in which performance was determined by a designated portfolio of risks; risks that were modeled. It was not a single-event instrument, but a portfolio.”
Hannover worked with the exotic derivatives group at Citibank and created a reinsurance agreement with a Caymandomiciled special purpose reinsurer that issued $ 100 million in principal-at-risk notes to investors. The whole process was long and complex, taking from July 1993 to January 1994.
“ Reinsurance is known to be driven by custom and practice,” Lohmann said.“ There is a standard reinsurance agreement that runs 12 pages. By the time we were done, the new reinsurance agreement itself ran to 72 pages. All of the supporting agreements— payment agent, escrow agreement, calculation agent and so forth— filled two binders. Everything had to be defined.”
It was also very expensive.“ I think we ran up 500,000 pounds sterling in legal fees,” Lohmann said.“ But we knew we were breaking new ground. We knew we were setting a new standard.”
It took a couple of years for the performance of that first structure to be seen in action, and also for others to review the terms and conditions. Lohmann noted that the next structure, George Town Re created at the end of 1997,“ mirrored our arrangement,” and was tradable under securities Rule 144A. According to industry resource Artemis, George Town was done by St. Paul Re as cedent / sponsor and Goldman Sachs as placement / structuring agent.
“ Cat bonds are a very precise sub-form of alternative financing in the reinsurance market through risk transfer,” said Axel Wichmann, senior underwriter with Hanover Re.
Wichmann said there are broadly two structures in the reinsurance market, proportional and non-proportional. Proportional is where an underwriter takes on business, and then farms out some of that on a 1:1 basis. The other firm might get 20 % of the revenue and be on the hook for 20 % of any claims. This structure, sometimes known as a sidecar, is used to expand capacity.
A non-proportional structure is protection for both insureds and underwriters
Axel Wichmann, senior underwriter with Hanover Re.
against large losses. It covers losses above the limits of what an insurer can normally accommodate. These options include cat bonds.
“ The first form of transferring risks on a proportional basis was developed in the mid-1980s,” Wichmann said. Hanover Re was a pace setter among reinsurance firms that had been ambitious in developing new business.“ The reinsurance companies had access to business that smaller companies did not, and they wanted to. Eberhard Mueller [ who was head of the mathematics and statistics department ] said we could just write more business and send out some at the back end. The partners would come on proportionately and pay just a bit for the work we do to originate business.”
Hannover was“ assessing many types of risk at the time,” Wichmann said.“ There was great innovation and evolution. We were diversifying and adding capacity. There was an evolution of the big players.”
“ Proportional systems allow companies to accept business that they would not be able to accept otherwise for capacity constraints or other restrictions,” Wichmann said.“ It is more a capacity tool than a protection. It also helps diversify risk and helps other players get access to business that they could not get otherwise.”
Cat bonds and other forms of alternative financing / risk transfer are the equivalent of non-proportional coverage arising in capital markets, not the insurance market. As is often the case, it took a couple of big losses for the insurance community to realize that new approaches were necessary for massive claims.
“ If every loss were just as expected, we might not need cat bonds and alternative capital,” Wichmann said.“ Then there was Hurricane Andrew in 1992 and Katrina in 2005. Those were different than the models told us. We learned the possibility that losses could be much bigger than we had thought. In insurance, the next event sometimes shows you what you didn’ t think of.”
According to Wichmann, those lowoccurrence, high-risk exposure events don’ t fit well into the traditional reinsurance model where insured values accumulate to undesired levels, but are ideal for capital markets and institutional investors. The losses are big, but infrequent. And, importantly, they are triggered and paid relatively quickly— within two or three years.
“ Those are just the opposite of many traditional risks in the reinsurance market, like liability risks for example,” he said.“ Reinsurers don’ t mind if the claim is open for 30 years.”
With cat bonds and alternative capital, investors set quick and simple rules, usually with a parametric trigger and fixed or graduated payments. That means actual losses do not have to be proven in many cases. Rather, the payment is triggered by external conditions, such as amount of rain, barometric pressure or storm surge as measured over a given time at specific places.
One recent example is Hurricane Hugo that hit Mexico. The parametric triggers indicated a 50 % payout for that storm, even though actual property damage was minimal.
“ The key year in development of alternative capital was 1994,” Wichmann said.“ We took part in the first securitization that took excess coverage out to the capital markets. Our structure at the time was called Kover, so the securitization was K-1. We have since gone up through K-6 and now just K.”
Gregory DL Morris is an independent business journalist, principal of Enterprise & Industry Historic Research( www. enterpriseandindustry. com) and an active member of the Museum’ s editorial board.
www. MoAF. org | Spring 2016 | FINANCIAL HISTORY 19