Abstract
This chapter discusses alternative/complementary mechanisms for enhancing the ability of conventional insurance markets to provide sustainable coverage for aviation war and terrorism risks. At the outset, it is important to recall that one of the fundamental reasons why conventional insurance markets withdraw coverage and sharply raise premiums charged for insuring aviation war and terrorism risks following the occurrence of a catastrophic event such as September 11, 2001, is the immense difficulty they experience in raising capital during those periods. As such, the need to find innovative, non-conventional ways of raising capital to back insurance coverage of catastrophic risks has been a subject of much deliberation in the conventional insurance industry over the years, and a number of steps have been taken in that direction. Alternative Risk Transfer (ART) mechanisms are one of the major areas that have been explored.
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Notes
- 1.
Rhee (2005) p. 461 According to the author, risk management techniques may be categorized into avoidance, reduction, control, transfer and retention. Conventional insurance falls within the transfer category since it encompasses the process of disaggregating, reconstituting and transferring various forms of risk from individuals and enterprises to the insurance system. The remaining risk management techniques may therefore be used to enhance the ability of conventional insurance to address the risks that are transferred to it.
- 2.
See idem., p. 453. Conventional insurance companies typically fund the risks they underwrite with capital raised from three primary sources: (1) equity; (2) accumulated reserves from premiums collected and any returns gained from investing same; and, (3) debt. Once a catastrophic event occurs and depletes the reserves of such companies, it becomes impossible to raise from these traditional sources the large amounts of capital needed to recapitalize such companies for them to continue their normal operations.
- 3.
Godbole (2004) p. 39.
- 4.
Idem.
- 5.
Idem., p. 40.
- 6.
Idem., p. 39.
- 7.
Idem.
- 8.
Idem., p. 41.
- 9.
Boyle (2002a).
- 10.
Idem.
- 11.
International Association of Insurance Supervisors (2006) p. 4.
- 12.
Idem., p. 5 [footnotes omitted].
- 13.
Idem., p. 12.
- 14.
Idem., p. 11.
- 15.
Idem., p. 13. According to this IAIS report, “[t]he portion of commercial premiums paid that are [sic] attributable to profit, overhead and acquisition costs can be as high as 40 % of the whole amount charged. The establishment of a captive seeks to mitigate these extraneous costs by allowing the company the benefit of retaining profit for its own account and participating in the risk exposure by paying a premium that more accurately reflects the parent loss history”.
- 16.
- 17.
In civil aviation, the term “Equitime” refers to the point in flight when the risk of going forward is equal to the risk of returning. See Pinkham (2002).
- 18.
Boyle (2002a).
- 19.
Idem.
- 20.
Idem.
- 21.
According to a comparative study conducted by Marsh Inc., the base premium rate per passenger under the Equitime scheme was to be fixed at 64 cents. This projected a maximum total estimated annual premium of US$ 435 million, assuming 100 % participation by all ATA member airlines. Out of this amount, US$ 75 million was to be paid to the US federal government for its excess coverage, leaving US$ 360 million per annum to fund Equitime plus the US$ 50 million initially garnered to set up the company. At the time, the “usual aviation markets” were asking for premium rates of US$ 1.25 per passenger for coverage of third party and war risks up to US$ 50 million. Additionally, the new “excess third party markets” were demanding premium rates of US$ 1.85 per passenger for coverage of third party and war risks beyond the US$ 50 million up to US$ 1 billion.
- 22.
Boyle (2002a).
- 23.
Idem.
- 24.
Idem.
- 25.
Hoeven (2005) p. 75.
- 26.
Boyle (2002a).
- 27.
Idem. See also Hoeven (2005) p. 75.
- 28.
Hoeven (2005).
- 29.
Fitzsimmons (2004) p. 82.
- 30.
This term was invented under the scheme to cover all operators, airlines, manufacturers, airports, maintenance service providers, security screeners etc. See idem., p. 83, fn. 26.
- 31.
Idem., p. 83.
- 32.
Idem.
- 33.
Idem.
- 34.
Idem.
- 35.
Idem.
- 36.
Idem.
- 37.
ICAO (2001c).
- 38.
ICAO (2001e).
- 39.
- 40.
- 41.
ICAO (2002b), Appendix 1 at para. 1.1.
- 42.
Idem.
- 43.
Idem., Appendix 1 para. 1.3.
- 44.
Idem., Appendix 1 para. 1.4.
- 45.
Idem., paras. 3.1–3.3. By way of projections, the total amount of premiums expected to be collected in the first year was estimated at US$ 850 million (equivalent to a premium of 50 cents per passenger segment based on an estimated total passenger segments of 1.7 billion). If this was achieved, then the premium for subsequent years could be kept at approximately the same level, provided there were no losses. In addition to allocating premiums on a per passenger segment basis, the SGWI also recommended that these other options for premium allocation be considered: (a) flat rate per departure flight; (b) flat rate per aircraft proportional to the maximum take-off weight; (c) flat rate per ton/km performed, including passenger and freight; and, (d) flat rate premium (for airports, service providers and others).
- 46.
Idem., paras. 3.4–3.5.
- 47.
See ICAO (2002a).This participation agreement was intended to be a legal agreement between the contracting states that would sign it and the Insuring Entity to be established under the scheme. Its purpose was for the Participating States to guarantee certain obligations of the Insuring Entity; to establish the proration, limits, and payment mechanisms related thereto; and, to provide for the obligations of the Insuring Entity towards the Participating States.
- 48.
With the participation of all ICAO states, the collective cap for participating States’ contributions was estimated at US$ 15 billion maximum (sufficient to meet 10 maximum claims), or a proportion thereof based on percentage of participation. Each State’s maximum liability under the scheme was also to be capped. The maximum exposure of each State would be the equivalent of their ICAO contribution percentage of US$ 15 billion on the basis of 100 % participation, and this individual cap was to remain constant.
- 49.
The ICAO Assembly is convened once every 3 years. One of the major resolutions adopted at each Assembly concerns how the activities of the organization will be funded during the ensuing 3 years. By convention, the estimated expenses of the organization are apportioned among all contracting states using a Scale of Assessment adopted in accordance with certain principles established by the Assembly in 1980 during its 23rd session. According to those principles, the lowest rate of contribution cannot be below 0.06 % and the highest rate may not exceed 25 %. See ICAO (1980a), published in ICAO (1980b). The contribution rates for 2003 upon which the Globaltime guarantee shares were to be based are found in: ICAO (2001b), published in ICAO (2001a).
- 50.
Japan’s ICAO contribution rate for 2003, for instance, was set at 14.36 % which meant that its guarantee share would be 14.36 % of the total amount of state guarantees if it decided to participate in Globaltime. The Japanese delegation to the SGWI-RG expressed concern that its Globaltime guarantee share was out of proportion to its exposure to aviation war and terrorism risk. The delegation suggested that, in order to more appropriately reflect each participating state’s respective exposure to those risks, the guarantee share of each state could, instead, be based on standards such as flight volume (e.g., the number of passengers carried). Another delegation proposed that indicative factors such as cargo volume and the historical background of states with ICAO contribution rates below the 25 % threshold should be taken into consideration in determining the guarantee share of such states. It was also suggested that Japan’s (and indeed other states with large contribution rates) guarantee share be capped at 10 %, and the excess redistributed among remaining participating states The SGWI-RG did not accept any of these suggestions. In its view, a state’s level of exposure to aviation war and terrorism risks could not be determined as proposed since, in reality, there is no place or region which could be considered as risk-free or permanently at lower risk from being targeted for terrorism or for initiating or carrying out preparatory terrorism actions. The SGWI-RG also noted that the principles which animate the calculation of ICAO contribution rates take into consideration a Contracting State’s importance in civil aviation, measured by the capacity in terms of tonne-kilometres available on each State’s scheduled air services, which includes both passenger and cargo services. As such, the computation of the ICAO contribution rates already takes into account factors such as flight, passenger and cargo volume. The SGWI-RG therefore recommended to the Council that Globaltime guarantee shares be allocated among states in the same manner as ICAO contribution rates are allocated. See ICAO (2003b), Agenda Item 2—Review of Globaltime pp. 2-1–2-2.
- 51.
Most countries consider that the level of any state’s exposure to terrorism in general and aviation war and terrorism risks in particular is heavily dependent upon factors such as the domestic and/or foreign policy being pursued by that state. As such, a scheme such as Globaltime which purports to allocate the cost of insurance for aviation war and terrorism risks on a global scale among states without reference to these factors is bound to be rejected by the vast majority of states, particularly those who do not consider themselves to be exposed to terrorism.
- 52.
Following completion of the SGWI’s initial deliberations, the Council decided on 4 March 2002 to establish a Council Group on Aviation War Risk Insurance (CGWI) to work with the ICAO Secretariat to review the recommendations presented by the SGWI. Meanwhile, the President of the Council sent state letters to all ICAO contracting states informing them about the Council’s approval in principle of the Globaltime scheme and seeking expressions of intent to participate in it from them. Several responses were received from contracting states some expressing an unconditional interest to participate; others indicating a willingness to participate subject to certain conditions; and some indicating no intent at all to participate. Accordingly, the Council entrusted a sub-group (“review group”) of the Special Group on Aviation War Risk Insurance (SGWI-RG) with the task of reviewing the Globaltime scheme in the light of the conditions of participation set by certain states in reply to the State letters and making any adjustments thereto and to the revised draft Participation Agreement. Upon recommendation of the SGWI-RG, the Council decided to approve an amended version of the participation agreement and to retain Globaltime exclusively on a contingency basis.
- 53.
- 54.
ICAO (2003a).
- 55.
Idem.
- 56.
See ICAO (2004) Appendix A.
- 57.
Idem.
- 58.
Idem.
- 59.
For a concise description of the capacity crises that various industries experienced in the years before 2002 and how they resorted to ART schemes in order to resolve them, see Boyle (2002b).
- 60.
Boyle (2002a).
- 61.
OECD (2005) p. 56.
- 62.
Outreville (1998) p. 152.
- 63.
Boyle (2002b).
- 64.
Idem.
- 65.
Idem.
- 66.
See Ali (2008) p. 352.
- 67.
The driving force behind such suggestions is that, taking their size into consideration, capital markets have a remarkable risk spreading potential and might be willing to take on new risks if they consider them imperfectly correlated with those they routinely accept. In theory, through the diversification of institutional investors’ investment portfolios, capital markets may manage to absorb high risk exposures, thereby optimizing investor’s risk-return ratios. See OECD (2005) p. 55.
- 68.
Idem.
- 69.
Idem.
- 70.
Idem., p. 56.
- 71.
Mutenga and Staikouras (2007) p. 238.
- 72.
OECD (2005) p. 56.
- 73.
Andersen (2005) p. 167.
- 74.
Mutenga and Staikouras (2007) p. 238. According to these authors, this sort of financing redresses the balance between equity and debt, and the potential embedded in the firm’s structure could be realized. The catastrophe hits the equity, which in turn triggers the exercise of the hedging device that restores the stock’s value. This circularity, known as the feedback effect, is also referred to by other authors as the “apparent paradox”.
- 75.
Idem., p. 227.
- 76.
Idem., p. 240.
- 77.
OECD (2005) p. 56, [emphasis added]. Contingent capital instruments may take the form of put option contracts or contingent surplus notes, the aim of which is to guarantee the issuance of medium-term securities on fixed terms if a certain event occurs.
- 78.
Andersen (2005) p. 167.
- 79.
Idem.
- 80.
Idem.
- 81.
Idem.
- 82.
Idem.
- 83.
Idem.
- 84.
- 85.
Andersen (2005).
- 86.
Mutenga and Staikouras (2007) p. 238.
- 87.
Idem.
- 88.
Idem.
- 89.
Idem., p. 240.
- 90.
Andersen (2005) p. 167.
- 91.
Bouriaux and Scott (2002).
- 92.
Mutenga and Staikouras (2007) p. 239.
- 93.
Idem.
- 94.
Idem.
- 95.
- 96.
Andersen (2005).
- 97.
- 98.
See American Academy of Actuaries (2001) p. 17.
- 99.
Bouriaux (2001) p. 102.
- 100.
Andersen (2005) p. 169. Under traditional reinsurance, the payout obligation is usually a function of the reinsured’s own losses and so there is little or no basis risk.
- 101.
Idem.
- 102.
Bouriaux and Scott (2002) p. 17.
- 103.
Idem.
- 104.
Doherty and Richter (2002) p. 11.
- 105.
Idem.
- 106.
Idem.
- 107.
Mutenga and Staikouras (2007) p. 239. On the other hand, the severity of the event that triggers the instrument could be substantial, resulting in the insolvency of the holder and leaving the provider with no capital repayment. In the literature, this phenomenon is referred to as credit risk.
- 108.
- 109.
Rhee (2005).
- 110.
Helfenstein and Holzheu (2006) p. 3.
- 111.
See Wemmer (2008) p. 2. In support, the author reports that, over the 25 year period ending in 2008, commercial banks developed various forms of asset-backed securities (ABS) and sold them to a broad spectrum of market participants. As a result, not only did the return on equity in the banking sector rise from single to double digits; there was also a sizeable reduction in the earnings volatility of commercial banks.
- 112.
Ali (2008) p. 349. The essential feature of a true sale securitization is that the transaction revolves around the sale (assignment) of the underlying assets from the originator to the SPV. Therefore, the originator sheds all risks (not just credit risk) associated with the assets. In a synthetic securitization, it is only the credit risk of the underlying assets that is transferred from the originator to the SPV. The originator retains all the other risks associated with the assets. See Vries Robbé et al. (2008) p. 6.
- 113.
Usually a bank that has originated mortgage loans or corporate loans.
- 114.
Credit risk generally refers to the risk of default. In other words, it is the risk that counterparties to a transaction will not meet their obligations thereunder. See Bouriaux (2001) p. 105. It is the risk of loss of principal or loss of financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Even if a counterparty to a transaction does manage to ultimately meet its obligations, the value of the underlying debt instrument may decline if its rating is downgraded. See Krenn and Oschischnig (2003) p. 66.
- 115.
“Closely related to market risk, liquidity risk is the risk of not being able to meet payment liabilities when due. The liquidity of an investment is defined by how quickly and to what extent it can be converted into cash”. See Krenn and Oschischnig (2003) p. 67.
- 116.
Market risk is defined as “potential losses owing to detrimental changes in market prices and/or other financial variables influenced by prices. This includes share prices, interest rates, asset prices or exchange rates. In other words, market risk makes up a key share of investment risks”. See idem., p. 65.
- 117.
The special purpose securitization vehicle is usually a corporate entity specifically established for the purpose of the securitization transaction. They are usually incorporated in countries or jurisdictions with the most favourable tax regimes.
- 118.
Ali (2008) pp. 349–350.
- 119.
Idem. Indeed, through securitization, the originator is able to de-link the value of the instruments issued to investors from its own creditworthiness (or the lack of it).
- 120.
Godbole (2004) p. 41.
- 121.
- 122.
Underwriting risks are the risks which an insurance contract is supposed to cover. To a large extent, these risks stem from the fundamental business of the insurance industry, namely selling insurance policies. Underwriting risks emanate from the dangers to which the object of the insurance contract is exposed. See Krenn and Oschischnig (2003) p. 63.
- 123.
De Mey (2007) p. 37. Depending on the terms of the securities, the principal and/or interest owed thereon to investors will be paid instead to the originator once the specified trigger conditions are satisfied. This may take one of two forms. On an indemnity-based deal, the parties agree on a trigger based on the actual loss experience of the originator or on the occurrence of an insured event of a specified magnitude. On a non-indemnity securitization, investor liability on the securities is triggered by an agreed index rather than the actual loss experience of the originator.
- 124.
Ali (2008) p. 354.
- 125.
De Mey (2007).
- 126.
Rhee (2005) p. 497.
- 127.
OECD (2005) p. 55 (footnotes omitted).
- 128.
See Rhee (2005) p. 500. It is reported that the first attempt to access the capital markets as a source for risk transfer capacity was made in 1993 by Dr. Richard Sandor and Morton Lane through the development of the concept of insurance derivatives. The main driver behind this innovation was the occurrence of hurricane Andrew in 1992. Insured losses from this hurricane amounted to approximately US$ 20 billion and this seemed to generate a capacity crisis in the insurance market for natural catastrophes. Richard Sandor and Morton Lane created reinsurance derivatives at the Chicago Board of Trade, based on US nationwide and individual region insurance market loss ratios for natural catastrophe property business. They were so confident about the derivatives that they announced that in 3 years’ time, there will no longer be any traditional reinsurance. Unfortunately, however, due to the injection of substantial amounts of fresh capital through existing and freshly established reinsurance companies, the capacity crisis did not materialize. Consequently, the reinsurance derivatives did not generate sufficient trading volume. See Materne (2007).
- 129.
Ali (2008) p. 350. Simulations conducted by modeling firms in the 1990s suggested that damages caused by a major hurricane in Florida could be at least US$ 75 billion, and those due to an earthquake in California could exceed US$ 100 billion. With prospective event losses exceeding US$ 50 billion, the capitalization of the insurance and reinsurance industry was at issue. Estimates of the total capital and surplus of U.S. insurers and international reinsurers were about US$ 300 billion and US$ 100 billion, respectively. Although such catastrophic losses were large enough to put the insurance industry under severe stress, they were estimated to be lower than one standard deviation of the daily value traded (about US$ 130 billion on average) in the US capital markets. As such, the simulations found that the pool of financial capacity provided by the financial markets is capable of bearing the most pessimistic estimated losses caused by a natural catastrophe. See Mahul (2001).
- 130.
To date, Cat-bonds constitute the commonest form of insurance securitizations. It is reported that between 1997 and 2006, a total of 97 Cat-bond securitizations were executed. The range of risks that have been securitized via Cat-bonds has also expanded from natural catastrophes to man-made disasters, and suggestions have been made following the events of September 11, 2001 that Cat-bonds (or a slight variation thereof) can potentially be used to transfer aviation war and terrorism risks to the capital markets. See Ali (2008) p. 351. Aside from Cat-bonds, other forms of insurance securitization include financial derivatives such as exchange traded and over-the-counter options contracts, futures contracts, and catastrophe risk swap agreements.
- 131.
Andersen (2005) p. 162.
- 132.
Idem. This is why the securitization vehicle in Cat-bonds is usually referred to as a special purpose reinsurance vehicle (SPRV) and not just a special purpose vehicle (SPV).
- 133.
Idem.
- 134.
Technically, this means that the originator of the premium (i.e., the insurer) cedes all or a portion of the premium to the SPRV in return for the reinsurance cover provided. Payment of the premium by the originator is usually synchronized with payment by the SPRV of interest on the Cat-bonds to the investors—typically on a quarterly basis. Thus, nonpayment of premiums by the originator on a matching basis would result in a cancellation of the reinsurance policy, a default of the bond terms, and a termination of the risk to the bondholders. See Rhee (2005) p. 502.
- 135.
The SPRV uses the up-front proceeds from the bond issue, less the expenses accrued in connection with the placement, to buy a portfolio of liquid securities with high credit quality and low interest rate sensitivity. The securities portfolio is placed in a trust account as collateral for the interest payments due on the Cat-bonds. The SPRV often enters into a fixed-floating interest rate swap agreement that converts the interest returns from the invested securities portfolio into monthly Libor-based floating payments. The investors receive a relatively high spread above the Libor rate to compensate for their exposure to the underlying catastrophe risk. See Andersen (2005) pp. 162–163. Concerning the interest rate swap agreement, see also Rhee (2005) p. 501.
- 136.
Rhee (2005) p. 502.
- 137.
Idem., pp. 502–503.
- 138.
Andersen (2005) p. 163.
- 139.
Idem.
- 140.
Rhee, supra note 2 at 503.
- 141.
These reasons are similar to those discussed above in connection with insurers’ preference for indemnity-based ARF instruments over non-indemnity based ARF instruments. See section 5.3.1 above.
- 142.
Rhee (2005) p. 503.
- 143.
Andersen (2005) p. 163.
- 144.
Idem.
- 145.
Idem.
- 146.
Idem. Investors assume a much greater risk with Cat-bonds as compared to regular corporate bonds. This is because, although rating agencies routinely provide credit ratings for Cat-bonds, information on natural catastrophes is not as voluminous or transparent as information on commoditized receivables. It is therefore difficult to model catastrophic risks. In consequence, Cat-bond investors receive a relatively high rate of return above the LIBOR rate to compensate for the exposure to catastrophic risk. See also Rhee (2005) pp. 500–501.
- 147.
Bouriaux and Scott (2002) p. 8.
- 148.
Idem.
- 149.
p. 354.
- 150.
Ali (2008) p. 353.
- 151.
Idem., pp. 353–354. The author notes further that, through securitization, it is possible to obtain multi-year coverage of catastrophic risks at a fixed price in the global capital markets, whereas multi-year coverage in conventional insurance and reinsurance markets is rare or nonexistent. See also OECD (2005) p. 57.
- 152.
Ali (2008), p. 354.
- 153.
Idem., p. 355. In expounding the modern portfolio theory, the author writes at 355–356:
This theory posits that the extent to which an investor can maximize the riskiness of a portfolio for a given level of risk or minimize the riskiness of the portfolio for a given level of returns depends upon the level of portfolio diversification, as measured by the extent to which the different portfolio constituents are correlated to one another. Thus the inclusion in a portfolio of securities such as those issued in an insurance securitization, whose returns are negatively or weakly correlated or not correlated to the returns of other portfolio constituents should increase portfolio returns (without increasing the riskiness of the portfolio) or reduce the riskiness of the portfolio (without reducing portfolio returns). Where securities bear the same interest rate and credit risk as other securities but, unlike the latter, are not or are only weakly correlated to the constituents of the investor’s portfolio (which is the relationship that the returns on cat-bonds bears to the returns on conventional debt securities), modern portfolio theory as well as the legal duty of prudence would favour the selection of the former securities.
- 154.
All conventional asset classes typically available for investment on the capital markets (e.g., stocks, commodities, real estate, etc.) share economic interdependencies and are therefore highly correlated with the overarching economic framework. To illustrate, a collapse of the Dow Jones Stock Index will certainly affect commodity prices and vice versa. Securitized natural catastrophe risks, on the other hand, provide a “non-correlating asset class”. This is because the underlying risk exposure is not affected by what happens within the economic framework. Still using the above example, a collapse of the Dow Jones Stock Index will not generate a natural catastrophe such as an earthquake or a hurricane (although the reverse may be the case—the occurrence of an earthquake or hurricane may affect the performance of the stock index). See Materne (2007) pp. 5–6.
- 155.
Bouriaux and Scott (2002) p. 8.
- 156.
Ali (2008) p. 354.
- 157.
“Weather derivatives are, uniquely, hedges against volumetric risk. They offer protection not against changes in the prices of commodities, financial instruments or indices, but against changes in the volume of demand for, or supply of, commodities or services due to changes in weather conditions. The demand for electricity, for example, rises in hot weather (due to increased use of air conditioners) but tapers off in cooler weather. The demand for gas and heating oil, on the other hand declines during warmer weather but rises in cold weather (due to increased demand for hot water and heating). Electricity utilities, and gas and heating oil suppliers can, by using temperature swaps, protect their earnings from cooler than usual summers and warmer than usual winters respectively”. See idem., pp. 361–362.
- 158.
Whether or not the diversification potential of insurance securitization exists in the case of terrorism risks (i.e., man-made disasters) is not clear and remains to be seen. For instance, the stock markets fell as a result of the September 11, 2001 terrorist attacks in the US. However, bond markets spiked as the US Federal Reserve liquefied financial markets in view of the attacks. See Bouriaux and Scott (2002) p. 9.
- 159.
OECD (2005) p. 58.
- 160.
Idem.
- 161.
Andersen (2005) p. 178.
- 162.
Idem.
- 163.
It is reported that FIFA “opted for this capital market arrangement after having carefully evaluated the traditional insurance alternative, which reportedly no longer met FIFA’s objectives. Among the main concerns was the fact that, after September 11, [2001] the insurance market shifted from multi-year to annual renewable cover”. See OECD (2005) p. 58.
- 164.
Idem. See also Andersen (2005) p. 178.
- 165.
USD, EUR and CHF.
- 166.
Class A note holders assumed the financial risk of cancellation of the World Cup “if no official result has been determined or declared in respect of the final match of the 2006 FIFA World Cup … and no final match will be held on or before 31st August 2007”. Class B note holders, on the other hand, assumed the financial risk if no official result has been announced by FIFA by August 2007 for scheduled matches other than the final match. See Andersen (2005) p. 178.
- 167.
- 168.
Contrary to this assertion, it is reported that, in 1992, Hanover Reinsurance Company (Hanover Re) launched the world’s first portfolio-linked swap using ISDA standard documentation. Known as K2, this transaction is reported to have broadened the scope of risks transferred to the capital markets by including aviation catastrophic risk in addition to property perils for defined peril regions. See Zeller (2008) p. 8.
- 169.
OECD (2005) p. 59. It has been argued by Neil Doherty and Harris Schlesinger that efficient securitization requires that any systemic risk first be pooled through insurance. See Doherty and Schlesinger (2002) p. 47. Thus, in a transaction such as the FIFA bond issue where the risks concerned were not pooled through insurance before being securitized, the resulting securitization was not considered to be optimal.
- 170.
OECD (2005).
- 171.
Idem.
- 172.
Idem., pp. 58–59.
- 173.
Idem.
- 174.
The coverage was based on a combined mortality index similar to other index-based insurance-linked securities. The mortality index measured annual general population mortality in five selected countries (US, UK, France, Switzerland and Italy) by applying predetermined weights to publicly reported mortality data from each country (70 % US; 15 % UK; 7.5 % France; 5 % Switzerland; and, 2.5 % Italy). The risk was also segmented according to age and gender. Payments to Swiss Re under the Vita Capital transaction were to be triggered if, during any single calendar year before final maturity of the notes in January 2007, the combined mortality index as described above fell between 130 % and 150 % of the 2002 baseline level. In terms of an absolute number of extra deaths, this was in the range of approximately 750,000. See idem., p. 60. See also Andersen (2005) p. 178.
- 175.
OECD (2005).
- 176.
Andersen (2005) p. 178.
- 177.
Ali (2008) p. 364.
- 178.
Idem.
- 179.
Idem.
- 180.
Salah El Din (1971) p. 27.
- 181.
Ali (2008) p. 365.
- 182.
Idem.
- 183.
It is this requirement that actually differentiates insurance and reinsurance contracts from other agreements to make payment conditional upon an uncertain event (i.e., gaming and wagering contracts which are generally illegal and unenforceable under common law). See idem.
- 184.
In those jurisdictions, the possession of a pecuniary or economic interest equates to the payee suffering a loss through damage to, or a diminution in the value of, the subject matter of the contract as a result of the occurrence of the stipulated event. See idem., p. 366.
- 185.
Idem., p. 366.
- 186.
Idem.
- 187.
In other words, the originator must have a pecuniary interest beyond the amount that may or may not be paid to it under the Cat-bond or other ART instrument which presently exists in the subject matter of that agreement. If the originator has no interest other than the amount to be paid on the occurrence of the stipulated event, the Cat-bond or other ART instrument cannot constitute an insurance contract, as the originator’s only risk is the risk created by the agreement. See idem.
- 188.
Idem., pp. 366–367. It will be recalled from the discussion above that although originators prefer such indemnity-triggered bonds because they ensure full coverage of actual losses through the elimination of basis risk, they are usually the exception as capital market investors tend to prefer non-indemnity triggered instruments. As a result, a critical feature of most ART instruments usually encountered in insurance securitizations is that the SPV or SPRV’s obligation to make payment to the originator is not conditional upon the actual suffering of a loss by the originator in relation to the subject matter. It is possible that the payment may have the effect of putting the originator back into the financial position in which it was before the occurrence of the loss, but this would only be coincidental. This is because the obligation to make payment is de-linked from the originator’s actual losses.
- 189.
Idem., pp. 367–369. Although this conclusion suggests that non-indemnity triggered ART instruments used in insurance securitizations are wholly free from the risk of an adverse judicial or regulatory recharacterization, in reality, this is not the case. Paul Ali points out that in late 2003, the Property and Casualty Insurance Committee of the US National Association of Insurance Commissioners (NAIC) voiced the opinion that weather derivatives were, in substance, insurance contracts. This caused a lot of unrest in the industry, and following intense lobbying by various industry associations, the NAIC white paper was withdrawn from publication. According to Paul Ali, this event well illustrates the persistent risk of an adverse judicial or regulatory recharacterization, notwithstanding that transaction participants may believe they have solid legal reasons for a contrary characterization. This event serves to highlight the fragile legal foundations of insurance securitization. If there is no statutory safe harbor from insurance laws for weather derivatives (and the securitizations that make use of them) in the jurisdiction whose laws are the proper law of the weather derivatives, they will be subject to the risk that a regulator or court may recharacterize them as insurance contracts. That concern also applies to the risk transfer instruments employed in other insurance securitizations.
- 190.
Rhee (2005) p. 501. For instance, in Bermuda, there is a statutory exemption for catastrophe bonds by virtue of which the transaction participants are deemed not to be carrying on an insurance business. See Bermuda Insurance Act, 1978 s. 57A(4). In the US also, a majority of states have passed statutes exempting catastrophe bond issuers from the insurance laws. See generally, Ali (2008) p. 369.
- 191.
OECD (2005) p. 60.
- 192.
Idem.
- 193.
Idem.
- 194.
Idem.
- 195.
Idem., p. 61.
- 196.
Idem., p. 60.
- 197.
David (2005) p. 168.
- 198.
For a comprehensive account of the background causes and consequences of the credit crisis, see Arner (2009).
- 199.
Idem., p. 1.
- 200.
Harrington (2009) p. 786.
- 201.
Pub. L. 95-128, Title VII (1977).
- 202.
Arner (2009) p. 21.
- 203.
- 204.
Harrington (2009) pp. 787–788. Because many subprime borrowers acquired property with little or no money down, they faced relatively little loss if housing prices fell and they defaulted on their mortgages. Many people took low-cost mortgages on investment property to speculate on housing price increases. Others took low-cost second mortgages to fund consumption.
- 205.
Vries Robbé et al. (2008) p. 7.
- 206.
According to one author, “loans came to be made not by banks with an ongoing interest in their repayment but instead by specialists – mortgage brokers for real estate … – intent on profiting from charging to arrange loans and with no intention of maintaining an interest in the ability of the borrower to repay in the future”. See Arner (2009) p. 3.
- 207.
This was driven in large part by the “originate and distribute” model of universal banking, initially adopted by the majority of international banks and investment banks in the early 1990s. Under the model, financial institutions would on a continual basis either create or purchase underlying assets from the originators. The assets would be pooled together into structured pools of risks designed to appeal to various classes of investors and held. Such pooling would take place either on-balance sheet or off-balance sheet through separate (though often not truly independent) entities such as conduits and Structured Investment Vehicles (SIVs). Pools where necessary would be supplemented by synthetic credit risk through credit default swaps (CDSs) to meet the requirements of complex quantitative models designed on the basis of portfolio theory to reduce risk and enhance return, including those of rating agencies. Pools then would be used to back a structure of securities rated by external credit rating agencies. Resulting securities would be sold or held (warehoused) depending on prevailing market conditions, with purchasers including banks and investment banks, insurance companies and pension and investment funds, including hedge funds. Funds resulting from the sales of securities (which might in turn be repackaged into collateralized debt obligations (CDOs) and eventually CDO2s etc.) would be used to collect new assets, thus continuing the process, so long as investors continued to be willing to purchase the resulting securities. See idem., pp. 21–22.
- 208.
Harrington (2009) p. 787.
- 209.
Idem. See also Arner (2009) pp. 18–19 where the author notes: “From the standpoint of financial institutions … [the ‘originate and distribute’] model had two benefits. First, it increased profitability by increasing velocity of transactions which in a low interest rate environment relied more on fees charged for the origination than on spread based income produced over the life of the asset. Second, it reduced the risks of any potential defaults because the originators did not own the assets originated; instead the resulting securities were widely distributed in the markets. From the standpoint of regulators, this model likewise had two benefits. First, banks were less risky because they were holding fewer loans and hence were exposed less to default risk in any future economic downturn. Second, by repackaging and distributing credit risks widely into the market, this brought down the charges which lenders had to charge borrowers, increasing home ownership and economic activity”.
- 210.
In this context, the technology of securitization was expanded to encompass a range of ever more complex techniques and structures. Simple securitization techniques (such as pooling of risks, off-balance sheet structure, and capital markets funding) were combined with over-the-counter (OTC) derivative techniques, especially credit derivatives such as credit default swaps. See Arner (2009) p. 4.
- 211.
“CDO securities are backed by – and thus their payment derives principally or entirely from – a mixed pool of mortgage loans and/or other receivables owned by an SPV”. See Schwarcz (2008) p. 376.
- 212.
“ABS CDO securities, on the other hand, are backed by a mixed pool of ABS and/or MBS securities owned by the SPV, and thus their payment derives principally or entirely from the underlying mortgage loans and/or other receivables ultimately backing those ABS and/or MBS securities”. See idem., p. 376. In fact, ABS CDOs are CDOs referencing other securitizations and this is why those transactions are sometimes referred to as “re-securitization”. On this, see Vries Robbé et al. (2008) p. 8.
- 213.
Vries Robbé et al. (2008). ABS CDO securities are typically issued in tranches, ranked by seniority of payment priority. The highest priority class is called senior securities, whereas lower priority classes are usually known as mezzanine securities, with the lowest priority class, which has a residual claim against the SPV, called the equity. “The senior classes of securities are more highly rated than the quality of the underlying receivables. For example, senior securities issued in a CDO transaction are usually rated AAA even if the underlying receivables consist of subprime mortgages, and senior securities issued in an ABS CDO transaction are usually rated AAA even if none of the MBS and ABS securities supporting the transaction are rated that highly. This is accomplished by allocating cash collections from the receivables first to pay the senior classes, and thereafter to pay more junior classes (the so-called waterfall of payment). In this way the senior classes are highly overcollateralized to take into account the possibility, indeed likelihood, of delays and losses on collection”. See Schwarcz (2008) pp. 377–378 [footnotes omitted].
- 214.
Arner (2009) p. 3.
- 215.
“In essence, the seller of a CDS agrees to pay the buyer if a credit event occurs, typically some sort of default by an unrelated borrower. The buyer of the CDS agrees to pay the seller a stream of payments roughly equivalent to the payments that would be made by the identified but unrelated borrower. As such, the seller of the CDS receives a stream of payments which mimic a loan – thus for one party, the CDS is a form of synthetic loan: a mechanism to acquire credit risk of an unrelated party. If the notional creditor defaults, the seller must pay the value of the defaulted obligation or deliver the underlying obligation to the buyer. The buyer in turn purchases a form of protection against the default of the underlying borrower/obligation, thereby hedging an actual credit to the notional borrower or speculating on notional credit risk”. See idem., p. 5.
- 216.
Harrington (2009) p. 790. Although CDSs have economic characteristics similar to insurance (i.e., they transfer risk from the protection buyer to the protection seller, and involve some degree of risk spreading by the protection buyer), they are not legally considered to be insurance since the protection buyer does not need to have an insurable interest in the underlying securities or exposure. In the US for instance, insurance regulation prohibits insurance companies from writing CDS.
- 217.
It is reported that at the end of 2007, AIG had US$ 533 billion (net notional amount) of CDS outstanding, out of which some US$ 61 billion represented its exposure to subprime mortgages. See idem., pp. 790–791.
- 218.
Idem., p. 787.
- 219.
Idem.
- 220.
Arner (2009) p. 6.
- 221.
Schwarcz (2008) pp. 378–379.
- 222.
Idem.
- 223.
Arner (2009).
- 224.
Idem. Bear Stearns was eventually bought by J.P. Morgan in May 2008.
- 225.
- 226.
Initially, an amount of US$ 85 billion was put up by the federal government. This was subsequently modified on several occasions bringing the total federal government commitment in bailout assistance to AIG to US$ 182.5 billion. Most of this assistance money was paid by AIG to bank and investment bank counterparties in CDS transactions. See Harrington (2009) p. 789.
- 227.
Schwarcz (2008) p. 393.
- 228.
This concept enabled mortgage lenders to sell off loans as they were made.
- 229.
- 230.
Arner (2009) p. 3.
- 231.
Schwarcz (2008) p. 383.
- 232.
Arner (2009) p. 7.
- 233.
In most countries, insurance laws and regulations require underwriters to maintain substantial contingency reserves, including a general requirement that half of all premiums written each year be held as a contingency reserve for 10 years. See. Harrington (2009) pp. 788–789.
- 234.
When insurance is contracted for on an excess-of-loss basis, the insured retains a portion of the risk and this is known as the deductible. This means that upon the occurrence of an insured event, the insured will be responsible for all losses that fall within the deductible limit, and the insurer will only cover losses that fall over and above the limit, if any.
- 235.
“Adequate capital reserves are essential to the sound management of financial institutions. Good capitalization requires that … [financial institutions] have sufficient financial resources at their disposal to provide adequate protection against financial losses and declines in the value of assets. A … [financial institution's] capital serves to cushion the effect of temporary operating losses. Capital reserves absorb these losses until profitability is restored, allowing the … [financial institution] to remain solvent and thus providing a measure of protection to depositors and creditors. Profitability and solvency are linked to the composition of a … [financial institution’s] portfolio of loans and deposits; therefore, the proper management of capital reserves is essential to both of these objectives. However, determining the “right” amount of capital reserves requires finding the right balance between a … [financial institution's] profitability and solvency. Diverting too many funds into capital reserves can drain a … [financial institution] of its liquidity and thus put it at a competitive disadvantage. On the other hand, if the level of capital reserves is too low, the … [financial institution] will be at greater risk of insolvency. Public confidence in the soundness of a financial institution depends on the perception that it holds satisfactory amounts of capital over assets (the capital ratio). If depositors believe their … [financial institution] is financially unsound, and that their deposits are at risk, there is an increased chance of an unexpected and substantial withdrawal of funds by depositors (i.e., a run on the bank). Even in cases where the liquidation of assets is considered unnecessary, a loss of public confidence can increase a … [financial institution’s] cost of raising funds. If the cost increase is significant, profitability will be impaired, once again putting pressure on an already thinly capitalized institution. Thus, by keeping adequate capital reserves, a … [financial institution] can help preserve public confidence in its financial integrity, reduce the risk of bank runs and thus lower its costs of doing business”. See Dupuis (2006) pp. 1–2.
- 236.
Idem., p. 2.
- 237.
Idem., p. 3.
- 238.
Idem.
- 239.
Idem.
- 240.
Basel Committee on Banking Supervision (2009) p. 1.
- 241.
Basel Committee on Banking Supervision (1988).
- 242.
The weights assigned to each class of assets were adjusted according to the credit risk associated therewith and they ranged from 0 % (for assets thought to be very safe, such as government debt in developed countries) to 100 % (for unsecured loans to consumers and companies). See Dupuis (2006) p. 4.
- 243.
See Basel Committee on Banking Supervision (2009) p. 2. In September 1993, a statement was issued confirming that all the banks in the G10 countries with material international banking business were meeting the minimum requirements laid down in the 1988 Accord.
- 244.
Basel Committee on Banking Supervision (2004).
- 245.
Basel Committee on Banking Supervision (2009) p. 3.
- 246.
Most significantly, these amendments include a consensus document governing the treatment of banks’ trading books under the new Framework published in July 2005 in close cooperation with the International Organization of Securities Commissions (IOSCO), the international body of securities regulators who monitor the activities of securities firms and investment houses. See idem., p. 3.
- 247.
Basel Committee on Banking Supervision (2006).
- 248.
Basel Committee on Banking Supervision (2009) p. 2.
- 249.
Idem., p. 4.
- 250.
Idem.
- 251.
See Basel Committee on Banking Supervision No. 35/2010 (2010). The Committee’s package of reforms will seek to increase the minimum common equity requirement from 2 % to 4.5 %. In addition, banks will be required to hold a capital conservation buffer of 2.5 % to withstand future periods of stress, bringing the total common equity requirements to 7 %. This reinforces the higher capital requirements for trading, derivative and securitization activities to be introduced at the end of 2011.
- 252.
See idem.
- 253.
The Basel Committee has been working closely with securities and insurance supervisors to study the challenges presented by the development of diversified financial conglomerates. Initially this cooperation was through an informal tripartite group of supervisors from each of the three sectors. This group was succeeded in 1996 by the Joint Forum on Financial Conglomerates, constituted under the aegis of the Basel Committee, IOSCO and the International Association of Insurance Supervisors (IAIS). In addition, the Committee, together with IOSCO, has issued ten joint reports since 1995 dealing with the management, reporting and disclosure of the derivatives activities of banks and securities firms. See Basel Committee on Banking Supervision (2009) p. 4.
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Nyampong, Y.O.M. (2013). Enhancing the Insurance of Aviation War and Terrorism Risks Through the Use of Alternative Risk Transfer and Risk Financing Mechanisms. In: Insuring the Air Transport Industry Against Aviation War and Terrorism Risks and Allied Perils. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-32433-8_5
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