2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Canadian
Institute
of
Actuaries
L’Institut
canadien
des
actuaires
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Reinsurance: cat bond process
and risk management
Pierre G. Laurin, FCAS, FCIA, MAAA
September 25, 2008
Montréal (QC)
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Contents
• Risk management issues
• Index linked securities
• Cat bond
• Side-car market
• PCS index trigger
• ILS over time
• Trends
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Risk management issues
• Reinsurance is a source of contingent capital
– Reduction of volatility of results on a excess of
loss basis
– Reduction of actual capital on a quota share basis
• Same concepts for primary insurers as for reinsurers
who use retro-cessions
• Need to ensure quality of such capital
Thousands
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Canadian context
30,000
60%
25,000
50%
20,000
40%
15,000
30%
10,000
20%
5,000
10%
-
0%
2003
2004
Total Equity
Source: AM Best data
2005
2006
2007
Ceded Reserve to Equity Ratio
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Risk management issues
• Availability of reinsurance
• Increase quality of capital
• Diversification of capital sources
• Cash flow issues
• Multi year covers
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Securitised cat cover
100%
Cat Bond
80%
Collaterised layers
60%
40%
Traditional
Reinsurance
Layers
20%
0%
Retention
Property Cat Cover
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Historical context
• Index linked securities started in 1992
• Response to risk management issues
• Alternative to hard reinsurance markets
• Need to find alternative sources of capital
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Development
• Purpose:
– Increase reinsurance capacity
– Reduce earnings volatility
– Reduce capital volatility
– Diversification of source of capital
• Overall:
– Increasingly important strategic component for
insurers & reinsurers
– Alternative to traditional reinsurance entities for
private investors
– Can be customized to handle any type of insurance
risk (e.g, workers comp.)
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Index linked securities
• Cat bonds
– Indemnity
– Parametric
– Hybrids
• Side cars
• PCS index trigger
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Overview of Nat Cat Trigger Types
Source: Swiss Re
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Cat bonds characteristics
• One sponsor
• Event based
• Only modeled exposures are covered
• Fully collaterised
• Non-indemnity cover (trigger based)
• Regular reset of attachment point
• Strict disbursements of proceeds
• High basis risk
• High yield
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Catastrophe bonds –
basic structure (diagram)
Sponsor/
Originator
Premiums
Issuer
Bankruptcy Remote
Special Purpose Vehicle
Insurance Company
LIBOR
Swap
Counterparty
Investment Income
Principal at maturity
and liquidation
Note Proceeds/Funding
Reinsurance Contract
LIBOR
Interest =
LIBOR + Premiums
Remaining
funds at
maturity
Note
Proceeds
Trust Account
Highly Rated
Short-Term Investments
Investors
(Qualified
Institutional
Buyers)
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Securitised cat cover
100%
80%
Cat Bond
Collaterised layers
60%
40%
Traditional
Reinsurance
Layers
20%
Retention
0%
Property Cat Cover
Attachment point
reset based on
pre-determined
excedence probability
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Reset of attachment point
• Timing is essential
• Renewal dates should be coordinated with traditional
program
• Pre-event
– Initial attachment point determined prior renewal
– Final attachment point determined mid-year
– Potential gap in coverage
• Post-event
– Attachment point revised depending on date of
event
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Compared to traditional reinsurance
• Utilizes normal reinsurance agreements
– Typically excess of loss
• Fully collaterised
• Different source of capital
• Defined perils coverage
• Consolidation issues
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Stakeholder perspectives
• Debt investor
– Relatively higher yield than corporate bonds
– Ability to customize terms & conditions
– Clearly defined risk categories & parameters
– Strong diversification of investments
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Stakeholder perspectives
• Sponsor perspective
– Addresses risk management issues
– Diversification of capital
– Collaterisation of cover
– Certainty of coverage
– Multi year cover
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Cat bonds
Indemnity
Parametric
• Based on company
actual losses
• Trigger on modeled
data
• No basis risk
• Higher basis risk
• Paid as losses get paid
• Can be paid
immediately
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Cat bonds requirements
• High level of sophistication in reinsurance thought
process
• High investment of time
• Typically cost more than traditional reinsurance
• Good medium to address risk management issues
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Historical context side cars
• “Traditionally” new reinsurers in market post large
event
• Capital available
• Current players wanting to increase writings
• Strong pressures from rating agencies
• Uncertainty with catastrophe models results
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Lessons learned
• From prior promotions
• Many new entrants have short time horizon
• Opportunistic perspective
• Need to change capital structure if reinsurer intends to
continue operations
• Many IPOs on survivors
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Side-car characteristics
• One sponsor
• Typically portfolio based
• While strong model based, include coverage of
unmodeled exposures
• Indemnity cover
• No real reset of attachment points but capacity resets
• strict disbursements of proceeds
• Low basis risk
• High yield for bond holder but somewhat lower than
cat bond
• Short tail lines of business
• Some commercial lines
• Actuarial opinion required
• Some pay-back mechanism
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Structure (diagram)
Proceeds
Debt Investors
Side-Car
Holding Co.
Notes: P&I
Proceeds
Shares
$ Capital
Reinsurer
Quota Share Reinsurance
Premium less Brokerage &
Commission
Dividends
Side-Car Reins. Co.
$ Contribution
held for benefit of Cedant
Distribution
(Debt Interest, Profits)
Payment for Losses
Collateral Trust
Equity Investors
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Structure
• How they operate:
– Newly created holding company funded by private
equity investors
• Usually hedge funds and other institutional
investors
– Typically funded by debt & equity financing
– Assumes risk & premiums; pay claims to ceding
company
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Analytic issues – legal structure
• Review of legal & structural documents
– Quota share reinsurance agreement
– Collateral trust agreement
– Debt prospectus & covenants
– Structural soundness
– Legal enforceability
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Analytic issues – business profile
• Review business profile
– Ceding company’s operations
– Underwriting management of insurance portfolio
• Risk tolerance levels
• Ability to avoid adverse selection
– Insufficient premium
– Excessive losses
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Analytic issues – portfolio &
modeling techniques
• Analysis of portfolio
– Develop default probability
– Can be multiple tranches
– Rating reflects ability to;
• Pay claims (side-car Reinsurer)
• Principal & interest (side-car holding
company debt)
• Catastrophe loss modeling techniques employed
• Quality of assets in collateral trust
• Analytics similar to evaluating catastrophe bonds &
other structured financings
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Compared to traditional
reinsurance
• Utilizes normal reinsurance agreements
– Typically quota share
• Depends on ceding company for reserving & claims practices
• Performance of side-car a result of underwriting & claimssettling capabilities of ceding company
• Typically private ownership
• Limited lifetime (not a going concern)
• Highly structured & limited purpose
• Typically limited to single cedant and/or contract
• Absence of active management team
• Cash disbursement tightly controlled by collateral trust
agreement
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Stakeholder perspectives
• Equity investor
– Opportunistic investment during hard markets
– Access to underwriting expertise
– Limited exposure to operating and legacy risks
– Relatively low cost to establish
– Can be established relatively quickly
– Allows for relatively easy exit
• Typically automatic winding down
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Stakeholder perspectives
• Debt investor
– Relatively high yield
– Ability to customize terms & conditions
– Clearly defined risk categories & parameters
– Side-car is not a going concern
• Not likely to be recapitalized after a loss
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Stakeholder perspectives
• Ceding company perspective
– Cedant can customize terms & conditions to meet
needs
– Ability to capture market share during hard market
– Potential to obtain management fee & profit
commission
– Allows for relatively easy exit of excess capital
– Diversification of source of capital
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
PCS index securities
• Bonds pay if the market loss is above a certain threshold
• Threshold determined by market loss
• Largest basis risk
• Very liquid
• Very popular alternative investment
8,000
30
7,000
25
6,000
20
5,000
4,000
15
3,000
Charlie, Francis,
Ivan, Jeanne
2,000
Katrina, Rita,
Wilma
10
WTC
5
1,000
0
0
1997
1998
1999
2000
2001
2002
Issuance volume ($millions)
Source: Guy Carpenter, 2007
2003
2004
2005
2006
2007
Number of transactions
2008
Number of transactions
Issuance volume ($millions)
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
P&C securization growth
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Risk capital by specific peril
5000
4500
4000
3500
3000
2500
2000
1500
1000
500
0
1997
1998
1999
U.S. Earthquake
2000
U.S. Hurricane
Source: Guy Carpenter, 2007
2001
2002
Europe Windstorm
2003
2004
Japan Earthquake
2005
Japan Typhoon
2006
Other
2007
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Risk Capital / Transactions by
Trigger Type
9
8
7
6
5
4
3
2
1
0
1997
1998
1999
Source: Guy Carpenter, 2007
2000
2001
2002
Indemnity
Parametric
PCS (Index)
2003
Modeled
2004
Hybrid
2005
2006
2007
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Trends - US
• Increase use of shelf offering
• Softening in the terms and conditions (multi perils and
locations)
• More investment grade ILS
• Primary insurers are getting more in the game, where
reinsurers were the principal driver of ILS
• Consolidation issues IFRS:SIC 12 vs US GAAP:FIN
46R
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008
Trends - Canada
• Availability of quality reinsurance market
• Limits generally lower in Canada vs US
• Few cat bonds covering Canadian exposures (Merna Re)
• Cat models not truly tested
• Increased awareness of ILS