Content uploaded by Vladimir Njegomir
Author content
All content in this area was uploaded by Vladimir Njegomir on Nov 04, 2016
Content may be subject to copyright.
Available via license: CC BY-NC-ND 4.0
Content may be subject to copyright.
57
COMMUNICATIONS
Vladimir Njegomir and DOI:10.2298/EKA0980057N
Rado Maksimović*
RISK TRANSFER SOLUTIONS FOR
THE INSURANCE INDUSTRY
* Vladimir Njegomir, Q-Sphere Beograd; Rado Maksimović, Faculty of Technical Sciences,
University of Novi Sad.
ABSTRACT: e paper focuses on the
traditional and alternative mechanisms
for insurance risk transfer that are
available to global as well as to domestic
insurance companies. e ndings suggest
that traditional insurance risk transfer
solutions available to insurance industry
nowadays will be predominant in the
foreseeable future but the increasing role
of alternative solutions is to be expected
as the complementary rather than
supplementary solution to traditional
transfer. Additionally, ndings suggest
that it is reasonable to expect that future
development of risk transfer solutions in
Serbia will follow the path that has been
passed by global insurance industry.
KEY WORDS: insurance, reinsurance,
alternative risk transfer, securitisation,
Serbian insurance market
JEL CLASSIFICATION: G22, D81, G28, E44
ECONOMIC ANNALS, Volume LIV, No. 180, January – March 2009
UDC: 3.33 ISSN: 0013-3264
58
Vladimir Njegomir and Rado Maksimović
1. INTRODUCTION
Insurance always involves risk transfer, which according to Rejda (2005: 21-22)
means that a pure risk is transferred from the insured to the insurer, who typically
is in a stronger nancial position to pay the loss than the insured. us, insurers
can better manage pure risks than individual insureds due to the application
of central limit theorem and the law of large numbers. However, in reality the
possibility that real losses will deviate from expected is very probable, especially if
there are positive correlations among risks in insurer’s portfolio, as it is in the case
with catastrophic events (OECD, 2005). In order to protect themselves from these
deviations insurance companies, in addition to the reserve formation, can raise
additional equity or debt capital and/or apply mechanisms of transferring risks to
other carriers. us, in insurance risk management the main dilemmas, related
to the aim of achieving optimal level of risk management, are to determine the
level of risk that will be retained and the level of risk that will be transferred and
which risk transfer solutions will be applied. As is shown in Figure 1, with regard
to the rst dilemma, the optimal level is achieved when retentions are established
at a given total reinsurance price (price of risk transfer) so that the remaining
variance cannot be further reduced by transferring more risk (Schmitter, 2003:
13).
Figure 1: Insurance risk management costs optimisation
Aer having made decision on optimal risk retention and transfer level, insurance
companies need to decide which risk transfer method or combination of them
will be used in order to further contribute to the optimisation of the total costs of
insurance risk management. In this regard we should know that the risk transfer
mechanism utilised by insurance companies for centuries has been reinsurance.
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
59
However, due to many factors, among which the most important has been the
capacity shortage of the global insurance and reinsurance industry1, the search
for alternatives of transferring the unbearable excess of insurance risks has
begun. e logical approach in obtaining additional risk transfer capacity was
to search for the possibilities of utilisation of large volumes of capital that are
available at capital markets.2 As a result of the innovations in insurance risk
transfer, insurance companies can now diversify their exposure, reduce the cost
of capital and expand the availability of insurance by transferring insurance risks
not only to reinsurers but also to capital markets investors. Numerous studies
(see for example, McGhee, C. et al., 2008, Global risks (2008), Klein and Mooney
(2008) and Cummins (2008)) indicate that although still modest in relation to
traditional reinsurance, the use of insurance-linked securities is broadening
and now can be considered as mainstream rather than alternative risk transfer
solutions.
Despite the fact that nowadays global insurance companies have the ability to use
traditional and/or alternative risk transfer solutions, in order to optimise their
risk transfer programs, the insurance companies in Serbia have only traditional
solutions at their disposal. However, it is reasonable to expect that capital market
solutions will be also developed and applied by Serbian insurance companies in
the future. In order to facilitate this development and to improve the eectiveness
of traditional solutions, it is important to understand the mechanisms of
currently available risk transfer solutions globally and their potential benets and
drawbacks. at is the rationale behind the fact why during the conceptualisation
we decided to rstly explore risk transfer solutions that are available to global
insurance companies and to determine if these solutions are mutually exclusive or
complementary to each other and then to briey describe the current practices of
domestic insurance companies, in regard to application of risk transfer solutions,
and to explain our opinion of their desirable future development in Serbia.
1 e capacity shortage has been provoked by increased frequency and severity of catastrophic
events. e rst event that marked the beginning of the new era in insurance risk transfer was
Hurricane Andrew that caused $23.654 million of insured losses indexed to 2007 (Enz, R.,
et. al. (2008), ‘Natural catastrophes and man-made disasters in 2007: high losses in Europe’,
Sigma No. 1, Swiss Re, Zurich, p. 40)
2 Capital markets are far more liquid and much more capital is available than on insurance and
reinsurance market. For example, according to BIS (2008) the notional amount of derivatives
outstanding at the end of 2007 was around $677 trillion, much more than the reinsurance
industry’s total capital of around $238 billion, measured as the sum of aggregate shareholders’
funds of the 30 leading reinsurance groups and subordinated debt (Beneld Group (2008),
Global Reinsurance Market Review: Changing the Game, London).
60
Vladimir Njegomir and Rado Maksimović
2. THE ROLE OF REINSURANCE IN INSURANCE RISK TRANSFER
In order to hedge portfolios of insurance risks that exceed their retention levels
insurance companies traditionally use reinsurance. Essentially, reinsurance is
insurance protection purchased by insurance companies. Although some forms
of reinsurance existed before3, the modern reinsurance started to develop from
1846, when Cologne Re was established as the rst professional reinsurance
company. Since then, reinsurance has the role of insurance risk reduction for
insurance companies, especially for the catastrophic risks. Although through
reinsurance insurance companies transfer insurance risks, which they initially
assumed from their insureds, there is no contractual relationship between
insureds and reinsurers. e need for reinsurance grew out from catastrophic
events, as was Hamburg re of 1842, but due to the increased frequency and
severity of loss events4 it was found that even the capacity of reinsurance market
is not enough. e reinsurers found solution in additional risk spreading through
the retrocession market. e mechanism of risk transfer through insurance,
reinsurance and retrocession is shown by Figure 2.
3 e oldest known trace of reinsurance existence is found in marine policy issued in Genoa in
1370. at policy covered the shipment of goods from Genoa to Sluys and the most dangerous
portion of the shipment trip, from Cadiz to Sluys, was reinsured (Herrmannsdorfer, F. (1926),
Bedeutung und Technik der Rückversicherung, Verlag von Piloty & Loehle, München,p. 332).
4 e increased frequency and severity of loss events are especially emphasised in the last
several decades due to the factors such as global warming, globalisation and accelerated rate
of economic development. For example, the number of human-made catastrophes worldwide
has risen from around 60 in 1970 to nearly 250 in 2005, while the number of natural
catastrophes over the same period has risen from around 30 to nearly 150. (Zanetti, A. and
S. Schwarz (2006), ‘Natural catastrophes and man-made disasters 2005: high earthquake
casualties, new dimension in windstorm losses’, Sigma No 2, Swiss Re, Zurich). Another
researches suggest the increased severity of catastrophes as possibility that future Hurricanes
impacting the Northeast USA and Florida could create losses of $20b and $75b, respectively,
a California earthquake or continental European windstorm could lead to losses of $50b to
$100b, an 8.5 magnitude earthquake in the New Madrid Seismic Zone of the central USA
could create $100b of losses, and a repeat of the devastating 1923 Tokyo Earthquake in today’s
market could lead to losses of $500b to $1t. (Banks, 2005: 10).
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
61
Figure 2: e mechanism of risk transfer through insurance,
reinsurance and retrocession
As is shown in Figure 2, the risk transfer can be accomplished through direct
or indirect relationships between contracting parties. Its path starts with the
insureds that transfer life or non-life insurance risks and accompanying premiums
through insurance market to insurers. If insurance company does not have
enough capacity to retain the total risk it transfer the total risk exposure or the
certain percentage of it, and accompanying premium, to one or several reinsurers
in the process called cession. For some exceptionally large risks, such as risks in
marine or aviation insurance, reinsurers transfer risks to other reinsurers5 in the
process called retrocession. If the loss event occurs, from own nancial resources
insurer will compensate insured for the nancial losses, but if that loss event or
its share was reinsured and later retroceded, retrocessionaire will compensate
reinsurer who will then compensate insurer in the same proportion as was the
proportion of initially transferred risk and premium.
e explained risk transfer mechanism is universal but many dierent types
of reinsurance coverage exist. e two basic types of reinsurance contracts
are facultative agreements, which are intended to cover individual risks6, and
5 Although in the Figure 3 the term retrocessionaire is used, there are no companies that
specialise in retrocession business alone. is term is used to describe the function of the
reinsurer who assumes the risk and receives the accompanying premium while reinsurer who
transfers risk and premium is called retrocedant.
6 ey are basically separate reinsurance agreements negotiated for each insurance policy that
insurance company wishes to reinsure.
62
Vladimir Njegomir and Rado Maksimović
treaty agreements, which are intended to cover portfolios of risks. Both types
of reinsurance agreements can be in proportional, which means that reinsurer
takes a determined share of risk for the same share of premium and when a loss
occurs it is indemnied in that same proportion, or non-proportional form of
reinsurance cover, which means that the reinsurer indemnies the ceding insurer
only for losses that are in excess of cedant’s retention, subject to the reinsurance
upper limit.7
Although there are numerous types of reinsurance cover, all of them have
the same major aim of reducing risk in insurer’s portfolio, or in other words,
the purchase of reinsurance can substitute for capital and allow an insurer to
hold less capital without increasing its insolvency probability (Harrington and
Niehaus, 2004: 89). In the same way as insurance reduce the standard deviation
of real claims from expected, reinsurance by pooling of risks of dierent insurers
reduce the standard deviations of claims costs for each of them. If we assume that
expected claims costs for insurer are equal to μ and his assets are equal to μ+x
and hence the capital is equal to x, then the reinsurance will lower the probability
of insolvency from the area under the “without reinsurance” curve in Figure 3 to
the area under the “with reinsurance” curve.
Figure 3: Probability distribution of claims costs with and without reinsurance
Source: Modied according to Harrington and Niehaus (2004: 90)
7 Insurers can use dierent types of reinsurance or their combinations, but usually non-life
insurers require more reinsurance than life insurers. According to IAIS (2007: 16) the share
of life insurance risks in 2006 was 24% while non-life insurance risks made the remaining
share in total reinsurance premiums. Also, proportional reinsurance contracts are used more
than non-proportional (International Association of Insurance Supervisors (2007), ‘Global
Reinsurance Market Report 2007’, Basel, Switzerland).
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
63
Figure 3 clearly shows that if there is reinsurance the variation of real from
expected losses will be lower and thus the need for capital for coverage of the
deviations would be lower. In addition to this basic function of reinsurance, it
has many other benets to insurance companies and other stakeholders, such
as nancial stability and solvency protection, reduction in volatility of earnings
or sudden uctuations in the premium rate, reduction of loss of equity capital,
reduction of the possibility of loss of job or regular tax payments, facilitates better
compliance with regulatory constraints, enhance insurability, insurance products
become less expensive, increase competitiveness and international spreading of
risks, reduce capital costs and increase protability and by lowering the necessary
capital it facilitates opportunities for development of new markets and products.
However, reinsurance has some drawbacks such as the need to renew cover as it
is provided usually on an annual basis; the capacity is limited and volatile as are
reinsurance premiums8 and having reinsurance cover means being exposed to
the credit risk.9
e transfer of insurance risk from insurers to reinsurers is done through the
global reinsurance market. e global nature of reinsurance market is one of its
key specic characteristics. Reinsurance market is de facto secondary market for
insurance risks and it may be seen, according to Rotar (2007: 565), as a market
where commodities to be exchanged are risks. is market is highly concentrated10
and for decades it was considered as adequately capitalised to oer additional
protection for the insurance risks coverage, especially for the catastrophic
ones. However, due to increased frequency and severity of loss events in the last
several years, and especially aer Hurricane seasons of 2004 and 200511, which
8 e volatility of reinsurance premiums is oen characterised by cyclical nature of reinsurance,
that is to say, reinsurance market continuously passes through phases of “so” and “hard”
market (Njegomir, 2006a). “So” market is the phase in reinsurance cycle when capacity is
freely available, pricing is cheap and terms, conditions and exclusions are not rigidly enforced
(Paine, 2004: 21).
9 Credit risk in reinsurance business is the risk of reinsurer default, or in other words, it is the
risk that reinsurer will fail to pay the claims under a reinsurance contract.
10 At the beginning of the new millennium the group of 10 leading reinsurance companies
accounted 60% of worldwide reinsurance premium, compared to 40% a decade earlier (Group
of irty, 2006: 12), while in 2006 in property and casualty reinsurance market, 10 leading
reinsurance companies had the market share of 54% (Beneld (2007), ‘Global Reinsurance
Market Review: Pick ‘n’ Mix’, Beneld Group, London, p. 23).
11 According to IAIS (International Association of Insurance Supervisors (2007), p. 20) natural
catastrophes are the most notable threat to the stability of the reinsurance industry as was
illustrated by hurricane season of 2004 and 2005, which cost insurance industry $30 billion
and $83 billion respectively.
64
Vladimir Njegomir and Rado Maksimović
demonstrated how catastrophe events can endanger even the upper layers of
reinsurance coverage, reinsurance and especially the retrocessional capacity
became limited due to the fact that large share of losses from these events have
been cover by reinsurers (see Figure 4).
Figure 4: Share of insured losses from the chosen
catastrophic events paid by reinsurers
Source: Insurance Information Institute (2007).
Although these losses had the great impact on the availability of reinsurance
and retrocessional coverage, the most important consequence of the recent
catastrophic events has been the perception change in relation to potential
size of losses as well as the lowered risk appetite towards large risks (Njegomir,
2006b: 69). As a result of combined eect of high reinsurance prices and limited
availability of coverage and subsequent increased scrutiny in solvency regulation
by supervisors and rating agencies, insurance and reinsurance companies rapidly
started to search for alternative risk transfer solutions. However, it must be noted
that some forms of alternative life and non-life insurance risk transfer solutions
existed even before the new millennium, but the stated combined eect gave
the impetus for exponential growth of new risk transfer solutions in the last few
years.
3. ALTERNATIVE INSURANCE RISK TRANSFER SOLUTIONS
e development of alternative risk transfer solutions is part of a bigger trend
of convergence of insurance and capital markets. e word converge means
“to come from dierent directions and meet at the same point to become one
thing” (Longman, 2003: 343). at is exactly what is happening with insurance
and capital markets. In addition to insurance risk transfer to capital markets,
this trend encompass developments such as issuance of insurance contracts for
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
65
risks that has previously been managed by capital market instruments or selling
of insurance contracts by banks, the process called bancassurance. In regard to
alternative risk transfer solutions and gradual disappearance of demarcation
lines between insurance and capital markets, the convergence is visible as it is
no longer important, from a purely economic view, whether a certain product is
formally insurance or reinsurance, or whether insurance solutions are combined
with banking approaches to create a mixed product (Bock and Seitz, 2002: 4).
e most comprehensive denition of alternative risk transfer found states that
“alternative risk transfer products are contracts, structures, or solutions provided
by insurance and/or reinsurance companies that enable rms either to nance or
to transfer some of the risks to which they are exposed in a nontraditional way,
thereby functioning as synthetic debt or equity in a customer’s capital structure”
(Culp, 2002: 352). Hence, alternative risk transfer (ART) is not a single product
and can be described as a way of doing business (Hartwig and Wilkinson, 2007:
925). e reason we use the term solutions rather than products or instruments
is because ART includes alternative carriers (such as captives, risk-retention
groups and pools) and alternative products (such as nite risk reinsurance, run-
o solutions, committed or contingent capital, multi-line, multi-year products,
multi-trigger programs, structured nance and new asset solutions, and capital
market solutions) which are available to corporations and insurance and
reinsurance companies. However, our discussion on the role of alternative risk
transfer solutions will be limited to the nontraditional12 solutions in insurance
risk management utilised by insurance and reinsurance companies.
Although the history of application of alternative risk transfer solutions can be
traced back to 1970’s13, the most important stimulus for their development, in
relation to risk transfer to capital markets, was the capacity shortage of the global
reinsurance and retrocession market during 1990’s and especially aer Hurricane
seasons of 2004 and 2005. In the last two decades these solutions pass through
the transformational change from “the exciting idea” (Hengesbaugh, 1998: 119)
through “the brave new world” (Laster and Raturi, 2001) to “mainstream” solution
(McGhee et. al., 2008).
12 ese solutions are nontraditional in the sense that insurance risks are transferred, or in other
words repacked and sold to capital market investors, in particular to institutional investors,
instead to be transferred to traditional reinsurance or retrocession market.
13 e rst ART forms were alternative carriers like captives and captive-like structures that
were developed during 1970’s while the rst form of alternative products, utilised by insurance
companies, were life insurance securitisation developed during late 1980’s.
66
Vladimir Njegomir and Rado Maksimović
As previously mentioned, the capital markets have come to be seen as an
alternative source of capacity for catastrophe protection, especially in the area of
natural catastrophes. Securitisations, in particular, have been used by insurance
and reinsurance companies in the circumstances of scarce capacity and high
prices at reinsurance and retrocession markets.14 However, other factors such
as the need for economic value maximisation, taxes, regulatory constraints
and deregulation of nancial services industry contributed to the development
of ART solutions. All mentioned factors contributed to the attractiveness of
these new solutions to insurance and reinsurance companies, but the growth
of ART solutions would not be of such pace if there was no interest from the
investors, who saw the attractiveness in this instruments because insurance
risk is uncorrelated with other risks in investors portfolio, thus provide the
diversication benet for investors and oers relatively high returns.15 Also, these
solutions enable investors to invest in insurance risk and prot from it without
the need to tie up their capital for a longer period, as it would be in the case of
investment in insurance and reinsurance companies’ equities. Hence, investors
participate only in sharing of insurance risks and not in sharing of all risks that
insurance or reinsurance company is exposed to. ese reasons, accompanied
with advances in technology16, attracted more diverse investor base17 and were
14 Aer Hurricane Katrina of 2005 majority share of new capital in 2005 and 2006 in insurance
and reinsurance industry has been raised by recapitalisation and by the foundation of new
companies despite the fact of the increasing role of ART solutions and especially cat bonds,
which issuance doubled in 2006 in relation to 2005, while the majority share of new capital
raised in 2007 was through utilisation of sidecars and cat bonds, which new issuance exceeded
$7 billion and doubled in relation to 2006. us, even aer Hurricane season of 2005, when
they have marked the highest development, alternative risk transfer solutions have been used
by insurers and reinsurers only as a supplement to traditional capacity.
15 For example, the return on catastrophe bonds, measured as a spread over some reference
rate such as LIBOR, has been reduced in 2007 (Beneld (2008), ‘Global Reinsurance Market
Review: Changing the Game’, Beneld Group, London). However, in the period from June 2007
to June 2008 Swiss Re’s BB-rated Cat Bond Total Return Index showed better performance
than Lehman’s BB High Yield Corporate, which means that cat bonds oered investors better
returns than corporate bonds in the period (GR, 2008: 68). is is particularly important as
this period is characterised by the existence of nancial crisis.
16 On the basis of new technologies such as catastrophe models, mapping soware, dynamic
nancial analysis, scenario testing and dynamic portfolio optimization investors that are
not familiar with insurance risks as insurance and reinsurance companies are can easily get
information on various types of natural disasters at a relatively low cost.
17 e leading investors in these solutions at their inception were insurance and reinsurance
companies but in such circumstances it could not be said that ART market actually attracted
very much new capital into the nancing of catastrophic risk (Cummins, 2008). However,
hedge funds, pension funds, money market funds, investment banks and dedicated
catastrophe funds recently started investing in the market.
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
67
behind the increased interest of investors in ART solutions during the nancial
crisis of 2007 and 2008. Finally, it must be noted that the development of ART
market was facilitated by the interest of intermediaries such as stock exchanges,
investment banks and insurance and reinsurance brokers who found possibilities
of new business opportunities.
e basic issue for insurance companies regarding utilisation of ART solutions
is to compare them to traditional reinsurance and on the basis of cost/benet
analysis choose the right solution or combination of solutions that would best
suit their needs. Both, reinsurance and ART solutions have certain advantages
and disadvantages that need to be factored in when making such decisions (see
Appendix 1).
ART solutions have been primarily used for accounting and capital relief purposes
by life insurance companies, thus they have been focused more on risk nance
than risk transfer. In the eld of non-life insurance ART solutions have been
primarily used for nancing peak catastrophe risks in conditions of scarce and
expensive capacity. However, these solutions can oer insurance companies other
benets in addition to supplementary capital. Actually, their primary objective
has been to increase insurability of risks. e main advantage of ART solutions
in comparison to traditional reinsurance is the possibility of moral hazard and
credit risk elimination, because by addressing these issues and oering coverage
where traditional capacity is not available or is limited, they can increase limits
of insurability. Moral hazard is present in insurance and reinsurance as they
are indemnity based, which means that the indemnication is directly linked
to actual losses what creates possibility, because of the information asymmetry
between buyers and sellers of coverage, for behavior change of insureds or
insurers in sense that they can directly inuence the underlying risks. By applying
triggers that are not indemnity based, such as indexed or parametric, the moral
hazard problem can be reduced or eliminated. Credit risk, that is inherent to
traditional reinsurance, as explained above, can be avoided by collateralisation,
which means that funds invested in risk-linked security are kept in collateral
trust that serves as a guarantor for future contingent payments. Additionally,
ART solutions can lower insurers’ and reinsurers’ costs by using indexes which
facilitates avoidance of administrative costs related to loss handling, as there
would only be need for index to reach certain attachment point (trigger) and thus
there would not be need for the provement of losses, and by sharing acquisition
costs with institutional investors, especially in life insurance. Also, they usually
oer multi-year coverage thus helping reduction in volatility of coverage prices
and avoidance of reinsurance market cycles.
68
Vladimir Njegomir and Rado Maksimović
However, the ART solutions have certain disadvantages as they are usually
complex to structure, time-consuming and expensive.18 e main issue, which
concerns insurance and reinsurance companies when they consider ART
solutions, is the presence of basis risk, the risk that coverage and losses will be
mismatched, if trigger other than indemnity-based is used.19 Also, ART solutions
are still not recognised by regulators and supervisors in relation to capital relief
on the same footing as is reinsurance. However, the recent developments in
regulation such as Solvency II project, which is designed to reward insurance
companies, in the form of capital relief in the context of solvency regulation, for
every kind of risk transfer as long as they can demonstrate that they understand
the nature and limitations of the techniques used and that the real transfer exists
and Reinsurance Directive, which gave the legitimacy to Special Purpose Vehicles
that are necessary in structuring of risk securitisation transactions, will solve the
problem and potentially will give additional impetus for the development of ART
solutions.
Finally, when choosing adequate risk transfer solution(s) insurance companies
need to consider the market conditions. Although it is reasonable to expect
that insurance and reinsurance companies will use ART solutions only when
reinsurance and retrocession capacity is limited and expensive, it is not really
true, as the empirical evidence from 2007 and 2008 showed. Despite the so
reinsurance market insurance-linked securities maintained the interest of
investors but also insurance and reinsurance companies. Actually, insurers and
reinsurers have followed the logic that even if one source of credit is slightly more
expensive than another, a company might still access both just to be prepared
for changing market conditions (Laster and Raturi, 2001: 15). In other words,
insurers and reinsurers showed interest in maintaining relationships with capital
market investors in order to be able, if market conditions harden, to transfer risks
to them.
3.1 Securitisation – catastrophe bonds
Securitisation rstly appeared in the US during 1970’s in the form of monetisation
of mortgages while in Europe it rstly appeared during 1980’s. Since then, until the
credit crisis of 2007 that became nancial crisis in 2008, there has been continuous
18 For example, securitisations of insurance risks through bonds are still very expensive and
they require about $100 million as a minimum volume to make them economically viable
(Zeller, 2008).
19 For example, a Hurricane or other catastrophic event may not trigger the insurance-linked
security although it can create substantial damages for insurer.
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
69
growth of these transactions in the US while growth in Europe continued even
in 2007 despite the crisis (ESF, 2008). ere are many dierent denitions of
securitisation which are essentially similar as the fundamental purpose of the
securitisation is transformation or monetisation of illiquid nancial assets, such
as credit, leasing and other receivables, into tradable securities. However, it is
worth mentioning denition given by Schwarcz (1994) who links securitisation
with an alchemy, technique used by medieval chemists to turn base metals
into gold, and explains that this alchemy really works as it enables companies
to partly “deconstructs” themselves by separating certain types of highly liquid
assets from the risks generally associated with the functioning of the company,
and then using these assets to raise funds in the capital markets at a lower cost
than would be the cost of raising funds by issuing more debt or equity. Securities
that are “born” as a product of securitisation transaction are fully collateralised
by assets, thus economic interest as well as associated risks in these assets are
transferred to investors.
In insurance business securitisations were rstly utilised by life insurance
companies during late 1980’s. ese securitisations were not specic to insurance
business except they referred to monetisation of receivables from insurance
contracts. Essentially, there are three types of life insurance securitisations:
securitisation of embedded value, reserve funding securitisation and insurance risk
securitisation. e reasons for the development of securitisation in life insurance
were more result of regulatory pressures and nancial needs than problems with
capacity shortages of reinsurance and retrocession market, although they allow
insurance companies to hedge risks in addition to capital raising. Additionally,
securitisation has the potential to improve market eciency and capital utilisation
thus enabling insurers to better compete with other nancial institutions, increase
return on equity and improve their operating performance (Cummins, 2004). As
their mechanism is similar to mechanism used in catastrophe bond transactions
they will not be discussed further.
Catastrophe bonds utilise securitisation in order to obtain additional capacity
for insurance risk transfer in the circumstances of capacity shortage of the global
reinsurance and retrocession market. Although the methods of securitisation
of receivables are implemented, catastrophe bonds actually represent risk
securitisation transactions that are intended to nance the risk transfer from
the originator, typically insurance and reinsurance companies, and securities
issuer, who is usually called Special Purpose Reinsurance Vehicle (SPRV). e
goal of these transactions is not raising funds, as it is with other securitisations,
70
Vladimir Njegomir and Rado Maksimović
but management of the insurable risk. Typical catastrophe bond transaction is
shown in Figure 5.
Figure 5: Mechanism of a typical catastrophe bond transaction
In a typical transaction of insurance risk transfer to the capital markets investors,
insurance company as a transaction sponsor transfers assumed insurance risks
from insureds to reinsurance company or directly to the SPRV, which has the
role of retrocessionaire in the rst case or reinsurer in the second. e coverage
provided by bankruptcy remote20 SPRV is similar to quota-share, excess-of-loss
reinsurance. e SPRV issues bonds that refers insurance risks and sell them to
investors, thus it repackages untradeable insurance risks to tradable securities.
e principal received and premiums are invested through the collateral trust,
thus the coverage for insurance or reinsurance company is fully collateralised and
thus credit risk is minimised. If needed the collateral trust can swap interest from
investment acquired for an interest rate based on LIBOR increased for a spread.
Insurance company acts as a servicer to investors as its obligation is to collect
premiums from insureds and transfer them to the SPRV. Sometimes investors
20 SPRV must be bankruptcy remote and not associated with the sponsoring insurance or
reinsurance company. is means that the obligations of insurance companies other than
those that originate from transferred insurance risks are not of investors’ interest. If insurer
or reinsurer goes bankrupt the obligations of SPRV to investors will not be aected.
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
71
can seek credit enhancement, for example in the form of credit guarantees. If
during the period of coverage the triggering event do not happen, investors will
receive the principal invested increased with interest based on LIBOR plus spread.
However, if triggering event does occur, the investors might lose the interest but
sometimes the principal as well.
e basic dierence between catastrophe bonds, as securities linked to insurance
risks, and other securities that are based on the nancial assets are triggers that are
used. Catastrophe bonds use four types of triggers: indemnity-based, modelled
loss, industry loss indexes and parametric triggers. Indemnity-based triggers
are based on actual insured losses experienced by the sponsoring insurance or
reinsurance company. ese triggers tend to be most favored by sponsors as the
cover is most closely aligned to the actual catastrophic loss and hence the basis risk
is minimal. Other three types of triggers have been more appealing to investors.
ese triggers include trigger that is based on modelled company losses, trigger
that is based on industry loss indexes such as the Property Claim Services index,
an indicator of catastrophe-related property losses products by Insurance Services
Oce, a New Jersey-based insurance data specialist, and parametric triggers
where the payout from a bond to sponsors is based on a certain independent
parameters, such as wind speed or the Richter scale for earthquakes.
Although rst catastrophe bonds appeared aer Hurricane Andrew of 1992
and Northridge Earthquake of 1994, the wider acceptance these alternative risk
transfer solutions gained aer hurricane seasons of 2004 and 2005.21 ey oer
insurance and reinsurance companies complementary capacity to traditional
reinsurance and retrocession, especially for peak catastrophe risks.22 ey also
eliminate counterparty credit risk as they are fully collateralised, oer multi-
annual coverage that helps eliminates the unpredictability in available capacity
and pricing that are inherent to each traditional reinsurance renewal season and
has not only the potential for improvement of the overall balance sheet position,
21 eir growth in the period from 2000 to 2007 was above 200% but the volume of transactions
of larger value, those exceeding $200 million, signicantly increased during 2006 and 2007
(Klein, and Mooney, 2008)
22 Catastrophe bonds are used for earthquake risk (for California, US Midwest, Japan, France
and Monaco), hurricane risk (for US Northeast/Atlantic, US Golf coast, Puerto Rico, Hawaii
and Japan) and for European windstorm and hailstorm risk (Banks, 2004: 124). Additionally,
Australian wind/earthquake and Mexican earthquake were perils for which catastrophe bonds
were rst issued in 2006 (Klein, and Mooney, 2008). During 2007 catastrophe bond coverage
expanded to include multiple perils as well as new risks such as European earthquake risk
(Beneld (2008), ‘Global Reinsurance Market Review: Changing the Game’, Beneld Group,
London).
72
Vladimir Njegomir and Rado Maksimović
but also helps in stabilisation of earnings and therefore in raising shareholder
value. As is the case with other alternative risk transfer solutions, catastrophe
bonds oer investors ability to invest in insurance risks that are uncorrelated
with other risks in their portfolios and to gain additional, relatively high income.
e main drawbacks of catastrophe bonds is the presence of basis risk in addition
to illiquidity, high expenses, the need for a lot of analytical work and modelling
which leads to relatively long periods of time for their establishment and in
Europe in particular, their development was hindered by lack of appropriate
indexes, such as Property Claims Services index in the US.
3.2 Contingent capital
Contingent capital is a pre-loss alternative risk transfer product that enables
insurance or reinsurance company with the possibility to issue securities such as
equities and bonds and structured securities such as catastrophe bonds. e word
“contingent” is used to dierentiate these structures from the paid-in capital,
which understands classical meaning of capital that is available to insurance and
reinsurance companies upon issuance of equities or bonds. Contingent capital
is low-cost o-balance sheet alternative (Culp, 2002a) that provides conditional
coverage upon the occurrence of some triggering insurable event. Figure 6 is
included in order to provide better understanding of the dierence between paid-
in and contingent capital by presenting their most simplied structures.
Figure 6: e dierence between paid-in and contingent capital
on the example of put option on stocks
Source: Modied according to Munich Re (2001).
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
73
Paid-in capital structures have been common for many years and they are
usually utilised in order to raise capital by issuing securities for which insurance,
reinsurance and other companies receive cash payments immediately aer the
completition of the transaction. Contingent capital structures, however, provide
insurers and reinsurers with the right, but not the obligation, to issue specied
security in the future at specied terms regarding price, triggering event and
the time frame. For example, if the catastrophe happens during the period of
option validity the insurer or reinsurer will have the right to sell securities to
investors (option writers) at prices that are agreed in advance. e predetermined
price is very important for insurance companies as aer the occurrence of
catastrophic event it is usually very hard to obtain nancial resources at prices
that were prevailing before the occurrence of the triggering event and in addition,
reinsurance and retrocession markets capacity becomes scarce and expensive.
e costs of structuring contingent capital deals are much lower than are for
catastrophe bonds as these deals are made through private placements (Culp, 2006)
and usually the main cost is option fee paid to option writer at agreed intervals.
Additional benets of contingent capital include balance sheet protection when
it is most needed and access to nancing with neither a corresponding increase
in leverage nor a dilution of shareholders’ equity (Beneld, 2008). However, due
to the fact that they are usually structured as private placements, by utilising
contingent capital structures insurers and reinsurers are exposed to the increased
credit risk of the option writer.
e most widespread type of contingent capital structures utilised by insurance
and reinsurance companies are catastrophe equity puts (Cat-E-Puts). e
structure rst developed by insurance and reinsurance broker Aon in the wake
of Hurricane Andrew and the Northridge Earthquake is the most popular
transaction format used mainly by reinsurers (Ehrhart, 2002). is puts enable
insurers and reinsurers to raise capital by issuing equities at a pre-agreed price
aer the occurrence of the catastrophic event. However, due to the exposure to
credit risk they haven’t attracted as much interest as catastrophe bonds.23
3.3 Insurance Derivatives
Insurance derivatives are nancial derivatives that are used for insurance risk
hedging. In order to understand the mechanism of insurance derivatives it is
important to briey explain nancial derivatives. e broadestly accepted
23 For example, while cat bond issuance in 2007 reached $7 billion the total size of contingent
capital deals reached $1.2 billion (ibid.).
74
Vladimir Njegomir and Rado Maksimović
denition of nancial derivatives is given by the Group of irty (1993) according
to which a derivatives transaction is a contract whose value depends on (or
“derives” from) the value of an underlying asset, reference rate, or index. Financial
derivatives rstly appeared during 1970’s and their origin was inuenced by
ination pressures, high oil prices and breakdown of the Breton Woods system
of monetary management that resulted in increased volatility of interest and
exchange rates. Financial derivatives are essentially contracts that are traded at
nancial markets either through organised exchanges (futures and options) or at
over the counter markets (forwards, options and swops).24
As nancial derivatives provided a good mechanism for interest and exchange
rate risk hedging, during 1990’s the similar mechanism is implemented for
insurance risks. e basic dierence of insurance derivatives is that they are
derived from insurance risks rather than from typical nancial market risks.
Insurance derivatives enable insurance and reinsurance companies to transfer
insurance risks to capital market investors and serve as a complement to
traditional reinsurance and retrocession while investors are oered additional
opportunity to diversify risks in their portfolios. Additionally, investors can
achieve supplementary returns by speculating on natural catastrophes (Doherty,
2000). Insurance derivatives include futures, options, catastrophe swaps and
industry loss warranties.
First insurance derivatives introduced by Chicago Board of Trade (CBOT) in
1992 were catastrophe insurance futures contracts. e values of these contracts
were derived from the value of the index which was based on a loss ratio for
the pool of 100 insurance companies in Insurance Services Oce index (Lane,
2006). In 1993 this exchange introduced options on these futures but because
of insucient interest both instruments were replaced with options based on
Property Casualty Services index, which measures loss instead of loss ratio.
However, these new instruments experienced the same fate as derivatives from
1992 and 1993 and were delisted in 2000. Until 2007 there was no trading of
24 Futures and forwards are contracts that obligate buyers and sellers to exchange specied assets
at specied price at specied future date. e only dierence is that futures are standardised
while forwards are not. Swaps are most widespread nancial derivatives and while also
refer to future they enable contracting parties to exchange cash ows from specied assets
instead of exchanging assets for specied price (Bank for International Settle ments, (2008),
BIS Quarterly Reviews, Basel, Switzerland, http://www.bis.org/publ/quarterly.htm, accessed
10 November 2008). Options are not standardised nancial derivatives that provide option
buyer with the right but not with the obligation to sell, in the case of put option, or to buy, in
the case of call option, certain assets at specied price during specied time period.
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
75
insurance risks at exchanges. However, in 2007 the New York Mercantile Exchange
(NYMEX), Chicago Mercantile Exchange (CME) and Chicago Climate Futures
Exchange (CCFE) started trading with futures and options that refer catastrophe
insurance risks (Beneld, 2008). Trading of futures and options25 on NYMEX
is based on the same index that was used by CBOT in 1992 although now exist
three separate indexes (National, Florida and Texas-Maine) that are calculated
by dividing insured losses by $10 million. CME uses CME-Carvill hurricane
index derived from hurricane risk in the US26 while CCFE uses index developed
by Insurance Futures Exchange Services27. e advantages of exchange traded
options and futures are transparency, standardisation, relatively low credit risk
and the fact that the standard margin requirements are dened by exchange.
However, due to the fact that these instruments are based on excessive modelling
or historical loss records they are not best correlated with industry losses thus the
basis risk is present. However, unlike to rst attempts from 1990’s the insurance
and reinsurance industry as well as investors expressed more interest in these
instruments.28 Although the trading volume is still low it could be reasonable
expected that in future these derivative instruments will have important role as a
supplement to traditional reinsurance programmes.
Catastrophe swaps are insurance derivatives instruments that enable insurance
and reinsurance companies to exchange two or more catastrophic risks. e risks
25 Options are actually exchanged in the over-the-counter market but the clearing is done on
NYMEX.
26 CME-Carvill hurricane index is actually a suite of products that covers ve zones: eastern
US coastline, Gulf coast, Florida, southern Atlantic (from Georgia to North Carolina) and
northern Atlantic (from Virginia to Maine). e indexes are calculated by using publicly
available information on maximum wind velocity and size of each storm provided by National
Hurricane Center of the National Weather Service (Smith, S. (2008), An index to measure the
destructive potential of hurricanes, Chicago Mercantile Exchange, http://www.cmegroup.com/
trading/weather/les/WEA_chi_whitepaper.pdf, accessed 05 November 2008).
27 is index is used for trading of event linked futures that are modelled on Industry Loss
Warranty reinsurance policies, but are contracts for dierence, rather than reinsurance
policies. Initially only ‘First Event’ contracts were listed and Second Event contracts
were introduced on May 2 2008. On July 11 2008 IFEX (Insurance Futures Exchange Services
website, http://www.theifex.com, accessed 05 November 2008) listed First and Second Event
Tropical Wind event linked futures contracts for Florida and for the US Gulf Coast (the states
of Alabama, Mississippi, Louisiana and Texas).
28 While the total number of contracts that were traded at CBOT was below 20000, during the
rst seven months of 2008 there was 30000 contracts traded at CME (Risk and Insurance
(2008), ‘Gustav’s ‘Live CAT’ Capacity’, Risk and Insurance magazine, LRP Publications,
Horsham, PA http://www.riskandinsurance.com/story.jsp?storyId=124326385, accessed 20
September 2008).
76
Vladimir Njegomir and Rado Maksimović
can be exchanged as a oating-for-oating swap contract, in which one reinsurer
makes cash payments to another reinsurer following a triggering event in exchange
for receiving LIBOR plus a spread, or they can be exchanged with one another
(Lane, 2006). Figure 7 presents the example of catastrophe swap transaction when
dierent catastrophe risks are exchanged between two companies.
Figure 7: Example of catastrophe swap transaction between Japanese insurance
company Mitsui Sumitomo Insurance and Switzerland-based reinsurer
Swiss Re
Source: MSI (2003)
In the shown transaction Mitsui Sumitomo Insurance company exchanged29 $50
million of Japanese typhoon risk for $50 million North Atlantic hurricane risk
and $50 million of Japanese typhoon risk for $50 million European windstorm
risk. is transaction is done on parity basis which means that there was no
exchange of money, although such swap transactions are also possible. Swap
transactions helped these companies to reduce their peak exposures to certain
risks and to diversify existing risks in their portfolios, thus freeing capital for new
business acquisition or for regulatory purposes. In addition, because a risk swap
transaction does not harm any existing prots of the swap counterparties, capital
eciency of both should improve (Takeda, 2002). Swap transactions are privately
placed transactions what makes them less expensive than other alternatives
but also exposes counterparties to the credit risk of the other counterparty.
Additionally, as they are based on excessive modelling basis risk is present
more than in some competitive solutions. However, the main problem for swap
transactions is nding the right counterparty. With the aim to solve this problem
the Catastrophe Risk Exchange was formed in 1994 in Princeton, New Jersey. It
is actually a company with the main objective to facilitate parties in buying and
selling reinsurance coverage and to transact reciprocal reinsurance swaps.
Another important development in the eld of insurance derivatives was
industry loss warranties. Industry loss warranties, originated in London in the
late 1980’s, are actually reinsurance contracts that have two triggers. e rst is
29 Each party respectively ceded and assumed specic catastrophe reinsurance contract(s) to/
from the other party.
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
77
indemnity trigger that is based on the losses that buying insurance or reinsurance
company experience and the second is warranty trigger that is based on losses
experienced by the whole insurance industry. All triggers must be hit in order
for industry loss warranty to pay o its buyers for specied catastrophe event in
specic geographic region. Because of the retention of the rst trigger industry
loss warranties have regulatory treatment as reinsurance contracts, what makes
them appealing for insurance and reinsurance industry participants. Although
industry loss warranties are exercised as private transactions (Beneld, 2008) and
thus the limitation of reliable data on utilisation of these instruments exists, there
are estimates that in 2007 the total market value of these instruments exceeds $4
billion (Pennay, 2007:3) and even $7 billion (Wheeler and Janeke, 2008: 4). Despite
the fact that the basis risk is present, which is certainly one of the main concerns
for insurers and reinsurers, the main obstacle to their development in Europe has
been the lack of reliable and independent industry loss index. Although Swiss
Re and Munich Re had developed two loss indexes they are not widely accepted
because insurance industry participants associate them with exposure to basis
risk and found them biased and of limited geographic spread (Beneld, 2008).
In order to solve this problem, Swiss Re, Munich Re, AXA, Zurich Financial
Services and Allianz started initiative for the development of independent body
that will create reliable European loss index such as that of Insurance Services
Oce in the US.
3.4 Reinsurance sidecars
Sidecars30 are alternative risk transfer solutions which have similarities to cat
bonds and traditional reinsurance and can be used as a supplement to both.
Although the similar structures existed for several years before,31 the true
enthusiasm for them was expressed aer hurricane season of 2005. During 2006
$3.6 billion of equity and loan capital was raised through sidecars to support
mainly North American catastrophe risk (Beneld, 2007), while in 2007 only
around $1.15 billion of new capital has been raised through sidecars (Beneld,
2008). Although they also marked signicant presence in 2008 (Klein and
Mooney, 2008) it is estimated that the interest for them is decreasing because
of the currently present “so” reinsurance market. However, because of their
30 Sidecars are small vehicles attached to the side of a motorcycle, in which a passenger can ride
(Longman, 2003: 1532). In the sense of their application in insurance and reinsurance the
term “sidecars” is used to describe that these vehicles are used as o-balance sheet solution.
31 e existence of sidecars can be traced back to 1999 when State Farm and Renaissance Re
formed joint venture which lead to the formation of Top Layer in order to provide high layer,
catastrophic property coverage for RenRe’s portfolio of property programs.
78
Vladimir Njegomir and Rado Maksimović
advantages in providing additional capacity, they would probably be a viable
alternative when the reinsurance market hardens again.
A.M. Best (2006) denes them as limited-life special purpose entities that
generally provide property catastrophe quota-share reinsurance exclusively to its
sponsor. is denition suggests that they have limited lifetimes32 in the sense
that they serve to fulll the specic reinsurance needs to the sponsor. ey are
usually used with the aim to provide additional retrocession capacity on a short-
term basis for property or marine risks, although some sidecars have been used
for the life/health risks. Usually the structure of sidecars is based on a quota-
share reinsurance. e simplied sidecar structure is shown by Figure 8.
Figure 8: Simplied sidecar structure
Source: A.M. Best (2006)
Figure 8 shows that sidecar is actually a holding company, usually found at
Bermuda, which issues debt and equities to investors and colateralises full amount
of the ceded limit with the trust account. Sidecars provide reinsurers with the
possibility to underwrite more risks than their balance sheet capital would allow
but without the treat that their credit rating will be endangered33, as some of peak
risks are transferred o-balance sheet. In addition to fully collateralised coverage
32 Because of their limited lifetimes they are also called “disposable reinsurers”.
33 However, there are concerns of rating agencies that when they are written on an ultimate net
loss basis, some of the risks for which it was supposed that are transferred to the sidecar can
actually be borne by the sponsoring reinsurer (Beneld Group (2007), Global Reinsurance
Market Review: Pick ‘n’ Mix, London).
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
79
that minimises credit risk to the sponsoring reinsurance company, sidecars are
attractive to reinsurers as there is no need to disclose information (Klein and
Mooney, 2008) such is needed in a typical retrocession transaction. Because of
the simplicity of their structure (see Figure 8 and Figure 5) in comparison to
catastrophe bonds they are less time-consuming and the costs are lower than the
costs of traditional reinsurance, debt or equity nancing or establishment of new
reinsurance companies.
Sidecars as other alternative risk transfer solutions could not be developed if there
was no interest from investors such as hedge funds and private equity investors.
e main attraction of sidecars to investors is that they allow investments in
insurance-linked risks without the need to take on long-term investment risk,
the problem associated with the establishment of a reinsurance company. Also,
in comparison to traditional investment in establishment of a new reinsurance
companies sidecars provide the advantage of easy entrance and exit. In other
words, sidecars provide easy entrance to the market during the “hard” and the
easy exit during the “so” phase of reinsurance market cycle. Additionally, they
enable investors to diversify their portfolios with insurance risks, as they can
with catastrophe bonds, but unlike catastrophe bonds sidecars are simpler to
understand as they are, from investors’ point of view, very similar to traditional
investments in equity and debt securities.
4. CURRENT STATE OF RISK TRANSFER SOLUTIONS IN
THE SERBIAN INSURANCE MARKET
Although some embryonic forms of risk sharing existed before34, the development
of insurance business in Serbia started in 1868 with the establishment of rst
insurance companies Gresom and Anker, which were in foreign ownership.
First insurance companies established with majority share of domestic capital
were Beogradska zadruga and Srbija (Marović, 2001: 7) Aer the Second World
War insurance industry passed through the all development phases of economic
and social system of former socialist Yugoslavia. e worst period in domestic
insurance history has been the period of hyperination that destroyed insurance
companies’ funds that combined with irregularities in the functioning of insurance
companies resulted in a loss of condence in insurance. e consequence of such
34 e traces of primitive forms of insurance in Serbia can be found in Dusan’s Code of 1349.
80
Vladimir Njegomir and Rado Maksimović
developments was currently undeveloped insurance market.35 Only aer the
introduction of the new insurance law in 2004 insurance and partially restored
condence in the insurance industry, market started to develop. However, despite
the increased development in recent years, the market is still undeveloped because
of slow overall economic development.
While the rst idea for the establishment of state-dominated reinsurance company
was born in 1940 (Kočović and Šulejić, 2002: 15), until 1977 there was no any
professional reinsurer, although coinsurance as a way of spreading the same risks
between insurance companies existed.36 In 1977 the rst professional reinsurance
company Dunav Re was established and this marked the beginning of reinsurance
operations in Serbia. Nowadays reinsurance market in Serbia is represented by
three reinsurance companies, Novi Sad Re, established in 1980, and Delta Re in
addition to Dunav Re. e market is highly concentrated as the leading reinsurer
Dunav Re has a market share of over 70%. Although there are no reliable data on
the functioning of reinsurance companies, from the data37 found at insurance
companies’ balance sheets it can be assumed that approximately 10% of direct
insurers’ premium is transferred to reinsurers while a great part of the accepted
premiums in reinsurance is transferred to global reinsurance market. In this way,
national reinsurers actually collect small risks from local insurance companies
and then repackage them into an oer with premium volumes that are attractive to
global reinsurers. e reason of such protected position of reinsurance companies
is the insurance law (Insurance Law, 2004, Article 15) which made it obligatory to
insurance companies to reinsure with domestic reinsurance companies. However,
International Monetary Fund had recommended to National Bank of Serbia to
phase out restrictive trade practices regarding mandatory reinsurance cessions
35 e share of total premium in GDP in 2007 was just 2.04%, much lower than the EU average
of 9% while the total insurance premium per capita was about $103, which is fairly enough
when we know that the average salary was approximately $400, but is too low in comparison
to regional average of between $300 and $1000 of premium per capita. Additionally, measured
by the total premium volume of $766 million in 2007, Serbian insurance market’s share in
total world premium was 0.02% , despite the achieved real growth of 8.2% (Staib, D. and L.
Bevere (2008), ‘World insurance in 2007: emerging markets leading the way’, Sigma No 3,
Swiss Re, Zurich)
36 For example, the Yugoslav oil pipeline in Rijeka was coinsured from re and associated perils
by three insurance companies: Croatia, Sarajevo and Vojvodina with 50%, 32% and 18% of
share in risk coverage respectively (Marović, 2001: 291).
37 e share of earned net premium in earned premium for the period from 2004 to 2007 ranged
between 90% and 92% for non-life and 99% for life insurance (National Bank of Serbia (2008),
Insurance Companies Operations, http://www.nbs.rs/export/internet/cirilica/60/60_2/index.
html, accessed 12 November 2008).
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
81
and long-term property insurance contracts (IMF, 2006: 43). Additionally, when
Serbia becomes member of the World Trade Organisation (WTO)38, the solid
position of domestic reinsurance companies will be lost, as the experience of
other Eastern European companies has shown. It is expected that with opening
of the domestic reinsurance market the only competitive advantage for domestic
over foreign reinsurers will be their experience in the local insurance business
and their ability to reduce their administrative expenses.
From the brief description of the reinsurance market it is clear that reinsurance
is the only39 and by Insurance law obligatory risk transfer solution for domestic
insurance companies. Currently, Serbian insurance industry lacks of even legal
basis for the development of capital market solutions for insurance risk transfer.
But besides the current insurance law incomprehensiveness in regard to range
of legally accepted insurance risk transfer solutions and undeveloped insurance
market40, the underdevelopment of capital market and the absence of catastrophic
events are additional factors that hindered the development of capital market
solutions.
Currently, Serbian capital market is represented by the trades that take place
at the Belgrade Stock Exchange as over-the-counter market does not exist.
Although the stock exchange has been established before the Second World
War, in the period aer the war it was closed until 1989, but the trading actually
started aer 2000 when privatisation process began and when restricted foreign
currency public saving bonds were issued by the Serbian government. Although
recently there has been an increase in the number and value of transactions41, the
38 Serbia is in negotiation for WTO membership from 2005.
39 Although the Insurance Law (2004) provide legislative basis for the existence of risk sharing
through coinsurance in addition to reinsurance, the only risk transfer mechanism exercised
in practice by domestic insurers is reinsurance.
40 e opinion of the authors is that undeveloped insurance market has led Serbian insurance
companies to form opinion that they cannot do anything in order to hedge against the
reinsurance market cycles. e rational behind such development has been the low share of
Serbian insurance market in the world’s total premium, which limited domestic reinsurers’
contractual position in relation to the possibility of changing conditions that are determined
in advance.
41 In the period from 2004 to 2007the total number of transactions rose by 113% and the total
volume of transactions rose by 307% (Belgrade Stock Exchange, 2008).
82
Vladimir Njegomir and Rado Maksimović
market currently lacks of wider investor base42 and wider diversity of investment
instruments available.43
Finally, we have seen that the most important stimulus for the development
of alternative risk transfer solutions were catastrophic events. e absence of
catastrophic events in Serbia in recent years, although generally positive trend,
had negative impact on the need of insurance companies to search for alternative
sources of capacity. Additionally, because of low insurance penetration, large
catastrophic events, even when they did occur44, were not born by insurance
companies but were compensated from public funds formed on the basis of social
solidarity principles.
5. EXPECTED FUTURE DEVELOPMENT OF
RISK TRANSFER SOLUTIONS IN SERBIA
Currently, insurance companies in Serbia lack of the opportunities of transferring
insurance risk to capital markets as the only relationship between insurance
and capital markets have been through investment operations of insurance
companies and direct investments of capital markets investors in shares of
insurance companies. However, in order to improve eciency of risk and
capital management and to make use of other advantages, which are conrmed
in developed insurance markets, it would be desirable for domestic insurance
companies to develop solutions that would enable transfer of insurance risks to
capital markets in addition to traditional transfer to reinsurance market.
e general fact is that economic progress has direct impact on the rise of capital
stocks and property values in economy and the level of people’s consciousness
about the importance of insurance protection. Additionally, the experience of
developed economies and economies that have passed through the changes from
administrative to market economy clearly shows that with increased economic
development the frequency and especially severity of loss events becomes
42 Although new laws on investment and pension funds provide the legal basis and had led to
the establishment of these institutions, even under these new legislations the establishment of
hedge funds, so important to the development of capital market solutions for insurance risk
transfer, is not anticipated.
43 Although in 2004 several transactions with corporate bonds and commercial papers were
recorded, only available instruments in 2005, 2006 and 2007 were shares and restricted
foreign currency public saving bonds (Belgrade Stock Exchange, 2008).
44 For example, Montenegrin earthquake of 1979 or Serbian oods of 2006.
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
83
greater as well as the volume of available income that can be used for insurance
protection. us, the economic development leads to increased demand for
insurance, but as the experience of developed market shows, usually the pace
of this increase is faster than that of the capacity of insurance and reinsurance
industry. us, it is obvious that the level of economic development, that could be
expected to signicantly increase in Serbia in the long-run, will lead to increased
need for additional sources of capacity. On the other hand, the development of
insurance market leads to increased competition, as it has been seen recently
in Serbia45, which further leads to increased pressures on capital of insurance
companies, as more money needs to be invested in the market development and
acquiring new customers. Combined with the increased insurance penetration
that leads to greater loss exposures of insurance companies, this would lead to
increased pressures on insurance companies’ solvency margins and thus the need
for alternative risk transfer solutions from insurance companies in Serbia can be
expected. Finally, the development of ART solutions is inconceivable without the
developed capital market. If Serbian capital market continue to develop at the
pace that was noted in the last four years, it is reasonable to expect that it would
become one of the major impetuses for the development of ART solutions.
However, we argue that alternative risk transfer solutions, which provide transfer
of insurance risks to capital market investors, have two-way relationships with the
level of development of insurance and capital markets as well as with the level of
overall economic development (see Figure 9). By providing the additional capacity
and more ecient capital utilisation they would enable insurance companies to
oer better coverage conditions and price stability which would directly lead
to increased development of insurance operations in Serbia. Additionally, the
development of ART solutions in Serbia would facilitate the development of
domestic capital market, as the subsequently greater variety of available nancial
instruments would improve risk diversication possibilities, which would
consequently provide basis for the increased attractiveness of greater number of
investors from the country and abroad. e positive eects on the development
of insurance and capital market would facilitate the overall economic growth,
which would in turn facilitate further development of insurance and capital
markets and ART solutions.
45 From November of 2007 when DDOR Novi Sad, the second largest insurance company in
Serbia, was privatised, Serbian insurance industry is in majority ownership of foreign capital
(National Bank of Serbia (2008), Insurance Companies Operations, Belgrade, http://www.nbs.
rs/export/internet/cirilica/60/60_2/index.html, accessed 12 November 2008).
84
Vladimir Njegomir and Rado Maksimović
Figure 9: e simplied two-way relationship between ART solutions on one side
and insurance and capital markets and overall economic development
on the other
However, in order to facilitate the development of ART solutions it will be needed,
in addition to changes in economic factors, to provide the legal basis for their
development. One of the positive signs in this regard has been the development of
the dra of the Law on Securitisation that will provide, if adopted, the legal basis
for the securitization of receivables. When this happens, as the experience of
developed economies shows, the basis for the development of risk securitisations
will be provided. However, the most important change would be the change in
the way how insurance and reinsurance companies’ solvency is regulated, which
means that the modied insurance law would have to provide the capital relief for
ART solutions on the same footing as for coinsurance and reinsurance. Although
we expect that reinsurance will retain the leading role as a risk transfer solution
in the future of Serbian insurance market, the mentioned changes will certainly
be made within the total eorts of making Serbia closer to the EU membership.
6. CONCLUSION
Risk transfer solutions that are available to contemporary global insurance
companies encompass traditional reinsurance and alternative risk transfer
solutions, which are one of the results of the long-term trend of convergence of
insurance and capital markets. It could be expected, by extrapolating the past
developments, that in the future the role of alternative risk transfer solutions
will be increased because of the increased interest of insurers and reinsurers, as
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
85
there is continuous discrepancy between the demand and supply of insurance
and reinsurance cover caused by slower growth of capacity in relation to growth
of risk exposures, and capital market investors, who can achieve relatively high
returns combined with proved diversication eect. Additionally, it is reasonable
to expect that alternative risk transfer solutions will be utilised not only for
catastrophe risks but also for non-catastrophe risks, such as further development
of already implemented solutions for the motor and liability insurance risks.
In support to the conclusion of growing importance of alternative risk transfer
solutions is the fact that in 2007 and 2008, despite the nancial crisis46 and “so”
reinsurance market, there was continued growth of interest from investors,
although there was slight decrease of interest from insurers and reinsurers.
However, in order to compete eectively with reinsurance, especially in the “so”
phase of reinsurance cycle, some fundamental issues, such as still relatively high
transaction costs in comparison to reinsurance, the need to obtain capital relief
on an equal footing as for reinsurance from regulators and rating agencies, lack of
liquidity, transparency, standardisation, reliable industry loss data and indexes in
Europe, expertise and insurance risk diversity, still need to be fully addressed.
On the basis of the mechanisms that underlie the functioning of reinsurance
and alternative risk transfer solutions, explained in the paper, we can draw the
conclusion that these solutions are complementary, although the term “alternative”
is used for the risk transfer solutions other than traditional reinsurance. e
fact that alternative risk transfer solutions have been used mainly in the eld
of catastrophic risks in the conditions of limited reinsurance and retrocession
capacity and high premiums as a supplementary method to this capacity goes
in support for this conclusion. Additional fact that support this conclusion is
that insurers and reinsurers make their decisions in relation to the choice of
traditional and/or alternative risk transfer solutions in the same way as they made
them in relation to the choice of risk retention and/or transfer, that is to say, they
made these decisions on the basis of the analysis of costs and benets of dierent
available alternatives in addition to having factored in objectives that they aim to
achieve, their size, risk tolerance and other specic characteristics. For example,
if the relatively small insurer has the aim to achieve wider annual cover with the
possibility of coverage renewal and relatively lower costs in “so” reinsurance and
retrocession market, with accepting credit risk but without accepting basis risk,
the priority would certainly be given to reinsurance. Dierent preferences would
46 One of the eects of the nancial crisis was the collapse of investment bank Lehman Brothers
that was guarantor in several catastrophe bond transactions, which consequently marked
decrease in credit rating.
86
Vladimir Njegomir and Rado Maksimović
Banks, E. (2004), Alternative Risk Transfer: Integrated Risk Management through Insurance,
Reinsurance and the Capital Markets, John Wiley & Sons, Ltd., West Sussex, England
Banks, E. (2005), Catastrophe Risk: Analysis and Management, John Wiley & Sons, Ltd, West
Sussex, England
REFERENCES
be that of a larger insurer or reinsurer with greater nancial strength, dierent
objectives and with dierent conditions in relation to reinsurance market cycle.
By detailed examination of domestic literature in the eld of insurance
and reinsurance as well as the risk transfer practices of domestic insurance
companies, it is evident that the only and even by the law obligatory risk transfer
solution available and utilised is traditional reinsurance. e most important
reasons behind such underdevelopment have been undeveloped and relatively
small domestic insurance market, undeveloped capital market that would enable
transferring of insurance risks to investors, the lack of or imperfection of current
laws that would provide regulatory framework for insurance risk transfer to
capital market investors and the absence of catastrophic events that created the
lethargy of insurance and reinsurance market participants in relation to the need
to search for alternative solutions.
However, on the basis of the experience gained in developed and countries that
have passed through the transformation of their socio-economic systems we argue
that the application of capital markets solutions, as complementary risk transfer
mechanism to traditional reinsurance, has the potential to play an important
role in the future of Serbian insurance industry. e most important drivers of
their development that we expect to be are development of capital and insurance
markets and overall economic progress. Although the need for alternative risk
transfer solutions will certainly be created by economic and the development
of insurance market, the stated problems that hindered their development in
the past will need to be fully addressed in order to achieve proven benets of
utilisation of complementary traditional and alternative insurance risk transfers,
such as guaranteed continuity of protection, greater capacity, price stability and
certainty of terms in Serbian insurance market.
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
87
Bock, K. J. and M.W., Seitz (2002), “Reinsurance Versus Other Risk-Transfer Instruments – e
Reinsurer’s Perspective”, in: Lane, M. (ed), Alternative Risk Strategies, Risk Books, Risk Waters
Group, London, pp. 3-18
Culp, C. L. (2002), e ART of Risk Management: Alternative Risk Transfer, Capital Structure, and
the Convergence of Insurance and Capital Markets, John Wiley & Sons, Inc., Hoboken, NJ
Culp, C. L. (2002a), “Contingent Capital and the Art of Corporate Finance”, in: Lane, M. (ed),
Alternative Risk Strategies, Risk Books, Risk Waters Group, London, pp. 119-154
Culp, C. L. (2006), Structured Finance and Insurance, John Wiley & Sons, Inc., Hoboken, NJ
Cummins, J. D. (2004), “Securitization of Life Insurance Assets and Liabilities”, e Wharton
School, University of Pennsylvania, Philadelphia, PA, http://c.wharton.upenn.edu/c/
papers/04/0403.pdf, accessed 01 November 2008
Cummins, J. D. (2008), “Cat Bonds and Other Risk-Linked Securities: State of the Market And
Recent Developments”, Risk Management and Insurance Review, e American Risk and
Insurance Association , Malvern, PA, Vol. 11, No. 1, pp. 23-47
Doherty, N. A. (2000), Integrated Risk Management: Techniques and Strategies for Managing
Corporate Risk , e Mcgraw-Hill Companies, Inc., New York, NY
Ehrhart, B. (2002), “Contingent Covers”, in: Lane, M. (ed), Alternative Risk Strategies, Risk Books,
Risk Waters Group, London, pp. 155-167
Global Risks (2008), Global Risks 2008: A Global Risk Network Report, World Economic Forum,
Geneva
Global Risks (2008), Global Reinsurance magazine, Newsquest Specialist Media, London
Group of irty (1993), Derivatives: Practices and Principles, Global Derivatives Study Group, e
Group of irty, Washington, DC
Group of irty (2006), Reinsurance and International Financial Markets, Reinsurance Study
Group, e Group of irty, Washington, DC
Harrington, S. E. and Niehaus, G. R. (2004), Risk Management & Insurance, McGraw-Hill/Irwin,
e McGraw-Hill Companies, Inc., New York, NY
Hartwig, R. P. and C. Wilkinson (2007), “An Overview of the Alternative Risk Transfer Market”,
in: Cummins, J. D. and B. Venard (eds), Handbook of International Insurance: Between Global
Dynamics and Local Contingencies, Springer Science+Business Media, LLC, New York, NY, pp.
925-953
88
Vladimir Njegomir and Rado Maksimović
Hengesbaugh, B. L. (1998), “Insurance Firms’ New Edge: Capital Market Ventures”, in: Himick, M.
(ed.), Securitized Insurance Risk: Strategic Opportunities for Insurers and Investors, e Glenlake
Publishing Company, Ltd, Chicago, IL
Insurance Information Institute (2007), Overview & Outlook for the P/C Insurance Industry: An
Industry at the Crossroads, Insurance Information Institute, New York, NY
International Monetary Fund (2006), Republic of Serbia: 2006 Article IV Consultation and Post-
Program Monitoring Discussions - Sta Report; Sta Supplement; Public Information Notice on
the Executive Board Discussion; and Statement by the Executive Director for the Republic of
Serbia’, from http://www.imf.org/external/pubs//scr/2006/cr06384.pdf, accessed 20 June 2008
Insurance Law (2004), Ocial Gazette of the Republic of Serbia, Nos. 55/2004,70/2004,
61/2005–other law, 85/2005 – other law and 101/2007, Belgrade
Klein, C. and S. Mooney (2008), “2008 Reinsurance Market Review: Near Misses Call for Caution”,
Guy Carpenter & Company, LLC, New York, NY
Kočović, J and P. Šulejić (2002), Osiguranje, Ekonomski fakultet Beograd, Beograd
Laster, D. S. and M. Raturi (2001), “Capital market innovation in the insurance industry”, Sigma
No 3, Swiss Re, Zurich
Longman (2003), Dictionary of Contemporary English, Pearson Education Limited, Essex,
England
Marović, B. (2001), Osiguranje i špedicija, Stylos, Novi Sad
McGhee, C. et al. (2008), “e Catastrophe Bond Market at Year-End 2007: e Market Goes
Mainstream”, Guy Carpenter & Company, LLC, New York, NY
MSI (2003), Catastrophe Risk Swap between MSI and Swiss Re, Mitsui Sumitomo Insurance
Company, Tokyo, http://www.ms-ins.com/english/news/2003/0804.html, accessed 07 October
2008
Munich Re (2001), “Risk Transfer to the Capital Markets: Using the Capital Markets in Insurance
Risk Management”, Munich Re ART Solutions, Munich Re, Munich
Njegomir, V. (2006a), “Savremeni trendovi na tržištu reosiguranja”, Industrija, Ekonomski
institut, Beograd, No 3, pp. 65-80
Njegomir, V. (2006b), “Ciklični karakter industrije osiguranja i reosiguranja”, Industrija,
Ekonomski institut, Beograd, No 4, pp. 47-61
OECD (2005), “Catastrophic Risks And Insurance”, Policy Issues in Insurance No 8, OECD,
Paris
RISK TRANSFER SOLUTIONS FOR THE INSURANCE INDUSTRY
89
Paine, C. (2004), Reinsurance, Institute of Financial Services, Canterbury, Kent, UK
Pennay, R. (2007), “Market loss index for Europe – Expanding capital market capacity”, Swiss Re,
Zurich
Rejda, G. E. (2005), Principles of Risk Management and Insurance, Addison Wesley, Boston, MA
Rotar, V. I. (2007), Actuarial Models: e Mathematics of Insurance, CRC Press, Boca Raton, FL
Schmitter, H. (2003), “Setting optimal reinsurance retentions”, Swiss Re, Zurich
Schwarcz, S. L. (1994), “e Alchemy of Asset Securitization”, Stanford Journal of Law, Business
& Finance, Stanford, CA, pp. 133-154
Takeda, Y. (2002), “Risk Swaps”, in: Lane, M. (ed), Alternative Risk Strategies, Risk Books, Risk
Waters Group, London, pp. 99-118
Wheeler, R. and L. Janeke (2008), “Monte Carlo 2008 - 1. Industry Loss Warranties”, Beneld
Group Limited, London
Zeller, W. (2008), “Securitization and Insurance – Characteristics of Hannover Re’s Approach”,
e Geneva Papers, e Geneva Association, Geneva, Vol. 33, No. 1, pp. 7-11
90
Vladimir Njegomir and Rado Maksimović
Appendix 1
Table A1: Comparison of capital market instruments with reinsurance
Cat bonds/swaps Exchange traded
options
Contingent
capital
Property
catastrophe
reinsurance
Compensation/
nancing
Compensates
buyer
against losses,
subject
to basis risk
Compensates
buyer
against losses,
subject to basis risk
Provides
nancing on
pre-agreed terms
in
case of loss
event.
No
indemnication
Compensates
reinsured
against losses
Basis risk Present in deals
with
trigger based on
index
Signicant Depends on the
index/trigger
used
Minimal
Credit risk Minimal.
Capital is
invested in safe
securities held
by
trustee
Minimal.
Obligations
guaranteed by the
exchange
Minimal.
Capital is
invested in safe
securities held
by
trustee
Depends on
solvency
of the reinsurer
Liquidity for
risk taker
Currently low.
Expected to
improve
as market
develops.
Currently low.
Expected
to improve as
market
develops
Low Limited to
retrocession
market
Well-established
underwriting
accounting
rules?
Yes No No Yes
Well-established
accounting rules
for investors?
Yes Yes No Yes
Standardisation Customised Standardised Customised Customised
Multiyear
pricing
Available No Available Availability
depends on
market conditions
Transaction
costs
relative to
reinsurance
High, expected
to
decrease as rms
gain experience
Low High, expected
to
decrease as rms
gain experience
N/A
Source: Laster and Raturi (2001)
