The Handbook of Insurance-Linked Securities
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Inhalt
About the Contributors xv
Acknowledgements xxv
1 Introduction 1
Pauline Barrieu and Luca Albertini
Part I Non-life Securitisation 7
2 Non-life Insurance Securitisation: Market Overview, Background and Evolution 9
Jonathan Spry
2.1 Market overview 9
2.2 Market dynamics 14
2.3 The question of basis risk remains 16
2.4 ILS and the credit crunch 18
3 Cedants' Perspectives on Non-life Securitization 19
3A Insurance-linked securities as part of advanced risk intermediation 21
Insa Adena, Katharina Hartwig and Georg Rindermann
3A.1 Motivation for Allianz to take part in ILS activities 21
3A.2 Objectives of insurance companies 23
3A.3 Case study: Blue Fin Ltd 24
References 28
3B Reinsurance vs Securitisation 29
Guillaume Gorge
3B.1 Keeping risk vs transferring it 29
3B.2 Reinsurance vs securitisation 30
3B.3 Application to main P&C risks 31
3B.4 Case studies: Aura re and Sparc 32
3B.5 Limits and success factors to securitisation 33
References 34
3C Securitisation as a diversification from traditional retrocession 35
Jean-Luc Besson
4 Choice of Triggers 37
Dominik Hagedorn, Christian Heigl, Andreas Müller and Gerold Seidler
4.1 General aspects 37
4.2 Indemnity triggers 38
4.2.1 Scope of coverage 39
4.2.2 Payout timing 39
4.2.3 Loss verification 40
4.2.4 Transparency 40
4.3 Non-indemnity triggers 41
4.3.1 Parametric triggers (pure and index) 41
4.3.2 Industry loss triggers 43
4.3.3 Modelled loss triggers 45
4.4 Choosing the optimal trigger 45
4.4.1 Comparison of trigger types 46
4.4.2 Choice of trigger and alternative solutions 47
5 Basis Risk from the Cedant's Perspective 49
David Ross and Jillian Williams
5.1 Introduction 49
5.2 Investor vs sponsor risk 50
5.3 Trigger types 50
5.4 Catastrophe models 52
5.4.1 Key components of catastrophe models 52
5.4.2 Uncertainty 54
5.5 Sources of basis risk 55
5.5.1 Source 1: Catastrophe model error/shortcomings 55
5.5.2 Source 2: Discrepancy between the modelled index loss and the modelled company loss 56
5.5.3 Source 3: Dynamic basis risk 56
5.6 Defining basis risk 56
5.7 Quantifying basis risk 58
5.7.1 Measures for pro rata hedges 58
5.7.2 Measures for digital hedges 59
5.7.3 Measuring positive basis risk 59
5.8 Minimising basis risk 60
5.8.1 Over-hedging 60
5.8.2 Choice of index 62
5.8.3 Reset clauses 62
5.8.4 Cat model input 63
5.9 Conclusion 63
Acknowledgements 63
References 64
6 Rating Methodology 65
Cameron Heath
6.1 Standard & Poor's ratings services' rating process 65
6.1.1 Initial interaction 65
6.1.2 Risk analysis 65
6.1.3 Documentation review 67
6.1.4 Transaction closing 67
6.1.5 Surveillance 67
6.2 Risk analysis 68
6.2.1 Trigger options 68
6.2.2 Indemnity vs non-indemnity triggers 68
6.2.3 Risk factors 70
6.2.4 Adjusted probability of default 72
6.2.5 Application of methodology 73
6.2.6 Default table 74
6.2.7 Multi-event criteria 74
6.3 Legal and swap documentation review process 75
6.3.1 Insurance focus points 75
6.3.2 Legal and structural focus points 75
6.4 Impact on sponsor 75
6.4.1 Capital model treatment of ILS 75
6.4.2 Summary of basis risk analysis 76
6.4.3 Sources of basis risk 77
6.4.4 Link to ILS revised probability of attachment 82
References 82
7 Risk Modelling and the Role and Benefits of Cat Indices 83
Ben Brookes
7.1 Components of a cat model 84
7.2 Insurance-linked securities 84
7.2.1 General overview 84
7.2.2 Insurance-linked security triggers 85
7.2.3 Basis risk 90
7.3 Cat indices 93
7.3.1 Property Claims Service (PCS) 93
7.3.2 Re-Ex - NYMEX 93
7.3.3 Insurance Futures Exchange Service (IFEX) 94
7.3.4 Carvill Hurricane Index (CHI) - Chicago Mercantile Exchange (CME) 94
7.3.5 Paradex 95
7.4 Summary 99
8 Legal Issues 101
Malcolm Wattman, Matthew Feig, James Langston, and James Frazier
8.1 The note offering - federal securities law implications 101
8.1.1 The distribution of the notes 101
8.1.2 Application of the anti-fraud provisions of the federal securities laws 102
8.1.3 Securities offering reform 103
8.1.4 Provision of information 103
8.1.5 The Investment Company Act of 1940 104
8.2 The note offering - the offering circular 104
8.2.1 Important terms 104
8.2.2 ERISA considerations 106
8.2.3 Other considerations regarding the proceeds and payment of interest 109
8.2.4 The risk analysis 110
8.2.5 Opinions 110
8.3 Types of transactions 110
8.3.1 Parametric, index and modeled loss transactions 111
8.3.2 Indemnity transactions 111
8.4 Conclusion 115
9 The Investor Perspective (Non-Life) 117
Luca Albertini
9.1 The creation of a sustainable and liquid market 117
9.1.1 Creation of common terminology 118
9.1.2 Risk analysis 119
9.1.3 Correlation with other investments in the portfolio 119
9.1.4 Relative value 121
9.1.5 Valuation and liquidity 121
9.2 Key transaction features from the investor perspective 122
9.2.1 Assessment of the underlying risks being securitised 122
9.2.2 Risk assessment of the instrument 124
9.2.3 Pricing and risk-return profile 125
9.3 Market evolution: the investor perspective 127
9.3.1 Collateral arrangements 127
9.3.2 Data transparency 128
9.3.3 Exposure monitoring 129
9.3.4 Modelling rigour 129
10 ILS Portfolio Monitoring Systems 131
Tibor Winkler and John Stroughair
10.1 Introduction 131
10.1.1 Completing the circle 131
10.1.2 'Square peg in a round hole?' 132
10.2 Miu - An ILS platform in a convergent space 133
10.2.1 Overview 133
10.2.2 Nuts and bolts - how the platform works 133
10.2.3 Step by step - entering a contract 134
10.2.4 Portfolio analysis 134
10.3 RMS library of cat bond characterisations 137
10.3.1 Motivation and objectives 137
10.3.2 How is it done? A bird's eye view 137
10.3.3 Apples to apples - a leap for the market 138
10.4 Conclusion 138
11 The Evolution and Future of Reinsurance Sidecars 141
Douglas J. Lambert and Kenneth R. Pierce
11.1 A brief history of the brief history of sidecars 142
11.2 Sidecar structures 143
11.2.1 Basic structure 143
11.2.2 Market-facing sidecar 144
11.2.3 Non-market-facing sidecar 145
11.2.4 Capitalising sidecars 146
11.2.5 How sidecars and catastrophe bonds are different 147
11.3 The appeal of sidecars 148
11.3.1 From a cedant/sponsor perspective 148
11.3.2 From an investor perspective 149
11.4 Structuring considerations 149
11.5 The outlook for sidecars 150
11.6 Conclusion 151
12 Case Study: A Cat Bond Transaction by SCOR (Atlas) 153
Emmanuel Durousseau
12.1 Introduction: SCOR's recent history 153
12.2 Atlas III and IV: Background 153
12.3 Atlas: Main characteristics 155
12.4 Basis Risk 158
12.4.1 Reset 158
12.4.2 Gross up 158
12.4.3 Overlap 158
12.4.4 Synthetic covers 159
12.5 Total Return Swap 160
12.6 Conclusion 160
Appendix A 161
A. 1 Definition of events 161
A. 2 Extension events 162
13 Case Study: Swiss Re's New Natural Catastrophe Protection Program (Vega) 163
Jay Green and Jean-Louis Monnier
13.1 A positive evolution of Swiss Re's ILS strategy 163
13.2 Swiss Re accesses multi-event natural catastrophe coverage 164
13.3 The first ILS to use a cash reserve account as credit enhancement 164
13.4 Innovation leads to more efficient protection 165
Part II Life Securitisation 167
14 General Features of Life Insurance-Linked Securitisation 169
Norman Peard
14.1 Life insurer corporate and business structures, risks and products 170
14.1.1 Mutual life offices 170
14.1.2 Proprietary life offices 171
14.1.3 Other forms of life office 173
14.1.4 Principal risks associated with life insurance business 173
14.1.5 Principal product types and associated risks 176
14.2 Actors and their roles 177
14.2.1 Sponsor 177
14.2.2 Investors 179
14.2.3 Regulators 179
14.2.4 External professional advisers 179
14.2.5 Ratings agencies 181
14.2.6 Monoline insurers 181
14.2.7 Liquidity providers 181
14.2.8 Swap providers 182
14.2.9 Others 182
14.3 Process 182
15 Cedants' Perspectives on Life Securitisation 189
15A A cedant's perspective on life securitisation 191
Alison McKie
15A.1 Why securitise? 191
15A.2 Life ILS can be complex 194
15A.3 Outlook for life ILS 198
15B A cedant's perspective on life securitisation 199
Chris Madsen
15B.1 Key considerations 199
15B.2 Examples of securitisation opportunities 202
15B.3 Differences between securitisation and reinsurance 205
16 Rating Methodology 207
Harish Gohil
16.1 Fitch's approach to the rating process 207
16.2 Insurance risk analysis 208
16.2.1 Risk modelling 208
16.2.2 Ratings benchmarks 209
16.2.3 Analysis of sponsor and other counterparties 210
16.2.4 Surveillance 210
16.3 Zest: a VIF case study 211
References 212
17 Life Securitisation: Risk Modelling 213
Steven Schreiber
17.1 Modelling of a catastrophic mortality transaction 213
17.2 Modelling of a VIF transaction 216
18 Life Insurance Securitisation: Legal Issues 219
Jennifer Donohue
18.1 Monetisation of future cash flows 219
18.1.1 Some background on monetisation 219
18.1.2 The market drivers of monetisation 220
18.1.3 Monetisation in the current climate 221
18.1.4 Some transaction structures 221
18.2 Legal aspects of life insurance securitisation - some key features 222
18.2.1 Closed book/open book 222
18.2.2 Unit-linked policies - not 'with profits' policies 222
18.2.3 Risk transfer versus no transfer 222
18.2.4 Warranties 222
18.2.5 Monoline wrap (payment obligation) 223
18.2.6 Recharacterisation risk 223
18.3 Some examples of value-in-force securitisation/monetisation 225
18.3.1 A classical VIF structure: Gracechurch 225
18.3.2 A private but reported transaction: Zest 226
18.4 Outlook 227
19 The Investor Perspective (Life) 229
Luca Albertini
19.1 Life insurance-linked risks and investor appetite 229
19.1.1 The role of the monolines 229
19.1.2 Understanding the risk 230
19.1.3 Correlation with other investments 234
19.1.4 Relative value 236
19.1.5 Valuation and liquidity 237
19.2 Key transaction features from the investor perspective 237
19.2.1 Risk assessment of the instrument 237
19.2.2 Pricing and risk-return profile 240
19.3 Market evolution: the investor perspective 242
20 Longevity Securitisation: Specific Challenges and Transactions 245
Jennifer Donohue, Kirsty Maclean and Norman Peard
20.1 Mortality and longevity risk 245
20.2 A market for longevity risk 246
20.2.1 Potential sources of longevity risk for securitisation 246
20.2.2 Demand for longevity risk 247
20.3 Key structural aspects of longevity risk securitisation 248
20.3.1 Isolating longevity risk 248
20.3.2 Analysis of longevity risks 249
20.3.3 Longevity risk - legal explanation 250
20.3.4 Examples and legal aspects of transaction structures 252
20.4 Some features of longevity risk 255
20.4.1 Model risk 255
20.4.2 Ratings 258
20.4.3 Pricing 258
21 Longevity Risk Transfer: Indices and Capital Market Solutions 261
Guy Coughlan
21.1 The nature of longevity risk 262
21.2 The market for longevity risk transfer 263
21.2.1 Hedgers 263
21.2.2 Investors 265
21.2.3 Intermediaries 265
21.3 Importance of indices, tools and standards 266
21.3.1 Longevity indices 266
21.3.2 Trading and liquidity 268
21.4 Capital market instruments for longevity risk transfer 268
21.4.1 Longevity bond 268
21.4.2 Survivor swap 269
21.4.3 q-forward 269
21.4.4 Survivor forward 271
21.4.5 Instruments and liquidity 272
21.5 Customised vs standardised longevity hedges 273
21.5.1 Customised longevity hedge 273
21.5.2 Standardised index-based longevity hedge 273
21.5.3 Advantages and disadvantages 274
21.6 Case study: customised longevity hedge 274
21.7 Implementing a standardised index-based longevity hedge 275
21.7.1 Liability sensitivity and hedge calibration 276
21.7.2 Hedge effectiveness analysis 278
21.8 Conclusions 280
References 280
22 Case Study: A Cat Mortality Bond by AXA (OSIRIS) 283
Sylvain Coriat
22.1 Catastrophic pandemic risk 283
22.2 Considered risk transfer tools 284
22.3 Detailed structure 285
22.4 Risk analysis 287
22.4.1 Modelling approach 287
22.4.2 Index construction 287
22.5 Investors' reaction 288
22.6 Spread behaviour 288
22.7 Next steps 288
Reference 291
23 Case Study: Some Embedded Value and XXX Securitisations 293
Michael Eakins and Nicola Dondi
23.1 Embedded value securitisation - Avondale S.A. 295
23.2 XXX securitisation 299
Part III Tax and Regulatory Considerations 305
24 The UK Taxation Treatment of Insurance-Linked Securities 307
Adam Blakemore and Oliver Iliffe
24.1 The Directive and the taxation of UK ISPVs 308
24.1.1 The implementation of the Directive in the UK 308
24.1.2 Implementation of the ISPV framework in the UK 308
24.1.3 UK tax treatment of ISPVs 310
24.2 Non-UK insurance special purpose vehicles 315
24.2.1 Tax residence status of the issuer 316
24.2.2 Tax residence status of the issuer's agents 317
24.2.3 Location and management of the issuer's assets 318
24.3 Indirect taxes and withholding of income tax 320
Further reading 321
25 The US Federal Income Taxation Treatment of Insurance-Linked Securities 323
David S. Miller and Shlomo Boehm
25.1 Avoiding US corporate income tax for the issuer 324
25.1.1 Overview 324
25.1.2 Trade or business in the United States 325
25.1.3 Procedures followed by catastrophe bond issuers to avoid substantive business activities in the United States 326
25.1.4 Section 864(b)(2) safe harbor 328
25.2 Withholding tax and excise tax 328
25.2.1 Overview 328
25.2.2 Descriptions of insurance-linked instruments written on standard ISDA forms 330
25.2.3 Federal income tax definition of notional principal contracts 331
25.2.4 Put options 334
25.2.5 The Bank of America case (income not clearly described within any other generally recognised category) 334
25.3 US federal income tax treatment of an investor in a catastrophe bond issuer: overview 335
25.3.1 US investors 335
25.3.2 Timing and character of income and gain of the issuer with respect to the permitted investments, the total return swap and the insurance-linked instrument 338
25.3.3 Foreign investors 339
25.3.4 Notes that are treated as indebtedness for federal income tax purposes 339
Reference 339
26 Regulatory Issues and Solvency Capital Requirements 341
Mark Nicolaides, Simeon Rudin, Rick Watson and Katharina Hartwig
26.1 Regulatory issues relevant for ILS sponsors 341
26.1.1 Solvency capital 341
26.1.2 Recognition of sponsors' claims against SPV as eligible assets 342
26.2 Solvency I 343
26.2.1 Overview 343
26.2.2 Requirement to maintain a solvency margin 344
26.2.3 Structuring ILS under EU Directives to enhance solvency margins 348
26.3 Solvency II 351
26.3.1 Valuation of assets and liabilities 353
26.3.2 Determination of technical provisions 353
26.3.3 Solvency capital requirement 354
26.3.4 Minimum capital requirement 358
26.3.5 Own funds 359
26.3.6 Investments 360
Appendix A: Standard formula, solvency capital requirement (SCR) 361
A. 1 Calculation of the basic solvency capital requirement 361
A. 2 Calculation of the non-life underwriting risk module 361
A. 3 Calculation of the life underwriting risk module 362
A. 4 Calculation of the market risk module 362
Index 363
There has been much said about the convergence of the insurance industry with the capital markets. Such convergence has taken many forms, and of the many attempts, some have been more successful than others. Insurance-linked securities, often referred to as ILS, have proven to be one of the most successful manifestations of this convergence, of how capital market technologies can find applications within the insurance industry, and how insurance-related risk can be transferred to capital market investors. As outlined in later contributions, there were approximately $13 billion of tradable non-life insurance-linked securities and $24 billion in tradable life insurance-linked securities as of the end of 2008. In addition, whilst traded insurance-linked securities are the most visible and headline-catching forms of risk transfer to the capital markets, there are a number of other forms of placement of insurance risk into the capital markets, including: • Private placements of insurance-linked securities (also called ‘club deals’) which involve a small number of skilled investors, and which are estimated to be of significant size. • Sidecars on non-life insurance risk, which reached an estimated $6 billion of capacity after Hurricane Katrina, and found new interest in 2008 with reduced retrocession capacity being available in the market. • Insurance-linked derivatives, which are mostly over-the-counter contracts in life and non-life risk, transacted by financial institutions, brokers and regulated exchanges. • Weather derivatives, also available via financial institutions, brokers and regulated exchanges. • Traded life insurance policies - life settlements - which have been warehoused in significant size by financial institutions and are being distributed to capital markets as well as private investors. • Collateralised reinsurance and industry loss warranties (ILW), which are typically reinsurance contracts but frequently backed by capital market investors (such as dedicated insurance-linked securities investors and hedge funds) which fund the collateral posting and assume the ultimate risk of the relevant insurance events. The outstanding capacity deployed by capital market investors on the above mix of instruments was estimated to be well above $50 billion in 2008. The Handbook of Insurance-Linked Securities Edited by P. Barrieu and L. Albertini © 2009 John Wiley & Sons, Ltd Moreover, the market has been enriched by a wider and deeper range of market participants over the last decade: • Each year, new originators have approached the insurance-linked securitisation market, including a number of insurance and reinsurance companies, corporations and government institutions. • Some of these originators who have tapped the insurance-linked securities market with a transaction have then sponsored new transactions covering new risks or repeat transactions on the same perils, thus capitalising on their positive experience with the technology, and in some cases have established risk trading units with the task of constantly monitoring opportunities for purchasing or ceding risk to the capital markets. • A number of modelling and actuarial firms have the ability to perform risk analysis on different life and non-life risks with the rigour and methodology needed to describe them to capital market investors. • A growing number of risks have been modelled for capital market transactions, thus enriching the potential for diversified exposures for investors. • Diverse range investors have approached life and non-life insurance-linked securities across the risk spectrum. Investor types have ranged from money market managers, pension funds, banks, other institutional investors, insurance and reinsurance companies to a growing number of asset management companies dedicated to investing only in insurance-linked securities risk. • There is a larger community of arrangers, financial institutions and brokers who have equipped themselves for origination and structuring of transactions, secondary trading of insurance-linked securities and in some cases providing secondary market pricing indications (although not yet at the level of market making). After a decade of continuous growth, the insurance-linked securities market is now at a stage of consolidation of its past successes and further expansion, despite the recent turmoil in the capital markets, as discussed later in various chapters of the book. However, one could argue that the actual size of the market is still very small compared to its full potential. Supporting market participants with a transparent discussion on various aspects of this market and introducing insurance-linked securities to a wider class of originators and investors are essential in making this niche market more understandable, more transparent and more accessible. This is really what has motivated us in undertaking this project and what we would like to achieve with this handbook. The main objective of this handbook is to present the state of the art in insurance-linked securitisation, by exploring the various roles for the different parties involved in the transactions, the motivation for the transaction sponsors, the potential inherent pitfalls, the latest developments and transaction structures and also the key challenges faced by the market. To do so, we have decided to gather specialists with different backgrounds and experts with many years of experience in this field, representing the various perspectives and aspects of this market. Each chapter is therefore a contribution by one or several experts in insurance-linked securitisation. As a result, this book presents an independent view on the sector, with contributions from some of the key market players who have agreed to support our initiative. On the other hand, due to the healthy growth of the market and to the number of credible market players, it has not been possible to include all of those institutions that would have been able to provide valuable contributions within the targeted size of this handbook. The handbook is organised into three parts, covering the various perspectives in insurance-linked securitisation, non-life and life. The first part focuses on non-life insurance securitisation, and has been organised so as to focus on some key aspects of this market. We start in Chapter 2 by offering an overview of the non-life insurance-linked securitisation market, its evolution and the key general structural features. We have then asked three key originators, each of whom has sponsored a number of transactions, to offer, in Chapter 3, the cedant’s perspective on this market and outline their motivations in approaching insurance-linked securities and the latter’s impact on their overall risk transfer strategy. Insurance-linked securities can be structured in a number of different ways. One of the most noticeable differences is the type of trigger which can be used to claim a payment from the securitisation structure. The various types of trigger are outlined in Chapter 4, and Chapter 5 guides you through an analysis for cedants in assessing the basis risk impact of the choice of a specific trigger for the transaction. As rating agencies and modelling firms have been instrumental in supporting the development of the insurance-linked securities market, and have established and enriched their rating and modelling methodology to allow the placement of new types of transaction, we have then asked a leading rating agency to outline, in Chapter 6, its approach to rating non-life risk, and a leading modelling firm to outline its risk modelling methodology as well as the structure and the benefits of its newly established indexes related to catastrophic risk in Chapter 7. Legal considerations are at the heart of the structuring of insurance-linked securities, and a number of transactions are affected by several legal aspects of federal and state legislation in the United States. Chapter 8 offers a perspective on such legal aspects, and on how structures have been affected. Chapter 9 then offers the perspective of investors in non-life insurance-linked securities, including the key elements that drive investors’ underwriting and pricing considerations and the key issues which are currently the focus of investors’ attention. In addition, given the complexities related to the management and the monitoring of an investor exposure to the different risks in a portfolio of non-life insurance-linked securities, Chapter 10 outlines the characteristic of one of the leading tools available to investors to perform such analysis. Having reviewed some of the key aspects of non-life insurance-linked securities, in Chapter 11 we offer an outline of sidecars, their role in cedants’ risk management strategies and a comparison with insurance-linked securities. To conclude the non-life insurance-linked securities section we offer two case studies with two different types of structures: a multi-peril first event excess of loss transaction (Atlas by SCOR) and a transaction triggered by a frequency of events (Vega by Swiss Re). The second part focuses on life insurance-linked securitisation, which requires specific focus points due to its specific characteristics. Chapter 14 offers an overview of the background of the general...
