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Retrocession vs. Alternative Markets in Managing a Reinsurers Accumulations
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Initial Summary
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
There is an ample supply of capital to service the catastrophe capacity requirements of any emerging market
Emerging markets present an attractive opportunity for further reinsurance or ART market diversification
It makes long term economic sense for any developing economy to take advantage of this capital
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Agenda
Introduction
– Some key points
Interpretation of who a “National Reinsurer” might be
Transfer mechanisms for attaining Nat Cat capacity and diversification
– Traditional reinsurance/retrocession
– Alternative market solutions
SummaryNatural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Introduction
Swiss Re is a large Global Property, Casualty, and Life Reinsurer with over 29 Bn (CHF) earned premium volume.
In addition to traditional reinsurance Swiss Re has been a leader in facilitating Alternate Risk Transfer (ART) solutions including being active in the development of the insurance linked-securities (ILS).
Swiss Re has sponsored independent studies throughout the world and has dedicated internal resources into researching natural catastrophes
Swiss Re has partnered with many non-profit organizations in making our expertise and experience available to support governments and society in developing strategies to mitigate the effects of natural disasters
Progressive failure onthe North Anatolian fault- Ross Stein USGS
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Key Points
There is an ample supply of capital to service the catastrophe capacity requirements of any emerging market
This capital can be accessed through traditional Reinsurance, Retrocession or through various Alternative Risk Transfer markets including the Capital Markets
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
Emerging markets present an attractive opportunity for further Traditional or ART market diversification
There are only a few regions
where the the peak amount of traditional reinsurance may be too concentrated
Throughout most of the
world the opportunity to diversify
is attractive and cost
effective to resinsurers
and cedants alike
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Key Point - Capacity at need?
TC Atlantic (*)
EQ California (*)
WS UK
TC Japan
EQ Japan
EQ New Madrid (*)
EQ Canada
WS France
EQ Australia
EQ Italy
EQ Mexico
WS Germany
EQ Portugal
EQ Columbia
EQ Israel
WS Netherlands
EQ South Africa
WS Belgium
World wide coverage(*) Estimated split based on SR book
Ideal level reinsurance would take for optimal diversification
World wide peak risks are an issue for the reinsurer prompting their need for more diversification and required capacity.
Peak risks would ideally be ceded to capital markets, which are better able to diversify these risks
Source: Swiss Re
There is approximately $24 Billion US in available catastrophe capacity
Approximately $3 Billion in Insurance Linked securities
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
Page 7
Key pointIs there sufficient cat capacity available?
The availability of traditional Natural Hazard catastrophe capacity is basically a function of:
– Accessible capital compared to exposed equity loss potential
– Realized rate vs. expected loss, expenses and cost of capital
– Diversification and appetite for “peak” risk in relation to the above
expected loss based on loss experience, underwriting expertise and application of sophisticated cat models
External costs (commission, brokerage)
Expected profit before tax
Earned premiums
Internal expensesTaxes
Economic profit
Expected profit after tax
Minimum price covering all fixedor expected costs = “technical price”
Cost of Capital
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
Page 8
Traditional reinsurance protocols
suggest that reinsurers use retrocession covers to expand capacity, diversify, and reduce
exposures
Interpretation of who can act as a “National Reinsurer”
Property Owner
Insurance Company or Insurance Pool
Local Reinsurer
Reinsurer
Reinsurer
National Government
World Bank
Insured
Insurance Policy
Reinsurance treaty
Retrocession
Retrocession
In the current environmentany one of these entities could act as a National
Reinsurer and seek reinsurance,retrocession, or alternative risk
transfer support
A National Government often acts as a reinsurer of last resort
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
Page 9
Insurance Company
Reinsurer
Reinsurer
Reinsurer
National Government
World Bank
Insured
Capacity and Diversification
There are two main reasons for seeking Retrocession or Alternative Market
Support Reduce loss potential
Increased need for capacity - expand the capital base in situations where the potential loss exceeds the financial capability of the risk bearer to absorb losses
– Sharing/expanding of capital increases the insurer/resinsurer’s ability to absorb additional risk
Diversification of exposure - the ultimate goal of insurance and reinsurance is to spread the risk.
– Diversification leads to more efficient pricing, increased capacity, stability, and sustainability
There are two main reasons for seeking Retrocession or Alternative Market
Support
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
Page 10
Turkish Catastrophe Insurance Pool - TCIP
Insurance Pool - TREIP
Indonesian EarthquakeReinsurance Pool - IERP
EQ Council - EQCNew Zealand
California Earthquake Authority - CEA
Alternative Risk Transfer Markets
What are they?
Risk Carriers• Self insurance / captives• Risk retention groups• Pools• Captive markets
Solutions• Finite Risk re-insurance• Contingent Capital• Multi-year / Multi-line products (MMP)• Multi-trigger products (MTP)• New Asset Solutions• Weather Derivatives• Securitization / Insurance-Linked Securities (ILS)
Alternative
Risk Transfer
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
Page 11
Alternative Market Solutions
Finite Risk re-insurance
– Smoothing mechanism where risk transfer, financing and the time value of money is emphasized
Contingent Capital
– Contractual commitment to provide capital in the form of senior debt, etc. after an adverse eent
Multi-year / Multi-line products (MMP) Multi-trigger products (MTP)
– Consolidate and combine uncorrelated risks with a trigger that is highly correlated to financial circumstances
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
Page 12
New Asset Solutions (Structured Finance / Asset backed Securities)
– Raising capital through the securitization of future cash flows
Weather Derivatives
Securitization / Insurance-Linked Securities (ILS)
– Innovative way of increasing insurance capacity by accessing the capital markets via bond issue. Capital received is transferred to a special purpose vehicles SPV who then acts much like a traditional reinsurance company.
– Most ILS are natural catastrophe driven due to the ease and transparency of identifying, isolating, understanding, evaluating the risk
Securitization / Insurance-Linked Securities (ILS)
Alternative Market Solutions
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Insurance Linked Securities
Cedant Reinsurer
Premium
Cat Cover
Bond Investors
Special Purpose Vehicle(SPV)
Bond Coupon
Bond Proceeds
Traditional reinsurance or retrocession is an exchange of premium for a transfer of risk cover. In all but a few of the “peak” exposed areas of concentration, reinsurance is still considered as the most economical and efficient risk transference of choice.
The majority of ILS transactions to date have involved catastrophe bonds. Typically three parties are involved. Investors purchase bonds from the SPV which simultaneously enters into a reinsurance contract with the cedant. The sole purpose of the SPV is to engage in the business relating to the securitization.
One of the main differences is that a traditional reinsurance program’s pay out is activated by the cedant’s actual sustained losses. An ILS limit is paid immediately upon the occurrence of a predetermined trigger and is priced according to the limit and event exceeding probability.
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Retrocession or ART
Increase surplus/capacity to assume risk
– Corresponds to the ability to increase volume
Reduce risk
– Transfer loss potential to another
Stability
– Mitigate fluctuations in revenue or growth
Diversify portfolio
– Optimize return/loss levels
In many ways the same motivation exists for purchasing a retrocessional cover or ART product
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Acceptance of ILS
On top of a $2 Bn existing portfolio in 2002
To date most ILS transactions are in regions with high severity, low frequency, peak exposures, and further need for diversification
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Combined Art and Traditional in Peak Exposed Areas
CEA $6,611 billion
Post EQ
Industry Assessments
Second Cat Bond/Contingent
Transformer Layer Multi Layer Cat
Reins. Contract
Line of Credit
Revenue Bond Layer
First Cat Bond/Contingent
Reins. 1st Layer
Post earthquake
Industry Assessments
CEA Capital
$2,183
$717m
$600m
$617m
$200m
$1,456
$400m
$100m
$338m
Coverage A$600m xs $2,9bFirst R/I Layerie- traditionalSold ROL 8.80%
Coverage BContingent Second$400m xs $3.5bSold ROL 7.25%
Coverage CContingent Fourth$338m xs $4,817bSold ROL 5.15%
Reinsurers must write the same sharein Covgs A, B and C
Often an ILS is combined with traditional reinsurance and retrocession in order to expand capacity and diversification
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Expected Loss and Realized Return or Selected Insurance-Linked Securities and Swaps
Indicative technical reinsurance pricing for peak cat areas
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
In most cases the
ILS is more costly then
a traditional
cover
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Some comparison features of ART vs Traditional to an Emerging market
Features ILS Traditional
Limits of insurability
Increases capacity especially in peak areas & independent of insurance
cycle
Perceived avoidance of low frequency and high severity
events
DiversificationCapital markets are uncorrelated to
insurance - improving portfolio diversification
Areas of peak exposure have high areas of insurance concentration
Counterparty credit risk
Investment grade securities held as collateral servicing only specified
contract
Ratings uncertain especially during times of industry duress or
extreme events
Multi-year contracts
Multi-year programs of up to 10 years have been issued
Natural catastrophe programs typically run for one year
Flexible Loss trigger
Three types, indemnity (cede sustained loss), index (industry loss)
or parametrc (physical event characteristic)
Tyically indemnity based but can be somewhat flexible
Activation of cover
Based on trigger regardless of actual claims
Paid on development of cede losses
DataFlexible - pricing based on coverage
limit and event probabilities
Requires - pricing based on expsoure data as well as limit
and event proabilites
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Concluding observations - Emerging Markets
Source: Swiss Re
Local Reinsurance and insurance markets are underdeveloped making the government a reinsurer of last resort - exposures hard to identify
– Developing Risk awareness, transfer and mitigation strategies
Low frequency/high severity events could endanger the financial being of the local reinsurer or state
Low country GDP - actual loss devastating in terms of % GDP and future sustainability
Need for immediate post event liquidity
High capital demands for necessities
Makes economic sense
Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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Example*
GDP $13.7 Bn .(2001)
5 earthquakes in the last 20 years1986 $2.3 Bn (US)
2001 $1.7 Bn (US)
Other losses $ . 4 Bn (US Total $4.4 Bn
Average Loss $ 220+ Million per year
Maximum Loss $2.3 Bn
What if?Country hedges itself through traditional or ART markets by purchasing a $2.5 Bn cover with a $100 MM retention
Pure risk premium $28 MM per annumAnnualized deductible $20 MMCapital and other costs ??
Pure risk premium $28 MM per annumAnnualized deductible $20 MMCapital and other costs ?? $14 MM
Average Loss $ 60 Million per year
Maximum Loss $100 MM
* Not an offering or exact analysis
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Final Summary
There is an adequate supply of capital to support the catastrophe capacity needs of the merging markets
Reinsurance/Alternate Risk Transfer mechanisms promote financial sustainability by reducing economic volatility due to Nat Cat shock losses
Both the Traditional and Capital segments offer a variety of solutions and are eager to diversify into new cat markets.
Reinsurance makes economic senseNatural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re
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