06 June 2013

BaFin: Advantages and risks of transferring insurance risks to the capital markets

Translated from the German

The term "alternative risk transfer" (ART) is used when insurers transfer any kind of insurance risks, not purely financial risks, to the capital markets using specific financial instruments. The use of ART allows for risks to be spread more broadly, thus increasing risk bearing capacity. Primary insurers and reinsurance undertakings use ART instruments primarily to steer their risk capital and finance additional insurance capacities. There are three classes of ART instruments:

• securitisation of insurance risks (insurance-linked securities)
• insurance derivatives
• contingent capital

Securitisation of insurance risks

Claims arising from major natural disasters can be securitised using catastrophe bonds and thus transferred to a broader investor base. As a general rule, catastrophe bonds are issued through a special purpose vehicle established specially for this purpose. They belong to the general class of instruments of insurance-linked securities (ILS). Although the cat bond market volume is still rather small in relation to the global reinsurance market, the frequent occurrence of natural disasters involving high losses on the part of (re)insurers is driving accelerated growth within this market segment.

Insurance derivatives and contingent capital

Further ART instrument classes are insurance derivatives and contingent capital. Insurance derivatives function in much the same way as other financial derivatives, albeit with the difference that with insurance derivatives a technical underlying – usually a claims index – is constructed. If a risk event occurs, a claims burden of the (re)insurers is partially offset by newly-created assets (asset hedge). Instruments of contingent capital have option character because they entitle the counterparty to take on equity or debt capital in the event of a loss depending on the contract arrangements of the instrument class (leverage management).

Advantages for insurers

For insurers, there are various motives for using ART. One of them is higher loss absorption for large catastrophe events made possible by cat bonds. Further advantages, particularly for life insurers, are the possibilities to transfer longevity risks to the capital markets via longevity bonds and mortality rists due to pandemics and increasing global interdependencies via mortality bonds.

With appropriately structured ILS transactions, ART can also minimise counterparty risks existing in traditional reinsurance business particularly for large risk events. With ART, (re)insurers can also diversify their portfolios by buying underwriting risks of other insurers.

Advantages for investors

Investors enjoy diversification benefits through ART. They can invest in risks which commonly exhibit a low correlation with other established risks on the capital markets (zero beta assets). Moreover, on the basis of ART investors can invest in insurance risks directly and in isolation.

Risks for insurers and investors

Investors and insurers have different information on the risks of ART transactions. Whereas insurers can thoroughly analyse the type, quality and composition of the securitised risks prior to an issue, this is often not possible for investors. They frequently also lack the technical know-how to evaluate the instruments in terms of their risk/reward characteristics. These information asymmetries between investors and issuers can be a cause for moral hazard and can also result in adverse selection issues. Other risks for investors stem from the weak secondary market.

Moral hazard and adverse selection

Adverse selection results from the information edge of the insurers: the price of an ILS transaction merely reflects the average of all risks securitised in it. Moral hazard and adverse selection are counteracted by the potential reputational risk this represents for insurers as well as the partial retention of risks.

Market outlook

Given its low market volume, the ART market does not present any systemic risks to the aggregate reinsurance market in the short-to-medium term. However, the market does have development potential. For that reason both BaFin and EIOPA continue to follow the ART market – particularly with regard to the risks outlined.

Full article (in German)

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