Ronald Gift Mullins charts the rise of credit derivatives within the re/insurance sector.
In just five years, the credit derivatives market has strengthened from about $200bn in notional value to an estimated $1.6trn in 2002, and it is expected to exceed $4.8trn by 2004. And while credit derivatives make up only a small portion of the overall derivatives market - estimated to be close to $110trn - it is growing at a faster pace than the total derivatives market.
Though developed initially by big banks to manage their credit risk by efficiently transferring it from one party to another, re/insurers have discovered the rewards of using credit derivatives and have leaped into the market vigorously, perhaps, some observers feel, too quickly and imprudently. In fact, a survey by the British Bankers' Association (BBA) found that re/insurers will have 33% of the sellers' market of credit derivatives by 2004, outstripping banks which now narrowly have a larger share.
Banks, re/insurers, hedge and pension funds and other large bondholders purchase credit derivatives to protect against the borrower defaulting on its bonds. Each credit derivative transaction must have a buyer seeking protection from the default of a bond, and a seller of that protection.
Various financial groups use credit derivatives for different reasons: banks tend to use them to lessen the capital dedicated to their loan portfolio and to spread their risk; re/insurance companies invest in them to achieve higher returns and as a means to manage their risk portfolios.
Credit derivatives come in many flavours - credit default options, credit limited notes and total return swaps to name a few. Single-name credit default swaps, however, continued to be the single most used product in 2001, capturing nearly half of market share, according to the BBA. Credit default swaps allow one party (the protection buyer) to buy protection from another party (the protection seller) to guard against a legal entity (a company or sovereign state) defaulting. For assuming the risk, the protection seller receives a fee or premium from the protection buyer until maturity of the contract or until a default or other event occurs. If such a `credit event' occurs, then the protection buyer will receive compensation from the protection seller.
Sovereign bonds represented more than a third of the credit derivative market in 1997, but in 2002, this share had shrunk to less than a fifth, with corporate assets increasing from 35% to an estimated 57%. The credit quality of underlying bonds in 1997 was 55% A-BBB (Standard & Poor's rating), BB-B 26% and AAA-AA 19%. In 2002, estimates were A-BBB 57%; BB-B 25% and AAA-AA 18%.
Roger Brown, executive director of the BBA, noted that confidence among market participants for continued growth and development of the credit derivatives market remained high and in a difficult economic environment "credit derivatives have proven their worth as efficient risk transfer and pricing instruments."
The major buyers of protection are large commercial banks and hedge funds. Increasingly re/insurance companies have become the sellers of protection, though they also buy protection for their bond portfolios.
Re/insurers have come to understand that credit derivatives can very effectively and inexpensively spread investment risks, according to Geoffrey Etherington, partner, insurance and reinsurance practice group of New York-based law firm Edwards & Angell. Credit derivatives are risk transfer mechanisms and "that is what insurance companies do. Re/insurers are investors and are used to taking big positions in large corporate issues."
He discounted the notion that re/insurers had become ensnared in the credit derivatives schemes because they were naïve. "The underwriting process for issuing an insurance policy requires specific expertise, gathering pertinent information and making an appropriate, educated guess at the expected loss or claim," he said. This, he added, was identical to the process used in buying or selling protection for a credit derivative.
Michael P Goldman, partner at Chicago law firm Sidley Austin Brown & Wood LLP, said that credit derivatives for re/insurers were unique in that they could be specifically groomed, structured and created for different layers of credit. Credit derivatives allow users to structure their portfolio exposure to specific industries, geographical regions and types/maturities of bonds. Achieving this diversification on a non-cash basis would be very difficult for a re/insurance company.
Moving risk around
According to Robert Grossman, chief credit officer at Fitch Ratings in New York, one reason credit derivatives have grown so rapidly within the past five years is because banks in Europe and the US decided that maintaining a managed portfolio approach to credit is better than keeping risk on balance sheets for ever. "So, now they are becoming more sophisticated in holding and managing their portfolios. A bank may have a lot of exposure to one industry and can reduce that concentration by buying a credit derivative," he said.
Sellers of protection for credit derivatives, by agreeing to assume the risk of default, are looking for a return without having to actually buy the asset. Obviously then, the protection seller's credit rating is extremely important for the protection buyer. The buyer must be confident that its counterparty will have the funds to pay off if the bond defaults.
Depending on the contract conditions, the two most common payment forms are physical delivery and cash settlement. With physical delivery, the seller pays the buyer of the protection the notional amount of the financial instrument and receives it in return. Under a cash settlement, the seller pays the buyer the difference between the notional value of the bond and its current market price. The buyer, however, retains ownership of the bond and could recoup further income from the issuer's remaining assets, if any.
One major player in the credit derivatives arena is Swiss Re. In 2001, the reinsurer reported total derivative contracts with a notional amount of $68.3bn, of which credit derivatives were $39.8bn. Of its credit derivatives in 2001, 80% were portfolio credit default swaps in which Swiss Re primarily sold credit protection. In most cases, the protection buyer retained a first loss deductible. The group has more than 90% of its notional exposure of credit derivatives assigned to the AAA quality category.
London - derivative central
In the forefront of developing the credit derivatives market, London now writes more than half of all credit derivatives in the world, and it seems determined to retain its dominant position.
Mr Etherington acknowledged that London was a dynamic centre of insurance, concentrated in Lloyd's and the London market. "There are a lot of talented, professional people in London," he said, "plus it's a major financial centre, all of which makes a perfect environment for credit derivatives to grow and develop. New York City, while a gigantic financial power house, doesn't have quite the same concentration of personnel and expertise that is manifest in London."
The credit derivative market developed in London, explained Roger Merritt, managing director, credit policy group at Fitch Ratings in New York, because European companies tended to borrow funds by issuing bonds, rather than stock, as is more common in the US. "European banks developed credit derivatives," he said, " to spread the risk of the investment grade bonds they own."
Contributing to the rapid growth of credit derivatives, as of 2001, Lloyd's underwriters for the first time since the 1920s are permitted to handle these risks. The reluctance to allow this type of alternative risk transfer at Lloyd's stems from the fear that credit derivatives concentrate risk and default can be triggered by a series of correlated macro-economic events. Lloyd's syndicates, however, are only allowed to enter this business if they comply with stringent capital adequacy requirements and have received permission from a number of regulatory agencies.
Since trading in credit derivatives is conducted Over-The-Counter, there is little oversight of the activity by government agencies, or data available about the exact nature of the trades. As the credit derivative market has expanded in product diversity and size of contracts, government agencies, regulators and rating organisations have begun investigating the scope and stability of this relatively new financial/investment instrument.
Fitch's Mr Grossman said: "We believe there should be more transparency in this market which is relatively opaque now." In December 2002, Fitch announced it was conducting a survey of banks, re/insurance companies and securities firms to achieve a better understanding of institutions' total net credit derivative exposure. Fitch will be focussing on sellers of credit derivatives. "The rapid growth, lack of transparency and relative immaturity of the market warrants closer review, particularly for unanticipated concentrations of credit risk," said Mr Grossman.
Commenting on credit derivatives, Howard Davies, chairman of the UK's Financial Services Authority, speaking at a conference in February 2002, said: "Are these risks properly priced? Are they being driven by sound risk diversification principles, or by reasons of differential tax treatment or, perhaps, regulatory capital arbitrage?"
He noted that recent default events such as Enron, Railtrack, Swissair and Argentina had provided important tests for the growing use of credit derivatives. "There have been concerns that significant defaults could expose flaws in the market's underlying legal infrastructure - with disputes about the definition of a credit event, the terms of delivery obligations, etc." He concluded that sellers of credit protection "are generally meeting their obligations." But urged firms "to exercise the maximum due diligence they can."
In the US, no less a monetary authority than Federal Reserve chairman Alan Greenspan cautioned against any hasty or undue regulations of the credit derivative market by government agencies. In a discussion at the Council on Foreign Relations in November 2002, Mr Greenspan observed that the relatively small but rapidly growing market in credit derivatives had functioned well to date, "with payouts proceeding smoothly for the most part. Obviously, this market is still too new to have been tested in a widespread downcycle for credit. But so far, so good.''
The value and worth of credit derivatives have certainly been put to the test in the past two years. Moody's, the credit rating agency, said the bond default rate, which measures the preceding 12 months, fell to 8.1% in December from 8.7% in November 2002, down from an 11-year high of 10.7% in January. In 2002, defaults totaled more than $170bn, easily surpassing the $110.2bn record set in 2001.
Yet the sellers of protection for bonds settled with the buyers in most cases without a hassle, though some had to go to arbitration to resolve what triggered a `credit event'. A prime reason there was no collapse of a re/insurer following the bankruptcy of Enron was that individual re/insurance companies had not bulked up providing protection of that company's bonds.
For example, Moody's observed that it estimated the US life insurance industry's direct exposure to Enron was about $3.9bn at year-end 2000. This is less than 2% of the consolidated statutory capital base of US life insurance companies rated by Moody's. Further, Moody's said it had not found any single life company that had enough exposure to Enron's bonds "to cause us to have significant credit concerns."
While some re/insurers, such as SCOR, the troubled French reinsurer, announced in 2002 that it had withdrawn from credit derivatives reinsurance and has "no plans whatsoever" to return to it, Tokio Marine and Fire Insurance Co, however, began dealing in credit derivatives in a big way ($4.2bn) in 2002.
Since credit derivatives are a relatively new financial tool, there has been some disagreement on the documentation in the contracts. To resolve these disagreements, the International Swaps and Derivatives Association (ISDA) has established important international contractual standards governing credit derivatives transactions. Its importance to the global financial community has been described as "no less than the creation of global law by contractual consensus". The revised 2002 ISDA Master Agreement was widely recognised as a groundbreaking document that had enabled the growth of the risk management industry by enhancing legal certainty and reducing credit risk, said Robert Pickel, ISDA's executive director and CEO. Over the last few years almost all participants in the credit derivatives market have used the ISDA agreement to document contracts.
Re/insurers' involvement in credit derivatives will continue to grow, Mr Etherington noted. "I think it is an excellent way for reinsurers and insurers to hedge their investment risk by tapping a pool of capital that is outside the insurance industry," he said. "I am a firm believer that the derivative market can be used to hedge practically everything. In fact, I see one day, on a larger level, credit derivatives substituting for the upper layers of reinsurance."
By Ronald Gift Mullins
Ronald Gift Mullins is an insurance journalist based in New York City.