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Proprietary and Exclusive
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Alternative Risk Transfer Mechanisms Presentation to: The Annual Insurance Executive Conference
Markus Schmutz Swiss Re Capital Markets December 2013
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What are Insurance Linked Securities?
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Natural catastrophe bonds (cat bonds for short) and other types of ILS are usually issued in order to provide re-/insurance protection to insurers, reinsurers, governments, and corporations
Cat bonds allow companies to obtain reinsurance protection from a new pool of capital separate from traditional reinsurers
– Money managers, hedge funds, and pension funds represent a new pool of capital for insurers and reinsurers to gain protection from
Investor capital provides collateralized cover
– Investor capital sits in a segregated collateral account, meaning that if an event occurs, dedicated funds are available to make a payment
– This virtually eliminates the credit risk inherent in traditional re-/insurance
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How do Cat Bonds work?
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SPV
. Return of
Remaining Principal
Premium
Risk Transfer Contract
Sponsor Collateral
Trust
Investors
Note Proceeds
Stable Value Investments
Investments Directed Investments Yield
Coupon: DIY + [ ]%
1. The sponsor (the insurer or reinsurer looking to get protection) enters into a risk transfer contract (reinsurance or derivative) with a special purpose company established specifically for the transaction (SPV)
2. The SPV capitalizes itself by issuing Notes (the "Cat Bonds") to Investors in the capital markets in an amount equal to the limit of the risk transfer contract
3. Proceeds from the securities offering are transferred into a collateral trust account and invested to provide a stable return
4. If no covered event occurs during the risk period the bonds will be redeemed at 100% of face value. In case of a covered event meeting the thresholds set forth in the risk transfer contract, funds will be withdrawn from the collateral account to make an event payment to the sponsor. The redemption price of the bonds is reduced accordingly
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How ILS emerged
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In 1992, Hurricane Andrew made landfall in Florida causing $15.5b in insured losses
The resulting shortage of reinsurance capacity prompted reinsurers, banks, and academics to investigate new ways of transferring catastrophe risk outside the traditional reinsurance capital pool
In 1997, Residential Re, the first catastrophe bond was sold to capital markets investors, protecting USAA against the risk of a major hurricane
Since then, approximately $54 billion of cat bonds have been issued, providing protection to over 80 insurers, reinsurers, governments, and corporations for a multitude of risks
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ILS Universe
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Currently $19.8 billion in cat bonds are outstanding, with an estimated $28 billion in other private non-life risk transfer to capital markets investors
Swiss Re has issued approximately $2.2 billion in Vita extreme mortality bonds since 2003. Post financial crisis, the embedded value and life settlement markets have slowed considerably
Catastrophe Bonds
Catastrophe Derivatives/ Industry Loss Warranties
Collateralized reinsurance/retro
Quota Shares/Sidecars
Non-Life
Extreme Mortality Bonds
Longevity swaps/bonds
Embedded Value Securitizations
Life Settlement Securitizations
Reserve Financing (e.g. Reg XXX)
Life
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Cat bond issuance and outstanding (USD bn)
Global cat bond market reaches all time high
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Source: Swiss Re Capital Markets;
2013 will become the second largest issuance year in history
28 deals YTD, pushing total volume outstanding to approximately USD 20bn, largest year end total on record
Repeat sponsors driving growth, taking advantage of low spreads and structural innovations
Since 2011, outstanding Cat Bond market has grown by approx. USD 6bn with new sponsors accounting for USD 2bn of the growth
Investor demand continues to outweigh supply
2013 new issuance volume is second largest ever; market grew by around 20% Y/Y
0.7 0.7 0.8 1.1 1.0 1.02.4
1.12.5
5.7
8.2
3.0 3.5
5.0 4.6
6.3 6.5
0.2 0.20.8 1.4 1.8
2.23.5
3.9
4.4
8.8
12.7
11.4
9.09.1
10.2
13.2
0.91.0
1.92.4
2.8
4.6 4.6
6.4
10.1
17.0
15.7
14.9
14.013.7
16.5
19.8
0
2
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8
10
12
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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
$b
n
Issued Outstanding from previous years
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0.40
0.90
1.40
1.90
2.40
Ja
n-0
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Jul-
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-12
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n-1
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Barclays Ba US High Yield S&P 500 Total Return Swiss Re Global Cat Bond Index Total Return
Cat bond market delivered a steady stream of uncorrelated returns
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Cat high yield performance January 2002 – November 2013
Cat bond market proved resilient despite financial market turmoil and natural catastrophes
5 bonds have been triggered by catastrophes(1) of the roughly 230 bonds issued (440 classes) since 2002, causing a total loss of USD 650m compared to USD 7.5bn of spread payments over the observed period
2002-2013 (YTD)
Barclays US High
Yield
S&P500 Total
Return
Global Cat Bond Index
Annualized Return
8.43% 5.63% 8.56%
Annualized Weekly
Volatility 6.58% 18.23% 2.60%
Majority of cat bonds are structured for very large catastrophes which, fortuitously, did not occur
Source: Swiss Re Capital Markets;
(1) 4 additional bonds lost some principal as a result of the Lehman Brothers default
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Catastrophe Bond Capacity Deployed
The ILS Market is heavily weighted towards U.S. Hurricane:
Two thirds of the outstanding notional is exposed to U.S. Hurricane Events
Sponsors would see significant pricing difference between U.S. Hurricane and non-peak perils, as investors have strong demand for non-peaks
Outstanding Cat Bonds by Peril
US Wind
US EQ
Non Peak
Peril Overview for Outstanding Bonds
65%
53%50%
44% 44%
38%
28%
15%19%
10% 8%5% 5% 3% 2% 2% 2% 1% 0%
0%
10%
20%
30%
40%
50%
60%
70%
Pe
rce
nt
Exp
ose
d t
o P
eri
l
Source: Swiss Re Capital Markets. As of December 3, 2013 with percentages calculated based on notional amount
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0
200
400
600
800
1000
1200
0 50 100 150 200 250 300 350 400
US Wind Non-US Wind
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Increased demand from investors pushed cat bond spreads to new lows
(1) Swiss Re Capital Markets pricing indications only; estimated primary issuance spread computed for an expected loss of 2% using regression analysis
Illustrative primary issuance spread (US Wind) 1
Spreads for U.S. wind exposed bonds are down by 40% y/y, while non-U.S. spreads decreased by approximately 35%
Non-U.S. wind risk continues to price at tighter levels as investors seek diversifying risk
2013 primary issuance spread
expected loss
spre
ad
sp
rea
d
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3%
6%
9%
12%
15%
2007 2009 2011 2013
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Spread tightening is slowing, indicating that the market may have found a new price baseline
1 Data source: SRCM. Seasonally adjusted secondary market spreads for a subset of bonds that have a rating between B-/B3 and BB+/Ba1, a stated expected loss between 1.25-2.5% and are exposed predominantly to U.S. peak perils
Historical Average Seasonally Adjusted Spreads 1
(Cat Bonds Secondary Market)
Cat Bonds secondary market spreads
High yields, along with benefits of diversification are the major factors attracting investors to cat risks
Some investors have hinted they would potentially consider slowing down their commitment to the asset class should spreads drop any further
Spreads for top layers have been fairly stable over recent months. However, short term variability for lower layers is expected
0%
3%
6%
9%
12%
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57.7%25.3%
13.0%
3.1%0.7% 0.3%
Dedicated
Money Manager
Reinsurer
Hedge fund
Insurer
Pension Fund
Shift from short term oriented to long term oriented investors
Pension funds through dedicated cat bond funds, mutual funds, institutional money managers are increasingly investing in cat bonds
The relative share of short term oriented hedge funds has decreased
While the investor base has broadened, dedicated cat bond funds remain the dominant category
Investors are increasingly comfortable with indemnity bonds and complex structures
50% of bonds issued in 2013 have an indemnity trigger
Cat Bonds expanded from providing "top-of-the-tower" cover with a remote ~1% Expected Loss towards the "working layers". A recent transaction featured an EL above 10%
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Typical investor breakdown by type 2013
Source: Swiss Re Capital Markets
Cat Bond Trigger Breakdown (2009-2013)
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Alternative capital is (re-)gaining market shares
Alternative capital grew sharply since 2011 to USD 45 bn
Dedicated cat funds are crowded out into collateralized reinsurance
Collateralized reinsurance grows fastest, reaching the volume of cat bond market
Indemnity capacity becomes widely accepted. ILW market shrinks significantly
Some sidecars are scaled back as a result of market softening
Alternative capital market share accounts for approximately 11% globally and about 17% in the U.S., exceeding the 2007 level (post-Katrina)
Estimated size of global market
Estimated market share (excl. Retro capacity)
0
5
10
15
20
25
30
35
40
45
50
2005 2006 2007 2008 2009 2010 2011 2012 2013
[bn USD]
Sidecar ILW Collateralized RI ILS
Source: Swiss Re Capital Markets
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Alternative capital is largely focused on peak risks
Alternative capital plays a significant role in the U.S. Nat Cat and retro market, characterized by low entry barriers and still relatively high margins
Alternative capital struggles to expand outside the U.S., due to:
– Ample traditional reinsurance capacity
– Reinsurers offer traditional reinsurance at very competitive rates, leveraging their capital multiple times
– Lack of market loss indices
– Less reliable risk modeling
– Cannot offer reinstatements 70%
25%
5% US cat
European cat
Other
Distribution by segment and peril
33%
67%
Backingreinsurers
Backinginsurers
Source: Swiss Re Capital Markets
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Demand for Nat Cat capacity will continue to increase
Demand for Nat Cat will further increase, on average by approx. 50% in mature markets and 100% in High Growth Markets by 2020
– Growth in exposed economic values
– Growing middle class in High Growth Markets (HGM) leading to higher insurance penetration
– Governments moving Nat Cat risks into the private sector
Alternative capital is expected to grow in the U.S. at least at the same pace and may gain further market shares
Increase in largest industry loss scenarios (2012 vs. 2020)
EQ: Earthquake (500 yrs)
TC/WS: Tropical Cyclones/Winter Storms (100 yrs); TC includes storm surge
FL: River Flood (250 yrs)
Nat Cat Demand Dynamic
Source: Swiss Re
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Low interest rates combined with financial market uncertainties will persist and will foster further capital inflows into the alternative capital market
– Capital inflows will keep the demand for cat bonds high and spreads tight
– Some sidecars are scaled back as the result of market softening
Alternative capital (including cat bonds) is likely to gain further market shares but will remain a complementary product in the global (re-)insurance market
– Growth of alternative capital markets products is largely confined to peak risks
– Reinsurance remains very efficient
The staying power of capital markets investors has yet to be tested in case of a rise in interest rates, decreasing Nat Cat returns or large catastrophe losses
Alternative capital increases competition and capacity, but large, diversified reinsurers will be less impacted
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Conclusion
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* An investment in Insurance Linked Securities involves potentially significant risks for an investor. In summary, these risks include (but are not limited to): •Investors may lose all or a portion of their investment in Insurance Linked Securities if a natural catastrophe or other event triggers a payment by the issuer of the Insurance Linked Securities under the underlying risk-transfer agreement that the Insurance Linked Securities relate to. •The maturity of Insurance Linked Securities may be extended without the prior consent of the investor. •The Insurance Linked Securities may be redeemed before their maturity date (including before any extension of such maturity date by the issuer). •If the Insurance Linked Securities are redeemed before maturity, the interest rate payable under the Insurance Linked Securities will be reduced. •Investors have limited recourse to assets of the issuer of the Insurance Linked Securities and no recourse to assets of the counterparties to the underlying risk-transfer agreements to which the Insurance Linked Securities relate. •If the issuer of the Insurance Linked Securities becomes insolvent, investors may lose some or all of their investment. •Investors may be required to consolidate the issuer for accounting purposes under certain circumstances. •An investment in the Insurance Linked Securities may have adverse tax consequences for investors. •Any claim you have against the issuer in the event of the issuer's insolvency will rank below any claim a counterparty to the underlying risk-transfer agreements, to which the Insurance Linked Securities relate, has against the issuer. •Enforcement of the security interest granted to a Trustee for the benefit of the investors may be limited. •The Insurance Linked Securities may not have a secondary market or the secondary market for the Insurance Linked Securities may have limited liquidity; the market price of the Insurance Linked Securities in the secondary market may be highly volatile. •The Rating Agenc(y)(ies) (if any) may change any rating assigned to the Insurance Linked Securities. Any credit rating given in respect of the Insurance Linked Securities may not reflect the potential impact of all risks related to the Insurance Linked Securities. A credit rating is not a recommendation to buy, sell or hold the Insurance Linked Securities and may be revised or withdrawn by the rating agency at any time. The risk factors relating to an investment in Insurance Linked Securities are set out in detail in the offering materials for the relevant Insurance Linked Securities. Before entering into any financial transaction, you should ensure that you fully understand the terms, have evaluated the risks and determined that the transaction is appropriate for you in all respects.
Risk Factors
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