The Handbook of Insurance-Linked Securities

"Luca Albertini and Pauline Barrieu are to be congratulated on this volume. Written in a period where structured projects in finance are having a difficult time, it is worthwhile to return to the cradle of securitisation: insurance. Spread out over three parts (life, non- life, and tax and regulatory issues) the 26 chapters, written mainly by practitioners, give an excellent overview of this challenging field of modern insurance. Methodology and examples nicely go hand in hand. The overall slant being towards actual analyses of concrete products. No doubt this book will become a milestone going forward for actuarial students, researchers, regulators and practitioners alike." —Paul Embrechts, Professor of Mathematics and Director of RiskLab, ETH Zurich The convergence of insurance with the capital markets has opened up an alternative channel for insurers to transfer risk, raise capital and optimize their regulatory reserves as well as offering institutions a source of relatively liquid investment with limited correlation with other exposures. One of the financial instruments allowing for the cession of insurance-related risks to the capital markets is Insurance-Linked Securities (ILS). This book provides hands-on information essential for market participants, drawing on the insights and expertise of an impressive team of international market players, representing the various aspects and perspectives of this growing sector. The book presents the state of the art in Insurance-Linked Securitization, by exploring the various roles for the different parties involved in the transactions, the motivation for the transaction sponsors, the potential inherent pitfalls, the latest developments and transaction structures and the key challenges faced by the market. The book is organized into parts, each covering a specific topic or sector of the market. After a general overview of the ILS market, the Insurance-Linked Securitization process is studied in detail. A distinction is made between non-life and life securitization, due to the specificities of each sector. The process and all the actors involved are identified and considered in a comprehensive and systematic way. The concepts are first looked at in a general way, before the analysis of relevant case studies where the ILS technology is applied. Particular focus is given to: the key stages in both non-life and life securitizations, including the general features of the transactions, the cedant's perspectives, the legal issues, the rating methodologies, the choice of an appropriate trigger and the risk modeling, the particular challenges related to longevity securitization, the investor's perspective and the question of the management of a portfolio of ILS, the general issues related to insurance-linked securitization, such as accounting and tax issues, regulatory issues and solvency capital requirements. The book is accompanied by a website www.wiley.com/go/albertini_barrieu_ILS which will feature updates and additions to the various contributions to follow market developments.

Table of Contents:
About the Contributors xv Acknowledgements xxv 1 Introduction 1 Pauline Barrieu and Luca Albertini Part I Non-life Securitisation 7 2 Non-life Insurance Securitisation: Market Overview, Background and Evolution 9 Jonathan Spry 2.1 Market overview 9 2.2 Market dynamics 14 2.3 The question of basis risk remains 16 2.4 ILS and the credit crunch 18 3 Cedants’ Perspectives on Non-life Securitization 19 3A Insurance-linked securities as part of advanced risk intermediation 21 Insa Adena, Katharina Hartwig and Georg Rindermann 3A.1 Motivation for Allianz to take part in ILS activities 21 3A.2 Objectives of insurance companies 23 3A.3 Case study: Blue Fin Ltd 24 References 28 3B Reinsurance vs Securitisation 29 Guillaume Gorge 3B.1 Keeping risk vs transferring it 29 3B.2 Reinsurance vs securitisation 30 3B.3 Application to main P&C risks 31 3B.4 Case studies: Aura re and Sparc 32 3B.5 Limits and success factors to securitisation 33 References 34 3C Securitisation as a diversification from traditional retrocession 35 Jean-Luc Besson 4 Choice of Triggers 37 Dominik Hagedorn, Christian Heigl, Andreas Müller and Gerold Seidler 4.1 General aspects 37 4.2 Indemnity triggers 38 4.2.1 Scope of coverage 39 4.2.2 Payout timing 39 4.2.3 Loss verification 40 4.2.4 Transparency 40 4.3 Non-indemnity triggers 41 4.3.1 Parametric triggers (pure and index) 41 4.3.2 Industry loss triggers 43 4.3.3 Modelled loss triggers 45 4.4 Choosing the optimal trigger 45 4.4.1 Comparison of trigger types 46 4.4.2 Choice of trigger and alternative solutions 47 5 Basis Risk from the Cedant’s Perspective 49 David Ross and Jillian Williams 5.1 Introduction 49 5.2 Investor vs sponsor risk 50 5.3 Trigger types 50 5.4 Catastrophe models 52 5.4.1 Key components of catastrophe models 52 5.4.2 Uncertainty 54 5.5 Sources of basis risk 55 5.5.1 Source 1: Catastrophe model error/shortcomings 55 5.5.2 Source 2: Discrepancy between the modelled index loss and the modelled company loss 56 5.5.3 Source 3: Dynamic basis risk 56 5.6 Defining basis risk 56 5.7 Quantifying basis risk 58 5.7.1 Measures for pro rata hedges 58 5.7.2 Measures for digital hedges 59 5.7.3 Measuring positive basis risk 59 5.8 Minimising basis risk 60 5.8.1 Over-hedging 60 5.8.2 Choice of index 62 5.8.3 Reset clauses 62 5.8.4 Cat model input 63 5.9 Conclusion 63 Acknowledgements 63 References 64 6 Rating Methodology 65 Cameron Heath 6.1 Standard & Poor’s ratings services’ rating process 65 6.1.1 Initial interaction 65 6.1.2 Risk analysis 65 6.1.3 Documentation review 67 6.1.4 Transaction closing 67 6.1.5 Surveillance 67 6.2 Risk analysis 68 6.2.1 Trigger options 68 6.2.2 Indemnity vs non-indemnity triggers 68 6.2.3 Risk factors 70 6.2.4 Adjusted probability of default 72 6.2.5 Application of methodology 73 6.2.6 Default table 74 6.2.7 Multi-event criteria 74 6.3 Legal and swap documentation review process 75 6.3.1 Insurance focus points 75 6.3.2 Legal and structural focus points 75 6.4 Impact on sponsor 75 6.4.1 Capital model treatment of ILS 75 6.4.2 Summary of basis risk analysis 76 6.4.3 Sources of basis risk 77 6.4.4 Link to ILS revised probability of attachment 82 References 82 7 Risk Modelling and the Role and Benefits of Cat Indices 83 Ben Brookes 7.1 Components of a cat model 84 7.2 Insurance-linked securities 84 7.2.1 General overview 84 7.2.2 Insurance-linked security triggers 85 7.2.3 Basis risk 90 7.3 Cat indices 93 7.3.1 Property Claims Service (PCS) 93 7.3.2 Re-Ex – NYMEX 93 7.3.3 Insurance Futures Exchange Service (IFEX) 94 7.3.4 Carvill Hurricane Index (CHI) – Chicago Mercantile Exchange (CME) 94 7.3.5 Paradex 95 7.4 Summary 99 8 Legal Issues 101 Malcolm Wattman, Matthew Feig, James Langston, and James Frazier 8.1 The note offering – federal securities law implications 101 8.1.1 The distribution of the notes 101 8.1.2 Application of the anti-fraud provisions of the federal securities laws 102 8.1.3 Securities offering reform 103 8.1.4 Provision of information 103 8.1.5 The Investment Company Act of 1940 104 8.2 The note offering – the offering circular 104 8.2.1 Important terms 104 8.2.2 ERISA considerations 106 8.2.3 Other considerations regarding the proceeds and payment of interest 109 8.2.4 The risk analysis 110 8.2.5 Opinions 110 8.3 Types of transactions 110 8.3.1 Parametric, index and modeled loss transactions 111 8.3.2 Indemnity transactions 111 8.4 Conclusion 115 9 The Investor Perspective (Non-Life) 117 Luca Albertini 9.1 The creation of a sustainable and liquid market 117 9.1.1 Creation of common terminology 118 9.1.2 Risk analysis 119 9.1.3 Correlation with other investments in the portfolio 119 9.1.4 Relative value 121 9.1.5 Valuation and liquidity 121 9.2 Key transaction features from the investor perspective 122 9.2.1 Assessment of the underlying risks being securitised 122 9.2.2 Risk assessment of the instrument 124 9.2.3 Pricing and risk-return profile 125 9.3 Market evolution: the investor perspective 127 9.3.1 Collateral arrangements 127 9.3.2 Data transparency 128 9.3.3 Exposure monitoring 129 9.3.4 Modelling rigour 129 10 ILS Portfolio Monitoring Systems 131 Tibor Winkler and John Stroughair 10.1 Introduction 131 10.1.1 Completing the circle 131 10.1.2 ‘Square peg in a round hole?’ 132 10.2 Miu – An ILS platform in a convergent space 133 10.2.1 Overview 133 10.2.2 Nuts and bolts – how the platform works 133 10.2.3 Step by step – entering a contract 134 10.2.4 Portfolio analysis 134 10.3 RMS library of cat bond characterisations 137 10.3.1 Motivation and objectives 137 10.3.2 How is it done? A bird’s eye view 137 10.3.3 Apples to apples – a leap for the market 138 10.4 Conclusion 138 11 The Evolution and Future of Reinsurance Sidecars 141 Douglas J. Lambert and Kenneth R. Pierce 11.1 A brief history of the brief history of sidecars 142 11.2 Sidecar structures 143 11.2.1 Basic structure 143 11.2.2 Market-facing sidecar 144 11.2.3 Non-market-facing sidecar 145 11.2.4 Capitalising sidecars 146 11.2.5 How sidecars and catastrophe bonds are different 147 11.3 The appeal of sidecars 148 11.3.1 From a cedant/sponsor perspective 148 11.3.2 From an investor perspective 149 11.4 Structuring considerations 149 11.5 The outlook for sidecars 150 11.6 Conclusion 151 12 Case Study: A Cat Bond Transaction by SCOR (Atlas) 153 Emmanuel Durousseau 12.1 Introduction: SCOR’s recent history 153 12.2 Atlas III and IV: Background 153 12.3 Atlas: Main characteristics 155 12.4 Basis Risk 158 12.4.1 Reset 158 12.4.2 Gross up 158 12.4.3 Overlap 158 12.4.4 Synthetic covers 159 12.5 Total Return Swap 160 12.6 Conclusion 160 Appendix A 161 A. 1 Definition of events 161 A. 2 Extension events 162 13 Case Study: Swiss Re’s New Natural Catastrophe Protection Program (Vega) 163 Jay Green and Jean-Louis Monnier 13.1 A positive evolution of Swiss Re’s ILS strategy 163 13.2 Swiss Re accesses multi-event natural catastrophe coverage 164 13.3 The first ILS to use a cash reserve account as credit enhancement 164 13.4 Innovation leads to more efficient protection 165 Part II Life Securitisation 167 14 General Features of Life Insurance-Linked Securitisation 169 Norman Peard 14.1 Life insurer corporate and business structures, risks and products 170 14.1.1 Mutual life offices 170 14.1.2 Proprietary life offices 171 14.1.3 Other forms of life office 173 14.1.4 Principal risks associated with life insurance business 173 14.1.5 Principal product types and associated risks 176 14.2 Actors and their roles 177 14.2.1 Sponsor 177 14.2.2 Investors 179 14.2.3 Regulators 179 14.2.4 External professional advisers 179 14.2.5 Ratings agencies 181 14.2.6 Monoline insurers 181 14.2.7 Liquidity providers 181 14.2.8 Swap providers 182 14.2.9 Others 182 14.3 Process 182 15 Cedants’ Perspectives on Life Securitisation 189 15A A cedant’s perspective on life securitisation 191 Alison McKie 15A.1 Why securitise? 191 15A.2 Life ILS can be complex 194 15A.3 Outlook for life ILS 198 15B A cedant’s perspective on life securitisation 199 Chris Madsen 15B.1 Key considerations 199 15B.2 Examples of securitisation opportunities 202 15B.3 Differences between securitisation and reinsurance 205 16 Rating Methodology 207 Harish Gohil 16.1 Fitch’s approach to the rating process 207 16.2 Insurance risk analysis 208 16.2.1 Risk modelling 208 16.2.2 Ratings benchmarks 209 16.2.3 Analysis of sponsor and other counterparties 210 16.2.4 Surveillance 210 16.3 Zest: a VIF case study 211 References 212 17 Life Securitisation: Risk Modelling 213 Steven Schreiber 17.1 Modelling of a catastrophic mortality transaction 213 17.2 Modelling of a VIF transaction 216 18 Life Insurance Securitisation: Legal Issues 219 Jennifer Donohue 18.1 Monetisation of future cash flows 219 18.1.1 Some background on monetisation 219 18.1.2 The market drivers of monetisation 220 18.1.3 Monetisation in the current climate 221 18.1.4 Some transaction structures 221 18.2 Legal aspects of life insurance securitisation – some key features 222 18.2.1 Closed book/open book 222 18.2.2 Unit-linked policies – not ‘with profits’ policies 222 18.2.3 Risk transfer versus no transfer 222 18.2.4 Warranties 222 18.2.5 Monoline wrap (payment obligation) 223 18.2.6 Recharacterisation risk 223 18.3 Some examples of value-in-force securitisation/monetisation 225 18.3.1 A classical VIF structure: Gracechurch 225 18.3.2 A private but reported transaction: Zest 226 18.4 Outlook 227 19 The Investor Perspective (Life) 229 Luca Albertini 19.1 Life insurance-linked risks and investor appetite 229 19.1.1 The role of the monolines 229 19.1.2 Understanding the risk 230 19.1.3 Correlation with other investments 234 19.1.4 Relative value 236 19.1.5 Valuation and liquidity 237 19.2 Key transaction features from the investor perspective 237 19.2.1 Risk assessment of the instrument 237 19.2.2 Pricing and risk-return profile 240 19.3 Market evolution: the investor perspective 242 20 Longevity Securitisation: Specific Challenges and Transactions 245 Jennifer Donohue, Kirsty Maclean and Norman Peard 20.1 Mortality and longevity risk 245 20.2 A market for longevity risk 246 20.2.1 Potential sources of longevity risk for securitisation 246 20.2.2 Demand for longevity risk 247 20.3 Key structural aspects of longevity risk securitisation 248 20.3.1 Isolating longevity risk 248 20.3.2 Analysis of longevity risks 249 20.3.3 Longevity risk – legal explanation 250 20.3.4 Examples and legal aspects of transaction structures 252 20.4 Some features of longevity risk 255 20.4.1 Model risk 255 20.4.2 Ratings 258 20.4.3 Pricing 258 21 Longevity Risk Transfer: Indices and Capital Market Solutions 261 Guy Coughlan 21.1 The nature of longevity risk 262 21.2 The market for longevity risk transfer 263 21.2.1 Hedgers 263 21.2.2 Investors 265 21.2.3 Intermediaries 265 21.3 Importance of indices, tools and standards 266 21.3.1 Longevity indices 266 21.3.2 Trading and liquidity 268 21.4 Capital market instruments for longevity risk transfer 268 21.4.1 Longevity bond 268 21.4.2 Survivor swap 269 21.4.3 q-forward 269 21.4.4 Survivor forward 271 21.4.5 Instruments and liquidity 272 21.5 Customised vs standardised longevity hedges 273 21.5.1 Customised longevity hedge 273 21.5.2 Standardised index-based longevity hedge 273 21.5.3 Advantages and disadvantages 274 21.6 Case study: customised longevity hedge 274 21.7 Implementing a standardised index-based longevity hedge 275 21.7.1 Liability sensitivity and hedge calibration 276 21.7.2 Hedge effectiveness analysis 278 21.8 Conclusions 280 References 280 22 Case Study: A Cat Mortality Bond by AXA (OSIRIS) 283 Sylvain Coriat 22.1 Catastrophic pandemic risk 283 22.2 Considered risk transfer tools 284 22.3 Detailed structure 285 22.4 Risk analysis 287 22.4.1 Modelling approach 287 22.4.2 Index construction 287 22.5 Investors’ reaction 288 22.6 Spread behaviour 288 22.7 Next steps 288 Reference 291 23 Case Study: Some Embedded Value and XXX Securitisations 293 Michael Eakins and Nicola Dondi 23.1 Embedded value securitisation – Avondale S.A. 295 23.2 XXX securitisation 299 Part III Tax and Regulatory Considerations 305 24 The UK Taxation Treatment of Insurance-Linked Securities 307 Adam Blakemore and Oliver Iliffe 24.1 The Directive and the taxation of UK ISPVs 308 24.1.1 The implementation of the Directive in the UK 308 24.1.2 Implementation of the ISPV framework in the UK 308 24.1.3 UK tax treatment of ISPVs 310 24.2 Non-UK insurance special purpose vehicles 315 24.2.1 Tax residence status of the issuer 316 24.2.2 Tax residence status of the issuer’s agents 317 24.2.3 Location and management of the issuer’s assets 318 24.3 Indirect taxes and withholding of income tax 320 Further reading 321 25 The US Federal Income Taxation Treatment of Insurance-Linked Securities 323 David S. Miller and Shlomo Boehm 25.1 Avoiding US corporate income tax for the issuer 324 25.1.1 Overview 324 25.1.2 Trade or business in the United States 325 25.1.3 Procedures followed by catastrophe bond issuers to avoid substantive business activities in the United States 326 25.1.4 Section 864(b)(2) safe harbor 328 25.2 Withholding tax and excise tax 328 25.2.1 Overview 328 25.2.2 Descriptions of insurance-linked instruments written on standard ISDA forms 330 25.2.3 Federal income tax definition of notional principal contracts 331 25.2.4 Put options 334 25.2.5 The Bank of America case (income not clearly described within any other generally recognised category) 334 25.3 US federal income tax treatment of an investor in a catastrophe bond issuer: overview 335 25.3.1 US investors 335 25.3.2 Timing and character of income and gain of the issuer with respect to the permitted investments, the total return swap and the insurance-linked instrument 338 25.3.3 Foreign investors 339 25.3.4 Notes that are treated as indebtedness for federal income tax purposes 339 Reference 339 26 Regulatory Issues and Solvency Capital Requirements 341 Mark Nicolaides, Simeon Rudin, Rick Watson and Katharina Hartwig 26.1 Regulatory issues relevant for ILS sponsors 341 26.1.1 Solvency capital 341 26.1.2 Recognition of sponsors’ claims against SPV as eligible assets 342 26.2 Solvency I 343 26.2.1 Overview 343 26.2.2 Requirement to maintain a solvency margin 344 26.2.3 Structuring ILS under EU Directives to enhance solvency margins 348 26.3 Solvency II 351 26.3.1 Valuation of assets and liabilities 353 26.3.2 Determination of technical provisions 353 26.3.3 Solvency capital requirement 354 26.3.4 Minimum capital requirement 358 26.3.5 Own funds 359 26.3.6 Investments 360 Appendix A: Standard formula, solvency capital requirement (SCR) 361 A. 1 Calculation of the basic solvency capital requirement 361 A. 2 Calculation of the non-life underwriting risk module 361 A. 3 Calculation of the life underwriting risk module 362 A. 4 Calculation of the market risk module 362 Index 363