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Americas edition August 2008
Insurance
Sharing insights on ey industry issues*
Insurancedigest
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The Americas Insurance digest is published twice ayear to address the ey issues driing the insuranceindustry. If you would lie to discuss any of theissues raised in more detail, please contact the
indiidual authors, or the Editor-in-chief, whosedetails are listed at the end of each article.
We also welcome your feedbac and comments onthe Insurance digest, and as such, we enclose aFeedbac Fax Reply form. Your feedbac will help
us to ensure our publications are addressing theissues that concern you.
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Insurance digest PricewaterhouseCoopers 1
Editors comment 2John Scheid
Bermuda reinsurance maret deelopments 4Arthur Wightman
Islamic insurance: A competitiely priced, ethical product with potentially
widespread appeal 10Bryan Joseph and Mohammad Khan
Contingent capital: Stepping into strategic capital planning 14Larry Rubin and Xiaokai Victor Shi
Recent deelopments in ris mitigation through reinsurance and capital marets 22Caroline Foulger
Life settlements: Inestment opportunity or irrational exuberance? 28Mary Bahna-Nolan, Larry Rubin, Steven Siow and Selina Wang
Corporate restructuring: The silent reolution 34Mark Batten and Jim Bichard
Improing budgeting and forecasting: Lining nancial planningwith strategic direction 38Randy Brown and Greg Galeaz
Global insurance and reinsurance tax deelopments 42Rick Irvine
Fair alue measurement: The fallout and the future 48Donald Doran, David Scheinerman, Mary Helen Taylor, Amie Thuener, Anne-Lise Vivier and Sergey Volkov
Is your ERM deliering? 56Paul Horgan and Nick Ranson
Americas edition August 2008
Contents
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Editors Comment
With few major catastrophes
and strong prices, recent
years hae been relatiely
good ones for most insurers.
In contrast, the current inestment maret is
ery challenging; although yield cures hae
shown some improement recently, economic
growth is slowing, marets are olatile, asset
alues are eroding, and interest rates remain
ery low by historical standards. Most notably
as is the case with many nancial institutions
life insurers are feeling the impact of maret
olatility, rising inestment losses and a credit
maret squeee, and pricing has becomea major concern for commercial insurers
and reinsurers.
Howeer, the insurance industry by and large
has sufcient capital and liquidity to withstand
these challenges. Moreoer, it is strengthening
underwriting practices and exhibiting an
increased appreciation for robust enterprise
ris management.
In this issue of the Americas Insurance Digest,
we focus on three topics of primary and
immediate importance to our readers:
marets and growth, product innoation,
and measurement/nancial reporting.
Our industry practice has identied recent
maret deelopments, assessed ey changes
in the maret, and presents seeral resulting
insights and ideas for your consideration.
Insurance digest PricewaterhouseCoopers2
JOHN S. SCHEID: CHAIRMAN, AMERICAS INSURANCE GROUP
Editors comment
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Insurance digest PricewaterhouseCoopers 3
I hope you nd the following articles of interest.
As in the past, please continue to proide us
with your ideas for future articles. You also
may be interested in the Asia-Pacic and
European editions of the Insurance Digest,
which are aailable at www.pwc.com/insurance.
Sincerely,
John S. Scheid
Editor-in-Chief
PricewaterhouseCoopers (US)
Tel: 1 646 772 [email protected]
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Bermuda reinsurancemaret deelopments
AutHOr: ARTHUR WIGHTMAN
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Insurance digest PricewaterhouseCoopers 5
As Bermuda reinsurers tae stoc following the 2008 insurance renewals and
rst-quarter earnings reports, Arthur Wightman explores some of the challengesin Bermudas deeloping maretplace and proides insight into the ey issues
facing the CEOs of Bermudas reinsurance companies.
Nobody wins the
Tour de France
on the at or
going downhill.
BErmuDA REINSURANCE MARkET DEvELOPMENTS
Oveview
With a second consecutie year
of faorable rates, benign losses,
and resere deelopment, the
Bermuda reinsurance maret is
booming. Share repurchase
programs hae recently realied
more than $4 billion in capital,
and strong net earnings continue
to boost boo alue and delier
high returns on aerage equity.
As Bermuda reinsurers tae stoc
following the 2008 insurance
renewals and rst-quarter earnings
reports, this article explores some
of the challenges in Bermudas
deeloping maretplace and
proides insight into the ey issuesfacing the CEOs of Bermudas
reinsurance companies.
Onoin soenin
With the exception of European
windstorm kyrill, 2006 and 2007
were notable for an absence of
major natural disasters. While
Bermuda reinsurers enjoyed
bumper returns, reports of a
softening maret grew in number
beginning in mid-2007, with some
sources reporting rate declines
een earlier. While the headlinenews is that rates are falling from
historically high pricing leels, the
2008 renewal season has also
thus far been characteried by
the following underlying factors:
Renewals placed relatiely late
in many marets;
Cedants electing to retain more
ris despite more attractie
rates and attritional losses;
Benign past-quarter losses and
seeral resere releases; and
Capacity changes, particularly
in the Gulf of Mexico region,
leading to increased
competition.
These factors hae sered as
catalysts for more attractie
pricing for reinsurance buyers.
In PricewaterhouseCoopers1
(PwC) biennial 2006 Bermuda
Maret Surey, Capitaliing on
Opportunity: A Time of Change,
Bermudas reinsurance CEOs
raned underwriting performance
and cycle management among
their top concerns. Early results
from the 2008 Bermuda Maret
Surey suggest that today een
more CEOs are raning these
issues among their biggest areasof focus.
Nobody wins the Tour de France
on the at or going downhill.
Everyone who has ever won the
race has done so climbing the
Alps. A sot market is the true testor an underwriter. Those are the
years when you separate the
winners rom the losers.
(Constantine Iordanou, President
and Chie Executive Ofcer, Arch
Capital Group)
As reinsurance marets soften,
the phrase underwriting
discipline is being referenced in
many inestor calls and in many
publications and press releases
as a defense against writing bad
business. A softening maret
calls for tough decisions, eenif it means waling away from
signicant renewal business.
On April 10, 2008, the Colorado
State Uniersity forecast team
upgraded its early-season
hurricane forecast, and predicted
that the US Atlantic basin will
liely experience a signicantly
aboe-aerage hurricane season.
Clearly, major natural disasters
will noticeably change the cycle
outloo, resulting in declining
rates. How well will Bermuda
reinsurers stand up to the
possibility of major lossesfollowing two unproblematic
1 PricewaterhouseCoopers refers to the global networ of member rms of PricewaterhouseCoopers International Limited,
each of which is a separate and independent legal entity.
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Insurance digest PricewaterhouseCoopers6
years? Hae underwriters been
disciplined enough to wal away
from technically inadequate riss
and leae business on the table?
How robust are the capital,
aggregation, management sills,
and underwriting talents of
Bermudas Class of 2005? How
will in-house stochastic models
hold up? Are the adjustments
made following Hurricanes
katrina, Wilma, and Rita robust?
Which companies are really
holding the underwriting line?
In tandem with a soft reinsurance
enironment, constrained growth,
inestment maret turbulence,
the wea dollar, and a string of
oil price records all indicate a
continuing decline in interest
rates in 2008. This decline will
hae a corresponding impact on
inestment returns principally
based on bond portfolios and,
ultimately, underwriting.
manain caia
Capital management is another
ey issue at the top of Bermudas
reinsurance CEOs agendas. By
the time second-quarter earnings
were reported in 2007, Bermuda
reinsurers had undertaen arious
initiaties to return underemployed
capital to their shareholders.
More than 15 major Bermuda
reinsurance companies
completed share repurchase
initiaties by the end of 2007,
with the notable exceptions of
ACE and validus (the latter onlyafter its IPO in July 2007). Both of
these companies elected to hold
capital to pursue acquisitions.
XL repurchased in excess of
$1 billion (approximately 10%
of opening shareholders funds),
and AWAC, only eighteen months
following its IPO, repurchased
in excess of 25% of opening
shareholders funds. Despite
these repurchases, most
Bermuda reinsurance companies
saw their capital swell by the
end of 2007, reecting the
considerable economic
successes of 2006 and 2007.
Of course, capital management
goes hand-in-hand with managing
an underwriting cycle, and
Bermuda reinsurance CEOs face
a ariety of pressures when
formulating their annual capital
management strategies. On one
hand, rating agency and
regulatory constraints proide
considerable impetus to retain
capital. As attention turns toward
a potentially destructie wind
season following 2007s
considerable capital returns, many
companies may decide to hold
surplus capital, at least for themedium term. But on the other
hand, shareholders objecties for
returns must be met, and after
two abundant years, shareholders
are understandably anticipating a
capital response. If Bermuda
reinsurance companies are
genuinely maintaining underwriting
discipline, further capital returns
or diidends are liely.
the sbie cisis
While few companies escaped
without a scratch from thesubprime lending crisis, the
relatiely conseratie inestment
policy of the Bermuda maret
(which tends to focus on boo
alue growth through high-quality,
xed-income inestments) sered
to minimie asset-side losses.
The exceptions hae generally
responded to declining interest
rates by widening their
inestment ris appetites.
Howeer, inestments in asset-
baced securities (including
mortgage-baced securities) hae
largely been sheltered from
signicant exposure due to the
propensity of the Bermuda
maret to inest in super-senior
inestment tranches. By holding
approximately 5% of its xed
income inestment portfolio in
securities exposed to subprime
and related riss, XL was
something of an outlier.
Directors and Ofcers and
Errors and Omissions liability
claims resulting from the
subprime mortgage crisis (e.g.,
claims against inestment
adisors, managers, and other
organiations) are causing
heightened concern amongBermuda reinsurers writing those
lines. Historically, claims from
these exposures are ery difcult
to predict or quantify. Maret
estimates ary wildly, with current
aluations rising in light of recent
maret deelopments (e.g., the
collapse of Bear, Stearns & Co.
Inc.; rst-quarter earnings
statements etc.).
Another issue that is reasonably
compartmentalied, but with
which the industry must still
contend, is losses stemming frominestments in nancial guaranty
companies. By guarantying
asset-baced securities (including
collateralied debt obligations
and mortgage-baced securities)
these companies hae incurred
steep losses lined to subprime
mortgages. XL reported
signicant losses relating to its
46% inestment in and other
reinsurance/indemnication
relationships with Security Capita
Assurance. Renaissance Re and
Partner Re also incurred losses
(albeit much less seere) from
their inestments in Channel Re.
taxaion sas
Bermudas tax status regarding
on-shore underwriting and
inestment income clearly
underpins the business models of
most reinsurance companies
attracted to the island, leading
Bermudas reinsurance CEOs to
focus on any circumstances that
could affect those models. In a
recent article,2 the rating agency
Fitch estimates that reinsurance
in the Bermuda marets median
20032007 effectie income tax
rate was roughly 15 percentagepoints lower than that of the US
maret. In late September 2007,
the Coalition for a Domestic
Insurance Industry (CDII), a group
of 14 large US-based insurance
groups led by W. R. Berley
Corporation, reported to the US
Senate Finance Committee that a
major tax adantage exists in
places such as Bermuda and the
Cayman Islands. This adantage,
said the coalition, allows foreign
insurance groups to legally aoid
paying billions of dollars in taxes
by moing sieable portions oftheir taxable underwriting and
inestment income from their
US-based businesses out of the
country by reinsuring the
business to another group
BErmuDA REINSURANCE MARkET DEvELOPMENTS continued
2 Fitch Ratings Insurance Property/Casualty Insurers Bermuda, US and Canada Special Report Bermuda Maret Oeriew.
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7Insurance digest PricewaterhouseCoopers
company. The impact of the
CDIIs actiities is liely to
crystallie oer the coming
months. In anticipation of this,
its worth noting that the Internal
Reenue Serice (IRS) already
possesses signicant tools to
address questions of unfairincome shifting (e.g., Section 482).
A further tax consideration that
Bermuda companies are
ealuating is the IRSs recent
guidance on the application of
federal excise taxes on foreign
insurers and reinsurers. The IRS
has interpreted certain releant
tax codes to mean that excise
taxes should not only be imposed
on each policy of insurance or
reinsurance coering US rississued by any foreign insurer or
reinsurer, but also on subsequent
reinsurance policies. This
application of the excise tax is
commonly referred to as the
cascading theory. This could
hae a potentially signicant
prospectie, as well as retroactie,
effect on Bermuda reinsurers.
As the race for the White House
unfolds, tax reform can be
expected to become a hot topic
on the agenda of the next
President and the next Congress.
For corporations, tax reform
could proide for the most
signicant reisions to the tax
code since 1986. Fitch notes,
howeer, that Despite the
heightened criticism, Bermudas
tax adantage is unliely to
disappear in the foreseeable
future () Washingtons
reluctance to gie up tax reenue
maes legislation that would
reduce taxes on US reinsurers,
to leel the playing eld between
them and their Bermuda-
domiciled competitors, een
more unliely.
Divesifcaion and acqisiions
PricewaterhouseCoopers 2006
Bermuda Maret Surey also
identied diersication (both
product-line and geographical) as
another item high on the agenda
of Bermuda reinsurance CEOs.
Indications from the 2008 surey
also highlight this trend as
remaining of ital importance,
particularly as the maret enters a
softer phase. The last 12 months
hae been extremely actie, with
some companies seeing out and
securing signicant operations tobolster their global franchises,
and there is eery indication that
this actiity will continue.
Product-line diersications
mostly aoided the property
casualty business, and
geographic diersication
focused both on traditional
marets such as those in London
continental Europe, and the US,
and newer marets in Dubai and
Latin America.
Other industry actiity included
ACEs acquisition of Combined
Insurance and Atlantic, AXISs
acquisition of Media Pro, Ariels
acquisition of Atrium, and
validuss acquisition of Talbot.
Arch, Flagstone, and others
established presences in Dubai,
with Aspen setting up in Dublin.
AWAC added to its presence in
the US through its Conerium
purchase. Montpelier established
syndicate 5151 at Lloyds of
London, and Partner Re opened
an ofce in Beijing. Bermuda
reinsurers hae traditionally
preferred to compete directly
in other marets by establishing
their own representatie ofces
or companies. But as Bermudareinsurance companies loo to
pursue opportunities in traditional
marets such as Lloyds of London
or in the US, they are beginning
to perceie the acquisition of
existing and successful groups as
offering more sustainable and
secure growth.
Ohe chaenes
Bermudas reinsurance success
story, with roots going bac to
the liability insurance capacity
shortages of the mid-1980s, hasgien rise to distinct challenges.
These challenges relate to
continued growth opportunities
in Bermuda, which is placing
a premium on ofce space,
BErmuDA REINSURANCE MARkET DEvELOPMENTS continued
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Insurance digest PricewaterhouseCoopers8
BErmuDA REINSURANCE MARkET DEvELOPMENTS continued
housing, and wor permits.
The need for local expertise is
ongoing, and the fact that a
degree of specialist expertise will
ineitably require continued
support outside Bermuda, these
local issues hae a direct impacton the simple expense ratios of
the islands reinsurance
companies. There is little doubt
that Bermuda, lie the rest of the
worlds high-cost reinsurance
locales including London and
New Yor will see an increased
focus on outsourcing or relocating
bac-ofce and other functions to
alternate lower-cost locations.
Oook
The future continues to be bright
for the Bermuda reinsurance
maret despite the global
softening phase and other
challenges. The next phase for
Bermuda is liely to include:
Increased consolidation and
acquisition actiity;
Further geographic distribution
and deelopment, as well as
product line diersication
including the growth in the use
of insurance-lined securities;
Capital returns and diidends;
Outsourcing, co-sourcing and
increased focus on expense
management; and
Further rate deterioration and reduced/negatie top
line growth.
Although Bermuda reinsurance
companies thrie on taing
big-ticet riss, those that hae
the resole to wal away when
technical pricing and disciplined
judgment do not support such
ris-taing will be rewarded.
AUTHOR
Ah WihanSenior Manager, Audit and Business Adisory SericesPricewaterhouseCoopers (Bermuda)
Tel: 1 441 299 7127
Beda: Ke acs
Bermuda is the largest reinsurance and general insurance domicile after London and New Yor.
Bermuda is also the largest domicile for capties, containing 65% of all capties globally.
In excess of 18,000 exempt or international companies are registered in Bermuda, taing adantage
of Bermudas faorable corporate tax structure and its highly professional business enironment.
Bermuda, a British oerseas territory, has a respected legal and regulatory system, the latter of which
is under the Bermuda Monetary Authority and a designated territory under the Uks Financial
Serices Act.
With a natie population of approximately 70,000 and an expatriate population of roughly 10,000,Bermuda is the third-most densely populated place on earth. It has one of the highest gross domestic
products in the world.
Bermuda is located in the North Atlantic Ocean, roughly 700 miles east-southeast of North Carolina
and roughly 3,000 miles west-southwest of London.
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9Insurance digest PricewaterhouseCoopers
BErmuDA REINSURANCE MARkET DEvELOPMENTS continued
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Islamic insurance: A competitiely
priced, ethical product withpotentially widespread appeal
AutHOrS: BRYAN JOSEPH AND MOHAMMAD kHAN
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Insurance digest PricewaterhouseCoopers 11
Taaful (Islamic insurance) is one of the fastest growing types of insurance
worldwide and has potentially signicant appeal beyond just Muslim populations.Bryan Joseph and Mohammad khan describe taafuls attributes and attractions,
and offer suggestions on how insurers can maret it.
Although insurers
can market takaul
products to the
adult US Muslim
population, there
is a potentially ar
larger market thatconsists o every
insurance-buying
adult in the US who
wants competitively
priced, ethical
insurance products.
ISlAmIC INSurANCE: A COMPETITIvELY PRICED, ETHICAL PRODUCT WITH POTENTIALLY WIDESPREAD APPEAL
Taaful (Islamic insurance) is one
of the fastest growing types of
insurance worldwide. In the
Middle and Far East, it has
experienced growth rates of1020% per year, compared to an
oerall 9% annual rate of growth
in emerging insurance marets
oerall and a 5% growth rate in
the OECD insurance marets.1
In addition, the return on capital
for taaful products has aeraged
between 15% and 25%, and
based on growth forecasts,
remains promising. Moodys has
predicted that total taaful
premiums will rise to $7bn by
2015, and some of the worlds
largest taaful companies enision
that approximately one-third oftheir premiums will come from
Western countries by 2020.
For North American insurers,
taaful has as-yet untapped
potential for future growth. In
commercial lines alone, there is
an opportunity for US and
Canadian insurers to proide
taaful insurance and reinsurance
for an estimated $1.5 trillion of
infrastructure that Arabian Gulf
countries are planning to
construct in the next decade.2
Moreoer, although insurers canmaret taaful products to the
adult US Muslim population of
1.5 million people,3 there is a
potentially far larger maret that
consists of eery insurance-
buying adult in the US who wantscompetitiely priced, ethical
insurance products.
Wha is aka?
Taaful means guaranteeing
each other and is a form of
mutual insurance that is similar in
concept to the mutual and
co-operatie schemes in Europe
and North America. Taaful
insurance pools resources to pay
for eents/losses that none of the
indiidual members of a group
could afford.
Taafuls main principles include:
The customers (policyholders)1.
of the taaful business agree to
pool their contributions and
share the liability of each
policyholder. Therefore, if one
policyholder has to be paid a
claim, then it is paid out of the
combined pool of the
policyholder contributions.
Because each policyholder
agrees to allow his or her
contributions to fulll his/herobligations of mutual help to a
fellow policyholder should
he/she suffer a dened loss,
uncertainty (Gharrar)
something Islam does not
allow is eliminated.
Similar to mutual insurance, the2.
policyholders share in the prot
and loss of the taaful business.
The policyholders all share the
insurance ris howeer, they
do not cede the ris to the
taaful company (as occurs in
a conentional shareholder or
mutual insurance company).
Consequently, if the taaful
business maes a surplus at
the end of a nancial year, then
it is shared among the taaful
policyholders.
If the policyholders fund3.
maes a loss at the end of
the nancial year, then a Qard
Al-Hassan (interest-free loan)
from the shareholders funds
the decit; any future surpluses
of the policyholders fund are
used to repay the shareholders
loan. The shareholders cannot
access the surplus from the
policyholders fund except
when the Qard Al-Hassan is
being repaid.
1 http://www.salaam.co.u/themeofthemonth/noember02_index.php?l=8 and
http://www.unicorninestmentban.com/default.asp?action=article&ID=38.
2 http://www.ameinfo.com/145251.html.
3 http://news.bbc.co.u/2/hi/americas/6680939.stm.
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Insurance digest PricewaterhouseCoopers12
The assets of the taaful4.
business hae to be inested
in Shariah (Islamic law)
compliant assets. For example,
inestments cannot be made
in gambling institutions,
businesses that mae alcohol,
businesses that sell weapons, or
assets that pay interest (Riba).
The operators of the business5.
are paid explicit fees for setting
up and running the company on
behalf of policyholders. These
fees coer all set-up costs,
operating costs, and prot
loading of the shareholders
(which is the only way they are
remunerated). These explicit
fees are in the taaful contract
that each policyholder signs
with the taaful company
and are fully transparent.
After the fees are deducted,
policyholders share any surplus
from the taaful business.
Taafuls appeal includes:
Taaful products are
competitiely priced against
conentional insurance
products. For this ery reason,
a signicant proportion of
taaful customers are non-
Muslim in deeloped taaful
marets (e.g., Malaysia);
By denition, taaful insurance
cannot inest in un-Islamic
products (such as arms
manufacturers, alcohol, and
gambling institutions). Anindependent committee, the
Shariah Board, annually
opines that the product meets
all releant ethical guidelines
and that the company is
operating in an ethical (Islamic)
manner. In the Uk, continental
Europe and North America,
where consumers are
increasingly spending a greater
proportion of their disposable
income on ethical products
(e.g., organic food),competitiely priced ethical
insurance has the potential to
be just as popular with non-
Muslims as it is with Muslims;
All charges and expenses are
explicit in insurance contracts,
thereby maing taaful products
transparent to purchasers;
If the taaful business
generates a surplus, then
shareholders are able to
distribute it amongst
themseles; and
A taaful company is lie a
mutual company within a
shareholder wrapper. It has the
benets of both mutuality and
shareholders capital, and
shareholders manage the
company on behalf of the
policyholders. Under the most
common taaful structure,
shareholders mae their return
on each taaful contract as
soon as the business is written.Shareholders are paid an
explicit proportion of each
taaful premium that coers
the expenses of running the
company and the shareholders
prot margin. Consequently,
the shareholders protability
is not wholly dependent on the
underwriting performance of
the insurance entity. Rather, it is
pre-allocated and only affected
by the cost of proiding an
interest-free loan to policyholders,
if the policyholders fund falls
into decit.
How is akas sce
dieen o conveniona
insance?
A taaful company is a mutual
company within a shareholder
wrapper. As Figure 1 shows,
the policyholder fund can be
thought of as the mutual
company as it receies the
policyholders contributions,
pays claims, sets up reseresto pay future claims and pays
broerage and Islamic
reinsurance premiums (Re-taaful
contributions). The shareholder
fund operates the taaful
business on behalf of the
policyholders and is paid explicit
fees for doing so. The two main
mechanisms that the shareholder
fund uses for charging fees to the
policyholder fund are a waala
fee (xed agency fee applied to
either contributions
or inestment income) or
mudharaba fee (percentageof contributions or inestment
income). Should the policyholder
fund fall into decit, then the
shareholders fund maes an
interest-free loan (qard al-hassan)
to the policyholders. As this is a
loan and not an equity loss, it is
repaid out of future surpluses in
the policyholders fund.
ISlAmIC INSurANCE: A COMPETITIvELY PRICED, ETHICAL PRODUCT WITH POTENTIALLY WIDESPREAD APPEAL continued
Policyholder
contributions
Surplus
Claims Retakaful Brokerage
Investment
income
Investment
income
Qard Al-Hassan
Explicit fees
Expenses
Shareholder
fund
Policyholder
fund
Figure 1 Policyholder und
Source: PricewaterhouseCoopers.
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Chaenes acin aka
Awaeness
Research has found that many
Muslims in the EU do not now
what the word taaful4 means.
Therefore, many Muslims
do not now taafuls ey
attributes and benets.
Accordingly, insurers rst tas
will be to increase awareness of
exactly what taaful is and
educate Muslims about how
it is Shariah compliant.
Similarly, when mareting to
non-Muslims, insurers will need
to maret taaful products in
such a way that potential
customers understand that they
are getting both an ethical and
competitiely priced mutual
product that returns any surplus
to them.
Shaiah coiance and
skied esoces
The Shariah Board is independent
of the taaful business andensures that both the operation
and the products of the taaful
business are compliant with
Islamic law. The Shariah Board
normally consists of a minimum of
three Shariah scholars educated
in economics. The taaful industry
as a whole is struggling to nd
scholars and silled resources
who understand both the
intricacies of Shariah law and the
complexities of modern nance.
reao coexi
The Shariah Board is an
additional regulator of the taaful
business. Taaful products are
subject to not only the national
and/or local regulators who ensure
that policyholders are adequately
protected, but also the Shariah
Board that eries if the taaful
business is operating in an
Islamically appropriate manner.
reaka
Being Shariah compliant also
requires that taaful businesses
place their retaaful (Islamic
reinsurance) programme with a
retaaful company. There is
currently a dearth of adequately
rated retaaful companies. As of
June 2008, there were fewer than
20 retaaful entities in the world,and only three retaaful
companies and retaaful windows
had a rating of A- or aboe.
Taaful companies may
be forced to use conentional
reinsurance until more retaaful
capacity becomes aailable.
Invesen coiance
To be Shariah compliant, taaful
businesses are required to inest
their assets in Shariah-compliant
inestments. Howeer, because it
is often difcult to nd a wide
range of such inestment
products, there can be regulatory
compliance challenges
associated with a lac of
diersied inestment ris. In
response to this dilemma, many
companies are establishing
ethical inestment funds that are
in compliance or can easily be
made compliant with Shariah law.
Concsion
Taaful has the potential to be
a protable, ethical business
for insurers who adequately
price and maret taaful
products, as well as mareting
them compellingly to both
Muslims and non-Muslims.
Companies considering setting up
taaful businesses will need toensure that their processes and
products comply with Shariah law,
as well as all national accounting
and solency regulations.
ISlAmIC INSurANCE: A COMPETITIvELY PRICED, ETHICAL PRODUCT WITH POTENTIALLY WIDESPREAD APPEAL continued
AUTHORS
mohaad KhanDirector, Uk Retaaful and Actuarial PracticePricewaterhouseCoopers (Uk)
Tel: 44 20 7213 1945
Ban JosehPartner, Actuarial & Insurance ManagementSolutions (AIMS)PricewaterhouseCoopers (Uk)
Tel: 44 20 7213 2008
4 Taaful Opportunities in Uk & Europe. Presentation by Bradley Brandon Cross, CEO, British Islamic Insurance Holdings, at the
International Taaful Summit 2007.
Insurers frst task
will be to increase
awareness o
exactly what
takaul is and
educate Muslims
about how it is
Shariah compliant.
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Contingent capital: Stepping intostrategic capital planning
AutHOrS: LARRY RUBIN AND XIAOkAI vICTOR SHI
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Would the insurance industry be able to withstand losses arising from a crisis
equialent to the subprime crisis that is facing bans? Is now the time for critical
capital planning as a component of core enterprise ris management (ERM)strategies? Larry Rubin and Xiaoai victor Shi reiew contingent capital as a
ey element in an insurers ERM strategy.
Would the
insurance
industry be able
to withstand
losses arising
rom a crisis
equivalent tothe subprime
crisis that is
acing banks?
CONtINgENt CApItAl: STEPPING INTO STRATEGIC CAPITAL PLANNING
In recent decades, a reolution
in ris and capital management
swept through the insurance
industry. Today, the global
insurance industry is actielydiscussing and implementing
economic capital as part of its
strategic nancial planning.
Also, alternatie capital funding
approaches such as insurance-
lined securities and arious
securitiations became more
popular recently when traditional
reinsurance marets failed to
proide sufcient capacities.
Howeer, insurers face threats
from unexpected eents such
as natural disasters, unusual
economic uctuations and capitalmaret crashes. These eents are
called paradigm shifts or blac
swans by many practitioners.
For example, the recent subprime
crisis led to earthquaes in the
entire nancial serice industry,
and some insurers also suffered.
Would the insurance industry be
able to withstand losses arising
from a crisis equialent to the
subprime crisis that is facing
bans? Is now the time for critical
capital planning as a component
of core enterprise rismanagement (ERM) strategies?
This article reiews contingent
capital as a ey element in an
insurers ERM strategy.
Wha Is coninen caia?
For readers unfamiliar with
contingent capital, the concept
can be made more transparent
by comparing it to some
traditional capital funding
methods such as lines of credit
and reinsurance.
Although similar to a line of
credit, contingent capital
arrangements are far more
complex. Contingent capital is
a trigger-based nancing option:
Agreements are entered into by
two or more entities that gie
the holders the right to raise
capital or sell securities (at
gien prices) when predenedtriggering eents occur. The
trigger eents could be a
natural catastrophe, signicant
economic eents, an act of
terrorism, buyer nancial
conditions, a liability eent or
another predened condition.
Contingent capital can be
iewed as a put option on a
companys balance sheet,
by which the buyer pays a
premium (capital commitment
fee) in exchange for the right
to issue or sell securities at
gien conditions.
Although contingent capital
differs from a line of credit due
to its post-eent nature, it will
moe to the balance sheet
once the put is exercised and,
thus, is similar to line-of-credit
agreements.
Contingent capital similarities
can also be drawn to traditional
reinsurance (or catastrophe
bond transaction) in the sensethat they both proide off-
balance-sheet capital for riss.
Howeer, contingent capital
differs from reinsurance
because it gies the option of
access to capital rather than
proiding indemnication. In
addition, unlie reinsurance,
funds raised ia contingent
capital must be repaid to the
capital proider. Finally,
contingent capital does not
really transfer riss or losses to
sellers, but it proides a capital
injection after specied eents.
Contingent capital can be
proided in arious forms of
securities: equity, debt or some
hybrids. Typical arrangements
include standby credit facility,
contingent surplus notes or
catastrophe equity put options:1
Sandb cedi acii
a line of credit with the right
to receie a loan upon eent
of a loss;
Coninen ss noes
the option to borrow or
the right to issue surplus
notes contingent upon
triggering eents;
Caasohe eqi
the right to issue shares
of stoc contingent upon
triggering eents.
1 Michael W. Elliott, Contingent capital arrangements,Risk Management Quarterly, vol. 18, No. 2, September 2001.
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CONtINgENt CApItAl: STEPPING INTO STRATEGIC CAPITAL PLANNING continued
Econoic caia odein
ais o cae exee
ai evens
Many will cite the standard
denition of economic capital
from Solency II, where economic
capital is dened as the amount
that an insurance company needs
so that it can absorb all losses
within a one-year time horion
with 99.5 percent probability. This
concept is shown in Figure 1.
Howeer, no matter how
sophisticated a companys
internal economic capital models
are, they still are often built based
on historical experiences (with
perhaps some additional stress
tests.) These models may fail to
capture some unnown
unnowns, the so-called
paradigm shifts and blac swans.
This is because:
By denition, these tail eents
cannot be modeled based on a
historical cure of losses;
The historical data set
represents one of many
possible outcomes; and
More importantly, recogniing
extremely unliely eents in
economic capital will require
insurers to hold excessie
amounts of equity capital, thus
lowering their return on equity.
Still, these unnown unnowns
are often the major driers behind
business failures. For decades,
Bear Stearns had been
recognied as one of the most
sophisticated ris modelers on
Wall Street. But Bear Stearns
recent failure was a direct result
of the subprime meltdown that,
according to its ris models, was
a 9 standard deiation eent.
When a paradigm shifts or a
blac-swan eent occurs,
disastrous consequences can
result (see Figure 2).
Paradigm shifts are either long-
or short-term changes in the state
of the world, which gies rise to
signicant losses to nancial
institutions. Examples include
the low leels of interest rates
experienced since 2000 (in the
early 1990s, most insurance
companies belieed we would notsee 3% interest rates in the
United States again) and
long-term-care policyholder
behaior. Paradigm shifts hae
higher impacts on insurance,
compared with many other
industries, due to the business
nature of the long-term
promises. Insurance products
are priced as the world existedrather than as it exists.
Paradigm shift
Paradigm
shift
Capital
needs
Loss Black swan event
Black swans
Figure 2 A paradigm shit or a black-swan event
Source: PricewaterhouseCoopers.
Balance sheet
Minimum
asset
Liability
Economic
capital 99.5% of solvent
over one year
Figure 1 Concept chart
Source: PricewaterhouseCoopers.
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CONtINgENt CApItAl: STEPPING INTO STRATEGIC CAPITAL PLANNING continued
Blac swans are large-impact
eents that are statistically
remote and beyond the realm of
normal expectations. The 1987
stoc-maret crash, the 9/11
attacs, the burst of the Internet
bubble and the recent subprime
meltdown are examples of blac
swans. Those eents pose great
challenges to insurers because
of their unpredictability, which
is difcult for ris specialists
to model.
The maret appears to hae
included these unexpected
eents when it assessed the
riss of inesting in insurance
business. This could be obsered
from the capital adequacy rating
criteria from rating agencies,
(the three to e multiples of
ris-based capital insurers must
hold for competitie reasons).
This could also be obsered
from some insurance-related
securitiations, where capital
required to execute the deal isgreater than the capital that is
determined by a companys
economic capital model. In
addition to the information
disparity and frictional costs of
insurance business, unnown
unnowns would be one
important contributor to
redundant capital holdings.2
Can existing techniques or
future innoations help sole
or mitigate this problem? If so,
what strategic decisions should
companies mae to buildhealthier balance sheets?
Coninen caia as a
o Erm
In addition to unexpected losses,
the consequences of extreme tail
eents are more liely to pose
liquidity problems than solency
troubles for insurers. Under the
NAICs ris-based capital
requirement in the United States,
leading insurers are less liely to
hae solency problems because
most hold far more capital than
the required minimum. Howeer,short-term liquidity troubles (as
well as subsequent ratings
downgrades) are major triggers
to many banruptcies and
opportunistic acquisitions.
In the 1990s, the failures of two
prominent insurers, General
American in the United States
and Confederation Life in
Canada, were good examples of
the consequences of liquidity
problems. In addition, liquidity
was a contributor in the recent
failure of Bear Stearns.
Contingent capital3 is a solution
that should be utilied to
supplement a companys
economic capital. In our iew,
contingent capital, in conjunction
with traditional ris management
programs such as reinsurance,
economic capital modeling and
hedging, should be considered by
CEOs/CFOs /CROs as part of
their ERM programs. Contingent
capital creates a bridge to access
nancing sources in cases where
capital marets fail to do so.
Contingent capital arrangements
hae grown more common this
decade. In 2000, Swiss Re
mareted a contingent capital
arrangement with Royal Ban of
Canada. The arrangement stated
the ban could use its C$200
million preferred shares in
exchange for C$200 million cash
from Swiss Re if the bans
general resere leel for loans
fell below a certain threshold.
The C$200 million preferred
shares represented about 1% of
Royal Bans equity. The major
incentie to enter into this
transaction was that it was less
expensie than general insurance.
An article published in 2001 at
CFO.com labeled the potential
capital deried from this type of
transaction as just-in-case capital.
In 2006, XL Capital and its
subsidiaries entered a
$350 million contingent capital
arrangement with Stoneheath Re,
a Cayman Islands exempted
company issuing perpetual
preferred securities. The structure
of this transaction gies XLs
subsidiaries access to capitalbased on coered triggering
eents including US wind,
California earthquaes, European
wind and global terrorism.
Stoneheath Re solely inests in
AAA assets, which will be
conerted into preferred shares of
XL Capital if specic eents occur.
This structuring deal, adised by
Goldman Sachs, is an innoatie
and successful transaction that
enables XL to gain access to
signicant capital upon the
occurrence of a tail eent.
Howeer, we hae not seen many
examples lie XL Capital in the
insurance industry that actiely
use contingent capital as a core
ERM strategy. The use of the
contingent capital approach, as
a tool to hedge balance sheet
riss and loc in an insurers cost
of capital, could be expanded in
the capital planning and ris
management decision process.
Some industry leaders hae
pointed out that insurers should
bac their economic capital
(results from internal models) with
their companys equity and fund
other capital portions with
cheaper sources such as debt or
securitiations. Howeer, funding
blac-swan eents by accessing
debt capital would be an incident
of default. Most securitiations
proide for holding company
recourse, which would also be
considered an incident of default
should it be accessed. As a result
creditors would tae ownership of
the company and shareholders
would lose all alue. In contrast,
accessing contingent capital as
represented in the Royal Banand XL Capital examples is the
exercise of a contractual
agreement between a company
and an entity that proides the
funds. Consequently, shareholders
do not lose ownership (although
in some structures ownership
may be diluted).
Insurers should be able to
leerage contingent capital as an
enhancement to their claims-
paying ability, which may improe
a companys competitie
position. Done correctly, it shouldlower the companys cost of
capital. As these contingent riss
are deemed to occur infrequently,
the loss distribution should more
2 See Locerman, Polsgroe, Rubin, Shi, Tillis, Economic Measurement of Insurance Liabilities: The Ris and Capital Perspectie, 2008.
3 See bacground information at side box of contingent capital introduction to understand the basic concepts of this product.
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CONtINgENt CApItAl: STEPPING INTO STRATEGIC CAPITAL PLANNING continued
closely resemble the loss
distribution of inestment-grade
debt instruments and be priced
accordingly (we see this with
holding company debt, which is
the simplest form of contingent
capital, but has the downside ris
of loss of control of the
company). Through strategic
contingent capital transactions
without signicant, expensie
equity buffering ones
companies can build maret
condences by mitigating the fear
of tail eents often disastrous
impacts to the company.
Admittedly, contingent capital
cannot remoe all unnown
unnowns from the balance sheet
due to its nature of dealing with
predened eents. Howeer,
gien certain shareholders ris
appetites, contingent capital, in
exchange for a reasonable cost,
is able to help companies build
both policyholder and inestor
condences and to surie large
tail eent losses. Capital marets,
on the other hand, see
diersication opportunities and
are expected to welcome some
orthogonal riss that are not
closely correlated with maret
riss. The popularity of
catastrophe bonds and other
arious insurance-lined
securities is eidence of this.
Our approach to capital structure
(also shown in Figure 3) is
two-fold:
Companies should use
shareholders equity to fund
economic capital, where
economic capital should be
sufcient to mae insurers
nance themseles at maret-
consistent cost of equity.4
Companies should utilie
contingent capital to hedge
out-of-the-money riss or riss
that are not captured in the
economic capital model.
This structure requires the
company to be able to explain to
the maret the sufciency of its
economic capital model in order to
receie contingent capital funding.5
Benefs o coninen caia
Contingent capital also proides
seeral economic benets as
alternatie capital funding. First, it
proides great exibilities in
capital funding and ris
management. It could include
triggering eents that may appear
in arious forms. It could be
one-year or multi-year period
coerage based on buyers ris
appetites and their iews on
potential riss. It could include
actual funds raised in the capital
marets, deep out-of-the-money
deriaties or traditional
reinsurance. There can be a
ariety of forms of exercising
triggers that are based on a
companys unique business
problems and that are able to
preent insurers from suffering
from different threats. For example
companies could enter some
transactions with the trigger as
the worse scenario for their
Guaranteed Minimum Withdrawal
Benet (GMWB) obligations in
the balance sheet. Insurance
companies or bans, as another
example, could dene their trigger
eent as a credit crash similar to
what is currently happening.
Second, contingent capital
proides a cheaper cost of capita
funding relatie to using equity
capital for out-of-the-money
riss. At certain points, insurance
companies are able to loc in
their cost of capital by paying
reasonable premiums (the cost
of the put). If the reduction in
cost of capital is lower than the
price of this put option, then
insurers are creating alue ia this
transaction.
Another signicant adantage ofcontingent capital is effectie
balance sheet protection for
some specied eents.
Uncertainties in companies
balance sheets incur additional
cost of capital and will put
shareholders and policyholders in
unfaorable positions if
something unexpected happens.
Leeraging contingent capital
enables insurers to hedge those
possible losses from their
corporate balance sheets without
losing capital ownership under
distressed situations. In addition,contingent capital proides
capital with stress-free spreads
under nancial distress.
Two-tier capital
structure
Contingent capital to
hedge xx o events
Economic capital
Components
Contingent capital
arrangements
Equity
Funding
LIBOR + ? bps
LIBOR + 500 bps
Cost (illustrative)
Figure 3 Two-tier capital structure
Source: PricewaterhouseCoopers.
4 One of our separate articles, Economic Measurement of Insurance Liabilities: The Ris and Capital Perspectie, argued that the economic leel of capital should be sufcien
to help insurers fund losses without paying additional equity ris premiums. The implication of this iew is that insurers should hold sufcient economic capital so that the
capital maret would be willing to fund the contingent capital.
5 See Locerman, Polsgroe, Rubin, Shi, Tillis, Economic Measurement of Insurance Liabilities: The Ris and Capital Perspectie, 2008.
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CONtINgENt CApItAl: STEPPING INTO STRATEGIC CAPITAL PLANNING continued
Finally, contingent capital could
also proide timely mid- to
long-term liquidity support. As
mentioned earlier, liquidity trouble
often contributes signicantly to
insurance business failures. If a
run on the ban happens, some
companies might hae difculties
accessing external liquidity
sources, or additional liquidity
may be ery expensie to obtain.
Entering contingent capital
transactions could effectiely
sole this problem if prespecied
eents transpire.
reao iicaions
Surplus notes are one type of
capital source that is similar to
contingent capital. Surplus notes,
where regulatory approal is
required, hae been popular in
the insurance industry to raise
capital, especially for mutual
companies. Surplus notes are
treated faorably from a
regulatory perspectie, and theyare iewed as equity for solency
purposes. If regulators preent a
company from maing coupon or
principal payments on the surplus
notes, the company would not be
considered in default.
It might be too early to assume
that regulatory pressure would
come into play to hold contingent
capital. But it should be a fair
presumption that regulators
would, at least, faor contingent
capital as another ehicle to
secure policyholders benets.If we accept that paradigm shifts
and blac swans will occur in the
future, and that by their nature
they cannot be captured in an
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CONtINgENt CApItAl: STEPPING INTO STRATEGIC CAPITAL PLANNING continued
economic capital model, then we
should expect that Solency II,
which moes in the direction of
regulating companies based on
internal capital models, may
result in increased insolencies in
the industry.
In the short term, absent
regulatory pressures, company
management teams may lac
enough incenties to see
contingent capital arrangements.
Unlie the European iew that
management is maximiing
staeholders alues, US rms
tend to beliee that management
is responsible for maximiing
shareholders benets.
Contingent capital primarily
protects policyholders. From the
shareholders perspectie, paying
additional costs to protect
policyholders may not be in their
best interests, gien that the
result of accessing contingent
capital could lead to dilution of
capital or een a loss of control.Considering that extreme eents
are unliely to occur during a
particular term of a management
team, management might aoid
haing to explain the additional
underperformance that resulted
from purchasing contingent
capital during their limited years
in executie positions. This is
because companies that hedged
their oerall balance sheets with
contingent capital would hae
relatie lower capital performance
(assuming other factors equal)
than peers that were notimpacted by the cost of
contingent capital. We expect the
result of regulatory pressures to
help nancial institutions surie
potential nancial crises,
especially in a Solency II world.
rain aenc views
Contingent capital has been
faorably receied by rating
agencies due to its nancial
exibility and demonstration of
efcient capital management.
In one of its recently published
special reports, AM Best
commented: Recently, seeral
companies hae issued
contingent capital securities as
part of a capital managementplan Companies that can issue
these types of securities tend to
hae stronger leels of nancial
exibility and maret
acceptability. Howeer, AM Best
also stated that it does not gie
credit in AM Bests capital
adequacy model (BCAR),
although they do receie a
certain leel of qualitatie credit
at rating committee meetings.
In one 2006 published
commentary letter in Standard &
Poors Global Bond Insurance,S&P stated, a bond insurer can
receie 100 percent credit in the
capital adequacy model for a
contingent capital structure in
which the inested assets meet
Standard & Poors qualifying
assets guidelines.
liiaions and e
innovaions
While contingent capital appears
to be a good solution to many
capital management problems,
it also has some limitations:
In the near term, companies
might lac enough incenties
to hold contingent capital.
Although contingent capital
would essentially mae
companies immune from
certain extreme eents,
companies would hae relatie
lower performance than those
not impacted. Before
contingent capital gains
popularity or regulatory
pressures come into play, a
CEO might hae to explain to
his or her shareholders why
entering a contingent capital
transaction is necessary;
The existing structuring of
contingent capital appears
oerly complex, thus increasing
the transaction costs and
reducing the transparency of
this facility; and
Cost-efcient pricing of certain
triggering eents requires more
sophisticated ris measurement
and technology support.
Going forward, both the
insurance industry and the capital
maret should continuously focuson innoation. Three ey aspects
players need to concentrate on
include increased transparency,
extended coerage and more
sophisticated pricing.
Transparency is the ey to
success for this innoatie
product. The major benets for
insurance companies with
contingent capital arrangements
stem from their enhanced ability
to surie a nancial crisis. The
major benets to inestors are the
ability to purchase inestment-grade assets whose default ris is
uncorrelated with the rest of the
portfolio. Howeer, unnecessary
complexities or other
nontransparencies could diminish
this adantage as inestors will
automatically add ris margins on
each nontransparency. In other
words, inestors are willing to pay
for extra transparency. Increased
transparency on transactions,
faourable accounting treatments
and regulatory and rating agency
endorsement, may well boost the
future deelopment of contingent
capital as a core component of
strategic capital planning.
Extended coerage of trigger
eents and improed pricing
abilities would also add alue.
The capital maret should be able
to digest riss from issuing
contingent capital options. How
to correctly measure and quantify
the riss is the ey. Gien the
coered eents hae ery low
probabilities of happening, we
expect that, with enhanced pricing
abilities in the capital maret,
contingent capital will become a
ery cost-efcient ehicle to fund
capital and to hedge the balance
sheet with the adancements in
product deelopment from thecapital maret.
Concsion
More and more institutions hae
started to feel the pain from the
subprime credit crunch.
Sacrices must be made for
nancial institutions to return to
their former secure states. But US
nancial serice industries also
need to thin hard about how to
enhance their ris management
abilities.
Contingent capital, as an
innoatie ehicle in capital
planning, could become a
aluable component to insurers
ERM strategies. Howeer, with a
lac of regulatory pressure, it
might tae extra effort for US
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CONtINgENt CApItAl: STEPPING INTO STRATEGIC CAPITAL PLANNING continued
rms to tae action regarding
purchasing contingent capital.
Management, which is primarily
responsible to shareholders,
might lac incentie to maximie
policyholders benets if
shareholders were paying the bill.
Looing bac in history, the
industry always climbed toward
higher destinations as it faced
more complex and risier realities.
Innoations from strategy, tools
and, most importantly, peoples
mindsets are the driers. We feel
contingent capital is one more
tool to help manage the insurance
industrys inherent complexities
and riss.
AUTHORS
la rbinPartner, Actuarial and Insurance Management Solutions (AIMS)PricewaterhouseCoopers (US)
Tel: 1 646 471 4017
Xiaokai Vico ShiSenior Associate, Actuarial and Insurance Management Solutions (AIMS)PricewaterhouseCoopers (US)
Tel: 1 646 471 8978
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Recent deelopments in ris
mitigation through reinsuranceand capital marets
AutHOr: CAROLINE FOULGER
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Insurance digest PricewaterhouseCoopers 23
Caroline Foulger focusses on ey deelopments in the relationship between the
capital and reinsurance marets, proides insight into the broader reactions ofreinsurers to this new wae of capital maret participation, and explores different
perspecties on other changes in the reinsurance space in a softening maret.
Sot market
is always a
relative term.
rECENt DEVElOpmENtS IN RISk MITIGATION THROUGH REINSURANCE AND CAPITAL MARkETS
Oveview
Casualty reinsurance maret
rates declined throughout 2007,
and, absent of a major catastrophe,
the property maret is now
following suit. While underwriting
and ris management actiity on a
global scale centers on
appropriate and sustainable
responses to maret softening,
the catastrophic corner of the
global reinsurance maret (worth
upwards of $400 billion) has seen
signicant actiity from a less
traditional reinsurance source:
capital marets. Recent actiity,
although compartmentalied,
highlights the continuing
appetites of both the inestingcommunity and reinsurance
consumers for polished and
economically rewarding
substitutes to conentional
reinsurance.
This article focuses on some ey
deelopments in the relationship
between the capital and
reinsurance marets, proides
insight into the broader reactions
of reinsurers to this new wae of
capital maret participation, and
explores different perspecties on
other changes in the reinsurancespace in a softening maret.
Sa-s, sidecas,
seciizaions, and so caia
Most ey indicators showed an
ongoing softening of property
catastrophe reinsurance pricing
in the rst four months of 2008.
But soft maret is always a
relatie term. Rather than curtail
capital marets interest in
reinsurance, recent credit maret
eents hae yet again focussed
the attention of hedge funds
and priate equity rms to
uncorrelated riss through
reinsurance-baced inestments.
Until the 2004 and 2005 maret
dislocation eents, inestment in
the reinsurance maret wastraditionally long term (e.g.,
through the proision of capital
by direct shareholdings in
reinsurance companies).
Howeer, global capital marets
hae long played a broader role
in the property catastrophe
reinsurance maret. Recently,
insurance-lined securities
(including catastrophe bonds and
industry loss warranties) hae
gained momentum, and hae
proided the capital marets with
uncorrelated short- to medium-
term inestment opportunities.Inestment actiity in late 2005
through 2008 has cemented what
now seems to be the ongoing role
of hedge funds and priate equity
rms in the property catastrophe
reinsurance maret. Below is a
summary of the major aenues
behind the stream (well in excess
of $10 billion) of capital maretinestment in the reinsurance
maret oer the past few years.
New sa-s
Probably the most traditional
form of the capital marets
inolement in reinsurance
companies is by direct inestment
in new start-up companies. This
was most eident in late 2005
(following Hurricane katrina) with
the establishment of four new
Bermuda companies, each with
start-up capital in excess of$1 billion directly funded by the
capital marets.1 Actiity has
since continued, albeit at a
reduced leel, with carriers
formed in both Bermuda and the
Cayman Islands in 2007. Since
the billion-dollar Bermuda babes
of 2005, there has been limited
start-up actiity in the property
catastrophe space, with the
exception of Aeolus Re.
Sidecas
Although initial ersions ofsidecars were created as early as
the 1990s (e.g., Renaissance Res
Top Layer Re and Olympus), the
Hurricanes katrina, Rita, and
1 Amlin Bermuda also had start-up capital of $1 billion, though funded principally through the Amlin Plc group.
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Insurance digest PricewaterhouseCoopers24
rECENt DEVElOpmENtS IN RISk MITIGATION THROUGH REINSURANCE AND CAPITAL MARkETS continued
Wilma (kRW) eents and the
formation of the Bermuda Class of
2005 companies proided the
impetus for a signicant inow of
hedge fund and priate equity into
sidecar structures, as shown in
Figure 1. From 2005 through 2007,
approximately $5.5 billion of
sidecar capital entered the
maretplace. More interesting is
that while a considerable portion of
that capital is now leaing the
maret, other sidecars (more
closely resembling catastrophe
bond structures) are being formed
with different objecties. Puma Re,
for example, has issued a three-
year catastrophe bond for the sole
purpose of nancing its sponsor
ehicle, Bridge Re (a new property
catastrophe retrocessionaire:
(reinsurer of a reinsurer).
Seciizaions
(caasohe bonds and
inds oss waanies)
The catastrophe bond maret is
probably the single largest growth
area in the property catastrophe
reinsurance maret, attracting
approximately $12 billion of
capital in 2006 and 2007. Unlie
sidecars, rating agencies hae
demonstrated a greater inclination
to rate certain bonds, which has
signicantly boosted this maretsgrowth. The subprime crisis has
proided a coincidental
compensator for price declines,
and the uncorrelated riss these
products proide inestors,
gien current maret conditions,
is fuelling the continued growth
of catastrophe bonds.
Original Industry Loss Warranties
(ILWs), traded in the 1980s,
resurged in 2006, proiding
similar inestor access to the
property catastrophe maret as
catastrophe bonds. Many maretobserers see ILWs as a huge
growth area, comparing them to
interest rate and credit deriatie
marets. But the absence of
recognied trading indices,
structure, pricing, liquidity, and
transparency (particularly in
secondary trading) is somewhat
stalling this growth.
Coninen caia
Contingent (or soft) capital has
long been a common feature of
the nancial guaranty maret. The
signicant benet that it brings,
(i.e., it is a protectie option
following a major catastrophic
eent without punitie post-
catastrophe costs and capital
dilution) has raised both the prole
and use of these products in other
sectors in the maret in recent
years. Signicant recent deals
totaled in excess of $1.3 billion
on a combined basis. Howeer,
while condence in these
products is growing, there are stil
reserations both on the issuer
side and by the rating agencies
related to essentially unrated,
off-balance sheet facilities.
lon-e vess sho-e?
Benefcia o advese?
As noted aboe, approximately
$6 billion of sidecar capital owed
into the reinsurance maret in
2005 through 2007, although that
ow has slowed oer the past 12
months. Seeral of the sidecars
established in late 2005 and early
2006 are now either cut off (i.e.,
their potential exposures hae
been settled by commutation as
they are expected to be minimal
or nil), or in run-off. In the past,
the inestment of such short-term
capital would hae been iewedas a lac of commitment to the
industry, but the maret has
changed in 2008. While surplus
capacity and declining rates
mae such entures less
attractie to some capital maret
inestors, the appeal of additiona
non-shareholder capital is less
important to reinsurance
company sponsors of sidecars,
thus aligning the interests of
both parties. This inow and
outow of hedge fund and priate
equity rm capital in response to
shifts between dislocated andstabilied reinsurance maret
conditions has been called the
bellows effect.
Among the reinsurance marets
leaders, there are mixed emotions
regarding the relatie benets of
this large inux of inestor capitalSource: PricewaterhouseCoopers.
Figure 1 Sidecar ormations (2005 to 2006)*
Sidecar Capital ($ millions) Cedant Setup
Olympus II $155 White Mountains 2005
Blue Ocean $355 Montpelier 2005
Cyrus Re $550 XL Capital 2005
Flatiron $840 Arch Capital 2005
Monte Fort Re $60 Flagstone 2006
Timicuan/RPP $70 Renaissance 2006
Sirocco $95 Lancashire 2006
BayPoint $150 Harbor Point 2006
Petrel $200 validus 2006Sector Re $220 Swiss Re 2006
Helicon $330 White Mountains 2006
Concord $730 AIG 2006
Syndicate 6105 $20 Syndicate 4020 2007
Syndicate 6104 $35 Syndicate33 2007
Monte Gele Re $60 Flagstone 2007
Cyrus Re II $105 XL Capital 2007
Norton Re I $120 Brit 2006
Norton Re II $120 Brit 2007
Puma Re $180 Bridge Re 2007
Starbound $315 Renaissance 2007
kaith/k5 $370 Hannoer Re 2007MaRI $400 Marsh / ACE 2007
$5,480
*This table is for informational purposes only. Aailable data relating to sidecars
is restricted, as much of it is not made public. The data in the table aboe is
based on information from press releases and other public sources, and
therefore there is no guarantee of its completeness or accuracy.
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25Insurance digest PricewaterhouseCoopers
Obiously, one of the major
maretplaces affected by this
trend is the Bermuda property
catastrophe reinsurance maret.
In PricewaterhouseCoopers
(PwC) 2006 Bermuda Maret
Surey, we ased a cross sectionof reinsurance CEOs how they
iewed the inolement of the
capital marets. Figure 2
illustrates the results.
At the 2007 Bermuda Insurance
Conference, sponsored by
PricewaterhouseCoopers and
Standard & Poors and titled
Global Challenge: Optimiing
Capital in a Softening Maret,
speaer Michael A. Butt,
chairman of AXIS Capital
Holdings, noted, Sidecar and
other short-term capital are nottrying to create franchise alue.
That is one factor that gies us
hope that we may this time
experience a smoother cycle.
There will be many occasions in
the future when we will need
surplus capital for specic,
identied needs, because some
elements of the maret will lose
their nere.
As some sidecars wind down and
their inestors depart for now, the
stability they hae deliered byproiding capital and capacity in
a dislocated maret is hard to
dispute, and their obious desire
not to hang around when the
specic short-term opportunity
they targeted starts to fade is
widely considered to be a positie
thing. But in a soft cycle
questions are being ased about
the impact this short-term capital
has had on reinsurance
purchasers. While some sidecar
capital has been returned, of the
considerable capital maret
inestment proided since kRW(conseratie estimates range
between $8 billion and
$14 billion), a considerable
portion remains. The length and
impact of this trend on traditional
reinsurance proiders are widely
debated questions.
Choice and coexi
Reinsurance purchasers hae had
an array of choices aailable to
them through the addition of
seeral capital maret
mechanisms. In the recent, harder
maret, all coerage has been
relatiely expensie, and the rapid
addition of capital through sidecar
structures has quicly proided
capacity in response to a ery
complex and difcult situation.
As the maret softens, it essentially
becomes a buyers maret
for reinsurance purchasers.
The stability of capital maret
structures has helped the more
traditional reinsurance proiders
continue to meet the coerage
needs of their customers.
Following the stellar returns oftwo benign years, those
traditional proiders now hae
less need for the capital marets
sidecar contributions. If that
capacity remains, it will worsen
the impact of the soft cycle for
established reinsurance
franchises; by departing, it assists
in smoothing the cycle.
The Bermuda Maret Surey also
ased a cross section of CEOs
whether they iewed the
inolement of the capital
marets as short- or long-term.
Opinions split, with those iewing
the inolement negatiely alsoiewing it as long-term (see
Figure 2).
While sidecar formation has
slowed, the growth of insurance-
lined security issuances (i.e.,
catastrophe bonds and industry-
loss warranties) and contingent
capital facilities has not. As the
nowledge and aailability of
these products becomes more
widespread among reinsurance
buyers and the inestment
community, these longer-term
products are gathering pace.This has obiously been assisted
by the outperformance of
traditional bond marets by
catastrophe bonds following a
tumultuous period in the credit
marets and a benign period in
the catastrophe maret.
rECENt DEVElOpmENtS IN RISk MITIGATION THROUGH REINSURANCE AND CAPITAL MARkETS continued
Negative
Positive
22%
78%
Figure 2 How do you view the signifcant capital provision into the market rom the capital markets (e.g. hedge unds)?
Source: PricewaterhouseCoopers.
Short-termLong-term
55%45%
Negatie s Positie Short term s Long term
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Insurance digest PricewaterhouseCoopers26
With all this additional and
potentially competitie capacity
aailable from the capital
marets, it is often reported that
traditional reinsurers are
becoming ictims to a predatory
attac on their core maret.
Reality is far different: thereinsurance maret is agile,
innoatie, and at the front edge
of the deelopment of this new
breed of ris mitigation techniques.
Conveence and
sohisicaion
Although designated for
inestment by the capital
marets, gien the complexity
of the riss these products
coer, it is essential that they
be in some way structured or at
least alidated by reinsurancespecialists. Swiss Re is widely
recognied as the pioneer of
the insurance-lined securities
maret, initiating catastrophe
bond trading since the hard
marets of the early 1990s
following Hurricane Andrew.
Since then, its specialities and
offerings hae eoled, and it
now includes signicant life
securitiations as well. Lloyds
insurer and Bermuda reinsurer
Amlin recently announced that
they will form an inestment
management partnership that will
manage funds focussed on traded
insurance ris. Other companiesare widely expected to follow this
trend. Although the partnership
is still subject to regulatory
authoriation in the Uk, Amlin
CEO Charles Phillipps has said,
Amlin intends to be an actie
participant in the insurance-lined
securities (ILS) maret, both to
enhance our capital and ris
management capabilities and to
generate returns from the growth
and high margins aailable in
the business. Amlin has
supplemented its team with a
preious head of ILS at Swiss Re.
Aeolus Re is a start-up Bermuda
reinsurer founded in 2006, and it
operates as an unrated
reinsurance platform that targets
the property catastrophe segment
of the worldwide reinsurance
maret. Specically, Aeolus
focusses on the industry loss
warranty (ILW) segment of the
maret. It has been so successful
that in early 2007 its capital base
was increased to oer $1 billion
by a group of inestors led by
Warburg Pincus and Merrill Lynch
Global Priate Equity.
In the meantime, so-called
traditional reinsurance
companies, including XL
and Renaissance Re, were
frontrunners in the formation
of sidecars, and both longer-
established and relatiely new
companies are maing extensie
use of contingent capital facilities.
Hedge fund and priate equity
rms are sophisticated and agile
inestors, and they will pursue
maret opportunities to secure
uncorrelated returns. Indeed, the
structured relationship between
inestment marets and
reinsurance companies through
sidecars and other shorter-term
products simplistically reects amutual recognition of where
expertise lies; hedge fund and
priate equity rms lac the
expertise of reinsurance
underwriters, just as reinsurance
underwriters lac the expertise of
hedge fund and priate equity
rms. The most signicant threat
to the stability of the reinsurance
maret usually occurs when those
lines are blurred.
Ohe deveoens
in einsance
Acqisiions
SCORs acquisitions of
Conerium and, on a smaller
scale, Toio Marines of kiln,
represent two of the major
reinsurance maret acquisitions
in 2007. There has also been
considerable actiity in the
Lloyds maret, particularly at
Bermuda companies (e.g. validus
acquisition of Talbot and Ariels
acquisition of Atrium). This
represents a reitalied appetite
for Lloyds following the ow of
capital in the opposite direction in
2005 and 2006.
Divesifcaion
Increased emphasis on the
diersication credit that rating
agencies can award has led
companies to broaden their
strategies respecting the breadth
of their business focus rather
than narrowly concentrating on
one business model. In a softening
maret, companies that put most
of their energies into deeloping
one narrow business model can
shrin disproportionately,
adersely affecting both their
bottom line and their maret
credibility. In 2007, Standard &
Poors downgraded IPC Re for
narrow underwriting that
concentrated principally on the
property catastrophe space. Thisdiersication credit, lie many
factors incorporated into rating
agency models, is a relatiely new
trend, perhaps causing some
chagrin at IPC Re gien their
consistent practice for oer a
decade of underwriting. It is
eident that Montpelier Re has
responded to the pressure to
diersify its business by
expanding into the US, Lloyds,
and Europe last year, earning a
positie rating agency response
in May 2008.
There is no doubt that
diersication can yield signicant
benets, ACE and AXIS being
notable examples. Howeer, the
penalty for diersication
perceied as beyond the core
resources or experience of a
company can also be damaging.
In the past, companies hae been
rECENt DEVElOpmENtS IN RISk MITIGATION THROUGH REINSURANCE AND CAPITAL MARkETS continued
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27Insurance digest PricewaterhouseCoopers
heaily penalied for this, the
writers of North American
casualty reinsurance being a
noteworthy example in the 1990s.
It will be interesting to reect a
few years in the future on the
results of the wide ariety of
diersication strategies now
being deployed by global
reinsurers, particularly in
emerging reinsurance
maretplaces.
Aenaive isk anse and
sced einsance
In the wae of a ariety of
industry inestigations a few
years ago, heightened sensitiity
to structured reinsurance has led
to a contraction in the aailability
of products in this space.
Howeer, interest in these
products has increased, and a
broader range of solutions are
being offered to the maret.
Consistent with heightened
sensitiity, howeer, the buyers of
structured products see obiousand higher leels of ris transfer.
Aggregate stop-loss coers are
among a wide range of products
proing to be popular.
Oook
The reinsurance maret is
eer-eoling as business cycles
continue to reole. In a hard
maret, the focus is always on
capacity, capital, and pricing. In
the current soft maret, the focus
is on deeloping creatie product
offerings and optimiing capitalreturns while also managing
pricing challenges. The challenge
for all parties reinsurance
companies, reinsurance
purchasers, and the capital
marets is to continue
recogniing where their expertise
and alue resides and where it
does not.
rECENt DEVElOpmENtS IN RISk MITIGATION THROUGH REINSURANCE AND CAPITAL MARkETS continued
gossa o es
Insurance-lined securities
Securitiation is a nancial
technique that pools assets
together and, in effect, turns
them into tradable securities.
Most insurance-lined securities
(in the property and casualty
insurance marets) sere as
collateralied protection for
extreme eent ris (i.e., most
protection is proided in thecatastrophe space). Catastrophe
bonds and industry loss