Convergence Insurance and Capital Markets

7/29/2019 Convergence Insurance and Capital Markets

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World Economic ForumOctober 2008

Convergence of Insuranceand Capital Markets

COMMITTED TO

IMPROVING THE STATE

OF THE WORLD

A World Economic Forum Reportin collaboration with

AllianzBarclays CapitalDeloitteState Farm

Swiss ReThomson ReutersZurich Financial Services


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

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REF: 091008


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3

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 142.2.5 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 293.2.4 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


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We are pleased to present this report on the

convergence of insurance and capital markets. It

stems directly from an initiative of the Financial

Services Governors launched at the World Economic

Forum Annual Meeting 2007, when the assembled

Governors agreed to carry the dialogue and work

beyond Davos in line with the Forums mission of

being Committed to Improving the State of the

World. Subsequently, working groups comprised of

industry representatives, academics, experts and

Forum staff took up work on several projects that

Governors felt were of broad interest, not only to thefinancial services industry but also the public. This

project, examining the convergence between capital

markets and the insurance sector, focused in particular

on the role new financial instruments could play to

better address and syndicate particular types of risk.

This report could not be more timely. While the credit

crisis, now going into its second year, was triggered

inter alia by faults associated with securitized

mortgages, insurance-linked securities (ILS) turned

out to be highly resilient at a time of extreme market

turbulence. In fact, ever since the outbreak of thesub-prime crisis, prices of catastrophe bonds

(perhaps the most prominent ILS example) have

performed strongly, easily outperforming indices of

credit instruments with similar debt ratings. However,

this outperformance has hardly registered with non-

specialists in light of overall market challenges.

In this environment, where the financial markets face

such turmoil, this publication aims to shed light on a

critical area in which the capital markets are showing

signs of success. Its authors make a convincing

case that insurance-linked securities are an

important asset class, and that the ILS market is not

only here to stay, but likely to grow at a strong pace

in the future. Of course, there are and will continue

to be obstacles to the growth and broad

acceptance of ILS. This report identifies many such

challenges. We believe that the benefits of

insurance-linked securities will ultimately appeal toinvestors and issuers alike and have an important

role to play for particular types of investment risks.

The report should help to create an elevated

baseline of understanding among a broader base of

non-specialist investors, discussing the impediments

and potential solutions to further the debate about

the use of these products.

A work of this caliber can only be written by many

talented people pulling together towards one

common goal. We thank our Governors, sponsors,

workshop participants, experts and team membersfor their dedication to this report. The ball is now in

the court of the market participants. They have it in

their hands to unlock the full potential of insurance-

linked securities, and we are confident therefore that

the increasing convergence of insurance and capital

markets will create value for all.

4

Foreword and Contributors

James J. Schiro

Group Chief Executive Officer and Chairman of the

Group Management Board

Zurich Financial Services Switzerland

Kevin Steinberg

Chief Operating Officer and Head of the Centre

for Global Industries (New York)

World Economic Forum USA


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Contributors

Co-authors

Katharina Hartwig (part 3)

Group Legal Services

Allianz

Kurt Karl (part 2)

Senior Vice-President

Head of Economic Research and Consulting

Swiss Re

Steven Strauss (Executive Summary)

Senior Adviser


Tom Watson (parts 4 and 5)

Project Manager


Operating Committee

Daniel Brookman

Head of Structured Insurance

Barclays CapitalDaniel Hofmann

Chief Economist

Zurich Financial Services

Kurt Karl

Senior Vice-President

Swiss Re

Ben Lewis

Head of Strategy

Thomson Reuters

Stephan TheissingHead of Group Treasury and Corporate Finance

Allianz

Deborah Traskell

Executive Vice-President

State Farm

Steering Committee

Paul Achleitner

Chief Financial Officer

Allianz

Jacques Aigrain

Chief Executive Officer

Swiss Re

Jerry Del Missier

President

Barclays Capital

Jim Rutrough

Vice-Chair and Chief Operating Officer

State Farm

James J. Schiro

Group Chief Executive Officer

and Chairman of the Group Management Board

Zurich Financial Services

Devin Wenig

Chief Executive Officer, Markets Division

Thomson Reuters

Key Knowledge Partners

Jack Ribeiro

Global Head of Financial Services

Deloitte LLP

Ed Hardy

Insurance Partner

Deloitte & Touche LLP

From the World Economic Forum

Kevin Steinberg

Chief Operating Officer and Head of the Centre for

Global Industries (New York)


Steven Strauss

Senior Adviser


Tom Watson

Project ManagerWorld Economic Forum USA

While not necessarily endorsing any of the specific

conclusions reflected in this report, both the Steering

Committee and Operating Committee provided

detailed feedback and helped ensure the overall

integrity of the work. Any opinions herewith are

solely the views of the authors and do not reflect the

opinions of the Steering Committee, the Operating

Committee or the World Economic Forum.

5


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Facilitating risk transfer and increasing transparency

have been dominant themes in the financial markets

since the end of World War II. Transferability and

transparency are widely believed to promote better

economic performance with important benefits not

just to investors but also to consumers and other

social stakeholders.

In certain risk areas we see an

increasing need for capacity. Weather-

related insurance claims, for example,have increased fifteen-fold over the last

30 years. In this challenging situation,

insurance-linked securities provide new

fully collateralized and multi-year

capacity for the risk-carrying industry,

along with a high degree of risk

diversification, which makes them

attractive for investors as well.

Paul Achleitner, Chief Financial Officer, Allianz, Germany

Financial innovation has allowed many types of risk

to become more tradable including credit, interest

rate, equity and foreign-exchange risk, to name but

a few. However, one important category still lacks a

liquid, transparent and tradable market: insurance

risk.

The potential market is vast, with total premiums of

all the worlds insurers equalling approximately US$

4.1 trillion. Insurance risk comes in many varietiesand can be segmented into broad categories (e.g.

life, property and casualty, etc.), as well as

geographic markets. This is not unlike other types of

risk widely traded in the capital markets. Credit risk,

for example, can be divided into corporate,

municipal, mortgage and consumer sectors, among

others.

However, it is necessary for investors and policy-

makers to recognize the distinctions between the

securitization ofassets (mortgages, car loans, etc.)

and the securitization ofliabilities. Most life insurancesecuritizations are similar to asset-backed securities

(ABS) currently offered by banks and prone to

many of the same issues associated with ABS.

Some life insurance, securitizations, for example, are

backed by the embedded value of future profit

streams from a book of life insurance policies.

In the case of property and casualty (P&C)

securitization, however, the distinction between the

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.

This creates a strong incentive for bankers to

transfer risks to the markets in order to diversify their

asset portfolios. P&C liabilities, on the other hand,are uncorrelated, or only weakly correlated.

Hurricane Katrina, to cite one example, severely

impacted a relatively small geographic region of the

United States, but had little or no effect nationally or

globally. The typical P&C portfolio, then, consists of

a wide spectrum of uncorrelated risks. This creates

diversification benefits, in that total risk in the

portfolio is less than the sum of the individual risks

reducing the incentive for P&C insurers to transfer

these risks to the market.

Yet, this diversification benefit is precisely whatmakes insurance-linked securities (ILS) potentially

desirable to investors they are uncorrelated with

their existing asset holdings. P&C insurers,

meanwhile, have another incentive to transfer risk,

as a means of obtaining additional capacity (mainly

for catastrophic risk). Thus, liability securitization can

be a tool for capital management for both buyers

and sellers.

Market development

Although the market still lacks a clear, transparentand tradable platform, ILS issuance and trading

activity has been growing at a rapid pace, albeit

from a small base. The tradable insurance risk

market currently has a notional value of only US$ 50

billion, but has been growing at 40-50% per year

since 1997. The premium equivalent is now about

US$ 3 billion, or 1.5%, of global reinsurance

premiums, which were about US$ 192 billion in

2007. In more mature risk markets, the tradable

portion is typically a multiple of the underlying

notional value. Hence, there appears to be ample

room for growth.

6

1. Executive Summary


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The development of the ILS market

has increased the ability of insurers and

reinsurers to accept peak natural

catastrophe risks such as US

hurricanes.

David J. Blumer, Head of Financial Services

Swiss Re, Switzerland

The need for capital, liquidity and transparency hasbecome even more urgent for the P&C industry as it

faces the challenge of global climate change, which

is increasing the risks of European windstorm

damage and American coastal flooding, among

other hazards. Accordingly, the industry would like to

move to more flexible and efficient capital structures,

which would be facilitated by greater development of

the insurance risk market. Even if the increased

access to capital were confined to reinsurers, this

would still indirectly benefit policy-holders by

increasing their capacity to absorb risk.

Finally, transparent pricing would also reveal the cost

of well-intentioned political solutions that increase

the provision of insurance but fail to adequately fund

those guarantees, by making it possible to mark

public sector insurance schemes to market.

Structural impediments to growth

While there are reasons to be optimistic about the

development of the insurance risk transfer market,

there are also some fundamental dynamics that

could slow its growth. Some of these factors arerooted in the distinctions between asset and liability

securitization mentioned earlier.

A simple comparison to the mortgage market may

illuminate the point. The originator of a mortgage

loan (particularly in the American market) can

completely remove itself from the risk equation by

executing a true sale of the note to a third party. In

effect, it can elect to have no further risk exposure to

the borrower going forward, even if it chooses to

retain other elements of a customer relationship.

This separation is feasible because the underlyingcontractual relationship is simple and relatively

unambiguous. The borrower is not dependent on

the credit quality of the lender and has no economic

or legal interest in the identity or financial strength of

the ultimate mortgage holder. The lender, on the

other hand, does have an incentive to understand

the borrowers creditworthiness although the

incentives for due diligence clearly can be weakened

by the originators ability to transfer the mortgage

quickly.

In an insurance contract, the situation is quite

different. As the ultimate risk holders, insurers mustmake significant investments in due diligence. To

manage their exposures, they must be aware of and

seek to control moral hazard. Policy-holders,

meanwhile, have a very real interest in knowing the

identity and understanding the business practices of

their insurance providers. They want to be sure their

claims will be met if losses are incurred.

Obviously, the average policy-holder cannot check

the creditworthiness and solvency of his/her carrier;

he/she has to rely on the assessments of regulators

and the rating agencies. Hence, the policy-holderwill always want approval regarding any assignments

of the insurance contract, while the primary insurer is

unlikely to ever be completely removed from the

value chain. While these interests may inhibit the

growth of the risk transfer market, they also may

provide some protection from the exuberance we

have witnessed in sub-prime lending.

Key findings

Over the course of this project, certain themes

emerged from our workshops and interviews withmarket participants. Sponsors (mostly reinsurers and

some insurers) identified the following key issues that

will need to be addressed in order to facilitate the

development of the insurance risk transfer market:

Lack of standardization: Insurance risk transfers

can take a long time to complete, costs can be

very high and the accounting treatment is

uncertain. The latter problem often stems from

the considerable uncertainty about regulatory and

rating-agency treatment of the transaction. The

result is a reluctance to engage in the market

among institutions subject to the most uncertainty.

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Insufficient cost/benefit analysis: Traditional

reinsurance is of a limited term, the list of

potential counterparties is small and the ceding

insurer ends up with a credit risk from the

reinsurer. Capital market transfer instruments

provide longer terms and reduce counterparty

risk, but increase complexity. The insurance

industry also lacks a language and a

methodology to evaluate the benefits of these

instruments and make quantitative comparisons

to conventional reinsurance.

Poor data quality: In many markets, tradeablemarket indices do not exist. In the US, there is

also a need for more granular data for parametric

transactions that can potentially be used as

market indices.1

Basis Risk: Any market structure in which the

insurers reimbursement is based on a market

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 capitaladequacy 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 incomeinstruments (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.

Uncertainty concerning the probability of

catastrophic loss: This presents a bit of a

Catch 22. One of the major reasons the

insurance industry wants to promote liquid

transfer markets is the uncertainty regarding risks

such as climate change and global pandemics.

However, this very uncertainty makes the capital

markets price these risks conservatively, limiting

the benefits of securitization.

Our recommendations for addressing these and

other issues are described in more detail in thefollowing sections. Our key point is that these

impediments will not be simple, fast or easy to

overcome. In order to maintain the growth of the

insurance risk market, concerted action will be

required from market participants over a multi-year

time horizon.

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Since its infancy in the early 1990s, the market for

insurance-linked securities has grown at high

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

instruments for transferring insurance risks. Second,

insurers need to efficiently manage their capital and

these new products provide flexibility and access to

a large pool of capital. This can be advantageous for

P&C insurers who have a sudden need for extra

capacity to write insurance following a major

catastrophe, for example.

Several trends are driving the

convergence of insurance and the

capital markets.

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)

or swap (cat swap). Even insurers that do notthemselves use these instruments may benefit from

the increased availability and affordability of

reinsurance as reinsurers tap into the additional

capacity made possible by market growth.

For life and health (L&H) insurers, using ILS to

access the capital markets is an effective way to

finance growth and manage excess reserves. Life

insurers may also desire protection against extreme

events, such as pandemics. Finally, there is growing

interest in ILS among investors, because in some

cases they represent a diversifying asset class withrobust yields.

Additional growth drivers include:

Attractive investment performance, despite major

losses such as Hurricane Katrina, the largest

insured loss in history

Enterprise risk management benefits, with ILS

making it possible for insurers and reinsurers to

supplement traditional capacity, diversify their

trading partners and reduce counterparty risk

Efforts by the rating agencies to improve and

document their methodologies for rating catbonds, which especially benefits the tranched

layers of multiple-peril cat bonds

Other factors are also driving the

growth of the risk transfer market.

The increased visibility of catastrophe modelling

firms in the capital markets, boosting the

credibility of their models

Dramatically improved distribution capacity, as

more investment banks and reinsurers offer ILS

products to investors

The availability of senior financing, which is nowobtainable at meaningful levels for ILS

Increased price transparency with the launch of

exchanges trading cat risks and brokered cat swaps

Lower transaction costs made possible by

document standardization and shelf financing

2.1 Market development

ILS issuance and capacity both set

records in 2007.

Issuance of insurance-linked securities totalled US$

14.4 billion in 2007, up 40% from US$ 10.3 billion in

2006. at the end of 2007, outstanding notional value

stood at US$ 39 billion, up 50% from US$ 26 billion

at the end of 2006. By May of 2008, the value of bonds

outstanding had reached about US$ 40 billion, with

life bonds accounting for 58% of market value of

bonds outstanding. The market still has significant

upside potential. P&C risks transferred to the capital

markets represented only 12% of global catastrophereinsurance limits in 2007 and under 1% of other

non-life reinsurance limits. There appears to be no

shortage of sellers of protection demand for this

asset class from dedicated cat funds has been

particularly strong. Issuance is expected to grow to

US$ 25-50 billion by 2011, while the notional value

of bonds outstanding could reach US$ 150 billion.

ILS issuance slowed in 2008.

Although long-term prospects for the market arerobust, ILS issuance slowed in the first half of 2008

due to the turmoil in the credit markets, which

9

2. The Existing Market for Insurance Risk


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Our experience with ILS-transactions

has been positive and these are an

important part of our capital market

activities and a key strategic lever.

Dieter Wemmer, Chief Financial OfficerZurich Financial Services, Switzerland

particularly affected investment-grade life and non-

life bonds. Life insurance issuance in particular

slowed to a standstill, due to the credit crisis as well

as issues related to embedded value and US

actuarial guidelines on valuation (commonly known

as Regulations XXX/AXXX). These instruments are

similar to asset-backed securities, which have been

dramatically affected by the current market turmoil,

increasing the price of life securitizations. However,

with the exception of the small investment-grade

sector, non-life issuance has not slowed as spreads

have generally tightened in line with the softeningreinsurance markets. As expected, tightening

spreads and softening reinsurance markets have

dampened sidecar activity.

The market for insurance-linked

instruments is developing rapidly.

Other recent ILS developments include:

The weather derivatives market has remained

healthy, with the notional value of trades rising toUS$ 32 billion in the 2007-2008 period from less

than US$ 10 billion in 2004-2005

The use of industry loss warranties and cat

swaps has grown at a strong pace and those

instruments now have an outstanding notional

value of about US$ 10 billion

Investor interest in natural catastrophe risk has

increased rapidly. Dedicated cat funds attracted

substantial new capital after it was seen that the

prices of cat bonds remained stable even as

corporate bond prices plummeted

Catastrophe risks are now traded on exchanges Many parties are developing tradable indices, with

an initial focus on longevity, cat bonds and natural

catastrophe risk

2.2 Market instruments

2.2.1 P&C bonds

Catastrophe bonds, the primary type of P&C bond,

originated in the hard market of the early 1990s

following Hurricane Andrew, when reinsurance

capacity for catastrophes was limited and expensive.

The earliest forms provided a simple mechanism to

transfer catastrophic risks to capital markets. In a

typical transaction, a fully collateralized special purpose

vehicle (SPV) enters into a reinsurance contract witha protection buyer, or cedent, and simultaneously

issues cat bonds to investors. The reinsurance is

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

for the use of their funds and their risk exposure. If,

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

to the cedent in fulfilment of the reinsurance contract.

The first catastrophe bonds were issued

after Hurricane Andrew. There are five

basic types of loss triggers.

There are five basic types of trigger, with varying

degrees of transparency for investors and basis risk

for the cedent:

An indemnity trigger is based on the actual losses

of the sponsor and has negligible basis risk

An industry index trigger is based on anindustry-wide index of losses, such as the

estimates published by ISOs Property Claim

Services (PCS) unit in the United States

Apure parametric trigger is based on the actual

reported physical event (i.e., magnitude of

earthquake or wind speed of hurricane) and has

the most transparency for the investor, but also a

great deal of basis risk for the sponsor

Aparametric index trigger is a more refined

version of the pure parametric trigger using more

complicated formulas and more detailed

measuring locations Amodelled loss trigger determines estimated

losses by entering actual physical parameters into

an escrow model, which then calculates the loss

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US$ billion

0

4

8

12

16

20

24

28

32

98 99 00 01 02 03 04 05 06 07

New issues Outstanding from previous years

Multi-peril 39%

31%

19%

3% 2% 5% 1%

21%

12%

6%

Wind

Earthquake

Liability

Credit

Auto

Other

Most P&C bonds transfer

catastrophic risks.

The overwhelming majority of P&C securitizations

are for catastrophic risks, such as windstorms

(hurricanes, typhoons) and earthquakes. These

serve as collateralized protection for extreme eventrisk, which eliminates counterparty risk, at a multi-

year fixed price. Additionally, however, bonds have

also been issued that transfer liability, credit, motor

and reinsurance recoverable risks.

The largest proportion of bonds outstanding are for

multiple perils. In 2007, almost half of total issuance

covered multiple perils. Also, cover has now been

extended to new perils beyond the peak Florida

wind risk that was typical in the market following

hurricanes Katrina, Rita and Wilma. One bond, forexample, now covers European earthquake risk in

Turkey, Greece, Israel, Cyprus and Portugal, while

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.

Some now have a lifespan of six years.

The cat bond market continued to

grow in 2007, even in a softening

insurance market.

The process of issuing cat bonds is increasingly

standardized, lowering the cost of issuance and

attracting new sponsors. The issuance of

standardized programme or shelf-offering

transactions accelerated in 2007, with shelf offerings

accounting for 72% of total non-life issuance. At the

same time, the size of the average bond increased

11

Transparency

forInvestor

Basis Risk to Issuer

Parametric

Index

Modelled

Loss

Indemnity

Industry

Index

Pure

Parametric

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

Source: Swiss Re Capital Markets

Figure 1: The different types of insuranceconvergence products


Multiple peril bonds now constitute the

largest proportion of outstanding cat

bonds. Average issue size has grown as

new sponsors have been attracted to

the market and standardization has

lowered the cost of issuance.


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from US$ 141 million in 2006 to US$ 271 million in

2007. Of the bonds issued in 2007, State Farms

Merna Re had a record value of US$ 1.2 billion,

while the Emerson Re and Longpoint Re bonds

were for US$ 500 million each.

Sponsors and indemnity-based bonds

increased last year.

There was also a further widening of the pool ofsponsors, which included large primary companies

such as State Farm and Chubb, and corporations,

such as East Japan Railway for the Midori bonds. In

another sign of a maturing market, the use of

indemnity triggers increased in 2007, as primary

insurers sought to minimize basis risk and investors

grew more comfortable with such triggers.

In 2005 and 2006, growth was supported by

catastrophe activity in 2004 (hurricanes Charley,

Ivan, Frances and Jeanne) and 2005 (hurricanes

Katrina, Rita and Wilma). However, underlining themarkets growing maturity, cat bond issuance

continued to grow robustly in 2007, even with

softening insurance market conditions and despite

the credit crisis.

2.2.2 Life bonds

Life bonds can be used to monetize intangible

assets, fund US regulatory capital requirements

under Regulations XXX/AXXX, and transfer risks,

such as extreme mortality events, to the bond

market. These bonds, and the regulatory

requirements for them, differ from existing P&C

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

life insurance policies. Risk is not fully transferred ina legal sense, since the life insurance company will

always retain the obligation of its policies. However,

the burden of risks, such as mortality and lapse risk,

are assumed by the investors. For these bonds,

investors and protection buyers share the benefits

and losses in the development of the underlying

policies that have been securitized. Extreme

mortality bonds are similar to P&C cat bonds in that

they, too, are fully collateralized and have a specified

trigger.

Life bonds are typically a financing tool.

12

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

US$ billion

0

4

8

12

16

98 99 00 01 02 03 04 05 06 07

New issues Outstanding from prev. years

39%

42%

7%

3%

9%

XXX

AXXX

Embedded Value

Extreme Morality

Other



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The flow of XXX/AXXX securitizations

weakened in 2007 after the credit

crunch hit the financial markets.

Funding of Regulation XXX/AXXX redundant reserves

in the United States has been the primary focus of

life securitizations in the past few years. These

redundant reserves are for fixed-length term life

(XXX) and universal life (AXXX) policies. In the second

half of 2007, pressure on the asset-backedsecurities market and on the monoline insurers

slowed issuance, but this is expected to be a

temporary factor. In 2007, XXX transactions were

executed publicly by Genworth (US$ 790 million)

and Aegon (US$ 550 million). Protective Life

completed a US$ 250 million AXXX securitization to

fund universal life reserves. These figures understate

the true transfer of risk as substantial private

transaction activity coexists with the public market.

Securitizations that monetize the embedded value

(EV) of a defined block of business accelerated in2007. The Bank of Ireland closed a US$ 573 million

EV transaction for its life insurance subsidiary, New

Ireland Assurance. UnumProvident issued a 30-year

bond (US$ 800 million) to monetize the value of its

closed block of individual income protection

insurance. In December, MetLife issued a 35-year

bond (US$ 2.5 billion) to provide statutory reserve

support for a large closed block of liabilities.

Securitizations of this type hold strong growth

prospects since they provide an effective tool for life

companies to improve capital efficiency and

profitability.

The issuance of mortality cat bonds

was unaffected by credit market woes.

The market for mortality risk transfer through

securitization continues to expand, as these bonds

were unaffected by the credit markets woes. So far,

mortality cat bonds have been issued by Swiss Re,

Scottish Re, AXA and Munich Re. Swiss Re issued a

fourth mortality cat bond (US$ 521 million) in early2007. In February 2008, Munich Re issued its first

five-year mortality cat bond (US$ 100 million) to

protect against an exceptional rise in mortality in the

US, Canada, England and Wales, and Germany.

2.2.3 Weather derivatives

Weather derivatives are primarily used by utility

companies to hedge against extreme heat and cold.

They are typically triggered by heating degree days

(HDD) or cooling degree days (CDD) and serve to

reduce the volatility of earnings by offsetting losses

from higher variable costs at fixed prices when demandsurges during extreme weather. HDD, for example,

is the number of average degrees of temperature for

a day below a reference value (usually 65F or 18C,

which have been shown to require no heating inside

buildings). Frequently, the derivative contracts are for

cumulative HDDs over a season, depending on local

weather patterns. Though HDDs are one of the most

common types of weather derivative, derivatives

have also been constructed with rainfall and other

weather-related triggers.

The weather derivatives market is

likely to grow by 30% per year for the

next several years.

Demand for weather derivatives remains healthy,

with the notional value of trades tripling in three

years, to US$ 32 billion in 2007-2008 from US$ 9.7

billion in 2004-2005 (the intervening 2005-2006

period was marked by some anomalous conditions,

13

0

5

10

15

20

25

30

35

40

45

50

00/01 01/02 02/03 03/04 04/05 05/06 06/07 07/08

Figure 4: Weather derivative contracts(in US$ billion)

Source: Weather Risk Management Association


14/44

including the rapid entry and exit of several hedge

funds as well as increased trading after the

Katrina/Rita/Wilma hurricanes). Growth of about

30% per year is expected for the next several years.

Counterparties for weather derivatives

are mostly utilities, construction

companies and farmers.

North America remains the main driver of the

weather derivatives market, although Europe is

increasingly significant. Counterparties are:

1) Mostly utilities hedging against a warm winter

2) Agribusinesses buying yield and revenue

protection influenced by temperature and

precipitation

3) Construction companies hedging against

precipitation or cold that can disrupt construction

schedules

4) Retailers hedging against the impact on buying

habits of temperature and precipitation

2.2.4 Industry loss warranties

ILWs, cat bonds and cat swaps are all

triggered by specified indexes.

Industry loss warranties (ILW) provide protection

against natural catastrophes. In their reinsurance

form, they are based on two triggers an agreed

upon industry-loss trigger and an indemnity-losstrigger based on the buyers actual losses. In the

United States, the industry loss data used is

frequently taken from the PCS, which provides

timely estimates of insured losses after a

catastrophic event. In other countries, Swiss Res

sigma data, Munich Res catastrophic loss data or

other loss estimates are used. Single ILWs may

provide anywhere from US$ 1 million to US$ 250

million of cover. By contrast, cat bonds typically

need to provide at least US$ 100 million of cover to

be economical.

2.2.5 Cat swaps

Cat swaps are over-the-counter, customized

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

very flexible and have been issued for protection

against US windstorms, US earthquakes, Japanese

earthquakes, Japanese typhoons, Turkish

earthquakes, aviation losses, terrorist attacks,

mortality, longevity and multi-perils.

It is difficult to establish the exact size of the ILW

and cat swaps markets since these are private

transactions. However, together the two instruments

are estimated to have about US$ 10 billion in

outstanding notional volume.

2.2.6 Exchange traded cat risks

Exchanges have been established to

trade insurance-linked derivatives.

Recently, exchanges have been re-established to

trade insurance-linked, index-based risks. Such risks

were traded on exchanges in the 1990s, but these

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

reported by the PCS excluding earthquake and

terrorism losses. The Chicago Mercantile Exchange

and Carvill & Company have set up an exchange to

trade derivatives based on an index of wind speedand hurricane force radius at landfall.

The Insurance Futures Exchange Services Ltd (IFEX)

has initiated trading in catastrophe event-linked

futures on the Chicago Climate Futures Exchange.

IFEX derivatives are based on an index of PCS

losses a named hurricane must breach the trigger.

Each of these exchanges lists derivatives for various

geographic regions (all US, Florida, North Atlantic

coast, etc.) However, all three trading venues are

relatively new and it is not yet clear if they will

succeed.

14


15/44

2.3 Market participants

Investor interest in insurance-linked

securities continues to grow.

Fixed-income investors are increasingly interested in

ILS and related risk-taking instruments, for several

reasons:

These instruments often provide exposure tospecific insurance risks, such as the risk of an

earthquake in a specific area, resulting in a pure

play investment

Their funds are held in trust, so investors face no

counterparty risk with the bonds sponsor, the

insurer or reinsurer

ILS investments often offer low correlation with

equity and credit markets, making them a

diversifying asset class

Most investors tend to focus narrowly with relatively

little overlap, for example, between investors incatastrophe bonds and investors in embedded-value

life bonds. The comments below focus on investors

in catastrophe bonds and related instruments.

Dedicated cat funds are now the largest

investors in cat bonds.

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

market trends such as the growing acceptance of

indemnity triggers. Dedicated cat funds continue to

attract funds at a rapid rate. Interest among otherinvestors, such as hedge funds and traditional pension

plans and mutual funds, is also rising. Investors are

attracted by the uncorrelated nature of cat bonds

and thus their portfolio diversification value, as well

as the increased liquidity of the secondary market.

Spreads on cat bonds continued to

narrow in the second half of 2007, even

as investors in other types of bonds

saw spreads widen.

Since 2002, spreads on cat bonds have narrowed

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

down following two consecutive benign hurricane

15

Creating loss indexes in Europe

Although Europe does not have

a recognized loss index, help is

on the way.

A recent European initiative aims to develop

indexes capable of measuring the scale of

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

capable of promptly providing estimates of insured

European natural catastrophe losses. This

information could be used to develop industry

loss indexes for insurance-related instrumentssuch as ILWs, cat bonds and cat swaps.

Dedicated Fund

44%

Money manager

22%

Bank13%

Hedge fund

14%

Reinsurer

4%

Insurer3%

Figure 5: Investors in cat bonds by typeAs of 31 Dec. 2007



16/44

seasons. This downward trend in spreads was

strongly reinforced in the second half of 2007,

despite the credit crunch. While yields on corporate

bonds widened in the second half of the year, cat

bond spreads, on average, continued to tighten.

By contrast, the credit crunch and the accompanying

uncertainty surrounding the major monoline insurers

have had a dramatic impact on the market for life

insurance bonds. These instruments became

dramatically less liquid and new issuance slowed to

a halt as transactions were reworked.

Since traditional insurance and

reinsurance leave gaps in customers

cover needs, we support efforts to

explore and develop innovative solutions,

such as an effective transfer of insurance

risk to the capital markets.

Jim Rutrough, Vice-Chairman and Chief Administrative

Officer, State Farm Insurance Group, USA

16

Sidecars

Sidecars provide capital when

prices are high.

Sidecar capacity shrank in 2007.

Sidecars are special purpose vehicles that are

temporary collateralized capital pools funded by athird party, such as a hedge fund. The pool is

structured as a retrocession vehicle for a top

flight reinsurer, which assumes a specific type of

business on its highly rated paper, and then cedes

it via a quota share or some other reinsurance

agreement to the sidecar. Typically, sidecars are

multi-year and created during hard insurance

markets, when prices are high for catastrophic

risks.

Because the P&C industry is now well capitalized

and returns are falling, sidecar capacity shrank in

2007. Last year, only nine new sidecars with US$

1.9 billion in capital (mostly debt) were establishedor renewed, while about US$ 4 billion in sidecar

capacity was retired. The remaining capacity is

roughly US$ 4 billion. Sidecars may regain their

popularity after future large catastrophic events.

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.54.0

4.5

2001 2002 2003 2004 2005 2006 2007

Value(US$billion)

Capital Debt

Gap in issuance illustrating

opportunistic sidecar use by

insurers after major

hurricanes (KRW)

Figure 6: New sidecar capacity from 2001 to 2007


17/44

Though growing rapidly, the insurance risk transfer

market is still small in absolute size and slow in its

development compared to some of the credit-linked

ABS markets.2This section will describe factors that

are impeding growth. Our findings are derived from

interviews with investors, insurers, reinsurers, rating

agencies, investment banks, modelling agencies and

other stakeholders, as well as a review of the

existing research literature. Except where noted,

most of our analyses focus on catastrophe bonds,

which represent the bulk of the P&C instruments

currently outstanding.

For sponsors, the transfer of insurance risk to the

capital markets is an alternative or a complement to

traditional reinsurance or retrocession. Accordingly,

they will compare the costs and benefits of

securitization to traditional reinsurance in terms of

both the scope of the protection provided and the

price. Relevant criteria are that an instrument

provides tailored cover with minimal basis risk, low

counterparty risk and favourable treatment with

respect to regulatory capital and credit ratings. For

sponsors, the key impediments to market growthare the potential for basis risk in transactions with

parametric triggers (as well as the accounting,

regulatory and rating consequences resulting from

basis risk) and the pricing of capital market

transactions compared to traditional reinsurance.

Investors, on the other hand, tend to value liquid

markets, objective and transparent triggers,

standardized documentation and short settlement

periods. Key impediments for investors include the

complexity of the underlying risks and the models

used to evaluate them, the lack of standardization in

the ILS market and the limited secondary market

this heterogeneity produces.

3.1 Impediments for sponsors

3.1.1 Basis risk

Traditional reinsurance, whether proportional or

excess of loss, provides indemnity-based protection

without or with only limited basis risk.3 However,

some capital market instruments, if not indemnity-

based, expose the primary insurer or reinsurer

seeking protection to varying levels of basis risk.

Traditional reinsurance or retrocession can be

divided in two types, proportional and non-

proportional. In proportional reinsurance, includingboth quota-share reinsurance and surplus

reinsurance4, insurer and reinsurer share premiums

and losses proportionally. In non-proportional or

excess-of-loss reinsurance, the reinsurance premium

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

exceed a certain amount and up to a specified limit.

However, all these types of reinsurance are

indemnity-based, meaning the recovery from thereinsurer is based directly on the specified losses

incurred by the primary insurer. Note, however, that

a limited amount of basis risk for the ceding

company may result from exclusions and other

contractual terms such as the exclusion of post-

event assessments that limit the extent to which

the reinsurer follows the fortunes of the ceding

company.

In capital market transactions, indemnity-based cat

bonds are structured similarly to excess-of-loss

reinsurance. Within the limits, the sponsor alsoreceives full protection, since the risk assumed by

17

3. Impediments to Growth

Two key differences between theABS and the ILS markets

It is worth noting following two key differences

between the ABS and the ILS markets: With ILS,

the insurer retains a considerable amount of

insurance risk. To date, ILS mostly have been used

to protect insurers against peak risks. Accordingly,

there is much less of a moral hazard problem,

compared to the securitization of an entire credit

portfolio. Secondly, there is no duration

mismatch in cat bond or sidecar structures.

Thus, the difficulties caused by the illiquidity of

the market for short-term notes issued by

structured investment vehicles in the ABSmarket will not be repeated in the ILS market.


18/44

the investors relates to the specific loss exposure of

the sponsors underlying portfolio. However, in any

other transaction where the trigger is based on an

index or is parametric, the insurer retains a basis risk

(which may be positive or negative) arising from the

imperfect match between the losses resulting from

the portfolio for which protection is sought and the

compensatory payment under the risk transfer

instrument, which are not fully correlated.

Basis risk will vary according to the granularity of the

trigger used i.e. whether an index provides ageographic breakdown that allows sponsors to

refine the trigger to geographic areas where their

exposures are significant as well as the deviation

of the specific portfolio from the industry-wide

exposure or losses.

The assessment of basis risk depends on the quality

of the risk model used to estimate the impact of

certain catastrophic events on the specific portfolio

for which protection is sought, the quality of the data

available with respect to such portfolio, and on the

specific peril. For example, there are only a fewrecalibrating events for high severity perils such as

earthquakes, which adds uncertainty to the models.

For the sponsor, basis risk presents an impediment

because the protection obtained from the risk

transfer instrument is imperfect. This must be

reflected in internal risk management.

In addition, under the applicable accounting rules, as

well as most regulatory regimes and rating-agency

rules, basis risk may have negative impacts. This

point is discussed in more detail in the next

subsection.

On the other hand, in indemnity-based transactions

investors expect to receive a premium for moral

hazard and adverse selection, the size of which is a

function of the type of business covered and the

associated modelling credibility, as well as the

market's confidence in the sponsor's underwriting,risk management, loss and claims adjustment

processes, among other factors.5 Furthermore,

investors will want to undertake more extensive due

diligence of the sponsor and the securitized

portfolio, increasing the cost and time spent to the

sponsor.

Catastrophe bond issuances in 2007 showed an

increasing volume of indemnity-based transactions.

This trend may reflect the surge in investors seeking

opportunities in the cat bond market, leading to

more favourable terms for sponsors. However, manyinvestors still express concerns over the modelling

integrity in indemnity-based deals, in particular with

respect to complex commercial exposures, reinsurer

portfolios (where portfolio information is less

granular) and portfolios outside the US6, where data

quality is generally lower.

18

Figure 7: Instruments with and without basis risks

Non Life

Life

Instruments with basis riskInstruments without or with

limited basis risk

Sidecars

Cat bonds with indemnity

based trigger

Embedded value securitization

XXX and AXXX bonds

Cat bonds with modeled loss,

industry loss or parametric triggers

Cat swaps

ILW

Extreme mortality bonds

Longevity ILS


19/44

Further standardization of risk transfer

instruments requires that sponsors

become comfortable with retaining

basis risk from a risk management,

accounting and regulatory perspective.

The standardization of risk transfer instruments can

be driven much further if these instruments are not

structured for an individual portfolio but insteadrelate to an objective index or parametric trigger.

Thus, further standardization by means of

standardized parametric or industry-loss triggers

requires that insurers become comfortable with

retaining basis risk, or have the means to cede basis

risk to a third party for a price that will still make the

overall transaction competitive with traditional

reinsurance. In either case, it will be necessary to

develop robust methodologies ones that are

understood and accepted by the rating agencies

and the regulators7 in order to evaluate basis risk

and determine the levels of regulatory and ratingcapital necessary to support it.

3.1.2 Accounting and regulatory treatment

Accounting

The accounting treatment of alternative risk transfer

instruments under International Financial Reporting

Standards (IFRS) and US Generally Accepted

Accounting Principles (US GAAP) depends on

whether such instruments are classified as

reinsurance contracts, and thus accounted for in thetechnical provisions and the insurance result, or

whether they are classified as financial derivatives,

and thus have no impact on the insurance result.

Under IFRS (IFRS 4), reinsurance accounting applies

only to risk mitigation instruments that have an

indemnity-based trigger. Under US GAAP, industry

loss warranties documented as reinsurance

contracts are treated as reinsurance since they have

a dual trigger one relating to industry losses, such

as those reported by the PCS; the other being an

indemnity trigger, which relates to actual lossesincurred by the protection buyer.

If the risk transfer instrument is classified as a

financial derivative, it will, under both IFRS and US

GAAP, be measured at fair value and marked to

market, with impact on profit and loss accounts.

This can create considerable volatility in the insurers

income statement compared to a traditional

reinsurance claim, which, subject to contract

exclusions, is measured consistent with the

treatment of underlying direct insurance liability.

However, this difference in accounting treatment

may be alleviated in the future with the move to fair

value measurement of insurance liabilities under bothIFRS and US GAAP. This would increase the volatility

of insurance liabilities and, correspondingly, of

reinsurance assets as well.

Solvency capital

In addition to creating volatility in the insurers

income statement, treatment as a financial derivative

has the consequence at least in many jurisdictions

that the risk transfer instrument will be disregarded

with respect to solvency capital as long as no gain is

realized.

Insurance undertakings and (in the European Union

since the Reinsurance Directive8) reinsurance

undertakings must maintain a minimum level of

solvency capital as a risk buffer. This supplementary

reserve over and above the technical reserves

serves as protection against adverse business

fluctuations and is an element of prudential

supervision.

In banking, the Basel I and Basel II accords have

allowed credit institutions to release regulatorycapital through the securitization of their credit

portfolios. This opportunity has had a considerable

impact on the development of credit securitization.

On the other hand, the insurance solvency regimes

in most jurisdictions do not yet award such

favourable treatment to the transfer of insurance

risks to the capital markets.

In the European Union, under the current Solvency I9

regime, capital adequacy and the determination of

the required solvency capital is based on the

liabilities side of the balance sheet and on insurancerisk only. For non-life insurance undertakings, the

19


20/44

required solvency margin is defined as the higher of

the premium index or the claims index. Under both

indexes, reinsurance reduces the required solvency

margin, but not by more than 50%, as shown in the

following (simplified) formulas:

For life insurance, the required solvency margin is

calculated as a function of the actuarial provisions or

the capital at risk, and is lowered within certain

limits to the extent that business is ceded by way

of reinsurance.

Solvency capital release varies by

jurisdiction and inter-alia depends on

reinsurance accounting.

Whether an alternative risk transfer instrument

reduces the required solvency margin depends upon

whether it is considered in the retention rate and,

therefore, under the Solvency I regime as currently

implemented in most EU member states, upon

whether the instrument qualifies as reinsurance.Treatment as reinsurance under the applicable

accounting rules is a necessary, though not sufficient,

prerequisite for regulatory treatment as reinsurance.

The reduction of the required solvency margin may

further depend on the jurisdiction of the special

purpose reinsurance vehicle used to transfer the risk

to the capital market, and whether the sponsor's

regulator accepts this jurisdiction as having sufficient

reinsurance supervision. While currently it is often

beneficial from a tax or capitalization perspective to

locate special purpose vehicles in Bermuda or theCayman Islands, jurisdictions outside the European

Union will not always be seen as providing adequate

reinsurance supervision. For the sponsor, this could

have a negative impact on the regulatory treatment of

the instrument. Using a transforming reinsurer may

solve this problem but may create additional costs.

This dependence of the regulatory treatment on the

accounting treatment is similarly found in the United

States: US insurers and reinsurers are required to

report their financial results consistent with Statutory

Accounting Principles (SAP), an insurance

accounting system that is more conservative thanUS GAAP. Under US GAAP (FAS 113, sections 9a

and b), the criteria for a risk transfer instrument to

qualify for reinsurance treatment include the

significance of the risk transferred and a certain

probability of significant loss. A significant transfer

of risk is only achieved if there is no positive basis

risk for the insurer.

Similar rules apply under SAP. Therefore, in many

transactions with parametric or industry-loss triggers,

sponsors will use a double-trigger reinsurance

contract similar to an ILW, thus capping the payoutto the sponsor at the sponsors actual losses. This

can also delay the payout until actual losses are

assessed. The interest paid for this extension period

can be an unintended benefit for investors.

In order to achieve solvency capital release from

alternative risk transfer mechanisms, sponsors must

ensure these instruments receive accounting

treatment as reinsurance. However, for the ceding

companies this may add complexity to transactions

in which solvency capital relief is an important

objective. The solution should be to look at theseinstruments from an economic viewpoint and place

the economic substance over the form of the

relevant risk transfer instrument.

In the European Union, progress in this direction has

been made under the Solvency II regime, as rules

detailing the Solvency II Directive Proposal11 are

being developed. Solvency II will be a principles-based

regime designed to take into account all types of risk

to which the insurer is exposed and to reflect

developments in the capital markets in a timelier and

more flexible way. New capital adequacy standardsare expected to come into force from 2012.

20

Premium Index = (18% x the first 50m gross

premiums + 16% x the remaining gross

premiums) x the retention rate

Claims Index = (26% x the first 35m gross

claims and 23% x the remaining gross claims)x the retention rate

Retention rate = net claims three-year

average of gross claims (but not less

than 50%)10


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Solvency II is expected to take a more

economic view on the recognition of

risk mitigation tools.

Solvency II envisages two levels of capital

requirement: the Minimum Capital Requirement

(MCR), which is the level of capital below which an

insurance operation presents an unacceptable risk

to policy-holders, and which will be measured with

simple, robust and objective methods, and theSolvency Capital Requirement (SCR), which is the

level of capital necessary to absorb significant

unforeseen losses and provide reasonable

assurance to policy-holders (to a confidence level of

99.5%) that all obligations will be met over a

specified time horizon.

Solvency II will provide for a total balance sheet

approach, taking into account both assets and

liabilities, to calculate the solvency capital required. It

will require insurers to hold capital against market

risk, credit risk and operational risk, all of which arecurrently not considered in the required solvency

margin. Similar to banks under Basel II, insurers will

have the option of calculating these amounts using

internal risk models rather than the standard model.

Quantitative impact studies released by the

Committee of European Insurance and Occupational

Pensions Supervisors (CEIOPS) set forth certain

principles in relation to the recognition of financial

risk mitigation tools. These principles rely on the

economic impact, enforceability and stability of the

instrument as well as the credit quality of the

counterparty.12

In the United States, no such development towards

a more economic view of financial risk mitigation

tools is currently observed, as such a development

would,inter alia, be largely dependent on a review of

the statutory reserving rules. However, the issuance

of certain types of life insurance instruments (such

as XXX and AXXX bonds) is motivated by existingUS reserving rules. These instruments can be

expected to lose their benefit if US insurance

regulations take a more economic view on reserving

and risk transfer.

In any case, the implementation of progressive

principles on the recognition of non-indemnity-based

risk transfer instruments will require a sound and

generally accepted method for the assessment of

basis risk, which should be based on a portfolio

rather than a transaction view.

No automatic recognition as eligible assets

Insurance undertakings must cover their technical

reserves with matching assets that are subject to

certain investment restrictions (eligible assets). These

restrictions are designed to maintain the safety, yield

and marketability of the investments as well as an

adequate level of mixture and diversification, while

21

Figure 8: Basis risk, accounting and regulation

Instrumentswith basis risk

Accountingtreatment

P&L volatility since qualifiedas financial derivative

No reduction of required solvency margin(in most jurisdictions)

Ratingtreatment

Regulatorytreatment

Uncertainty and inconsistency w/r to creditforsponsors financial strength rating

Economic view with respect to solvency (see Solvency II) and rating

Development of robust and recognized methods to evaluate basis risk


22/44

ensuring the insurance undertaking's liquidity at all

times. EU member states can allow these technical

provisions to be covered by claims against

reinsurers, subject to certain limits.13 Claims against

reinsurers would thus automatically qualify as eligible

assets. However, this is not the case for all

alternative risk transfer instruments. Qualification

does not occur per se, but rather may depend on

the general rules for mixture and diversification of

investments, the jurisdiction of the special purpose

reinsurance vehicle, or the funding of the structure.

Complexity of transaction structures

Uncertainties about the accounting and

tax treatment drives complexity and

thereby cost of transactions.

While it has been possible in past years to establish

fairly standardized transaction structures for

catastrophe bonds, no such structures yet exist forembedded-value securitizations in the life insurance

sector. The efficiency of transaction structures is

highly dependent on accounting and tax rules,

requiring in-depth analysis of the applicable rules

(e.g. consolidation rules) involving external parties

such as accounting firms, regulators and rating

agencies. Different treatment under local accounting

rules and IFRS often adds complexity.

In this respect, certainty about the accounting

treatment and the development of tested structures

would facilitate the securitization of insurance risk.Although the clarification in 2002 of US FIN 46,

which interprets FAS 94 and RAB 51, led to an

increase in issuance volumes, the rules still require a

time-intensive assessment of the accounting

treatment for each unique transaction and lead to

complex transaction structures. Unfortunately, these

accounting rules remain in flux, further frustrating

standardization efforts.

3.1.3 Inconsistent ratings treatment

With respect to the financial strength rating of the

sponsor particularly its capital adequacy ratio the

rating agencies do not always give full credit for risk

securitizations, but rather apply "haircuts" for basis

risk. As with the regulatory treatment, the

development of sound methods to evaluate basis

risk and allocate capital to it would be necessary for

consistent recognition of alternative risk transfer

instruments with basis risk.

Some rating agencies have applied a cap on the

rating of the ILS themselves because of the

uncertainty of the catastrophe modelling. The rating

of the instrument may be capped at a certain level

(e.g. AA) even though expected loss or probability of

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

of them, should allow the rating agencies to

abandon such practices.

The development of fully standardized

methodologies for quantifying and rating insurance

risk transactions would help avoid inconsistencies in

the assessment of the risk transfer that, as of today,

are observed in the sponsor's financial strength

rating on one side and rating of the instrument on

the other. As always, the transparency of the applied

methodology is key, though investors should also

expect rating agencies to exercise judgement in

applying their criteria.

3.1.4 Pricing of traditional reinsurance

In an ideal world, insurers would cede risk to a

seamless risk market, comprising both traditional

reinsurance and alternative instruments. Risk would

be placed based on price and best use, regardless

of form. However, in practice the market has not yet

reached such a degree of efficiency.

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 abundantcapacity and further softening in the reinsurance

22


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23

pricing cycle following two years of mild natural

catastrophe losses. However, it is difficult to

compare pricing for traditional reinsurance to pricing

for cat bonds or other alternative risk transfer

instruments because of the following differences:

Reinsurance cover is usually bought for one-year

periods while cat bonds typically provide multi-

year cover

Cat bonds and some cat swaps are collateralized

and have less counterparty credit risk than

reinsurance, which is generally uncollateralized

Non-indemnity catastrophe bonds may allow forquicker recovery, producing a significant time

value of money advantage over most reinsurance

contracts

Cat bonds usually do not include a reinstatement14,

unlike most reinsurance contracts

Sponsors will want to apply a discount for

transfer instruments with basis risk since they

provide incomplete protection compared to

traditional reinsurance

As there are different pricing methods and also

different dynamics in reinsurance and the capitalmarkets, the relevance of these pricing impediments

can vary over time. In traditional reinsurance, a

technical price can be determined based on the

expected loss and the expected volatility of the

contracts result. However, the commercial price is

driven by industry capacity, by the occurrence of

large loss events, and by investment returns15. This

has resulted in reinsurance pricing cycles.

Hard markets occur after major loss events such as

natural catastrophes or terrorist attacks; soft

markets occur if reinsurance capacity increases dueto competition. During hard markets, alternative risk

transfer instruments emerge as compelling options

and are clearly a complement to traditional

reinsurance.

Pricing for capital market transfer instruments is

primarily derived from the market and dictated by

the laws of supply and demand. With respect to

catastrophe instruments, the main driver is the

expected loss as modelled by one of the

independent modelling firms. Modelling results are

key for ratings. Ratings, in turn, allow marketparticipants to compare prices for instruments with

similar characteristics, but this is of only secondary

importance for catastrophe instruments. Pricing of

the instruments further takes into account the

current pricing of catastrophe securities traded in

the secondary market, with the yield on outstanding

instruments capturing the secondary market's

current return requirements.

Pricing on the secondary market reflects probability

of loss at any point in time prices to sponsors for

US hurricane instruments, for example, will increase

at the beginning of the hurricane season. With

respect to rating, it has been the case historicallythat most cat bonds have traded at a relative spread

to similarly rated corporate securities of between

100 and 200 basis points16, due in part to their

binary nature, novelty premium, low liquidity and

perceived mechanical complexity. However, more

recently spreads have tightened, both as a result of

the higher spreads of corporate bonds during the

recent financial turmoil, but also because of a

reduction in the risk spreads for cat bonds. The low

correlation of insurance-linked instruments with

credit-related investments is shown by the stability of

prices amid the recent market turbulence. Anincreased and more liquid market, driven by further

standardization and an increasing investor base, can

be expected to bring spreads down further.

3.1.5 Time and cost

Sponsors are concerned about the time spent and

the costs paid for executing securitization transactions.

This is particularly true for first-time issuances, where

senior management involvement is usually higher than

in repeated issuances. These transactional costs

may constitute an impediment to market growth.

Compared to traditional reinsurance, securitization

poses a number of additional costs for sponsors,

including rating agency services, legal advice, risk

modelling and risk analysis, as well as an arranger

fee (although traditional reinsurance often involves a

brokerage fee). Time must be spent modelling the

risk to be transferred, preparing offering

documentation and assessing the transaction with

auditors, tax authorities, regulators and rating

agencies. In general, indemnity-based transactions

require more detailed disclosure by the sponsor and,accordingly, are likely to require more time and

expense.


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On the other hand, it has been shown that more

repeated issuance and the use of shelf programmes

can bring down transaction costs. Furthermore, as

deal sizes get larger, fixed costs decrease as a

percentage of total costs. Finally, transformer

issuance with wholesalers, such as reinsurers, can

largely eliminate complexities for insurers in much

the same way that wholesale universal banks front

for local and regional banks, giving them ready

access to the credit securitization markets.

Increased standardization, particularly

in the use of derivative instruments,

would also lead to less time consuming

and less costly transactions.

Increased standardization, particularly in the use of

derivative instruments, would also lead to less time

consuming and less costly transactions.

3.1.6 Data quality and transparency

Data relevancy

Transferred insurance risk is assessed on the basis

of complex risk models developed by third-party

providers. Catastrophe risk models take into

account the probability of relevant catastrophic

events, certain hazards resulting from such events,

and the insured exposures in the relevant

geographic areas. Expected losses are modelled on

the basis of analytical, engineering and empirical

techniques. The risk models used in capital markettransactions are generally the same as those used

for internal risk management by the sponsors as well

as by reinsurance underwriters.

Results of risk modelling depend on the

quality of the model as well as of the

used exposure data.

The reliability, credibility and transparency of the

modelling process are crucial to both investors andsponsors. However, the results of the risk analysis

depend highly on the data input i.e. historic loss

data, historic parametric data and exposure data.

The quality of the exposure data relating to the

portfolio for which protection is bought is relevant to

assessing the expected loss from the instrument

and, if any, the basis risk remaining with the sponsor.

With respect to life insurance instruments, the

output of the actuarial models similarly depends on

the quality of the asset and liability portfolio

information fed into the model.

Key portfolio information taken into account in non-life risk models includes:

The location, construction classes, number of

stories, age and occupancy of insured buildings

Values at risk (buildings, contents, business

interruption)

Insurance structure (limits, deductibles)

Furthermore, in indemnity-based transactions, the

sponsors underwriting guidelines and claims-

management capacities are of great importance to the

investors. Accordingly, due diligence extends to the

sponsors management, track record and incentives.

Insufficient data quality and disclosure

There are regional variations in the

metrics used by the insurance industry.

Insufficient data quality and disclosure impede the

development of the insurance risk market in a

number of ways:

The quality of exposure-related data tends to belower for non-US portfolios17. In the European

Union, there are no standard formats for

collecting policy data nor for reporting them, and

available portfolio data are in general less

detailed. In some cases, different metrics are

used in different EU countries. Variation exists, for

example, in building valuations. Also, policies in

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

exercise is therefore a complex task. In contrast,more comprehensive portfolio data are

aggregated in the United States to satisfy

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regulatory reporting requirements, and these data

must be made public by the insurers

(nevertheless, the development of unified mortality

tables would be a useful US standardization, as it

would facilitate the comparison of different life

insurance portfolios).

Insurers have been reluctant to disclose portfolio

data as they may be of proprietary nature and

their disclosure valuable to competitors. However,

less reluctance is shown by US insurers, as they

are subject to more extensive disclosure

requirements under both statutory reporting andthe Sarbanes-Oxley Act compliance rules.

The presentation of data i.e. not the amount of

data, but the quality of its disclosure has been

criticized as not allowing the investors to perform

the necessary analysis according to their

methods.

Information is less granular with respect to

reinsurance portfolios.

Granularity of US parametric wind

speed data

Whereas exposure data is generally of higher quality

in the United States than in Europe, obtaining

parametric US wind speed data remains an

impediment, as no hardened, high-density network

of measuring stations currently exists. By contrast,

parametric earthquake data availability in both the

United States and Japan is excellent.

A recent initiative by WeatherFlow and Risk

Management Solutions (RMS) is in the process of

building such a network, consisting of hardened

weather stations specifically designed to measurehurricane-force winds up to and exceeding 140

miles per hour. A first phase of this initiative involves

installing over 100 hardened weather stations in

vulnerable areas in the coastal United States, based

on likely storm paths and the potential for loss of

property and lives. Improved parametric hurricane

data will also be beneficial for risk prevention and

risk underwriting.

Disclosure standards

Although traditional reinsurance assumes some of

the same risks now being placed in the capital

markets, data quality and disclosure seem to be

more of an impediment to the capital markets than

to reinsurance:

Capital markets have higher disclosure requirements.

This is particularly true for transactions in a Rule

144A private placement offering, and other

transactions for which an offering document must

be prepared. Higher disclosure requirements tendto be less relevant for the placement of

reinsurance sidecar equity, where investor due

diligence is more likely to focus on the sponsor's

management than on its portfolio.

The capital markets are not subject to pricing

cycles to the same degree as the reinsurance

market, and thus do not allow investors to

recover from bad transactions by increasing risk

spreads for future transactions except for

sidecar equity, where a subsequent season

reinstatement is standard.

Disclosure to reinsurers is not public and isprovided within a long-established relationship.

Thus, there may be less reluctance by primary

insurers to release data. Particularly in indemnity-

based transactions, substantial disclosure of

internal information often sensitive or proprietary

is required.

Increasing transparency

The need for transparency is one of the important

lessons learned from the current sub-prime crisis,

and improvement of transparency with respect toinsurance-linked securities should focus on the

following two objectives:

Availability of the aggregated portfolio data

needed to make an informed risk assessment.

The information flow between sponsors and

investors should also be improved, as this

facilitates the evaluation of the issued instrument

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.

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The quality of disclosure has recently become more

important in life insurance transactions as investors

will have to rely less on financial guarantees provided

by the monoline insurers, and more on their own

evaluations of the assumed risks. Investors thus

have a need for underwriting expertise in order to

understand the insurance risks they are assuming.

As of today, a degree of standardization of data-

reporting formats has been created by the exposure

data requirements resulting from the reporting

formats of the modelling firms (such as UNICEDE,the standard data format developed by AIR

Worldwide Corporation). However, this

standardization is limited by the differences of the

formats used by different modelling firms.

Furthermore, CRESTA, created by the insurance

industry in 1977 as an independent organization for

the technical management of natural hazard

coverage, has determined country-specific zones for

the uniform and detailed reporting of accumulation

risk data relating to natural hazards, and has also

created corresponding zonal maps for each country.

The Association for Cooperative Operations

Research and Development (ACORD) has also set

up a working group on catastrophe exposure data

standards. ACORD standards allow different

companies to transact business electronically with

agents, brokers and other data partners in the

insurance, reinsurance and related financial services

industries. They serve as a common communication

method for use by multiple parties.

3.1.7 Limited types of risk

The range of securtized insurance perils

is still somewhat limited.

Beyond natural catastrophe risk, a variety of life and

non-life insurance risks has been transferred to the

capital markets in recent years, including automobile

insurance risk, long-term disability reserve risk,

catastrophic mortality risk, the

Convergence Insurance and Capital Markets

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