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Trending in Finance 27 Jul 2017 Honey, does my finger look fat in this?

How the capital markets could be just the right fit for managing operational risk

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In a series on the ways insurance-related risks may be transferred or otherwise dealt with in the insurance sector, longevity risk transfers using derivatives and value in force monetisation have previously been explored. In this piece, the innovation of capital markets instruments to transfer operational risks is considered, specifically through the catastrophe bond ('CAT bond') structure.

'Fat fingers'

Every minute on any given trading day, the technological infrastructure of global markets allows for multitudes of transactions to occur between financial institutions and actors. It was on one such minute on one such day in June 2015 that a junior member of a major investment bank's foreign exchange sales team processed a trade to a hedge fund client – something fairly unremarkable were it not that this junior had accidentally processed the quantum of the trade as a gross figure rather than a net value, resulting in a US$6 billion mistake for the bank. Fortunately for the junior and for the bank, the money was recovered in this case but the incident is typical of what is infamously known in financial circles as a 'fat finger' trade: when an input mistake like the accidental typing of extra digits causes institutions to buy or sell a much larger position than was actually intended. As recently as June 2017, 'fat finger' trading has been linked to drastic plunges in the price for gold.

Operational risks more generally

The risk of losses to an institution from 'fat finger' trades and associated trading irregularities is a specific example belonging to the much broader concept of operational risk. Operational risk encompasses risks of loss resulting from inadequacies or failures in internal processes, people and systems and from external events. By way of example, loss incidents arising from business disruption, system failures (including failures in cyber-security), process management, business practices and fraud are all losses connected with operational risk. Given the broad nature of operational risk, the measurement of losses associated with operational risk losses is difficult to quantify precisely, but in the past decade alone, it is estimated that losses from operational risk have totalled in excess of US$300 billion. The capital management and earnings implications of operational risk for financial institutions and other actors (such as asset managers) in the global markets continue to be significant and this is especially so with the increasingly complex nature of certain operational risks such as cyber security.

Enter the CAT bond

Financial institutions have historically looked almost exclusively to traditional insurance products and ultimately reinsurance in the management of operational risk losses, and to a large extent this remains the case. There is however, an emerging willingness in the market among financial institutions and their insurers to consider many different solutions to offset operational risks.  It is for this purpose that the capital markets, and specifically CAT bonds, are a relevant offering. 

CAT bonds are insurance-linked securities that transfer risks of loss from a specified event (for example, an Australian cyclone or Japanese earthquake) that would otherwise be borne by insurers to capital market investors. Where the specified event does not occur during the term of the bond, the investor can expect to receive regular interest payments in addition to the return of their principal on the maturity of the bond. Where the specified catastrophe does occur, the entire principal invested will be used to cover insurance claims against the sponsor of the CAT bond. CAT bonds form the main proportion of an insurance-linked securities market worth US$75 billion, but the basic structure of the CAT bond is amenable to application to risks other than catastrophes, such as operational risk. The mechanisms of a typical CAT bond structure are illustrated below.

Bonds Structure 1

The sponsoring insurer and the SPV enter into a traditional reinsurance contract and the SPV issues bonds to the investors. The proceeds from the sale of bonds are placed by the SPV into a trust that collateralises the reinsurance contract with the sponsor. The premium payments made to the investors consist of the reinsurance premiums paid to the SPV from the sponsor and the returns on investments in the collateral trust. Where a qualifying event occurs, the sponsor will make a reinsurance claim and will be paid out from the collateral trust. On the maturity of the bond, any remaining principal is returned to the investors.

New breeds of CAT bond: the operational risk bond

The proof of concept for the CAT bond applied to operational risk is Credit Suisse's issue of bonds worth 220 million Swiss Francs (CHF) in May 2016 to partially cover operational risk losses under an operational risk insurance policy from Zurich. The figure below illustrates the transaction.

Bonds Structure 2

This figure is based on research from Artemis.

In general, the fundamental mechanics of a CAT bond as between the sponsoring insurer, reinsurer SPV and investors are retained. Credit Suisse and Zurich entered into a CHF 270 million operational risk insurance policy, which is to apply only after more than CHF 3.5 billion in operational risk losses are sustained by Credit Suisse. As part of the overall transaction, Zurich agreed to retain CHF 50 million of risk and act as the sponsor to the bond issue, thereby entering into a reinsurance arrangement with Credit Suisse's SPV Operational Re Ltd. The balance of CHF 220 million under the operational risk insurance policy between Zurich and Credit Suisse was securitised and issued as bonds by the SPV to investors in three tranches according to investor risk appetite.

Credit Suisse's Operational Re Ltd transaction sets a precedent for the use of insurance-linked securities by financial institutions in collaboration with their insurers to at least partially manage non-traditional risk losses from operational risk and other types of corporate risk. The risks underlying an operational risk bond are more complex to model than the catastrophe risks underlying a CAT bond, and this comparatively lesser degree of transparency will, as in the case of the Operational Re Ltd transaction, likely result in relatively higher rates of interest payable to investors. Yet operational risk bonds, similar to CAT bonds and other classes of insurance-linked securities, will be attractive to investors seeking to diversify their risk exposure from traditional assets since insurance-linked risk and the returns on insurance-linked instruments generally have a low correlation with traditional financial risks such as interest rate and market risks. Higher risk adjusted returns may thereby be achieved by investors. Operational risk bonds reduce a sponsoring insurer's reserve requirements and may reduce the costs of coverage to both the participating insurer and financial institution. Better risk diversification may also be achieved as operational risk bonds partially transfer the underlying operational risk outside the insurance sector. These advantages offered by insurance-linked securities and the marketability of the Operational Re Ltd transaction demonstrate that operational risk bonds have started to emerge as one compelling alternative over pure reinsurance for the management of operational risk.

Authors: Jamie Ng, Partner; Wilson Lu, Lawyer.

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This publication is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specific issues or transactions.

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