"We wanted access to the capital markets on a long term basis," says Jürgen Gräber, deputy member of the board at Hannover Re, responsible for securitisation.
"We want to be known as one of the most innovative reinsurers in the world and by issuing these sort of bonds early we could reinforce that reputation.
We also had a real capacity need. The figure of $100m for the deals is an actuarial figure. We looked at the variety of our risks and did some risk-based capital calculations and found that that was the level of coverage that we were comfortable with for our exposures.
We were caught in a dilemma between our own risk-based capital requirements and the capital requirements of the ratings agencies. In order to maintain our high rating we had to over-capitalise, but we did not want to use hard capital -- which I define as capital held within the company which is at the disposal of management to be applied where they choose -- because that would have eroded our returns. So we decided to use soft capital instead -- capital which is standing by for when we have a particular need.
The gross-for-net underwriting approach of Hannover Re is important as to why we decided to securitise some risks. We have always said we do not want to be unduly reliant on retrocessionaires. The capital we tapped into with these deals is independent capacity which is unaffected by market cycles in the insurance industry. We want long-term access to capital markets because of the cycles in the insurance and reinsurance markets. The capital markets will not be affected by anything that happens in the reinsurance market in the same way as retrocessionaires.
The beauty of using the capital markets was that we did not need to disclose our underwriting guidelines to our competitors, as we would have had to do if we sought retrocessional capacity from the traditional market. We only made the prospectus available to a small number of capital-market investors.
The last point is what we call economic substance. In a hard market these deals are more attractive. This is more for the profit release they have rather than the overall premium paid, because global gross price can be misleading. If you say that $10m is the most you are willing to pay, and $8m may be the expected loss amount, it is the $2m which you are offering to investors as profit. In a hard market the profit release compares favourably with traditional methods of coverage.
It would be untrue to say the process was easy. The 1994 one was really difficult -- that took almost two years to complete. But now we have done a couple, that process could be brought down to six months. We have samples of clauses, we can employ the same lawyers and we now have a sense of what the most important parts are, whereas in 1994 it was really pioneering work.
The critical issue, which was the most difficult, was to supply information in a much more detailed way than we would ever have been asked for by retrocessionaires. Whatever data you supply you must also be able to keep in your computer systems and update regularly, so you need to add on to your existing systems.
When you give information to retrocessionaires, they ask you questions, perhaps want to look at some premiums, claims and some profiles. Investors, however, immediately wanted a far more detailed actuarial report and they want to see it stress tested -- you have to change one of the variables and see if the result changes and if the different outcome is disproportionate. This requires the greatest flexibility of your data, otherwise the deal cannot be placed. That took a great deal of time to prepare.
There is also the wording. In a reinsurance contract there is usually a contract with 20 pages of standard wording. With the securitisations, we had to draft a prospectus which had to be cross-checked and scrutinised by lawyers. In the first deal that alone took six months.
You can only successfully place securitised bonds if they are multi-year deals, because you can amortise the costs of setting up the deal. Short-term deals would be an administrative loser, because the upfront costs are so high. The costs involved were into seven figures. If you compare those costs to the risk capital raised, which was $100m, then these costs are crucial. As a company you must have a critical mass, otherwise the costs involved in a deal will create a born loser.
Also, the risks which you want to securitise must be severe enough to merit a rate of return to investors which make the deals attractive to them.
The bonds have performed both to our expectations and to those of our investors. We have got the capacity to write more business and investors have got their returns.
Our investors are, however, in it for the long term because the amount they have invested in cat bonds so far is insignificant compared to the value of their overall investments.
When more deals filter through to the markets, investors will begin to face problems of accumulation of exposures. At the moment, with the size of the financial markets, these deals can hardly be felt compared to the solvency of the reinsurance market worldwide.
Pension funds are looking for deals that will outperform other investments; they have invested in our bonds and in others like them. So far cat bonds have provided them with high yields. But if the first loss experience of investors on cat bonds is not a good one, then that could slow or stop the growth of securitisation. If investors have to pay the full amount at risk, how will they react? Will investors begin to spread the word about these risks?
So far they have only calculated the returns."
Wolf Becke, member of the board, Hannover Re was responsible for its life securitisation deal. "We are very different from our competitors in the life and health business in that we are not so interested in arranging risk transfer but we look at ourselves as a stochastic banker. That is, we provide our clients with secondary capital: providing them with liquidity, profit/loss account support and cash with which they can fund their own growth.
Our success in doing this for the past three years means we have had to find alternative ways of financing these risks. Up to 1997 we could fund these out of our existing resources: we used the profits from the good non-life reinsurance market and the favourable investment markets to absorb the original statutory accounting losses and yet still come up with a very decent profit-and-loss account. But my colleagues on the non-life side told me last year that the slump in premiums was so dramatic that they would lead to a drastic reduction in profits. The alternatives open to us on the life side were either to cut back on our new business, which we did not want to do, or to look for ways of finding outside financing.
We preferred to approach the capital markets rather than the traditional retrocessional markets. Our need for capital reduced our options among traditional retrocessionaires to only around half a dozen. This included the big four -- Munich Re, Swiss Re, ERC and General Re/Cologne Re -- because they have the financial muscle, but we did not want to give them a deep insight into our own marketing and pricing models. So instead, we decided to access the capital markets.
We approached a number of investment banks to participate in a beauty contest last September. The winning team was from Rabobank, which was unexpected because they are rather new in this kind of business. But their offer was tailor-made to our needs.
We needed a facility to refinance acquisition expenses for up to three years and Dm100m ($56m). They hit that on the spot. We also specified that we wanted particular currencies to be covered. They did that and even suggested that the scope of the financing could be extended to cover the entire western European region. This attracted us because with our acquisition of Skandia International we have far more business opportunities available than before in France and Scandinavia.
They suggested that we use an existing reinsurance facility they had, Interpolis Re in Dublin, that would save us all the start-up costs involved with a special purpose vehicle.
Its costs were only a six-figure Deutschmark amount, whereas all the other banks quoted a seven-digit US dollar figure. It is flexible in how we can extend the arrangement; we think we will probably exhaust this Dm100m by next autumn, and may need to double this amount to carry on writing new business in the fourth quarter of 1999 and into 2000. It means we do not have to slow down our marketing through a shortage of internal funds. It gives us an ideal way of refinancing our business; it gives us the financial muscle to be a big player in the life reinsurance market."