GR interviews: the man who invented cat bonds

The catastrophe bond market has come a long way from one man’s Eureka moment on the London Underground 20 years ago. GR interviews the man who came up with the idea to find out how he invented it, what he thinks of it now, and what the future of cat bonds might look like.

What is your background and career path?

I am a real mathematician by education. I started off as an assistant professor at the University of Hamburg. I started 1 April 1982 at Hannover Re as assistant to the chairman, and then later establishing the non-life actuarial department. When I came up with this cat bond idea, I was head of a department called Mathematics, Statistics and Product Development. I have been with Hannover Re for 33 years.

Currently I am chief risk officer. I’m working with five departments and 70 people on all aspects of risk management. That’s reserving, internal models, natural catastrophe modelling, aggregate monitoring and qualitative risk management.

Describe how you first came up with the idea of catastrophe bonds

That was late summer, 1993, in London. I was responsible for our natural catastrophe facility K-Cover. That was our top-level natural catastrophe treaties, excluding Japan and the US, in those good old times. We had set this up in the late 80s to create capacity, but to create this capacity, given the size of Hannover Re in those times, we were heavily relying on retrocession partners.

I found it increasingly difficult to find retrocessional capacity for shares half a percent, one percent, and so on, and to do all the accounting - especially in case of losses for all those partners -so I thought it might be a good idea to have one big player, perhaps outside of the insurance industry, to agree with those outside players to retrocede a major piece of the business with one single partner doing all the accounting and having security already on hand. That was the initial idea.

Describe the exact time and location you were in when you first had the idea to securitise catastrophes in this way?

It was one of those moments thinking about the business on the tube on the long journey from London Heathrow Airport to the City.

How did you take that idea and make it a reality?

When I heard from Citibank that they were enthusiastic about this idea, I took this to the board and got the board’s decision. In those times, my luck was the chief executive, Michael Reischel, was an actuary by education, so he immediately believed in the idea because of the great diversification benefits it would give to both parties. I was granted permission to form a working party comprising our legal adviser, our investment officer, and underwriter and myself. Together with Citibank we proceeded.

When was the launch date?

I think it was somewhere in March, 1994.

Are you proud of your idea?

Absolutely I am proud. But I am not as proud as to say, everyday, ‘I have invented this’.

The growth of cat bonds has been one of the biggest talking points of the market over the past few years, and a challenge to the status quo. What do you think will be the next big idea to change the reinsurance sector in this way?

If I give you one word, we could spend the next half an hour speaking about it. This one word is ‘regulation’. Regulation will certainly change our world. It will change it in two aspects. It will change it in the way reinsurers are conducting their business, but it will also create new opportunities for reinsurers. A very simple example is: if a regulation like Solvency II is requiring capital up to the 1-in-200-year risk level, and insurers are not thinking of being protected up to this level before this kind of regulation. It is requiring capital on their side. So why not buy reinsurance rather than provide their own capital for this? This is one of the examples.

The only thing I should give you in addition: the natural catastrophe facility which was the foundation of our treaties had the name K-Cover. So the name of the securitisation, an $85m facility based on the Cayman Islands, was ‘Kover’.

 What kind of natural perils did Kover bundle up?

Top layer: natural catastrophes, especially windstorm, earth quake and flood (Australian flood was one of the covered risks).

 What do you think of how your idea has grown and been adopted so widely?

To be honest with you, nothing serious has happened. Nobody has really lost money. My experience is the following – perhaps I am a little bit different, but I have been following this for more than twenty years.

You have some hypes. You have a lot of positive expectations, that this market will explode and be a real challenge for traditional reinsurers. Like you saw last year at Monte Carlo.

Then something happens.

Did you foresee it becoming so popular?

Yes, of course. Because the idea is great, and the idea was great for 20 years. We have had a lot of similar ideas that were similarly great, but that never flew as some optimists might have expected. The two examples I have in my mind are the Chicago Board of Trade with their cat options and futures, and the other idea, even more sad, is the Bermuda Commodity Exchange. They also tried to exchange cat pieces, and that also did not fly, because everybody was interested, there was a lot of hype, a lot of support in the media, but actually the trading volume was minimal.

What will the cat bond market look like in the future? Does it all hinge on a big loss?

We have different scenarios. One is that, if nothing happens, it will proceed like it is currently doing. But the interesting point is what will occur if a major risk realisation takes place. Here I am not too sure that all the people that have invested their money, and now lost it because of a major event, will reinvest it in the next wave of cat bonds. I can imagine that a similar situation to 2005 might occur, where they would rather reinvest in real reinsurance companies, based perhaps on Bermuda or the Cayman Islands or somewhere else, to take advantage of a favourable tax environment and allow them to regain, on a broader than just natural catastrophe basis.

Do you think cat bonds will become common for risks and locations outside of windstorms and North America?

The other development, always on the horizon, is taking securitisation beyond natural catastrophes. It is hard for me to imagine that there will be a real success in securitising the run-off of long tail liability workers’ compensation business in the US, and perhaps emanating from the underwriting years 1997-2001, for example. I can’t see the investment appetite.

From time to time, I have thought motor business might be a good piece. Because there you have a lot of data and can do a reliable modelling. Agricultural business might be another piece. But I doubt that real long tail lines, because of the nature of the risk periods, will make it quite difficult to convince people to invest in such bonds rather than invest directly in insurance companies, which is the alternative for their money.