1 art for art’s sake derek newton 2nd december 2002 abcd
TRANSCRIPT
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ART for ART’s sake
Derek Newton2nd December 2002
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Agenda
ART market overview what is it? how did we get here? size, players, etc.
Product review what do they look like & how do they work?
Market trends market direction
Outstanding market issues
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Definition of Alternative Risk Transfer
No wholly accepted definition Anything that is not traditional insurance
Often uses both banking and insurance techniques Tailor-made solutions Multi-year policies Risks that the conventional market would regard as uninsurable Transfer of non-insurance risk Hybrid products
Some definitions also include some traditional insurance Maybe also some self-insurance
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Meeting in the middle
Capitalmarkets
Insurancecompanies
Traditional risk transfer ART Traditional financing
Insurance policy
Packagedinsurancepolicies
Multi-line multi-year policies
Loss-sensitivepolicies
Finite-risk contract
SecuritisationContingent capitalReal options
Capital structureFinancial hedges
Source: The Economist
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History
The real driver of the growth was the desire to discount claims reserves to offset significant deterioration in the early 1980s
This was highly attractive business for the reinsurer; therefore many joined in
Closing the accounting loop holes stimulated reinsurers’ desire for alternative lucrative sources of business
Growth of the use of captives also stimulated demand for new approaches to risk funding
Developments in the property catastrophe reinsurance market also affected the market.
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Estimated size of insurance market worldwide $2,129bn (Sigma Vol. 2/1999)
Market size
ART market still very fragmented - mostly a few large deals
Estimated size of reinsurance market worldwide = $124bn (Sigma Vol. 2/1999)
Estimated size of ART market worldwide = $13bn (Tillinghast)
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Market centres and players
London, New York, Bermuda, Zurich, Dublin, Luxembourg and the German centres
Most large brokers have specialist ART units e.g. Aon, Marsh, Heath Lambert, Benfield Grieg, etc.
Most large reinsurance entities have specialist ART units e.g. Swiss Re, Munich Re, Zurich (Centre Solutions), etc.
Many insurance groups have specialist ART operations e.g. ACE, XL, AIG, etc.
Many banks have specialist ART operations (as writers or intermediaries)
e.g. Citibank, Goldman Sachs, Lehmans, RBC
Many risks eventually placed (at least in part) in Lloyd’s
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Common types of contracts
Discounting covers e.g. run-
off covers, funding covers
Other funding mechanisms, e.g. insurance derivatives,
swaps
Integrated risk covers, e.g. multi year - multi line,
blended covers
Securitisation, e.g.
catastrophe, other
Post loss funding, e.g. contingent
nature, capital injections
Captives, mutuals and
other forms of self insurance
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Discounted covers
Provide full cover without immediate need to finance full undiscounted liability
Uses: solvency, risk transfer, capping losses Can be prospective or retrospective Run-off covers are a typical example
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Integrated risk covers
Typically between insurance/reinsurance entities Therefore not an example of convergence in the markets but
can be used as a substitute for debt or equity in books of cedant
Uses: one-stop shop, avoidance of buying excessive cover, smoothing of results, locking into attractive terms
Multi-year, multi-line covers premium savings due to cost savings and to greater stability
of results over longer period/across more (uncorrelated) lines
Blended covers
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Securitisation
Transfer of insurance risk to the banking and capital markets, e.g.
Catastrophe Life embedded values
Banking and capital markets used because of capacity and/or because risks are ones with which the banking and capital markets are more comfortable
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Catastrophe securitisation
Essentially a low grade bond (BB or similar) Default is subject to the insured peril - e.g. earthquake,
storm, flood - and can be coupon, principal or both May respond to actual losses or parameter derived losses Rationale has been that insurance catastrophe risk is not
correlated with market (systematic) risk so of benefit to investors
Financial markets large and capable of absorbing catastrophe risk
Pricing to date similar to traditional cat reinsurance and much more expensive than similarly rated Corporate Bonds
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Typical securitisation process
InsurerReinsurer
“SPV”Investors
CollateralAccount
Reinsurance Treaty
Premium
Issue Notes
Note Proceeds
NoteProceeds Interest
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Post loss funding
Major losses deplete capital and increase its cost Post-loss funding guarantees that funding will be provided in
the event of a specified loss in exchange for a commitment fee
Funding usually a loan, on pre-agreed terms, or equity (contingent puts)
Commitment fee is less than insurance costs (as the cost of the funding will be borne largely post the event) - hence this appears (pre-loss) to be cheaper than conventional insurance
No benefit to underwriting results
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Other funding mechanisms: insurance derivatives
Chicago Board of Trade ("CBOT") Cat Insurance Options launched in 1995 nine catastrophe loss indices covering US exposures established by Property
Claims Services (PCS) failed to generate sufficient trades to establish a viable market
Bermuda Commodities Exchange (BCE) inaugurated 1997, suspended due to lack of trading volume 1999
Catastrophic Risk Exchange (CATEX) founded 1996 in New York continues to operate, volume of actual cat transactions unknown
Weather-based derivatives look more promising
generally at the lower end of catastrophe exposures
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Other funding mechanisms: swaps
Swapping of risks between insurers to provide greater
diversification but without some of the costs of reinsurance e.g. Swiss Re & Tokio Marine and Fire Insurance Co.
The swap is structured in three risk exchanges of $150m each 1. Japan earthquake for California earthquake
2. Japan typhoon for Florida hurricane
3. Japan typhoon for France storm
Note the need to find good, matching, non-correlated exposures
Could also swap risks between parties with opposite risks,
e.g. energy supplier and household insurer
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Example: Cat risk transfer mechanisms
Reinsurance - catastrophe excess of loss (Cat XoL)
Securitisation: Cat Bonds Multi-year spread loss contracts / blended
covers Contingent capital - Surplus Notes, Cat Equity
Puts Derivatives Swaps
“There’s more than one way to skin a CAT”
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Cats, costs and management
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Example: large UK manufacturer
Issue Solution
European competitionUse currency markets to minimise competitive risk
Large closed defined benefit pension plan
Use equity markets with a spread loss contract to reduce the pension fund exposures
Weather has a material impact on salesUse weather derivatives to hedge sales issue
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Common motivations for taking out an ART contract
Stabilisation
of results
Solvency margin
Taxation
Source of capital
Cheaper cover More effective
provision of risk managementGreater
security
of
payment
Provides cover that might otherwise be unavailable
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What should be drivers for ART market growth
Volatility of conventional markets Rapidly rising cost of conventional reinsurance Lack of capacity for natural catastrophes Greater requirements for risk transfer from buyers Need for multi-year smoothing Convergence of financial markets Concentration of talent in ART providers Historic profitability of ART market
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11th September 2001
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Acceleration for ART?
Insurance rates soar? Reinsurance rates soar? Market capacity slashed? Risk awareness heightened - demand for cover higher?
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Market premiums
Cat XL rates for 13 major markets
0
20
40
60
80
100
120
1994
1995
1996
1997
1998
1999
2000
2001
2002
Source: Swiss Re Study, updated by Heath Lambert observations for 2002 renewal season
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Market premiums
Catastrophe Reinsurance
0
50
100
150
200
250
300
350
400
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Wo
rld
rat
e o
n l
ine
Source: Guy Carpenter & Co World Catastrophe Reinsurance Market 2002
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…but...
Rising rates have attracted capital - so there is still capacity Opportunity to make good returns on conventional covers have
focused insurers/reinsurers back onto key activities ART market hardening too ART deals remain expensive to organise, with questionable triggers Enron
financial reinsurance, balance sheet manipulation growing puritanism in accounting
Regulation
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Some regulatory issues with ART
ART increases market capacity and protection good for consumers and market confidence
Complexity poses danger for unsophisticated purchasers Rarely transparent and can frustrate intentions of regulators
solvency accounting consumer information
Definitions Multi-regulatory environment Global regulatory environment
differences in exposure to ART fair value accounting
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So what has happened?
Not altogether clear little publicly available data increase in finite deals at lower ends more non-cat securitisations continuing activity in contingent funding, weather derivatives, cat
bonds, cat swaps, etc., but not the anticipated big surge need for transparency, and delivery of real benefit most products remain insurance or capital markets - not a great
deal of truly hybrid solutions continuing regulatory and accounting activity (CP144, Solvency II,
Basel, IFRS, etc.) Market issues continue to emerge that lend themselves to ART-
type solutions
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What does the future hold?
Reinsurance has worked well over many years, is relatively simple and is well
understood
has limited and variable capacity (or supporting capital) prone to violent swings in premiums for the same exposure
Capital Markets relatively recent interest in insurance linked products, cautious and
mistrustful of industry, which it does not yet understand well many insurance risks not (closely) correlated with financial risks almost unlimited capacity to handle insurance cat risks
Therefore there must be a role for both to provide increasing levels of risk management/mitigation capacity and stability
The future is yours