ART Phillip Petterson Gillian James

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ARTPhillip PettersonGillian James
abcd

• General Insurance Spring Seminar
• 19-20 May 2003
• Scarman House

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ART

• This presentation aims to give an overview of
  ART, however it does not cover all products that
  might be considered to fall under the ART heading
• The opinions presented are those of the authors,
  and do not necessarily reflect the views of the
  Benfield Group

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ART

• No simple definitions of alternative risk
  transfer (ART)
• Originally methods by which companies financed
  part of their insurance risks
• Hard market in the mid 1980s brought serious
  shortages in cover problems with affordability
• Consequently financial reinsurance capital
  market products developed

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ART

• The Art landscape can be divided into the
  following silos
• Alternative Carriers
• Alternative products such as
• Alternative Risk Transfer Products (Cat Bonds)
• Risk Financing Products (Finite structures)
• Hybrid Structures (could be a combination of
  Capital market and traditional reinsurance such
  as a cat option)

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ART (Motivators) 1

• Regulatory or Accounting drivers
• Solvency margin
• Stabilisation of results
• Regulatory arbitrage
• Discounting of reserves
• Taxation
• Transfer of taxable profits / losses to a more
  favoured environment / company
• Use of tax favoured status
• More effective provision of cover
• New sources of capacity and diversification

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ART (Motivators) 2

• Greater customer focus /alignment
• May include risks otherwise uninsurable
• Highly customised to clients specific needs no
  standard solutions
• Integrated risk management
• Better alignment of risk transfer to customers
  financial needs
• Funding rather than transferring
• Locking in terms for more than 12 months
• Greater security of payment
• Credit enhancing by utilising reinsurers balance
  sheet
• Credit enhancing by substituting reinsurer
  balance sheet for cash e.g. Cat Bond

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Traditional View of Matrix of Operating Risks
Non- Traditional Insurable
Financial Risk
Traditional Risk
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Financial Traditional Non-Traditional
Risks Insurable
Risks
Equity Risk Property Risk Price Volatility and
Stabilisation Currency Risk Liability Credit
enhancement Interest Rate Risk Casualty
Risk Residual GAP risk Commodity Risk Employee
Benefits Lease-End risk Credit Risk Business
Interruption Environmental Risks Correlation
Risk Workers Comp Cat Bonds Investment Risk D
O Performance Risk Guarantees Aviation Film
Finance Refinancing Risk
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Metamorphic View Matrix of Operating Risks
Financial Risk
Non-Traditional Insurable
Traditional Risk
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Alternative carriers

• Self insurance (US)
• Captives
• Risk retention groups
• Pools
• Contingent capital

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Self Insurance

• By definition, does not provide risk transfer
• Commonly used in the US for
• Workers compensation
• General liability
• Products liability
• Auto liability
• Property
• US workers compensation and auto liability only
  self insured as regulated programs

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What Is a Captive?

• Insurance or Reinsurance company
• Generally owned through a common interest which
  may or may not primarily be engaged in the
  business of insurance or reinsurance
• All or a significant portion of risks written in
  the captive
• Related to the shareholders
• Third party risks which shareholders may control

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Definition of industry segments that form captives

• Most early captives formed by industrial or
  manufacturing companies i.e. not insurance or
  reinsurance companies
• Other types of captives were industry groups or
  associations, rent-a -captives etc
• Their bespoke needs are different to the
  formation of insurance /reinsurance captives by
  players within the insurance and reinsurance
  arena!

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The common captive drivers and reasons when
captives make sense
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The principle motivators

• The assumption of uninsurable or hard to place
  risks
• Additional retentions in a hard market
  environment
• The creation of a Special Purpose Reinsurer (SPR)
  as a vehicle for capital market proposals such as
  Cat Bonds, Swaps, Options etc (note Tokio
  Millennium Re and MS Frontier Re)
• The assumption of the so called Enterprise
  Risks
• Cash flow reasons (usually related to long tail
  claims)
• To enhance underwriting capacity or to assist
  growth strategy

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The principle motivators

• Other benefits
• Regulatory arbitrage the captive is usually
  able to take advantage of a more flexible
  regulatory environment than that of the home
  domicile, which leads to financial benefits for
  example the creation of equalisation reserves
• Taxation - the captive is able to take advantage
  of a more generous tax environment which can
  bring benefits when accumulating reserves for
  example

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Captives - Tax

• Until 1970, use of captives was very
  tax-efficient
• Since then, tax benefits reduced
• In US premiums to captives with substantial third
  party business are tax deductible
• In most European countries, company must
  demonstrate substantial risk transfer
• Premiums must reflect underwriting risk
• But still a number of tax advantages

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The business the captive may write

• Catastrophe business as long as it does not
  increase the overall correlation
• Non-cat risks currently reinsured externally
  focus on high reinsurer margins and building
  balanced retained risk profile
• Internal LPTs (loss portfolio transfers) which
  move past activities to a more beneficial
  regulatory / tax environment.
• Specific gaps in historic risk protection e.g.
  EMF, RSI, toxic mould, passive smoking

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The business the captive may write

• Any mismatches between original coverage and
  reinsurance where captive might offer DIC (e.g.
  terrorism?)
• PML error and/or reinstatement exhaustion cover
• Write finite prospective risks or retrospective
  risks for example pharmaceutical liability
  business
• Deterioration in guaranteed annuity provisions
• Own insurances (at least current retentions)

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A summary of when does a Captive make Sense?

• Special risk needs
• Cost control center
• Tax efficiency desires
• Regulatory arbitrage
• Increase efficiency by retaining high-frequency
  risks
• Low-risk companies can benefit from their
  superior risk profile

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Interesting Captive Facts!

• Average premium for direct captives US223m
  although the range was from US1m to US1.98bn
• The median premium income US316.5m
• Reinsurance captives average is up from US107m
  to US 131m and the range is estimated to be
  between US5m to US550m
• The median is US15.5m
• It is expected that the direct and reinsurance
  premium volumes will increase by 24

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Risk retention groups

• Introduced in the US in 1986
• Specialised liability insurance companies
• Allow US companies to access liability insurance
• Mainly professional services and healthcare (PI,
  med mal)
• Premium close to USD 1bn

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Pools

• Arrangements between companies to protect against
  very large risks
• Typically organised on a national basis
• Cover a specific risk class
• US workers compensation pools
• Spanish natural catastrophe pool
• Nuclear risk pool in Germany
• UK terrorism pool

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Contingent capital

• Used since 1995
• Deals worth USD6bn written to date
• Provide capital after specific event
• Purchaser has right to sell its securities
• At pre-set price, for fixed period after
  specified event
• Provides capital when it is most needed
• Pre-set price is better than post-event market
• Has been regarded as uncorrelated with other
  investments........

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(No Transcript)
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Alternative products

• Loss Portfolio Transfers (LPTs)
• Adverse Development Covers (ADCs)
• Finite quota share
• Multi-trigger protections
• Multi-year spread loss
• Whole account stop Loss
• Credit securitisation
• Insurance securitisation

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Alternative products

• Multi year and/or multi class
• Complement existing (re)insurance to improve
  efficiency of risk transfer
• Expand range of insurable risks
• New risk classes
• Classes with insufficient market data
• Classes close to business risks and so with
  potential moral hazard risks

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Loss Portfolio Transfers (LPTs)

• Transfer reserves for specific blocks of business
• But this is reinsurance, not novation
• Cedant still ultimately responsible for claim
  payments
• So some credit risk remains
• Policies usually have limit on maximum recoveries
• Policies sometimes have additional features
• sub-limits for specific classes, claims etc
• additional premiums
• profit share
• co-insurance

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LPTs

• Net of inuring - inuring reinsurance deemed
  fully recoverable
• Gross with benefit of inuring protects
  against any irrecoverable inuring reinsurance
• Claims handling may be taken on by reinsurer
• Or claims handling agreements determine how
  cedant will manage claims
• Potential moral hazard if cedant has ongoing
  relationships

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LPTs

• Cedant
• Crystallises future investment income on reserves
• Removes impact or reserve deterioration
• Improves stability in earnings
• Protects solvency
• Retains / enhances credit rating
• May enable MA activity
• Reinsurer
• Receives large premium at outset
• May regard this as inexpensive capital source
• Assumes risk of reserve deterioration up to
  policy limit
• Has benefit of reserve improvements

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Adverse Development Covers (ADCs)

• Protect against reserve deterioration for
  specific blocks of business
• Policies always have limit on maximum recoveries
• Policies may have additional features
• Sub-limits
• Additional premiums
• Profit share
• Co-insurance

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ADCs

• Cedant retains claims handling
• Although reinsurer will impose reporting
  requirements
• Reinsurer may want features to encourage good
  behaviour once attachment point is breached
• Common to see some co-reinsurance or profit share

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ADCs

• Cedant
• Crystallises future investment income on reserves
• Retains benefit of reserve improvements, but
  transfers deteriorations
• Improves stability in earnings
• Protects solvency
• Retains / enhances credit rating
• May enable MA activity
• Reinsurer
• Assumes risk of reserve deterioration up to
  policy limit
• But has no direct benefit from reserve
  improvements
• Rarely assumes credit risk on inuring reinsurance
• May appear expensive compared to LPTs

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ADC example

• Booked reserves 200m
• Company wants to protect against reserve
  deterioration to 300m
• ADC options
• 150m xs 150m
• 100m xs 200m
• 75m xs 225m
• Cedant pays claims to excess, then reinsurer pays
  up to limit

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Finite quota share

• Quota share with finite ceded loss ratio
• May also have loss corridor, in which cedant
  funds claims
• Usually has sliding scale ceding commission
• May be a financing contract
• Commonly used is the US
• Purchased to improve solvency position, or for
  financing benefits
• Under increased scrutiny to ensure appropriate
  risk transfer

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Finite quota share example

• 25 QS
• Claims ceded up to 125 loss ratio
• Sliding scale commission
• Maximum 30, for loss ratios lt 70
• Reduces by 0.5 for each 1 by which loss ratio
  exceeds 70
• Minimum 15

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Multi-trigger protections

• Multi-trigger payments for insurance losses are
  only made if a second event is triggered
• Second event often linked to index outside
  influence of policyholder
• Choice of index may cause accounting issues for
  US companies (FASB 133, embedded derivatives)
• Often discussed, rarely achieved!

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Multi-year spread loss

• Insurer pays annual premium for specific coverage
  e.g. multi-peril cat
• Premiums less margin credited to experience
  account balance (EAB)
• Claims paid in first instance from EAB
• When EAB is exhausted, reinsurer pays
• May be profit or loss shares at end of term
• Funds transferred or funds withheld

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Multi-year spread loss example

• 4 year term
• Annual premium 3.5m
• Payable 0.5m 1/1 and 3.0m 15 months later for
  Y1
• Payable in full 1/1 for subsequent years
• Annual limit 10m, term limit 30m
• 30 AP payable on the second limit, 50 on third
  limit
• Can be cancelled at 12 months if loss free, with
  no further premium payment
• So clean price is 0.5m p.a.
• Accounting benefit for first (total) loss is
  6.5m (65)
• Nominal risk transfer is 8m

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Multi-year spread loss

• Often purchased for large, infrequent
  catastrophes
• Provides cashflow relief, results smoothing
  following single major loss, risk transfer in the
  event of multiple major losses
• Typically cheaper than traditional market if
  contract is loss free
• Available where traditional reinsurance is
  unavailable e.g. for retrocession
• Can be purchased to protect a number of classes,
  for example property, marine and aviation
• Accounting treatment may reduce balance sheet
  benefit

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Stop Loss - Key Features

• Potential for multi line, whole account coverage
• Versatile structure allows protection of multiple
  trading entities
• Ability to achieve multi year coverage
• Significant profit share/loss share incentives to
  cement long term relationships
• Potential for low attachment to achieve
  discounting benefits
• Variable limits, variable attachment points
• Funds transferred or funds withheld
• Scaling of coverage to annual premium volumes

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Example Contracts - Features
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Example Contract - A
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Example Contract - B
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Example Contract - C
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Example Contract A - Graphical View
Contract A, 107 net loss ratio
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Credit securitisation

• Credit securitisation structures a portfolio of
  credit risks into layers
• Each layer has its own credit rating
• Highest layer may be AAA
• Lowest is equity layer
• In event of a default, lowest layer utilised
  first
• By 2001 notional principle was USD1,200bn
• Market has been hit in 2001 / 2002 by increased
  default rates
• IAS phase 1 (2005) credit risk transfer will no
  longer be accounted as (re)insurance

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Insurance securitisation

• Transfer reinsurance risk into capital markets
  via a bond issue
• Most issues to date are catastrophe or life
  bonds
• If the specified risk is triggered, bondholders
  forfeit interest and principal on bond to insurer
• Often achieved by placing reinsurance with
  special purpose vehicle (SPV) that then issues
  bonds
• Removes credit risk from reinsurance
• Frictional costs are high
• Traditional reinsurance often cheaper

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Securitisation cat bond triggers

• Trigger may be parametric, modelled loss or
  indemnity based
• Parametric
• Based on objective measurable variable
• Leaves basis risk with cedant
• Less disclosure about cedant
• Modelled loss
• Based of modelled impact of trigger event on
  pre-identified portfolio
• Leaves some basis risk with cedant
• Requires substantive disclosure about cedant
• Indemnity
• Based on actual cedant loss
• No basis risk
• Required greatest disclosure about cedant

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Accounting complications
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Accounting

• To justify treatment as insurance/reinsurance -
  requires transfer of significant insurance risk
• Transfer of significant insurance risk requires
  both
• Reasonable possibility for insurer to suffer
  significant loss
• Reasonable possibility of significant range of
  outcomes
• Significant - assess in context of
• Commercial substance of contract as a whole
• Range of outcomes reasonably expected in practice
  (not full range of possible outcomes)
• Assessment must be on an NPV basis

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Accounting

• Insurance risk - comprises either or both
• U/w risk - uncertainty of occurrence/amount of
  loss
• Timing risk - uncertainty re timing of claim
  payments
• Not sufficient if insurer only receives a
  lenders rate of return under all reasonably
  possible scenarios
• Assessment of contract performed prospectively

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Accounting - US Regime

• Guidance in FAS 113 - Accounting and reporting
  for reinsurance of short-duration and
  long-duration contracts
• To qualify as reinsurance
• reinsurer must assume significant insurance risk
• must be reasonably possible for reinsurer to
  realise significant loss
• Timing risk alone is not sufficient (i.e. tougher
  than UK)
• Significance of loss assessed on PV of cash flows
  under the contract
• Different accounting treatment for prospective
  and retroactive reinsurance
• EITF 93-6 Accounting for multi-year
  retrospectively rated contracts. Deals with
• Additional premiums payable by cedant due to loss
  experience
• Payments to cedants due to favourable loss
  experience
• Changes in contract coverage

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Accounting
Treat as
Insurance contract
Yes
Significant transfer of risk
No
Financing contract
If there are distinct and separable insurance and
financing elements, split into two parts for
accounting - bifurcation
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Comparison of deposit and reinsurance accounting
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International Accounting Standards (IAS)

• IAS to be used by all European listed companies
  by 2005
• Currently no reporting standard for insurance and
  insurance contracts are exempt from existing
  standards
• Latest guidance is the Draft Statement of
  Principals (DSOP)

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IAS why does it matter to ART?

• ART is often about arbitrage between
  accounting/regulatory/economic effect
• IAS will introduce a new accounting basis for
  valuing insurance assets and liabilities
• Existing International standards, say on
  consolidation, already have an impact (SPVs)
• Treatment of credit protection

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Securitisation

• A brief overview

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The Emergence of Insurance Securitisation has
highlighted the following concerns!

• Will Capital Market products be in the long run,
  superior to conventional reinsurance?
• And
• Could it replace traditional reinsurance?
• In BG view it is not an issue of either or, but
  the concept must be seen as a tool of the risk
  financing spectrum and therefore its use will be
  determined by client needs.

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Convergence of Insurance and Capital Markets

• Many of todays products are hybrids combining
  insurance risk with capital markets techniques
• A modern Broker must not only provide know how
  over the different traditional insurance lines
  but also offer capital markets expertise

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Convergence of Insurance and Capital Markets -

• available products
• Traditional reinsurance
• Finite Reinsurance
• Double Trigger Covers
• ILWS
• OTC Cat Swaps
• Securitisation
• Exchange traded Cat Options
• Contingent Capital arrangements

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- Integrated Concept -
Return period or exposure
? 100
ART
75-100
Financial Re Spread Loss
15-75
Traditional Reinsurance
5-15
Financial Re Funding / Working Layers
Retention
5
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Identify and understand the underlying objectives
driving a need for Securitisation.

• Capacity creation and or enhancement
• Arbitraging capacity and or price inefficiencies
• Profit smoothing by locking in price capacity
• Eliminate Counterparty risk
• Alternative to traditional capacity
• A non indemnity structure facilitates cash flow
• Maximisation of shareholder wealth
• Balance sheet constraints or enhancement
• Market maker / leader

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Establish any underlying issues with regard to

• The public disclosure of information
• Volume of underwriting information required
• Accounting, Tax Regulatory issues.
• Legal implications (prospectus)
• Level of risk transfer required
• Trigger structure and Basis risk
• Rating Agency considerations
• Cost considerations
• Model creation and validation.

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Evaluation of competing products
Traditional Reinsurance (Price
,capacity,period) Finite structured
alternatives Catastrophe options Other contingent
capital products. Blended solutions of
traditional/options etc.
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A Typical function a broker may perform

• Analysing the risk iro
• Determining probability of loss for single event
  risk
• Determining probability of multiple losses
• Stress test assumptions
• Compare estimated loss with credit default models
• estimate return required for investors (premium).

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Excedance Probability Curve
Annual Probability of Excedence
Probability of Attachment
Expected Loss to XOL Layer
Probability of Exhaustion
Portfolio Loss
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Sample Transaction Pricing
Cumulative Probability Exhausting
Spread to Libor
Expected Loss
Probability Attaching

• 70 C 26.70 2.22 17.7 B to BB
  600-650
• 70 B 2.22 0.04 1.4 BBB to A
  90-150
• 60 A 0.04 0.00 0.005 AAA
  50-100
• 200 Total Total Expected Loss 6.79
  260-315

National
Tranche
Rating
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Overview of Risk Assessment
Analytical Models
Databases
Input Data
Windstorm Database
Stochastic Techniques
Type of Analysis
Hazard Module
Earthquake Database
Building location information
Vulnerability Damage Module
Vulnerability Actual damage Databases
Values at Risk Insurance Structure
Financial Analysis Module
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Modeling Considerations

• Examples
• Peril(s) Covered 2003 Hurricane / Windstorm
• Geographic Region(s) Covered Florida / Germany
• Total Coverage/Limit 54M (90 of 60M)
• Type of Trigger Indemnity Losses / Parametric
• Underlying Portfolio US Hurricane/Country
  Portfolio
• Trigger Attachment Point 70M
• Duration 1 year or multiple years
• Reset Mechanism Post-event Reset of Terms
• Rated/Non-rated Rated (Moodys, Fitch)
• Instrument Bond / Option

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Modeling Challenges

• Feasibility analysis
• Definition of underlying exposure data
• Limiting exclusions
• Catastrophic loss vs background loss
• Secondary uncertainty and demand surge
• Timing
• Reset and drop downs

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Integrating additional resources into the time
frame
Rating Agency Review (2-6 weeks)
Modelling (2-6 weeks)
Investor Interface (2-6 weeks)
Post-Analysis Involvement (ongoing)
Data Audit, Verification, Preparation (variable)
Feasibility Analysis (3-6 weeks)
Offering Memorandum (variable)
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Designing a Suitable Structure

• A Reinsurance contract with a Special Purpose
  Reinsurer (SPR) would be placed
• The SPR would hedge itself in the Capital
  Markets
• Evaluate if the risk could be placed with
  different investors E.g.- First loss could be
  placed privately- Second third losses as part
  of a rated program

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Designing a possible Transaction Structure
Financial Instrument(s)
Cedant
Cash or Collateral
SPR
Reinsurance Contract Premium
Funds
Floating Return
Trust
Swap Counterparty
Investment Income
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Placement Options Available

• Private Placement
• Market read to verify pricing
• Determine whether funds required
• Unfunded Swap Option - Collateralised by
  letter of credit
• Funded Insurance Linked Securities Route -
  Identify potential investors and merchant
  Banking Partner