Abcd ART Phillip Petterson Gillian James General Insurance Spring Seminar 19-20 May 2003 Scarman...

ART

Phillip PettersonGillian James

General Insurance Spring Seminar

19-20 May 2003

Scarman House

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

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 1980’s brought serious shortages in cover & problems with affordability

Consequently financial reinsurance & capital market products developed

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)

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

ART (Motivators) 2

Greater customer focus /alignment May include risks otherwise “uninsurable” Highly customised to client’s 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

FinancialRisk

TraditionalRisk

Non-TraditionalInsurable

Traditional View ofMatrix of Operating Risks

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 Worker’s Comp Cat Bonds

Investment Risk D & O Performance Risk

Guarantees Aviation Film Finance

Refinancing Risk

FinancialRisk

TraditionalRisk

Non-TraditionalInsurable

Metamorphic ViewMatrix of Operating Risks

Alternative carriers

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

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

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

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!

The common captive drivers and reasons when captives

make sense

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

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

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

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

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)

A summary of “when does a A summary of “when does a Captive make SenseCaptive 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

Interesting Captive Facts!

Average premium for direct captives US$223m although the range was from US$1m to US$1.98bn

The median premium income US$316.5m Reinsurance captives average is up from US$107m

to US$ 131m and the range is estimated to be between US$5m to US$550m

The median is US$15.5m It is expected that the direct and reinsurance

premium volumes will increase by 24%

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

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

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........

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

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

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

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

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 M&A 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

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

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

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 M&A 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

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

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

Finite quota share example

25% QS Claims ceded up to 125% loss ratio Sliding scale commission

Maximum 30%, for loss ratios <= 70% Reduces by 0.5% for each 1% by which

loss ratio exceeds 70% Minimum 15%

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!

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

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

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

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

Example Contracts - FeaturesFeatures scales as a percentage of net premium income

- so can accommodate changes in business volumes

• Attachment point : A - 80% B - 90% C - 100%

• Limit : A - 42.5% B - 32.5% C - 22.5%

• Term Limit : A - 40% B - 30% C - 20%

• Premium : A - 14% B - 9% C - 5%

• Adjustment premiums and refund premiums due annually, reflecting experience

• Profit share 55% of experience account

• Loss share 40% of experience account

Example Contract - AContract A

2001 2002 2003 2004 all yearsNet, before stop lossNet premium 110 119 123 114 466

Net ultimate claims 108 112 131 137 488Net ultimate loss ratio 98.0% 94.0% 107.0% 120.0% 104.7%

Net, after stop lossNet premium 94 105 101 89 389


Stop lossattaches at: 80.0% 80.0% 80.0% 80.0%cover 42.5% 42.5% 42.5% 42.5%

annual premium 15 17 17 16 65AP 0 -1 1 3 4

recoveries 20 17 33 46 115Potential profit / loss share 0 2 -4 -6Profit / loss share -8

Net benefit (cost) of stop loss 4 3 11 20 38

Estimated net present value at 5% discount rate

Net benefit (cost) of stop loss -1 -3 3 9 8

Year of account

Example Contract - BContract B






annual premium 10 11 10 10 41AP -1 -1 1 3 2

recoveries 9 5 21 34 69Potential profit / loss share 2 4 -3 -6Profit / loss share -3

Net benefit (cost) of stop loss 1 0 7 15 24



Year of account

Example Contract - CContract C






annual premium 6 6 6 6 23AP -1 -1 0 2 0

recoveries 0 0 9 23 31Potential profit / loss share 3 3 0 -5Profit / loss share 2



Net benefit (cost) of stop loss -2 -2 0 4 -1

Year of account

Example Contract A - Graphical View

Contract A, 107% net loss ratio

0%

20%

40%

60%

80%

100%

120%

140%

1 2 3 4 5 6 7 8 9 10 11 12Year

Loss r

ati

o

Paid loss ratio Attachment Limit + Attachment

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

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

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

Accounting complications

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

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 lender’s rate of return under all reasonably possible scenarios

Assessment of contract performed prospectively

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

AccountingTreat

as

Yes

No

Significant transfer of

risk

Insurance contract

Financing contract

If there are distinct and separable insurance and financing elements, split into two parts for accounting - bifurcation

Comparison of deposit and reinsurance accounting

Cedant books Reinsurance Accounting Deposit Accounting

Premium Reinsurance premiumspayable –P&L (B/S forunearned element)

Deposit asset B/S(To extent recoverable)

Recovery Reinsurance recoveries –P&L (and B/S until settled)

Reduce deposit asset B/S

Any expenses (egreinsurer’s return) andincome on contract to P&L

Reinsurer books Premium Premiums receivable- P&L

(B/S for unearned element)Asset (usually cash) andliability – owed to cedant

Claim Claims payable- P&L(liability in B/S until settled)

Reduce liability owed tocedant (when settled)Net return to reinsurerunder contract in P&L

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)

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 (SPV’s)

Treatment of credit protection

SecuritisationSecuritisation

A brief overview

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 it’s use will be determined by client needs.

Convergence of Insurance Convergence of Insurance and Capital Marketsand Capital Markets

Many of today’s 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

Convergence of Insurance and Capital Convergence of Insurance and Capital MarketsMarkets -

available products: Traditional reinsurance Finite Reinsurance Double Trigger Covers ILW’S OTC Cat Swaps Securitisation Exchange traded Cat Options Contingent Capital arrangements

- Integrated Concept -

Return period or exposure

ART

Retention5

5-15

Financial Re: Spread Loss

Financial Re: Funding / Working Layers

Traditional Reinsurance15-75

75-100

100

Identify and understand the underlying Identify and understand the underlying objectives driving a need for Securitisation.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

Establish any underlying issues with regard to: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.

Evaluation of competing products:Evaluation of competing products:

Traditional Reinsurance

(Price ,capacity,period)

Finite structured alternatives

Catastrophe options

Other contingent capital products.

Blended solutions of traditional/options etc.

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).

Excedance Probability Curve

Portfolio Loss

AnnualProbability

of ExcedenceProbability ofAttachment Expected Loss

to XOL LayerProbability ofExhaustion

Sample Transaction Pricing

$ 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

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Overview of Risk Assessment

StochasticTechniques

Analytical Models

HazardModule

Vulnerability & DamageModule

FinancialAnalysisModule

WindstormDatabase

Databases

EarthquakeDatabase

Vulnerability & Actual damage

Databases

Type of

Analysis

Input Data

Buildinglocation

information

Values atRisk

Insurance Structure

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 (Moody’s, Fitch) Instrument Bond / Option

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

Integrating additional resources into the time frame

Rating AgencyReview

(2-6 weeks)

Modelling

(2-6 weeks)

Investor Interface

(2-6 weeks)

Post-AnalysisInvolvement

(ongoing)

Data Audit,Verification,Preparation

(variable)

FeasibilityAnalysis

(3-6 weeks)

OfferingMemorandum

(variable)

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

Designing a possible Transaction Structure

Cedant

SPRCash or Collateral

Financial Instrument(s)

Reinsurance Contract Premium

TrustSwapCounterparty

Floating Return

Investment Income

Funds

Placement Options Available

Private Placement Market read to verify pricing Determine whether funds required:

Unfunded: SwapOption

- Collateralised by letter of credit

Funded: Insurance Linked Securities Route- Identify potential investors and merchant Banking Partner

Abcd ART Phillip Petterson Gillian James General Insurance Spring Seminar 19-20 May 2003 Scarman...

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