COMMITTED TO IMPROVING THE STATE OF THE WORLD Convergence of Insurance and Capital Markets

A World Economic Forum Report in collaboration with Allianz Barclays Capital Deloitte State Farm Swiss Re Thomson Reuters Zurich Financial Services

World Economic Forum October 2008 The Convergence of Insurance and Capital Markets is published by the World Economic Forum. The Working Papers in this volume are the work of the authors and do not represent the views of the World Economic Forum.

World Economic Forum USA Inc. 3 East 54th Street 17th Floor New York, NY 10022 Tel.: +1 212 703 2300 Fax: +1 212 703 2399 E-mail: [email protected] www.weforum.org/usa

World Economic Forum 91-93 route de la Capite CH-1223 Cologny/Geneva Switzerland Tel.: +41 (0)22 869 1212 Fax: +41 (0)22 786 2744 E-mail: [email protected] www.weforum.org

© 2008 World Economic Forum USA Inc. All rights reserved.

No part of this publication may be reproduced or transmitted in any form or by any means, including photocopying and recording, or by any information storage and retrieval system without explicit written permission from the World Economic Forum USA and the respective authors.

REF: 091008

Order number: 1504095_08_EN Contents

Foreword and Contributors 4 1 Executive Summary 6 2 The Existing Market for Insurance Risk 9 2.1 Market development 9 2.2 Market instruments 10 2.2.1 P&C bonds 10 2.2.2 Life bonds 12 2.2.3 Weather derivatives 13 2.2.4 Industry loss warranties 14 2.2.5 Cat swaps 14 2.2.6 Exchange traded cat risks 14 2.3 Market participants 15 3 Impediments to Growth 17 3.1 Impediments for sponsors 17 3.1.1 Basis risk 17 3.1.2 Accounting and regulatory treatment 19 3.1.3 Inconsistent ratings treatment 22 3.1.4 Pricing of traditional reinsurance 22 3.1.5 Time and cost 23 3.1.6 Data quality and transparency 24 3.1.7 Limited types of risk 26 3.1.8 Cultural factors 26 3.2 Impediments for investors 27 3.2.1 Lack of standardization 27 3.2.2 Limited secondary market 29 3.2.3 Long payout periods 29 3.2.4 Valuation complexity 30 4 Conclusions and Recommendations 31 Appendices 33 Appendix A: Project Description 33 Appendix B: Findings 34 Appendix C: Current Initiatives 37 References 39 Acknowledgements 40 Footnotes 41

3 Foreword and Contributors

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

James J. Schiro Kevin Steinberg Group Chief Executive Officer and Chairman of the Chief Operating Officer and Head of the Centre Group Management Board for Global Industries (New York) Zurich Financial Services Switzerland World Economic Forum USA

4 Contributors Jerry Del Missier President Co-authors Barclays Capital Katharina Hartwig (part 3) Jim Rutrough Group Legal Services Vice-Chair and Chief Operating Officer Allianz State Farm

Kurt Karl (part 2) James J. Schiro Senior Vice-President Group Chief Executive Officer Head of Economic Research and Consulting and Chairman of the Group Management Board Swiss Re Zurich Financial Services

Steven Strauss (Executive Summary) Devin Wenig Senior Adviser Chief Executive Officer, Markets Division World Economic Forum USA Thomson Reuters Tom Watson (parts 4 and 5) Key Knowledge Partners Project Manager World Economic Forum USA Jack Ribeiro Global Head of Financial Services Operating Committee Deloitte LLP Daniel Brookman Ed Hardy Head of Structured Insurance Insurance Partner Barclays Capital Deloitte & Touche LLP Daniel Hofmann From the World Economic Forum Chief Economist Zurich Financial Services Kevin Steinberg Chief Operating Officer and Head of the Centre for Kurt Karl Global Industries (New York) Senior Vice-President World Economic Forum USA Swiss Re Steven Strauss Ben Lewis Senior Adviser Head of Strategy World Economic Forum USA Thomson Reuters Tom Watson Stephan Theissing Project Manager Head of Group Treasury and Corporate Finance World Economic Forum USA Allianz

While not necessarily endorsing any of the specific Deborah Traskell conclusions reflected in this report, both the Steering Executive Vice-President Committee and Operating Committee provided State Farm detailed feedback and helped ensure the overall integrity of the work. Any opinions herewith are Steering Committee solely the views of the authors and do not reflect the Paul Achleitner opinions of the Steering Committee, the Operating Chief Financial Officer Committee or the World Economic Forum. Allianz Jacques Aigrain Chief Executive Officer Swiss Re

5 1. Executive Summary

Facilitating risk transfer and increasing transparency Some life insurance, securitizations, for example, are have been dominant themes in the financial markets backed by the embedded value of future profit since the end of World War II. Transferability and streams from a book of life insurance policies. transparency are widely believed to promote better economic performance – with important benefits not In the case of property and casualty (P&C) just to investors but also to consumers and other securitization, however, the distinction between the social stakeholders. transfer of assets and the transfer of liabilities is critical. Risks in bank assets tend to be correlated, as the recent sub-prime crisis has demonstrated. “In certain risk areas we see an This creates a strong incentive for bankers to increasing need for capacity. Weather- transfer risks to the markets in order to diversify their related insurance claims, for example, asset portfolios. P&C liabilities, on the other hand, have increased fifteen-fold over the last are uncorrelated, or only weakly correlated. Hurricane Katrina, to cite one example, severely 30 years. In this challenging situation, impacted a relatively small geographic region of the insurance-linked securities provide new United States, but had little or no effect nationally or fully collateralized and multi-year globally. The typical P&C portfolio, then, consists of capacity for the risk-carrying industry, a wide spectrum of uncorrelated risks. This creates along with a high degree of risk diversification benefits, in that total risk in the portfolio is less than the sum of the individual risks – diversification, which makes them reducing the incentive for P&C insurers to transfer attractive for investors as well.” these risks to the market.

Paul Achleitner, Chief Financial Officer, Allianz, Germany Yet, this diversification benefit is precisely what makes insurance-linked securities (ILS) potentially desirable to investors – they are uncorrelated with Financial innovation has allowed many types of risk their existing asset holdings. P&C insurers, to become more tradable including credit, interest meanwhile, have another incentive to transfer risk, rate, equity and foreign-exchange risk, to name but as a means of obtaining additional capacity (mainly a few. However, one important category still lacks a for catastrophic risk). Thus, liability securitization can liquid, transparent and tradable market: insurance be a tool for capital management for both buyers risk. and sellers.

The potential market is vast, with total premiums of Market development all the world’s insurers equalling approximately US$ 4.1 trillion. Insurance risk comes in many varieties Although the market still lacks a clear, transparent and can be segmented into broad categories (e.g. and tradable platform, ILS issuance and trading life, property and casualty, etc.), as well as activity has been growing at a rapid pace, albeit geographic markets. This is not unlike other types of from a small base. The tradable insurance risk risk widely traded in the capital markets. Credit risk, market currently has a notional value of only US$ 50 for example, can be divided into corporate, billion, but has been growing at 40-50% per year municipal, mortgage and consumer sectors, among since 1997. The premium equivalent is now about others. US$ 3 billion, or 1.5%, of global reinsurance premiums, which were about US$ 192 billion in However, it is necessary for investors and policy- 2007. In more mature risk markets, the tradable makers to recognize the distinctions between the portion is typically a multiple of the underlying securitization of assets (mortgages, car loans, etc.) notional value. Hence, there appears to be ample and the securitization of liabilities. Most life insurance room for growth. securitizations are similar to asset-backed securities (ABS) currently offered by banks – and prone to many of the same issues associated with ABS.

6 “The development of the ILS market unambiguous. The borrower is not dependent on has increased the ability of insurers and the credit quality of the lender and has no economic or legal interest in the identity or financial strength of reinsurers to accept peak natural the ultimate mortgage holder. The lender, on the catastrophe risks such as US other hand, does have an incentive to understand hurricanes.” the borrower’s creditworthiness – although the incentives for due diligence clearly can be weakened David J. Blumer, Head of Financial Services by the originator’s ability to transfer the mortgage Swiss Re, Switzerland quickly.

In an insurance contract, the situation is quite The need for capital, liquidity and transparency has different. As the ultimate risk holders, insurers must become even more urgent for the P&C industry as it make significant investments in due diligence. To faces the challenge of global climate change, which manage their exposures, they must be aware of and is increasing the risks of European windstorm seek to control moral hazard. Policy-holders, damage and American coastal flooding, among meanwhile, have a very real interest in knowing the other hazards. Accordingly, the industry would like to identity and understanding the business practices of move to more flexible and efficient capital structures, their insurance providers. They want to be sure their which would be facilitated by greater development of claims will be met if losses are incurred. the insurance risk market. Even if the increased access to capital were confined to reinsurers, this Obviously, the average policy-holder cannot check would still indirectly benefit policy-holders by the creditworthiness and solvency of his/her carrier; increasing their capacity to absorb risk. he/she has to rely on the assessments of regulators and the rating agencies. Hence, the policy-holder Finally, transparent pricing would also reveal the cost will always want approval regarding any assignments of well-intentioned political solutions that increase of the insurance contract, while the primary insurer is the provision of insurance but fail to adequately fund unlikely to ever be completely removed from the those guarantees, by making it possible to mark value chain. While these interests may inhibit the public sector insurance schemes to market. growth of the risk transfer market, they also may provide some protection from the “exuberance” we Structural impediments to growth have witnessed in sub-prime lending.

While there are reasons to be optimistic about the Key findings development of the insurance risk transfer market, there are also some fundamental dynamics that Over the course of this project, certain themes could slow its growth. Some of these factors are emerged from our workshops and interviews with rooted in the distinctions between asset and liability market participants. Sponsors (mostly reinsurers and securitization mentioned earlier. some insurers) identified the following key issues that will need to be addressed in order to facilitate the A simple comparison to the mortgage market may development of the insurance risk transfer market: illuminate the point. The originator of a mortgage • Lack of standardization: Insurance risk transfers loan (particularly in the American market) can can take a long time to complete, costs can be completely remove itself from the risk equation by very high and the accounting treatment is executing a true sale of the note to a third party. In uncertain. The latter problem often stems from effect, it can elect to have no further risk exposure to the considerable uncertainty about regulatory and the borrower going forward, even if it chooses to rating-agency treatment of the transaction. The retain other elements of a customer relationship. result is a reluctance to engage in the market This separation is feasible because the underlying among institutions subject to the most uncertainty. contractual relationship is simple and relatively

7 • Insufficient cost/benefit analysis: Traditional • Uncertainty concerning the probability of reinsurance is of a limited term, the list of catastrophic loss: This presents a bit of a potential counterparties is small and the ceding “Catch 22”. One of the major reasons the insurer ends up with a credit risk from the insurance industry wants to promote liquid reinsurer. Capital market transfer instruments transfer markets is the uncertainty regarding risks provide longer terms and reduce counterparty such as climate change and global pandemics. risk, but increase complexity. The insurance However, this very uncertainty makes the capital industry also lacks a language and a markets price these risks conservatively, limiting methodology to evaluate the benefits of these the benefits of securitization. instruments and make quantitative comparisons to conventional reinsurance. Our recommendations for addressing these and • Poor data quality: In many markets, tradeable other issues are described in more detail in the market indices do not exist. In the US, there is following sections. Our key point is that these also a need for more granular data for parametric impediments will not be simple, fast or easy to transactions that can potentially be used as overcome. In order to maintain the growth of the market indices.1 insurance risk market, concerted action will be • Basis Risk: Any market structure in which the required from market participants over a multi-year insurer’s reimbursement is based on a market time horizon. index or formula creates basis risk, which is the difference between the actual claims paid out and what is received from the counterparty based on the index/formula. (Note that this can result in either a gain or a loss for the insurer). For some companies, basis risk may reduce the capital adequacy relief provided by such transactions – thereby favouring transactions by other companies (such as reinsurers) that receive regulatory and/or rating-agency treatment that more closely matches the actual claims paid out.

Investors and risk assumers involved in the insurance convergence project identified the following key issues: • Limited secondary market: While liquidity conditions in insurance risk markets typically equal or exceed markets for similar fixed income instruments (such as collateralized debt obligations, high-yield corporates and off the run ABS), investors still believe that many existing products “trade by appointment” – particularly if the investor needs to trade in size. This presents a challenge for market participants who mark to market or who need liquidity on short notice, etc. As is the case in the collateralized fixed-income markets, these perceptions also impact pricing. • Valuation requires specific knowledge, models and data: A wealth of material and tools exists for valuing most other risk categories. However, this store of intellectual capital does not yet exist to the same extent for the insurance risk market.

8 2. The Existing Market for Insurance Risk

Since its infancy in the early 1990s, the market for Other factors are also driving the insurance-linked securities has grown at high growth of the risk transfer market. double-digit rates. This convergence is being driven by a number of major trends. First, financial innovation is playing a key role by developing new • The increased visibility of catastrophe modelling instruments for transferring insurance risks. Second, firms in the capital markets, boosting the insurers need to efficiently manage their capital and credibility of their models these new products provide flexibility and access to • Dramatically improved distribution capacity, as a large pool of capital. This can be advantageous for more investment banks and reinsurers offer ILS P&C insurers who have a sudden need for extra products to investors capacity to write insurance – following a major • The availability of senior financing, which is now catastrophe, for example. obtainable at meaningful levels for ILS • Increased price transparency with the launch of Several trends are driving the exchanges trading cat risks and brokered cat swaps convergence of insurance and the • Lower transaction costs made possible by document standardization and shelf financing capital markets.

2.1 Market development At other times, the most efficient way to transfer a particular risk may be through a non-traditional instrument, such as a catastrophe bond (cat bond) ILS issuance and capacity both set or swap (cat swap). Even insurers that do not records in 2007. themselves use these instruments may benefit from the increased availability and affordability of reinsurance as reinsurers tap into the additional Issuance of insurance-linked securities totalled US$ capacity made possible by market growth. 14.4 billion in 2007, up 40% from US$ 10.3 billion in 2006. at the end of 2007, outstanding notional value For life and health (L&H) insurers, using ILS to stood at US$ 39 billion, up 50% from US$ 26 billion access the capital markets is an effective way to at the end of 2006. By May of 2008, the value of bonds finance growth and manage excess reserves. Life outstanding had reached about US$ 40 billion, with insurers may also desire protection against extreme life bonds accounting for 58% of market value of events, such as pandemics. Finally, there is growing bonds outstanding. The market still has significant interest in ILS among investors, because in some upside potential. P&C risks transferred to the capital cases they represent a diversifying asset class with markets represented only 12% of global catastrophe robust yields. reinsurance limits in 2007 and under 1% of other non-life reinsurance limits. There appears to be no Additional growth drivers include: shortage of sellers of protection – demand for this • Attractive investment performance, despite major asset class from dedicated cat funds has been losses such as Hurricane Katrina, the largest particularly strong. Issuance is expected to grow to insured loss in history US$ 25-50 billion by 2011, while the notional value • Enterprise risk management benefits, with ILS of bonds outstanding could reach US$ 150 billion. making it possible for insurers and reinsurers to supplement traditional capacity, diversify their trading partners and reduce counterparty risk ILS issuance slowed in 2008. • Efforts by the rating agencies to improve and document their methodologies for rating cat Although long-term prospects for the market are bonds, which especially benefits the tranched robust, ILS issuance slowed in the first half of 2008 layers of multiple-peril cat bonds due to the turmoil in the credit markets, which

9 particularly affected investment-grade life and non- 2.2 Market instruments life bonds. Life insurance issuance in particular slowed to a standstill, due to the credit crisis as well 2.2.1 P&C bonds as issues related to embedded value and US actuarial guidelines on valuation (commonly known Catastrophe bonds, the primary type of P&C bond, as Regulations XXX/AXXX). These instruments are originated in the hard market of the early 1990s similar to asset-backed securities, which have been following Hurricane Andrew, when reinsurance dramatically affected by the current market turmoil, capacity for catastrophes was limited and expensive. increasing the price of life securitizations. However, The earliest forms provided a simple mechanism to with the exception of the small investment-grade transfer catastrophic risks to capital markets. In a sector, non-life issuance has not slowed as spreads typical transaction, a fully collateralized special purpose have generally tightened in line with the softening vehicle (SPV) enters into a reinsurance contract with reinsurance markets. As expected, tightening a protection buyer, or cedent, and simultaneously spreads and softening reinsurance markets have issues cat bonds to investors. The reinsurance is dampened sidecar activity. usually an excess-of-loss contract. If no loss event occurs, investors receive a return of principal and a stream of coupon payments that compensate them The market for insurance-linked for the use of their funds and their risk exposure. If, instruments is developing rapidly. however, a pre-defined catastrophic event – defined by a trigger – does occur, investors suffer a loss of interest, principal, or both. These funds are transferred Other recent ILS developments include: to the cedent in fulfilment of the reinsurance contract. • The weather derivatives market has remained healthy, with the notional value of trades rising to US$ 32 billion in the 2007-2008 period from less The first catastrophe bonds were issued than US$ 10 billion in 2004-2005 after Hurricane Andrew. There are five • The use of industry loss warranties and cat basic types of loss triggers. swaps has grown at a strong pace and those instruments now have an outstanding notional value of about US$ 10 billion There are five basic types of trigger, with varying • Investor interest in natural catastrophe risk has degrees of transparency for investors and basis risk increased rapidly. Dedicated cat funds attracted for the cedent: substantial new capital after it was seen that the • An indemnity trigger is based on the actual losses prices of cat bonds remained stable even as of the sponsor and has negligible basis risk corporate bond prices plummeted • An industry index trigger is based on an • Catastrophe risks are now traded on exchanges industry-wide index of losses, such as the • Many parties are developing tradable indices, with estimates published by ISO’s Property Claim an initial focus on longevity, cat bonds and natural Services (PCS) unit in the United States catastrophe risk • A pure parametric trigger is based on the actual reported physical event (i.e., magnitude of earthquake or wind speed of hurricane) and has “Our experience with ILS-transactions the most transparency for the investor, but also a has been positive and these are an great deal of basis risk for the sponsor important part of our capital market • A parametric index trigger is a more refined activities and a key strategic lever.” version of the pure parametric trigger using more complicated formulas and more detailed Dieter Wemmer, Chief Financial Officer measuring locations Zurich Financial Services, Switzerland • A modelled loss trigger determines estimated losses by entering actual physical parameters into an “escrow model”, which then calculates the loss

10 Figure 1: The different types of insurance Multiple peril bonds now constitute the convergence products largest proportion of outstanding cat bonds. Average issue size has grown as new sponsors have been attracted to Parametric Pure Parametric

tor the market and standardization has

s Index lowered the cost of issuance. Modelled Loss Industry extended to new perils beyond the peak Florida parency for Inve parency Index s Indemnity wind risk that was typical in the market following Tran hurricanes Katrina, Rita and Wilma. One bond, for example, now covers European earthquake risk in Basis Risk to Issuer Turkey, Greece, Israel, Cyprus and Portugal, while

Source: Swiss Re Capital Markets another covers Japanese typhoon risk. Also, the average lifespan of the bonds has lengthened, from two years in 2006 to three-and-a-half years in 2007. Most P&C bonds transfer Some now have a lifespan of six years. catastrophic risks. The cat bond market continued to The overwhelming majority of P&C securitizations grow in 2007, even in a softening are for catastrophic risks, such as windstorms (hurricanes, typhoons) and earthquakes. These insurance market. serve as collateralized protection for extreme event risk, which eliminates counterparty risk, at a multi- year fixed price. Additionally, however, bonds have The process of issuing cat bonds is increasingly also been issued that transfer liability, credit, motor standardized, lowering the cost of issuance and and reinsurance recoverable risks. attracting new sponsors. The issuance of standardized “programme” or “shelf-offering” The largest proportion of bonds outstanding are for transactions accelerated in 2007, with shelf offerings multiple perils. In 2007, almost half of total issuance accounting for 72% of total non-life issuance. At the covered multiple perils. Also, cover has now been same time, the size of the average bond increased

Figure 2: Total P&C securitizations over time and split by peril

US$ billion 3% 2% 5% 1% 32 28 19% 24 21% 20 16 Multi-peril 39%

12 12% 8 6% 4 0 31% 98 99 00 01 02 03 04 05 06 07 Wind Liability Auto New issues Out standing from previous years Earthquake Credit Other

Source: Swiss Re Capital Markets

11 from US$ 141 million in 2006 to US$ 271 million in 2.2.2 Life bonds 2007. Of the bonds issued in 2007, State Farm’s Merna Re had a record value of US$ 1.2 billion, Life bonds can be used to monetize intangible while the Emerson Re and Longpoint Re bonds assets, fund US regulatory capital requirements were for US$ 500 million each. under Regulations XXX/AXXX, and transfer risks, such as extreme mortality events, to the bond market. These bonds, and the regulatory Sponsors and indemnity-based bonds requirements for them, differ from existing P&C increased last year. bonds in a very crucial respect: they are typically used as a financing tool. That is, asset-backed life bonds are secured by the flow of future profits from There was also a further widening of the pool of life insurance policies. Risk is not fully transferred in sponsors, which included large primary companies a legal sense, since the life insurance company will such as State Farm and Chubb, and corporations, always retain the obligation of its policies. However, such as East Japan Railway for the Midori bonds. In the burden of risks, such as mortality and lapse risk, another sign of a maturing market, the use of are assumed by the investors. For these bonds, indemnity triggers increased in 2007, as primary investors and protection buyers share the benefits insurers sought to minimize basis risk and investors and losses in the development of the underlying grew more comfortable with such triggers. policies that have been securitized. Extreme mortality bonds are similar to P&C cat bonds in that In 2005 and 2006, growth was supported by they, too, are fully collateralized and have a specified catastrophe activity in 2004 (hurricanes Charley, trigger. Ivan, Frances and Jeanne) and 2005 (hurricanes Katrina, Rita and Wilma). However, underlining the market’s growing maturity, cat bond issuance Life bonds are typically a financing tool. continued to grow robustly in 2007, even with softening insurance market conditions and despite the credit crisis.

Figure 3: Life bonds issued and outstanding in US$ billion

US$ billion 9%

16 7%

12

39% 8

4 42% 3% 0 98 99 00 01 02 03 04 05 06 07 XXX Embedded Value Other New issues Outstanding from prev. years AXXX Extreme Morality

Source: Swiss Re Capital Markets

12 The flow of XXX/AXXX securitizations five-year mortality cat bond (US$ 100 million) to weakened in 2007 after the credit protect against an exceptional rise in mortality in the US, Canada, England and Wales, and Germany. crunch hit the financial markets. 2.2.3 Weather derivatives

Funding of Regulation XXX/AXXX redundant reserves Weather derivatives are primarily used by utility in the United States has been the primary focus of companies to hedge against extreme heat and cold. life securitizations in the past few years. These They are typically triggered by heating degree days redundant reserves are for fixed-length term life (HDD) or cooling degree days (CDD) and serve to (XXX) and universal life (AXXX) policies. In the second reduce the volatility of earnings by offsetting losses half of 2007, pressure on the asset-backed from higher variable costs at fixed prices when demand securities market and on the monoline insurers surges during extreme weather. HDD, for example, slowed issuance, but this is expected to be a is the number of average degrees of temperature for temporary factor. In 2007, XXX transactions were a day below a reference value (usually 65°F or 18°C, executed publicly by Genworth (US$ 790 million) which have been shown to require no heating inside and Aegon (US$ 550 million). Protective Life buildings). Frequently, the derivative contracts are for completed a US$ 250 million AXXX securitization to cumulative HDDs over a season, depending on local fund universal life reserves. These figures understate weather patterns. Though HDDs are one of the most the true transfer of risk as substantial private common types of weather derivative, derivatives transaction activity coexists with the public market. have also been constructed with rainfall and other weather-related triggers. Securitizations that monetize the embedded value (EV) of a defined block of business accelerated in The weather derivatives market is 2007. The Bank of Ireland closed a US$ 573 million likely to grow by 30% per year for the EV transaction for its life insurance subsidiary, New Ireland Assurance. UnumProvident issued a 30-year next several years. bond (US$ 800 million) to monetize the value of its closed block of individual income protection insurance. In December, MetLife issued a 35-year Demand for weather derivatives remains healthy, bond (US$ 2.5 billion) to provide statutory reserve with the notional value of trades tripling in three support for a large closed block of liabilities. years, to US$ 32 billion in 2007-2008 from US$ 9.7 Securitizations of this type hold strong growth billion in 2004-2005 (the intervening 2005-2006 prospects since they provide an effective tool for life period was marked by some anomalous conditions, companies to improve capital efficiency and profitability. Figure 4: Weather derivative contracts (in US$ billion)

50

The issuance of mortality cat bonds 45 was unaffected by credit market woes. 40 35

30 The market for mortality risk transfer through 25 securitization continues to expand, as these bonds 20 were unaffected by the credit market’s woes. So far, 15 mortality cat bonds have been issued by Swiss Re, 10 Scottish Re, AXA and Munich Re. Swiss Re issued a 5 fourth mortality cat bond (US$ 521 million) in early 0 2007. In February 2008, Munich Re issued its first 00/01 01/02 02/03 03/04 04/05 05/06 06/07 07/08 Source: Weather Risk Management Association

13 including the rapid entry and exit of several hedge 2.2.5 Cat swaps funds as well as increased trading after the Katrina/Rita/Wilma hurricanes). Growth of about Cat swaps are over-the-counter, customized 30% per year is expected for the next several years. derivative contracts similar to ILWs, in that they require less documentation and are often set at lower levels of payouts than bonds. Cat swaps are Counterparties for weather derivatives very flexible and have been issued for protection are mostly utilities, construction against US windstorms, US earthquakes, Japanese companies and farmers. earthquakes, Japanese typhoons, Turkish earthquakes, aviation losses, terrorist attacks, mortality, longevity and multi-perils.

North America remains the main driver of the It is difficult to establish the exact size of the ILW weather derivatives market, although Europe is and cat swaps markets since these are private increasingly significant. Counterparties are: transactions. However, together the two instruments 1) Mostly utilities hedging against a warm winter are estimated to have about US$ 10 billion in 2) Agribusinesses buying yield and revenue outstanding notional volume. protection influenced by temperature and precipitation 2.2.6 Exchange traded cat risks 3) Construction companies hedging against precipitation or cold that can disrupt construction schedules Exchanges have been established to 4) Retailers hedging against the impact on buying trade insurance-linked derivatives. habits of temperature and precipitation

2.2.4 Industry loss warranties Recently, exchanges have been re-established to trade insurance-linked, index-based risks. Such risks ILWs, cat bonds and cat swaps are all were traded on exchanges in the 1990s, but these triggered by specified indexes. listings were discontinued due to a lack of interest. The New York Mercantile Exchange has partnered with Gallagher Re to create an exchange based on an index of aggregate insurance industry losses Industry loss warranties (ILW) provide protection reported by the PCS – excluding earthquake and against natural catastrophes. In their reinsurance terrorism losses. The Chicago Mercantile Exchange form, they are based on two triggers – an agreed and Carvill & Company have set up an exchange to upon industry-loss trigger and an indemnity-loss trade derivatives based on an index of wind speed trigger based on the buyer’s actual losses. In the and hurricane force radius at landfall. United States, the industry loss data used is frequently taken from the PCS, which provides The Insurance Futures Exchange Services Ltd (IFEX) timely estimates of insured losses after a has initiated trading in catastrophe event-linked catastrophic event. In other countries, Swiss Re’s futures on the Chicago Climate Futures Exchange. sigma data, Munich Re’s catastrophic loss data or IFEX derivatives are based on an index of PCS other loss estimates are used. Single ILWs may losses – a named hurricane must breach the trigger. provide anywhere from US$ 1 million to US$ 250 Each of these exchanges lists derivatives for various million of cover. By contrast, cat bonds typically geographic regions (all US, Florida, North Atlantic need to provide at least US$ 100 million of cover to coast, etc.) However, all three trading venues are be economical. relatively new and it is not yet clear if they will succeed.

14 2.3 Market participants Dedicated cat funds are now the largest investors in cat bonds.

Investor interest in insurance-linked securities continues to grow. Dedicated cat funds are now the largest buyers for cat bonds, making up 44% of the investor base. Last year, they continued to invest in higher yielding non- investment grade bonds and often set the pace for Fixed-income investors are increasingly interested in market trends such as the growing acceptance of ILS and related risk-taking instruments, for several indemnity triggers. Dedicated cat funds continue to reasons: attract funds at a rapid rate. Interest among other • These instruments often provide exposure to investors, such as hedge funds and traditional pension specific insurance risks, such as the risk of an plans and mutual funds, is also rising. Investors are earthquake in a specific area, resulting in a “pure attracted by the uncorrelated nature of cat bonds play” investment and thus their portfolio diversification value, as well • Their funds are held in trust, so investors face no as the increased liquidity of the secondary market. counterparty risk with the bond’s sponsor, the insurer or reinsurer • ILS investments often offer low correlation with Spreads on cat bonds continued to equity and credit markets, making them a narrow in the second half of 2007, even diversifying asset class as investors in other types of bonds Most investors tend to focus narrowly – with relatively saw spreads widen. little overlap, for example, between investors in catastrophe bonds and investors in embedded-value life bonds. The comments below focus on investors Since 2002, spreads on cat bonds have narrowed in catastrophe bonds and related instruments. from about 400-800 basis points to 200-400 basis points over LIBOR. Spreads on US wind-peril instruments spiked after Katrina, but are now back Creating loss indexes in Europe down following two consecutive benign hurricane

Although Europe does not have Figure 5: Investors in cat bonds by type a recognized loss index, help is As of 31 Dec. 2007 on the way. Insurer Reinsurer 3% 4%

A recent European initiative aims to develop Hedge fund Dedicated Fund indexes capable of measuring the scale of 14% 44% natural catastrophes in Europe. The initiative was launched through the Chief Risk Officer Forum and is supported by numerous major insurers and reinsurers. The goal is to develop a data service Bank 13% capable of promptly providing estimates of insured European natural catastrophe losses. This information could be used to develop industry loss indexes for insurance-related instruments Money manager 22% such as ILWs, cat bonds and cat swaps. Source: Swiss Re Capital Markets

15 seasons. This downward trend in spreads was “Since traditional insurance and strongly reinforced in the second half of 2007, reinsurance leave gaps in customers’ despite the credit crunch. While yields on corporate bonds widened in the second half of the year, cat cover needs, we support efforts to bond spreads, on average, continued to tighten. explore and develop innovative solutions, By contrast, the credit crunch and the accompanying such as an effective transfer of insurance uncertainty surrounding the major monoline insurers risk to the capital markets.” have had a dramatic impact on the market for life insurance bonds. These instruments became Jim Rutrough, Vice-Chairman and Chief Administrative dramatically less liquid and new issuance slowed to Officer, State Farm Insurance Group, USA a halt as transactions were reworked.

Sidecars it via a quota share – or some other reinsurance agreement – to the sidecar. Typically, sidecars are multi-year and created during “hard” insurance Sidecars provide capital when markets, when prices are high for catastrophic prices are high. risks. Sidecar capacity shrank in 2007. Because the P&C industry is now well capitalized and returns are falling, sidecar capacity shrank in Sidecars are special purpose vehicles that are 2007. Last year, only nine new sidecars with US$ temporary collateralized capital pools funded by a 1.9 billion in capital (mostly debt) were established third party, such as a hedge fund. The pool is or renewed, while about US$ 4 billion in sidecar structured as a retrocession vehicle for a “top capacity was retired. The remaining capacity is flight” reinsurer, which assumes a specific type of roughly US$ 4 billion. Sidecars may regain their business on its highly rated paper, and then cedes popularity after future large catastrophic events.

Figure 6: New sidecar capacity from 2001 to 2007

4.5 Capital Debt 4.0

3.5

3.0

$ billion) 2.5 S Gap in issuance illustrating 2.0 opportunistic sidecar use by insurers after major 1.5 Value (U Value hurricanes (KRW) 1.0 0.5

0.0 2001 2002 2003 2004 2005 2006 2007

16 3. Impediments to Growth

Though growing rapidly, the insurance risk transfer Investors, on the other hand, tend to value liquid market is still small in absolute size and slow in its markets, objective and transparent triggers, development compared to some of the credit-linked standardized documentation and short settlement ABS markets.2 This section will describe factors that periods. Key impediments for investors include the are impeding growth. Our findings are derived from complexity of the underlying risks and the models interviews with investors, insurers, reinsurers, rating used to evaluate them, the lack of standardization in agencies, investment banks, modelling agencies and the ILS market and the limited secondary market other stakeholders, as well as a review of the this heterogeneity produces. existing research literature. Except where noted, most of our analyses focus on catastrophe bonds, which represent the bulk of the P&C instruments 3.1 Impediments for sponsors currently outstanding. 3.1.1 Basis risk For sponsors, the transfer of insurance risk to the capital markets is an alternative or a complement to Traditional reinsurance, whether proportional or traditional reinsurance or retrocession. Accordingly, excess of loss, provides indemnity-based protection they will compare the costs and benefits of without or with only limited basis risk.3 However, securitization to traditional reinsurance in terms of some capital market instruments, if not indemnity- both the scope of the protection provided and the based, expose the primary insurer or reinsurer price. Relevant criteria are that an instrument seeking protection to varying levels of basis risk. provides tailored cover with minimal basis risk, low counterparty risk and favourable treatment with Traditional reinsurance or retrocession can be respect to regulatory capital and credit ratings. For divided in two types, proportional and non- sponsors, the key impediments to market growth proportional. In proportional reinsurance, including are the potential for basis risk in transactions with both quota-share reinsurance and surplus parametric triggers (as well as the accounting, reinsurance4, insurer and reinsurer share premiums regulatory and rating consequences resulting from and losses proportionally. In non-proportional or basis risk) and the pricing of capital market excess-of-loss reinsurance, the reinsurance premium transactions compared to traditional reinsurance. is not expressed as a specified share of the primary insurance losses and premiums but rather in absolute terms. The reinsurer assumes all losses of the primary insurer in a class of business that Two key differences between the exceed a certain amount and up to a specified limit. ABS and the ILS markets However, all these types of reinsurance are indemnity-based, meaning the recovery from the It is worth noting following two key differences reinsurer is based directly on the specified losses between the ABS and the ILS markets: With ILS, incurred by the primary insurer. Note, however, that the insurer retains a considerable amount of a limited amount of basis risk for the ceding insurance risk. To date, ILS mostly have been used company may result from exclusions and other to protect insurers against peak risks. Accordingly, contractual terms – such as the exclusion of post- there is much less of a moral hazard problem, event assessments – that limit the extent to which compared to the securitization of an entire credit the reinsurer follows the fortunes of the ceding portfolio. Secondly, there is no duration company. mismatch in cat bond or sidecar structures. Thus, the difficulties caused by the illiquidity of In capital market transactions, indemnity-based cat the market for short-term notes issued by bonds are structured similarly to excess-of-loss structured investment vehicles in the ABS reinsurance. Within the limits, the sponsor also market will not be repeated in the ILS market. receives full protection, since the risk assumed by

17 the investors relates to the specific loss exposure of In addition, under the applicable accounting rules, as the sponsor’s underlying portfolio. However, in any well as most regulatory regimes and rating-agency other transaction where the trigger is based on an rules, basis risk may have negative impacts. This index or is parametric, the insurer retains a basis risk point is discussed in more detail in the next (which may be positive or negative) arising from the subsection. imperfect match between the losses resulting from the portfolio for which protection is sought and the On the other hand, in indemnity-based transactions compensatory payment under the risk transfer investors expect to receive a premium for moral instrument, which are not fully correlated. hazard and adverse selection, the size of which is a function of the type of business covered and the Basis risk will vary according to the granularity of the associated modelling credibility, as well as the trigger used – i.e. whether an index provides a market's confidence in the sponsor's underwriting, geographic breakdown that allows sponsors to risk management, loss and claims adjustment refine the trigger to geographic areas where their processes, among other factors.5 Furthermore, exposures are significant – as well as the deviation investors will want to undertake more extensive due of the specific portfolio from the industry-wide diligence of the sponsor and the securitized exposure or losses. portfolio, increasing the cost and time spent to the sponsor. The assessment of basis risk depends on the quality of the risk model used to estimate the impact of Catastrophe bond issuances in 2007 showed an certain catastrophic events on the specific portfolio increasing volume of indemnity-based transactions. for which protection is sought, the quality of the data This trend may reflect the surge in investors seeking available with respect to such portfolio, and on the opportunities in the cat bond market, leading to specific peril. For example, there are only a few more favourable terms for sponsors. However, many recalibrating events for high severity perils such as investors still express concerns over the modelling earthquakes, which adds uncertainty to the models. integrity in indemnity-based deals, in particular with respect to complex commercial exposures, reinsurer For the sponsor, basis risk presents an impediment portfolios (where portfolio information is less because the protection obtained from the risk granular) and portfolios outside the US6, where data transfer instrument is imperfect. This must be quality is generally lower. reflected in internal risk management.

Figure 7: Instruments with and without basis risks

Instruments with basis risk Instruments without or with limited basis risk

Non Life • Cat bonds with modeled loss, • Sidecars industry loss or parametric triggers • Cat bonds with indemnity • Cat swaps based trigger • ILW

Life • Extreme mortality bonds • Embedded value securitization • Longevity ILS • XXX and AXXX bonds

18 Further standardization of risk transfer If the risk transfer instrument is classified as a instruments requires that sponsors financial derivative, it will, under both IFRS and US GAAP, be measured at “fair value” and marked to become comfortable with retaining market, with impact on profit and loss accounts. basis risk – from a risk management, This can create considerable volatility in the insurer’s accounting and regulatory perspective. income statement compared to a traditional reinsurance claim, which, subject to contract exclusions, is measured consistent with the treatment of underlying direct insurance liability. The standardization of risk transfer instruments can However, this difference in accounting treatment be driven much further if these instruments are not may be alleviated in the future with the move to fair structured for an individual portfolio but instead value measurement of insurance liabilities under both relate to an objective index or parametric trigger. IFRS and US GAAP. This would increase the volatility Thus, further standardization by means of of insurance liabilities and, correspondingly, of standardized parametric or industry-loss triggers reinsurance assets as well. requires that insurers become comfortable with retaining basis risk, or have the means to cede basis Solvency capital risk to a third party for a price that will still make the overall transaction competitive with traditional In addition to creating volatility in the insurer’s reinsurance. In either case, it will be necessary to income statement, treatment as a financial derivative develop robust methodologies – ones that are has the consequence – at least in many jurisdictions understood and accepted by the rating agencies –that the risk transfer instrument will be disregarded and the regulators7 – in order to evaluate basis risk with respect to solvency capital as long as no gain is and determine the levels of regulatory and rating realized. capital necessary to support it. Insurance undertakings and (in the European Union 3.1.2 Accounting and regulatory treatment since the Reinsurance Directive8) reinsurance undertakings must maintain a minimum level of Accounting solvency capital as a risk buffer. This supplementary reserve over and above the technical reserves The accounting treatment of alternative risk transfer serves as protection against adverse business instruments under International Financial Reporting fluctuations and is an element of prudential Standards (IFRS) and US Generally Accepted supervision. Accounting Principles (US GAAP) depends on whether such instruments are classified as In banking, the Basel I and Basel II accords have reinsurance contracts, and thus accounted for in the allowed credit institutions to release regulatory technical provisions and the insurance result, or capital through the securitization of their credit whether they are classified as financial derivatives, portfolios. This opportunity has had a considerable and thus have no impact on the insurance result. impact on the development of credit securitization. On the other hand, the insurance solvency regimes Under IFRS (IFRS 4), reinsurance accounting applies in most jurisdictions do not yet award such only to risk mitigation instruments that have an favourable treatment to the transfer of insurance indemnity-based trigger. Under US GAAP, industry risks to the capital markets. loss warranties documented as reinsurance contracts are treated as reinsurance since they have In the European Union, under the current Solvency I9 a dual trigger – one relating to industry losses, such regime, capital adequacy and the determination of as those reported by the PCS; the other being an the required solvency capital is based on the indemnity trigger, which relates to actual losses liabilities side of the balance sheet and on insurance incurred by the protection buyer. risk only. For non-life insurance undertakings, the

19 required solvency margin is defined as the higher of Union will not always be seen as providing adequate the premium index or the claims index. Under both reinsurance supervision. For the sponsor, this could indexes, reinsurance reduces the required solvency have a negative impact on the regulatory treatment of margin, but not by more than 50%, as shown in the the instrument. Using a transforming reinsurer may following (simplified) formulas: solve this problem but may create additional costs.

This dependence of the regulatory treatment on the • Premium Index = (18% x the first € 50m gross accounting treatment is similarly found in the United premiums + 16% x the remaining gross States: US insurers and reinsurers are required to premiums) x the retention rate report their financial results consistent with Statutory • Claims Index = (26% x the first € 35m gross Accounting Principles (SAP), an insurance claims and 23% x the remaining gross claims) accounting system that is more conservative than x the retention rate US GAAP. Under US GAAP (FAS 113, sections 9a • Retention rate = net claims ÷ three-year and b), the criteria for a risk transfer instrument to average of gross claims (but not less qualify for reinsurance treatment include the than 50%)10 “significance of the risk transferred” and a certain “probability of significant loss”. A significant transfer For life insurance, the required solvency margin is of risk is only achieved if there is no positive basis calculated as a function of the actuarial provisions or risk for the insurer. the capital at risk, and is lowered – within certain limits – to the extent that business is ceded by way Similar rules apply under SAP. Therefore, in many of reinsurance. transactions with parametric or industry-loss triggers, sponsors will use a double-trigger reinsurance contract similar to an ILW, thus capping the payout Solvency capital release varies by to the sponsor at the sponsor’s actual losses. This jurisdiction and inter-alia depends on can also delay the payout until actual losses are reinsurance accounting. assessed. The interest paid for this extension period can be an unintended benefit for investors.

In order to achieve solvency capital release from Whether an alternative risk transfer instrument alternative risk transfer mechanisms, sponsors must reduces the required solvency margin depends upon ensure these instruments receive accounting whether it is considered in the retention rate and, treatment as reinsurance. However, for the ceding therefore, under the Solvency I regime as currently companies this may add complexity to transactions implemented in most EU member states, upon in which solvency capital relief is an important whether the instrument qualifies as reinsurance. objective. The solution should be to look at these Treatment as reinsurance under the applicable instruments from an economic viewpoint and place accounting rules is a necessary, though not sufficient, the economic substance over the form of the prerequisite for regulatory treatment as reinsurance. relevant risk transfer instrument.

The reduction of the required solvency margin may In the European Union, progress in this direction has further depend on the jurisdiction of the special been made under the Solvency II regime, as rules purpose reinsurance vehicle used to transfer the risk detailing the Solvency II Directive Proposal11 are to the capital market, and whether the sponsor's being developed. Solvency II will be a principles-based regulator accepts this jurisdiction as having sufficient regime designed to take into account all types of risk reinsurance supervision. While currently it is often to which the insurer is exposed and to reflect beneficial from a tax or capitalization perspective to developments in the capital markets in a timelier and locate special purpose vehicles in Bermuda or the more flexible way. New capital adequacy standards Cayman Islands, jurisdictions outside the European are expected to come into force from 2012.

20 Solvency II is expected to take a more risk mitigation tools. These principles rely on the economic view on the recognition of economic impact, enforceability and stability of the instrument as well as the credit quality of the risk mitigation tools. counterparty.12

In the United States, no such development towards Solvency II envisages two levels of capital a more economic view of financial risk mitigation requirement: the Minimum Capital Requirement tools is currently observed, as such a development (MCR), which is the level of capital below which an would, inter alia, be largely dependent on a review of insurance operation presents an unacceptable risk the statutory reserving rules. However, the issuance to policy-holders, and which will be measured with of certain types of life insurance instruments (such simple, robust and objective methods, and the as XXX and AXXX bonds) is motivated by existing Solvency Capital Requirement (SCR), which is the US reserving rules. These instruments can be level of capital necessary to absorb significant expected to lose their benefit if US insurance unforeseen losses and provide reasonable regulations take a more economic view on reserving assurance to policy-holders (to a confidence level of and risk transfer. 99.5%) that all obligations will be met over a specified time horizon. In any case, the implementation of progressive principles on the recognition of non-indemnity-based Solvency II will provide for a total balance sheet risk transfer instruments will require a sound and approach, taking into account both assets and generally accepted method for the assessment of liabilities, to calculate the solvency capital required. It basis risk, which should be based on a portfolio will require insurers to hold capital against market rather than a transaction view. risk, credit risk and operational risk, all of which are currently not considered in the required solvency No automatic recognition as eligible assets margin. Similar to banks under Basel II, insurers will have the option of calculating these amounts using Insurance undertakings must cover their technical internal risk models rather than the standard model. reserves with matching assets that are subject to Quantitative impact studies released by the certain investment restrictions (eligible assets). These Committee of European Insurance and Occupational restrictions are designed to maintain the safety, yield Pensions Supervisors (CEIOPS) set forth certain and marketability of the investments as well as an principles in relation to the recognition of financial adequate level of mixture and diversification, while

Figure 8: Basis risk, accounting and regulation

Accounting P&L volatility since qualified treatment as financial derivative

Instruments Regulatory No reduction of required solvency margin with basis risk treatment (in most jurisdictions)

Rating Uncertainty and inconsistency w/r to credit treatment for sponsor’s financial strength rating

• Economic view with respect to solvency (see Solvency II) and rating • Development of robust and recognized methods to evaluate basis risk

21 ensuring the insurance undertaking's liquidity at all 3.1.3 Inconsistent ratings treatment times. EU member states can allow these technical provisions to be covered by claims against With respect to the financial strength rating of the reinsurers, subject to certain limits.13 Claims against sponsor – particularly its capital adequacy ratio – the reinsurers would thus automatically qualify as eligible rating agencies do not always give full credit for risk assets. However, this is not the case for all securitizations, but rather apply "haircuts" for basis alternative risk transfer instruments. Qualification risk. As with the regulatory treatment, the does not occur per se, but rather may depend on development of sound methods to evaluate basis the general rules for mixture and diversification of risk and allocate capital to it would be necessary for investments, the jurisdiction of the special purpose consistent recognition of alternative risk transfer reinsurance vehicle, or the funding of the structure. instruments with basis risk.

Complexity of transaction structures Some rating agencies have applied a cap on the rating of the ILS themselves because of the uncertainty of the catastrophe modelling. The rating Uncertainties about the accounting and of the instrument may be capped at a certain level tax treatment drives complexity and (e.g. AA) even though expected loss or probability of thereby cost of transactions. loss would otherwise allow for a higher rating. This practice may increase prices in the more remote layers. It can be expected that improvements in the models, and in the understanding and acceptance While it has been possible in past years to establish of them, should allow the rating agencies to fairly standardized transaction structures for abandon such practices. catastrophe bonds, no such structures yet exist for embedded-value securitizations in the life insurance The development of fully standardized sector. The efficiency of transaction structures is methodologies for quantifying and rating insurance highly dependent on accounting and tax rules, risk transactions would help avoid inconsistencies in requiring in-depth analysis of the applicable rules the assessment of the risk transfer that, as of today, (e.g. consolidation rules) involving external parties are observed in the sponsor's financial strength such as accounting firms, regulators and rating rating on one side and rating of the instrument on agencies. Different treatment under local accounting the other. As always, the transparency of the applied rules and IFRS often adds complexity. methodology is key, though investors should also expect rating agencies to exercise judgement in In this respect, certainty about the accounting applying their criteria. treatment and the development of tested structures would facilitate the securitization of insurance risk. 3.1.4 Pricing of traditional reinsurance Although the clarification in 2002 of US FIN 46, which interprets FAS 94 and RAB 51, led to an In an ideal world, insurers would cede risk to a increase in issuance volumes, the rules still require a seamless risk market, comprising both traditional time-intensive assessment of the accounting reinsurance and alternative instruments. Risk would treatment for each unique transaction and lead to be placed based on price and best use, regardless complex transaction structures. Unfortunately, these of form. However, in practice the market has not yet accounting rules remain in flux, further frustrating reached such a degree of efficiency. standardization efforts.

Currently, spreads in the traditional reinsurance market, which are lower than risk spreads for cat bonds, constitute an impediment to the securitization of catastrophe risk, due to abundant capacity and further softening in the reinsurance

22 pricing cycle following two years of mild natural importance for catastrophe instruments. Pricing of catastrophe losses. However, it is difficult to the instruments further takes into account the compare pricing for traditional reinsurance to pricing current pricing of catastrophe securities traded in for cat bonds or other alternative risk transfer the secondary market, with the yield on outstanding instruments because of the following differences: instruments capturing the secondary market's • Reinsurance cover is usually bought for one-year current return requirements. periods while cat bonds typically provide multi- year cover Pricing on the secondary market reflects probability • Cat bonds and some cat swaps are collateralized of loss at any point in time – prices to sponsors for and have less counterparty credit risk than US hurricane instruments, for example, will increase reinsurance, which is generally uncollateralized at the beginning of the hurricane season. With • Non-indemnity catastrophe bonds may allow for respect to rating, it has been the case historically quicker recovery, producing a significant time that most cat bonds have traded at a relative spread value of money advantage over most reinsurance to similarly rated corporate securities of between contracts 100 and 200 basis points16, due in part to their • Cat bonds usually do not include a reinstatement14, binary nature, novelty premium, low liquidity and unlike most reinsurance contracts perceived mechanical complexity. However, more • Sponsors will want to apply a discount for recently spreads have tightened, both as a result of transfer instruments with basis risk since they the higher spreads of corporate bonds during the provide incomplete protection compared to recent financial turmoil, but also because of a traditional reinsurance reduction in the risk spreads for cat bonds. The low correlation of insurance-linked instruments with As there are different pricing methods and also credit-related investments is shown by the stability of different dynamics in reinsurance and the capital prices amid the recent market turbulence. An markets, the relevance of these pricing impediments increased and more liquid market, driven by further can vary over time. In traditional reinsurance, a standardization and an increasing investor base, can “technical price” can be determined based on the be expected to bring spreads down further. expected loss and the expected volatility of the contract’s result. However, the “commercial price” is 3.1.5 Time and cost driven by industry capacity, by the occurrence of large loss events, and by investment returns15. This Sponsors are concerned about the time spent and has resulted in reinsurance pricing cycles. the costs paid for executing securitization transactions. This is particularly true for first-time issuances, where Hard markets occur after major loss events such as senior management involvement is usually higher than natural catastrophes or terrorist attacks; soft in repeated issuances. These transactional costs markets occur if reinsurance capacity increases due may constitute an impediment to market growth. to competition. During hard markets, alternative risk transfer instruments emerge as compelling options Compared to traditional reinsurance, securitization and are clearly a complement to traditional poses a number of additional costs for sponsors, reinsurance. including rating agency services, legal advice, risk modelling and risk analysis, as well as an arranger Pricing for capital market transfer instruments is fee (although traditional reinsurance often involves a primarily derived from the market and dictated by brokerage fee). Time must be spent modelling the the laws of supply and demand. With respect to risk to be transferred, preparing offering catastrophe instruments, the main driver is the documentation and assessing the transaction with expected loss as modelled by one of the auditors, tax authorities, regulators and rating independent modelling firms. Modelling results are agencies. In general, indemnity-based transactions key for ratings. Ratings, in turn, allow market require more detailed disclosure by the sponsor and, participants to compare prices for instruments with accordingly, are likely to require more time and similar characteristics, but this is of only secondary expense.

23 On the other hand, it has been shown that more depend highly on the data input – i.e. historic loss repeated issuance and the use of shelf programmes data, historic parametric data and exposure data. can bring down transaction costs. Furthermore, as The quality of the exposure data relating to the deal sizes get larger, fixed costs decrease as a portfolio for which protection is bought is relevant to percentage of total costs. Finally, transformer assessing the expected loss from the instrument issuance with wholesalers, such as reinsurers, can and, if any, the basis risk remaining with the sponsor. largely eliminate complexities for insurers – in much With respect to life insurance instruments, the the same way that wholesale universal banks “front” output of the actuarial models similarly depends on for local and regional banks, giving them ready the quality of the asset and liability portfolio access to the credit securitization markets. information fed into the model.

Key portfolio information taken into account in non- Increased standardization, particularly life risk models includes: in the use of derivative instruments, • The location, construction classes, number of would also lead to less time consuming stories, age and occupancy of insured buildings and less costly transactions. • Values at risk (buildings, contents, business interruption) • Insurance structure (limits, deductibles)

Increased standardization, particularly in the use of Furthermore, in indemnity-based transactions, the derivative instruments, would also lead to less time sponsor’s underwriting guidelines and claims- consuming and less costly transactions. management capacities are of great importance to the investors. Accordingly, due diligence extends to the 3.1.6 Data quality and transparency sponsor’s management, track record and incentives. Data relevancy Insufficient data quality and disclosure Transferred insurance risk is assessed on the basis of complex risk models developed by third-party There are regional variations in the providers. Catastrophe risk models take into metrics used by the insurance industry. account the probability of relevant catastrophic events, certain hazards resulting from such events, and the insured exposures in the relevant Insufficient data quality and disclosure impede the geographic areas. Expected losses are modelled on development of the insurance risk market in a the basis of analytical, engineering and empirical number of ways: techniques. The risk models used in capital market • The quality of exposure-related data tends to be transactions are generally the same as those used lower for non-US portfolios17. In the European for internal risk management by the sponsors as well Union, there are no standard formats for as by reinsurance underwriters. collecting policy data nor for reporting them, and available portfolio data are in general less detailed. In some cases, different metrics are Results of risk modelling depend on the used in different EU countries. Variation exists, for quality of the model as well as of the example, in building valuations. Also, policies in used exposure data. France are not reported by insured sum as they often are in Germany, but rather by the number of square metres in the insured building. Bringing these data together in the same modelling The reliability, credibility and transparency of the exercise is therefore a complex task. In contrast, modelling process are crucial to both investors and more comprehensive portfolio data are sponsors. However, the results of the risk analysis aggregated in the United States to satisfy

24 regulatory reporting requirements, and these data Disclosure standards must be made public by the insurers (nevertheless, the development of unified mortality Although traditional reinsurance assumes some of tables would be a useful US standardization, as it the same risks now being placed in the capital would facilitate the comparison of different life markets, data quality and disclosure seem to be insurance portfolios). more of an impediment to the capital markets than • Insurers have been reluctant to disclose portfolio to reinsurance: data as they may be of proprietary nature and • Capital markets have higher disclosure requirements. their disclosure valuable to competitors. However, This is particularly true for transactions in a Rule less reluctance is shown by US insurers, as they 144A private placement offering, and other are subject to more extensive disclosure transactions for which an offering document must requirements under both statutory reporting and be prepared. Higher disclosure requirements tend the Sarbanes-Oxley Act compliance rules. to be less relevant for the placement of • The presentation of data – i.e. not the amount of reinsurance sidecar equity, where investor due data, but the quality of its disclosure – has been diligence is more likely to focus on the sponsor's criticized as not allowing the investors to perform management than on its portfolio. the necessary analysis according to their • The capital markets are not subject to pricing methods. cycles to the same degree as the reinsurance • Information is less granular with respect to market, and thus do not allow investors to reinsurance portfolios. recover from bad transactions by increasing risk spreads for future transactions – except for Granularity of US parametric wind sidecar equity, where a subsequent season speed data reinstatement is standard. • Disclosure to reinsurers is not public and is Whereas exposure data is generally of higher quality provided within a long-established relationship. in the United States than in Europe, obtaining Thus, there may be less reluctance by primary parametric US wind speed data remains an insurers to release data. Particularly in indemnity- impediment, as no hardened, high-density network based transactions, substantial disclosure of of measuring stations currently exists. By contrast, internal information – often sensitive or proprietary parametric earthquake data availability in both the – is required. United States and Japan is excellent. Increasing transparency A recent initiative by WeatherFlow and Risk Management Solutions (RMS) is in the process of The need for transparency is one of the important building such a network, consisting of hardened lessons learned from the current sub-prime crisis, weather stations specifically designed to measure and improvement of transparency with respect to hurricane-force winds up to and exceeding 140 insurance-linked securities should focus on the miles per hour. A first phase of this initiative involves following two objectives: installing over 100 hardened weather stations in • Availability of the aggregated portfolio data vulnerable areas in the coastal United States, based needed to make an informed risk assessment. on likely storm paths and the potential for loss of The information flow between sponsors and property and lives. Improved parametric hurricane investors should also be improved, as this data will also be beneficial for risk prevention and facilitates the evaluation of the issued instrument risk underwriting. and, thus, supports portfolio management and secondary trading. • Ability to understand the transaction. This involves the clarity of summaries in offering documents as well as the detailed disclosure of cash-flow waterfall, ratings, special risk factors, business risks, etc.

25 The quality of disclosure has recently become more However, the range of securitized insurance is still important in life insurance transactions as investors somewhat limited from a diversification perspective. will have to rely less on financial guarantees provided Even with respect to natural catastrophe risk, the by the monoline insurers, and more on their own scope of perils is still limited, although expanding. A evaluations of the assumed risks. Investors thus number of natural catastrophes occurring in the first have a need for underwriting expertise in order to quarter of 2008 and causing significant insured loss understand the insurance risks they are assuming. were not covered by perils under any catastrophe bond. These include the earthquake at Market As of today, a degree of standardization of data- Rasen, United Kingdom, in February 2008, and the reporting formats has been created by the exposure flood in Queensland, Australia, in January 2008.18 data requirements resulting from the reporting Also, transactions have so far concentrated on low formats of the modelling firms (such as UNICEDE, probability/high severity risks, whereas investors the standard data format developed by AIR have started to become comfortable with assuming Worldwide Corporation). However, this lower risk layers. standardization is limited by the differences of the formats used by different modelling firms. Increasing the transfer of risks with lower attachment probability could greatly increase the supply of Furthermore, CRESTA, created by the insurance insurance risk to the capital markets. There are, industry in 1977 as an independent organization for however, several impediments: the technical management of natural hazard • The availability of reinsurance capacity makes the coverage, has determined country-specific zones for business case for transferring non-peak and the uniform and detailed reporting of accumulation lower-layer risks to the capital markets less risk data relating to natural hazards, and has also compelling. created corresponding zonal maps for each country. • There is a lack of third-party models to analyse risk, particularly non-catastrophic risk. The Association for Cooperative Operations • There is little overlap between the investor bases Research and Development (ACORD) has also set for investment-grade and non-investment grade up a working group on catastrophe exposure data insurance risk. standards. ACORD standards allow different • Where no other trigger mechanisms have been companies to transact business electronically with developed, only indemnity-based risk transfer is agents, brokers and other data partners in the possible. insurance, reinsurance and related financial services industries. They serve as a common communication 3.1.8 Cultural factors method for use by multiple parties.

3.1.7 Limited types of risk There is still a lack of common language between the insurance and the capital markets world. The range of securtized insurance perils is still somewhat limited.

Insurers’ lack of experience with securitization as well as a traditional insurance mindset are thought Beyond natural catastrophe risk, a variety of life and by many industry participants to pose considerable non-life insurance risks has been transferred to the obstacles to the further development of the market capital markets in recent years, including automobile for insurance-linked securities. Reflecting the insurance risk, long-term disability reserve risk, relatively short history of ILS, there are still many catastrophic mortality risk, the embedded value of a first-time sponsors.19 book of life insurance policies, redundant life insurance reserves and longevity risk.

26 The insurance world and the capital markets to be a reinsurer). Similarly, on the investors’ side a currently lack a common language. This begins with lack of trusting relationships was found to impede contract terminology and continues with the unique demand for insurance-linked instruments. accounting rules for the various financial services sectors and the unique legal and regulatory One way to overcome such cultural impediments treatment of certain instruments – all of which must would be for sponsors to develop internal risk be understood by all stakeholders despite a high management functions that integrate traditional degree of complexity. reinsurance and alternative risk management. However, this would require internal organizations Sponsors are accustomed to fairly lean that do not operate in “silos” with incremental documentation of reinsurance agreements. Market decision-making20. This approach, consistent with practice has developed a very specific terminology, enterprise risk management techniques, would allow and disputes are solved according to such market sponsors to manage risk transfer more efficiently, practice. On the other hand, the practice in the improving capital management and profitability. capital markets is to require considerably more documentation, especially if a placement is made to investors under Rule 144A. Investors, who are 3.2 Impediments for investors typically not familiar with reinsurance terminology, require comprehensive terms and conditions. Investors are primarily interested in objective and transparent triggers, standardized documentation, In addition, lack of familiarity can be a barrier. Capital liquid markets and short settlement periods. market transactions typically involve transactional However, these needs have not yet been fully met. relationships with a variety of counterparties, including proprietary trading groups within large banks, hedge 3.2.1 Lack of standardization funds, asset managers and other non-reinsurer liquidity holders. Relationships with traditional Although basic structures now follow a standardized reinsurance providers, on the other hand, often span approach, most deals are still bespoke transactions. several decades. Trust levels in these established This lack of standardization is an impediment to relationships are higher (which may prove beneficial if growth of the ILS market in terms of both issuance the arranger of a capital market transaction happens and secondary trading.

Figure 9: Credit securitization – model for expansion and lessons learned

The Growth in Credit Securitization in the US$ billion Development of indices (e.g. ABX) 1,400 Student Loans Other key milestones: CDOs dominate for Other Development started in the investors in subordinate 1,200 HEL 1970s in the US; with credit risk national standards for Equipment documents, terms and Credit Cards 1,000 conditions Introduction of standardized CDO Basel I allowed/encouraged ISDA forms (e.g. CDS for ABS) 800 Auto securitization Subordination and third party guarantees as credit 600 enhancement?

400

200

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: Barclays Capital, World Economic Forum analysis

27 The development of the credit securitization market triggers) allow non-insurers to sell catastrophe risk illustrates how standardization can lead to growth without any underlying insurance exposure but (although it also demonstrates the potential for based on an objective trigger. This makes it possible introducing systemic risks, which should be avoided for investors to hedge their ILS portfolios. in the insurance risk market). In the United States, the Property Claims Service A more standardized market, with standardized (PCS), which has existed for over 50 years, reports products and increased transparency with respect to industry-wide property insurance losses by state and risks transferred and instruments traded, would risk type from natural or man-made catastrophes in increase liquidity and allow for more active portfolio the United States causing losses of at least US$ 25 management. It would also reduce transaction costs million. The PCS index is used as a trigger for cat and legal risk, increase price transparency and, as a bonds, ILWs and many catastrophe derivatives. result, tighten risk spreads. To the extent this proves difficult to achieve within the securitization context, At present, no such industry-loss indices exist in exchange-traded insurance risk contracts may achieve Europe nor Asia. The lack of industry-wide exposure success as they automatically have these qualities. and loss information restricts the ability of industry participants to accurately price, manage and trade Insurance products natural catastrophe insurance risk. For this reason, the CFO Forum has launched an initiative to create Compared to mortgages – where national standards an independent organization that will collect loss and exist in the United States for documentation, terms exposure data from insurers and then provide and conditions – as well as to student loans and aggregated data to insurers, reinsurers and other other securitized credit products, insurance policies potential subscribers. This data-gathering effort are not standardized. Product differentiation adds would cover windstorm exposures and losses in complexity to transactions, increases the time spent Ireland, the UK, France, Switzerland, Luxembourg, to prepare and analyse them, and makes Belgium, the Netherlands, Germany, Denmark, comparison between ILS products more difficult. Norway and Sweden, and would be broken down by lines of business and CRESTA zones. On the other hand, the “industrialization” of policies is viewed with reluctance, as product particularities The development of non-indemnity-based triggers may also represent competitive advantages for also includes the Paradex Index for EU windstorms insurers – particularly for products that do not and US hurricanes, which is based on modelled differentiate solely on the basis of premiums. The industry losses, and pure parametric indices such as future will show whether certain types of insurance WindX for US hurricanes and the Carvill Hurricane policies will become commodities where primary Index (CHI). The United States Geological Survey insurers act as risk intermediaries while retaining (USGS) has also developed readily accessible some risk for themselves. parameters for use in earthquake indices in the United States and, to some extent, worldwide. Triggers With respect to life insurance, several longevity Further standardization requires transparent and indices have been developed, such as LifeMetrics, objective triggers. These provide some level of launched in March 2007 by JP Morgan, and the comfort to investors who are unfamiliar with Credit Suisse Longevity Index, launched in January insurance portfolios. They can be analysed 2006. Similarly, mortality indices are readily available independently of an insurance book of business and for many developed countries. are not subject to moral hazard. Additionally, parametric triggers (as opposed to indemnity

28 ILS products, transaction structures and type of ILS instrument. Dealers assert that the documentation liquidity of life insurance instruments resembles that of highly structured investment grade ABS. As such, A current trend is the development of catastrophe some instruments guaranteed by monoline insurers risk derivatives, such as cat swaps or futures, either are particularly illiquid. On the other hand, liquidity exchange traded or OTC, which allow trading and for cat bonds is currently equal to or better than for assignment by any counterparty. Furthermore, similarly rated non-investment grade ABS. derivative instruments can be collateralized or uncollateralized. Because their prices should, in theory, be lower, unfunded derivatives with “As a neutral data aggregator, we are comparable risk characteristics are attractive excited to help this market evolve by instruments for hedging cat bond portfolios. New increasing transparency and creating insurance-linked derivatives include the NYMEX’s ILS specific content, bringing value CAT Risk contracts (Re-Ex Index) launched in from our involvement to all members of December 2006, the CME-Carvill Hurricane Index Futures (CHI) and the IFEX’s Event Loss Futures this community.” (binary PCS losses), launched in 2007. Ben Lewis, Head of Strategy, Thomson Reuters, USA

Further standardization would simplify products and make them Low transparency and liquidity create inefficient markets. Pricing between different types of more accessible to a broader range products, such as sidecar instruments and Rule of investors. 144A cat bonds, has not always been efficient. Increasing issue size and improving transparency would improve efficiency. In order to reduce transaction costs and improve the comparability of instruments, industry standards Transparency is the focus of many industry efforts, should be further developed – e.g. for loss including the market indices for US cat bonds development periods (indemnity, industry loss), early launched by Swiss Re in 2006, as well as various redemption rights and standard trigger levels (return other initiatives to make trading more transparent. periods, etc.). Standardized documentation can be created in ISDA format, as shown in recent 3.2.3 Long payout periods developments for cat swaps. However, because different investors prefer different instruments (equity Investors are interested in recovering their capital at or debt), product diversity also will be necessary. maturity or quickly thereafter, except to the extent Standardization can simplify products and allow for that they receive adequate compensation during any their benchmarking, thus making them more extension period. Losses on cat bonds with accessible to a broader range of investors. parametric triggers are determined very quickly. However, indemnity-based transactions that incur 3.2.2 Limited secondary market losses may have long payout periods as these losses develop following a catastrophic event. In this Today, few insurance-linked instruments are case, investors prefer as much transparency and exchange traded, and the transparency of OTC information as possible on loss development. trades is still improving. The ILS market also has relatively low liquidity. In part, this is because many Unsurprisingly, the loss development period for a cat investors are “buy and hold investors” who tend to bond mirrors that for similar layers of excess-of-loss hold instruments to maturity. However, amid the reinsurance contracts. An example is KAMP Re current market turmoil, trading dynamics in the 2005 Ltd, which is the first cat bond where the secondary market have varied dramatically by the investors will not get their full principal back. The

29 bond was issued in August 2005, triggered by Developing a better understanding of the underlying Katrina at the end of that month, and a partial write risk is particularly critical for life insurance instruments, down was not achieved until December 2007. The where investors have tended to rely on financial remaining part is still outstanding. One benefit guarantees provided by the monoline insurers. In the investors receive in such cases is an extended past, most life instruments received AAA credit ratings period of interest payment, based on the original because they included a credit “wrap”, in which a principal. bond insurer, typically a monoline insurer with an AAA rating, guaranteed interest and principal payments on 3.2.4 Valuation complexity the underlying securities. Thus, investors were insulated from direct exposure to the credit risk associated Valuation of ILS requires specific knowledge of the with the sponsor or the issuing company. However, insurance risk involved and an understanding of embedded value securitization is similar to ABS for complex models. For this reasons, investors in ILS credit portfolios, and prone to the same issues currently are mainly specialists – such as specialized hedge affecting the ABS market. Given the recent difficulties funds, other money managers and investment banks experienced by monoline insurers, investors will want that have acquired the specific knowledge needed to directly evaluate the risks they are now assuming. to evaluate ILS by hiring experienced people from This will require further disclosure by the sponsors. the insurance industry – as well as reinsurers. Risk models are not yet used by the larger investing One would hope that over time, improvements in community because they must not only be understood these areas will foster the development of a more but also licensed on an individual basis from the mature market, one where investors are assuming modelling firms that created them. Only certain the underlying insurance risk and have the ability to specialized investors have obtained licenses. However, price such risk. risk models are necessary to re-price instruments for secondary market trading. Compared to credit investments, the entrance level for ILS investors in terms of understanding and evaluating the underlying risk is higher.

Ways to increase the understanding of ILS could include granting investors access to a more accessible and less costly basic evaluation tool for their ILS investments, such as the Risk Management Solution’s Miu platform.

30 4. Conclusions and Recommendations

The convergence of insurance with the capital “Allocation to Insurance-Linked markets has been a topic of discussion for some Securities has finally become an years now, during which time there has been strong growth, but not the explosion that might have been investment strategy in its own right. expected. The World Economic Forum and its (Re)insurers, investment banks, partners in this project wish to advance the debate intermediaries, exchanges, index by establishing links among stakeholders and providers, rating agencies and the trade providing them with a platform for addressing key press have all thrown their weight issues. Many participants in this project aspire to increase visibility, provide renewed impetus for behind the asset class and it’s now market development and, it is hoped, place being pursued by respected investment insurance risk on the agendas of a larger, more firms around the world.” diverse group of investors – the key to future growth. A rudimentary roadmap for the development Jerry del Missier, President, Barclays Capital of this market was conceived during a recent United Kingdom workshop and is shown below.

Figure 10: Roadmap to illustrate the prioritization of solutions

Longer Term

Medium Term

Short Term

NDENCY Develop TH DEPE PA Industry Loss Indices

Develop Standardized Standardized Market Insurance Triggers Indices Products

Broad Dialogue Dialogue with Standardized Improve Market with all CEOPS and Documentation Transparency Dependency Stakeholders Modellers

Education Common Language

Timeline

Short Term Medium Term Medium to Longer Term Communication and Education Market transparency Standardization

• Establish a dialogue with key • Development of market • Complex tasks, such stakeholders, such as CEIOPS and indexes was ranked as as the standardization modelling firms highly important and of data gathering and • Educate those unaware of or achievable in the mid-term reporting – and ultimately, inexperienced in the risk transfer the standardization of markets, including investors, insurers insurance products – were and reinsurers rated as long-term • Create a common language to help objectives capital market participants understand the complexities of insurance

Source: Workshop Participants

31 To accelerate the convergence of insurance with the industry to support this goal, and could require capital markets, project participants noted that significant investment in back office data sponsors and investors must both be encouraged to collection processes and systems. Equally there take a stronger interest in the opportunities this is a need to educate investors about the basic convergence trend is creating. This can be principles of insurance risk. accomplished not only by making risk instruments simpler and more attractive, but also by opening up • Rating agencies, accounting authorities and the debate on this asset class to a wider investor regulatory bodies must develop the capability to audience. The investors so courted must increasingly evaluate the risks transferred and the treatment of come from the mainstream investment community, basis risk. This will require all parties in the rather than the specialist firms that currently dominate transaction chain, including modelling firms, to the market. To achieve this goal, a broad focus on enhance their current methods. educating previously untapped investor groups will be required, aided by the following recommendations: Appendices B and C include summary tables of both the proposed solutions generated by the project • Transaction structures should be standardized in participants and current initiatives. These tables terms of contracts, deal type and the data comprehensively illustrate the project’s findings. provided. This would both help with the accessibility to a broader investor base, while also reducing the transactional costs both in terms of “Although this topic has been top of arranger fees (lawyers, accountants, etc) and the mind for some years, with the current time required to complete deals. turmoil in the markets, this initiative demonstrated the collaborative efforts • Transactions must be made more transparent, of the Partners in creating more through disclosure by the sponsor of better data on the risks being transferred. This solution aims visibility into the potential for future to address both the issue of trust between the growth of this market.” sponsor and investor, as well as aiding market Jack J. Ribeiro, Managing Partner, Global Financial communication more generally. However, it will Services Industry, Deloitte, USA require a broad consensus across the insurance

This report marks the conclusion of the first phase of Figure 11: Phases of the insurance the insurance convergence project. The impetus will convergence project now pass to the identified stakeholder groups in the project’s second stage. This phase will aim to build off existing initiatives from project partners, as well Project Partners External Parties as efforts by external parties to drive change, using & Workshop Participants the alignment shown below.

The Forum and the project team welcome the Project Partner Offers External Recommendations Initiatives of Help Initiatives participation of all stakeholders who would like to further the progress of these recommendations. Interested parties should contact one of the report authors.

2nd Stage Project Initiatives

Source: World Economic Forum

32 Appendices Appendix A: Project Description

Process Represented stakeholder groups

This project was first suggested by the Financial • Academics • Investment banks Services Governors at the World Economic Forum • Insurers • Investors Annual Meeting 2007, under the chairmanship of • Re-insurers • Modelling firms James J. Schiro, CEO of Zurich Financial Services. • Intermediaries • Rating agencies At that session, a number of Governors expressed (advisors, lawyers) • Regulators concern about the need to make insurance risk more transparent and tradable. After various exploratory discussions and scoping exercises the project was officially launched in late 2007. Benchmarks The project was divided into four phases: The goal of the insurance convergence project is to 1) Information gathering: The project team develop actionable recommendations to promote interviewed over 50 market participants from the continued development of liquid capital markets various organizations (these are listed in the for insurance risk. Success will be measured against acknowledgements on p. 41). two criteria: 2) Analysis: The raw data was reviewed by the • Have the recommendations of this report been project team. Invaluable feedback was also acted upon by industry participants? provided by industry representatives. • Will future market participants view these 3) Synthesis: An initial analysis was presented to an recommendations as having significantly industry workshop at the Forum’s 2008 Annual contributed to the further development of the Meeting in Davos. Extensive feedback was Insurance risk market? obtained. 4) Recommendations: Based on the feedback at the 2008 Annual Meeting, the project team held a workshop in London in April, where we received additional feedback and preliminary recommendations.

An overview of these activities is shown below.

Figure 12: Stages of the insurance convergence project

September ‘07 January ‘08 March/April ‘08 October ‘08

Project Information Analysis Synthesis Recommendations Stages gathering

• Individual meetings • Davos session • London Workshop Events • Publication of Report

Tasks • Identification of key parties • Interviews • Review of solutions • Strive for buy -in from Stakeholders • Review of Barriers • Facilitate transfer of ownership

Source: World Economic Forum

33 Appendix B: Findings

The summary tables below illustrate the project’s findings, including proposed solutions to the impediments identified in this report.

Table 1: Culture, Complexity, Cost

Impediments Details Proposed Solutions

Culture Insurer’s lack of experience with • Education; publications on existing transactions securitization; traditional insurance mindset

Lack of common language • Develop common language

Complexity Dependency on and complexity • More frequent data updates of cat models; dependence on • Some sharing/ greater access to models data for valuation

Management of basis risk • Develop internal models to manage basis risk

Lack of Complexity of transactions • Develop trigger indices (industry loss or standardization modelled industry loss) • Standardize triggers (parametric, industry loss, unified mortality tables in the United States) • Standardize insurance products (e.g., term life insurance)

No standardized contracts • Launch multistakeholder discussion, including modelling firms, rating agencies, accounting firms and ISDA, for the development of standardized documentation for event scenarios and certain other structural transaction features

Limited Limited secondary market; • Standardize instruments secondary market not yet efficient • Increase market transparency by working with market information providers, portfolio managers, etc., and by developing indices • Develop derivative instruments

Time Transaction cost; extensive • Use repeated issues and shelf offerings; consuming and management involvement in first increase deal sizes expensive transaction • Standardize documentation

34 Table 2: Data availability and transparency

Impediments Details Proposed Solutions

Inconsistent Inconsistent data collected in • Standardize data metrics and industry standards data metrics Europe • Standardize insurance products

Insufficient data collected in • Improve data-reporting processes and formats Europe

Poor data quality Insurer data is not as clean or • Set quality standards for data reporting accurate as it could be • Launch insurer-wide initiative to clean up data

Poor data Insurers are reluctant to provide • Improve transparency and technical availability disclosure portfolio data, often for of non-proprietary data competitive reasons • Provide a common framework for data disclosure

Lack of track Little historical data for • No solution as such, need time and adequate record insurance-linked securities volume of transactions • Create a robust data-collection and publishing system

Lack of Industry Lack of Industry loss indices in • Develop such indices (definition and data loss indices Europe and Asia contribution by the industry; aggregation by an independent organization) • Develop loss indices for other types of risk

Lack of granular Lack of US granular parametric • Build hardened network of wind-measuring parametric data data stations in the United States and ensure data delivery

35 Table 3: Regulation, accounting and credit ratings

Impediments Details Solutions

Treatment of Limited solvency credit for non- • Develop robust methods for evaluation of basis basis risk indemnity-based risk transfers risk and allocation of capital to support it (principles-based reserving is a prerequisite in the United States)

• Encourage third parties to warehouse basis risk

• Persuade rating agencies and legislators/regulators to establish partial solvency credit for non-indemnity-based risk transfer

Accounting rules High complexity of transaction • Provide tax exemption for reserving for onshore structures as a result of taxation SPRVs (proposed for the United States, but and accounting rules topic is highly sensitive) (consolidation rules; treatment of reinsurance vs. derivatives) • Clarify accounting and tax treatment for parametric risk transfer (economic substance over form)

Inconsistent Inconsistencies in rating • Encourage rating agencies to set transparent rating treatment treatment of risk transfer and consistent requirements (instruments vs. credit rating of sponsor; rating of monoline reinsurers vs. rating of traditional reinsurers)

Inconsistent Inconsistent rules for • Develop consistent rules regulation acceptance of SPVs as reinsurers (jurisdiction, capitalization)

Below Many transactions are not • Potential for alternative rating strategies investment grade investment-grade rated

36 Appendix C: Current Initiatives

Table 1: Ratings and regulation

Title of Initiative Description

Change from a rules-based approach to regulation to Solvency II a principals-based approach, allowing greater flexibility for insurers

IFRS project on insurance contracts Specify the financial reporting for insurance contracts

Implementation of reinsurance directive in the Acknowledgement of EU reinsurance SPVs) European Union

Principles-based reserving in the United States Shift from rules-based to principles-based reserving

Table 2: Standardization and transparency

Grouping Title of Initiative DescriptionTitle of Initiative

ACORD standards allow different companies to transact business electronically with ACORD working group on agents, brokers and other data partners in Standardization and catastrophe exposure data the insurance, reinsurance and related communication standards. financial services industries. They serve as a common communication method for use by multiple parties

Exposure data reporting formats required by Standardization UNICEDE data reporting format modelling firms (e.g., UNICEDE, developed by AIR)

Thomson Reuters launching initiative to Transparency & Insurance Linked Securities Initiative aggregate and integrate ILS data for the communication capital markets

WeatherFlow Hurricane Mesonet in Private networks of hurricane-hardened Transparency the United States weather stations

37 Table 3: Data Transparency

Title of Initiative Description

An independent organization for the technical management of natural hazard coverage. One of CRESTA's main tasks is to determine country-specific CRESTA zones for the uniform and detailed reporting of accumulation risk data relating to natural hazards and to create corresponding zonal maps for each country Based on industry exposures, such as RMS’s Modelled industry loss indices Paradex

Pure parametric indices WindX for US hurricane; Carvill Hurricane Index (CHI)

CRO Forum/ European windstorm industry loss index; Industry loss Re-Ex Index, based on US industry losses reported by PCS

LifeMetrix Mar. 2007, Credit Suisse Longevity Index, Longevity indices Jan. 2006)

Table 4: Education

Title of Initiative Description

Swiss Re Sigma, and numerous publications by Periodic publications providing insight other firms

Numerous conferences, etc.

Further education needs to be directed outside of the New project initiative same group – to reach pension funds and other non- core investor types

Table 5: Development of Indices

Title of Initiative Description

NYMEX CAT Risk contracts (Re-Ex Index) Developed in December 2006

CME Carvill Hurricane Index Futures (CHI)

IFEX Event Loss Futures Binary PCS losses, developed in 2007

38 References

“Sigma No. 7/2006: Securitization – New opportunities Cummins, D. J., “Securitization of Life Insurance for insurers and investors”. Swiss Re, 2006. Assets and Liabilities”, Wharton, 2004 http://www.swissre.com/resources/fc02f680455c6b 548a5fba80a45d76a0-sigma7_2006_e.pdf “Catastrophe Insurance Risk – The role of Risk- Linked Securities and Factors Affecting Their Use”, “Reinsurance and International Financial Markets United States General Accounting Office, September (chapter 4: Insurance securitization and the capital 2002 markets)”. Group of 30, 2006. http://www.group30.org/pubs/pub_1320.htm Banks, E., “Alternative Risk Transfer: integrated risk management through insurance, reinsurance, and “The Catastrophe Bond Market at Year-End 2007”. the capital markets”, Wiley Finance Series, 2004 Guy Carpenter, 2008. http://gcportal.guycarp.com/portal/extranet/popup/p Lane, M. (ed.), “Alternative Risk Strategies”, Risk df/GCPub/Cat%20Bond%202006.pdf Books, 2002

Swiss Re Special Report: Beyond Cat Bonds. Swiss Gibson, R., Habib, M., Ziegler, A., “Why Have Re. Zurich, December, 2007. Exchange-Traded Catastrophe Instruments Failed to Displace Reinsurance?” Pennay, R. “Market loss index for Europe – http://ssrn.com/abstract=964916 expanding capital market capacity”. Swiss Re, 2007. http://www.swissre.com/resources/afa63900455c7a b8b250ba80a45d76a0-Publ07_FR_Market_loss_ Europe.pdf

Modu, E. “Gauging the Basis Risk of Catastrophe Bonds”. AM Best, September 2006

Gatzert, N., Schmeiser, H., Toplek, D. “An Analysis of Pricing and Basis Risk for Industry Loss Warranties”, Working Paper on Risk Management and Insurance No. 43, Institute of Insurance Economics, University of St. Gallen, June 2007

39 Acknowledgements

We are particularly grateful to the following industry We would also like to acknowledge the following partners of the World Economic Forum (and their companies and organizations: representatives on the project steering and operating committees) for their oversight, feedback and AIR management of this project: AM Best AXA Allianz Equecat Barclays Capital FASB Deloitte (knowledge partner) Fermat Capital State Farm Financial Services Authority Swiss Re Fitch Thomson Reuters G30 Working group on Securitization Zurich Financial Services (which chaired this project) Generali Goldman Sachs Guy Carpenter IAIS Lehman Brothers London School of Economics Moody's Munich Re New York State Regulator Risk Management Solutions Sidley Austin Standard & Poor’s University of St Gallen University of Zurich University of Pennsylvania

40 Footnotes

1 In an indemnity transaction the insurer is 14 If contractually agreed, reinstatement is allowed reimbursed for actual losses. In a parametric under traditional excess loss reinsurance transaction the payment is based on an index contracts. After the insured’s claims exceed the and a formula. For example, in the case of limit, the insured can reinstate the reinsurance hurricane damage, reimbursement would be coverage by paying a reinstatement premium. based on a formula saying (simplistically) that if a 15 Banks, Alternative Risk Transfer: integrated risk storm of strength x strikes region y, for time management through insurance, reinsurance, and period z, the payment will be dollar amount a. the capital markets”, 2004, p. 37. This may or may not correspond to the actual 16 Catastrophe Bond Market at Year-End 2007, loss. p. 33. 2 See box on page 17: Two key differences 17 The Catastrophe Bond Market at Year-End 2007, between the ABS and the ILS markets. p. 15. 3 Basis risk is the risk associated with an imperfect 18 Swiss Re. hedge. 19 For example, 11 out of the 27 sponsors of cat 4 In quota share reinsurance, the reinsurer assumes bond transactions in 2007 were first time a specified percentage of each risk in a certain sponsors. The Catastrophe Bond Market at Year- class of business. In surplus reinsurance, the End 2007, p. 27. reinsurer assumes a specified amount of each 20 Banks, “Alternative Risk Transfer: integrated risk insurers losses that exceeds a specified retention, management through insurance, reinsurance, and up to an overall limit. the capital markets”, 2004, p. 194. 5 The Catastrophe Bond Market at Year-End 2007. February, 2008. New York: Guy Carpenter. p.16. 6 The Catastrophe Bond Market at Year-End 2007, p.15. 7 In this regard, see: Gauging the Basis Risk of Catastrophe Bonds. September 2006. New York: AM Best; and An Analysis of Pricing and Basis Risk for Industry Loss Warranties. June 2007. St Gallen: Centre for Finance at the University of St Gallen. 8 EU Directive 2005/68/EC. 9 EU Directives 2002/13/EC, 2002/83/EC and 2005/68/EC (Solvency I). 10 A different regulatory treatment of traditional reinsurance and alternative risk transfer instruments is mainly an impediment where the premium index is the constraining factor for the minimum solvency margin. 11 Amended Solvency II Proposal of the Commission of the European Communities, COM (2008) 119 final. 12 CEIOPS. Call for Advice on QIS4, Annex: QIS4 Technical Specifications (MARKT/2505/08). March, 2008; and QIS3 Technical Specifications, Annex B (CEIOPS-FS-13/07). April, 2007. 13 EU Directives 2002/13/EC, 2002/83/EC and 2005/68/EC (Solvency I).

41

The World Economic Forum is an independent international organization committed to improving the state of the world by engaging leaders in partnerships to shape global, regional and industry agendas.

Incorporated as a foundation in 1971, and based in Geneva, Switzerland, the World Economic Forum is impartial and not-for-profit; it is tied to no political, partisan or national interests. (www.weforum.org)