May 4, 2017 / 3:49 PM / 6 months ago

Banks look to insure against exceptional losses

LONDON, May 4 (IFR) - Banks and other financial institutions are increasingly looking to protect their earnings, and capital positions, by taking out insurance to reduce their exposure to unexpected financial shocks, such as major IT problems or employee misconduct.

Last year Credit Suisse managed to insure against the possibility of large one-off charges through a SFr250m (US$252m) policy, less than the SFr700m initially sought. However, this was only possible after the insurer said the bank would have to pay a large “excess” before the policy paid out.

Now other lenders are assessing such products or related ones that for example might insure against commodity price falls forcing them to write down the value of loans exposed to such risks.

“The concept is spreading beyond major banks to smaller and mid-sized firms,” said Angelos Deftereos, senior underwriter, operational risks, at XL Catlin.

“Larger banks are looking at many different solutions [to offset operational risks] rather than taking whole products,” he said. “There has been an upsurge in interest in the last few months in this area.”

He said there was also “increasing interest” from other financial institutions such as asset managers and insurers. “Operational risk is the main risk that asset managers have as opposed to credit and market risk which banks face.”

However, some bankers also believe that credit risk could be offset using insurance products, given the capacity now available in the insurance market.

“There is some CDS hedging but these risks are starting to be written by insurers,” said a London-based senior commodities executive at an investment bank.

“In the FX or commodity market you can hedge risks but there is no equivalent of hedging a bank’s loan book positions against changes in commodity prices that might affect the ability of a creditor to pay.”

In 2016 the oil price fell as low as US$27 per barrel, forcing many banks to write down their outstanding loans to oil and gas explorers and producers. The price has since recovered to nearer US$50/bbl, making those loans more viable again and highlighting how dramatically valuations can change.

INVESTOR DEMAND

The interest from banks in insuring more risks comes as investors seek more esoteric products to increase their returns during a period of exceptionally low interest rates.

The bank risk insurance products are based on catastrophe bonds, which insure against damage caused by natural disasters such as hurricanes and tropical storms.

Credit Suisse’s operational risk insurer, Zurich, reinsured SFr220m, or 90%, of its exposure by issuing unrated insurance-linked securities to investors, mainly specialist funds, paying a coupon above 4%.

Over half of the US$27bn of outstanding ILS at the end of 2016 relates to protection against property damage arising from extreme weather events in the US.

Such hurricanes and storms are usually rare, and have been particularly so in recent years, meaning investors in such products are looking for other equivalent risks to improve their returns.

“With no major disasters, insurers have been more willing to look at other risks to insure to make use of this capacity and demand for higher premiums,” said the banker.

Investors seeking greater yields have been pouring money into specialist funds prepared to buy cat bonds allowing insurers to offset the risk of paying out if a disaster happened triggering a policy.

In the two years to the end of 2016, figures provided by law firm Mayer Brown said that these insurance-linked securities funds had increased assets under management by 35% to US$68bn, more than double the total ILS market.

Only US$7.1bn of new ILS was issued in 2016. However, funds are cutting smaller reinsurance deals direct with insurers.

“Many newly formed funds give the investment manager broad discretion to deploy capital as reinsurance opportunities arise,” said the report. “The pipeline for 2017 looks strong.”

Banks and other financial institutions have been showing greater interest in the market following Credit Suisse’s foray last year, particularly given the excess capacity available.

Stephen Rooney, partner at Mayer Brown, also noted that older maturing ILS bonds was also adding to the amount available. “Many three-year bonds issued in 2014 are maturing and this money needs to be redeployed by funds,” he said.

Deftereos said clients were looking at more bespoke policies rather than seeking comprehensive cover against operational risk, meaning reduced demand for ILS issues like Credit Suisse’s last year.

“Initially people were interested in product to cover everything but now people are looking more at specific risks,” he said. “Clients need to identify risks and then sort out how to cover them.”

“Banks are used to credit and market risks but now operational risks are part and parcel of doing business with some harder to control. How to manage this is being discussed in boardrooms now.”

As well as Credit Suisse, Goldman Sachs and Barclays are other banks active in the ILS space. (Reporting by Christopher Spink)

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