Growth Agenda for the Insurance Industry

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Growth Agenda for the Insurance Industry

• A Capital Markets Perspective

René Cotting, PhD Financial Institutions
Solutions Group - Insurance International
Insurance Society Berlin, July 8-11, 2007
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Growth Agenda for the Insurance Industry

• A Capital Markets Perspective
• Markets size, growth and interaction
• Innovations recent pending
• Requirements to facilitate growth
• Conclusions

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1. Insurance Capital Markets Areas of
Interaction
Risk-Capital Map

• How can the Capital Markets support
• Your Business?
• Capital Accelerate the B/S Flexible Capital
  Structures
• RBC Associates Risk with Capital and hence
  Cost
• Applies to Economic, Regulatory and Signal
  Capital
• Risk Transfer / Risk Management

Senior Debt Subordinated Debt Equity
Insurance Linked Securities (Cat Bonds)
risk
CFO
R/I XL / SL QS /Sidecars
Credit Lines Contingent Capital
Derivatives Equity, Rates, FX, Commod.,
Inflation, Weather,
Capital Off-B/S Paid-Up
risk
RM
Risk Transferred Retained
Adapted from P. Shimpi, Integrating Corporate
Risk Management
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1. Global Capital Markets Size (matters..)
Total FI27,700
Source SIFMA

• Total Global Capital Markets Outstanding
  Estimate2
• Equity 75000 bn
• Fixed Income 75000 bn
• Total 150000 bn (100)

1 only liquid investable assets, as of March
2006 2 Extrapolation based on U.S. gross-up
factors
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1. Insurance Market Size

• Global Insurance Premiums1
• non-life 1619 bn
• Life 1707 bn
• Total 3311 bn
• Global Catastrophe Market2
• Premium 12.9 bn
• Limit 143 bn (0.1)

• Capital Increase (following KRW)
• Existing Companies 5.3 bn
• Start-Ups 1.9 bn
• Alternative Capacity2,3,4
• ILS 28.0 bn
• of which cat. 10.3 bn
• ILW 6.5 bn
• Side Cars 5.1 bn
• Private Placements ???
• Total Alternative Insurance Capacity 40
  bn (0.027)

1 OECD markets 2004, source OECD 2 1/2007
figures, source Guy Carpenter 3 source Swiss
Re sigma 4 source LaneFinancial
Alternative Cat Capacity accounts for gt15 of
Global Catastrophe Limits
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1. Growth of Alternative Insurance Capacity

• Life Risks securitized to date
• XXX/AXXX regulatory reserves
• Catastrophic Mortality
• Embedded Value
• PC Risks securitized to date
• Natural Catastrophe
• Big Four US HU, US EQ, EU WS, JP EQ
• JP TY, Med EQ, TW EQ, Aus CY/EQ, Mex EQ, UK
  river flood,
• Credit (Trade, R/I Recoverables)
• Liability
• Motor
• Longevity conspicuously absent

• Insurance Linked Securities (ILS)
• 20061 has been a banner year
• 60 of ILS is life related
• Still only 0.03 of Global FI Markets

CAGR 42
Source Swiss Re sigma Updated with company
disclosures for full 2006
1 trend continued in 1H07
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1. Impact on Reinsurance Market - Cycle is
flattening

• Rate Impact per Dollar Loss1 decreased
  significantly
• Andrew 92 2.4 / bn
• WTC 01 1.2 / bn
• KRW 05 0.7 / bn
• Speed of Capital is increasing
• Cycle Amplitude is flattening
• Post-Loss Recuperation is no longer a viable
  strategy
• 1 indexed, not trended
• 2 Source Swiss Re Sigma 2/07(liability and
  NFIP flood losses excluded)
• 3 Source Lane Financial LLC Trade Notes April
  2007 (with data from Paragon)

The eight largest global catastrophe insured
losses 1970-2006, indexed, not trended2
Rita Wilma Katrina
10
13
Loss
Sidecars
Charley Ivan
Andrew
ILS
WTC
Northridge
Start-Ups
45
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Recapitalization
23
21
19
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55 / 23bn 2.4 / bn
1.2 / bn
0.7 / bn
Reinsurance Rate Changes3
YoY Index Change (detrended)
55
45
YoY Index Change
25
1985 1990 1995 2000 2005 1Q07
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1. Capital Market Comparables

• Credit Default Swaps (CDS)
• CDS credit insurance
• today the global CDS market exceeds the cash
  market

• Mortgage Backed Securities (MBS)
• Allowed banks to sell down risks previously held
  on B/S (de-risk accelerate B/S)
• Facilitated by Government Agencies
• Acceptance criteria ?Standardization
• Creation of secondary market
• Guarantee timely payment to investors

Global CDS Market (Notional Amounts)
(U.S. only)
Source SIFMA
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1. Private Equity Markets

• Total PE capital raised 800 bn of which by
  top-50 PE firms 551 bn
• Cumulative buying power1 4000 bn
• Global IPOs 2322 bn
• Top-5 PE firms Capital Raised
• The Carlyle Group 32.5 bn
• Kohlberg Kravis Roberts 31.1 bn
• Goldman Sachs Principal Investment Area 31.0 bn
  
• The Blackstone Group2 28.4 bn
• TPG (Texas Pacific Group) 23.5 bn

• Top-50 PE firms by Location
• Insurance
• Post KRW Sidecars raised 5.1 bn capital 3.6
  bn of which equity
• Corresponds to 0.45 of average annual PE buying
  power
• High Sidecar activity in 2006 abated in 2007

source Dealogic / Private Equity International
All data for the period 1.1.2002 18.4.2007 1
assumes 5-times leverage multiple 2 IPO on June
22, 2007
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2. Examples of Recent Innovations
A Elimination of Credit Cliff in Catastrophe
Bonds

• A standard catastrophe bond gives investors and
  rating agencies no early default warning (digital
  credit cliff)
• Cat bond rating ceiling of A and strong pricing
  compared to CDO/ABS market
• Applying CDO technology to a basket of natural
  catastrophe perils1
• Decouples security rating from individual layer
  risk profile
• Results in gradual rating migration rather than
  digital default
• As a result, the Senior Tranche of Fremantle
  achieved AAA/Aa1 rating

Senior (Class A) AAA/Aa12
Mezzanine (Class B)BBB/A3
Junior (Class C) BB-/Ba2
1 Bay Haven, Fremantle, Gamut Re 2
Fitch/Moodys rating
33.375m Each Event
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2. Examples of (not so) recent Innovations

• B Dynamic Hedging of Secondary Guarantees
• Guaranteed Minimum Benefits (GMB) are value added
  guarantees embedded into U.S. style savings
  products such as Variable Annuities
• A Guaranteed Minimum Death Benefit (GMDB) for
  example represents a mortality ? investment
  hybrid risk with sensitivity to
• Equity (delta, gamma, vega)
• Interest rates (rho)
• Realised mortality
• Persistency / policyholder behaviour
• Dynamic hedging of complex guarantees with
  liquid, traded instruments (i.e. swaps,
  futures, options)
• Requires periodic / frequent hedge adjustment
• Net Market Risk Minimized
• Hedging Activity prompted by introduction of new
  regulation (C-3 Phase II Market Risk Requirement
  Nov. 2005)

Investment risks
Insurance risks
GMDB Guaranteed Minimum Death Benefit GMAB
Guaranteed Minimum Accumulation Benefit
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2. Examples of recent pending Innovations

• C Regulatory Reserve Financing (i.e. XXX /
  AXXX reserves)
• Move from pure credit support (i.e. standard 5-7y
  LoCs) to mortality linked credit structures as
  alternative to securitizations
• Resulting credit risk is conditional upon
  underperformance of underlying block (double
  trigger)
• Allows to secure capital support for much longer
  tenors (e.g. 30y) for a similar pricing as 7y
  LoCs
• Requires insurance (mortality / persistency) as
  well as credit expertise

• D Longevity (pending)
• Not much securitization activity to date
• Attempt to create liquid swap market
• Difference in expectation between buyer and
  seller in particular on tenor
• Negative accounting arbitrage for corporate
  sponsors
• Current FTSE 100 pension deficit at Dec.06 is
  38bn from 75bn at Dec.051

1 source Deloitte, FTSE 100 went up 12
during 2006
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3. Requirements for Capital Markets Solutions
Growth

• Risk Standardization (I) Documentation
• Insurance policy / reinsurance treaty vs. ISDA
  Master Schedule
• Lack of standardization introduces basis risk
• Risk Standardization (II) Natural Catastrophe
  Indices
• Indices create liquidity reduce transaction
  costs
• PCS-style market loss reporting for non-U.S.
  perils
• Longevity Indices (relevant and independent)
• Market Consistent Valuation of Risks Reserves
• Reduces arbitrage / creates level playing field
• Facilitates economically motivated hedging
  decisions
• Insurance Rates remain at technical levels
• Capital is not locked into insurance sector
• Will be reallocated quickly, if return
  expectations no longer meet expectations

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3. Requirements Growth (cont.)

• Further educate develop investor base
• Reach for investors beyond cat. / hedge fund
  world
• CDO / ABS investors
• Institutional investors
• Continuous flow of new issues
• Allowing investors to build portfolio
• Economy of scales

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4. Conclusions

• Capital Markets Solutions are well established by
  now
• But more work needs to be done
• Self-enforcing process (supply, liquidity,
  demand, granularity of hedging indices)
• We are only at the beginning
• Basis Risk as an Opportunity for Risk Aggregators
• Wholesale risk transfer to capital markets based
  on parametric / industry triggers
• Basis risk fully priced in and retained where
  expertise is highest
• Likely to become a lesser issue as markets mature
  
• Longevity market expected to explode
• Global Correlation of Mortality Improvement
  greatly reduces Diversification Benefits
• Size of Exposure 19000 bn of global pension
  assets1 (13)
• Set-up of dedicated pension / closed block
  buy-out firms
• 1 OECD, FIAP, IFSL estimates, Dec. 2004

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4. Conclusions (cont.)

• Paradigm Change
• From Claims experience driven capital level and
  variable rates (recuperation)
• To Pro- and retroactively managed capital level
  and stable rates
• And ultimately to
• A Fee-based rather than Risk-based Insurance
  Business Model
• Based on Sourcing, Characterizing, Packaging
  and Selling of Insurance Risks
• With the majority of the Risks transferred to
  investors
• Similar to how banks manage loans, mortgages
  and credit card debt