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Erscheinung:14.06.2013 08:32 AM | Topic Investments of insurance companies Önder Lale, BaFin

Alternative risk transfer: Advantages and risks of transferring insurance risks to the capital markets

How can catastrophe risks be spread more broadly with a view to achieving better risk bearing capacity? One possibility is provided by catastrophe bonds, also referred to as cat bonds.

When in 2012 Hurricane Sandy swept over the US, the risk bearing capacity of many insurers would have been higher if they had previously issued catastrophe bonds for the risks they had underwritten and had placed these on the capital markets on reasonable conditions. This article provides an overview of the advantages as well as risks of catastrophe bonds and other instruments of alternative risk transfer (ART). The possible future development of the ART market is also outlined.

The term “alternative risk transfer” is used when insurers transfer any kind of insurance risks, not purely financial risks, to the capital markets using specific financial instruments. For insurance undertakings such instruments – in addition to traditional risk transfer through reinsurance – represent an additional instrument of risk policy. By means of ART instruments, primary insurers and reinsurers may both supplement and substitute reinsurance and/or retrocession, the traditional forms of risk transfer.

EIOPA Report

The European Insurance and Occupational Pensions Authority (EIOPA) is currently preparing a report on the subject of ART which it plans to publish late in the summer of 2013. The present article is a first interim update on the work being done.

The global risk environment is in a constant state of flux. Accelerated growth in emerging markets, growth in asset volumes and asset concentrations, global interconnectedness, demographic change and the growing need to take out coverage against natural disasters will see risk coverage expand further in future as well. Various factors are impelling primary insurers and reinsurers to pool these risks and to transfer them to a broader base of investors through the capital markets. The use of alternative risk transfer allows for risks to be spread more broadly, thus increasing risk bearing capacity. Primary insurers and reinsurance undertakings use ART instruments primarily to steer their risk capital and finance additional insurance capacities. On account of their size and the broader group of investors reached, the capital markets offer greater risk bearing scope. There are basically three classes of ART instruments:

  • securitisation of insurance risks (insurance-linked securities)
  • insurance derivatives
  • contingent capital

Securitisation of insurance risks

Claims arising from major natural disasters can be securitised using catastrophe bonds and thus transferred to a broader investor base. As a general rule, catastrophe bonds are issued through a special purpose vehicle established specially for this purpose. It usually issues bonds with different risk liabilities in a private placement. Interest payments to the investors are fed from two sources: from the regular premium payments for securitised risks and from income on investments.

Primary insurers and reinsurers use catastrophe bonds to cover risks with a high loss potential and low probability of losses occurring. Often, such risks cannot be reinsured economically given the high costs. In addition, there is a considerable counterparty risk on the reinsurance market for large catastrophe events where coverage is offered by only a few reinsurers. Currently, the most important catastrophe risks traded on the market are wind and earthquake risks in the US, multi-peril risks as well as wind risks in Europe.

Catastrophe bonds belong to the general class of instruments of insurance-linked securities (ILS). The characteristic of this class of instruments is that obligations of the (re)insurer are reduced on the occurrence of risk events because investors waive part of their interest and redemption claims (debt forgiveness). In this way, the claims burden on insurers is partially offset (liability hedge). Additional ILS instruments are, for example, longevity bonds and mortality bonds.

The cat bond market is the most advanced ILS market. Although the cat bond market volume is still rather small in relation to the global reinsurance market, the frequent occurrence of natural disasters involving high losses on the part of (re)insurers is driving accelerated growth within this market segment.

Insurance derivatives and contingent capital

Further ART instrument classes are insurance derivatives and contingent capital. Insurance derivatives function in much the same way as other financial derivatives, albeit with the difference that with insurance derivatives a technical underlying – usually a claims index – is constructed. If a risk event occurs, a claims burden of the (re)insurers is partially offset by newly created assets (asset hedge). Instruments of contingent capital have option character because they entitle the counterparty to take on equity or debt capital in the event of a loss depending on the contract arrangements of the instrument class (leverage management). Since these instruments are usually traded in private placements, primary and reinsurance undertakings are exposed to a counterparty risk with regard to the option writer.

Advantages for insurers

For insurers, there are various motives for using alternative risk transfer. One of them is the already mentioned higher loss absorption for large catastrophe events made possible by cat bonds. A further motive, particularly for life insurers, is the increasing life expectancy of insured persons: some life insurers are seeking to transfer longevity risks as part of pension risks to the capital markets via longevity bonds. Likewise, higher mortality risks due to pandemics and increasing global interdependencies are prompting insurers to transfer these risks to a broader group of investors using mortality bonds.

ILS transactions allow particularly life insurers to segregate expected future income flows from an insurance portfolio and to realise such implicit profits directly (embedded value financing). This form of risk financing is a further motivation for insurers to broaden their insurance capacity and increase their market shares. Another aspect is the optimisation of reinsurance costs: in a market phase in which insurance premiums rise following a large catastrophe event (hard market phase), ART can offer an economical alternative for primary insurers. For example, primary insurers can offset cyclical price volatilities on the reinsurance market since the instruments usually have a maturity of several years. In addition, ART can help smooth net annual profit over a horizon of several years.

With appropriately structured ILS transactions, ART can minimise counterparty risks existing in traditional reinsurance business particularly for large risk events. Risks which on the traditional reinsurance market cannot be (fully) insured given the scale of the risk can be transferred to the capital market by means of ART. With ART, (re)insurers can also diversify their portfolios by buying underwriting risks of other insurers. Lastly, one peculiarity of the US life insurance market is the possibility to take on debt capital on the capital markets to partly finance the regulatory requirements for capital reserves (triple X/AXXX securitisation).

Advantages for investors

Investors enjoy diversification benefits through ART. They can invest in risks which commonly exhibit a low correlation with other established risks on the capital markets (zero beta assets). That allows them to structure their portfolios more efficiently from a risk/reward viewpoint. But since large catastrophe events conceivably might also have a strong impact on the market, the zero-beta assumption does not apply without qualification – as in the case of Fukushima.

Moreover, on the basis of ART investors can invest in insurance risks directly and in isolation. Before ART instruments existed, investors wishing to have insurance risks in their portfolio could only buy shares of insurance undertakings. However, such investments, besides insurance risks, also carry others such as corporate and operational risks. By contrast, ART allows for specific investment in certain insurance risks.

Currently, insurers are offering investors higher returns as an additional purchasing incentive, also because the instruments in some cases are still relatively new. For example, the spread of ILS transactions is up to six times higher than corporate bonds considered to carry a similar risk. That is meant to serve as compensation for the information asymmetries between insurers and investors and also to offset the uncertainties regarding the risk-adequate pricing of these financial instruments. Assuming that the ratings are reasonable and adequately reflect the underlying risk, investors are thereby able to achieve a potentially higher return in their ILS investments.

Risks for insurers

Some of the potential risks of ART instruments are detailed here by way of example based on cat bonds. Cat bonds fall under the category of bonds whose payment profile is event-risk driven: repayment of the investment amount as well as interest payments depend on the occurrence of one or several predefined catastrophe events. Payment may be triggered in different ways. Depending on what trigger has been chosen, a balancing takes place to a varying degree between the interests of the investors in greater transparency and the interests of primary insurers and reinsurers in minimising their basis risk. Basis risk refers to the difference in the payouts between the (re)insurer’s own claims burden arising from the risk event and the risk transfer mechanism structured to hedge against those losses, and thus to the coverage in this case functioning only partially.

However, the opposite scenario is also conceivable: a payment takes place under the ART instrument without the (re)insurers having suffered losses (windfall profit). Depending on which type of trigger is chosen, a higher or lower basis risk arises for the (re)insurers compared with traditional reinsurance or retrocession. The different trigger types range from the purely parametric trigger activated in the event of certain physically observable data (for example on the Richter scale for earthquakes) to indemnification-based triggers for which the individual claims burden of the insurer acts as the basis of the trigger. The degree of transparency of the instrument for the investor depends on the agreed trigger.

Given the advance payment of potential catastrophe claims by the investment amounts of the bond investors (full collateralisation), the counterparty risk for the insurer is largely eliminated if a sufficiently conservative investment strategy is pursued within the transaction structure.

Risks for investors

The promise by insurers of high returns, especially with ILS transactions, compares with the potentially high losses on the part of investors. The precise extent of losses may vary depending on the type of the securitised risk, the terms of the transaction and the choice of trigger. Even a total loss of the investment amounts cannot be ruled out. Moreover, investors are exposed to risks that are inherent to ART instruments and are described below.

Generally, investors and insurers have different information on the risks of ART transactions. Whereas insurers can thoroughly analyse the type, quality and composition of the securitised risks prior to an issue, this is often not possible for investors. They frequently also lack the technical know-how to evaluate the instruments in terms of their risk/reward characteristics. These information asymmetries between investors and issuers can be a cause for moral hazard and can also result in adverse selection issues.

Moral hazard and adverse selection

For example, in an ILS transaction investors undertake already on concluding the contract to waive interest and redemption payments if a trigger event occurs. As a result, primary insurers may be tempted to take fewer measures to prevent future losses than if they had to bear the risks themselves – for example by applying a more lax risk monitoring process (ex ante moral hazard). In the same way, a primary insurer, following a risk event, might adopt a less restrictive claims settlement policy to the detriment of the investors (ex post moral hazard).

Adverse selection likewise results from the information edge of the insurers: the price of an ILS transaction merely reflects the average of all risks securitised in it. If the insurer alone knows the true risk profile of the securitised policies, he might be tempted to securitise only particularly risky policies and to make only inadequate disclosure of this fact to investors. However, moral hazard and adverse selection are counteracted by the potential reputational risk this represents for insurers as well as the partial retention of risks.

By engaging rating agencies it is possible to mitigate information asymmetries to a certain extent. But here, too, there will always be a certain residual risk for investors. That is because the rating agencies are paid for their ratings by the insurers, from whom they also receive the information about the securitised risks.

Other risks for investors stem from the weak secondary market. Since ART instruments are usually traded through private placements and on an OTC basis, the instruments used as a rule are illiquid. Moreover the issuers, depending on the terms of the transaction, enter into swap agreements with third parties, for example for total return swaps, in order to guarantee the return and redemption payment to investors. Under such swap agreements within an ILS transaction structure counterparty risks may arise, as demonstrated by the default of Lehman Brothers during the financial crisis.

Market outlook

Given its low market volume, the ART market does not present any systemic risks to the aggregate reinsurance market in the short-to-medium term. However, the market does have development potential. For that reason both BaFin and EIOPA continue to follow the ART market – particularly with regard to the risks outlined.

Further development of the ART market will primarily depend on the extent to which the industry succeeds in reducing the existing information asymmetries. For that, market participants would have to implement, among other things, trigger types which on the one hand are highly correlated with the claims burden of the insurers so as to reduce any basis risks. On the other hand, these trigger types would have to satisfy investors’ high transparency requirements to limit the risk of moral hazard and adverse selection. The challenge for the industry is finding an acceptable balance between the interests of insurers and those of investors. Another question is the extent of standardisation that the industry will be able to achieve with the instruments traded. Moreover, the industry should develop standardised valuation models for ART instruments. In addition, rating agencies could also help reduce information asymmetries by providing for consistent ratings.

Nevertheless, when valuing ART instruments market participants should question whether capital market risks are adequately priced in. The Lehman Brothers default has shown that counterparty risks were not sufficiently taken into account in the swap agreements within the transactions. Insurers and investors should create transaction structures in which counterparty risks and collateral are adequately managed.

Additional information

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