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. 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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.