For insurers and reinsurers, the transfer of risks to capital markets functions not only as a substitute for equity capital but also as an alternative to traditional reinsurance markets. The funds extended in this way by capital markets create - like equity capital or traditional reinsurance - the capacity needed to expand business volume systematically.
Economically, securitisation of (re)insurance risks makes sense either when conventional reinsurance capacity is unavailable or insufficiently available, or when capital market capacities can be secured at more reasonable conditions.
Thus, reinsurance risks were securitised for the first time in February 1994 when retrocessions markets had virtually collapsed following the catastrophes losses of 1989 to 1992.
How does securitisation work?
The principle of securitising reinsurance risks was first put into practice by Hannover Re in February 1994. Known as “Kover”, this pioneering transaction was based on a structure whose underlying principle - albeit with changes in details (for example, limitation of the risk of loss in exchange for a corresponding limitation on the opportunity for profit) - has been shared with most of the transactions which have followed. (see table overleaf)
The placing bank established a reinsurance company (a special purpose vehicle or SPV) with minimal capital resources. Hannover Re could not hold a majority stake in the company because then it would have been required to consolidate the SPV in its accounts. The SPV was established in a country with liberal insurance supervisory laws and no corporation tax liability, in this case the Cayman Islands. The solve purpose of this SPV was to reinsure part of Hannover Re's natural hazards portfolio by way of a quota share treaty.
The company was capitalised through the sale of bonds which were either subscribed by way of cash notes or secured in the form of credit notes. These notes pay interest at a rate dependent on the performance of the reinsured portfolio and are repaid at the end of the contract term to the extent that they are not needed to settle losses from the reinsured portfolio. In the worst case scenario, the loss from the portfolio would be so high that no repayment would be made.
In November 1996, we successfully implemented a very different kind of structure, a so-called portfolio linked swap. This transaction, referred to as K2, dispensed with the establishment of an SPV. Instead, based on the model of stop loss reinsurance, the result of the reinsured natural hazards portfolio is simply swapped. The entire invested capital is again at risk. This transaction was extended through an option on a further $50 million (known as K2+amendment).
Almost all securitisation transactions concluded to date were geared to (re)insurance risks from natural hazards. At first glance this may appear surprising, since highly volatile catastrophe risks would appear to contradict the ideal investment profile. The first exception to the rule involved life insurance policies, when in April 1998, Hannover Re transferred acquisition costs from life reinsurance to the capital markets. Designated L1, the structure of this transaction is comparable to that of Kover. The only difference is that the placing bank already had a reinsurance subsidiary, and, therefore, there was no need to establish an SPV first. (See diagram)
As German accounting rules - like statutory requirements in most jurisdictions - require acquisition costs from life and health reinsurance business to be written off immediately in the year in which they are incurred, they impose a heavy burden on the profit and loss account of rapidly growing life (re)insurers. By transferring such burdens to the capital markets, we are able to ensure the necessary capacity to continue to expand our strategic priority segment of life and health reinsurance at the accustomed high growth rates.
We are continuing to experiment with further transactions, including the securitisation of crop insurance in the United States, of residual values for leased assets such as motor vehicles, ships and aircraft etc. Yet, capital market products will not replace traditional reinsurance; most will function as a supplement for those risks for which the capacity of (re)insurance markets is either unavailable or insufficient. Only special situations such as these can justify the enormous transaction costs.
We shall see further securitisations of natural catastrophe portfolios. For our part, we have more recently concluded the L2. L3 and L4 transactions under which the acquisition costs from life reinsurance treaties in the amounts of EUR 130 million, EUR 50 million and EUR 200 million, respectively, were again transferred to the capital markets. In contrast to its L1 predecessor, the L2 facility was geared to so-called block assumption transactions. In this case, the reinsurer does not only finance the acquisition costs from new business, but assumes existing (generally closed) portfolios against payment of a single commission. A further difference between L2 and L1 is that L2 may also include personal accident and health insurance business rather than only life reinsurance.
L3 encompasses all classes of life, health and personal accident reinsurance and is specially designed to meet the needs of insurance companies in the Asian emerging markets.
L4 is geared to unit-linked life insurances from German-speaking markets.
Hannover Re not only draws upon the capital markets as a source of underwriting capacity, but also participates actively in the securitisation sector as an investor. A budget of $100 million was set aside for this purpose, and this has already been intensively utilised with an amount of some $75 million deriving from participation in eight transactions.
The longer term development of securitisation will not least depend on how investors react to a major natural catastrophe that causes them to lose their invested capital.
A further decisive factor will be the fulfilment of profit expectations that are transparent and comprehensible from the investor's point of view and that are commensurate with the risks. As far as profit expectations are concerned , catastrophe bonds which not only may fail to provide interest payments, but which may also result in the loss of the entire invested capital are generally categorised as high yield bonds. The (re)insurance industry currently offers few examples for which such high returns can be anticipated.