Insurance and capital markets: convergence or collision course?
In February 2008, Munich Re unveiled an unusual $1.5 billion programme for transferring extreme mortality risk to the capital markets. Through an issuing vehicle, Nathan, it launched an initial $100 million of principal-at-risk variable rate notes paying Libor plus 135 basis points to protect the company against large losses deriving from an exceptional rise in mortality rates in the US, Canada, England and Wales, and Germany.
What might trigger such a distressing event? A nuclear war would do it. More likely, it would be an outbreak of bird flu leading to a human pandemic. The World Health Organization has been notified of 348 cases of human infection with H5N1, resulting in 216 deaths between January 2004 and January 2008. Most cases of human infection have been linked directly to contact with infected poultry or contaminated surfaces, although the first human-to-human infection was reported in Indonesia in May 2006.
Governments and large companies have been considering how to respond to any pandemic break-out.
"This is a five-year deal," says Rupert Flatscher, head of the risk trading unit at Munich Re. "From a risk management perspective, the fund could be used for losses arising from the asset or liability side." He reassures a worried Euromoney that he doesn’t really think anything so terrible is likely to happen.
There is something other-worldly about parceling up and selling such risks. It is not, however, the first time extreme mortality risk has been sold in bond form. Swiss Re has a similar deal outstanding, giving investors a pricing comparable.
It is striking just how run-of-the-mill an activity it is becoming. Like a frequent issuer in the conventional capital markets, Munich Re has set up its shelf programme, seen its initial test issue oversubscribed by hedge funds, dedicated bond funds and generalist investors, and is now sitting back, with this low-cost issuing mechanism in place, ready to use it whenever it sees a need to manage down its exposure to mortality risk.
Future deals could even cover different perils measured by different indices. It just seems so routine.
Munich Re is keen to diversify its risk management tools for ceding certain risks and has set up a specific risk-trading unit to innovate structures and build long-term relationships with capital markets investors. "We are talking to these investors all the time," says Fletcher. "If you look at the performance of the dedicated insurance-linked bond funds, they have all made very good returns in recent years. Now some may come to us, if their models suggest that certain risks suit their portfolios, and ask us to provide them through securitizations. As we have this shelf established, we should be able to do the next deal in a very timely fashion."
This first bond has a parametric trigger, so investors are not simply carving out a chunk of Munich Re’s own exposures. Any loss of principal will reference a gender and age weighted combined mortality index referenced 45% to the US, 25% each to the UK and Canada and 5% to Germany. This broadly matches Munich Re’s own exposure but the index is maintained by Milliman, an independent modelling agent, and pays out only if the combined index hits 120% of the prior year level, with losses of principal capped if the index exceeds 130%.
Fletcher says: "Because it is a parametric index and not dependent on any re-insurer’s individual book of exposure, investors have much greater confidence that they can model the risk themselves."
The expected loss rate, according to Milliman, is just 4.7bp, making the spread over Libor look like a very good deal. Mind you, that is what investors were saying about the returns on CDOs of mortgage-backed securities two years ago. Of course, if death rates do reach that 120% level, triggering loss of principal, investors will probably have other things to worry about than the performance of their bond portfolios.