Alternative Risk Transfer Mechanisms

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1 Enterprise Risk Management for the Oil Industry Alternative Risk Transfer Mechanisms Julian M. Roberts Aon Capital Markets Ltd Mexico, November 5, 2002

2 Contents Alternative Risk Management A broader perspective of Risk Management The Convergence of Insurance and Capital Markets Risk Transfer into the Capital Markets Cat Bonds Other Alternative Risk Concepts Conclusions 2

3 A new definition of Risk Management The capital perspective Efficient capital utilisation or enough of the right sort of capital to finance a company s obligations - both expected and unexpected. To satisfy: Clients Shareholders other providers of funds Regulatory Bodies and Rating Agencies analysts expectations Management performance-related remuneration To manage volatility of performance and achieve optimum return on that capital. 3

4 Transfer or Retain?? Each corporation has a unique profile of risk and its own tolerance for risk bearing this may change according to the specific risk type Insurance risks event risk liabilities Financial risks commodity price foreign exchange Other business risks Brand / Reputation Asset Values How much risk to retain and how much to transfer? depends upon the cost of risk transfer and the cost of alternative (including own) sources of capital This is essentially about innovative Corporate Finance alternatives 4

5 What does alternative mean? Any mechanism used to substitute for traditional risk transfer products offered by re/insurers A planned approach to financing risk involving: Alternative risks not traditionally reinsurable eg. interest rate or commodity exposure, brand image Alternative structures, not reinsurance contracts eg. weather derivatives, catastrophe bonds Alternative markets, not Insurers or Reinsurers eg. capital market entities such as pension funds, banks and fund managers 5

6 Convergence of insurance and capital markets Capital markets Financial hedges Cat Bonds Securitisation Contingent capital - CatEPuts Alternative Risk Transfer or Finance Multi-line nsurance markets Guaranteed Cost Insurance policy Captive Quota Share Surplus Risk XL Cat. XL Aggregate XL Stop Loss Whole Account Stop Loss ML/MY Portfolio Transfer Finite Risk Double Trigger CatEPuts Cat bonds Hybrid Capital 6

7 Insurance Policies and Financial Contracts There are some key differences in the way that Insurance Policies and Financial contracts manage risk Insurance policies Downside risk only Bespoke policies Claims subject to negotiation Claims payment can be delayed Not tradable Pricing opaque Indemnity Financial contracts Downside and upside risks Standard contracts Black & White trigger Instant settlement Tradable Pricing transparent Basis risk 7

8 A Convergence of Markets Where do we fit in the world of risk? On Balance Sheet Off Balance Sheet Equity Hybrid/ Convertible Subordinated Debt Senior Debt Contingent Capital Financial Derivatives Non Traditional Insurance Traditional Insurance Capital Markets??? Insurance 8

9 Risk Transfer in the Capital Markets How can a financial instrument be structured so as to provide risk transfer? We must consider the separate requirements of both the buyer and seller of risk - each have separate drivers. Insurance Linked Securities (ILS) are investments sold to Institutional Investors (not private investors) investors receive a risk premium which makes an attractive investment ILS provide fully collateralised (debt) capital to provide for potential future claims. Debt is a more efficient source of capital for the management of catastrophe risk than equity 9

10 The Structure of a Cat Bond Company seeks insurance accounting Investors seek to purchase a security Insurance Agreement Charitable Trust Trust 100% Ownership Bonds Company SPV SPV Investors Cash Collateral pledged as Security Collateral Trust Trust Cash 10

11 The Structure of a Cat Bond Cashflows assuming no event loss Swap Swap party Counterparty Premium plus interest on Assets Coupon = LIBOR plus Spread Company Premium SPV SPV Interest on Collateral Assets Coupon (or interest + premium) Investors Collateral Trust Trust 11

12 Risk transfer securities Cashflows following an event loss Swap Swap party Counterparty Company Claims Payment SPV SPV Collateral Assets Sold to cover amount of claim Cover shortfall in Assets, if any Principal Outstanding on Bonds reduced by amount of claim Investors Collateral Trust Trust 12

13 Key Points - product Fixed cost during period price is not a function of the insurance market cycle Multi-Year 3-5 years: the norm Perfect security SPV is fully collateralised ($ capital for $ risk) Index or Parametric deals no indemnity process no need to prove insurable interest or losses 13

14 Key Points - economics Debt Capital Markets as opposed to Equity Expected Losses in range 0.5% to 5.0% as modelled by independent agent (e.g. AIR/EQE/RMS) requires robust, consistent data Cost is a function of Expected Loss AND a multiple varies according to data, modelling,complexity & other uncertainty plus transaction expenses typically 750k - 1,000k (modelling, lawyers, rating agencies) Advisor Fee Rating (S&P, Moody, Fitch) 14

15 Cat Bond Case Study 15

16 Case Study - Oriental Land Co., Ltd. Securitised Catastrophe-linked Cover Transaction Overview Cover Issuer Parametric index linked insurance based on the magnitude and location of earthquake Oriental Land Co., Ltd Term 5 years maturing May, 2004 Limit Purpose US$ 100 million To provide issuer with earthquake related risk transfer capacity not normally offered by insurance market Expected Loss 41.3 bps (Burning Cost %) Cost 310 bps (Premium % ROL) 16

17 Case Study - Oriental Land Co., Ltd. Middle Circle Inner Circle JMA Inner Middle Outer Magnitude Circle Circle Circle Tokyo Yokohama Chiba Boso Peninsula % % % % % % % 25.0% % 37.5% % 50.0% % 62.5% % 75.5% % 87.5% 25.0% % 100% 50.0% % 100% 75.0% 7.9 & higher 100% 100% 100% Izu Peninsula Outer Circle Proportion of US $ 100 million limit payable to Oriental Land based on grid dependent upon location and magnitude of Earthquake Depth of hypocentre of Earthquake must be less than or equal to 101 km. 17

18 Cat Bond Applications for the Oil Industry A parametric style Cat Bond could be used to provide protection against : hurricane (off-shore or on-shore) and/or earthquake Pay-out could cover physical damage or business interruption losses Help to ease pressure on requirement for catastrophe capacity for use elsewhere in program 18

19 Other Alternative Risk Transfer Concepts Contingent Capital Environmental Political Risk Weather Risk 19

20 What is Contingent Capital? Contingent Capital is finance provided on the occurrence of a specific trigger form of capital various: debt / equity Facilitates access to finance contingent upon the occurrence of pre-defined event(s) such events may (otherwise) prevent access to funding may represent an enhanced trading opportunity insurers can price the contingency Beneficial long-term corporate finance strategy negotiate terms before events strike from a position of strength not distress competitive advantage (speed and price) value in optionality 20

21 Contingent Capital Example ResidenSea is an example of a project which used just this Conceived in the mid-1990 s, ResidenSea was a project to build a ship containing permanent residents sailing around the world By the beginning of 1998 the project had become a real prospect, and the management set about to raise finance to build it Unable to raise capital through the equity and debt capital markets, the company decided to look elsewhere for finance The solution used a combination of debt and equity, but most importantly contingent equity An Insurer provided an option that would be triggered if there was a shortfall in capital required through insufficient sales The option was paid for with cash and shares in the company, raised as part of the initial equity financing If the contingent capital is not required, the option need not be exercised 21

22 Environmental Insurance Risk Application Environmental Protection Programme combines: risk transfer and risk financing elements To manage current and future environmental liabilities related to the long-term clean-up of a contaminated site. Unforeseen Clean-Up Costs contamination greater/worse than expected change in agreed statutory clean-up plan unknown conditions Known Clean-Up Costs 22

23 Environmental Insurance Structured Solution What can be achieved? PROJECTED COST OVERRUN RISKS Certainty through cost capping Effective Risk Financing Value of time recognition Year Profit sharing when cost contained Funding in possible tax efficient manner CLEAN UP MAINTENANCE TIME OVERRUN Facilitate the transaction Broken deadlock Walk-away approach Claim / Remediation expertise Cost Overrun Coverage One Policy Expected Costs Risk Transfer: Cost Overruns Funded Element, function of: Payout Pattern Cash component and/or Collaterals 23

24 Alternative Risk Markets Applications for Political and Country Risks 24

25 Political Risk and Capital Raising Concept Certain high credit quality borrowers suffer through the Sovereign Ceiling, caused by the sovereign risk being lower rated than the corporate credit risk BBB 10 year debt +2.50% B+ 10 year Sovereign +5.00% This ceiling can be removed through political risk insurance with the following advantages Significantly reduce all-in costs to the borrower Broader investor base Enable issuance of longer maturities 25

26 Weather Risks 26

27 Weather Risk application The weather represents a substantial source of uncertainty for a large number of energy companies Deviations from usual weather patterns may lead to problems over budgeting and the utilization of resources Weather variations impact either Revenues Production of goods Volume of sales Price of products Costs Increased volume of goods purchased Increased price of goods or services Additional charges due to bad weather conditions Weather hedged businesses may achieve lower (or more effective) cost of capital 27

28 Weather Other Aspects The variability of weather may have unexpected impacts on future business planning The Kyoto Protocol calls for absolute CO 2 caps at the level of production excess demand caused, say, by extreme cold or heat will result in surplus CO 2 emission financial penalty for non-compliance supplmentary to emissions trading strategies? Weather variability may impact the feasibility of renewable energy projects: hydro-electricity wind farms 28

29 Conclusion The risk management landscape is changing the diversity, complexity and severity of risk The insurance price cycle is at a peak more restrictive, credit concerns Time to consider the alternatives risk retention and financing captives contingent capital risk transfer capital markets / Cat Bonds 29

30 For further information, please contact: Julian M. Roberts Director Aon Capital Markets Ltd Tel: +44 (0) Fax: +44 (0) /1 8 Devonshire Square London EC2M 4PL tel: fax:

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