About Insurance Planet

INSURANCE PLANET SCOPE AND STRUCTURE

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Insurance Planet has the simple objective of describing insurance- linked securities
and insurance risk transfer from a practitioner’s perspective – a viewpoint
that is particularly important in a market that is new and still evolving. The
blog is designed to be a resource to those active in the marketplace, while
also aiding basic understanding of the topics for those new to the field.

The scope was chosen to be very broad and to include all types of
insurance- linked securities. While some hold the view that certain types of
the securities described here do not belong in this category, choosing the
broadest possible definition can only help in understanding the investment
potential of ILS.

Part I, “Introduction to Investing in Insurance Risk”, provides an outline of the ways to obtain insurance exposure in investment portfolios. Insurance risk in general is discussed, after
which “pure” insurance risk is defined and described. A brief overview of
direct investment in insurance risk then follows, outlining the main types of
insurance- linked securities. Motivation of both transferors and transferees
of securitised insurance risk is also examined.

The next part, “Investing in and Modelling Securities Linked to Property
and Casualty Risk”, looks at the main types of securities used for transferring
property and casualty insurance risk to the capital markets. It starts
with an overview of cat bonds, which are the most widely known type of
insurance- linked securities.

Part II also describes derivative and derivative type
products linked to catastrophic events. An introduction to modelling
catastrophe risk embedded in these securities is provided to help the
investor to better understand their risk profile. Other types of insurance linked
securities, such as reinsurance sidecars and industry loss warranties,
Investing in Insurance Risk, might sound strange to an investor unfamiliar with securities linked to insurance.

Any investment involves risk, so investors are not averse to accepting it; but risk is not what we generally want to invest in. We want to invest in securities that will likely
generate healthy returns. When investing in a security, we pay for its probabilistically
distributed future return.

The uncertainty associated with the investment return, including the chance of the return being negative, is the risk we assume. In fact, many investors actively seek risky assets to invest
in, as long as they believe they will be properly compensated for assuming
those risks.

While risk is an integral part of investing, we generally do not think in
terms of “investing in risk.” For securities whose performance is directly
linked to insurance risk, however, the focus on the risk is so great and its
nature so unusual, that it does makes sense to speak in terms of investing in
insurance risk. The insurance industry is concerned with measuring and
managing risk, and so are the investors in securities with embedded insurance
risk.

INSURANCE- LINKED SECURITIES

Any investment in traditional securities – such as common stock or bonds –
of an insurance or reinsurance company may be seen as an investment in
insurance risk, if we define insurance risk as simply any risk to which insurance
companies are exposed.

In addition, insurance securitisation has created
a new asset class – referred to as insurance- linked securities (ILS) – that
affords investors exposure to a more “pure” form of insurance risk. Examples
include the risks of catastrophic insured losses, from hurricanes and earthquakes
to those resulting from spikes in mortality rates due to pandemic events.

This type of risk does not have to be associated with a catastrophic
event, though; potential improvements in human longevity, for example,
could have a severe financial impact on insurance companies selling annuity
products. Longevity improvements are not a catastrophic event per se, but the
financial consequences can be catastrophic. Such risks, although labelled insurance risks, do not have to originate in the insurance industry.

Pension plans are even more exposed to longevity risk than insurance companies.
Furthermore, insurance risk transferred to the capital markets does not have
to involve any catastrophic component at all; as is the case when an insurance
company transfers some of its pure insurance risk to investors simply to use
its capitalmore efficiently or to reduce earnings volatility. Insurance risk lacks a clear, unambiguous definition, and so do insurancelinked securities.

The best known types of insurance- linked securities – catastrophe bonds and life insurance settlements – are clearly in the ILS category, but some others, such as weather derivatives or collateralised reinsurance, can reasonably be seen as not belonging to this asset class.

Insurance- linked securities include a number of risks that can be highly
correlated to traditional financial assets. At the same time, however, the “pure” insurance risk typically has low correlation with the rest of the capital markets. This low correlation is one of the primary reasons investors have been watching this asset class with interest. The overall degree of correlation of insurance- linked securities with the markets can vary; for example, the correlation of properly structured catastrophe bonds is much lower than that of embedded value securities.

INSURANCE INDUSTRY

Even though not all “insurance risk” originates with insurance companies,
the vast majority of it does. Some of the very first types of insurance- linked
securities were catastrophe bonds and catastrophe insurance derivatives.
Their purpose, as is the purpose of most insurance- linked securities, is very
simple: to transfer to the capital markets the risks that are too big for the
balance sheets of insurance companies, or the risks that can be retained but
whose transfer allows insurance companies to use their capital in the most ILS such as reinsurance sidecars, value- in- force securities or securities designed to transfer excess reserves to the capital markets serve the same general purpose, with an emphasis more on capital management
than on true risk transfer.

Insurance- linked securities serve as a link between the insurance industry
and the capital markets. They provide insurance companies with new
options in managing their risk and using their capital efficiently. Such direct
transfer of insurance risk to the capital markets might not always be the best
solution for insurance companies; however, it gives insurance companies
another important tool that can be used in both risk management and capital
management.
efficient way.

At the same time, most of the insurance industry has been unhappy with
the development of such types of insurance- linked securities as life settlements
and has seen this as “cannibalisation” of life insurance. Despite the
initial negative reaction, it is likely that the industry will adjust to this development
and might ultimately see it as a positive, since the transferability
adds value to the life insurance product and can thus lead to growth in its
sales. All insurance- linked securities make the markets more efficient, which
is a positive for all parties.

INVESTORS

Investors never stop their search for yield. The search has intensified with
the need to make up for the losses incurred during the 2008–2009 financial
crisis and the realisation that traditional investment approaches are not
going to accomplish this goal.

The urgency of the search for sources of extra
return is compounded by the growing emphasis on capital preservation and
reduction in investment risk. These contradictory goals – maximising return
and minimising risks – have always characterised the reality of investing.
This duality has not changed, but the urgency of the first and the emphasis
on the second have increased.

As unrealistic as it is, the desire to achieve high investment returns while
taking low investment risks is as great as it has ever been. The Madoff affair
demonstrated how very sophisticated investors might be willing to believe
in the possibility of high returns delivered consistently, year after year, with
very little volatility. People believe what they want to believe.

The financial crisis of 2008–2009, however, brought fear to the markets, and the focus
shifted from high returns to simple capital preservation. That fear remains,
but we are now back to a situation where investors want high returns. The
potential of high investment returns does exist, but in this quest there is a
price to be paid in the form of greater risk. The choice of the right tradeoff
between risk and return is as difficult as it has ever been.

In this environment, assets that have low correlation with the rest of the
financial markets should be particularly attractive to an investor. Insurance linked
securities can serve the objective of capital preservation and
contribute to portfolio diversification.

While the common characterisation of insurance- linked securities as zero- beta assets is incorrect, many of them do have only weak correlation with the capital markets. The financial crisis
demonstrated that for most types of ILS the relatively low degree of correlation
with traditional financial assets stays low even under extreme
circumstances, in the “tail” of the probability distribution where standard
correlation assumptions tend to break down.

Insurance- linked securities, in particular those with a low degree of correlation
with the financial markets, can be seen as a source of exotic beta. The
exotic beta – the return associated with exposure to insurance as a risk factor
only weakly correlated with the traditional markets – is really another form
of alpha in the investment return.

The ability to generate abnormal returns through this factor exposure should remain as long as the market inefficiencies exist. In insurance- linked securities, these inefficiencies are particularly
great and likely to persist, in part due to the low level of investor expertise
in the analysis of insurance risk. This situation makes insurance- linked securities
all the more attractive to investors who currently do have the required
expertise, as they can expect to generate sizable excess returns.
 are examined. A brief overview of weather derivatives is provided. Credit
risk and other issues relevant to the analysis of property and casualty
insurance- linked securities are also analysed.

Part III, “Securities Linked to Value- in- Force Monetisation and Funding
Regulatory Reserves”, deals with insurance securitisations where the
primary purpose is other than the transfer of insurance risk. Some such
securitisations monetise the expected future cashflows from a book of insurance
business, while others have to do with regulatory or accounting
arbitrage. Not all of them fall under the strict definition of securitisation; in
many cases, monetisation is the proper characterisation.

The following part, “Investing in and Modelling Securities Linked to
Mortality and Longevity Risk”, describes securities that transfer to the
capital markets the risk of mortality and longevity being different from
expectations. Extreme mortality bonds, for example, are tied to the risk of a
sharp spike in mortality.

Derivatives linked to mortality risk are introduced, with a focus on catastrophe risk. These securities have a strong resemblance to the catastrophe bonds and catastrophe insurance derivatives described in Part II.

Life settlements are discussed next, and it is explained how a life
insurance policy can be viewed as a tradable asset. Some of the legal and
accounting considerations involving life settlements are also introduced as
they are particularly important for investors in life insurance policies. Key
concepts in the modelling of mortality and longevity are outlined, with a
focus on the issues relevant to analysing insurance- linked securities. Issues
that have to do with longevity improvements and stochastic modelling of
longevity are also described.

Valuation of mortality- linked securities is discussed, with a focus on life settlements. Finally, longevity- linked securities are examined, with consideration of the role they can play in hedging
the longevity risk of pension liabilities, life annuities, and portfolios of
insurance- linked securities.

While the primary emphasis is on longevity derivatives, other longevity- linked securities are discussed as well. Part V, “Managing Portfolios of Insurance Risk”, deals with portfolio
issues in the investment management of insurance risk. This final section
reviews key aspects that have been touched upon in the preceding parts of
the book, and describes a number of tools for managing securitised insurance
risk on a portfolio basis.

The first part of the section deals with catastrophe insurance risk. This is followed by a broader analysis of managing portfolios of insurance- linked securities of multiple types.
Investment portfolio optimization is discussed in the context of managing
securitised insurance risk.

Part V, summarizes the main ideas introduced
in the blog, and focuses on current trends in the insurance- linked securities
market. It makes general observations about the market and discusses the
expectations of how it will develop.
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