The Handbook of Insurance-Linked Securities

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