Overview of global risk financing

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Overview of global risk financing
trends
Stephen Cross
25th October 2005
SOLUTIONS FOR COMPLEX RISK
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What causes a trend to emerge?

• Slow
• Shift in pricing
• Change in attitude
• Economic shift
• Fast
• Dynamic
• Extraordinary
• Policy shift
• Shocking

Pool Re 1993IRA Bombing
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Trends - Drivers Compelling Influences
Risk
Reinsurer
Corporate Client
Insurer

• Capital Issues
• Losses
• Security Rating
• Capacity
• Solvency/Collateral
• Cash-flow
• Investment Risk
• Product Pricing

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Trend. Risk is being re-defined.

• External factors are having a strong influence on
  the role of the Risk Manager or Chief Risk
  Officer
• Complexity of risk
• Globalization of risk
• Concentration of risk
• emerging trend in approach to risk.. .
  Enterprise Risk Management.

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Trend Risk Concentration

• Since 1955, 1857 companies appeared on the USA
  F500 list
• Only 27 of companies on the list in 1985 are
  still on in 2005
• Meaning.growth concentration of risk
• Local examples

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Risk Concentration - local facts - Global 500
Sales in US Billions
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Emerging Trend - Enterprise Risk Approach

• There is no DNA
• A shift from avoidance based risk management
• Risk should not simply be viewed as negative
  .ERM takes into account the upside potential.
• Identification, assessment and response.

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World of Risk....ERM
When things go pear-shaped!
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1 Losses
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Hurricane Katrina
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Hurricane Katrina

• Estimates still wildly apart
• 40 to 60 billion
• Range is the size of Hurricane Andrew!
• Most expensive natural catastrophe to hit the US
  in recent history
• The hurricane
• Cat 1 when it hit Florida
• Cat 5 Hurricane prior to landfall
• Hit Mississippi at 5.30am on Mon 29th Aug
• Maximum sustained winds of 150 mph
• Storm surge of up to 30ft

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Hurricane Katrina a legal mess!

• Issues
• Wind vs. Flood .what if both perils caused a
  total loss?
• Valued Policy Laws
• Storm Surge
• Evacuation Order
• Act of God Defense
• Force Majeure
• Multiple events / multiple deductibles
• Voluntary or ex gratia payments
• Political sympathy will not extend to commercial
  sector.

Reaction Distrust
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Other losses
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The Maharashtra Floods - India

• 94 cm of rain on July 24th, 2005 in Mumbai
• US821m
• 20,000 claims
• 1000 dead
• Directive from Finance Minister to settle all
  claims up to a certain value by August 31st, 2005
• Expected to harden reinsurance rates for the
  sub-continent.

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The Pakistan Earthquake

• 7.6 Magnitude
• Loss of life possibly 50,000
• Insured loss probably small
• Are we due a major hit in a heavily insured zone?

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Insurance losses Australia New Zealand

• January 2005 South Australia Fires A26M
• February 2005 NSW, Victoria Tasmania A245M
• May 2005 Western Australia A25M
• May 2005 New Zealand Flooding Tens of millions
• June 2005 New Zealand EQ Commission NZ14.6M
• June 30th, 2005 Queensland NSW A25M

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Sharp loss increase for insurance market
Reaction ????
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2 Security Rating
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Reaction Security Downgrades
Top 10 (re)insurers in 2001 lost an average of
over 2 notches in four years

• (Re)insurer
• AIG
• Munich Re
• Swiss Re
• Berkshire Hathaway
• Employers Re
• Allianz
• Hannover Re
• Zurich
• AXA
• Lloyds

• 9/11/2001
• AAA
• AAA
• AAA
• AAA
• AAA
• AAA
• AA
• AA
• AA
• A

Aug 2005 AA A AA AAA A AA- AA- A AA- A
Notches -1 -4 -2 0 -5 -3 -2 -2 -1 -1
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Reinsurer downgrades the impact

• Downgrade to B level can invoke cancellation
  provisions in many contracts.
• A lot of companies that have faced such a
  downgrade end up exiting the market
• Trenwick Group in Bermuda
• Gerling Global Re Group
• Some survivors
• SCOR
• Converium Holdings Ltd.
• Survival may mean provision of LOCs or other
  collateral

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6 Investment Risk
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Investment Risk

• Investment return rates trending downwards
• Fx movements
• Asset / Liability unmatched
• Prior year deterioration
• USA Non-life insurers boosted prior year reserves
  for past 6 years
• 2004 10b
• 2003 14b
• 2002 22b
• Can you actually make an underwriting profit?

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Changing gears Does Insurance actually
match the needs of todays business?
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Aon Risk Financing Survey
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Aon Biennial Risk Management Risk Financing
Survey - Some Interesting Facts

• Revenues
• 57 responding with revenues of 2B
• 13 responding with revenues of 1B to 2B
• 18 responding with revenues of 500m to 1B
• Locations
• UK Europe 68
• Americas 21
• Asia Pacific 7
• Rest of World 4

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Aon Biennial Risk Management Risk Financing
Survey Top 10 Risks
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Alternatives to Insurance
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Why Alternative Risk Transfer?

• Typical policies are one year duration
• Policies do not contain any indication of
  expectation for future pricing
• No reflection of future supply and demand
• No spot price you cannot store the
  commodity
• Multi-year contracts contain renegotiation risk
• Multi-year policies are risky in that they can be
  written at the wrong point on the pricing cycle
• Cannot properly manage the pricing cycle.

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Finite Structured Reinsurance
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Structured reinsurance

• Size of finite market in 2001 estimated_at_ 27B
  .Swiss Re Est.
• Image problem ..reliance by regulator,
  policyholders, investors and now regulatory
  scrutiny, subpoenas, reputation risk
• Definitions EU,RAA
• At issue is the accounting treatment for the
  transactions.
• Usually a combination of different elements
• Multi-year, Multi-line, Double trigger, Profit
  commissions risk sharing, Investment gains
  shared, Commutation provisions, side agreements,
  internal transactions between parties.
• Additional disclosures.

Trending downwards
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Bonds
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Bonds Why not?

• Speculation makes markets work
• Its all about betting on future prices
• Buyers sellers crystallize prices at particular
  points in the future
• Why adverse price movements would be
  disruptive
• Converse is that with no second-hand market in
  place, pricing can remain uneconomical for
  extended periods
• All commercial buyers and sellers will exit a
  market if conditions cannot meet stakeholders
  interests.

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Bonds in the industry

• Mostly earthquake and hurricane with parametric
  triggers
• 7.5 Richter Scale reading for earthquake
• Cat 4 Wind speed for hurricane
• Expanded from reinsurers towards large
  corporations or events
• 2006 World Cup Cancellation coverage for
  sponsors
• Theme park earthquake risks in Tokyo
• French electric company windstorm losses to
  power lines
• Aviation liability
• Why Bonds?
• Credit risk traded out .transaction fully
  collateralized
• 5.8 Billion of Cat Bonds outstanding as of July
  2005
• Widely stated that demand exceeds supply.

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Trend Cat Bonds _at_ y/e USM
Source Swiss Re Capital Markets
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Hedge Funds
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Hedge Funds

• Date back to 1949!
• Approx 8350 in existence today
• Competitors or partners to traditional
  reinsurers?
• Form of additional capacity and options
• Fully collateralizing potential future claims
• Unencumbered by past losses (asbestos, EIL)
• Take advantage of imperfections in the
  marketplace
• Opportunistic capital . Unlike insurance??
• So why is capacity withdrawn or limited after
  market events?

Trend Expected Growth
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Weather Related Products
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Weather Products

• Product Spread
• Energy 56
• Agricultural 13
• Retail 9
• Construction 7
• Transportation 4
• Other 11
• Current notional value of 4.6B
• Temperature, price volume
• Farming cover yield variability

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Weather Product Examples

• Pirelli
• Put on number of days average temperature was
  below 7C degrees
• Aligned to marketing campaign for sale of winter
  tyres in Germany.
• ABN Amro
• Dutch bank
• Put on average temperature in August.
• Bid to attract new clients with increased
  interest rates on savings accounts during a cold
  summer.

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Trend Weather Contracts

• Chicago Mercantile Exchange
• Heating Degree Day
• Cooling Degree Day
• Done on monthly and seasonal futures and options.
• Global Trading
• US, Europe Japan.
• Stats
• 2004 total of 123,000 contracts traded
• By June 2005 total was 307,000 contracts traded

Trend Considerable Growth
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Overview of global risk financing
trends
Stephen Cross
25th October 2005
SOLUTIONS FOR COMPLEX RISK