The compelling maths of insurance bonds

  • 01 Sep 1998
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Securitisation has taken the insurance industry by storm. Very quickly the capital markets have become a primary source of cover for insurers' catastrophic risks. But you still need to have a lot of money and patience to take a deal to market. Will issuers persist with insurance bonds?By Simon Challis, editor ofReactions.

The securitisation of insurance risk is the biggest talking point the industry has had in the past decade. The prospect of risks which are normally insured or reinsured in the traditional markets being hived off to the capital markets could present the biggest shift yet in the way the business is conducted in its history.

The idea that companies may look elsewhere for a cheaper and more stable alternative to insurance and reinsurance capital has sent a shiver down the industry's spine.

Over the past two and a half years, 14 insurers have securitised over $2bn in catastrophic insurance risk. These deals and their predecessors have been both a cause and effect of seismic change in the insurance business. The transactions were the result of companies being confronted by their inability to pay for a large catastrophe.

But the reinsurance industry has also been made to take a long, hard look at how cheaply and efficiently it can assume risk, and how it can start to give higher rewards to shareholders.

This has encouraged the industry to embrace more active ways of managing its capital; the more innovative companies have seen the advantages of buying in cheap capacity from the capital markets rather than going to the debt or equity markets to raise money to exploit new business opportunities.

It is possible to identify some specific turning points in the insurance market which have led to the rise of securitisation.

The first was Hurricane Andrew which hit Florida in 1992, causing over $18bn in insured losses. Craig Pettengell, manager, customised reinsurance, St Paul Re in London says: "Hurricane Andrew scared insurers silly. It made companies take their variable exposures far more seriously, both the risks they carried themselves and those they passed on to reinsurers.

As a result, companies began to take a far more professional attitude to the aggregation of risk in their portfolios. Before companies would guess how much of the total limit they might lose because they did not have the quality of data to accurately assess the underlying risk. But after Andrew, companies started to realise that if they did not accurately know the risks they were running then they had to assume they would lose the lot. The insurance industry woke up."

A key contributing factor to this reassessment of companies' financial position was the fact that in the early 1990s the catastrophe models came of age. Regarded with some scepticism when they were first developed, the increasing accuracy of cat models allowed insurers to know for the first time exactly how much money they could lose in the event of a big natural disaster.

The big increase in reinsurance prices which followed Hurricane Andrew, when many buyers saw the cost of their reinsurance cover increase tenfold, simply meant many companies could not afford to buy the amount of coverage they needed.

The capacity crunch Hurricane Andrew created convinced several buyers that the reinsurance market was too illiquid - often swinging from very low prices to very high if a large loss occurred - to be able to plan a long-term protection strategy.

Jürgen Gräber, deputy member of the board of Hannover Re says: "The disproportionate hardening of the market between 1989 and 1992 meant that companies had to find new providers of capital; securitisation was one way of doing that. We did our first securitised deal in 1994 [which took two years to put together] as a direct reaction to the most difficult period in the market in history."

The shocks being experienced by the insurance and reinsurance markets coincided with the investment banks' realisation they could make money from insurance. The profits they made from funding the creation of the Bermuda insurance market and corporate capital vehicles at Lloyd's - both as a direct result of Andrew - meant they were hungry for more opportunities to invest insurance.

Investment bankers were quick to see the potential insurance applications for products they had recently designed in other markets. Prakash Shimpi, principal at Swiss Re New Markets, who has structured a string of securitised deals, says: "Two techniques developed in the capital markets showed what could be done to cover catastrophic exposures. One of those was developed in the asset-backed market, where you can put very specific pools of risks into securities and have a payment structure depending on the performance of those pools, as in mortgage-backed assets and credit card receivables.

"The other development was in high-yield bonds; they are not straight equity in companies and they are not the type of debt which people assume in the very highly rated debt market." Once the techniques had been developed, "it was only a matter of time before they were applied to the insurance market," he says.

Certainly, insurers' reassessment of their catastrophic exposures has led more forward-thinking companies to take a closer look at how they manage their capital and liabilities as a whole. The rise of interest in creating shareholder value has given companies added impetus to search for new, cheaper forms of capital to run their business.

Gräber says: "The recent securitised deals are in fact a reaction to the over-capitalisation of the reinsurance market. The export of US risk-based capital theories means that everyone knows how much capital is at risk in their business. Companies have created too much hard capital [capital owned and managed by the company] so they are looking for ways to substitute that with soft capital [capital they can buy in for emergencies]. This awareness of risk-based capital and the willingness of managements to support shareholder value principles has supported the growth of securitisation."

Yet in spite of the trends encouraging the convergence between insurance and the financial markets, and investors' enthusiasm for insurance risk, the market has not taken off. Despite investment bankers' efforts to persuade them that securitisations are suited to their needs, insurers have been reluctant to enter into what they consider to be a new, untested market.

Those insurers which have issued bonds have done so for a host of reasons apart from tapping the capital markets' vast pools of capacity. Many are self-conscious pioneers, doing securitisations to create or affirm their reputations for innovation. Richard Sandor, chairman of Hedge Financial Products, says: "Many companies are concerned, in spite of the ready availability of cheap reinsurance, to find another way to hedge their risks if big losses occur. They have begun to issue bonds so that their names are known in the capital markets in anticipation of the day when the capital markets become more of a player in providing capacity for insurers."

For the majority of insurers, however, Ruby Schmidt, executive vice-president of American Re Financial Products, says that the price and complexity of the deals has so far put them off considering a securitised deal.

She says: "Insurance companies, by nature, tend to be conservative. The process of putting together an insurance risk bond issue is new, time consuming and difficult. The types of data and analyses required for pricing are not always easy for an insurer to access."

Few have been prepared to devote the time and resources required to putting a securitised deal together, and have balked at the idea of having to reveal their business's most intimate details in a public offering document for a securitised deal.

The growth of the market has been hampered by an inability to come up with a standard product structure which issuers feel fully reflects their needs. Some of the insurers which have done securitisations have complained of the tortuous process involved in taking their deals to market. The race to customise insurance risk bonds, blending bankers' wishes for an easily-tradable generic product with insurers' desires for unique coverage, is being contested by the financial markets divisions of global reinsurers - Swiss Re New Markets, American Re Financial Products and ERC Financial Markets Products - and the insurance arms of investment banks. During the last year both Goldman Sachs and Lehman Brothers have launched Bermuda-based reinsurers of their own, Arrow Re and Lehman Re. They hope to kickstart the insurance risk securitisation market by appealing to insurers' conventional tastes, writing traditionally-styled reinsurance coverage for them, then acting as a warehouse for risks to be repackaged and sold on to the capital markets.

Shimpi at Swiss Re New Markets says: "I'd be comfortable to say that there are a lot of elements in the deals we do today which could be seen as off-the-shelf. If it's an area we've been involved in before, and if it's a type of risk we are familiar with from another deal, then the next deal is in effect off-the-shelf.

"In the deal we worked on for Tokio Marine we spent quite a lot of time characterising the risk, effectively creating the index we used in that deal. The Mitsui deal was done as a swap rather than as a security, but we were able to piggy-back off a lot of the work done for the Tokio deal. So if another Japanese deal came along which involved similar issues, we have something we can put together very quickly. Likewise if we wanted to do another deal in California the template is pretty much there."

The development of an off-the-shelf product which would cut down the time and expense involved in issuing insurance risk bonds would encourage more insurers to securitise their risks. But this seems far off. Derrell Hendrix, who structured all three of Hannover Re's securitised deals and now runs RISConsulting, a company which advises insurers on risk financing, says: "I don't think you can build an off-the-shelf product without rating. You must have some way of distinguishing between risks, like between General Motors and Mazda in the motor industry. I think that is what Goldman Sachs is trying to do at the moment. But the problem is that you need companies which are willing to submit themselves to that process. A lot of companies don't want information such as how they underwrite business or what the status of their portfolios is to be publicly available. But they don't mind reinsurers doing that on their behalf with the same data, providing you can find reinsurers willing to do it. So far you haven't seen too many reinsurers willing to put themselves between the insurer and capital markets for specific programmes. You'll only do these sorts of deals if you perceive the need, and I don't think insurers perceive that at the moment. Insurers feel they have invested decades in developing reinsurers and those companies have more capital than ever."

Insurance companies' insularity has been a hurdle to the development of a standardised insurance security. "Buyers will say, 'I will do something different but I'm going to do it my own way,'" says Hendrix. "They are willing to see their risk transfer methods evolve, but only in a way which they're comfortable with." This problem has been accentuated by the initially slow pace of securitised product development. Schmidt says: "Up to now, the insurance risk bond structures have improved only slightly, allowing some extra flexibility for the issuers.

"Reinsurance, by contrast, can be very flexible and can respond to the specific needs and particular risk characteristics of the ceding company. This is a challenge for the capital markets, which currently prefer standardised risks and a few deal structures."

The most common source of friction has been between insurance issuers which want to see their own needs covered exactly in a bond and investment banks and investors who want to create a market comprising a range of identical securities. The idea that the issuer will have to retain those of its risks which investors are unwilling to accept because they do not fit within a packaged product has raised the question: 'Who is the market being developed for - insurers or investors?

Hendrix says: "The bottom line is that the insurers think of their risks as being unique and they all want a tailor-made reinsurance solution. But investment banks are seeking economies of scale by designing commodity products. This obviously doesn't allow the creation of uniform, off-the-shelf products - the universal cat bond. You can't build commodity products in this type of environment because the products don't travel from one insurance company to another.

Insurers will only do deals if they suit their needs. I don't see many companies going along with the mould-breaking ideas of the investment bank intermediaries. Insurers want deals that fit their needs and don't want their needs being fitted into the market-standard securitisation products. So you're going to see more new types of deals being done rather than companies taking off-the-shelf products based on the emerging cat bond mould."

Those bonds which are linked to a loss index are the ones which most closely resemble a standardised product in the market at the moment. Cover is triggered by a measure independent of an issuer's own losses. Shimpi, whose company structured the Tokio and Mitsui deals, the two most notable examples of index-linked bonds, says: "If you want to create a market which is actively traded then it is useful for investors to be able to look across the landscape of deals which have been done so far.

"If all the deals were based on a company's portfolio then it would mean having to go in and check the company's underwriting standards every time. That prevents the creation of a secondary, derivative market. But if you can create a family of indices they help to attract investors.

"I remember when I first came into the insurance market people told me why securitisation in insurance would never happen. One thing they said was that you have to base securitisations on insured losses. I said 'No you do not' and created the index-based loss trigger in the [Tokio Marine] Parametric Re deal. It is important to keep in mind that the insurer must have what risks it wants covered. There is no point having a Parametric-like trigger if it has no relation to the issuer's risks. I would say that between insurers and reinsurers we have a better handle on that: we know how much an earthquake measuring 7.0 on the Richter scale means in terms of an insurers' loss estimates.

"The deal's credibility is much greater among investors if it is index linked too. The investor feels more comfortable that we have no way to manipulate the loss trigger. That 7.0 number can be used on a variety of deals without investors having to worry about the impact on an insurers' book of business. There can be two deals out in the market both with the same trigger but the impact on the clients can be very different because of the nature of their portfolios."

But many insurers fail to see the value of index-linked bonds. Pettengell at St Paul Re says: "I find these index-linked deals hard to understand. The issuer is taking on basis risk, so I can't see how the economics of them make sense. A lot of these deals are being done for kudos. They tend to be small compared to the overall reinsurance spending of these companies. They know if they do a securitisation on an index-linked basis it will be easy to place. If you want to get your name up there as a company that's done an insurance securitisation, then you do an index-linked deal because they're easy to do and they're dirt cheap. But they don't really meet your needs because you have to take the basis risk."

Insurers are unsure how long investors will be interested in insurance bonds. They are reluctant to end relationships they have developed with reinsurers over decades in favour of capacity which may disappear after the first large loss. Pettengell suggests that investors may not fully understand the risks they are assuming from insurers. He says: "I'm not sure they know enough about the down side. It's nothing like what they are accustomed to. In this business you may make a lot of money for 19 straight years and then lose it all in the twentieth. I don't think they understand that and may not be pricing for the risk as they need to." He fears a loss may see issuers and investors fall out over the terms of their coverage and could envisage capacity from investors drying up as a result.

Richard Sandor, chairman of Hedge Financial Products, believes that investors are far savvier than insurers may view them. He says: "Professional investors will understand the increases in rates which should follow a large event will offset the losses they make, and they will realise that the risk/reward ratio will be even higher after a loss. They will adopt the same investment approach as Warren Buffett, who through National Indemnity is one of the biggest investors in catastrophe risks in the US. He apparently doesn't see the business as taking a series of isolated risks: if, like him, they look at these as long-term positions, develop a portfolio of cat risks which are intertemporal diversified in terms of the estimated frequency of losses of the various risks, then a spike in earnings created by a loss will not deter them."

Both issuers and investors would like to strike longer deals which would more closely cover insurers risks, suggests Karen Clark, president of Applied Insurance Research, the cat modeller for several deals. But investors lack the nerve to do so. Clark says: "Investors would like to make the best use of their resources by doing longer deals, but they are not comfortable enough with the risks so far to do so. Investors are still worried that reinsurers have a better knowledge of the risks contained in deals and can better compare the quality of the risks across the market. Investors are worried they might not have asked the right questions or might have missed something out when they price the deals. But the capital markets are under pressure to price their deals competitively."

The price of securitised deals has come down to the point where they are almost the same as traditional reinsurance on some risks. In the first deal of its kind, XL Mid Ocean Re last month placed a retrocessional cover by having an open bidding process between reinsurers and the capital markets. The company told investment banks that if the prices they quoted were too high then reinsurers would would get the entire $200m placement. While its prices were still marginally higher (predominantly because the deal was done as a swap as it didn't have the time to issue bonds) the capital markets shared the cover with reinsurers.

The steady stream of catastrophe bonds issued shows that the capital markets have become an established source of capacity for disaster risk. Insurers and securitisation structurers are now investigating which of their other risks can also be securitised.

Pettengell says: "I expect to see a flurry of non-cat securitisations in the near future. The cat reinsurance market is so soft at the moment; I don't sense the capital markets are prepared to go as low as reinsurers. That will mean the pressure will increase on investment bankers to deliver more types of insurance risk to investors."

This question goes back to the issue that it is not only which risks insurers want to securitise but which ones investors want to assume. "We must consider how investors look at risk," says Gräber. "They want to know exactly where they stand on the day when the bond expires. That would exclude long-tail liabilities. Among short-tail exposures 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."

Aviation, satellite and marine risks are tipped to be the next insurance exposures to be securitised. A number of deals have already included these exposures. The risks are easily understandable to investors and even though the loss triggers are not connected to an index, they are clear and uncontroversial - if an aeroplane crashes or ship sinks then investors must pay out. Insurers are desperate to offload their Year 2000 exposures, but investment bankers are grappling with the problems of how to structure such a product.

For all these risks, securitisation remains strictly an activity which as an insurer you consider to cover your peak risks - those low-frequency, high-severity losses which can rip a hole in your balance sheet. The capital markets provide capacity which insurers may never need to use, a relief fund on standby which, unlike reinsurance, contains no credit risk.

This role for the capital markets as a sort of catastrophic reinsurer of last resort could stymie the development of a wider market for less volatile risks. Shimpi says: "Securitisation was developed in the capital markets to free up the assets of the corporation, to leverage its performance. It can do that by financing its predictable exposures with debt capital rather than equity capital. That's the argument behind mortgage-backed securities and credit-card receivables. It may also be the argument for certain types of insurance risk. But that is yet to be determined."

Hendrix says: "I see life risks as being the main potential risks outside the cat arena to be securitised. In some ways, insurance began the securitisation process in reverse order to that of the banking market, which saw the first deals done in stable classes of risk like mortgages and consumer loans.

This is probably due to securitisation being used in insurance not so much to solve capital-related issues but those of price and supply in a particular risk class - catastrophe. As insurers begin to focus more on their capital the trend for insurance securitisation is likely to parallel that of the banking market, with transparent, stable lines of business being looked at next." For the same reasons, America Re's Schmidt adds motor liability and workers' compensation as being other potentially securitizable risks.

The idea is that a large proportion of an insurers' capital base is being used to underwrite very predictable but capital-intensive risks such as life and motor exposures. Because of this, it is in fact forced to look elsewhere for the capital it needs to write more volatile but lucrative risks. If insurers' securitised their motor and life portfolios, effectively acting as packagers of risks for the capital markets, it would free up their capital to concentrate on risks which their expertise makes them uniquely qualified to underwrite. This is just one possibility for further securitisation of insurance risks as the convergence between insurance and the financial markets deepens.

Sandor sees securitisation as a vital tool for those companies seeking to take advantage of this convergence by selling corporate customers coverage for both their traditional insurance risks as well as the risks they would conventionally look to the capital markets to assume.

Sandor says: "One can envisage an airline being given cover by an insurance company which includes underwriting its hull and liability exposures, a cap on the price of its fuel, cover against the foreign exchange risks it takes on through international ticket sales, as well as insurance on loss of revenue from ticket sales. The endgame is where the insurer gives the company what effectively amounts to an earnings-per-share guarantee.

"This will come about because it is increasingly difficult to separate risk management in the traditional insurance risk transfer sense from treasury management. It is ironic to think that insurance was, in fact, the first derivative."

Insurance companies' growing financial sophistication and dynamism could see the number of securitised deals they do increase. For example, insurers are beginning to adopt the proactive, balance-sheet risk-management tools developed by commercial banks. This involves evaluating your company's liabilities on a daily basis rather than when its policies come up for renewal at the end of the year. Up to now, Sandor says: "Risk management is static in insurance. It has to become more active; insurers are where commercial banks were 15 years ago, when asset liability management didn't exist. For example, insurers should be evaluating their hurricane risks on a daily basis, comparing the value of that exposure with the time left until the end of the hurricane season. Companies could easily be trading those risks regularly on the financial markets."

Further consolidation in the insurance industry could also have a powerful effect on managements' idea of what risks could be transferred to the capital markets.

Gräber says: "The rise of holistic risk modelling may lead managers to think about securitizing the whole value of the company. By using these techniques, insurers have come to understand that they have larger exposures on the asset side of their balance sheet than they do on their liability side. With this in mind, CFOs may advise managements to take a more comprehensive view about the risks they run. That may well mean securitizing them."

He says the industry is "three years away from doing that".

Hendrix says: "Barring large catastrophes, you would have to see growing capital pressures in the insurance markets as the other big catalyst for more transactions. This will probably come about as a result of regulatory changes such as the introduction of risk-based capital guidelines to cover liabilities as well as assets. Insurers' appetite to retain risks could be affected by regulators or ratings agencies focusing on companies' liabilities.

"But that cannot be done without a systematic framework, which we do not have yet. Dynamic financial analysis (DFA) is one development on the horizon which may be key in this regard. It may be years, however, before the substance of the DFA is up to the theory, and even longer before regulators and/or ratings agencies employ DFA tools constructively."

The real issue, which is likely to make or break the insurance securitisation market, is how the conventional reinsurance market acts over the next few years.

If reinsurers remain catastrophe-free for another four or five years they are likely to push the price of their capacity down to a point which the capital markets are unwilling to match.

The more stable insured risks, like life and motor, which could represent the future for the securitisation market, are those which are regarded by reinsurers as their bread-and-butter business. They are in a highly competitive mood and are not prepared to see their business move to the capital markets.

Schmidt notes the irony that the reinsurance and capital markets are remarkably similar at the moment: both industries, flushed with high profits, are awash with capital which they are looking to invest in new ventures.

Schmidt says: "But even with their abundance of capital, the capital markets have not been able to compete with the traditional reinsurance markets on price, and probably will not until they become more experienced in differentiating risk."

The present state of the reinsurance market has meant a profound complacency has settled over the deeply ingrained traditionalism which remains among insurers. This could scupper the growth of insurance risk bonds.

Hendrix says: "A reason why more companies are not issuing insurance bonds is one which many people choose to ignore. But the most common reaction I have received going around the insurance market is 'Why would I want to do anything different? That would put me out of a job. I am useful around here because I know lots of reinsurers. I do not know any bankers, certainly not any investors.'

If I am a risk manager or reinsurance buyer, doing something different does not prolong the length of my career. And there is so much traditional capacity around now that people do not need to think about anything different."

P ettengell agrees, saying: "I think the deepening of the reinsurance market cycle could kill securitisation. Buyers think 'Why go through all this hassle when I can get traditional reinsurance coverage cheaper?'"

Sandor however, is confident that time is on the side of insurance securitisation. He says: "I am a student of markets and I think the insurance market will be like the oil market. Typically one shock creates a market, the second matures it. Oil prices went sky-high after the 1973 crisis; by the mid-1970s we saw the introduction of energy futures. And when the next crisis occurred in 1979, the energy futures market went boom.

"In insurance, let's say the period between Hurricane Hugo and Hurricane Andrew saw the market being created, and it picked up pace with events like Northridge.

"The next wave of catastrophes will cause the market to mature. All the time the infrastructure is being built for a market. The arithmetic is too compelling: the US insurance industry has approximately $265bn in available capital which must cover property risks of $15bn, as well as the liability exposures of a $7 trillion economy.

"The industry has shown itself able to pay for small catastrophes but is unable to take a large cat which could cost between $50bn and $100bn.

"That is without other huge areas of risk such as in the healthcare sector, which makes up 15% of US GDP. We will see the securitisation market develop inexorably; it is just a question of speed." *

  • 01 Sep 1998

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