how do your odds really stack up in nature's casino?
TRANSCRIPT
By: Alexander Pui
How do your odds stack up in Nature’s Casino?
Global Catastrophe Losses (1970 – 2013)
H. Katrina (2005)
Japan/NZ EQ, Thai Floods
(2011)
Northridge EQ (1994)
Source :Swiss Re Economic Consulting and Research
Global Catastrophe Losses (2015)
Who pays for these losses?
• Self insurance?• Insurers (IAG/ Suncorp/ QBE… ) ?• Reinsurers (Swiss Re/ Munich Re/ Warren Buffett…)?• Alternative Capital (Investors in Insurance Linked Securities
(ILS)?• Governments/ Tax payers ( 2011 Queensland Flood Tax
Levy…)?
Who pays for these losses?
Source: Dahlen and Peter, Natural Catastrophes and global reinsurance: Exploring the Linkages, BIS Quart. Review, 2012
Actual losses from natural catastrophes and risk transfer in 2011
Outline
• Short Primer on Reinsurance• Overview of the ILS Market• Pricing and Structuring of Cat Bonds• Examples of ‘exhausted’ Cat Bonds• Will investor appetite continue to grow?
Short Primer on Reinsurance
Primer on Traditional Reinsurance (TRI)
Reinsurance purchased to protect against risk of ruin (smooths volatility) but only if it makes economic sense.
8
Retained by Insurer
Absorbed by Reinsurer
Reinsurance decisions reflect a firm’s risk appetite and shareholder expectations (RoE)
Protection against adverse volatility
9(800.000)
(600.000)
(400.000)
(200.000)
-
200.000
400.000
600.000
800.000
1,000.000 1% 4% 7% 10
%
13%
16%
19%
22%
25%
28%
31%
34%
37%
40%
43%
46%
49%
52%
55%
58%
61%
64%
67%
70%
73%
76%
79%
82%
85%
88%
91%
94%
97%
Profi
t / L
oss
Probability
Holistic ApproachDistribution of Profit/Loss
Percentiles
Profi
t/Lo
ss
Caps Max loss at $400m
When does reinsurance make ‘economic sense’?
$11bn Capital
$1.5bn Profit
Mooncorp
RoE = 13.6% (1.5 / 11 bn)
$3.7bn Capital
$900m Profit
$600m Expense
Perkshire (International Reinsurer)
$600m reinsurance cost for $7.3 bn of capital ‘relief’
$3bn Capital
RoE = 20%(0.6/3 bn)
$600m Profit
$4.3 of Diversification Benefit
Backed by
$1.5bn Profit
Mooncorp reinsured by Perkshire
$7.3bn ‘Saved’ Capital
RoE = 24.3%(0.9/ 3.7 bn)
$7.3bn Capital
$600m Profit
Hence ‘value’ of reinsurance is an improved RoE of 10.7%
ILS instead of TRI‘Hedge Fund Re’(Special Purpose Vehicle)
$7.3bn Capital
$11bn Capital
$1.5bn Profit
Mooncorp
RoE = 13.6% (1.5 / 11 bn)
$3.7bn Capital
$900m Profit
$600m Expense$600m reinsurance cost for $7.3 bn of capital ‘relief’
$1.5bn Profit
Mooncorp reinsured by Perkshire
$7.3bn ‘Saved’ Capital
RoE = 24.3%(0.9/ 3.7 bn)
$600m Profit
Hence ‘value’ of reinsurance is an improved RoE of 10.7% !
$7.3bn Capital
RoE = 9.58%(0.6/7.3 bn)
$600m Profit
Backed by
Investors
Overview of the ILS Market
Growth of the Cat Bond Market
• Growth punctuated by significant increases when RI markets harden.
• Bond durations are getting longer.
Source: Artemis
H. Katrina (2005) Japan/NZ EQ, Thai Floods
(2011)
Growth of Cat Bonds and Other ILS
• Collateralized Re* growth has accelerated in last 6 years
• Coll. Re and Cat Bonds now dominate the ILS market
Source: Insurance Information Institute (Aon Benfield)
Collateralized Re* is similar to cat bonds where investors participate directly in (for e.g.) reinsurance programs but are private transactions and non-tradable.
2015 ILS issuance by Peril
• Key Perils such as US Wind and EQ continue to dominate• Emergence of international perils + non CAT related – life and mortgage insurance losses (?!?)
Source: Artemis
ILS growth outpaces traditional RI
• ILS has doubled its share of the global RI market since 2010 (5.4% to 11.5%)
• Changes are more pronounced in property catastrophe space.
Source: Insurance Information Institute (Aon Benfield)
Pricing and Structuring of Cat Bonds
Idealized Cat Bond Structure
Other parties typically involved in a Cat Bond transaction include:• Risk Modelling Firms• Investment Banks• Loss Reporting
Agencies• Rating Agencies
Pricing of underlying peril risk*
Simulated Hurricane Tracks Simulated Earthquake Events (Epicenters)
Sources : Franco, G. (2010) “Minimization of Trigger Error in Cat-in-a-Box Parametric Earthquake Catastrophe Bonds “
* For Natural Peril premised bonds, catastrophe models are used to assess underlying base risk through stochastic simulation of natural disasters and associated economic costs.
Relevant Catastrophe Model OutputEx
ceed
ance
Pro
babi
lity
Loss
p
RP Loss
AAL
• Average Annual Loss (AAL) or ‘area under the Exceedance Probability Curve’
• Return Period Losses (i.e. 1 in 200 year loss for any given year , p = 1/200 = 0.005)
• XSAAL ~ contribution from events that exceed a certain loss
• Uncertainty in loss estimatesXSAAL
Hypothetical Cyclone Based Cat Bond
Estimated based upon cat model output + loadings for uncertainty, expenses and profit margins.
Upper Layer (Cat Bond)
Lower Layers (TRI)
Retention (Mooncorp)
L0
L1
0
10m
100m
150m
Loss ($) Return Period
500
100
5
Bond ‘Trigger’ considerations Parametric: • EQ Richter Scale,
Cyclone Peak Wind Gust/ Central Pressure
Industry Index:• Losses sustained by
‘market portfolio’ affected region
Modelled Loss:• Losses for portfolio est.
by Cat Models
Indemnity:• Actual Claims
experience of indvd. insurers
Source: Swiss Re Capital Markets
Addressing Adverse Selection
• Issuer/Sponsor participates in its own product to avoid perception of shipping out the duds’
• Limits losses to account for portfolio growth
Source: Canabarro et al., Analyzing the pricing of ILS, Journal of Risk Finance 2000
Circumventing uncertainty in model loss estimates
• Complex underlying commercial portfolio means high uncertainty in modelling results
• Parametric trigger that accounts for distance to major EQ circumvents this issue.
Source: Canabarro et al., Analyzing the pricing of ILS, Journal of Risk Finance 2000
Examples of ‘exhausted’ Cat Bonds
List of losses to investors
Source: Insurance Information Institute (Aon Benfield)
Failure of Swap Counterparty
Who pays for these losses?
USD 300m
Source: Dahlen and Peter, Natural Catastrophes and global reinsurance: Exploring the Linkages, BIS Quart. Review, 2012
Actual losses from natural catastrophes and risk transfer in 2011.
Muteki (USD 300m)
984
1420
0
Dropdown Trigger Vaue
Event Attachment
Index Value Exceedance Probability
0.6%
1.02%
4%
Event Exhaustion
Key Features/Details: • Principal Amount: USD 300M• Event: Japanese EQ• Cover: Per Occurrence• Trigger Type: Parametric• Risk Period: 2 May 08 – 1 May 11• Moody’s Rating: Ba2• Modelling Agency: AIR• Issuer: Muteki Ltd.• Reinsured: Zenkyoren• Reporting Agent: K-NET
Source: Artemis, Strong Motion Networks: K-Net Japan
Muteki (USD 300m)
Source: Twelve Capital, Cat Eye
While a number of bonds were deemed ‘at risk’ after 2011 Tohoku EQ & Tsunami, Muteki was the only bond to exhaust completely.
Muteki (USD 300m)
Sources: Twelve Capital, Cat Eye
• Did parametric index reflect best view of seismic risk?
• Was bond spread of 4.4% commensurate with high uncertainty in underlying risk?
• Investors were not ‘spooked’ and retained appetite for Japanese EQ risk
Mariah Re (USD 200m)
Key Features/Details: • Principal Amount: USD 200M• Event: US Severe Thunderstorm• Cover: Aggregate• Trigger Type: Industry Index• Risk Period: Nov 10– Nov 11• S&P Rating: B• Modelling Agency: AIR• Issuer: Mariah Re• Reinsured: American Family Mutual• Reporting Agent: Property Claims
Services (PCS)
Mariah Re (USD 200m)
• Initial estimates from PCS suggested losses unlikely to reach exhaustion point
• PCS revised its estimates months later, resulting in complete exhaustion – prompting disgruntled investors to sue AIR and PCS.
• The legal action threatened to open ILS Pandora’s box, challenging touted benefits of catastrophe bonds such as :– East of Settlement– Counterparty Risk– Impartiality of loss modelling and reporting agents
Mariah Re (USD 200m)
• Courts found no impropriety in execution of contractual obligations
• Issues with aggregation and weighting methods were flagged by certain funds (who chose not to participate)
• Onus on investors to perform proper due diligence
“Having gambled and lost on the weather ……Mariah now attempts to convert its unsuccessful risk venture into a game of “gotcha” on the contracts.” Sullivan J.
Will investor appetite continue to grow?
Will impressive historical performance continue?
• Cat Bonds have historically performed well as an ‘uncorrelated’ asset class
• Issues with swap counterparties (i.e. Lehman Bros) have been addressed.
• Onus on investors to perform proper due diligence
Factors impacting future prospects
• Low interest rate environment• Influx of longer term investors
(Pension Funds)• Increased investor comfort with
product?• New range of products beyond
natural catastrophes (ie. Longevity/ Operation risk)
• Efforts to bridge protection gap /under-insurance in developing countries could push up demand
Alexander PuiEmail: [email protected]
Linkedin : https://au.linkedin.com/in/alexander-pui-94a33821
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