Insurance companies already have a track record transferring extreme mortality risks to the capital markets. This is normally done by issuing a special kind of catastrophe bonds, called extreme mortality bond. These bonds pay a higher coupon in exchange for insuring the risk of a catastrophic increase in deaths due to a pandemic or plague. Should a certain threshold of deaths above the average materialise, interest and/or capital will be foregone for investors and paid out to the insurance company. According to an October 2008 report by Guy Carpenter, there are around USD1.5 billion of such bonds outstanding. However this is only a drop in a bucket since estimates are that in case of a full-fledged pandemic it could cost US life insurance alone between USD31 billion and USD133 billion, says Reuters.
Despite the outbreak of swine-flu the outstanding cat bonds have not shown any great price reaction. The main reason for this might be that in order to be triggered millions of people have to die which currently - thank God - does not look very likely. Additionally the outstanding mortality bonds cover only the United States, Britain, Canada, France, Germany and Japan.
So the possibility of insurance companies being hit by a pandemic seems very low since a lot of people would have to die first. But what about the travel companies, that feel the pain immediately? Shares in companies like Lufthansa (LHA), Thomas Cook (TCG), Accor (AC), Iberia (IB) and others suffered immediately from booking cancellations, health warnings and possible travel restrictions. These companies are not hedged against pandemics and other catastrophes such as terrorism except for the normal insurance policies. Cat bonds and other insurance linked securities might be cost efficient, long-term new hedging universe still to be tapped by such companies. Travel companies would benefit by issuing cat bonds from long-term insurance without the need to renegotiate every year the terms. Cat bonds issued by tourism enterprises could be triggered by events like travel restrictions, sudden fall in passenger numbers, orders to ground aircrafts such as during 9/11 and other similar incidents.
Another advantage of using cat bonds in general is that since being also some kind of securitisation and alternative risk transfer (ART) they have learned from the errors made by other securitisation vehicles, such as CDOs, RMBS etc. The latest cat bond structures have implemented increased transparency provisions and other safeguards (for more information see article “How state guaranteed bonds can help to free up capital in insurance companies” at www.hedgeFund-Lawyer.com) in order to allow investors an adequate assessment of risk. In addition to this, insurance for the travel industry is a sector well studied by legions of actuaries which would increase the acceptance of travel companies cat bonds by the capital markets.
Sunday, 3 May 2009
Travel companies should start looking into swine-flu ART
Next sovereign debt crisis around the corner!?
According to a study by the OECD sovereign debt crisis are announced by high fees charged by the investment banks placing the sovereign bonds. So in the view of latest sovereign issues, especially from Eastern Europe which had enormous fees charged, and that for example Deutsche Bank's Q1 profits were mainly driven by bond issuance (although both, sovereign and corporate), is the next crisis underway and if so where?
And what about if sovereigns,a s pointed out in a previous post, do not find enough buyers.
What role do government guaranteed bonds play, do we have to include their fee spreads in the equation?
Very disturbing outlook.
CDS, CDOs and arsonists
The CDS-market is basically an insurance market. Insurance has to calculate risk probabilities on a basis that can be objectively reproduced. However, an insurance company would not underwrite a policy for an event that may be influenced by the policy holder or at least would not concentrate large parts of its business in such policies as long as it cannot be diversified away, as for example in car insurance (most claims are accidents and only a few might have a fraudulent background) or there are strong incentives not to manipulate the payout (such as in life insurance).
Another way to insure risks that may be influenced is to underwrite charging high premiums, as happens with director’s liability or terrorism policies. This may dissuade people in defrauding their insurance because the gain achieved through fraud must be proportionally much higher.
CDS, on the other hand, may be manipulated quite easily over OTC markets and also by a third party which is the respective company subject of the CDS protection. Premiums are not high enough to be dissuasive and diversification is also limited.
Yet a step further is insurance on CDOs either through a CDS or monoline. CDOs pose an additional problem for insurance protection due to a basic flaw in their structure. They are not so complex instruments as is always said, but their problem lies within the fact that no one knows exactly what is packaged into them. One does not know whether one has sufficiently diversified away any risk, because policies are underwritten by others, i.e. one just gets the repackaged mortgages or loans and has to believe. Though, insurance, or investments in general, should not be a matter of faith but of verifiable statistics.
Regulation of risk management should therefore start where it is supposed to start: not with capital requirements based on complex valuation and risk management tools, but with the obligation to see whether risk management is actually possible for certain areas. Would you be able to manage the risk of underwriting fire insurance policies to an arsonist?
Good examples of a new generation o transparent investments are the cat-bond structures that have been issued this year. Collateral is marked-to-market daily and there are to-up obligations for swap counterparties. Something that should lead the way in other areas of securitisation.
www.HedgeFund-Lawyer.com
Read more
Another way to insure risks that may be influenced is to underwrite charging high premiums, as happens with director’s liability or terrorism policies. This may dissuade people in defrauding their insurance because the gain achieved through fraud must be proportionally much higher.
CDS, on the other hand, may be manipulated quite easily over OTC markets and also by a third party which is the respective company subject of the CDS protection. Premiums are not high enough to be dissuasive and diversification is also limited.
Yet a step further is insurance on CDOs either through a CDS or monoline. CDOs pose an additional problem for insurance protection due to a basic flaw in their structure. They are not so complex instruments as is always said, but their problem lies within the fact that no one knows exactly what is packaged into them. One does not know whether one has sufficiently diversified away any risk, because policies are underwritten by others, i.e. one just gets the repackaged mortgages or loans and has to believe. Though, insurance, or investments in general, should not be a matter of faith but of verifiable statistics.
Regulation of risk management should therefore start where it is supposed to start: not with capital requirements based on complex valuation and risk management tools, but with the obligation to see whether risk management is actually possible for certain areas. Would you be able to manage the risk of underwriting fire insurance policies to an arsonist?
Good examples of a new generation o transparent investments are the cat-bond structures that have been issued this year. Collateral is marked-to-market daily and there are to-up obligations for swap counterparties. Something that should lead the way in other areas of securitisation.
www.HedgeFund-Lawyer.com
Monday, 20 April 2009
How state guaranteed bonds can help to free up capital in insurance companies
In this short article, I will explore the latest developments in the cat bond market and how such changes may help on the one hand troubled banks to sell their debt and insurance companies to free up capital.
The full article can be found here.
www.HedgeFund-Lawyer.com
Read more
The full article can be found here.
www.HedgeFund-Lawyer.com
Sunday, 19 April 2009
OECD recommends Cat Bonds
The OECD has recently recommended that member states should protect their infrastructure better. In a report released the organisation suggests that it would be beneficial to use cat bonds to protect infrastructure. This is only a little step away from the suggestion made some time ago on this blog when we proposed to finance infrastructure projects through the issuance of cat bonds (see article here).
www.HedgeFund-Lawyer.com
Read more
www.HedgeFund-Lawyer.com
Monday, 3 November 2008
Cat-Bonds and PPP: An interesting financing idea in times of recession
This week I have prepared a small article which should serve as an introduction into cat-bonds, how they work and what advantages they have in portfolio construction.
I also explore the possibility merging two familiar concepts, cat-bonds and Public Private Partnership (PPP). By doing so, infrastructure could be financed in a way that would help balance sheets to show lesser a burden than with "normal" debt financing.
The full article can be found here.
www.HedgeFund-Lawyer.com
Read more
I also explore the possibility merging two familiar concepts, cat-bonds and Public Private Partnership (PPP). By doing so, infrastructure could be financed in a way that would help balance sheets to show lesser a burden than with "normal" debt financing.
The full article can be found here.
www.HedgeFund-Lawyer.com
Porsche, the index and a fundamental flaw
We have all read and heard about the short squeeze in Volkswagen caused by Porsche, some even felt the pain. I think Porsche did a great job, considering that its methods were accepted by the relevant regulators. Nevertheless, it would be a cleaner solution to spin-off the options business from the car business and make a hedge fund out of it.
What is really disturbing about the whole story is the fact that Volkswagen-shares drove several stock indices - and as a consequence index-funds - crazy. And, although the press is of another opinion, this was not just particular to Germany and its blue chip index DAX. The question is whether market capitalization indices are not fundamentally flawed by not taking into account stock held outside the free float (for a description of the DAX see here). In a situation as with Volkswagen, where only a little less than 6% of the shares were available for trade, supply and demand over such a small portion of the capital determines the market capitalization. I agree that VW is an extreme example, but in an up-market where buy and hold strategies prevail, the free float logically also will be lower, which probably might lead to similar phenomena, i.e. bubbles, although they might not be so obvious. Cutting the exposure of an index to a certain limit of a specific stock does not remedy the illness: the price of such stock is still determined by very few market players and therefore is a distorted reality. One has to distinguish between the market price of a stock, which is relevant for persons that want to actually trade such stock, and the value of a stock. An index should not be prisoner of the market price without taking into account stock outside the free float. Not-selling is also a view worth considering, especially if one or more investors own a substantial part of a company's capital. The lower the free float the less the market price should influence the index and the more the views of holders of locked-in shares should be taken into account. An index build with such a dynamic rule would mirror far better economic realities as it would take into account the views of actual buyers and sellers on the share price as well as of holders of locked-in shares.
By the way: the figures in the media of losses in hedge funds of up to US$30bn because of the short squeeze in VW seem far overreaching. Actual losses seem to be more in the area of US$4bn, which is still painful but - taken as a single event - not a killer-event (see FT).
http://www.hedgefund-lawyer.com/
Read more
What is really disturbing about the whole story is the fact that Volkswagen-shares drove several stock indices - and as a consequence index-funds - crazy. And, although the press is of another opinion, this was not just particular to Germany and its blue chip index DAX. The question is whether market capitalization indices are not fundamentally flawed by not taking into account stock held outside the free float (for a description of the DAX see here). In a situation as with Volkswagen, where only a little less than 6% of the shares were available for trade, supply and demand over such a small portion of the capital determines the market capitalization. I agree that VW is an extreme example, but in an up-market where buy and hold strategies prevail, the free float logically also will be lower, which probably might lead to similar phenomena, i.e. bubbles, although they might not be so obvious. Cutting the exposure of an index to a certain limit of a specific stock does not remedy the illness: the price of such stock is still determined by very few market players and therefore is a distorted reality. One has to distinguish between the market price of a stock, which is relevant for persons that want to actually trade such stock, and the value of a stock. An index should not be prisoner of the market price without taking into account stock outside the free float. Not-selling is also a view worth considering, especially if one or more investors own a substantial part of a company's capital. The lower the free float the less the market price should influence the index and the more the views of holders of locked-in shares should be taken into account. An index build with such a dynamic rule would mirror far better economic realities as it would take into account the views of actual buyers and sellers on the share price as well as of holders of locked-in shares.
By the way: the figures in the media of losses in hedge funds of up to US$30bn because of the short squeeze in VW seem far overreaching. Actual losses seem to be more in the area of US$4bn, which is still painful but - taken as a single event - not a killer-event (see FT).
http://www.hedgefund-lawyer.com/
The CDS nightmare that was no nightmare
This week, Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, explained in an article in the FT how counterparties to CDS trades on Lehman Brothers cash-settled their transactions. The media was announcing payout figures of up to US$ 400bn, however, after paying 91 cents on the dollar and after netting, the real pay-out reached somewhat between US$ 6-8bn. Most of it has apparently been collateralized. So. luckily, the world did not go under because of the bad derivatives and the evil hedge funds. Effectively, CDS markets helped to avoid further losses during the short selling bans, since a lot of funds used CDS as proxies for shorting stock.
www.HedgeFund-Lawyer.com
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www.HedgeFund-Lawyer.com
Starving out the locusts
On the regulatory side the guys from AIMA seem to be unstoppable, first they published the HedgeFund Matrix, now the new AIMA website went live and they also issued the latest capital adequacy guidance to UK hedge fund managers (see press release). Great job and very useful stuff.
Some managers in Hong Kong should have had a closer look at AIMA's best practice guidelines - it might have avoided them being rebuked by the Honk Kong SFC.
A little further west, the FSA (!) said that there is no need for more hedge fund regulation. CEO Hector Sants stated "Hedge fund managers in general are weathering the market turmoil pretty well in the circumstances, certainly versus other components of the financial services industry". Is this the confession that the unregulated industry did far better than the regulated one? Perhaps in the UK the regulator finally got it right.
However, there is always Germany: according to the FT Deutschland the German socialist party wants to tax private equity funds. Hedge funds should according to the SPD only be able to act in Germany when registered in an EU country and should disclose their ownership and asset structure. The party also wants to prevent insurance companies and pensions funds to invest in hedge funds. For them the solution to the financial crisis seems to be to starve out what they call "locusts". However, Germans saving for theîr pensions might think that someone else should be dubbed locusts.
http://www.hedgefund-lawyer.com/
Read more
Some managers in Hong Kong should have had a closer look at AIMA's best practice guidelines - it might have avoided them being rebuked by the Honk Kong SFC.
A little further west, the FSA (!) said that there is no need for more hedge fund regulation. CEO Hector Sants stated "Hedge fund managers in general are weathering the market turmoil pretty well in the circumstances, certainly versus other components of the financial services industry". Is this the confession that the unregulated industry did far better than the regulated one? Perhaps in the UK the regulator finally got it right.
However, there is always Germany: according to the FT Deutschland the German socialist party wants to tax private equity funds. Hedge funds should according to the SPD only be able to act in Germany when registered in an EU country and should disclose their ownership and asset structure. The party also wants to prevent insurance companies and pensions funds to invest in hedge funds. For them the solution to the financial crisis seems to be to starve out what they call "locusts". However, Germans saving for theîr pensions might think that someone else should be dubbed locusts.
http://www.hedgefund-lawyer.com/
Butterflies that whip the financial markets
I found this interesting video on YouTube, where Benoit Mandelbrot, founder of the chaos theory, and Nicholas Taleb, author of the Black Swan, discuss the probabilities of the improbable. Basing their discussions on the fact that each time a highly improbable event does not occur it becomes even more improbable and therefore causing a wrong feeling of security, they stress that such events are not normally distributed and still can occur any time. Some recent examples found during the last days in the press:
- the mathematical impossibility of negative swap spreads [www]
- the link between Mrs Watanabe's mood swings and the price level of exotic currencies, distant equity markets and sundry commodities [www]
- the "Great Moderation" argument that brought back volatility [www]
So are we now posed to abandon historical series and calculate probabilities based on previous performance? Should we start to look increasingly for self similarity in financial markets? Or should we just get rid of butterflies?
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