page 1 retrocession vs. alternative markets in managing a reinsurers accumulations natural disasters...

Retrocession vs. Alternative Markets in Managing a Reinsurers Accumulations

Natural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re

Initial Summary


There is an ample supply of capital to service the catastrophe capacity requirements of any emerging market

Emerging markets present an attractive opportunity for further reinsurance or ART market diversification

It makes long term economic sense for any developing economy to take advantage of this capital

Agenda

Introduction

– Some key points

Interpretation of who a “National Reinsurer” might be

Transfer mechanisms for attaining Nat Cat capacity and diversification

– Traditional reinsurance/retrocession

– Alternative market solutions

SummaryNatural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re

Introduction

Swiss Re is a large Global Property, Casualty, and Life Reinsurer with over 29 Bn (CHF) earned premium volume.

In addition to traditional reinsurance Swiss Re has been a leader in facilitating Alternate Risk Transfer (ART) solutions including being active in the development of the insurance linked-securities (ILS).

Swiss Re has sponsored independent studies throughout the world and has dedicated internal resources into researching natural catastrophes

Swiss Re has partnered with many non-profit organizations in making our expertise and experience available to support governments and society in developing strategies to mitigate the effects of natural disasters

Progressive failure onthe North Anatolian fault- Ross Stein USGS


Key Points

There is an ample supply of capital to service the catastrophe capacity requirements of any emerging market

This capital can be accessed through traditional Reinsurance, Retrocession or through various Alternative Risk Transfer markets including the Capital Markets


Emerging markets present an attractive opportunity for further Traditional or ART market diversification

There are only a few regions

where the the peak amount of traditional reinsurance may be too concentrated

Throughout most of the

world the opportunity to diversify

is attractive and cost

effective to resinsurers

and cedants alike

Key Point - Capacity at need?

TC Atlantic (*)

EQ California (*)

WS UK

TC Japan

EQ Japan

EQ New Madrid (*)

EQ Canada

WS France

EQ Australia

EQ Italy

EQ Mexico

WS Germany

EQ Portugal

EQ Columbia

EQ Israel

WS Netherlands

EQ South Africa

WS Belgium

World wide coverage(*) Estimated split based on SR book

Ideal level reinsurance would take for optimal diversification

World wide peak risks are an issue for the reinsurer prompting their need for more diversification and required capacity.

Peak risks would ideally be ceded to capital markets, which are better able to diversify these risks

Source: Swiss Re

There is approximately $24 Billion US in available catastrophe capacity

Approximately $3 Billion in Insurance Linked securities


Key pointIs there sufficient cat capacity available?

The availability of traditional Natural Hazard catastrophe capacity is basically a function of:

– Accessible capital compared to exposed equity loss potential

– Realized rate vs. expected loss, expenses and cost of capital

– Diversification and appetite for “peak” risk in relation to the above

expected loss based on loss experience, underwriting expertise and application of sophisticated cat models

External costs (commission, brokerage)

Expected profit before tax

Earned premiums

Internal expensesTaxes

Economic profit

Expected profit after tax

Minimum price covering all fixedor expected costs = “technical price”

Cost of Capital


Traditional reinsurance protocols

suggest that reinsurers use retrocession covers to expand capacity, diversify, and reduce

exposures

Interpretation of who can act as a “National Reinsurer”

Property Owner

Insurance Company or Insurance Pool

Local Reinsurer

Reinsurer

Reinsurer

National Government

World Bank

Insured

Insurance Policy

Reinsurance treaty

Retrocession

Retrocession

In the current environmentany one of these entities could act as a National

Reinsurer and seek reinsurance,retrocession, or alternative risk

transfer support

A National Government often acts as a reinsurer of last resort


Insurance Company

Reinsurer

Reinsurer

Reinsurer

National Government

World Bank

Insured

Capacity and Diversification

There are two main reasons for seeking Retrocession or Alternative Market

Support Reduce loss potential

Increased need for capacity - expand the capital base in situations where the potential loss exceeds the financial capability of the risk bearer to absorb losses

– Sharing/expanding of capital increases the insurer/resinsurer’s ability to absorb additional risk

Diversification of exposure - the ultimate goal of insurance and reinsurance is to spread the risk.

– Diversification leads to more efficient pricing, increased capacity, stability, and sustainability

There are two main reasons for seeking Retrocession or Alternative Market

Support


Turkish Catastrophe Insurance Pool - TCIP

Insurance Pool - TREIP

Indonesian EarthquakeReinsurance Pool - IERP

EQ Council - EQCNew Zealand

California Earthquake Authority - CEA

Alternative Risk Transfer Markets

What are they?

Risk Carriers• Self insurance / captives• Risk retention groups• Pools• Captive markets

Solutions• Finite Risk re-insurance• Contingent Capital• Multi-year / Multi-line products (MMP)• Multi-trigger products (MTP)• New Asset Solutions• Weather Derivatives• Securitization / Insurance-Linked Securities (ILS)

Alternative

Risk Transfer


Alternative Market Solutions

Finite Risk re-insurance

– Smoothing mechanism where risk transfer, financing and the time value of money is emphasized

Contingent Capital

– Contractual commitment to provide capital in the form of senior debt, etc. after an adverse eent

Multi-year / Multi-line products (MMP) Multi-trigger products (MTP)

– Consolidate and combine uncorrelated risks with a trigger that is highly correlated to financial circumstances


New Asset Solutions (Structured Finance / Asset backed Securities)

– Raising capital through the securitization of future cash flows

Weather Derivatives

Securitization / Insurance-Linked Securities (ILS)

– Innovative way of increasing insurance capacity by accessing the capital markets via bond issue. Capital received is transferred to a special purpose vehicles SPV who then acts much like a traditional reinsurance company.

– Most ILS are natural catastrophe driven due to the ease and transparency of identifying, isolating, understanding, evaluating the risk

Securitization / Insurance-Linked Securities (ILS)

Alternative Market Solutions


Insurance Linked Securities

Cedant Reinsurer

Premium

Cat Cover

Bond Investors

Special Purpose Vehicle(SPV)

Bond Coupon

Bond Proceeds

Traditional reinsurance or retrocession is an exchange of premium for a transfer of risk cover. In all but a few of the “peak” exposed areas of concentration, reinsurance is still considered as the most economical and efficient risk transference of choice.

The majority of ILS transactions to date have involved catastrophe bonds. Typically three parties are involved. Investors purchase bonds from the SPV which simultaneously enters into a reinsurance contract with the cedant. The sole purpose of the SPV is to engage in the business relating to the securitization.

One of the main differences is that a traditional reinsurance program’s pay out is activated by the cedant’s actual sustained losses. An ILS limit is paid immediately upon the occurrence of a predetermined trigger and is priced according to the limit and event exceeding probability.


Retrocession or ART

Increase surplus/capacity to assume risk

– Corresponds to the ability to increase volume

Reduce risk

– Transfer loss potential to another

Stability

– Mitigate fluctuations in revenue or growth

Diversify portfolio

– Optimize return/loss levels

In many ways the same motivation exists for purchasing a retrocessional cover or ART product


Acceptance of ILS

On top of a $2 Bn existing portfolio in 2002

To date most ILS transactions are in regions with high severity, low frequency, peak exposures, and further need for diversification


Combined Art and Traditional in Peak Exposed Areas

CEA $6,611 billion

Post EQ

Industry Assessments

Second Cat Bond/Contingent

Transformer Layer Multi Layer Cat

Reins. Contract

Line of Credit

Revenue Bond Layer

First Cat Bond/Contingent

Reins. 1st Layer

Post earthquake

Industry Assessments

CEA Capital

$2,183

$717m

$600m

$617m

$200m

$1,456

$400m

$100m

$338m

Coverage A$600m xs $2,9bFirst R/I Layerie- traditionalSold ROL 8.80%

Coverage BContingent Second$400m xs $3.5bSold ROL 7.25%

Coverage CContingent Fourth$338m xs $4,817bSold ROL 5.15%

Reinsurers must write the same sharein Covgs A, B and C

Often an ILS is combined with traditional reinsurance and retrocession in order to expand capacity and diversification


Expected Loss and Realized Return or Selected Insurance-Linked Securities and Swaps

Indicative technical reinsurance pricing for peak cat areas


In most cases the

ILS is more costly then

a traditional

cover

Some comparison features of ART vs Traditional to an Emerging market

Features ILS Traditional

Limits of insurability

Increases capacity especially in peak areas & independent of insurance

cycle

Perceived avoidance of low frequency and high severity

events

DiversificationCapital markets are uncorrelated to

insurance - improving portfolio diversification

Areas of peak exposure have high areas of insurance concentration

Counterparty credit risk

Investment grade securities held as collateral servicing only specified

contract

Ratings uncertain especially during times of industry duress or

extreme events

Multi-year contracts

Multi-year programs of up to 10 years have been issued

Natural catastrophe programs typically run for one year

Flexible Loss trigger

Three types, indemnity (cede sustained loss), index (industry loss)

or parametrc (physical event characteristic)

Tyically indemnity based but can be somewhat flexible

Activation of cover

Based on trigger regardless of actual claims

Paid on development of cede losses

DataFlexible - pricing based on coverage

limit and event probabilities

Requires - pricing based on expsoure data as well as limit

and event proabilites


Concluding observations - Emerging Markets

Source: Swiss Re

Local Reinsurance and insurance markets are underdeveloped making the government a reinsurer of last resort - exposures hard to identify

– Developing Risk awareness, transfer and mitigation strategies

Low frequency/high severity events could endanger the financial being of the local reinsurer or state

Low country GDP - actual loss devastating in terms of % GDP and future sustainability

Need for immediate post event liquidity

High capital demands for necessities

Makes economic sense


Example*

GDP $13.7 Bn .(2001)

5 earthquakes in the last 20 years1986 $2.3 Bn (US)

2001 $1.7 Bn (US)

Other losses $ . 4 Bn (US Total $4.4 Bn

Average Loss $ 220+ Million per year

Maximum Loss $2.3 Bn

What if?Country hedges itself through traditional or ART markets by purchasing a $2.5 Bn cover with a $100 MM retention

Pure risk premium $28 MM per annumAnnualized deductible $20 MMCapital and other costs ??

Pure risk premium $28 MM per annumAnnualized deductible $20 MMCapital and other costs ?? $14 MM

Average Loss $ 60 Million per year

Maximum Loss $100 MM

* Not an offering or exact analysis

Final Summary

There is an adequate supply of capital to support the catastrophe capacity needs of the merging markets

Reinsurance/Alternate Risk Transfer mechanisms promote financial sustainability by reducing economic volatility due to Nat Cat shock losses

Both the Traditional and Capital segments offer a variety of solutions and are eager to diversify into new cat markets.

Reinsurance makes economic senseNatural DisastersWorld Bank - June 2-3Andrew Castaldi - Swiss Re

page 1 retrocession vs. alternative markets in managing a reinsurers accumulations natural disasters...

Documents