Insurance securitisation: advantages and perspectives

Insurance securitization [4] is a financial technique which consists in transferring insurance risks to investors operating on the international financial markets. This transfer is carried out by gathering these risks and turning them into notes on the capital markets.

The general concept of insurance securitization, therefore, includes two elements:

• the transformation of liquidity generated by the underwriting into notes on the financial market.
• the transfer of the risks underwritten toward financial markets through notes trade.

The first element is about financial engineering, common process in the banking world.

The second aspect consists in diverting the investment of the risks underwritten by the insurer towards the major international financial stock markets where millions of stakeholders operate on a daily basis instead of the traditional and narrow reinsurance market, where few actors operate.

This is made possible thanks to the purchase and sale of financial products whose cash flows are related to the insurance cover to which they are bound: The occurrence or non-occurrence of the insured element shall impact the results of the underlying securities.

Most common structure of insurance securitization

An ad-hoc entity called Special Purpose Vehicle is set up by the ceding company. The establishment of such a structure is designed to protect the investors against the bankruptcy of the reinsured.

A financial contract is concluded between the Special Purpose Vehicle and the issuer (the ceding company). After the payment of a premium¹, the ceding company is protected against the realisation of a predefined event².

The Special Purpose Vehicle covers the financial contract concluded with the issuer through the issuance of securities on the financial markets³. The investors are therefore provided with the possibility of purchasing these securities⁴.

Thanks to the liquidity thus obtained, the Special Purpose Vehicle invests on the financial markets⁵ and receives the earnings of its investment⁶.

In the final stage, a swap counterparty move shall allow thanks to derivatives (swaps) to trade the investment earnings⁷ for the payment of interests⁸ whose rate is set according to Libor to which the risk premium is added.

In case a trigger event occurs (there are several types of triggers: claims, parametric index, industry-based index, …), the Special Purpose Vehicle compensates the ceding company whereas the investors sustain losses on their investments in the securities.
In the absence of claims, investors receive interests on the principal as well as payments for coupon.

The advantages of insurance securitization

Securitization has numerous benefits in both life and non-life insurance.

Securitization in the life insurance

In the life business, securitization stands as capital management tool. Indeed, by transferring part of their risks to investors, life insurers improve their return on equity.

Securitization consolidates capital efficiency as it lowers the need in equity. Bonds are one of the tools of securitization which allow to monetize intangible assets such as deferred acquisition costs and the present value of expected profits. Monetizing these assets represents a new source of funding for the insurer. The increase of the cash flow which results may:

• either reinforce the capacity of underwriting new policies
• comply at minimal level in terms of capital
• or, fund any operation for the company

Furthermore, securitization enables insurers to transfer catastrophe risks (extreme mortality due to a pandemic for instance) towards financial markets, which is notably the case of life bonds. 

Eventually, securitizations yield tax advantages to the insurer.

Securitization in the non life insurance

In non-life insurance and due to the market's volatility, insurers have a wide range of tools allowing them not only to manage their capital but also to carry out risk transfer.

Among these tools, we may mention: natural catastrophe bonds, natural catastrophe swaps, industry based-loss warrantees, contingent capital, the side cars or the exchange-traded options.

The mechanisms designed for risk transfers toward financial markets

• Natural catastrophe bonds (CAT). Designed for peak risks by transferring the exposure to the financial markets. They indemnify the issuer of due losses in the event of a pre-defined claim happening (see first figure).
• Natural catastrophe swaps (CAT). Thanks to this tool, floating payments attached to the occurrence of a claim shall be swapped against the fixed payment whose amounts and deadline have been predefined.
• Industry based-loss warrantees.  Like a classical reinsurance contract, this tool is yet characterized by its triggering aspect linked to an industry claim level.

Tools specific to the management of shareholders' equity

• Contingent capital. It enables the trade securities at a predefined price and for a given period of time. It, therefore, puts an additional capital at the disposal of the purchaser, should the insured element occur.
• The side cars. This mechanism offers additional capacity for a limited period of time. It makes it possible to face a temporary deficit in capacity. Spare capacity is given back in soft periods. It may also be used as a mean to benefit from high leverage in capital management.
• Exchange-traded options. They are no longer used nowadays. These standard type of contracts clear liquidity payments when a CAT claim index goes beyond a threshold called the option's striking price.

Perspectives of insurance securitization

For the time being, most of securitization moves are wrapped around the “natural catastrophes” covers (the CAT bonds) in USA and Japan. Nonetheless, all risks may, in theory, be securitized (except operational risks).

Securitization perspectives and potential are quite promising. In addition to major American and Japanese markets, Europe is slowly getting acquainted to it, especially with the appearance of Solvency II.
Today, in life insurance, the overall market of embedded value securitization is below 10 billion USD for a potential estimated at 500 billion USD.

Non-life bonds pertaining to natural catastrophes are poised to witness a great boost. According to an important number of analysts, these bonds shall jump from 8 billion USD in the end of 2006 (6% generated by traditional insurance) to 230 billion USD in less than ten years (19% generated by traditional insurance). In the near future, securitization in non-life business could well extend to the motor sector. The huge volumes produced in this line of business are utmostly attractive.

Bank Al-Maghrib, Rabat © Davide Cesare Veniani [5] , CC BY-SA 3.0 [6]

Some emerging countries, with top financial engineering, have already adopted this technique and are using it today quite easily. Others like Morocco and Tunisia are shyly trying it. In both countries, the strict regulatory framework is currently restricting the use of those techniques. Only two operations in Morocco and three in Tunisia have been reported in the recent ten years.

Today, these complex techniques are accessible only to large insurance groups. They are going to be gradually disseminated with new rules to be imposed on the markets. They are also likely to contribute to the smoothing of insurance markets cycles. They do not intend to replace traditional reinsurance, but will supplement the latter by providing alternative [7] solutions in terms of covering low-frequency extreme risks and even those high-frequency small risks.