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