Five years ago (re)insurance securitisation was being pursued by a few financial mathematicians, and many reinsurers were unreceptive to the concept. Today, it is one of the most exciting areas in the reinsurance marketplace. Dennis Chookaszian examines this change in attitude toward the securitisation concept, as well as the implications for the reinsurance industry.
When the Chicago Board of Trade (CBOT) first presented the securitisation idea to CNA, we were not very enthusiastic. CNA is active in insurance and reinsurance, and we viewed securitisation as a threat to our reinsurance operations. Today, we are actively involved in securitisation, having launched our own securitisation firm, Hedge Financial Products, in 1997.
We changed for the same reason many of our peers have changed. The trend toward securitisation presents reinsurers with two choices - participate in the trend or get run over by it. We decided that securitisation is a business that is going to grow and we wanted to be involved in a significant way.
The evolution of the mortgage-backed securities market provides a useful yardstick for measuring the development of insurance securitisation. It took 15 to 20 years for mortgage-backed securities to go from an interesting idea to what has become a deep, broad market. If we view the cat contract of the CBOT as the starting point for (re)insurance securitisation, the market is probably three to four years along a 15 to 20 year course of evolution.
Along the way, we will see a number of interesting product and service ideas. Some will work and some won't. Analytic tools for fractioning and bundling risk will be developed. We will see firms jumping into securitisation from insurance, reinsurance, investment banking and insurance brokerage. Ultimately, (re)insurance securitisation will be a robust addition to the financial markets.
There are three primary drivers of the trend toward insurance securitisation: a mismatch between risk transfer needs and the capital base of the insurance industry, increasing demand and restructuring of the insurance industry.
The mismatch between risk transfer needs and the capital base of insurance was dramatised by the series of major catastrophes in the early 1990s. The adequacy of the base is only part of the problem, however. Equally important is that insurance capital is not organised in a way that makes it possible to spread catastrophe risk across the base broadly. Securitisation will solve this structural problem by providing tools for fractioning the risk and spreading it more rationally over insurance and non-insurance capital.
The second driver is demand. Weather-related risks have given rise to most of the demand thus far. But a much bigger market will emerge as techniques are developed to fraction a broad range of property/casualty, life and health insurance risks. For insurers and reinsurers, these techniques will enable them to respond to pressures from their investors for more stable returns. Meanwhile, growing understanding of insurance risk among the investment community will fuel demand for instruments linked to this type of risk.
The changing nature of risk management will also build demand. Insurers are recognising that they have to provide services to large commercial customers in a more sophisticated way. Hybrid-style products with securitisation features will be created to manage a broader range of insurance and financial risks.
The third driver of insurance securitisation is the restructuring of the insurance industry. Consolidation is a clear sign of this restructuring. We are also seeing a restructuring of the industry's financial base as investors with a shorter term, more aggressive orientation enter the business. A third level of restructuring relates to the management of liabilities as exemplified by the formation of Equitas at Lloyd's. All these fundamental changes are driving demand for the more flexible strategies made possible by securitisation.
Challenges to reinsurance
The emergence of insurance securitisation will have a significant impact on the future of the reinsurance business. In fact, reinsurers have been using securitisation-type techniques for many years. And, today, many of the larger reinsurers already have securitisation operations.
In addition to the CBOT cat futures and options, other examples of securitisation include:
* CATEX is a computer based trading exchange which provides a facility for reinsurers and insurers to swap property exposures.
* The Bermuda Commodity Exchange, launched in 1997, provides contracts or options for homeowners' losses resulting from perils tracked by a new index, produced by Guy Carpenter.
* Contingent capital structures respond to specified events with equity or debt rather than loss recoveries.
* Most of the private cat bonds issued have involved the formation of a single purpose reinsurer. This approach is generally more expensive than an indexed transaction. On the other hand, it can be structured to provide full reinsurance coverage, versus options or futures which are tied to industry dominated indices.
Over the last few years, the number and size of the transactions involving securitisation of (re)insurance risk have increased. Compared to traditional reinsurance, many of these transactions to date have incurred high transaction costs or have not been customised. As these issues are resolved, however, securitisation will have a significant impact on the future of reinsurance.
The participation by the capital markets as risk takers will likely result in greater efficiencies and should ultimately reduce the long term cost of risk transfer - with both reinsurers and the capital markets playing major roles.
Reinsurers, such as CNA Re, bring to the table established customer relationships, underwriting experience and financial expertise. The capital markets for their part offer large capacity and potentially lower marginal cost of risk transfer, depending upon the correlation of the asset class with the rest of their portfolios.
Even with a robust securitisation market, reinsurance customers will still require traditional protection and "follow the fortunes" structures. The role of the sophisticated reinsurer is likely to evolve to one where the reinsurer provides efficient pooling mechanisms for the exposures retained, ultimately translating a portion of that risk into the capital markets.
Challenges for reinsurers
This new role presents the reinsurance industry with several challenges.
Reinsurers need to develop an understanding of the risk appetite of capital market investors, who will gravitate toward risk that can be standardised and indexed. There will be a greater emphasis on the relationship of this risk to assets which are highly correlated with various stock market indices.
Reinsurers also need to develop the ability to fraction traditional exposures into two major classes: risks that can be packaged and sold to the capital markets and residual (or basis) risk segments. The residual exposure would be largely retained, supported with some level of traditional retrocession protection. The risk packaged for the capital markets will have to be geared to investors, not reinsurers. In many cases, investor expectations will require that risk be translated into homogeneous packages that can be tied to publicly available indices.
Ultimately, reinsurers will need to put increased emphasis on financial risk management practices. Deciding whether to transfer or retain risk is not unfamiliar territory to reinsurers. However, the additional capital available through the evolving securitisation mechanisms presents opportunities that were previously inaccessible except through traditional debt or equity offerings.
In addition, the nature of the risk transfer will differ in important ways from traditional retrocessional risk transfer. The residual exposures retained by reinsurers will have new and complex risk attributes that must be priced and structured for appropriate return on risk. Understanding efficient frontier concepts and analytical modelling of reinsurance portfolios will become critical success factors. Dynamic financial analysis (DFA), which provides insight into the probabilistic impact of management decisions on assets, liabilities and other financial variables, is likely to play a major role in the movement of reinsurers into the securitisation arena.1
In summary, securitisation is coming and it is bringing challenge and change to the (re)insurance industry. For forward looking companies, however, securitisation represents an opportunity to shape what will ultimately become a significant and dynamic component of the financial services infrastructure.
Dennis Chookaszian is chairman and ceo, CNA.
1. A more detailed discussion of DFA is available in the Global Reinsurance 1998 Bermuda edition.