Alternative Risk Transfer: Integrated Risk Management through Insurance, Reinsurance, and the Capital Markets

239 Pages·2004·1.33 MB·English

by  Erik Banks

Alternative Risk Transfer
WileyFinanceSeries
AlternativeRiskTransfer:IntegratedRiskManagementthroughInsurance,ReinsuranceandtheCapitalMarkets
ErikBanks
ACurrencyOptionsPrimer
ShaniShamah
NewRiskMeasuresinInvestmentandRegulation
GiorgioSzego¨(Editor)
ModellingPricesinCompetitiveElectricityMarkets
DerekBunn
Inflation-IndexedSecurities:Bonds,SwapsandOtherDerivatives,2ndEdition
MarkDeacon,AndrewDerryandDariushMirfendereski
EuropeanFixedIncomeMarkets:Money,BondandInterestRates
JonathanBatten,ThomasFetherstonandPeterSzilagyi(Editors)
GlobalSecuritisationandCDOs
JohnDeacon
AppliedQuantitativeMethodsforTradingandInvestment
ChristianL.Dunis,JasonLawsandPatrickNa¨ım(Editors)
CountryRiskAssessment:AGuidetoGlobalInvestmentStrategy
MichelHenryBouchet,EphraimClarkandBertrandGroslambert
CreditDerivativesPricingModels:Models,PricingandImplementation
PhilippJ.Scho¨nbucher
HedgeFunds:AResourceforInvestors
SimoneBorla
AForeignExchangePrimer
ShaniShamah
TheSimpleRules:RevisitingtheArtofFinancialRiskManagement
ErikBanks
OptionTheory
PeterJames
Risk-adjustedLendingConditions
WernerRosenberger
MeasuringMarketRisk
KevinDowd
AnIntroductiontoMarketRiskManagement
KevinDowd
BehaviouralFinance
JamesMontier
AssetManagement:EquitiesDemystified
ShantaAcharya
AnIntroductiontoCapitalMarkets:Products,Strategies,Participants
AndrewM.Chisholm
HedgeFunds:MythsandLimits
Franc¸ois-SergeLhabitant
TheManager’sConciseGuidetoRisk
JihadS.Nader
SecuritiesOperations:AGuidetoTradeandPositionManagement
MichaelSimmons
Modeling,MeasuringandHedgingOperationalRisk
MarceloCruz
MonteCarloMethodsinFinance
PeterJa¨ckel
BuildingandUsingDynamicInterestRateModels
KenKortanekandVladimirMedvedev
StructuredEquityDerivatives:TheDefinitiveGuidetoExoticOptionsandStructuredNotes
HarryKat
AdvancedModellinginFinanceUsingExcelandVBA
MaryJacksonandMikeStaunton
OperationalRisk:MeasurementandModelling
JackKing
InterestRateModelling
JessicaJamesandNickWebber
Alternative Risk Transfer
Integrated Risk Management through Insurance, Reinsurance,
and the Capital Markets
Erik Banks
Copyright(cid:1)C 2004 JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester,
WestSussexPO198SQ,England
Telephone [phone]
Email(forordersandcustomerserviceenquiries):[email protected]
VisitourHomePageonwww.wileyeurope.comorwww.wiley.com
AllRightsReserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem
ortransmittedinanyformorbyanymeans,electronic,mechanical,photocopying,recording,
scanningorotherwise,exceptunderthetermsoftheCopyright,DesignsandPatentsAct1988
orunderthetermsofalicenceissuedbytheCopyrightLicensingAgencyLtd,90Tottenham
CourtRoad,LondonW1T4LP,UK,withoutthepermissioninwritingofthePublisher.
RequeststothePublishershouldbeaddressedtothePermissionsDepartment,JohnWiley&
SonsLtd,TheAtrium,SouthernGate,Chichester,WestSussexPO198SQ,England,oremailed
[email protected],orfaxedto([phone].
Thispublicationisdesignedtoprovideaccurateandauthoritativeinformationinregardto
thesubjectmattercovered.ItissoldontheunderstandingthatthePublisherisnotengaged
inrenderingprofessionalservices.Ifprofessionaladviceorotherexpertassistanceis
required,theservicesofacompetentprofessionalshouldbesought.
OtherWileyEditorialOffices
JohnWiley&SonsInc.,111RiverStreet,Hoboken,NJ07030,USA
Jossey-Bass,989MarketStreet,SanFrancisco,CA94103-1741,USA
Wiley-VCHVerlagGmbH,Boschstr.12,D-69469Weinheim,Germany
JohnWiley&SonsAustraliaLtd,33ParkRoad,Milton,Queensland4064,Australia
JohnWiley&Sons(Asia)PteLtd,2ClementiLoop#02-01,JinXingDistripark,Singapore129809
JohnWiley&SonsCanadaLtd,22WorcesterRoad,Etobicoke,Ontario,CanadaM9W1L1
Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappears
inprintmaynotbeavailableinelectronicbooks.
LibraryofCongressCataloging-in-PublicationData
Banks,Erik.
Alternativerisktransfer:integratedriskmanagementthroughinsurance,reinsurance,andthecapital
markets/ErikBanks.
p. cm.—(Wileyfinanceseries)
Includesbibliographicalreferencesandindex.
ISBN0-470-85745-5(Cloth:alk.paper)
1.Finance. 2.Riskmanagement. 3.Capitalmarket. 4.Risk(Insurance) 5.Reinsurance.
I.Title. II.Series.
HG173.B3362004
658.15(cid:2)5—dc22 2003025310
BritishLibraryCataloguinginPublicationData
AcataloguerecordforthisbookisavailablefromtheBritishLibrary
ISBN0-470-85745-5
Typesetin10/12ptTimesbyTechBooks,NewDelhi,India
PrintedandboundinGreatBritainbyTheCromwellPress,Trowbridge,Wiltshire
Thisbookisprintedonacid-freepaperresponsiblymanufacturedfromsustainableforestry
inwhichatleasttwotreesareplantedforeachoneusedforpaperproduction.
Contents
Acknowledgements ix
Biography xi
PARTI: RISKANDTHEARTMARKET 1
1 OverviewofRiskManagement 3
1.1 Riskandreturn 3
1.2 Activeriskmanagement 5
1.2.1 Riskmanagementprocesses 6
1.2.2 Riskmanagementtechniques 7
1.2.3 Generalriskmanagementconsiderations 10
1.3 Riskconcepts 12
1.3.1 Expectedvalueandvariance 12
1.3.2 Riskaversion 14
1.3.3 Risktransferandtheinsurancemechanism 16
1.3.4 Diversificationandriskpooling 17
1.3.5 Hedging 20
1.3.6 Moralhazard,adverseselectionandbasisrisk 21
1.3.7 Non-insurancetransfers 22
1.4 Outlineofthebook 22
2 RiskManagementDrivers:TheoreticalMotivations,Benefits,andCosts 25
2.1 Maximizingenterprisevalue 25
2.2 Thedecisionframework 29
2.2.1 Replacementandabandonment 31
2.2.2 Costsandbenefitsoflosscontrol 31
2.2.3 Costsandbenefitsoflossfinancing 32
2.2.4 Costsandbenefitsofriskreduction 35
2.3 Copingwithmarketcycles 35
2.3.1 Insurancepricing 35
2.3.2 Hardversussoftmarkets 37
2.4 Accessingnewriskcapacity 42
2.5 Diversifyingthecreditriskofintermediaries 43
vi Contents
2.6 Managingenterpriserisksintelligently 44
2.7 Reducingtaxes 45
2.8 Overcomingregulatorybarriers 46
2.9 Capitalizingonderegulation 47
3 TheARTMarketanditsParticipants 49
3.1 AdefinitionofART 49
3.2 OriginsandbackgroundofART 51
3.3 Marketparticipants 52
3.3.1 Insurersandreinsurers 53
3.3.2 Investment,commercial,anduniversalbanks 55
3.3.3 Corporateend-users 56
3.3.4 Investors/capitalproviders 57
3.3.5 Insuranceagentsandbrokers 57
3.4 Productandmarketconvergence 58
PARTII: INSURANCEANDREINSURANCE 61
4 PrimaryInsurance/ReinsuranceContracts 63
4.1 Insuranceconcepts 63
4.2 Insuranceandlossfinancing 64
4.3 Primaryinsurancecontracts 65
4.3.1 Maximumrisktransfercontracts 65
4.3.2 Minimalrisktransfercontracts 66
4.3.3 Layeredinsurancecoverage 76
4.4 Reinsuranceandretrocessioncontracts 78
4.4.1 Facultativeandtreatyreinsurance 81
4.4.2 Quotashare,surplusshare,excessofloss,andreinsurancepools 81
4.4.3 Finitereinsurance 86
5 Captives 89
5.1 Usingcaptivestoretainrisks 89
5.1.1 Backgroundandfunction 89
5.1.2 Benefitsandcosts 91
5.2 Formsofcaptives 94
5.2.1 Purecaptives 94
5.2.2 Sistercaptives 95
5.2.3 Groupcaptives 95
5.2.4 Rent-a-captivesandprotectedcellcompanies 96
5.2.5 Riskretentiongroups 99
5.3 Taxconsequences 100
6 Multi-riskProducts 103
6.1 Multipleperilproducts 103
6.2 Multipletriggerproducts 106
Contents vii
PARTIII: CAPITALMARKETS 113
7 CapitalMarketsIssuesandSecuritization 115
7.1 Overviewofsecuritization 115
7.2 Insurance-linkedsecurities 116
7.2.1 Overview 116
7.2.2 Costsandbenefits 118
7.3 Structuralfeatures 119
7.3.1 Issuingvehicles 119
7.3.2 Triggers 121
7.3.3 Tranches 123
7.4 Catastrophebonds 124
7.4.1 Hurricane 124
7.4.2 Earthquake 127
7.4.3 Windstorm 129
7.4.4 MultiplecatperilILSandperilbytrancheILS 129
7.4.5 Bond/derivativevariations 130
7.5 Otherinsurance-linkedsecurities 131
8 ContingentCapitalStructures 135
8.1 Creatingpost-lossfinancingproducts 135
8.2 Contingentdebt 139
8.2.1 Committedcapitalfacilities 139
8.2.2 Contingentsurplusnotes 140
8.2.3 Contingencyloans 141
8.2.4 Financialguarantees 142
8.3 Contingentequity 142
8.3.1 Lossequityputs 143
8.3.2 Putprotectedequity 146
9 InsuranceDerivatives 149
9.1 DerivativesandART 149
9.2 Generalcharacteristicsofderivatives 150
9.3 Exchange-tradedinsurancederivatives 156
9.3.1 Exchange-tradedcatastrophederivatives 156
9.3.2 Exchange-tradedtemperaturederivatives 157
9.4 OTCinsurancederivatives 162
9.4.1 Catastrophereinsuranceswaps 162
9.4.2 Purecatastropheswaps 164
9.4.3 Temperaturederivatives 164
9.4.4 Otherweatherderivatives 166
9.4.5 Creditderivatives 167
9.5 Bermudatransformersandcapitalmarketssubsidiaries 168
viii Contents
PARTIV: ARTOFTHEFUTURE 171
10 EnterpriseRiskManagement 173
10.1 Combiningrisks 173
10.1.1 Theenterpriseriskmanagementconcept 173
10.1.2 Costsandbenefits 177
10.2 Developinganenterpriseriskmanagementprogram 179
10.2.1 Strategicandgovernanceconsiderations 180
10.2.2 Programblueprint 182
10.2.3 Programcosts 186
10.3 End-userdemand 188
11 ProspectsforGrowth 193
11.1 Driversofgrowth 193
11.2 Barrierstogrowth 194
11.3 Marketsegments 196
11.3.1 Finitestructures 196
11.3.2 Captives 197
11.3.3 Multi-riskproducts 197
11.3.4 Capitalmarketsissues 198
11.3.5 Contingentcapital 198
11.3.6 Insurancederivatives 199
11.3.7 Enterpriseriskmanagement 199
11.4 End-userprofiles 201
11.5 Futureconvergence 202
Glossary 205
SelectedReferences 221
Index 223
Acknowledgements
Iwouldliketoexpressmygratitudetovariousindividualsfortheirhelpinmakingthisproject
cometofruition.Specifically,greatthanksareduetoSamanthaWhittaker,publishingeditorat
JohnWiley&Sons,forhersupportonthis,andvariousother,writingprojects.Thanksgoalso
toPatriciaMorrison,publishingeditor,andCaroleMillett,editorialassistant,forhelpalong
theway.ThanksalsogotoSamanthaHartley,productioneditor,forherhelpincoordinating
productionofthebook.
Iwouldalsoliketoacknowledgethevaluableassistanceprovidedbynumerousindividuals
from various organizations, including the Insurance Services Office, Insurance Information
Institute, XL Capital, and Merrill Lynch. They provided important input and information as
theprojectdeveloped.
And,mostofall,mythankstoMilena.
E.Banks
Redding,CT
2003