3.

4 ALTERNATIVE RISK
TRANSFER (ART)
Basile Kernen, Frederic Luebke, Luis Miranda Cardoso, Abdel Karim Morad
and Elettra Moro
Introduction

● Purchase coverage and transfer risk without having to use traditional

commercial insurance.
● Complex, sophisticated and huge risks.
● Reduce the cost of risk over time.
● For example: self-insurance is a form of ART.
How does ART work?

● Alternative carriers:
○ Captives / self-insurance
○ Reinsurance pools
○ Capital market
○ Risk retention groups
 Structure of ART – Alternative solutions

Alternative Risk Transfer

Hybrid products:
Risk pools and • Finite reinsurance Financial instruments:
insurers: • Multi-year products • Contingent capital
• Self insurance plans • Multi-peril products • Options
• Captive insurance • Multiple-trigger • Swaps
companies products • Cat bonds
• Risk retention • Industry loss • Mortality bonds
groups warranties • Longevity bonds
• Sidecars
Captives

● Insurance/corporation/group of companies fund their own insurance or

reinsurance company.
● Main goal: insure the risks of their owner.
● Ideas:
○ Avoid many of the regulations that are applied to primary insurers.
○ Reduce costs from insurance transactions.
Captives as an insurance
Capital/Equity

Premium

Corporation Captive

Insurance

Interests/Dividends
 Captive as a reinsurance
Capital/Equity

Premium Premium

Corporation Insurance Captive

Insurance Reinsurance

Interests/Dividends
Finite reinsurance

● Bank account between insurer and reinsurer.

● Finite since: limited risk transferred to the reinsurer.
● Insurer pays premium in the account.
● If there’s a claim: insurer takes out an amount.
● More risk over time: since some years no claims, some year a lot of claims.
Risk-sharing of the ultimate result (positive or negative balance).
Finite reinsurance

● Features:
○ Risk transfer and risk financing: into single contract.
○ Less underwriting risk is transferred to reinsurer.
○ Multi-year period (vs. one year).
○ Investment income on premium are considered during pricing.
○ Risk-sharing of the ultimate results.
Finite reinsurance

● Standard type of finite reinsurance contracts:

○ Time and distance
○ Loss portfolio transfer
○ Adverse development cover
○ Spread loss cover
○ Financial quota share
Retrospective vs Prospective Reinsurance

•Prospective reinsurance : focuses on liabilities that are incurred and

settled after the contract has come into effect.

•Retrospective reinsurance : looks at losses that occurred before the

contract came into effect but have not been settled yet.
 Retrospective vs Prospective Reinsurance

• Policy Underwritten : Contract

• Liability Incurred : Loss occurs

• Policy Triggered : Known loss

• Claim Made : Asking for reimbursement

 Contract types

•Time and Distance

•Loss Portfolio Transfers
•Adverse Development Cover
•Spread Loss Cover
•Financial Quota Share
Time and distance

•The most elementary type of finite (re)insurance.

•The cedant pays a specified premium.
•An insurer/reinsurer agrees to pay an agreed schedule of loss payments in the future
without assuming any losses that are greater than those in the schedule.
•There is so little risk transfer embodied in the program that it is not even viewed as an
insurance contract.
Loss Portfolio Transfers (LPTs)
•Retrospective form of finite reinsurance.
•A reinsurer assumes and accepts the insurer’s outstanding claims through the transfer of the
insurer’s loss reserves plus a loading for administrative expenses.
•The reinsurer is now responsible for paying claims.
•Transfer of timing risk.
•Reinsurers gain the chance to generate investment income from the transferred reserves.
•Long-tail lines of insurance, ex : medical malpractice.
Adverse Development Cover

•Retrospective form of reinsurance.

•Similar to LPT without a transfer of the reserve.
•A reinsurer will be involved in the insurer’s outstanding claims and IBNR (incurred but not
yet reported) claims.
•The cedant pays a premium for the transfer of losses exceeding an established reserve and
receives financing on existing liabilities in excess of that reserve level from the
reinsurance.
•Timing risk and underwriting risk are transfered.
Spread Loss Covers

•Prospective form of reinsurance.

•The cedant pays premium to the reinsurer through an experience account.
•This account earns contractually agreed investment return.
• Losses incurred by the reinsurer are debited from the account.
•The reinsurer holds the credit risk of the insurer.
•At the end of the contract, the balance of the experience account is settled with the
client.
Financial Quota Share

•Prospective form of reinsurance.

•It’s a quota share agreement with implicit financing via ceding commissions.

•Cover underwriting risks.

Timing Risk vs Underwriting Risk

•Timing risk : the risk that actual loss claims occur faster than
expected and that invested reserves (including investment income)
are too low to fund those claims when they occur.

•Underwriting risk : the risk that premiums collected (generally set to

cover expected claims payments plus transaction costs) are
insufficient to cover actual claims payments.
Simple model analysis
•Premium π at t=0 => Claims payment L in time T
•i : required return
•E[L] : expected claim size
•Premium :
•Technical risk :
where τ is the time of loss occurrence (i.e. random time 0≤τ≤T)
•Loss : L = E[L] + ε [C]
where ε denote the deviation of L from its expected value, with E[ε]=0.
Simple model analysis
•Replace [A] and [B] in equation [C] we obtain :

•Underwriting risk
•Timing risk (interest on assets due early)
•Hybrid term : underwriting + timing risk
Multi-trigger Reinsurance Contracts

•Multiple trigger products : contracts that provide coverage only if multiple events occur.
•Multiple-trigger contracts are successful in the industry loss warranty (ILW)
•Ex : XL/R contract with layer Q and priority R; Y = capital market index
•The reinsurance pays only if i < Y AND L > R.
•Mathematically : Loss Dual Trigger = 1{i<Y}∙min(max(L-R;0);Q).
XL/R contract with layer Q and priority R; Y =
capital market index
Industry Loss Warranty (ILW)

•Definition : ILW are dual trigger contract, the pay off will depend on the occurrence of a
joint event. The ILW will pay a fixed sum if the total industry loss exceeds the
predetermined limit as well as the company retention. In other words, two triggers have
to be satisfied for a pay-out to be activated; i.e. the industry loss trigger and the
company’s retained loss trigger.
•Let’s consider an example :
 Example of ILW

•ABC insurance company purchases an Industry Loss Warranty for protection against catastrophe
losses with the following details :
•Territorial scope : United States
•The limit of cover : 5’000’000$
•The retention : 20’000$
•The period : 12 months from 01 January
•Index used : The property Claim Service
•Perils covered : Earthquake
•Reporting period : 24 months
•Warranty : 1 billion
Scenario A

•If during the period, ABC suffers losses to its property portfolio of up to 20’000’000 $
and the Total Industry Losses stand at 850’000’000 $. In such a scenario, ABC wouldn’t
be able to recover anything from the contract because the trigger limit hasn’t been met.

•20’000’000 $ > 20’000 $

•850’000’000 $ < 1 billion $

Scenario B

•During the 12 months period, ABC suffers losses to its property portfolio of up to
20’000’000 $. And Total Industry Losses hit a record of 2 billion $. ABC would be able to
recover from the contract since the conditions for payout have been met :

•20’000’000 $ > 20’000 $

•2 billion $ > 1 billion $

Securitized risk-transfer solutions

● Non-life insurance securitization

○ Catastrophic (Cat) Bonds

● Life insurance securitization

○ Mortality bonds
○ Longevity bonds
Typical insurance-linked security (ILS)
structure
Stable Value
investment
(Collateral trust)

Ceding company
Special purpose Investors
(Protection buyer)
vehicle (issuer) (Protection Seller)
Sponsor
 Typical insurance-linked security (ILS)
structure
1. The reinsurer (sponsor) enters
into a financial contract with the
SPV
a. Premiums are paid in Stable Value
investment
exchange of protection on a
(Collateral trust)
particular risk event
(Hurricane) if it occurs
during a particular time.

Premiums
Ceding company
Special purpose Investors
(Protection buyer)
vehicle (issuer) (Protection Seller)
Sponsor
Hurricane
Cover
 Typical insurance-linked security (ILS)
structure
2. The SPV hedges the financial contrat
by issuing notes to the investors in
the capital market.
a. SPV issues a financial contract Stable Value
investment
(bond) in the market and receive
(Collateral trust)
its proceeds.
b. Investors will receive the
revenues from investments
(Bond Coupon) in case there is
no event. Premiums
Bond
Coupon
Ceding company
Special purpose Investors
(Protection buyer)
vehicle (issuer) (Protection Seller)
Sponsor Bond
Hurricane
Cover Proceeds
 Typical insurance-linked security (ILS)
structure
3. Proceeds from the securities are
invested in high quality securities
and held in a Collateral trust .
a. Proceeds are invested in a Stable Value
investment
stable value investment in
(Collateral trust)
order to have a favorable
return.
Investment
earnings

Bond
Premiums
Coupon
Ceding company
Special purpose Investors
(Protection buyer)
vehicle (issuer) (Protection Seller)
Sponsor Bond
Hurricane
Cover Proceeds
 Typical insurance-linked security (ILS)
structure
4. Investment returns are used to pay
back whether Investors or Ceding
company or both according to the
occurence/intensity of the event. Stable Value
investment
(Collateral trust)

Investment Scheduled
earnings Interest

Bond
Premiums
Coupon
Ceding company
Special purpose Investors
(Protection buyer)
vehicle (issuer) (Protection Seller)
Sponsor Bond
Hurricane
Cover Proceeds
Typical insurance-linked security (ILS)
structure
Stable Value
investment
(Collateral trust)

Investment Scheduled
earnings Interest

Bond
Premiums
Coupon
Ceding company
Special purpose Investors
(Protection buyer)
vehicle (issuer) (Protection Seller)
Sponsor Bond
Hurricane
Cover Proceeds
Non-life insurance securitization:
Catastrophe (cat) bonds
Definition: Cat bonds
● Financial instruments (securitizations) whose values are mainly
driven by catastrophe risk
● Designed to hedge sponsors (protective buyers) against losses
caused by (natural) disasters.

● Two elements to be specified:

○ Covered territory: Geographic area in which catastrophes need to occur to
be relevant under the bond indenture. Usually defined in terms of countries ,
regions or states.
○ Reference peril: Type of disaster covered by the transaction, may include
secondary perils such as fires/tsunamis. Typically windstorms(e.g.,
hurricanes, typhoons) or earthquakes but also multiple perils possible.
Common combinations of territory and peril
● US Wind
○ Bonds that reference severe windstorms in the United States
○ Florida and Gulf Coast hurricane deals are the most actively traded cat bonds
to date
● US Earthquake
○ Hedge sponsors against the damage dealt by seismic events in the United
States
○ Most transactions are focused on the state of California
● Europe Wind
○ Cover extratropical cyclones that form during the winter months in the North
Atlantic
○ Northern and Western European countries are most exposed to such storm
systems
● Japan Earthquake
○ Earthquakes that occur due to the rifts of the four tectonic plates
underneath Japan
○ If the epicenter lies off coast, additional losses may be caused by a
subsequent Tsunami.
Cat bonds are the most successful form of
insurance-linked securities to date
Reasons
● Insurance loss potentials from natural catastrophes are on the rise globally
○ Increasing concentration of insured values in disaster-prone areas
○ Climate change: more extreme weather patterns and shorter intervals between
mega events.
○ Growing complexity and interconnectedness of globally economies and value
chains
● The size of the global capital markets is well-suited to absorb losses from mega events.
● No-correlation with the economical environment since the natural event does not
depend on market activity
● Reliable scientific models and large databases for meteorological and seismic events
● Modern pricing approaches that are compatible with financial theory
● Attractive security format for (institutional) fixed income investors
Typical cat bond structure

Stable Value
investment
(Collateral trust)

Cat Bond Money Market

Principal Fund Returns
(MMF)
Premiums Cat Bond
Cat Bond Spread +
Spread
Ceding company Principal
Special purpose Investors
(Protection buyer)
vehicle (issuer) (Protection Seller)
Sponsor Cat Bound
Contingent
Payment Principal
Typical cat bond structure

Sponsor pays Premiums equivalent to the Cat Bond

Spread to the Special Purpose Vehicle (SPV) in
exchange of protection for catastrophic event
losses.

Premiums
Contingent payment is conditional on the
Cat Bond
Spread
realization of the catastrophic event. In case there
Ceding company
is no loss during a specified period the there is no
(Protection buyer)
Sponsor payment from the SPV.
Contingent
Payment
 Typical cat bond structure
The SPV is an intermediary entity that will transfer the risk from the sponsor directly to
the investors by the creation of a cat bond. This bond will be sold to Investors in the
financial market. The proceeds from this transaction is invested in high quality
securities that will generate a return.

Cat Bond Money Market

Principal Fund Returns
(MMF)
In case of catastrophic Premiums
Cat Bond
Cat Bond In case no event has
Spread +
event the amount Spread Principal occurred during the
generated by the Special purpose
predetermined period the
vehicle (issuer)
transaction and its return Contingent Cat Bound investor receives back the
will be used to cover the Payment Principal
principal plus the Cat Bond
loss. Spread (Earnings)
 Typical cat bond structure

Stable Value
investment
(Collateral trust)

Cat Bond Money Market

Principal Fund Returns
(MMF)

Collateral: money market funds that invest in short-term sovereign debt

(discount notes) such as US T-Bills on a rolling basis.

US T-Bills are very secure, highly liquid, have easily observable prices, and
minimize interest rate risk.
 Typical cat bond structure

Investors enjoy from a bond that is not

correlated with the market since it is
entirely determined by the condition of a
natural event to happen.

Investors will pay the Cat Bound Principal at

the beginning of the relation and are betting Cat Bond

on the no-realization of the catastrophic Spread +

Principal

event. Investors
(Protection Seller)
Cat Bound
In case there is no event, they will receive Principal

back the Principal plus the earnings on it.

Typical cat bond structure

Stable Value
investment
(Collateral trust)

Cat Bond Money Market

Principal Fund Returns
(MMF)
Premiums Cat Bond
Cat Bond Spread +
Spread
Ceding company Principal
Special purpose Investors
(Protection buyer)
vehicle (issuer) (Protection Seller)
Sponsor Cat Bound
Contingent
Payment Principal
Overview of cat bond pricing models

● Actuarial Pricing
○ Idea: cat bonds are tradable form of reinsurance, hence employ the same
pricing approaches
○ Can use actuarial premium principles to determine a risk loading above the
expected loss (EL)
● Econometric pricing
○ Preference-free valuation based on option theory (also called “contingent
claims approaches”)
● Utility-based pricing
○ Idea: insurance markets are incomplete such that a unique martingale
measure does not exist.
○ Resort to equilibrium theory and assume a utility function for the
representative agent
Cat bond issuance 1997-2020
Two digits growth rates, important growth after post-crises years
Catastrophe (cat) derivatives
● Derivative contracts whose underlying is and index of
insurance losses or disaster severity

● Can be used to hedge property-catastrophe (e.g. cat

bonds) or speculation

● Underlying no traded and hence physical delivery

(buying/Selling of an asset) impossible

● In general, all classical derivative formats are feasible

○ Options
○ Futures
○ Swaps
Goals of indices as underlying in
catastrophe derivatives
● What are they?
● Objectivity
● Transparency
● Simplicity
● Rapid Settlement
● Standardization of instrument and documentation
Life insurance securitization

Various risk in life insurance:

● Mortality risk
● Lapse or persistency risk
● Credit risk
● Other risk
 Mortality vs longevity risk
Definitions Who is exposed?
● Negative financial impact of ● Insurance and life insurance
(much) greater-than-expected companies that sell life
mortality rates. insurance contracts

● Mortality rates: proportion of ● Investors in (extreme)

deaths in a population within mortality-linked securities
a certain time period and derivatives (longevity
bonds, mortality bonds)
● Increasing awareness of
potential mortality shocks
due to pandemics or terrorist
attacks.
 Mortality vs longevity risk
Definitions Who is exposed?
● Negative financial impact of ● Insurance companies that sell
greater-than-expected annuities
survival rates ● Defined benefit pension plans
(private and governmental)
● Survival rates: proportion of ● Investors in longevity linked
survival in a population securities and derivatives as
within a certain time period well as life settlements
● Reverse mortgage lenders
● Has unfortunately been and providers of
overlooked and free/subsidized medical
underestimated for a long benefits to retirees.
time.
 Life perils and Vitagions
Life perils: Vitagions:

● causes of excess ● Causes of longevity

mortality improvements

● Diseases, terrorism and ● Social, economic and

disasters medical factors

● Drive the tail volatility of ● Extreme trajectories less

mortality likely
Natural hedging against mortality and
longevity risks
Definition

● Net mortality/longevity risk is lower if both life policies

and annuity products are written

● Increases in death claims may be offset by drops in

annuity liabilities
Natural hedging against mortality and
longevity risks
Practical considerations

● In reality this type of hedge can almost never be perfect

● Reason: differences in mortality characteristics of the
pools of insured and annuitants
● Hedge effectiveness can be estimated by carefully
assessing the relationship of the risks
● can turn to mortality/longevity-linked instruments to
hedge the remaining net exposure
 Extreme Mortality
Bonds
Overview:

● Alternative of risk transfer for Life (re)insurance

● Designed to Hedge sponsors against sharp increases in mortality rates

● Main focus is on pandemics and major terror attacks

 Extreme Mortality Bond Structure
Collateral
(Trust Account)

fixed Coupons
Mortality Bond Principle
Contingent Payment
Mortality Bond Principle
eeeeeee SPV Investors
Sponsor (issuer)
awdasds Total Return Swap Spread+Ext. MB Spread

LIBOR+PRINCIPAL+[Link] Spread

LIBOR-Total return

Swap Spread
Fixed Coupons + Collateral value Gains

Swap
Counterparty
 Transfer of Extreme Mortality risk to Capital Markets
Structural Features

● Similar to a Cat Bond but there is one trigger type (Mortality- based index)

● Multi Year Protection of the Sponsor , usual its a 3-5 years term

● Total Return Swap protects against default risk and value fluctuations of Collateral
 Advantages and Disadvantages of Mortality risk Securitization
Positive Signs
● Insurers are able to convert future life insurance profits into liquidity .

● Growing awareness of extreme mortality exposures and need for risk transfer.

Negative Signs
● Extremely high cost for the issuing of a bond ( minimum of 250-300 M $)

● Many Players are needed (Bankers , lawyers , rating agencies )

 Longevity Risk: The Blind Spot
Traditional approaches no longer reliable
● Hard to predict future changes in life expectancy , mainly due to medical
advancements

● Next generation modelling and risk management tools needed

Small changes have massive implications
● Pension Corporation:
1 year life expectancy extension= 3.5% rise in UK pension Liabilities
● 5 year life expectancy extension=10% rise in US pension liabilities as per
RMS
Drivers of Future Longevity Improvements
 Longevity bonds:various structures have been discussed
Zero Coupon Longevity Bonds
● only one payment to investors at the end of the term linked to a longevity index

Fixed and Open-term longevity bonds

● Coupons of the bond are tied to the longevity experience of a population
(decline over time)
● Open-term: no fixed maturity
Inverse longevity Bonds
● Inverse relation between coupons and the value of a longevity index(survival rate)

● Opposite of regular longevity bonds in that their coupons rise rather than fall over
the term
What makes ILS attractive for capital market investors?
Thank you for your attention!
Do you have questions?