Post on 24-Mar-2020
Catastrophe Bonds: Using the Capital
Markets to Create Risk Protection
Wednesday, April 30, 2008
8:00 am – 9:15 am
Milken Institute
Global Conference 2008
Wednesday
8:00 AM - 9:15 AMCatastrophe Bonds: Using the Capital Markets to Create Risk Protection
Speakers:John Brynjolfsson, Managing Director and Portfolio Manager, PIMCO
Jeffrey Cooper, Assistant Vice President, Protection Finance, Allstate Insurance CompanyBeat Holliger, Managing Director, Munich American Capital Markets
Dan Ozizmir, Managing Director and Head of Insurance-Linked Capital Markets andEnvironmental and Commodity Management, Swiss Re Financial Products
Jose Siberon, Director, Merrill Lynch & Co.Moderator:
Glenn Yago, Director of Capital Studies, Milken Institute
Catastrophe bonds first appeared on the radar screens in the early 1990s, after Hurricane Andrewleft insurers footing a bill for more than $23 billion in damages. A number of insurers went
bankrupt, and alarms sounded across the industry worldwide. The accelerating pace of climatechange may trigger weather systems that strike more frequently and with greater intensity, andexplosive population growth in coastal areas spells greater exposure to natural disaster. The
current market volume of catastrophe bonds exceeds $15 billion, but more issuance is neededto protect individuals, communities and companies from disaster. How can existing capital-market solutions for catastrophic risk be improved to provide greater global risk protection?
What products would attract a more diversified investor base and increase the availablecapital? How can we develop strong public-private partnerships to address catastrophic risk
management?
“Financial Innovationsfor Catastrophic Risk:
Cat Bonds and Beyond”
Milken Institute
Financial Innovations LabReport prepared by:
Glenn Yago and PatriciaReiter
The funding challenge for catastrophic riskmanagement
Twenty most costly insurancelosses 1970-2006
Source: Wharton Risk Center.
Impact of catastrophes onemerging markets
Source: Allstate Insurance Company.
Financial Innovations Lab forCatastrophic Risk: Cat Bonds and Beyond
October 25, 2007, New York
Financial Innovations Lab forCatastrophic Risk: Cat Bonds and Beyond
The challenge:
How can catastrophic risk be financed anddistributed utilizing the capital markets?
The Lab participantsidentified the following barriers…
Barrier I: There is insufficient supply ofinsurance-based securities issuances.
Barrier II: There is insufficient demand frommainstream investors.
Barrier III: Transaction fees are too high.
Barrier IV: Regulation hinders growth.
Barrier V: Large markets remain untapped.
….and came up with thefollowing solutions
Solution 1: Address the needs ofthe issuers
• Address basisrisk
• Reducetransaction costs
• Improve legalframework
Source: Swiss Re.
Solution 2: Securitize low-riskevents
Source: Merrill Lynch.
• 85% of all cat bond issuances received a below-investment-grade rating from 1997 through 2006.
• Investment-grade ratings are essential for tapping thelarge institutional investor base.
Solution 3: Diversify risksecuritizations
• The vast majority of cat bonds are issued on U.S. risk:
• In 2007:
– California earthquakes (22%)
– U.S. wind (32%)
– Others included: U.S. river flood risk, earthquake riskcovering Greece, Turkey, Israel, Cyprus and Portugal.
• An important driver of market growth will be thesecuritization of new risk – both a greater range of perilsand geographic distribution.
• Investors request new transactions to diversify theirportfolios.
Solution 4: Legitimize cat bondsas an asset class
Sources: Swiss Re, Lehman Brothers.
• Increased number and volume of issuances are key tothe recognition of an asset class.
• Educate investors about cat bonds and other ILSproducts.
Solution 5: Develop tools forinvestors
• Improve risk management tools for fixed-incomeinvestors and pension funds.
• Develop appropriate benchmarks for Europe andemerging markets (similar to most popular U.S. indices -Property Claim Service [PCS]).
• Issue more collateralized debt obligations (CDOs) basedon catastrophic risk (cat bonds, derivatives, reinsurancecontracts, etc.).
Solution 6: Increase liquidity andtransparency in the secondary market
The future of the cat risk market
Sources: Swiss Re.
Solution 7: Promote increasedparticipation from rating agencies
Source: Merrill Lynch. Note: AUM = Assets under management
Rating decisions and investors
Solution 8: Standardizetransactions, and lower legal fees
• Increase the use of shelf programs.
• Establish International Swaps and DerivativesAssociation industry loss warranty (ILW) documents forOTC transactions.
• Standardize issuance structuring and documentation.
• Establish the special purpose vehicle (SPV) onshore(costly under current tax code).
Solution 9: Address regulationthat promotes growth
• A strong public-private partnership is essential forprotecting individuals, enterprises and communitiesfrom large-scale disasters.
Recommendations for future legislation:
• Granting tax benefits to insurers and reinsurers forholding catastrophe reserves.
• Establishment of a federal charter for insurancecompanies.
Solution 10: Expand to emergingmarkets and attract new issuers
Source: Víctor Cárdenas, Ministry of Finance, Mexico.
The Cat-Mex transaction
Market overview and developments
Capital market solutions forcatastrophic risk management
Source: Allstate Insurance Company.
Basic cat bond structure
Source: Swiss Re.
Total ILS and cat bondsoutstanding 1997-2007
Source: Swiss Re, Guy Carpenter & Co.
Milestones in the market forcatastrophe bonds
Source: Milken Institute. *as of September 2007
Panelists’ Slides
John Brynjolfsson
Managing Director and Portfolio Manager
PIMCO
Different Perspectives,Different Skills
• Capital-market investors and reinsurance companies are drawnto concentrations of wealth and abundance. Historically,premiums and insured losses are confined to these areas.Sadly, financial players have been oblivious to pain andsuffering caused by catastrophes in less affluent regions.
• Private and governmental relief agencies try to deal withcatastrophic losses on an occurrence basis. They find thevariability and unpredictability of events make it difficult torespond as quickly and forcefully as they’d like.
• To benefit the underprivileged, the catastrophe-bond markethas successfully extracted the synergies of companies lookingto do good, and charities charged with responding to disasters– and can do so even more in the future.
Global warming Climate fluctuates, but recent temperature
increases may continue
Source: American Geophysical Union.
• Global warming is detectable and operates on ascale of centuries and millennia.
• Global warming theoretically leads to hurricanes;this may lead to increased insurance demand.
• Increasing storm intensity may lead to “tail events”that traditional reinsurance market finds hard tobear.
Global warming Some facts
Global markets are huge Capital and Property & Casualty Markets, 2005
Sources: Bank for International Settlements, Insurance Information Institute, World Federation of Stock Markets.
Conclusions
People in underdeveloped parts of the world areexposed most harshly to nature’s fury.
The catastrophe-bond market and disaster-reliefcharities are natural long-term partners.
They complement one another to diversify the risks.
Working together, we can develop charitable event-linked bonds and use them to their full potential.
We can all look forward to developing innovativesolutions that may make insurance more affordable foreveryone and more available to the people who need itmost.
Jeffrey Cooper
Assistant Vice President
Protection Finance
Allstate Insurance Company
Insured assets exposed tocatastrophe losses are huge
Insurance investors dislike earnings volatility tied to
catastrophe losses.
Typhoon exposures nationwide
Earthquake exposures nationwide
Japan
North Atlantic winter storms
Floods in Central Europe
Earthquake in Southern Europe
Europe
Hurricane landfalls along Gulf and Atlantic coastlines
Earthquake epicenters on West Coast, in Central U.S.
USA
Asia: Rapidly expanding middle class creating new exposure
concentration. India, China, other developing countries.
Expanding urban areas are in exposed zones.
London, Dublin, Amsterdam, Paris all growing steadily.
Europe:
Population migration to hurricane - exposed coastal states.
Population growth 1980-2003:
Florida 75%
Texas 52%
Insured values in coastal properties is exploding.
Florida coastal property values $1.94 trillion.
NY coastal property values $1.9 trillion.
LA+MS coastal property values $66 billion.
LA, SF, Seattle highly exposed to earthquakes.
U.S.:
Exposure growing rapidly incatastrophe - exposed areas
Insurance exposure isconcentrated in few balance sheets
11.7%
6.1%
6.1%
4.9%
3.4%
32.2% Top 10 46%
AIG
Travelers
Zurich
Liberty Mutual
CNA
Top 5
U.S. commercial property insurance market share:
21.8%
11.1%
6.7%
4.5%
4.4%
48.5% Top 10 63%
State Farm
Allstate
Zurich
Nationwide
Travelers
Top 5
U.S. homeowners insurance market share:
Insurers seek risk transferpartners pre-event
Lloyds of London
Berkshire Hathaway
Bermuda market: 25+ reinsurance companies
Swiss Re / Munich Re
Other U.S., Euro-based companies
Reinsurance sources concentrated:
$150 billion contract limit purchased
in U.S.
Reinsurance:
Historical source of insurers’ risk transfer
Pay annual premiums in negotiated contracts with third parties.
Net risk exposure is key determinate in their credit rating.
Uninsured exposure tocatastrophe also huge and growing
Financing needs for infrastructure repair and humanitarian
relief
Central, South America: Earthquakes
Caribbean, Central America: Hurricanes
Asia: Typhoons, tsunamis, earthquakes
Governments unable to fund by themselves
Large events typically trigger post-event relief efforts
Tsunami relief commitments: $2B post-event
Beat Holliger
Managing Director
Munich American Capital Markets
Risk management concepts
Capital Markets
Reinsurer
Participation in
placements
Secondary market
trading
Book building
Private
placement
Placement Agent
Insurer Insurer Insurer Insurer
Source: Munich Re Capital Markets.
Cat bond structure
Insurer
Reinsurer
Principal
At-Risk
Var. Rate
NoteholdersCollateral
Account
Total Return
Swap
Provider
SPV
Reinsurance
Agreement
Premiums
Premiums
Retrocession
Agreement
LIBOR –
Eligible Bank
Fee
Bank Deposit
LIBOR + xx bps
Note Proceeds
Outstanding Principal
Amount at Redemption
LIBOR generated by collateral investments
and are not to be paid by client (xx bps only)
Insurer
Reinsurer
Principal
At-Risk
Var. Rate
NoteholdersCollateral
Account
Total Return
Swap
Provider
SPV
Reinsurance
Agreement
Premiums
Premiums
Retrocession
Agreement
LIBOR –
Eligible Bank
Fee
Bank Deposit
LIBOR + xx bps
Note Proceeds
Outstanding Principal
Amount at Redemption
LIBOR generated by collateral investments
and are not to be paid by client (xx bps only)
Source: Munich Re Capital Markets.
• Softening traditional markets with tighter spreadsand looser terms and conditions also spilled overto the cat bond market.
• The crisis in the financial markets impacted theselection of the permitted assets as well as theselection of the total return swap provider.
• Both effects will be discussed in detail.
Impact of softer re/insurancemarkets and credit crisis
• Investors can accept tighter spreads becauseof growing market maturity, but demandproducts that are well structured.
• Intransparent cat bonds are difficult to sell toinvestors.
• On the other hand, well structured andtransparent deals are very well received and aregenerally oversubscribed.
Terms and conditions
• While the quality of the permitted assets in thetrust account was previously not of particularconcern, both cat bond investors and sponsorsdevote more attention to the selection of suchpermitted assets.
• Quality of total return swap provider has gainedimportance due to the heavily impaired balancesheets of financial institutions and total returnswap providers.
Collateral quality and total returnswap (TRS) provider
Market development 2002-2008
Source: Munich Re Capital Markets.* Up to Q1
Dan Ozizmir
Managing Director and Head of Insurance-Linked Capital Markets and Environmental
and Commodity Management
Swiss Re Financial Products
Insured value concentrationgrowing in areas of peak catastrophes
Projected population change1994-2015
Count of observed hurricanesin the US in the last 110 years
3020100
Sources: Swiss Re’s Nat Cat team, National Oceanic and Atmospheric Administration (NOAA).
The P&Creinsurance worldknows about 5 socalled “peakrisks”
Peak risk =Geographicalzone with:
- High risk ofnatural hazards(e.g. earthquakes)- High density ofinsured values(e.g. houses)
Transfer to capital markets isexpected to increase
•Securitisation
• ILW
• Collateralisedquota shares
• Sidecars addto the
flexibility ofcapital in the
industry
0
100
200
300
400
500
600
'97 '99 '01 '03 '05 '07 '09F '11F '13F '15F '17F
US$ billions
Cash format is only thetop of a larger potential;derivative format is key
Potential future growth of ILS outstanding Projections using 75% of actual historical CAGR
Source: Swiss Re Capital Markets.
Risk securitized from 1997-2008
Source: Swiss Re Capital Markets. *As of 5 March2008
Embedded Value (USD 9.3bn)
Extreme Mortality (USD 2.1bn)
Life XXX (USD 8.9bn)
Multi-peril (USD 7.8bn)
US Wind (USD 5.9bn)
Other – Life (USD 2.6bn)
California EQ (USD 3.2bn)
Others (USD 6.8bn)
Total 100% (USD 46.7 bn)
19%
20%
6%4%
17%
7%
13%
14%
US$ billions
Source: Swiss Re Capital Markets.
Who participates in the ILS market? A diverse range of institutional investors
Market size USD 15.4 bn
Insurer
3%Reinsurer
4%
Money Manager
22%
Bank
13%
Hedge Fund
14%
DedicatedFund
44%
Market Size = US$ 15.4 bn
Source: Swiss Re Capital Markets. *As of 5 March2008
Who participates in the ILS market? Primary insurance companies make up the largest percentage of sponsors
0
5
10
15
20
25
30
35
40
45
50
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Gov't Entity
Corporate
Reinsurer
Insurer
Hedge Fund
Previous
Example: GlobeCat Ltd.
Donors
Charity GlobeCat Ltd.SPV
Donations
No CatastropheEventTrust
Disaster Relief inDevelopingCountries
Investors
Notes
Proceeds
Interest
CatastropheEvent
Proceeds PrincipalRepayment At Maturity
BondPrincipal
BondPrincipal
Source: Swiss Re Capital Markets.
Example: GlobeCat Ltd.
IssuanceStructure
Size: $25,000,000
Maturity Date: Dec30, 2008
Term: 1 year
Risk: Latin AmericaEarthquake
Call Feature: NoCall
Nat CatExposure
Latin AmericaEarthquake Event
Covered Area:Guatemala and ElSalvador
Populations:
El Salvador – 6.5million (31%)
Guatemala – 14.2million (69%)
TriggerDescription
Index: PopulationExposed to severeshaking
Trigger Level:750,000 peopleexposed
Exhaustion Level:1,000,000 peopleexposed
Source: Swiss Re Capital Markets.
Satellite Based Vegetation Indices
Source: Swiss Re Capital Markets.
Satellite Based Vegetation Indices
• Problem: Remote areas lack historical field data andmany emerging markets have no suitable insurancemechanism or government subsidy.
• Solution: Satellite imagery provides objective means andsolves issue of lack of local measurement data atnumerous locations.
• Index: Vegetation Index (VI) computed from NormalizedDifference Vegetation Index (NDVI) from satellite data,ideally suited for pasture and range land.
• Coverage: Lack of green matter, approximately 300 LatinAmerican locations during growing season.
Satellite Based Vegetation Indices
• Concept extendible to emerging markets such as Africa andBRIC
• Swiss Re worked with Millennium Promise, a 501(c)(3) entityled by Jeffrey Sachs, Director of Columbia University's EarthInstitute‘s, operating in 78 villages across 10 countries insub-Saharan Africa to mobilize the private sector to findsolutions to key problems that contribute to extreme povertyin Africa
• Swiss Re combined NDVI coverage with a local waterrequirements satisfaction index (WRSI) to create a combinedNDVI/WRSI Climate Impact Index to cover grains and othercrops not suited for a pure satellite coverage
• Payout-digital if trigger is met with flexibility for scaledpayments such that moderate drought can trigger onepayment, catastrophic drought a higher payout
Jose Siberon
Director
Merrill Lynch & Co.
Insurance-linked securities Why issuers engage in securitization
Risk management (alternative risk transfer tools)Alternatives to reinsurance
Multi-yearReduce counterparty credit riskQuicker payment of claims
Capital managementImprove the risk based capitalRegulatory relief
Enhance ROEImprove claims recovery mechanismUnlock value of a run-off block
Catastrophe bonds and swaps (natural, mortality)Embedded value monetizationLeveraged acquisitionFund new business strainFund redundant reserves (Reg. XXX,AXXX)Capital relief transactionsSidecarsLife settlement and premium finance trusts
Insurance-linked securities Types of insurance-linked transactions
Insurance-linked securities Examples of risks being securitized
1. Mortality/longevity2. Morbidity3. Auto insurance4. Hurricane/typhoons5. Quake6. Flood7. Fire8. Variable annuity M&E fees9. Tornados10. Terrorism
and…many others!
Dis
trib
uti
on
s o
nIn
vesto
rS
ecu
riti
es
Dis
trib
uti
on
s o
nN
ote
sIn
co
me f
rom
Rein
su
ran
ce
Tru
st
Investors
Cash/ Collateral
InvestorSecurities/CDS
FinanceVehicle
(SPV)
Originator/ Retailer
OwnershipInterest
Cash/ Risk Protection
Customer
Cash/Collateral
Notes/CDS
Financial Guarantee
FinancialGuarantor
Traditional asset-backedsecurities structure • Security holders
• SPV pass-through• Counterparty on a CDS• Leveraged hedge fund• Risk Buyer
• SPV• SPV Reinsurer• Counterparty on a CDS• Trust
• Insurance Company• Reinsurance Company• Counterparty on a CDS• Life Settlement Provider•Intermediary
• Insurance Company• Reinsurance Company• Policyholder• Risk Seller
How does a cat bond work?
Insurer Special Purpose Vehicle Investors
Trust Account
Premium
Principal and
Coupon
Property Cat
Cover
Principal
PrincipalPrincipal and
Investment
Returns
Return on
Liquidity Swap
Yield on
Underlying
Assets
Asset Manager or Swap Counterparty
Insurer Special Purpose Vehicle Investors
Trust Account
Premium
Principal and
Coupon
Property Cat
Cover
Principal
PrincipalPrincipal and
Investment
Returns
Return on
Liquidity Swap
Yield on
Underlying
Assets
Insurer Special Purpose Vehicle Investors
Trust Account
Premium
Principal and
Coupon
Property Cat
Cover
Principal
PrincipalPrincipal and
Investment
Returns
Return on
Liquidity Swap
Yield on
Underlying
Assets
Asset Manager or Swap Counterparty
Reg. XXX/AXXX overview What is Reg. XXX/AXXXX?
Regulation 30 (i.e. XXX) was passed to controlinsurance companies misreserving formortality risk, particularly for term insurance
Statutory reserves, which are calculated basedon rule-based methods and assumptions,resulted in substantial increases in reserves
New Statutory reserves are now 2-5x theeconomic/GAAP reserves creating asubstantial strain in statutory capital
Insurance Companies funded the excessreserves by reinsuring the business to off-shoreaffiliates and LOC collateral (1-5 yr terms)
Actuarial Guideline 38 (AXXX) wasadapted to adjust Reg. 30 to addressuniversal life policies with no lapseguarantees
Prudential funded the excessreserves by issuing public debt(recourse transactions)
Genworth established a non-recourse securitization to fund theexcess reserves
Rating Agencies require that the fundingsolutions have a longer tenor (min 8 yrs for reg.30 & 15 for AXXX)
LOCs Capacity for long tenor is limited
Banks began to offer more creative solutions[LOC, Private Funding, Principal Investments,Public Funding, Securitization (term &Auction-market)]
Estimated future funding need estimated to bebetween $100-$150 B over the next 5 yrs by therating agencies
Market estimate of fundingsolution estimated to be $35-$45 B(mostly private)
Auction-Market fundedSecuritization failed causinginsurance companies to look forterm-out alternatives
2001 2003 2005 2007
Insurance-linked securitization Full securitization solution
Investors
CashInvestorSecurities
FinanceVehicle
CaptiveReinsurer
OwnershipInterest
Cash
ReinsuranceTrust
Eligible Assets
Right of Draw
Ceding Insurer
Reinsurance Agreement
Cash Notes
Financial Guarantee
FinancialGuarantor
Insurer Parent
Cash
Equity*
InvestorsInvestors
CashInvestorSecurities
FinanceVehicle
CaptiveReinsurer
OwnershipInterest
Cash
ReinsuranceTrust
Eligible Assets
Eligible Assets
Right of Draw
Ceding Insurer
Reinsurance Agreement
Cash Notes
Financial Guarantee
FinancialGuarantor
Insurer Parent
Cash
Equity*
Event-linked futures
CCFE (Chicago Climate Futures Exchange) IFEX
Source: Chicago Climate Futures Exchange.