|Cat bond prices are quoted on Bloomberg by Swiss Re New Markets|
Finally, last October, BAe opted for an insurance industry solution. Marsh & McLennan harnessed eight insurance companies to protect $3.9 billion of BAe's expected leasing income over the next 15 years.
Was this a victory for insurers against investment bankers who are trying to encroach on their territory and securitize or monetize every risk in the world? Hardly, although the deal was dubbed "The empire strikes back".
It was mainly a question of price: British Aerospace paid a premium of $70 million which a company spokesman says was "probably a quarter of the cost of a capital markets solution".
That highlights the gap today between the risk premiums accepted by insurers and reinsurers, and those that capital markets investors still demand for large and difficult-to-quantify insurance risks - such as hurricanes, typhoons, earthquakes, air crashes and satellite failures. Nevertheless, securitization of such insurance risks continues apace, every month producing a new structure - insurance-linked notes, contingent notes, options to issue bonds, swaps on an index, cat equity puts and so on. More than a handful of practitioners are convinced that when the market cycle comes right, these instruments will see a surge in demand from capital market investors. But until circumstances change the revolutionaries are fighting an uphill battle.
The main problem is a difference in risk perception. Reinsurers judge the risks of earthquakes, hurricanes and other catastrophes in economically significant parts of the world on a portfolio basis, benefiting from the effects of diversification. Capital markets investors still tend to judge a security or derivative on its individual probability of default. Some are forced to because the securities they buy must have an investment-grade rating.
Issuing such securities also involves lawyers' fees, SEC clearance, bankers' fees, independent assessment by risk-modelling companies and the blessing of at least one rating agency, all of which drive up the expense.
But the main obstacle to securitization today is soft reinsurance prices. There is huge overcapacity in the reinsurance market, especially for catastrophe risk. Although last year's hurricanes were fierce and murderous, they didn't strike at much heavily insured territory.
The last heavily insured catastrophe etched in insurers' memories was hurricane Andrew in 1992. That drove up premiums, but only for a year. Since then rates-on-line (the rule-of-thumb premium for events that may happen only once in 100 years) have fallen to pre-1992 levels (see chart on page 40).
So it is not a good time to persuade reinsurers to seek spare capacity by selling some of their risk to the cash-rich and asset-hungry capital markets.
Visionaries saw 12 years ago that insurance risk is an asset class that can be traded. Hurricane Andrew gave their argument some force. There was a flurry of activity in the early 1990s, resulting in some landmark securitizations (see table on page 41) and the launch of a catastrophe options contract on the Chicago Board of Trade. But the softness of the reinsurance market robbed the initiative of impetus. The CBOT cat options lost volume and open interest last year. The Bermuda Commodity Exchange, which started with a fanfare in November 1997, won't say what volume of trades it is doing. "We're still in the very early stages here," says BCOE president Thomas Heise. Only members are given sight of prices and volumes. The world's major exchanges are too preoccupied with the battle for market share in traditional products, to give new contracts in this area much thought.
Some insurers who support securitization and other forms of ART (alternative risk transfer) are praying for a major catastrophe as the only way to bring the market to its senses and stiffen reinsurance prices.
But the transformation continues, in less spectacular fashion, as ART practitioners from the capital markets and insurance industries work at educating clients and potential clients. Type "catastrophe bond" or "alternative risk transfer" into an internet search engine and you will find dozens of articles devoted to the subject, from 1996 to the present. The websites of many reinsurers, such as Centre Re, General Re, Hannover Re, Munich Re, and brokers, such as Aon Capital Markets and Marsh & McLennan, give detailed histories and biographies of their specialized ART teams and the deals they have done - mostly private placements. Some have formed ART subsidiaries. A handful of investment banks, led by Goldman Sachs, have ART teams too. Goldman says it has done 13 of the 25 most public insurance securitizations since 1995. Lehman has established its own reinsurance company, Lehman Re, in Bermuda, which buys reinsurance risk, including securitizations. Swiss Re and Goldman claim to make markets in catastrophe (cat) bonds and other issued insurance instruments. Swiss Re posts cat bond prices on its Bloomberg page (see above). But the spreads are wide: from 30 basis points to 140bp on lots of $3 million to $5 million of mostly one-year bonds.
Hopefuls compare this market to that of mortgage-backed securities in the late 1970s or derivatives in the early 1980s: the principle makes sense but the critical mass isn't there. It took a bout of extreme interest-rate volatility to get those markets going, after which they grew exponentially. Given the right circumstances the ART market will do the same and these pioneers will look like heroes.
Richard Sandor, recognized as one of the fathers of Chicago financial futures, also championed the trading of pollution futures and insurance derivatives. "Sandor stunned us in London in 1994," says one ART expert, "by saying that he'd make us a two-way over-the-counter price in insurance."
Sandor was chief economist and board member at the CBOT. In 1993 he formed Centre Financial - now called Centre Solutions - a joint venture with Centre Re. Last year he became chairman of the newly formed Hedge Financial Products, a subsidiary of CNA Financial Corporation. "The industry has yet to find itself," he admits. "We're like those creations of Pirandello: six characters in search of an author."
Given the "reasonable" pricing in the reinsurance market he's surprised that ART is developing with relative speed. But, he says, "the financial innovation is done, it's all a question of the cycle".
The innovation began with the catastrophe bonds of the mid-1990s. There were three or four unsuccessful attempts before a landmark deal in June 1997 for United Services Automobile Association (USAA), securitizing $477 million of one-year hurricane risk. Since then there have been over 20 well-publicized securitizations totalling around $3 billion of insurance cover. That is only a fraction of the estimated $275 billion of insurance covering the world catastrophe market. It is an even smaller fraction of the trillions of investment dollars sloshing around the international capital markets.
But many other kinds of ART deals have been done that aren't public, according to industry sources. In fact financial markets and reinsurance had been flirting with each other for years and there are many overlaps, such as contingent funding, which require financial market providers to take some account of insurance risks. Sedgwick, recently bought by Marsh & McLennan, was one of the ART pioneers in London, tinkering with option products in the late 1980s. "We tried building an options contract but we couldn't quite find an index," recalls Andrew Martin, managing director of Sedgwick Insurance Strategy Limited (Instrat). The CBOT launched an option contract based on the US Property Claims Services (PCS) index in 1992. Sedgwick did "some successful trades" in 1993 which it hedged with the CBOT contract, says Martin. "We've placed a lot of reinsurance option contracts which behave like capital market instruments." Part of Sedgwick's competitive edge is a joint venture in Chicago - Sedgwick Lane Financial - with ART pioneer Morton Lane. Like Sandor, Lane bestrides the insurance and financial markets, with a career that included a managing directorship at Bear Stearns, lecturing at the University of Chicago and membership of the CBOT.
Lane first suggested in 1997 that an option on rates-on-line would get securitization out of the bind of today's depressed prices. Sedgwick structured the first such deal, the option to issue an insurance-linked note, for Reliance Re in May 1998. Goldman revisited the structure in a deal for Allianz in December. Allianz Risk Transfer, the insurer's Zurich-based ART subsidiary, bought a three-year option to issue $150 million of bonds related to German hail and storm damage. It effectively protected itself against a rise in the price of new reinsurance, if storm damage pushes up rates. "It's a forward price on the price of your reinsurance," says an ART specialist.
Lane is bullish on the future of ART ("This is the year of the option," he says) and he criticizes the exchanges for taking their eye off the ball. "I'd list contracts on aviation, satellite and marine risk," he says. "either on insurance cover or the reinsurance price. The market will tell me which is best."
Lane clashed in print last May with Warren Buffett, legendary equity investor and chairman of insurer Berkshire Hathaway, who in his last annual report castigated catastrophe bonds for luring investors into risks they don't understand. Buffett is famous in the ART market for having snapped up $1.5 billion of Californian earthquake risk in November 1996, just as it was about to be securitized by Morgan Stanley. Berkshire Hathaway, Buffett wrote, is able to "estimate a range of probabilities for such events" whereas investors are at the mercy of "promoters who typically employ an 'expert' to advise the potential bond buyer about the probability of losses".
Lane argues that corporate bond buyers rely just as much on experts: the rating agencies. If, as Buffett suggests, cat bond investors are foolish, Buffett "should securitize his cat exposure, sell his own cat bonds, pocket the profit and pass the risk," wrote Lane. Interestingly, the following month Buffett bought General Re which also owns Cologne Re, both active in the ART market.
Unfortunately, one of the problems so far of the cat bond market is the difficulty of arbitraging between the securities and the underlying market. The major obstacle, says Robert Miller, an insurance derivatives consultant, is the 18th-century concept that behind every deal must be an insured interest. Ultimately the bargain cannot be cash-settled - someone must have suffered a loss.
Because of this and other structural factors it is difficult to compare the economic value of a risk premium to an insurer and its economic value to a bond investor. A reinsurer may have a portfolio of 30 different Japanese catastrophe risks for which it has taken $1 billion of risk, committed $100 million capital and taken $10 million premium. It can invest the $10 million in government securities. A bond investor putting $10 million into a single-risk cat bond enjoys no portfolio diversification, cannot reinvest the risk premium, and possibly enjoys no leverage. The investor naturally seeks a return commensurate with the risk of loss and the opportunity cost of tying up capital. The rule of thumb is around 400bp over Libor for a risk of total loss estimated at under 1%. Rates-on-line for the same risk are around 100bp.
The bond issuer has to pay that difference. Not only that, it must pay the investment bank, the lawyers, a risk-modelling firm and a rating agency, and go through four to six months of work for its first issue. Issuers are reluctant to discuss overall fees, but one hints that legal fees might amount to $500,000, risk modelling from $100,000 to $500,000 depending on the complexity, a rating another $100,000, leaving little change out of $1 million, before mentioning the investment bankers' commission.
Wooing the investor
Why then do issuers continue to issue? "Some of our competitors do it for marketing reasons," says a reinsurance issuer whose firm has done three capital market transactions. The rationale is name recognition and market access. When reinsurance capacity shrinks, capital markets will be needed to fill the gap. Reinsurers with issues already trading will be able to sell down their risk more quickly and efficiently. That's the theory.
But even at these high premiums over the rate-on-line, investors aren't flocking to cat bonds or other issues. Morgan Sze, executive director of the risk markets group at Goldman Sachs, says there are around 400 investors looking at insurance-linked bonds of whom about 90 have portfolios. Reinsurers, which could be seen as the most natural buyers, form only "about 10% of this market", says Sze. Other investors include investment advisers, mutual funds, hedge funds, banks and life insurance companies. Life insurers are eager buyers since they understand insurance risk and there's no correlation with their main portfolio. "The core investor group is insurance," says Derrell Hendrix, another ART pioneer, who developed the product at Citibank before heading derivatives trading at Bank of Boston then in 1996 setting up ART boutique Risconsulting in Boston, with Hannover Re and Rabobank as minority shareholders. "Even when you get into pension funds you'll find the individual fund manager is insurance-knowledgeable," Hendrix says. A few banks dabble in this market: "Some investment banks warehouse the risk," he adds. "But that's not the right place to put investment banking capital."
Several insurers and fund managers are experimenting with cat bond funds. Lehman Re has capital of $500 million, some of which is invested in cat bonds. Hannover Re is a buyer of cat bonds that fit with its overall portfolio and is setting up to trade weather derivatives. Mercury Asset Management has a joint venture with Munich Re intending to invest up to $100 million in cat bonds. PXRe and Phoenix have a catastrophe bond fund. Willis Corroon Catastrophe Management is investing money from institutional investors. Teachers' Insurance & Annuity Association of America has around $95 million invested so far in six separate deals. "We're very happy with the performance so far," says Mike O'Kane, managing director of the securities division at TIAA-CREF. It would take several catastrophes at once to dent the portfolio, he says. In all but two investments the principal has been defeased by coupon payments (some securitized tranches bear less underlying risk than others), leaving pure catastrophe exposure of around $45 million.
The trick is to diversify the portfolio. At Lincoln Re, predominantly a life insurer, senior vice-president Kenneth Clark invests selectively in cat bonds. He prefers those that are already spread over several risks - such as Reliance bonds, issued in tranches over the last three years. They cover a basket including property catastrophe in the US and the rest of the world, marine drilling, satellite launch failure and aviation.
But other investors aren't convinced there's enough diversity yet. "Only about a dozen larger transactions have come to the market," says Manfred Seitz, head of the financial reinsurance and ART division at Munich Re. "I don't think you could create a portfolio management even if you participated in all the issues. Say you get an excess spread of 400bp over Libor and you participate in 10 transactions - a total premium of 40 - risking 100 in a singe risk."
Clearly the more catastrophe deals that are done, the greater the diversity. Deals for Winterthur in 1997 and Allianz last year have begun to open up the market for European storm risks. The solution may be to smooth out these lumpy risks with the less spectacular flows from life insurance. Says Clark at Lincoln Re: "Longer-term, if securitization came to the life insurance arena, we'd become a player." There is increasing incentive, says Clark, since rating agencies are demanding that life insurers carry more and more capital.
Hannover Re and National Provident Institution each did life insurance securitizations early last year. Hannover Re is preparing to securitize a further Dm250 million of life cover. Life insurance risk offers the advantage, from the investor's point of view, that its performance is easier to model.
Cat bond critic Buffett criticized the risk modelling "expert" who receives an up-front payment "no matter how inaccurate his predictions". He was referring to the handful of catastrophe risk modelling firms that thrive on the bond buyers' need for independent analysis of the peril they are exposing themselves to. The top names include Applied Insurance Research, Milliman & Robertson, EQECAT, Risk Management Solutions, and Tillinghast Towers Perrin. They will take historical data on hurricanes, earthquakes and other disasters, and run through simulations that give a spread of probabilities of future occurrences. That calculation allows rating agencies to put a number on the probability that the issued security, or special purpose vehicle, will suffer loss. Investors can compare the rating, generally around double-B, directly with that given to other bonds, such as corporate bonds.
Cat bond investors are reluctant to buy these bonds without a rating attached. An early deal, George Town Re, has no risk rating, but it is more of a profit-share than a bond structure. Allianz was able to get a prospective rating of PB3 from Moody's - the first time Moody's has given one - despite the fact that Allianz's bonds may never be issued if the option isn't triggered.
Risk modellers have a healthy respect for the rating agencies: "Their willingness to get involved has been fundamental," says Paul VanderMarck, vice-president at Risk Management Solutions at Menlo Park, California, which modelled the Allianz deal.
Yet Buffett is right to be sceptical. However rigorous the risk modellers are, they are dealing with events that could happen tomorrow or in 100 years' time, or never. Earthquake occurrences and epicentres are almost totally unpredictable, hurricane landfalls are predictable only hours before they happen. Forecasts of corporate or sovereign defaults on the other hand can be reviewed daily - the rating in this case being a guide that tends to lag the most recent information.
Earthquake and hurricane risk models aren't particularly useful when the buyer's risk is concentrated on a single roll of the dice (to borrow a Buffett analogy). Yet the probability number becomes an integral part of each bond issue. The risk modeller, however independent, becomes one of the actors at the issuer's roadshow, helping to persuade investors to buy. "I can give you a model which gives you an answer A or B," says a reinsurance-based ART expert. "There's no single correct answer for the price of the risk."
Reinsurance companies take their own view of such risks, although the most sophisticated have in-house modelling capability. "We have a tremendous amount of data and we have our own models," says Prakash Shimpi, principal at Swiss Re New Markets. "But it's usually good practice to have these modellers provide information independently."
London broker Willis Corroon has its own modelling group at Cordis Consulting, where "we develop advanced mathematical models to price these products", says Cordis managing director Oliver Peterken. Cordis doesn't just model hazard risk, it uses financial risk models too.
Among the rating agencies Moody's believes it is the only one that has developed its own models for earthquake and hurricane risk. "We spend a great deal of time going through the models," says Jeremy Gluck, managing director for structured derivative products. "We don't accept black boxes and we ask hundreds of tedious questions." He accepts, however, that the risk modellers "have had to educate us and we've educated ourselves". A great deal of earthquake and hurricane data is on the internet, he says.
So has Moody's ever had the temerity to reject a model? "There are certain risks we regard as unmodellable," says Gluck. One is for bonds linked to satellite disruption - the chance that a satellite will be hit by meteorites or space debris. Moody's has also rejected transactions where an issuer wishes to hedge a basket of risks, some of which cannot be modelled - "such as flood, conflagration and meteor strike", says Gluck. Insurers can and do accept risks that can't be modelled, but if they securitize them they are unlikely to get a rating.
The models are only half the equation when rating a cat bond, says VanderMarck at RMS. "The other half is the quality of the exposure data for the portfolio in question."
Without an index, or some objective measure of damage or loss, it is impossible to fix the payout on a security linked to a catastrophic event. The CBOT picked the PCS (Property Claims Services) index for its family of regional US cat options. The BCOE picked the Guy Carpenter index of hurricane loss for its GCCI options. Swiss Re used the PCS index for its SR Earthquake bonds.
Those keen to see insurance risk traded are searching for the holy grail: a robust index. The use of an index opens up basis risk against the underlying exposure, but the trade-off is tradability - in theory. The CBOT PCS options "will probably not be used to hedge cat bonds," suggests Hilmar Schaumann, associate director at Swiss Re New Markets, "because if an investor is buying earthquake bonds, he probably doesn't want to hedge away the earthquake risk."
A Lloyd's-based index
Instrat in London has hopes of an index it has begun to use that is based on global underwriting performance as published by the Lloyd's of London insurance market. Instrat is promoting options trading on the index, which offers a hedge on the performance of global underwriting. "We've done some OTC transactions on derivatives of the index," says Martin at Instrat.
|Issue date||SPV* or nickname||Cedant||Total size*||Risk capital||Risk period||Risk||Spread*|
K1 and K2
George Town Re
St Paul Re
3 and 10 years
Sedgwick Lane Fin
Residential Re 97
582 and 276
625*,475,275 or 259
Mutual Securitisation plc
T-bills + 375
Residential Re 98
Single east and Gulf hurricane
Yasuda Fire & Marine
5 and 7 years
F&G RE (St Paul Re)
Various US perils
440, 820, 215
XL Mid-Ocean Re
US hurricane & earthquake
Auto leases residual value
3 year (option)
German wind and hail
Finite risk portfolio
|*Special purpose vehicle *$ millions unless otherwise stated *Over Libor unless otherwise stated|
Source: Goldman Sachs, Guy Carpenter and others
There are good reasons, however, why encouraging speculative trading on an insurance index has proved difficult. Markets thrive on asymmetry of information. A market with perfect information is not worth trading, as the capital-asset-pricing model indicates. Information on catastrophe risk is not perfect, but everyone can share it: much of it is published on the internet. The news of hurricanes and earthquakes is flashed instantaneously to every part of the globe. There is no special inside information to be had in the bars of Wall Street, London or Chicago, although last September, when hurricanes were careering around the west Atlantic, there was a flurry of activity in the Florida windstorm bonds, Residential Re and Trinity Re.
Usually cat bond investors take positions only on the technicalities of their own portfolios, not on new information, although traders of hurricane exposure see the risk diminish as the season draws to a close. Buyers of earthquake exposure usually want to keep it. "A client obviously wants the exposure - that's a more fundamental decision," says Schaumann at Swiss Re New Markets. The bond prices shift not only as appetite for exposure changes, but also because of the interest rate exposure. If a client wants just the earthquake exposure "we can structure a total-return swap, which gives the client the earthquake exposure without having to hold the bond".
The most liquid bond is Residential Re, a $477 million issue by USAA, lead-managed by Lehman Brothers, Goldman Sachs and Merrill Lynch. Although these bonds are mostly double-B rated "they don't trade like double-B corporate bonds", says David Moran, associate director at Swiss Re New Markets. "They're less liquid than double-B mortgage-backed securities or even double-B structured notes." Swiss Re New Markets holds inventory but also takes account of the positions and risk appetite of its parent Swiss Re in Zurich. Other secondary market participants are Goldman Sachs and Aon Capital Markets, which acts mostly as a broker.
Events last year in emerging markets may have triggered a fresh look at catastrophe exposure. The horrible correlation that affected all bond and equity markets from Russia to Argentina didn't affect cat bonds. Cat bond holders benefited from a smoothing effect on the rest of their portfolio. Of course cat bonds haven't yet seen a major loss.
Learning to live with risk
A bigger lesson learnt by financial risk managers last year is that all financial assets are exposed to extreme-event risk. The insurance industry is more familiar with extreme events. Financial risk managers can learn something from an insurance portfolio's robustness to stress. "Bankers want beautiful formulae and they want to hedge out any residual risk," says an ART expert, "while insurers take the open risk they're comfortable with."
Convergence of the two philosophies is bound to come. But which empire will be the winner? Insurance firms seem readier to embrace the financial markets, judging by the number that have financial subsidiaries.
Many of the convergent insurance/finance deals have been a way of securing cheaper finance, rather than a transfer of insurance risk to new entities. The life insurance deals "are really financing deals, they're not risk transfer," says Sze at Goldman. But in the drive to bring more investors into the insurance market, the more inventory that can be built and traded the better. Hannover Re has been one of the pioneers of cat risk transfer and life insurance transfer. Hannover Re Advanced Solutions was set up in Dublin in 1992. Its keenness to woo and keep bond investors shows in its prolongation policy. "If major losses occur," says Reinhard Elers, managing director at HRAS, "we offer the investors the opportunity to continue on a prolongation deal - their capital, which has been committed for five years, has the option to continue for another two or three years."
Securitization is only a part of alternative risk transfer. ART can involve OTC swaps or options. AIG Risk Finance has tended to favour such OTC deals. "The bond transaction is less economical than the swap transaction if you use an index," says Michael Canter, senior vice-president at AIG Risk Finance. AIG is also an investor in the BCOE, and trades weather derivatives.
Willis Corroon sees a lot of similarity between ART contracts and financial options. "The same modelling techniques can be used in both cases," says Peterken at Cordis Consulting. Broker Aon Capital Markets developed the CatEput in 1996, which involves underwriters writing a put option on the equity of an insurance company. That allows the insurer to sell its equity to the option writer at a fixed price, making sure that it has future reinsurance capacity even after a severe loss has hit its share price and its credit rating. Aon sold this structure to insurer RLI Corp, with Centre Reinsurance as underwriter of up to $50 million, against RLI shares.
Centre Solutions, a subsidiary of Zurich Re, was among the first to offer finite insurance: defeasing large operational risk insurance premiums over several years.
The future depends on establishing more transparent pricing which investors understand. In the prevailing market "vanilla cat bonds are dead boring, but contingent notes and options are more interesting," says a practitioner. Once a price curve is established, investors and speculators can trade off it. Consultant Robert Miller is convinced that exchanges should list contracts based on price, rather than attempting to transfer the physical insurance risk. But unfortunately, price speculation and trading can only develop from contracts based on the underlying risk. Moreover, brokers rely on being the main source of a two-way price. "To get them to change is like trying to turn the sky from blue to red," says one supporter of insurance derivatives.
The market is waiting for the right conditions to bring in more participants. Conditions could come right soon, with a hardening of reinsurance rates. "The insurance cycle hardens for peculiar reasons," says Lane. "It could harden because of Year 2000 liability, or tobacco litigation as well as a more obvious large physical catastrophe." Investor O'Kane at TIAA-CREF muses: "Somebody else's earthquake would suit me just fine."
The ghost at the feast is Lloyd's of London, once expert at transferring risk to syndicates of unwitting investors. Because of Lloyd's present structure, Lloyd's members cannot carry business year to year and they don't have securities licences, so they can't structure and sell cat bonds or derivatives.
But Lloyd's is the world's biggest centre of reinsurance expertise. If the mindset and the rulebook changed it could also become the biggest centre of two-way insurance risk trading. "The smart people went into investment banking, and the people who want a quiet life went into insurance," says a frustrated insurer. Insurance contracts are still hampered by the tortuous small print, referred to as "the right to argue about the meaning of English at a future date". While this is being sorted out, the reinsurers in Dublin, Zurich, Bermuda, New York, Chicago, and Fort Wayne, Indiana, are showing the way.