OECD – Banco de España Workshop on securitisation Madrid May 2010 Securitisation of insurance-related risks Dominique Durant Omar Birouk

1.Mechanics of Insurance-linked securities (ILS) 2.ILS Typology 3.Regulatory perspective of ILS 4.The ILS market at a glance 5.ILS from investors point of view 6.Insurance securitisation in OECD countries 7.Insurance securitisation in France 8.Insurance securitisation in ECB statistics Outlines

1. Mechanics of Insurance-linked securities (ILS) (1) The Insurance-linked securities (ILS) are a means of selling insurance-related risks to the capital markets by using synthetic securitisation techniques. The selling insurance company enters into a financial contract with a Special Purpose Vehicle (SPV) where the former transfers premiums to the latter in exchange of claim payments (1) The SPV issues notes to investors in the capital markets (2) Proceeds from the notes are invested in high-quality securities and held in a collateral trust (3) Investment returns from the collateral are swapped to a LIBOR-based rate by the Swap Counterparty (4) Investors receive a stream of coupon payments that compensate them for the use of their funds (LIBOR) and their risk exposure (spread financed by the premiums) (5)

1. Mechanics of ILS (2) Insurance company SPV Investors Collateral Swap counterparty : Investment bank 1 2 Premiums Claim payments Notes proceeds Libor + spread Investment Returns Libor Investments 3 4 5

2. ILS Typology (1) ILS can be issued for two main purposes : 1) To transfer Insurance risks to financial markets 2) To finance insurance activities 1)ILS used as a risk transfer instrument : include catastrophe bonds, life bonds linked to extreme mortality risk are alternatives to: traditional reinsurance: risk carried by financial institutions while ILS transfer risk to financial markets different types of risk sharing: proportional contracts, excess of loss contracts, stop loss contracts derivatives: no financing while ILS provide upfront funding example: Industry loss warranties (ILW) of which the pay off depends not only on the insured loss of the buyer but also on an industry loss index.

2. ILS Typology (2) 2) ILS used for their financing function include life bonds linked to regulatory arbitrage (regulation XXX/AXXX in the US), life bonds used to finance payments in advance (fees to brokers) or receivables (future profits) are an alternative to : finite reinsurance where only a limited amount of risk is transferred to the reinsurer: Side-cars where investors finance a new fenced activity and obtain a return based on premium earned

3. Regulatory perspective of ILS (1) Accounting treatment of ILS under IFRS and US GAAPs : are treated as assets covering technical provisions ILS with indemnity based trigger, not with index trigger (IFRS 4) are not treated as assets covering technical provisions: reinsurance contracts with insufficient risk transfer (finite reinsurance) derivatives (except ILW under US GAAPs since they have dual trigger: indemnity based-trigger and index trigger) Solvency treatment of ILS : Under Solvency I, claims against an SPV with its head office in the European union (EU) can be treated as assets covering technical provisions Solvency II sets out a new framework supporting the development of ILS: Stress on the economic transfer of risk, not on the nature of the risk transfer tool : securitisation, derivatives and reinsurance are equally eligible to cover technical provisions

4. The ILS market at a glance (1) Source : Guy Carpenter ILS were issued for the first time in the early 1990s while the reinsurance market reached its limits because of major natural catastrophes like Hurricane Andrew (1992) or earthquakes in California (1994). At inception, they were Cat bonds.

4. The ILS market at a glance (2) The ILS Market with an outstanding of USD 38 bn is very small compared to the credit securitisation market and represents only 1% of all securitisation business. The ILS outstanding are composed essentially of life bonds (mainly financing instruments) because of their long maturity Source : Guy Carpenter

4. The ILS market at a glance : Life Bonds (3) Life Bonds have mainly financing function No issues in 2009 due to liquidity shortage. Source : Munich Re Cat Bonds are issued for their risk transfer function There were still issues in 2009 Source : Aon

4. The ILS market at a glance : Non-life Bonds (6) Cat Bonds with indemnity trigger are considered as reinsurance contracts. They represent only 32% of the total issuance in 2009 Source : Aon

5. ILS from investors point of view (1) Investors are interested essentially in Cat Bonds which show an exceptional risk/return profile and are weakly correlated with other financial assets However, for insurers and reinsurers, holding cat bonds may increase the risk as asset and liability may be correlated Source : Bloomberg

5. ILS from investors point of view (2) Primary Insurers and Reinsurers were the largest investors in Cat Bonds in In 2009, Catastrophe Funds hold 46% of the total outstanding. Source : Guy Carpenter

5. ILS from investors point of view (3) Investors in Cat Bonds are essentially located in the United States. Bermudas investors represent 17% of the total outstanding for tax reasons. Source : Aon

6. Insurance securitisation in OECD countries Most of the operations are located in the US In Europe, insurance securitisation operations were observed in the UK (cat bonds, mortality bonds), France, Ireland, Luxembourg Cross-border initiatives : Axa securitisation of mortality risk in Ireland (Osiris plc), Irish life insurance ceeding risk to a SPV in Luxembourg (Avondale) No specific regulation in Europe for insurance securitisation, except in France

7. Insurance securitisation in France In France, according to the 13 June 2008 law, a SPV can buy Insurance risks 3 SPVs holding insurance risk had been created under the previous French law: FCC Sparc (200 Mns) : created in 2005 and closed in 2009, dealt with the securitisation by AXA of its French automobile risk 2 FCC securitising the same underlying portfolio : Europe Sparc Senior (411 Mns) and Europe Spar Junior (115 Mns) were created in 2007 to deal with the securitisation by AXA of its pan-european automobile risk

8. Insurance securitisation in ECB statistics ECB regulation 24/2009 on statistics on securitisation vehicles defines securitisation in a way that may exclude insurance securitisation from the scope of the reporting (art.1. para 2) : synthetic securitisation is included only for credit risk This may impede collection of data on a still (very) limited but potentially increasing activity. However, many countries may also collect data for the implementation of ECB regulation on the basis of national law for SPVs. This is not consistent with the development of statistics on insurance corporations (ITIP statistics) and for macro-prudential analysis Where such financial intermediaries should be classified in national accounts if they are not Financial Vehicle Corporations (FVCs)? This may create gaps in the identification of holders of bank deposits as these entities may invest in such deposits

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