Risk Transfer Innovation: The Key To Emerging Markets For Global Reinsurers

Primary Credit Analyst: Victor Cardenas, Mexico City (52) 55-5081-4482; [email protected] Secondary Contacts: Anvar Gabidullin, CFA, London (44) 20-7176-7047; [email protected] Neil Gosrani, London (44) 20-7176-7112; [email protected] Philip P Chung, CFA, Singapore (65) 6239-6343; [email protected]

Table Of Contents
The Big Shift Innovation And Results What Lies Ahead? Understanding The Risks Why These Economies? Why Now?

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Challenging operating conditions are forcing global reinsurers to look beyond their traditional markets in order to maintain relevance and increase profitability. As a result, reinsurers are now turning their focus to the emerging and less-developed economies in their search for growth opportunities in new regions and via new products. The chasm that exists between the demand for insurance protection in these economies and the supply from local and global markets provides regional and global reinsurers with opportunities to offset slowing growth in their mature markets, offer innovative products, and enforce the industry's relevance. The products and schemes that result provide affordable risk solutions for unattended consumers, especially in low-penetrated insurance markets, and create incentives for global reinsurers to take advantage of the high economic growth forecasted for emerging and less-developed economies. Overview Global reinsurers face numerous challenges in their traditional markets, forcing them to look elsewhere for growth opportunities. They're turning to the emerging and less-developed economies, which have high economic growth forecasts and offer reinsurers new sources of revenue and opportunities to diversify their risk portfolios and improve their competitive positions. We believe the new risk transfer mechanisms that reinsurers have created for advanced markets could help to expand reinsurance business in developing markets and fill the insurance gap in those countries to some extent. They also create opportunities for new risk schemes that could lead to future industry growth. We believe that the demand for new innovative risk-transfer reinsurance schemes in the emerging markets could increase to $10 billion by 2023 from about $2.8 billion in 2013.

The reinsurance industry is facing stiff competition from new and existing business lines in advanced markets, saturation in products and distribution channels in developed markets, and low interest rates, which hurt their two mains sources of revenue: premiums and investments returns. Meanwhile, structural changes in historical mortality patterns threaten the life insurance business and the property and casualty insurance segment has recorded higher frequency in natural and man-made disasters, which imply bigger losses and thus higher costs for reinsurers. These conditions are exhausting business opportunities in the traditional reinsurance markets over the past decades. Still, the future isn't grim for the industry even as reinsurers are under pressure to improve or maintain their credit ratings. In response, they have developed innovative risk structures, such as pooling schemes, insurance-linked securities, and others, particularly for emerging and less-developed economies. Global reinsurers customized these structures to provide solutions to meet growing demand in these markets. These products also helped to expand their businesses in those markets, diversify their business and risk portfolios, and increase their reinsurance capacity and premium revenue. And based on their strengths and our criteria, we've rate most of the global reinsurers with this profile 'A-' rating or higher. Overall, we believe that global and regional reinsurers' involvement in innovation and

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exploration beyond advanced markets could benefit their business positions over the next decade.

The Big Shift

Global reinsurers are using innovative schemes to diversify their risk portfolio and optimize capital mix. However, some of these types of schemes have proven to have remarkable value and are opening doors in underpenetrated insurance markets. Over time in these markets, we expect reinsurers to shift away--as they have done in advanced economies--from strategies in which the main target and final insured are governments to schemes focused on consumers and businesses, where the main clients are not necessarily governments and the client base is broader. (The advanced markets are the U.S., Canada, Western Europe, including the U.K., and Japan; the emerging markets are Brazil, China, India, Russia, Korea, Mexico, Peru, Colombia, Indonesia, Malaysia, Philippines, Thailand, Vietnam, South Africa, and Middle East and North Africa (MENA) countries; and the less-developed countries constitute the rest of the world.) The developing economies are ripe with possibilities for new reinsurance business. According to Swiss Re's Sigma Magazine, emerging markets represent only 16% of the $4.6 trillion global insurance industry, while advanced markets represent a whopping 84%. Here's the breakdown: Western Europe: 31.7%; The U.S. and Canada: 30.2%; Advanced Asia markets (Japan, Korea, Taiwan, Hong Kong, and Singapore): 20.3%; Emerging Asia: 8%; Latin America and the Caribbean: 3.7%; Oceania: 2.1%; Central and Eastern Europe 1.6%; Africa 1.6%; and The Middle East and Central Asia: 0.9%.

Economic and demographic factors play integral roles in the performance of macroeconomic variables in emerging and less-developed economies. Advanced economies are already mature with fewer growth prospects, and, therefore, reinsurers have more growth opportunity in developing markets where insurance penetration is low. Despite the adjustments made in some countries, we expect the GDP growth rate in emerging markets to continue expanding at a faster pace than in developed economies over the coming years (see chart). We also expect per capita income in emerging markets to continue improving gradually and result in a larger middle class with higher disposable personal income and more available assets. The demographic trends in the region should also result in a larger population of young people who will consume more and demand more services, including all type of financial services and insurance and, implicitly, additional reinsurance capacity. We believe the stability of financial variables such as inflation and interest rates throughout most emerging market economies should support this growth in the financial sector, including the insurance and reinsurance industries, if the trend continues.

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Innovation And Results

Reinsurance capacity (the total supply of capital reinsurance companies provide to insurance companies) strongly supported the wave of innovation in reinsurance products that was well under way by the end of the 1990s. Some of these products--pooling schemes as a mutuality structure (mutuality is an insurance structure where the policyholders share the profits, losses, and expenses and there are no shareholders) and catastrophe bonds (cat bonds)--were specifically targeted for emerging and less-developed economies. In many cases, these products' growth reflected support from the international donor community of high-income countries, and they were organized either by multilateral agencies, such as the World Bank, or developed locally, such as Mexico's Natural Disaster Fund or Taiwan's Residential Earthquake Insurance Fund. The transactions we've seen over time can be classified into three types: pooling risks, innovative risk transfer schemes, and innovative insurance policies (see table 1). Each of these new risk transfer mechanisms helps create value and expand business in the related countries and fill the insurance gap to some extent. They also create precedents that develop and pave the way for new structures in those countries' reinsurance industries, which are often in an early stage of development.

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Table 1

Innovative Risk Transfer Mechanisms For (Re)Insurance

Scheme Pooling risk Synopsis Mutualization of risk for buyers protection by creating reserve funds that retain and distribute the risk efficiently Structured (re)insurance products that provide access to the capital markets and investors Insurance policies developed in a traditional manner (through an insurer as carrier of reinsurer) but structured specifically for complex risk Protection provided to Governments, local insurers, and individuals Protection provided by Reinsurers and peer insurers Benefits to reinsurers Access to diversifying and pooling risk arranger, which can help increase brand awareness in a protected market and better understanding of risk in emerging and less-developed economies Access to a broader source of capital and more diversified risk portfolio and investment portfolios Diversify risk and business portfolios

Innovative risk transfer Innovative insurance policies

Global reinsurers, larger insurers, and government agencies Producers or individuals for agriculture, livestock, housing, and food security

Capital markets investors Reinsurers

Local and regional reinsurers can help develop these types of risk transfer strategies by leveraging their knowledge, experience, and networking capabilities. Still, these reinsurers are at a disadvantage compared with their global counterparts, which are generally well-positioned in the global industry and have strong business risk positions. They typically hold excess capital for the amount of risk taken locally and have high-quality investment portfolios, in many cases, with moderate to high concentration in markets such as the U.S., Western Europe, and Japan. As a result, they are better positioned to reap the benefits from reinsurance transactions sooner because they can leverage economies of scale and lower cost of capital. In many cases, large global reinsurers have already invested in research and technology and have developed expertise with a wider range of emerging and less developed economies. Diversification of their business and investment portfolio is also a key factor for large global reinsurers because advanced reinsurance markets account for 84% of their risk concentration, in terms of premiums collected. This implicitly imposes limits on reinsurers' ability to underwrite new capacity in these markets and, therefore, makes diversification a priority for their ultimate survival. However, the relationship between local and global reinsurers doesn't need to be completely competitive. Local and regional reinsurers hold the advantage of local knowledge, licensing, relationships, and expertise, which is especially critical for extreme or complex risk structures. This may make them attractive to global reinsurers as local partners that provide inroads for global business. Meanwhile, local and regional reinsurers can learn and benefit from the underwriting expertise, research, information, and cheaper capital that global reinsurers could provide. We expect regional reinsurers to eventually transition from having pass-through roles to being risk takers--and with higher retention levels.

What Lies Ahead?

We believe that the demand for new reinsurance capacity in the emerging markets considering innovative structures could total about $2.8 billion in 2013 (see table 2). Although it is still too early to determine the potential market size, we believe that, given organic growth and its potential scale, this number could increase to $10 billion in 10 years. This wave of activity will likely translate into more reinsurance premiums from those countries as the schemes developed

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grow organically and indirectly improve insurance market conditions, promoting stronger (re)insurance markets locally. We also believe that local and global reinsurers are committed to making investments in research in those countries, and reinsurers that are fully committed will have the "first-mover" advantage.
Table 2

Key Examples Of Innovative Schemes In Emerging And Less-Developed Economies

Project The Caribbean Catastrophe Risk Insurance Facility Pacific Catastrophe Risk Insurance Pilot Natural Disaster Fund X-Loss Coverage Natural Disaster Fund Turkish Catastrophe Insurance Pool Turkish Catastrophe Insurance Pool *Estimated for December 2013. Country 16 countries in the Caribbean Five countries in the South Pacific Mexico Mexico Turkey Turkey Reinsurance capacity demanded (mil. $)* Type of capacity 107.5 Pooling 45 Pooling 315 Insurance and pooling 400 Catastrophe bond 1,500 Pooling 400 Catastrophe bond

Risk pooling
We expect a growing trend in pooling risk schemes. These schemes represent a key component of potential growth in the reinsurance industry, particularly in the less-developed economies, given the implicit economic scale for pooling members, which, in many cases, results in affordable insurance premiums and increased bargaining power for them in reinsurance markets. Fundamentally, risk pooling structures bring certain benefits to the global reinsurers involved. These include an opportunity for them to showcase and share their technical expertise in their markets, for instance with regional reinsurers. Global reinsurers typically assume a leading role in pools, which could allow them to obtain access to a wider geographic area and develop their profile beyond their "natural" remit. It also allows them to create new client connections and stronger relationships, which could bolster their competitive position and marketing opportunities, increase brand awareness, and bring further differentiation from the competition. Furthermore, by having insight into wider pools of risks, reinsurers gain access to additional market data that could assist with risk selection and pricing in their core portfolios. Ultimately, risk pooling allows reinsurers to potentially benefit from management fees and profit sharing based on the pool's performance. We examined several examples risk pools that promote insurance penetration in the developing economies. These include the Turkish Catastrophe Insurance Pool, the Caribbean Catastrophe Risk Insurance Facility, the Pacific Catastrophe Risk Assessment and Financing Initiative, and others.

Risk pooling schemes in state-island countries: the Caribbean Island and the Pacific Islands*
There are two independent examples, both developed with similar structures: the Caribbean Catastrophe Risk Insurance Facility (CCRIF) and the Pacific Catastrophe Risk Insurance Pool (PCRIP), both structures provide insurance protection against natural disasters and liquidity to the member governments via insurance payments after a catastrophe. The CCRIF was successfully implemented in 2005, and the PCRIP is currently being tested through a pilot that consists of five state-islands. The World Bank guides both schemes, with funding from the donor community. The

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function of both schemes is to operate as a mutual insurance company controlled by participating governments. These schemes helped member countries gain access to affordable insurance by pooling their risk exposures. A portion of the pooled risks is retained through reserves from the pool, which is an independent company, that reduces the regular cost of insurance premiums. Each scheme transfers the risks it cannot retain by purchasing reinsurance in global reinsurance markets. Typically, the largest global reinsurers take risk from CCRIF, and, given the complexity of the risk, the protection the pool offers does not compete with insurers locally. We expect PCRIP to receive a similar response from the reinsurance community.

Risk insurance facility: The African Union*

After hard drought conditions led to food security risks and humanitarian crises, including widespread hunger, member states of the African Union and regional bodies are currently structuring a risk pooling scheme in order to get (re)insurance protection against food security risk. The scheme would provide financial support for emergency response after droughts, floods, earthquakes, and cyclones for governments and citizens. The requirements for participation are under consideration. The scheme is envisioned as a Pan-African stand-alone financial entity that will pool weather risk across the continent and, through aggregation, significantly reduce risk transfer and risk management costs for participants. The payouts will be based on transparent and objective criteria identified through a software platform, Africa RiskView (ARV), which uses satellite rainfall information to produce near real-time response cost estimates for crop losses. The capital in the pool will be based on initial contributions from member countries and donors. Participating countries will pay an annual fee (coverage), based on their risk exposure, as calculated by ARV. The scheme is under development, but we expect to see strong participation from the largest global reinsurers, who would take risk from the higher layers of the reinsurance structure.

Innovative risk transfer financial instruments in middle-income countries: Turkey and Mexico
Mexico and Turkey are two of the most advanced emerging economies. Mexico developed a national scheme of risk management to provide insurance protection for public assets that are exposed to natural disasters and to protect the country's public finance against contingent spending in poor population following natural disasters. The scheme integrates innovative risk transfer schemes, such as cat bonds, pooling risk for retention, and excess-of-loss risk transfer reinsurance contracts. The entire scheme is now comparable in size and structure with similar regional arrangements organized by government of developed economies that focus on providing insurance protection for housing, such as the U.S. for the states of California and Florida. With the World Bank's support, Turkey developed a pooling scheme to provide insurance protection for housing through a mandatory insurance mechanism. The scheme was integrated in higher layers of reinsurance through a debt structure financed by the World Bank and reinsurance contracts provided by global reinsurers. As part of the protection structure, a cat bond (Catastrophe Bond Bosphorus 1 Re Ltd.) was issued in 2013 to cover part of the higher layers of the reinsurance program.

Innovative risk transfer financial instruments: Peru*

Extreme El Nio is a cyclical phenomenon linked to major ocean currents, and it is believed to have caused catastrophic rainfall and flooding in Peru, particularly in the northern region. With predictions for the frequency and

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severity of El Nino events to increase the potential for loss in coming years, the Peruvian government looked to the insurance market for insurance protection. With initial support from the U.S. Agency for International Development (USAID) and later the Bill and Melinda Gates Foundation and The German Agency for International Cooperation (GIZ), an insurance product was designed to protect against the consequences of extreme El Nio. The insurance, which the international reinsurance company PartnerRe Ltd. offers with local support from Peruvian insurance company La Positiva Seguros, is highly innovative and represents a number of important breakthroughs. These include the world's first regulated "forecast" insurance, the first index insurance contract based on sea surface temperature (because the events that trigger insurance payment generally occurs in November and December of one year and the losses occurs in January of the following year), and the first index insurance to be framed as contingent insurance. Eventually, a small, popular Peruvian savings institution bought the insurance scheme and supported it by increasing its lending capacity in regions typically affected by extreme El Nio.

Innovative risk transfer financial instruments: Mongolia*

Severe livestock mortality is one of the main national concerns in Mongolia. Through a public-private partnership, herder households across the country utilize county-level estimates of livestock mortality to insure herders against correlated livestock losses. Under this partnership, Commercial insurance products are priced to cover losses from 6%-30% mortality, and the government of Mongolia finances losses higher than 30% as an integrated disaster assistance component. The public-private partnership began as a pilot program in 2006 in three provinces. In 2010, the scheme was sold to nearly 7,000 herders in nine provinces; and, by 2012, the insurance was implemented as a national program in all 21 provinces. The partnership has obtained reinsurance to finance a layer of catastrophic loss that was mostly retransferred to global reinsurers.

Facilitating affordable catastrophe protection: Thailand's National Catastrophe Insurance Fund

Although Thailand experiences varying degrees of flooding annually, the scale and timing of the floods in 2011 caused a discontinuity in the insurance market that interrupted reinsurance capacity. Asset owners were unable to obtain flood protection or were only able to do so at significantly higher costs. As a result, Thailand's pooling scheme (National Catastrophe Insurance Fund; NCIF) was established in 2012 to help individuals and businesses obtain catastrophe protection at an affordable cost. For those local insurers whom opt to get protection from NCIF, there is a risk retention requirement for risk that is ceded to the NCIF. But if the insurer chooses not to cede to the NCIF because of market conditions, this requirement is not applicable, since Thailand no longer has mandatory cession, and the insurer is free to choose the best alternative. These developments suggest increased affordability in catastrophe protection in Thailand, given the market's willingness to retain higher exposure and charge prices lower than those the NCIF provides. Still, although there may be "cherry picking" in the part of the portfolio ceded to the NCIF, the creation of the insurance fund has facilitated continuity in business activities in times of uncertainty.

Adding to regional value chain: Energy industry in the MENA countries

The Gulf Cooperation Council (GCC) insurance market follows the macroeconomic dynamics of MENA countries, supporting the boom in infrastructure and construction projects with insurance protection. However, insurance penetration in this region is still very low. With total premiums accounting for less than 1.5% of GDP, insurance penetration in GCC countries is a mere 20% of the global average. This massive underpenetration, combined with

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continued robust GDP growth in most GCC states, suggests a major potential for the region's insurance markets. The pipeline of planned infrastructure and construction projects in the region is worth close to $1 trillion, with Saudi Arabia and Qatar displaying a continued boom and the United Arab Emirates experiencing a strong recovery from the impact of the global financial crisis. In Qatar alone, more than $70 billion was allocated by the government to infrastructure projects between 2005 and 2011. As of January 2012, $63 billion worth of projects were underway in the country, with an additional $108 billion in the pipeline for the next three years. Sources: *Cardenas et al 2012, "Risk Management Instruments for Food Price Volatility and Weather Risk in Latin America and the Caribbean," Inter-American Development Bank, Working Paper IDB-DP-220; Cardenas et al, 2011, "Catastrophe Financing for Governments," OECD Working Papers on Finance, Insurance and Private Pensions, No. 9, OECD Publishing; Chung Philip & Tanaka Reina, 2013, S&P Insurance Japan.; and The Report (Insurance), Abu Dhabi, 2013.

Understanding The Risks

A basic economic formula states that in equilibrium, a quantity demanded equals quantity supplied for a certain level of prices. Likewise, the risk pooling projects we've mentioned demand reinsurance capacity, which offers the global reinsurance industry opportunities to provide the supply. Several factors drive the rationale behind reinsurers' risk management strategies and decision-making processes. For example, reinsurers are typically cautious to participate in these risk pooling schemes, given the complexity of the risks involved. And regional reinsurers tend to pass the risk through to global reinsurers, particularly in structures that are highly concentrated in catastrophe risk. Still, even in small pieces, pooling schemes provide interesting benefits such as diversification in the business or investment portfolio, and, in some cases, high profitability (such as for cat bond investors).

Why These Economies? Why Now?

For global reinsurers, the attraction of the emerging and less-developed economies lies not only in the additional source of revenue they could provide but also in the opportunities they offer reinsurers to diversify their risk portfolio--even through small risk pieces--and improve their competitive positions. For reinsurers that have higher portfolio risk concentrations in some regions (even with excess of capital), this implies a constraint on its underwriting capacity and a more diversified portfolio could make room for additional risk even in the already concentrated markets. As more reinsurers delve into this last frontier of the reinsurance industry, we expect to see more transactions that boost reinsurers' business profiles and sustain or possibly improve their competitive positions. These opportunities could in turn attract several new players in the industry as global reinsurers pave the way for smaller reinsurers in this segment, even among those with speculative-grade ratings ('BB+' and lower). The emerging and less-developed economies position reinsurers for robust future business expansion. However, the

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market dynamics in these economies follow a slower process, particularly in local insurance industries, and reinsurers need a deeper understanding of the exposures and risks involved, which typically implies several years commitment. Therefore, the breadth of reinsurers' future business expansion in those markets will depend not only their desire for increased profitability and market share but also on how involved and invested they are in their understanding of those economies. GRH2013

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