financial markets challenging financial environment is in 2006 and 2007 due to attractive and the fallout from the default Lloyd’s. In 2006, Lloyd’s introduced market conditions for sponsors and of Lehman Brothers, had a major the Special Purpose Syndicate (SPS) investors (see graph). impact on the sidecar market. The to increase the attractiveness of The market peaked in 2006 effects of (re)insurer investment the Lloyd’s market to new capital, with 16 vehicles launched. Most losses and claims from Hurricane and to improve market access for vehicles provided single-year Ike drained reinsurers’ balance traditional Names’ capital. underwriting capacity, although sheets by around 18 percent of A SPS shares many features with some did have an option to extend shareholders’ funds. Capital erosion a traditional sidecar, as it derives for a further underwriting year if sparked a temporary increase in its business from the quota shares market conditions were acceptable. sponsors’ interest in reinsurance of the host syndicate. SPS capital A further 11 sidecars were launched sidecar structures. requirements for a whole account in 2007, including four renewals of However, the expectation of quota share are aligned with the 2006 vehicles. renewed sidecar growth was host syndicate, so they have inbuilt As the traditional US property thwarted, as analysts’ forecasts leverage which has proved very catastrophe market stabilised – of rate hardening proved over- attractive during a period where influenced in part by increased optimistic. other forms of leverage have been capacity from the Florida Hurricane The usual equity investors in virtually non-existent. Catastrophe Fund – prices began previous reinsurance sidecars – The first SPS was launched for to soften and the attraction of these the 2007 underwriting year by the sidecar vehicles began to wane for R einsuranceREINSURANCE sidecar SIDECAR issuance ISSUANCE 2001-2009 2001-2009 MAP syndicate. It was joined by sponsors and investors alike. Many 5 , 0 0 0 2 0 the Hiscox syndicate and the Ark of the vehicles did not renew their syndicate for the 2008 underwriting 4 , 0 0 0 1 6 capacity in 2008 and were closed. year, and by the Amlin syndicate for 3 , 0 0 0 1 2 the 2009 underwriting year. Market

$ Millions 2 , 0 0 0 8 T icking over of Sidecars No. capacity from these four SPSs

Meanwhile, 2008 saw the evolution 1 , 0 0 0 4 totalled £160mn during 2009. The of the traditional quota share capital supporting these transactions 0 0 reinsurance sidecar with the launch 2001 2002 2003 2004 2005 2006 2007 2008 2009 has been generated almost entirely of Globe Re Limited, sponsored Total Capital ($m ) Total Sidecars from third-party Names’ capital by Hannover Re. This transaction Source: Aon Benfield Securities arranged by Members’ Agencies. www.trading-risk.com 2009 Review; 2010 Preview 48 TR reinsurance report

Capital restored… benign US hurricane season, Global reinsurance capital base L argest reinsurers A narrowing credit spreads by premium and continuing improvements in capital and debt market conditions volume 2008

spurred ratings agency Fitch to Reinsurer Gross Market Premium revise its outlook on the global -15% written share change +9% premium (%) on 2007 reinsurance sector from negative to ($bn) (%)

stable at the end of 2009. Munich Re 21.44 15.9 10 With capital bases returning to 2007 levels, Fitch said reinsurers Swiss Re 17.07 12.6 2 were in a “strong competitive Lloyd’s 11.56 8.6 6 position”. $bn $362bn Berkshire 7.96 5.9 -40 In its Reinsurance Market $337bn Hathaway Outlook, Aon Benfield estimated $309bn Hannover Re 7.3 5.4 3 that reinsurers had been able to rebuild capital by 9 percent to SCOR 4.55 3.4 43

$337bn over the first six months of Transatlantic 4.42 3.3 3 2009, with the logical conclusion Re being that “insurers looking for Partner Re 3.44 2.6 7 more capacity are likely to find Everest Re 2.91 2.2 -9 the January 2010 market more Q4 2007 Q4 2008 Q2 2009 conducive than at any time during Source: Aon Benfield Korean Re 2.87 2.1 -15 2009”. Capital and Solvency Mapfre Re 2.6 1.9 19 Swiss Re noted that insurance capital and solvency had 300 180 XL Capital 2.26 1.7 -15 rebounded more quickly than 250 150 Caisse 1.77 1.3 12 Centrale de expected, with capital for both 200 120 Reassurance insurers and reinsurers back to 150 90 Toa Re 1.73 1.3 14 2007 levels. 100 60 The firm added that insurers AXIS 1.55 1.1 0 50 30 profited from improved investment Odyssey Re 1.5 1.1 -3 results during 2009, which – 0 0 99 00 01 02 03 04 05 06 07 08 09 10 coupled with a benign loss year QBE Re 1.45 1.1 28 Primary insurers' capital Reinsurers' capital – boosted the financial strength Primaries' solvency [RHS] Reins' solvency [RHS] Paris Re 1.4 1 0 of the sector. Indeed, our sister Source: Swiss Re Source: Aon Benfield Research publication, The Insurance Insider revealed that property catastrophe reinsurance pricing for California But (re)insurers’ strong 2009 run trails off in Q4 2009… earthquake perils fell around 20 percent at the 1/1 renewals, 140 following shifts in the main model assumptions during the year. 130 Meanwhile, national US programmes typically renewed 120 within a flat to minus 5 percent range, while regional programmes 110 saw average price decreases of approximately 7.5/10 percent. 100 FTSE All Share Price Index Price The 1/1 renewal season was also S&P 500 notoriously late this year as buyers 90 EUROTOP 100 12 Month performance: held out for higher discounts FTSE 100: +30.6% AP (Re)insurance Index S&P 500: +34.2% which, if anything, suggests the 80 Eurotop100: +19.7% year ahead is likely to see further AP (Re)insurance Index: +31.0% pressure on reinsurance rates. Will 70 reinsurers hold the line in 2010? Dec-08 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Source: Atlas Partners LLP Notes: 1. Atlas Partners Non-Life (Re)insurance Index includes Amlin, Beazley, Brit, Catlin, Chaucer, Hardy, Hiscox, Novae, Omega, Hannover Re, Munich Re, Paris Re, RSA, Scor, Swiss Re, Arch, Argo, Aspen, AWAC, Axis, Endurance, Flagstone Re, Lancashire, Max Capital, Montpelier Re, Platinum, Validus Re , Ace, Everest Re, Partner Re, Renaissance Re and XL Capital 2. Based on share prices for the 12 months to 30/11/09 2009 Review; 2010 Preview www.trading-risk.com Source: Atlas Partners analysis, Datastream t r reinsurance report 49

… as cats stay away t around $20bn, the industry’s A tlantic hurricane vs early season forecasts A2009 cat losses were less than halve the previous year, enabling 8 Average forecast the reinsurance industry to restore its balance sheets. But another 7 Actual benign year is unlikely if the predictions of the storm scientists 6 are correct. Tropical Storm Risk (TSR) and 5 Colorado State University (CSU) researchers anticipate 2010 activity 4 to be some 35 percent above the 1950-2009 average. 3 TSR predicted 13.9 named storms, 7.4 hurricanes and 3.4 2 intense hurricanes for next season, which runs from 1 June to 30

Number of hurricanes 3 or above cat 1 November, while CSU predicted up to eight hurricanes. 0 In total, 2009’s Atlantic hurricane average season saw nine named storms 2003 2004 2005 2006 2007 2008 2009 1999 - 2008 and three hurricanes form, Source: Numis Securities, The Insurance Insider whereas the average since 1950 has been 9.6 storms and 5.9 Southern California 30-year earthquake probability hurricanes. All in all, it was the quietest year since 1997, despite 100 forecasters’ high predictions. 80 However, it’s been more than 15 years since 1994’s Northridge 60 earthquake took its place among (%) the costliest natural disasters for 40 the US insurance industry, and AM Best warned that the “threat of a 20 major earthquake lurks” beneath 0 the US or offshore. 6.7 7 7.5 8 “According to a state-wide, 30-year forecast for California Magnitude Source:AM Best earthquakes released in 2008, there’s more than a 99 percent US quake property losses – $1bn plus probability for one or more Rank Earthquake Year Magnitude Insured Losses (2009 $bn) quakes of magnitude 6.7 or greater 1 San Francisco (Earthquake & Fire) 1906 7.8 32.9 occurring in the state in the next 2 Northridge 1994 6.7 20.0 30 years,” AM Best said in a 2009 3 Prince William Sound, Alaska, Earthquake & 1964 9.2 4.6 report. Tsunami The probability of a quake of 4 San Fernando 1971 6.5 3.0 that magnitude striking in the 5 Loma Prieta (San Francisco Bay Area) 1989 6.9 1.9

Los Angeles region is 67 percent, Source: AM Best compared with 63 percent in the San Francisco region, according to Most costly insured losses in 2009 the Uniform California Earthquake Ranking Insured losses (in US$ mn) Date (start) Event Country Rupture Forecast. The big one will come one year. 1 3,540 24.01.2009 Winter Storm Klaus, winds up to 170 km/h, heavy rain France, Spain Question is: “Will it be in 2010?” 2 1,350 10.02.2009 Winter storm, winds up to 145 km/h, heavy rain US 3 1,250 23.07.2009 Hail, thunderstorms; damage to buildings and some crops Switzerland, Austria, Poland, Czech Rep.

4 1,130 09.04.2009 Tornadoes, storms with winds up to 105 km/h, hail US

5 1,050 10.06.2009 Thunderstorms with winds up to 128km/h, hail US

Source: Swiss Re www.trading-risk.com 2009 Review; 2010 Preview 50 TR deal directory

2009 Insurance linked securities deal directory Transaction Sponsor Lead Mgrs. Domicile Risk/Peril/ Size (mm) Issuance Maturity date/ Spread (bps) Moody’s S&P AM Modeller Type Date no.years Best 2009 Redwood XI* Swiss Re SRCM CA Q $150 Dec-09 Dec-10 TMM+625 B1 EQE

Lakeside Re II* Zurich American AB/BNPP/MR CI CA Q $225 Dec-09 Jan-13 TMM+ BB- RMS

Longpoint Re Travelers BNPP/GS CI US W $500 Dec-09 Dec-12/13 TMM+540; 540 BB+; BB+ RMS II - A, B Indemnity

Atlas Capital VI - A SCOR Global Aon Benfield Eire Euro W; EUR75 Dec-09 Dec-13 E+950 BB- RMS P&C (AB) JP Q

Successor X - S, Swiss Re SRCM US W & Q; $150 Dec-09 Dec-10 Discounted notes; 80%; NR; B-; NR EQE U, X Euro W 88%; 84%

Montana Re - A, B Flagstone Re GS/AB CI US W & Q $175 Nov-09 Nov-12 L+975; 1325 BB-; B- bb-; b RMS Suisse

Vita Capital IV Swiss Re SRCM CI Extreme $75 Nov-09 Jan-14 Collateral +650 BB+ RMS mortality

MultiCat Mexico Swiss Re/ SRCM/GS Mex W $290 Oct-09 Oct-12 TMM+1150;1075;1025;1025 B; B; B; BB- AIR 2009 - A, B, C, D FONDEN & Q

Eurus II Hannover Re BNPP/AB CI Euro W EUR150 Jul-09 Mar-12 E+675 BB AIR

Parkton Re 2009-1 Swiss Re/NCJUA SR/GC CI North $200 Jul-09 May-11 MM+1050 B+ AIR Carolina W

Ianus Capital Munich Re MRCM/JPM Euro W; EUR50 Jun-09 Jun-12 E+900 B2 EQE TurkQ

Calabash Re III ACE/Swiss Re SR CI US W & Q $100 Jun-09 Jun-12 L+1525; 550 BB-; BB- RMS - A, B

Residential Re 2009 USAA GS/AB/BNPP CI US W & Q $250 May-09 Jun-12 MM+1300; 1700; 1250 BB-; B-; BB- AIR - 1, 2, 4

Successor II Swiss Re SR US W & Q $60 Apr-09 May-10 L+78.5

Ibis Re Ltd Series Assurant Inc GS CI US W & Q $150 Apr-09 May-12 L+1025; 1425 BB; BB- RMS 2009-1 - A, B

Blue Fin II Allianz Argos 14 GS/AB CI US W & Q $150 Apr-09 May-12 L+1350 BB- AIR

Mystic Re II-2009 Liberty Mutual GS/SR CI US W & Q $225 Mar-09 Mar-12 L+1200 BB AIR

East Lane Re III Chubb GS CI US W & Q $150 Mar-09 Mar-12 L+1025 BB AIR Series 2009-1 - A

Atlas V - 1, 2, 3 SCOR DB/BNPP Eire US W & Q $200 Feb-09 Feb-12 L+1450;115;1250 B+;B+;B AIR

L7 Hannover Re EV EUR100 Jan-09

*Not closed at time of going to press N on-life bond maturities Dec 2009 – Dec 2010 Transaction Sponsor Lead Mgrs. Domicile Risk/Peril/ Size (mm) Issuance Maturity date/ Spread (bps) Moody’s S&P AM Modeller Type Date no.years Best

Bay Haven - A, B Multiple ABN-AMRO CI MP $200 Oct-06 Nov-09 L+425; 150 BBB-; AA RMS

Successor 6 - C,D Swiss Re SR CI US W $60 Dec-07 Dec-09 B; B EQE

Residential Re 2007 USAA GS CI US W & Q $600 May-07 Jan-10 L+775; 600; 1225; 1025; 725 BB+; BB+; B; AIR - 1, 2, 3, 4, 5 B; BB

Calabash Re II - E-1, ACE/ Swiss Re SR CI US W & Q $250 Dec-06 Jan-10 L+1090; 960; 840 BB; B+; BB EQE D-1, A-1

Lakeside Re Zurich American Aon CI CA Q $190 Dec-06 Jan-10 L+650 BB+ RMS Ins. Co / Munich Re

Atlas Re III SCOR GS Eire Euro W; EUR120 Dec-06 Jan-10 E+400 / E+1000 BB+ EQE JP Q

Carillon Ltd Class Munich Re LB CI US W $51 Jun-06 Jan-10 L+1000 B+ AIR A – I

Gamut Re - E, D, Portfolio Mgr - GS CI MP $310 May-07 Jan-10 N/A; L+1500; L+700; L+300; NR; NR; NR; NR; BB-; AIR C, B, A Nephila L+140 Ba3; Baa3; BBB-; A- Aa3

Foundation Re - D Hartford GS CI US W & Q $105 Feb-06 Feb-10 L+725 BB RMS

Blue Fin - B, A Allianz Global MS CI Euro W $65/ EUR155 Nov-07 Apr-10 L+440; E+445 BB+; BB+ RMS

Successor II Swiss Re SR US W & Q $60 Apr-09 May-10 L+78.5

Longpoint Re - A Travelers GS, SR CI US W $500 May-07 May-10 L+525 BB+ RMS

Fremantle - C, B, A Brit Insurance ABN-AMRO CI MP $200 Jun-07 Jun-10 L+700; 200; 90 Ba2; A3; BB-; Ind. loss Aa1 BBB+; AAA

Merna - C, B, A State Farm Aon/Citi/ML Bermuda MP $1,059 Jun-07 Jun-10 L+275; 175; 65 Baa2; A2; A-; AIR Aa2 AA+; AAA

Foundation Re II - A Hartford GS CI US W $180 Nov-06 Nov-10 L+675 BB+ RMS

Newton Re - A, B Catlin JPM/Aon CI US W & Q $225 Dec-07 Dec-10 L+465; 695 BB+; BB PCS

Atlas Re IV SCOR GS Eire Euro W; EUR160 Nov-07 Dec-10 E+1025 B EQE Jap Q

Carillon Ltd - E - II Munich Re MS CI US W $150 May-07 Jan-11 L+1525 B AIR

Green Valley Groupama SR Euro W EUR200 Dec-07 Jan-11 E +370-400 BB+ RMS

Legend: Peril Q:earthquake W: windstorm MP: multi-peril EV: embedded value CA: California FL: Florida JP: Japan Domicile CI: Cayman Islands Companies SRCM: Swiss Re Capital Markets GS: Goldman Sachs ML: Merrill Lynch MRCM: Munich Re Capital Markets LB: Lehman Bros JPM: JP Morgan BNPP: BNP Paribas AB: Aon Benfield GC: Guy Carpenter DB: Deutsche Bank 2009 Review; 2010 Preview www.trading-risk.com ■ Sidley is one of the world’s largest law firms, with approximately 1,700 lawyers in 17 offices located in Europe, North America, Asia and Australia.

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■ Sidley has a market leading practice in alternative risk transfer and the use of innovative risk finance strategies and structures – including cat bonds, sidecars and derivatives – to transfer P&C and life insurance risk to the capital markets.

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Trading Risk-ad-DEC2009.indd 1 12/22/09 10:55:08 AM