Financing Catastrophic Risks
The Effect of Capacity Cycles on Developing Countries
Jonathan Barnes
Aon Capital Markets
December 2005
Aon Limited is authorised and regulated by the Financial Services Authority in respect of insurance mediation activities only
Disclaimer
This document has been prepared for information purposes only, and is not intended, nor shall it
be considered, as an offer to sell or the solicitation of an offer to enter into any contract for
purchase of any security, loan or financial product. Aon Capital Markets makes no representation
that any transaction can be effected at the prices provided, and all material contained herein,
including proposed terms and conditions, are for preliminary discussion purposes only. This
information is intended to aid the recipient, and is not a confirmation or statement of Aon Capital
Markets. We accept no responsibility for any costs, losses or damages resulting from the use of,
or reliance upon, this document.
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Risk Matrix
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3
Risk Matrix
Risk
Retain
Risk Control
Transfer
Risk Finance
Unfunded
Traditional
Alternative
Pre-loss
Post-loss
Loss
Prevention
Loss
Reduction
Cash
Flow
Risk Transfer
Funded
Pre-loss
Post-loss
Reserves
Debt / LOC
Captives
Contingent
Capital
Pre-loss
Insure
Reinsure
Post-loss
Equity
Finite
Finite
(prospective)
(retrospective)
Cat Bond
& ILS
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Focus on Risk Financing and Transfer
Risk
Retain
Risk Control
Transfer
Risk Finance
Unfunded
Traditional
Alternative
Pre-loss
Post-loss
Loss
Prevention
Loss
Reduction
Cash
Flow
Risk Transfer
Funded
Pre-loss
Post-loss
Reserves
Debt / LOC
Captives
Contingent
Capital
Pre-loss
Insure
Reinsure
Post-loss
Equity
Finite
Finite
(prospective)
(retrospective)
Cat Bond
& ILS
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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First Priority is Risk Control
Risk
Retain
Risk Control
Transfer
Risk Finance
Unfunded
Traditional
Alternative
Pre-loss
Post-loss
Loss
Prevention
Loss
Reduction
Cash
Flow
Risk Transfer
Funded
Pre-loss
Post-loss
Reserves
Debt / LOC
Captives
Contingent
Capital
Pre-loss
Insure
Reinsure
Post-loss
Equity
Finite
Finite
(prospective)
(retrospective)
Cat Bond
& ILS
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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First Priority is Risk Control
• Financing and Transfer is secondary to Risk Control
– Awareness, education, preparation (warnings, disaster planning
evacuation procedures and recovery planning)
– Building codes, retrofitting
– Planning and land use
– Flood defences
– Natural defences - planting to reduce landslide, coastal erosion and
flooding
• Financing programme needs to reinforce risk control
– Scheme incentives: eligibility, deductible and premium incentives
– Other financial incentives: tax, mortgage and improvement loans
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Catastrophe Risk Financing
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Catastrophe Risk Financing
• Low penetration of private insurance in developing countries
– Life and savings policies a higher priority than property
• Requirement for State participation in a national or regional
scheme
– Insurability depends on portfolio diversification
– Catastrophe exposure is a systematic risk for domestic insurers
• Government involvement can
– Help to spread loss over time
– Integrate scheme with Risk Control measures
– Introduce and enforce an element of compulsion
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Catastrophe Risk Financing
• The case for compulsion
• Low take-up of optional insurance cover in developed countries
– NFIP:
flood cover is available
– California: earthquake must be offered
– Florida:
wind coverage must be included
• Makes economics more efficient by removing the anti-selection
prevalent in optional schemes
• For developing countries, infrastructure financing may be the
primary economic consideration
– Highways, bridges, tunnels, ports, power & water networks, hospitals,
schools
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Catastrophe Risk Financing
• First task is to understand the nature of the threat
– Frequency and severity of potential occurrences
– Areas most at risk
• Implications for land use
– Construction vulnerabilities
• Cost of repair / replacement - including post loss demand surge
• Implications for loss mitigation and construction code
• Develop models for risk financing / transfer planning
– Quantify the financial exposures
– Determine how risk is to be financed
– Determine appetite / budget for risk retention / transfer
– Models used by protection buyers and protection sellers to assess risk
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Influence of the Insurance Cycle
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Influence of the Insurance Cycle
• Insurance industry is notoriously cyclical
• Recent incidence of catastrophe losses is exerting upward pressure
on catastrophe reinsurance prices
• “Seven of the ten most expensive hurricanes in US history occurred in
the fourteen months from August 2004 to October 2005: Katrina, Rita,
Wilma, Charley, Ivan, Frances and Jeanne”
Robert P Hartwig Ph D, CPCU,
Senior Vice President & Chief Economist Insurance Information Institute
• 2004/5 insured hurricane damage estimated at circa USD 75 billion
• Standard & Poor’s revised its global reinsurance outlook from stable to
negative on September 28, 2005
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Influence of the insurance cycle
• Price increases most pronounced in loss impacted areas (US hurricane)
– Upward pressure on pricing elsewhere
– Particularly for peak concentration perils
• Cyclical price fluctuations are generally most pronounced for contracts
covering remote events (1-in-50 to 1-in-250 year losses)
– Covers generally purchased by national pools / schemes
– Movements in absolute minimum prices relative to the limit provided
– Particularly for non-peak ‘diversifying’ risks such as those provided by
developing countries
• ‘Minimum rates on line’ can fluctuate from 0.5% to 1.5% of limit
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Influence of the insurance cycle
US Catastrophe Risk Price Index - per Insurance Information Institute
40%
12 0
30%
10 0
21 %
20%
80
1 6%
?
11 %
10%
60
2%
40
0%
-4%
-5 %
-1 0 %
-11 %
-9 %
- 4%
-8 %
-6 %
-2 0 %
20
0
94
95
96
97
98
99
'0 0 '0 1 '0 2 '0 3
ra te c h a nge s [le ft]
'0 4 0 5 E 0 6 F
ind e x le v e l [right]
is a division
of AonInformation
Capital Services
Limited
authorised
regulated by the Financial Services Authority.
Sources: Swiss Re,Aon
CatCapital
MarketMarkets
Research;
Insurance
Institute
estimate
forand
2006.
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Structuring Efficient Risk Transfer
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Structuring Efficient Risk Transfer
• Advantages for developing countries seeking catastrophe risk
cover
– Market is dominated by exposures in developed countries
– Protection sellers seek to develop diversified portfolios of catastrophe risk
– Developing countries with exposures that don’t correlate with protection
sellers’ existing risks provide diversification
– Diversification benefit is reflected in lower margin charge
• Disadvantages
– Coverage typically required for low probability events, subject to higher
margin charges and cyclical pricing volatility
– Some protection sellers are deterred by the availability and quality of
catastrophe models
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Structuring Efficient Risk Transfer
Understanding how the markets price risk
• Premium as a multiple of the expected loss to the contract
• Margin expressed as a percentage of the standard deviation of
expected losses (cat bond Sharpe Ratio)
– Sharpe ratio
Expected Premium - Expected Loss
Standard Deviation of Expected Losses
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Structuring Efficient Risk Transfer
Illustrative 2005 retro contract pricing
Expected Loss Multiples
50%
45%
Study based on 5 clients / 25 contracts
Expected loss to contract
40%
N.B. Expected losses and premiums calculated
for contracts providing one paid reinstatement
35%
30%
25%
y = 2.6257e -1.4993x
R2 = 0.9014
20%
15%
10%
5%
0%
1.0
1.5
2.0
2.5
3.0
Contract premium expressed as a multiple of the expected loss
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Retro Pricing Discussion
2005 Sharpe ratios vs. expected loss
EL vs Sharpe Ratio
50%
Study based on 5 clients / 25 contracts
45%
N.B. Expected losses and Sharpe ratios
calculated for contracts providing one paid
reinstatement
40%
35%
EL
30%
25%
20%
15%
10%
5%
0%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
Sharpe Ratio
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Structuring Efficient Risk Transfer
Example for contracts covering low probability windstorm risks
(peril outside US & Europe peak territories)
5.0%
Expected Loss
4.0%
3.0%
2.0%
y = 0.0523x-1.4034
R2 = 0.9121
1.0%
0.0%
0.0
2.0
4.0
6.0
8.0
10.0
Multiple
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Structuring Efficient Risk Transfer
• Developing countries with non-correlating catastrophe exposures
should consider purchasing protection collectively
• Achieves pricing efficiency - particularly for remote events
– Events with return periods of 1-in-50 to 1-in-250 years
• Illustrative example – separate purchasing
– Two countries each seeking to purchase reinsurance of USD 50 million per event
(standard policy also provides one reinstatement at 100% additional premium)
– Expected losses to each policy = 1.5%
– Premium expressed as a multiple of expected loss = (say) 2.75x
– Premium rate expressed as a percentage of cover (1.5% x 2.75) = 4.125%
– Cost to each country USD 50m x 4.125% = USD 2,062,500
– Combined cost of the two separate policies USD 2,062,500 x 2 = USD 4,125,000
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Structuring Efficient Risk Transfer
• Illustrative example – collective purchasing
– Two countries collectively purchase reinsurance of USD 50 million per event
(standard policy also provides one reinstatement at 100% additional premium)
– Expected losses to combined peril policy = 1.5% 2.956%
– Premium expressed as a multiple of expected loss = (say) 2.75x 1.75x
– Premium rate expressed as a percentage of cover (2.956% x 1.75) = 5.17%
– Cost of combined peril policy USD 50m x 5.17% = USD 2,585,000
– Saving over purchase of separate policies = USD 1,540,000 = 37%
• Reinsurance provides one automatic reinstatement at 100% additional
premium (covers two events in any one year)
– Slightly less cover, but
– Probability of combined policy being exhausted circa 0.044%
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Structuring Efficient Risk Transfer
• Global reinsurance brokers are best placed to assist
– Independent advice on structuring and distribution
• Experience in developing national pools for developed countries
• Extensive risk modelling expertise
– Vendor models (AIR, EQECAT, RMS)
– Proprietary models
• Routinely negotiate with protection sellers to obtain most efficient
pricing for clients
– Reinsurance markets
– Capital markets
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Closing Comments
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Closing Comments
Role for the World Bank
• Initiate and co-ordinate catastrophe risk model development
• Co-ordinate and structure collective risk transfer arrangements
World Bank Re ?
• Assume individual country risk
• Structure collective risk transfer products
• Distribute to reinsurance / capital markets
Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority.
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Financing Catastrophic Risks
The Effect of Capacity Cycles on Developing Countries
Jonathan Barnes
Aon Capital Markets
December 2005
Aon Limited is authorised and regulated by the Financial Services Authority in respect of insurance mediation activities only