Abstract
One of the most significant economic developments of the past decade has been the development of innovative risk-financing techniques in the insurance industry. Innovation has been driven by the increase in the frequency and severity of catastrophic losses, capital management needs in the life insurance industry, market inefficiencies created by (re)insurance underwriting cycles and regulation, advances in computing and communications technologies, and other factors. These developments have led to the development of hybrid insurance/financial instruments that blend elements of financial contracts with traditional reinsurance as well as new financial instruments patterned on asset-backed securities, futures, and options that provide direct access to capital markets. This chapter provides a survey and overview of the hybrid and pure financial markets instruments, not only emphasizing CAT bonds but also covering futures, options, industry loss warranties, and sidecars. The chapter also covers life insurance securitizations executed to provide capital release, respond to reserve regulations, and hedge mortality and longevity risk.
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Notes
- 1.
Although there is also a growing literature on mathematical/financial pricing models for insurance derivatives, this literature is outside the scope of this literature review. For example, see Aase (2001), Bakshi and Madan (2002), Grundl and Schmeiser (2002), Lee and Yu (2007), Egami and Young (2008), Muermann (2008), and Wu and Chung (2010). We briefly discuss pricing models in Sect. 20.3.
- 2.
A practitioner perspective on insurance-linked securities is provided in Albertini and Barrieu (2009).
- 3.
- 4.
Triggers are discussed in more detail below, especially in Sect. 20.5.5.3.
- 5.
This finding is consistent with Major (1999), who, using simulation analysis, finds that contracts based on zip-code level loss indices provide better hedges than those based on statewide data.
- 6.
- 7.
These costs are discussed and modeled in more detail in Froot et al. (1993).
- 8.
- 9.
For example, RMS developed the Miu Platform, a computer progam to facilitate ILS portfolio and risk management, and in 2012 introduced the Miu Pricing service, a collection of reports and metrics to help ILS investors make better investment decisions.
- 10.
The classic complete markets pricing model involves a replicating strategy. For example, for options, the standard option on a stock is replicated using a portfolio with cash (risk-free securities) and the stock itself. Consequently, a replicating strategy could be utilized if there were a liquid market in the underlying risk. For most types of insurance-linked securities (e.g., Cat bonds, mortality-linked bonds), it is difficult to envision a market in the underlying risk. However, a replicating strategy could be used for more complex options if there were highly liquid markets in at least two insurance-linked derivatives, such as Cat bonds and options. Given the world-wide growth in exposure to catastrophic property and mortality risk, it is not difficult to envision the development of liquid markets in both insurance-linked bonds and options.
- 11.
Risk transfer is less important in life than in nonlife insurance because life insurance is a relatively stable business with a significant savings component. The nonlife reinsurance market is about three times as large as the life reinsurance market in terms of premium volume (Swiss Re 2012b).
- 12.
- 13.
The rate-on-line measures the price of XOL reinsurance as the ratio of the reinsurance premium to the maximum possible payout under the contract.
- 14.
The loss-on-line is the expected loss on the layer expressed as a percentage of the maximum possible payout.
- 15.
Insolvency aversion arises because insurance pays off when the marginal utility of customer wealth is relatively high and because insurance customers face higher costs of diversification of insured risks than investors in traded financial assets (Merton 1995).
- 16.
The rules governing the deductibility of premiums paid by a parent corporation to a captive are complex. However, premiums now appear to be deductible for captives with a “sufficient” amount of business covering firms other than the parent, captives that cover other subsidiaries owned by the same parent, and group captives jointly owned by several parents. For further discussion, see Wohrmann and Burer (2002) and Swiss Re (2003).
- 17.
The original captives were single-parent captives, which insured only the risks of the parent corporation. The market evolved to include profit-center captives, which also assume risks from unrelated third-parties. Group and association captives insure the risks of several firms from the same industry or association. Insurance intermediaries offer rent-a-captives to insure the risks of smaller firms. The most recent form of the rent-a-captive is the segregated cell captive, which provides stronger legal protection for firms in a multiple-parent captive.
- 18.
RRGs were authorized in the Liability Risk Retention Act of 1986. The law contains a regulatory pre-emption provision that permits RRGs to write policies for member-owners nationwide after meeting the licensing requirements of the RRG’s state of domicile. RRGs can write all types of commercial casualty insurance except workers compensation (Business Insurance, September 5, 2011).
- 19.
The term “finite” reinsurance is somewhat misleading in that conventional reinsurance is also finite, i.e., subject to policy limits, deductibles, etc. Nevertheless, the term does express the idea that the intent of the contract is to provide more limited risk transfer than under conventional policies. In several jurisdictions internationally, finite reinsurance must transfer significant underwriting risk to receive regulatory, tax, and/or accounting treatment as reinsurance. In the USA, the relevant GAAP accounting rule is SFAS 113 (Financial Accounting Standards Board 1992). For further discussion, see Swiss Re (1997, 2003).
- 20.
Other types of finite reinsurance include finite quota share reinsurance, which involves the proportionate sharing of the premiums and losses of a block of business. This serves a financing function for the ceding insurer, enabling it to recover the prepaid underwriting expenses on a block of business, thus reducing its leverage ratio.
- 21.
The OBS feature of these contracts runs afoul of U.S. GAAP accounting rules. Under FASB 113 and EITF 93-6, U.S. insurers must show positive account balances as assets and negative balances as liabilities unless there is no contractual obligation to repay negative balances, mitigating the smoothing aspects of the contract for U.S. firms.
- 22.
The convictions are presently being appealed.
- 23.
The rules regarding risk transfer in U.S. GAAP were originally expressed in FAS 113 and EITF 93-6, both issued in 1993. FASB codified the rules in 2009, and most rules regarding risk transfer are now found under FASB Accounting Standards Codification (ASC) Topics 944 and 340. In practice, FAS 113 was supplemented by the so-called 10–10 rule, which requires at least a 10% probability of a 10% loss for legitimate reinsurance. Because the 10–10 rule holds that many high level catastrophe reinsurance contracts would not constitute risk transfer, it has been expanded in practice by the “product rule,” which looks both at loss probability and loss amount (Munich Re 2010). If reinsurance does not involve legitimate risk transfer, according to U.S. GAAP, it is treated as a deposit, with no effect on underwriting results. Related regulatory rules include the NAIC’s Statement of Statutory Accounting Principles (SSAP) 62 in the U.S. and the European Union (EU) Directive 2005/68/EC in Europe.
- 24.
RXLs are most important under occurrence-based liability policies, where coverage is provided during a specified period (the accident year) and claim settlement covers a lengthy period of time following the end of the coverage period. At the end of the accident year, the majority of claim payments has not been made but can only be estimated, leading to the creation of the loss reserve. The process through which the reserved claims become payments is called loss reserve development, and RXL contracts protect against adverse loss reserve development.
- 25.
If developed losses incurred exceed the retention (strike price) specified in the contract, the cedent receives payment from the reinsurer to partly defray the costs of the adverse development. The reinsurer may assume some liability in the event that one or more of the cedent’s other reinsurers default.
- 26.
ILWs were the first index-based insurance contacts, introduced during the 1980s (Swiss Re 2009b).
- 27.
Insurance regulators sometimes object to non-indemnity products on the grounds that they expose insurers to excessive basis risk and potentially can be used for speculation rather than hedging.
- 28.
Several important contractual provisions must be defined in an ILW, such as the geographical regions and perils covered. The contract also specifies the warranty, i.e., the magnitude of the index that triggers payment, the size of the indemnity trigger (e.g., $10,000), and the maximum limit of coverage (e.g., $10 million). In addition, the contract must specify the index that triggers the contract, such as one of the Property Claims Services (PCS) indices. Index triggers are usually binary, whereby the contract pays 100% of value once losses breach the warranty, but can be pro rata, whereby the contract pays proportionately based on how much the index exceeds the warranty.
- 29.
The market has expanded to include the so-called cold spot ILWs, which are reinsurance derivative contracts that trigger on industry loss estimates for nonpeak risks such as New Zealand earthquakes.
- 30.
Sidecars can also be “market-facing,” i.e., directly issue reinsurance to third-parties other than the sponsoring reinsurer. Some industry observers question whether such structures are true sidecars (Sclafane 2007).
- 31.
Source, Federal Reserve Flow of Funds Accounts, as of December 2011. Securities include all credit market debt outstanding plus the value of corporate equities.
- 32.
Froot’s estimates are based on data for 1994, with losses expressed in 2011 price levels.
- 33.
Insurers can and do raise significant amounts of equity capital following large loss shocks such as Hurricane Andrew, Hurricanes Katrina, Rita, and Wilma, and the Financial Crisis of 2008–2010 (Cummins and Mahul 2008; Berry-Stölzle et al. 2011). However, this tends to be capital to support their ongoing insurance operations rather than capital to be held in anticipation of large catastrophic events.
- 34.
- 35.
An example of a contingent debt transaction is the $500 million Farmers Insurance Group transaction in 2007, which gave the insurer the option to issue loan notes at a fixed price to a group of banks, triggered by a Texas, Arkansas, Oklahoma or Louisiana windstorm loss of at least $1.5 billion. The deal represented the first time a commercial bank had cooperated with a reinsurer to provide regulatory capital for an insurer and in doing so assumed the subordinated credit risk of the insurer and catastrophe risk.
- 36.
The task of educating insurance industry professionals in the use of options is likely to be somewhat more difficult than for many of the other financial instruments discussed here. Sidecars, ILWs, and Cat bonds all have features that closely resemble reinsurance, whereas options are pure derivative contracts that are less familiar to insurance industry participants. The same is probably true as well for swaps. Nevertheless, the other concerns mentioned are probably more important than lack of insurer expertise in explaining the slow take-off of Cat options.
- 37.
Although ELFs generally resemble ILWs, they do not contain an indemnity trigger, and traders do not need to have underwriting exposure in order to utilize the contracts.
- 38.
Because of the “1st event-binary” feature, the contact would not pay off if two catastrophes occurred, one causing damage of $5 billion and the next causing damage of $6 billion. If the 1st event contract is triggered, the insurer could obtain additional protection by purchasing 2nd event contracts.
- 39.
The NYMEX contracts have an annual coverage period, while the CME contracts cover the hurricane season (June 1 through November 30).
- 40.
Cat bonds can also be securitized through collateralized debt obligations (CDOs), which in theory do not have the “cliff risk” posed by principal-at-risk Cat bonds (Forrester 2008). However, the recent problems in the CDO market and the general complexity and lack of transparency of CDOs relative to Cat bonds raise questions about the role of CDOs in financing catastrophe risk.
- 41.
Volume is defined as the principal of the bond issuance and hence equals the amount available to pay losses covered by the bonds. The data in the figure apply to nonlife Cat bonds. Event-linked bonds have also been issued to cover third party commercial liability, automobile quota share, and indemnity-based trade credit reinsurance.
- 42.
Shelf registrations (offerings) have played an important role in reducing the transactions costs of issuing Cat bonds. First implemented in 2002, shelf offerings allow sponsors to create a single set of offering documents summarizing the general characteristics of an offering, which then provide the basis for issuing additional bonds (takedowns), up to a maximum limit over the course of a stated risk period. In addition to enabling sponsors to spread the fixed costs of a transaction over multiple issues, shelf offerings also allow sponsors to access capacity on an as-needed basis, rather than having to make an estimate of their capacity needs several years in advance. Cat bond investors tend to view shelf offerings favorably as they tend to be a reliable source of transaction flow and increase investor confidence by building up a track record of successful transactions (MMC Securities 2007).
- 43.
Some Cat bond issues have included principal protected tranches, where the return of principal is guaranteed. In this tranche, the triggering event would affect the interest and spread payments and the timing of the repayment of principal. Principal protected tranches have become relatively rare, primarily because they do not provide as much risk capital to the sponsor as principal-at-risk bonds.
- 44.
In modeled industry triggers (“MITs”), industry index weights are set post-event (Swiss Re 2009b).
- 45.
- 46.
Lane and Beckwith (2008) find a long-term spread ratio ranging from 2.33 to 2.69, reinforcing this conclusion.
- 47.
Direct comparisons of Cat bond and reinsurance pricing are somewhat difficult due to the different characteristics of Cat bonds and reinsurance contracts. Most Cat bonds provide multiple year coverage, whereas reinsurance contracts typically cover only 1 year. Therefore, Cat bond prices are expected to including a pricing premium to compensate investors for their inability to reprice annually. On the other hand, reinsurance prices are likely to incorporate a premium for the reinstatement provision contained in most reinsurance contracts, whereas most Cat bonds are not subject to reinstatement. Other contractual features also may lead to price differences.
- 48.
A description of Cat bond deals is provided at the following link: http://www.artemis.bm/deal_directory/.
- 49.
The 1999 breakdown is based on unpublished data from Swiss Re.
- 50.
Life ILS data are from Leadenhall Capital Partners. Nonlife data are from Swiss Re (2012a).
- 51.
Putting this £2 trillion risk in context, U.K. life insurers collected £138.3 billion in premiums in 2010 and had equity capital of about £80 billion (Swiss Re estimate). Hence, it would not be feasible for insurers to manage longevity risk solely by raising equity capital. Worldwide, the life insurance industry had premium volume of $2.5 trillion and equity capital of $1.4 trillion (Swiss Re 2011c). Raising large amounts of equity capital not needed for current operations is not cost effective for insurers, as explained above.
- 52.
For example, the French prospective life tables were updated in 2006, replacing the previous set of tables from 1993. The resulting disparities between the 1993 prospective tables and observed longevity caused French insurers to sharply increase their reserves by an average of 8%.
- 53.
The term q-forward was adopted because q is standard actuarial notation for the probability of death.
- 54.
The first publicly announced index-based mortality swap was completed in 2008 between J.P. Morgan and SCOR. The first index-based longevity swap was completed in 2008 between J.P. Morgan and Lucida (Swiss Re 2009b).
- 55.
In November 2004, the European Investment Bank (EIB) attempted to launch an offering of longevity bonds to hedge longevity risk for pension funds and annuity providers. The deal failed due to insufficient demand.
- 56.
Capital markets investors prefer short-dated notes or highly liquid long-dated notes. The financial crisis strengthened these preferences. To develop a market in long dated longevity risk, true market making must be developed, and the question of collateral becomes even more important.
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Cummins, J.D., Barrieu, P. (2013). Innovations in Insurance Markets: Hybrid and Securitized Risk-Transfer Solutions. In: Dionne, G. (eds) Handbook of Insurance. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-0155-1_20
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DOI: https://doi.org/10.1007/978-1-4614-0155-1_20
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