Risk transfer mechanisms - converging insurance, credit and financial markets

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Dorthy Townsend
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1 Risk trasfer mechaisms - covergig isurace, credit ad fiacial markets Presetatio at OECD/CIRC Techical Expert meetig o Reisurace, Jue Jes Verer Aderse, OECD 1

2 Outlie Itroductio Growth of risk trasfer markets Factors uderpiig growth Implicatios for fiacial stability Cocludig remarks 2

3 Itroductio Risk trasfer mechaisms comprise a wide group of fiacial istrumets: Credit liked securities (credit derivatives) trasfer risks embedded i credit ledig, i.e. borrowers are ot repayig debt. Isurace liked securities such as some ART products ad Cat bods are desiged to shed risks from uderlyig isurace risks. Chage fiacial sector ladscape: Bridgig bak ad isurace activities with capital markets 3

4 Itroductio (co d) - Structure of deals Protectio buyer Ower" of risk (e.g. bak) Paymet o evet Periodic paymet Special purpose vehicle Itermediate protectio seller Paymet upfrot Protectio seller Buyer of risk (e.g. isurer) Retur: Libor + spread Fuds ivested Risk-free cash flow Collateral accout Highly rated securities 4

5 Growth of risk trasfer markets - credit-liked securities USD billios 1800 Outstadig otioal amouts Before Note: Figures for 2001 ad 2002 are based o expectatios Source: British Bakers Associatio 5

6 Growth of risk trasfer markets (co d) - credit-liked securities Per cet of otioal value 70 Market participats ad market shares 60 Protectio buyers Protectio sellers Commercial baks Securities firms Isurace compaies corporates Hedge fuds Mutual fuds Pesios fuds Gov t/credit agecies Source: British Bakers Associatio 6

7 Growth of risk trasfer markets (co d) - credit-liked securities USD billios Net sale of credit protectio (estimate) Commercial baks Securities firms Isurace compaies Corporates Hedge fuds Mutual fuds Pesios fuds Gov t/credit agecies Source: British Bakers Associatio ad ow calculatios 7

8 Growth of risk trasfer markets (co d) - isurace-liked securities USD millios 1600 Catastrophic issuace Q1 Source: Swiss Re 8

9 Growth of risk trasfer markets (co d) - isurace-liked securities Cat bods: Market participats Baks 8% Isurers 21% Hedge fuds 22% Reisurers 21% Mutual fuds ad Ivestmet advisors 28% Source: Bak leu; Goldma Sachs 9

10 Factors uderpiig growth -credit-liked securities Protectio buyers Dispersio of risks: Improved risk maagemet opportuities Relatioship bakig: Retai commercial cliets without havig egative cocetratio impacts. Capital optimisatio: Icreased focus o capital charges as a itegral part of credit ledig. Protectio sellers Ehacig yields: Declie i iterest rates across the board i combiatio with lower supply of sovereigs have icreased ed-ivestors demad for ew istrumets. Retur o Capital: Deploy capital more efficietly - obtai higher risk adjusted returs. 10

11 Factors uderpiig growth (co d) - isurace-liked securities Protectio buyers: Capacity/Premiums: Alterative to traditioal reisurace whe isurace cycle hardes. Diversificatio effects: Sheddig risks to fiacial markets i areas where exposures are over-cocetrated. Couterparty risks: Solutio via special purpose vehicles offers lower couterparty risk. Costs: High trasactio costs have restricted diffusio of trasactios. 11

12 Factors uderpiig growth (co d) - isurace-liked securities Protectio sellers Favourable market returs: Provide risk premiums compared with corporate bods havig almost idetical ratigs. Compesated for illiquidity, possible model iaccuracies ad ewess premiums. Diversificatio effects: Risk profile that is less correlated with the credit cycle or traditioal isurace products. Cocetratio:Ivestor reluctace to build up exposures outside kow areas: ivestors have reached limits for ivestmets to specific regios. 12

13 Implicatios for fiacial stability - cocer amog supervisors Arbitrage (Regulatory, Capital, Accoutig, Tax) Capital arbitrage oe of the factors that catalysts iterest for risk trasfer markets. Evidece idicate that this factor is dimiishig. However other types of arbitrage may uderpi iterest? Learig curve risks Complex busiess o the borderlie betwee bakig ad isurace: Do market participats uderstad risks? Pricig of risks Adequate pricig ad proper valuatio are demadig but importat whe risks crystallise. 13

14 Implicatios for fiacial stability (co d) - creatig value i isurace compaies Separatig value creatio ito two etities: Isurig risks: Issuig isurace cotracts that more tha cover the associated productio costs, icludig capital cost. Ivestig cash from premiums util claims are paid: Achievig a ivestmet result that beats the bechmark o a risk-adjusted basis. Creative isurers focus o shareholder value by: Aggressive approach to maagig capital more efficietly: costrai capital to busiess geeratig sufficiet profit. Risk trasfer techiques: Credit ehacemet is iovative use of surplus capital. 14

15 Cocludig remarks YES There are beefits Risk trasfer markets offer opportuities for improved risk maagemet. Facilitate more maageable credit- ad isurace cycles as deploymet of capital is improved. BUT care is eeded i maagemet of ew risks Capital market iovatio is a challege for users ad authorities. Capital market itegrity issues related to accoutig, capital ad regulatio. 15

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