Insurance Risk Manager of the Year - Swiss Re

Doubling a securitisation book in just two years would challenge the biggest of monoliths in the financial world. But when the underlying exposures range from wind damage in Europe to US industrial accidents and Mexican earthquakes, bundling that risk into a form that is palatable to capital market investors requires innovation, hard work and a deep understanding of investor appetite for specialised risk.

Swiss Re has revolutionised risk transference in the reinsurance industry. Over the past 12 months, the Zurich-based reinsurer has offloaded risks linked to life span, multi-peril, wind, earthquake and credit exposures worth a whopping $7 billion. To put that in perspective, that is almost three times the company's average issuance over the past nine years - and 22% bigger than its 2005 issuance.

This year's issuance volume is set to be bigger still, in line with the Swiss company's plans to create further capital efficiency across the business. The aim is to share risk with investors, while freeing capital to reinvest in growth areas. But more than that, the strategy is a major step forward in preparation for Solvency II, the regulatory capital framework for insurance companies that, when implemented at the end of 2008, is expected to stimulate a sea change in risk management.

"Swiss Re is making a big push into securitisation," says Alban Fauchere, head of portfolio steering and optimisation at Swiss Re's credit solutions division in Zurich. "The market environment is certainly favourable compared with five or 10 years ago, with many investors looking into new asset classes. That means we can finally address the entire book and not only a small piece of it."

A major development this year has been a move down the credit spectrum by investors keen to enhance returns. Spreads on the iTraxx Europe credit default swaps (CDSs) index hit a low of 16 basis points in October compared with around 40bp a year ago, on the back of strong investor appetite and a relatively benign credit outlook. As a result, investors have begun to consider other, higher-yielding investments in hitherto unknown strata of the credit market.

"Investors on the credit side are getting more and more sophisticated," says Davide Crippa, Zurich-based head of portfolio management and analytics in the reinsurer's credit solutions division. Swiss Re spotted this appetite for higher returns and a willingness by investors to take exposure to lesser-known, higher-yielding companies as an ideal opportunity to offload the reinsurer's credit insurance book, which the credit solutions group had previously been unable to place in the capital markets.

"A number of things came together here," says Crippa. "Firstly, investor understanding of the risks has really developed. But on the insurance side, over the past few years we've been developing a modelling platform that has allowed us to quantify these risks, capture the underlying exposures and report them on a regular basis. Years ago, the industry simply did not have the required data or the know-how to bring this to the table."

That's because Swiss Re's credit insurance book is, by capital market standards, very much an unknown quantity. Credit insurers such as Madrid-based Credito y Caucion, Amsterdam-based Atradius, and Paris-based Coface and Euler Hermes (the four make up 85% of the total credit insurance market between them) provide protection for corporates against a business partner's non-payment on receivables. Swiss Re's credit solutions division, in turn, underwrites this business and currently generates around Sfr1 billion (EUR625 million) in premia by reinsuring credit and surety companies.

But the risk inherent in the book is extremely fragmented. Swiss Re faces risks linked to more than 7.8 million individual credit lines linked to predominantly European companies. Historically, some 59% of these credit lines have been worth EUR2 million or below (indeed, 44% are lower than EUR200,000), and many of these companies are unrated by any of the rating agencies.

That meant that Swiss Re had a challenge on three fronts: first, to securitise the portfolio in a way that would create the most efficient use of economic capital; second, to build investor confidence in small and medium-sized enterprise (SME) credit risk without the normal rating agency data on the individual obligors; and third, to persuade the rating agencies to rate each tranche in a way that would make the transaction appealing to investors.

Fauchere, together with the credit solution division's head of European structured credit, Thomas Rothenberger, came up with Crystal Credit as a solution to these problems at the end of 2005. The transaction, which closed in January last year, collateralised the claims Swiss Re might face for the underwriting years 2006, 2007 and 2008, with the portfolio being actively managed to reflect new and old business flows to and from the book.

"We managed to do it in a way that was economically interesting for us and to do it with the support of rating agencies and investors," says Fauchere. "Transparency, data and modelling capabilities were all absolutely key." Indeed, it was the first-ever securitisation of credit risk posed by European SMEs, and has been seen by many in the industry as another milestone in the commoditisation of specialised unhedgeable risk.

The portfolio was split into five tranches: an equity portion covering the first EUR666 million of losses, which was retained by Swiss Re; a EUR63 million tranche rated B by Standard & Poor's and B2 by Moody's Investors Service; an EUR81 million BB/Ba2 tranche; a EUR108 million BBB-/Baa2 tranche; and a super-senior tranche of an undisclosed amount. The mezzanine tranches were attached at three-year average loss rates of 74%, 81% and 90% (compared with historical loss rates of around 60%), paying out monthly coupons of Euribor plus 800bp, 425bp and 150bp. Once the loss rates are hit, investors lose their capital.

"The transaction was structured to optimise capital relief, both internal economic capital relief and ratings agency capital relief," says Crippa. "But we wanted to retain the equity tranche and therefore the upside of the book, as well as the super-senior risk that doesn't tie up much capital."

Convincing Standard & Poor's and Moody's Investors Service to issue appropriate ratings was difficult due to the sheer number of risks involved with the transaction, and the fact that the agencies hadn't previously modelled credit risks of this type andon this scale before. But the credit solutions team worked closely with the agencies to explain their historical data and the correlations of the risks involved in the transaction.

Swiss Re also decided to hold on to 10% of each of the mezzanine tranches. Crippa says that by participating in the profit and loss of those tranches, investors were reassured that Swiss Re would manage the portfolio in accordance with their interests.

"It's all about alignment of interests on the risks side and on the economics side," says Crippa. "On the risks side, the vertical retention means that Swiss Re is aligned in all outcomes with the investors and at no time will we stop managing the portfolio in the investors' interests. All across the risk transfer chain, you see people participating in the loss. The economic alignment is also an important one, and what happens here is that we have incentives to improve the performance because the upside is to Swiss Re's benefit. That makes investors very comfortable."

The transaction reduced Swiss Re's economic capital tied to the credit book by 40%, according to company figures - in effect, a huge saving on previous risk management techniques. "We had been using CDSs since 2000 for some of our peak risks that are really more liquid in the market, and we had done first-to-default baskets," says Fauchere. "But really, it was only the peak of the iceberg, because out of the 7 million risks in this book there's only a few hundred we were actually able to hedge on."

Indeed, one of the major motivations behind the deal was to eliminate the basis risk from using CDSs - something that brought with it additional economic capital requirements. As well as the obvious basis risk between tradable names and the names on the book, CDS contracts actually provide protection against a company defaulting on a bond or loan. That trigger differs from Swiss Re's exposure, which is to a company not being able to meet timely payments on their receivables to suppliers. Consequently, a company might stop paying for goods and raw materials, yet might not actually meet the legal terms of a default on the CDS contract, and vice versa.

Considering the amount of economic capital saved, the reinsurer aims to use this technique again in future. The team anticipates that the Solvency II regulatory capital rules will be very much in line with its economic capital requirements, and so expects to distribute further risks to the capital markets to release similar amounts of capital.

"We absolutely intend to use this kind of structure in future," says Crippa. "And although we are pretty much covered from the trade credit book point of view through this issue, as 90% of our book is in there, we have other portfolios where we are considering the benefits of such an approach."