Insurance development and the capital market

By Festus Epetimehin, Chairman,
Mofes Insurance Brokers Ltd.

Festus Epetimehin

The recapitalization of the insurance industry has brought into the capital market forces of change, to both sectors which I think is good for the economy. No doubt, it is a welcomed change for the populace as they are more being sensitized in what investment in shares is all about and the role they have to play as stakeholders in some of these companies.

Competition has transformed the insurance industry, forcing insurance companies to invent a stream of new products and supply their services more cheaply. At the same time, their clients constantly raise the bar for services that will enable them manage their capital base in ever more efficient and sophisticated ways, while shareholders’ expectations are also rising.

These factors are shaping evolution of risk financing reflecting financial management needs, capital productivity, value creation and the minimization of risk- as a technical, guideline-driven process of buying and selling is becoming increasingly led by corporate finance.

Most of the capital market deals for insurance companies are still primarily financially driven. To strengthen their capital position, companies can raise equity or debt and more recently also hybrid capital. Hybrid capital is being raised in different sorts and formats with the quality of the hybrid capital covering the broad area between equity and bonds. Hybrids make up for a large part of the primary capital market transaction in insurance. The insurance sector is capable of raising substantial amounts of equity in the market. Moreover, the access to the debt markets has improved substantially for insurers over the last few years. The market has gained a better insight into the credit risk for insurers. Pricing of debt transactions has become a more standardized practice.

Overall, the credit spread of debt transactions in insurance is similar to the credit spread in banking.

Where in the past, insurers without a strong credit rating had to rely on reinsurance, they can today more easily issue debt in the market place as it is been done globally with a growing trend in companies bundling up insurance risk and transferring it to an increasingly willing capital market, giving rise to securitizations. The insurance risk transfer to the capital markets is still very much a market in development. Insurance securitizations are infact complementing the traditional reinsurance and will help in developing insurance and the capital market if adopted.

Role of Insurance
The term “underwriting” originated in one of the oldest current insurance markets in the world: Lloyd’s of London, which was originally a coffee shop. Commercial shipping companies that sought insurance for their vessels would place details of the ship and its cargo on a chalkboard. Interested individuals with the funds to insure risks examined the board and wrote their names under the ship’s details (hence underwriting), indicating that they had assessed the risk and were willing to take it. (Churchill et al. 2003). This risk pooling provided both an efficient means for protecting against certain types of risk, such as those at sea, and also a source of complexities in delivering and designing insurance products.

Insurance and Economic Activity
The existence of insurance markets facilitates economic activity. This follows directly from the idea that risk averse individuals are willing to pay at least a fair premium to ensure compensation should a specific event occur in the future. An insurer supplies a contract, which details future payments under specified circumstances. Such a contract is favourable to the insurer; so far the premium paid is at least as high as the expected payment to the policy holder (adjusted for the probability of occurring). Premiums charged to all policy holders are redistributed to those entitled to payments. For each policy for which the insurer may incur losses, the law of large numbers indicates that when the number of contracts increases and the policy is appropriately priced – so that the premium equals the expected loss of each individual contract – insurer gains non-negative profits in the long run and finds motivation to undertake the risk and promote economic growth and activity (Moss 2003).

Insurance markets take many forms, because the motivation for buying insurance differs between agents. Insurance policies can be divided into three classes: Life, business and property. For life insurance, the annuities component is a contract that details payments at specific dates, as long as the policy holder is still alive. Life insurance contracts can also entail a fixed payment to specific parties in case of the death of the policy holder. A business insurance policy is a method of sharing and reallocating risk between or within businesses. Business insurance arran-gements entail credit-risk transfer between banks and insurer; reinsurance; and direct insurance contracts between insurers and businesses. Property and casualty insurance consists of a wide range of insurance policies sold to individuals who wish to protect themselves against property and health related losses. The market for such contracts is large, and buyers of policies tend to have little bargaining power. It follows that the variety of policies available is often limited to a few standardized contracts.

Insurance and Capital Markets. The role of insurance is not only complementary to productive activities but also very significant for financial sector development. Insurers enter the market with equity capital and issue insurance policies, which are in form of debt capital. The funds raised by issuing both types of capital are invested, until needed to pay claims. In this context, an effective insurance sector is not only relevant for productive and economic activity and for facilitating the sharing of risk but also plays a crucial role in the investment of savings.

Insurance companies as institutional investors in corporations not only help improve capital allocation but also further enhance their investment through increased levels of monitoring. Capital markets can also be a driving force for and benefits from the development of institutional investors. Insurance companies have a composition of liabilities that are mostly long term, with liquidity needs, and constitute a natural complement for capital market development. Insurance companies have a large availability of cash (linked to the premium paid) that is partly invested in less liquid instruments such as government and corporate bonds, equities that are all typical instruments of a developed capital market. In the absence of capital market instruments, insurance companies would invest in government bills and bonds with little diversification and benefit to capital market development.

In the context of financial market development, insurance services play a crucial role in risk management, in allocating savings, and in capital market development. The development of sound, modern, and open insurance markets is an essential components of financial reform and capital market development in emerging market and transition countries.

Insurer Risks
Although the primary purpose of insurance is to be able to meet claims at all times. Insurers are exposed to a number of risks. Solvency risks are labeled technical and investment risks. Technical risks consist of two types of risk: underpricing and underprovision. Underpricing refers to the situation in which the insurer attracts buyers by setting excessively low premiums that do not cover the expected claims. Technical reserves represent the largest share of insurers ‘debt and they are measure of its obligations to policy holders. In case of underprovision, the technical reserve is inadequate to meet the obligations.

Investment risk is generated by the insurer’ role as a financial intermediary and reflects the fact that the insurer is exposed to a risk similar to those of banks with insolvency.

The risk of insolvency generates a market failure when the market price does not reflect the insolvency risk. In a world of perfect information, economic theory proposes that competition and rational behaviour ensure that the risk should be reflected in consumers’ willingness to pay and, therefore, induce efficient risk management among insurers. To correctly assess the insurer’s insolvency, however, the buyer should be equipped with efficient data on the joint distribution of loss claims, the return on the insurer’s asset portfolio, and the technical reserves that the insurer will hold at the time of the payment of benefits. Such information is, in practice, costly or unavailable for buyers. It is thus plausible to think that they cannot fully access the financial strength of their insurer and thereby the quantity of the insurance contract. In addition to technical and investment risks, the insurer is exposed to the risk of default by a partner (e.g. reinsurer), risk of mismanagement, and systemic risk.

The discussion above points to two important aspects of asymmetric information that create situations of market failure of moral hazards and adverse selection. “Moral hazard” refers to situations where one side of the market cannot observe the actions of the other. For this reason, it is sometimes called a “hidden action problem”. Adverse selection occurs when a negotiation between two people with different amounts of information – that is, asymmetric information- restricts the quality of the good traded.

This typically happens because the person with more information is able to negotiate a favourable exchange.

Capital markets and insurance risk transfer
Unlike in capital raising and structuring, where banking and insurance are steadily converging, banking and insurance still differ massively in the use of securitization. Securitisation in banking aims at transferring the risks linked to certain assets to the capital markets, whereas the risks to transfer in insurance are typically linked to liabilities.

Through the securitisation of insurance risk, an insurance company transfers underwriting risks to the capital markets by transforming underwriting cash flows into tradeable financial securities. The cash flows resulting from the securities issued are contingent upon an insurance event or risk. When an insurer underwrites a risk, he has to decide on the adequate pricing of accepting that risk. Risk acceptance has immediate consequences for the capital structure of insurance companies. Each insurer has to balance through his capital management the interests of his stakeholders (policyholders, shareholders, bondholders, regulators) and his risks with his solvency.

When the insurer accepts a risk, he can decide to keep on his books, or pass (part of) the risk on to his reinsurance providers.

More recently, insurance companies started using risk securitisation techniques for transferring insurance risk to the capital markets. In general, the capital markets have the potential to help the insurance market by providing additional capacity beyond what is available from the reinsurance market. The overall reinsurance capacity is set by the access of the reinsures to the capital markets. So far, CAT bonds are the most developed insurance risk transfer instrument, but outstanding amounts remain modest.

About half of the catastrophe bonds outstanding have trigger criteria based on objective parameters, such as wind speed or earthquake force. These triggers are often set at a “once in a century” probability level. The other half of the outstanding bonds are indemnity bonds: they pay out according to actual reported insurance losses.

In non-life, we notice that market is developing from only risk transfer relating to infrequent but extreme losses to also risk transfer to the impact of sudden changes in loss patterns on books with smaller and more frequent losses. Life securitization is expected to develop in the following areas: capital release through embedded value securitization, financing of new business activities, product-specific applications, mortality and longevity risk. Embedded value deals provide insurers with the opportunity to unlock the embedded profits in blocks of life insurance presently carried on balance sheet and to provide an alternative source of financing in an industry where traditional financing mechanisms are often restricted due to regulation. The essential objective is to sell the future profit stream without going through the sale of the life book. Unlike other alternative risk transfer devices, this securitization is not essentially a risk transfer device- it is predominantly a device to monetize the profits inherent in already-contracted life insurance policies. In the securitization deals that hit the market to date, the transfer of value still prevailed over the transfer of life risk.

Longevity risk- the paradoxical risk of living too long- is becoming a major challenge for insurers and pension funds. What is important is not the average life expectancy but rather the life expectancy past the age of retirement, when workers cease to be economically active. And it is among this population that life expectancy is rising fastest.

While annuity providers and pension schemes have risk management tools to protect them from adverse movement in markets and rates, there are no tools to shield from rising life expectancy. The fundamental problem for making longer plans for the future is that there is no certainty about the life expectancy going forward. Some scenario predict a life expectancy by 2050 of 90 years or more, whereas in other scenario with less optimism about the progress of medical science or because of new threats or social developments, the life expectancy would be at 80 years. Longevity also varies widely with socio-economic group and geography.

Swiss Re successfully issued a longevity bond in 2003 with a three-year maturity. This bond offered investors a relatively high floating coupon payment in return for accepting the risk of reduced principal payment in the event of catastrophe mortality deterioration such as that associated with the Spanish flu pandemic of 1918. This transaction was repeated by Swiss Re in 2005 (with a five-year maturity). Before longevity can be traded, it should be adequately measured.

Advantages of Insurance risk transfer to Capital market
Overall, the effective insurance risk transfer to the capital market is still very limited. We can say that securitization in insurance is in its experimental development phase, comparable to where the banking industry stood some years ago. The limited number of transactions makes it difficult to establish a broad investor base that is sufficiently familiar with the specificities of holding insurance risk. Despite the relatively small volume of insurance securitization transactions to date, securitization has significant potential to improve market efficiency and capital utilization in the insurance industry.

Securitization creates the possibility of separating the insurance policy origination function from the investment management, policy servicing and risk bearing functions, thereby enabling insurer to make a more efficient use of their capital resources. For longevity risk, an interesting case could be made for offsetting the opposite impact of mortality improvements on annuity providers and life insurance providers. If longevity risk is to be traded successfully in the capital markets, market participants with opposite interests are essential.

Securities based on these risks also are likely to have relatively low covariance with market systemic risk, making them valuable for diversification purposes. Investors can improve portfolio efficiency by adding these securities to their portfolios. But the market may continue to grow slowly as the more complicated transactions require substantial time, cost and energy. Traditional reinsurance will continue to play a very important role in the insurance industry. Reinsurers add value by providing underwriting expertise, pricing efficiencies and flexible risk-transfer solutions for insurance companies. By using securitization, reinsurers can concentrate on offering products with higher risk-adjusted returns in conjunction with well-understood and manageable risks and they can take advantage of innovations in the capital markets to broaden or improve their product offerings.

Conclusion
It is clear from the above that a lot still has to be done in order to be able to transfer insurance risks in a more significant way to the capital markets. Making the insurance securitization market more liquid will require more issues on the market, since broadening the investor base is crucial to move from essentially a private placement market today towards a public market place tomorrow. Effective pricing of insurance risk also require s the development of sound risk-based capital models.

It’s my believe that the main issues to overcome are the lack of transparency and consistency in modeling insurance risks. Enhanced standardization of rates and liquidity through the prompt payment of insurance premiums will be crucial for the success of insurance risk securitization.

The recapitalization of the insurance industry has brought into the capital market forces of change, to both sectors which I think is good for the economy. No doubt, it is a welcomed change for the populace as they are more being sensitized in what investment in shares is all about and the role they have to play as stakeholders in some of these companies.

Competition has transformed the insurance industry, forcing insurance companies to invent a stream of new products and supply their services more cheaply. At the same time, their clients constantly raise the bar for services that will enable them manage their capital base in ever more efficient and sophisticated ways, while shareholders’ expectations are also rising.

These factors are shaping evolution of risk financing reflecting financial management needs, capital productivity, value creation and the minimization of risk- as a technical, guideline-driven process of buying and selling is becoming increasingly led by corporate finance.

Most of the capital market deals for insurance companies are still primarily financially driven. To strengthen their capital position, companies can raise equity or debt and more recently also hybrid capital. Hybrid capital is being raised in different sorts and formats with the quality of the hybrid capital covering the broad area between equity and bonds. Hybrids make up for a large part of the primary capital market transaction in insurance. The insurance sector is capable of raising substantial amounts of equity in the market. Moreover, the access to the debt markets has improved substantially for insurers over the last few years. The market has gained a better insight into the credit risk for insurers. Pricing of debt transactions has become a more standardized practice.

Overall, the credit spread of debt transactions in insurance is similar to the credit spread in banking.

Where in the past, insurers without a strong credit rating had to rely on reinsurance, they can today more easily issue debt in the market place as it is been done globally with a growing trend in companies bundling up insurance risk and transferring it to an increasingly willing capital market, giving rise to securitizations. The insurance risk transfer to the capital markets is still very much a market in development. Insurance securitizations are infact complementing the traditional reinsurance and will help in developing insurance and the capital market if adopted.

Role of Insurance
The term “underwriting” originated in one of the oldest current insurance markets in the world: Lloyd’s of London, which was originally a coffee shop. Commercial shipping companies that sought insurance for their vessels would place details of the ship and its cargo on a chalkboard. Interested individuals with the funds to insure risks examined the board and wrote their names under the ship’s details (hence underwriting), indicating that they had assessed the risk and were willing to take it. (Churchill et al. 2003). This risk pooling provided both an efficient means for protecting against certain types of risk, such as those at sea, and also a source of complexities in delivering and designing insurance products.

Insurance and Economic Activity. The existence of insurance markets facilitates economic activity. This follows directly from the idea that risk averse individuals are willing to pay at least a fair premium to ensure compensation should a specific event occur in the future. An insurer supplies a contract, which details future payments under specified circumstances. Such a contract is favourable to the insurer; so far the premium paid is at least as high as the expected payment to the policy holder (adjusted for the probability of occurring). Premiums charged to all policy holders are redistributed to those entitled to payments. For each policy for which the insurer may incur losses, the law of large numbers indicates that when the number of contracts increases and the policy is appropriately priced – so that the premium equals the expected loss of each individual contract – insurer gains non-negative profits in the long run and finds motivation to undertake the risk and promote economic growth and activity (Moss 2003).

Insurance markets take many forms, because the motivation for buying insurance differs between agents. Insurance policies can be divided into three classes: Life, business and property. For life insurance, the annuities component is a contract that details payments at specific dates, as long as the policy holder is still alive. Life insurance contracts can also entail a fixed payment to specific parties in case of the death of the policy holder. A business insurance policy is a method of sharing and reallocating risk between or within businesses. Business insurance arran-gements entail credit-risk transfer between banks and insurer; reinsurance; and direct insurance contracts between insurers and businesses. Property and casualty insurance consists of a wide range of insurance policies sold to individuals who wish to protect themselves against property and health related losses. The market for such contracts is large, and buyers of policies tend to have little bargaining power. It follows that the variety of policies available is often limited to a few standardized contracts.

Insurance and Capital Markets
The role of insurance is not only complementary to productive activities but also very significant for financial sector development. Insurers enter the market with equity capital and issue insurance policies, which are in form of debt capital. The funds raised by issuing both types of capital are invested, until needed to pay claims. In this context, an effective insurance sector is not only relevant for productive and economic activity and for facilitating the sharing of risk but also plays a crucial role in the investment of savings.

Insurance companies as institutional investors in corporations not only help improve capital allocation but also further enhance their investment through increased levels of monitoring. Capital markets can also be a driving force for and benefits from the development of institutional investors. Insurance companies have a composition of liabilities that are mostly long term, with liquidity needs, and constitute a natural complement for capital market development. Insurance companies have a large availability of cash (linked to the premium paid) that is partly invested in less liquid instruments such as government and corporate bonds, equities that are all typical instruments of a developed capital market. In the absence of capital market instruments, insurance companies would invest in government bills and bonds with little diversification and benefit to capital market development.

In the context of financial market development, insurance services play a crucial role in risk management, in allocating savings, and in capital market development. The development of sound, modern, and open insurance markets is an essential components of financial reform and capital market development in emerging market and transition countries.

Insurer Risks
Although the primary purpose of insurance is to be able to meet claims at all times. Insurers are exposed to a number of risks. Solvency risks are labeled technical and investment risks. Technical risks consist of two types of risk: underpricing and underprovision. Underpricing refers to the situation in which the insurer attracts buyers by setting excessively low premiums that do not cover the expected claims. Technical reserves represent the largest share of insurers ‘debt and they are measure of its obligations to policy holders. In case of underprovision, the technical reserve is inadequate to meet the obligations.

Investment risk is generated by the insurer’ role as a financial intermediary and reflects the fact that the insurer is exposed to a risk similar to those of banks with insolvency.

The risk of insolvency generates a market failure when the market price does not reflect the insolvency risk. In a world of perfect information, economic theory proposes that competition and rational behaviour ensure that the risk should be reflected in consumers’ willingness to pay and, therefore, induce efficient risk management among insurers. To correctly assess the insurer’s insolvency, however, the buyer should be equipped with efficient data on the joint distribution of loss claims, the return on the insurer’s asset portfolio, and the technical reserves that the insurer will hold at the time of the payment of benefits. Such information is, in practice, costly or unavailable for buyers. It is thus plausible to think that they cannot fully access the financial strength of their insurer and thereby the quantity of the insurance contract. In addition to technical and investment risks, the insurer is exposed to the risk of default by a partner (e.g. reinsurer), risk of mismanagement, and systemic risk.

The discussion above points to two important aspects of asymmetric information that create situations of market failure of moral hazards and adverse selection. “Moral hazard” refers to situations where one side of the market cannot observe the actions of the other. For this reason, it is sometimes called a “hidden action problem”. Adverse selection occurs when a negotiation between two people with different amounts of information – that is, asymmetric information- restricts the quality of the good traded.

This typically happens because the person with more information is able to negotiate a favourable exchange.

Capital markets and insurance risk transfer
Unlike in capital raising and structuring, where banking and insurance are steadily converging, banking and insurance still differ massively in the use of securitization. Securitisation in banking aims at transferring the risks linked to certain assets to the capital markets, whereas the risks to transfer in insurance are typically linked to liabilities.

Through the securitisation of insurance risk, an insurance company transfers underwriting risks to the capital markets by transforming underwriting cash flows into tradeable financial securities. The cash flows resulting from the securities issued are contingent upon an insurance event or risk. When an insurer underwrites a risk, he has to decide on the adequate pricing of accepting that risk. Risk acceptance has immediate consequences for the capital structure of insurance companies. Each insurer has to balance through his capital management the interests of his stakeholders (policyholders, shareholders, bondholders, regulators) and his risks with his solvency.

When the insurer accepts a risk, he can decide to keep on his books, or pass (part of) the risk on to his reinsurance providers.

More recently, insurance companies started using risk securitisation techniques for transferring insurance risk to the capital markets. In general, the capital markets have the potential to help the insurance market by providing additional capacity beyond what is available from the reinsurance market. The overall reinsurance capacity is set by the access of the reinsures to the capital markets. So far, CAT bonds are the most developed insurance risk transfer instrument, but outstanding amounts remain modest.

About half of the catastrophe bonds outstanding have trigger criteria based on objective parameters, such as wind speed or earthquake force. These triggers are often set at a “once in a century” probability level. The other half of the outstanding bonds are indemnity bonds: they pay out according to actual reported insurance losses.

In non-life, we notice that market is developing from only risk transfer relating to infrequent but extreme losses to also risk transfer to the impact of sudden changes in loss patterns on books with smaller and more frequent losses. Life securitization is expected to develop in the following areas: capital release through embedded value securitization, financing of new business activities, product-specific applications, mortality and longevity risk. Embedded value deals provide insurers with the opportunity to unlock the embedded profits in blocks of life insurance presently carried on balance sheet and to provide an alternative source of financing in an industry where traditional financing mechanisms are often restricted due to regulation. The essential objective is to sell the future profit stream without going through the sale of the life book. Unlike other alternative risk transfer devices, this securitization is not essentially a risk transfer device- it is predominantly a device to monetize the profits inherent in already-contracted life insurance policies. In the securitization deals that hit the market to date, the transfer of value still prevailed over the transfer of life risk.

Longevity risk- the paradoxical risk of living too long- is becoming a major challenge for insurers and pension funds. What is important is not the average life expectancy but rather the life expectancy past the age of retirement, when workers cease to be economically active. And it is among this population that life expectancy is rising fastest.

While annuity providers and pension schemes have risk management tools to protect them from adverse movement in markets and rates, there are no tools to shield from rising life expectancy. The fundamental problem for making longer plans for the future is that there is no certainty about the life expectancy going forward. Some scenario predict a life expectancy by 2050 of 90 years or more, whereas in other scenario with less optimism about the progress of medical science or because of new threats or social developments, the life expectancy would be at 80 years. Longevity also varies widely with socio-economic group and geography.

Swiss Re successfully issued a longevity bond in 2003 with a three-year maturity. This bond offered investors a relatively high floating coupon payment in return for accepting the risk of reduced principal payment in the event of catastrophe mortality deterioration such as that associated with the Spanish flu pandemic of 1918. This transaction was repeated by Swiss Re in 2005 (with a five-year maturity). Before longevity can be traded, it should be adequately measured.

Advantages of Insurance risk transfer to Capital market
Overall, the effective insurance risk transfer to the capital market is still very limited. We can say that securitization in insurance is in its experimental development phase, comparable to where the banking industry stood some years ago. The limited number of transactions makes it difficult to establish a broad investor base that is sufficiently familiar with the specificities of holding insurance risk. Despite the relatively small volume of insurance securitization transactions to date, securitization has significant potential to improve market efficiency and capital utilization in the insurance industry.

Securitization creates the possibility of separating the insurance policy origination function from the investment management, policy servicing and risk bearing functions, thereby enabling insurer to make a more efficient use of their capital resources. For longevity risk, an interesting case could be made for offsetting the opposite impact of mortality improvements on annuity providers and life insurance providers. If longevity risk is to be traded successfully in the capital markets, market participants with opposite interests are essential.

Securities based on these risks also are likely to have relatively low covariance with market systemic risk, making them valuable for diversification purposes. Investors can improve portfolio efficiency by adding these securities to their portfolios. But the market may continue to grow slowly as the more complicated transactions require substantial time, cost and energy. Traditional reinsurance will continue to play a very important role in the insurance industry. Reinsurers add value by providing underwriting expertise, pricing efficiencies and flexible risk-transfer solutions for insurance companies. By using securitization, reinsurers can concentrate on offering products with higher risk-adjusted returns in conjunction with well-understood and manageable risks and they can take advantage of innovations in the capital markets to broaden or improve their product offerings.
Conclusion

It is clear from the above that a lot still has to be done in order to be able to transfer insurance risks in a more significant way to the capital markets. Making the insurance securitization market more liquid will require more issues on the market, since broadening the investor base is crucial to move from essentially a private placement market today towards a public market place tomorrow. Effective pricing of insurance risk also require s the development of sound risk-based capital models.

It’s my believe that the main issues to overcome are the lack of transparency and consistency in modeling insurance risks. Enhanced standardization of rates and liquidity through the prompt payment of insurance premiums will be crucial for the success of insurance risk securitization.