Download Risk transfer mechanisms

Risk transfer mechanisms
- converging insurance, credit and financial markets
Presentation at OECD/CIRC Technical Expert
meeting on Reinsurance, June 2002.
Jens Verner Andersen, OECD
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Outline
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Introduction
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Growth of risk transfer markets
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Factors underpinning growth
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Implications for financial stability
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Concluding remarks
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Introduction
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Risk transfer mechanisms comprise a wide group of
financial instruments:
– Credit linked securities (credit derivatives) transfer risks
embedded in credit lending, i.e. borrowers are not repaying
debt.
– Insurance linked securities such as some ART products and
Cat bonds are designed to shed risks from underlying
insurance risks.
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Change financial sector landscape: Bridging bank
and insurance activities with capital markets
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Introduction (con’d)
- Structure of deals
Protection buyer
Protection seller
Periodic payment
“Owner" of risk
(e.g. bank)
Payment upfront
Special purpose vehicle
Payment on event
Intermediate
protection seller
Funds invested
“Buyer” of risk
(e.g. insurer)
Return: Libor + spread
Risk-free cash flow
Collateral account
Highly rated securities
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Growth of risk transfer markets
- credit-linked securities
Outstanding notional amounts
USD billions
1800
1600
1400
1200
1000
800
600
400
200
0
Before 1997
1997
1998
1999
Note: Figures for 2001 and 2002 are based on expectations
2000
2001
2002
Source: British Bankers Association
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Growth of risk transfer markets (con’d)
- credit-linked securities
Market participants and market shares
Per cent of notional value
70
60
Protection buyers
Protection sellers
50
40
30
20
10
0
Commercial Securities
banks
firms
Insurance corporates
companies
Hedge
funds
Mutual
Pensions Gov’t/credit
funds
funds
agencies
Source: British Bankers Association
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Growth of risk transfer markets (con’d)
- credit-linked securities
Net sale of credit protection
USD billions
300
1999
250
2002 (estimate)
200
150
100
50
0
-50
-100
-150
-200
-250
Commercial Securities
banks
firms
Insurance Corporates
Hedge
Mutual
Pensions Gov’t/credit
companies
funds
funds
funds
agencies
Source: British Bankers Association and own calculations
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Growth of risk transfer markets (con’d)
- insurance-linked securities
Catastrophic issuance
USD millions
1600
1400
1200
1000
800
600
400
200
0
1994
1995
1996
1997
1998
1999
2000
2001 Q1
Source: Swiss Re
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Growth of risk transfer markets (con’d)
- insurance-linked securities
Cat bonds: Market participants
Banks
8%
Insurers
21%
Hedge funds
22%
Reinsurers
21%
Mutual funds and
Investment advisors
28%
Source: Bank leu; Goldman Sachs
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Factors underpinning growth
-credit-linked securities
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Protection buyers
– Dispersion of risks: Improved risk management opportunities
– Relationship banking: Retain commercial clients without
having negative concentration impacts.
– Capital optimisation: Increased focus on capital charges as
an integral part of credit lending.
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Protection sellers
– Enhancing yields: Decline in interest rates across the board
in combination with lower supply of sovereigns have
increased end-investors’ demand for new instruments.
– Return on Capital: Deploy capital more efficiently - obtain
higher risk adjusted returns.
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Factors underpinning growth (con’d)
- insurance-linked securities
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Protection buyers:
– Capacity/Premiums: Alternative to traditional reinsurance
when insurance cycle hardens.
– Diversification effects: Shedding risks to financial markets in
areas where exposures are over-concentrated.
– Counterparty risks: Solution via special purpose vehicles
offers lower counterparty risk.
_________________________________________________
– Costs: High transaction costs have restricted diffusion of
transactions.
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Factors underpinning growth (con’d)
- insurance-linked securities
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Protection sellers
– Favourable market returns: Provide risk premiums compared
with corporate bonds having almost identical ratings.
Compensated for illiquidity, possible model inaccuracies and
newness premiums.
– Diversification effects: Risk profile that is less correlated with
the credit cycle or traditional insurance products.
__________________________________________________
– Concentration:Investor reluctance to build up exposures
outside known areas: investors have reached limits for
investments to specific regions.
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Implications for financial stability
- concern among supervisors
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Arbitrage (Regulatory, Capital, Accounting, Tax)
– Capital arbitrage one of the factors that catalysts interest for
risk transfer markets. Evidence indicate that this factor is
diminishing. However other types of arbitrage may underpin
interest?
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Learning curve risks
– Complex business on the borderline between banking and
insurance: Do market participants understand risks?
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Pricing of risks
– Adequate pricing and proper valuation are demanding but
important when risks crystallise.
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Implications for financial stability (con’d)
- creating value in insurance companies
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Separating value creation into two entities:
– Insuring risks: Issuing insurance contracts that more than
cover the associated production costs, including capital cost.
– Investing cash from premiums until claims are paid:
Achieving an investment result that beats the benchmark on
a risk-adjusted basis.
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Creative insurers focus on shareholder value by:
– Aggressive approach to managing capital more efficiently:
constrain capital to business generating sufficient profit.
– Risk transfer techniques: Credit enhancement is innovative
use of surplus capital.
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Concluding remarks
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YES – There are benefits
– Risk transfer markets offer opportunities for improved risk
management.
– Facilitate more manageable credit- and insurance cycles as
deployment of capital is improved.
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BUT – care is needed in management of new risks
– Capital market innovation is a challenge for users and
authorities.
– Capital market integrity issues related to accounting, capital
and regulation.
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