Cross-sector Risk Transfer

1. Banking Asset Management Cross-sector Risk Transfer Richard Flavell Johannesburg August 2002 Insurance

2. CDOs, ABSs, CDs Financial guarantees Surety bonds Buying bonds with embedded options Selling options Operational and political risks Hedging embedded options in life products Catastrophe bonds Nothing new? Types of risks Credit Market Insurance Bank equities and bonds Trade credit insurance Bank equities and bonds Insurance on bank property, liabilities, etc Insurance to borrowers Banks  Insurers Insurers Banks and Capital Markets Letters of Credit Liquidity facilities

3. Cross-sector risk transfer – the headlines • Three main forms: • Credit risk transfer from banks and asset managers to insurers • Global credit derivative market: $2 tr in 2001 • Growing at over 50% pa. • Insurers have about 25% market share as risk buyers • Operational risk transfer from banks to insurers • Also has been growing significantly • But has been given great stimulus by new Basel Accord proposals • Insurance risk transfer from insurers to capital markets • Mainly through Catastrophe Bonds: earthquakes, floods, wind, fire, etc. • And Life Securitisations • Despite the hype, remains relatively small: only 37 public cat issues upto mid-02 • Reinsurance is still the traditional approach • Agenda: • Overview of the current market: products and players • Factors driving it – and factors giving concern

4. Debt tranches AAA rated AA rated A rated BB rated Unrated Underlying securities Issued securities Bank SPV Cash Cash Underlying securities Transferring credit risk – using assets • Banks can transfer the legal right to assets • Directly, for example, by selling/trading loans • Securitising the assets through a Collateralised Debt Obligation or Asset Backed Security • Underlying portfolio of CDO may contain a range of assets • And may be substituted according to pre-defined criteria • Asset managers may buy/sell tranches to acquire desired portfolio profile • Insurers, as institutional investors, may buy tranches • Multiline insurers have been mainly buyers of junior tranches • Quote from Chairman of FSA: concern about insurers taking on “toxic waste” • Monoline insurers have been providing “insurance” wraps

5. Size of Global CDO market • Other estimates: eg. Bank of England suggest 50% larger

6. Payment Protection buyer Protection seller Premium Transferring credit risk – using derivatives • Banks use these to transfer the economic risk, not the assets • Most common form: credit default swap Where the payment requires: • A definition of the credit event: bankruptcy, restructuring, administration, etc. • A definition of the credit event payment (usually cash or asset) • Many other forms of derivative now available: • Vanilla such as credit-linked notes, total return swaps • Hybrids such as basket and spread structures • Synthetic securitisations: • Creating CDO tranches by using derivatives/credit linked-notes instead of transferring the assets into the SPV • Easier to create wide range of structures for investors

7. Size of the Global CD market • These estimates include assets swaps as well • Still very small compared to $100 tr size of OTC derivative market • Strong growth likely to continue

8. Who are the major market participants? • London currently trades about 50% of CD/CDOs • BBA do regular surveys of protection sellers: Institution 1997 1999 2002 (est) Banks 54% 47% 38% Insurers 10% 23% 26% Securities houses 22% 16% 16% Hedge funds 4% 5% 5% Pension funds 2% 3% 5% Corporates 3% 3% 5% Mutual funds 4% 2% 4% Government agencies 1% 1% 1% • Insurers are growing rapidly • Monolines are very active • Taking senior/AAA tranches • Providing credit enhancement to A risk in (say) project finance • Global reinsurers are the other major players • Taking mezzanine and lower tranches • UK insurers not very active as yet (as big equity investors already) • Unlike European ones, especially German • Some members of the London market have been writing business Putting this into context: Regulatory capital Monolines $10.8bn Top 20 reinsurers $134.3bn Total assets of global life insurers: $10 tr

9. CDS Parent Insurer Bank A Bank B 1.6% capital 8% capital Transformer Corporate What’s in it for everybody? • Banks: initially to free up regulatory capital • Typically bank is subject to 8% capital requirement • This is reduced to 1.6% if c/p is another bank or investment firm • Under new Basel Accord, would deal directly with good-credit insurer • Trading/market making becoming increasingly important • Management of individual credit lines • Insurers: under a risk-based capital regime (similar to new Accord) • Require far less capital for good credits • Still arbitrage under new Accord • Insurers: diversification • Low correlation with other business • High yielding • Asset managers: active portfolio management • Adjusting the credit risk profile

10. Insurers diversify into a new asset class Banks reduce capital Funds actively manage their credit risk profile Win-win? • Lot of regulatory concern about this market: • Credit derivatives are fundamentally different to insurance • Do insurers understand/have processes & controls for the new asset class? • Does the risk transfer actually work? • Lack of transparency and liquidity • Is the current regulatory environment adequate?

11. Derivatives and Insurance • Derivatives are “complete” contracts: • Spell out obligations and rights in all relevant states • Protection buyer has no obligation to disclose information to the seller • Typically arms-length marked-to-market and closed out at market value • Typical insurance policies: • Indemnify the insured against particular losses following an insurance event • Often subject to limits, retentions, excesses • Designed to protect insurer against possibility that insured has better information about the event • Insurer usually has right to delay settlement whilst investigating validity and size of claim (loss adjustment) • Policies are not traded or market-valued • Insurance policies are not unconditional guarantees • Except for monolines • Highly unlikely that multilines will ever provide such guarantees: • Phoenix: Chase insured film funding using contracts which explicitly waived normal conditions • But insurers refused to pay claiming initial information had been misrepresented

12. Mahonia (SPV owned by JP Morgan) • In June 1998, JPM entered into pre-paid forward gas & oil contracts with Enron: • JPM paid Enron $2bn up-front • Enron would supply gas & oil over 6 year period • JPM bought “surety bonds” from a group of insurers to: “guarantee obligations of Enron under the forward contracts” • The cost  10% of equivalent credit default swap • In December 2001, Enron filed for Chapter 11 • JPM had (about) $1bn of deliverables still outstanding • So turned to its insurers for payment • They refused! • Claiming that the contracts were disguised loans • And that it was illegal to use surety bonds to guarantee loans • JPM accused the insurers of fraud • Next court hearing: 2 December 2002

13. Quality of Insurers’ processes & controls • Findings from a recent FSA survey: • Lack of senior management oversight • Little or no group strategy • Inadequate credit risk management processes & controls • Poor credit assessment – typically use internal and not external • Lack of central management: poor counterparty/portfolio aggregation • Reinsurers are subject to little or no regulatory scrutiny in some countries • Despite being major players • Market did have some “naïve” capacity in 99/00 • But do not appear to be writing new business now • But of course old business is still in place

14. Does the risk transfer work – how big is the basis risk? • Documentation: • ISDA docs rewritten following failure to deliver during Eastern Europe crash • Definition of “credit event” – remember National Power? • Identification of reference entity – remember Armstrong? • Definition of deliverable – remember Railtrack? • Attempts to standardise vs. Accurate coverage of all possible issues • Moral Hazard: • Do the banks know more (better at it) than the insurers? • Financial Enhancement Rating (from S&P) • assesses the willingness and ability of an insurer to behave in a “capital markets” fashion

15. Market conditions • Lack of transparency: • Very few established markets and screens • Extensive use of offshore centres • No established pricing methodologies: • Most banks use probabilities implied from credit spreads • Whilst insurers often use actuarial methods • Plus differing assumptions about jointly-correlated events • Variety of accounting treatments: • Banks use short-term, volatile mark-to-market • Insurers use long-term, embedded value (or accrual) • Lack of liquidity: • Especially in the junior tranches of CDOs • Probably concerns banks more due to m-t-m • Than insurers who can take a long-term view

16. Regulatory issues • Can insurers legally sell credit derivatives? • Caveat emptor (the banking model) vs. utmost good faith (Phoenix) • In the UK, the insured must have an insurable interest, ie. “both an economic and a legal connection with the risk” • Feasible to construct speculative credit derivatives where buyer has no interest • Are credit derivatives insurance? • Current BIS capital requirements do not cover credit derivatives • So each country has devised its own rules • Can/do insurers report extent of risk transfer? • In UK, they do not have to separate out from other classes of risk • And in many cases, probably couldn’t anyway • Given the above: • FSA has concerns about the effectiveness of the credit risk transfer market • Especially now in a downturn • Whilst small relative to insurance capital, may contain substantial concentration risks which have not been identified • Which may exacerbate current solvency short-falls

17. Full circle? • Banks and asset managers are increasingly transferring credit risk to the insurance sector • Insurers are increasingly using capital markets to hedge their embedded options • But such risk transfer is very difficult to track • So there maybe unknown risk concentrations being created • But is the transfer effective? • There are contractual and implicit residual risks • Insurance appetite may wane if diversification benefits do not materialise • If credit losses crystallise and insurers have to pay out rapidly, they are likely to turn to banks for liquid funds • Hence banks are ultimately the contingent takers of credit risk

18. Bankers Blanket Bond Computer Crime Policy Unauthorised Trading Policy Property Insurance Policy Business Interruption Policy Bankers Professional Indemnity Commercial General Liability Employment Practice Liability Directors & Officers Liability Electronic Insurance Policy submitted by a group of 11 major insurers to BIS Nov 2001 Operational risk and Insurers • Insurers already provide a wide range of relevant policies – see box • Argue that, with some limited increase in coverage, these policies will cover Operational Risk as defined in the new proposed Basel Accord • And therefore should be regarded as mitigants of Operational Risk • With concomitant reduction of bank capital • BIS raised the following concerns: • Exclusions and loss adjustments • Timeliness of payments • Effectiveness of insurance to cover systemic risk • Similar concerns over credit protection • Joint banking-insurance working parties • Evolution of insurance policies

19. Banking Asset Management Cross-sector Risk Transfer Insurance