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INSURANCE - Risky Business

Jacques Algrain has made Swiss Re the world's biggest reinsurer. Can he consistently generate high returns?

For a self-proclaimed optimist, Jacques Aigrain spends an awful lot of time contemplating doomsday. The chief executive of Zurich-based Swiss Reinsurance Co. kicked off the New Year at the company’s missile-shaped London office tower by addressing a conference on potential catastrophes, which featured nerve-rattling scenarios of possible terrorist attacks on American cities, interruptions of Europe’s energy supplies, massive earthquakes in Japan, a lethal bird-flu pandemic and Katrina-scale hurricanes unleashed by climate change. Any of these cataclysms would severely strain the reserves of even Swiss Re, the world’s biggest reinsurer, whose business it is to insure the world’s insurance companies.

Yet Aigrain is full of cheer. “Risk is growing faster than capacity to reinsure, and this is forcing our industry to turn to the capital markets to transfer some of that risk,” explains Aigrain, 53, a longtime JPMorgan Chase & Co. executive who joined Swiss Re six years ago and became its CEO in January 2006. That risk transfer is taking place through insurance-linked securities (ILSs) such as catastrophe bonds, known as “cat bonds,” whose returns are tied to the incidence of natural disasters, and “life bonds,” which securitize a future stream of life insurance profits. From virtually nothing at the start of the decade, companies had issued a total of $25 billion of ILSs by the end of 2006; Swiss Re has been involved in about $10 billion worth of these bonds, underwriting $4.9 billion and originating the rest. The company predicts the market for ILSs will mushroom to more than $300 billion in a decade.

Besides its growing importance in risk management, securitization holds the promise of a more efficient use of capital in an industry that has long suffered poor returns on equity. To hear former investment banker Aigrain tell it, in the next five to ten years, cat and life bonds could raise profits for the insurance world the way mortgage, car and credit card securitizations have done for banking over the past decade.

The recent turmoil in global credit markets, sparked by problems with securitizations of subprime U.S. mortgage loans, could shake confidence in other engineered financial products, but Swiss Re executives insist they remain committed to securitization. “There is no change in our strategy,” says company spokesman Henner Alms. “In fact, market participants view insurance-linked securities as uncorrelated to the subprime problems.”

Aigrain’s drive for securitization has gone hand in hand with a push to expand the company’s presence. Even before taking over as chief executive, he led the negotiations that culminated in the November 2005 agreement to buy General Electric Insurance Solutions, the fifth-largest reinsurer, for $6.8 billion. That deal allowed Swiss Re to overtake Munich Re as the world’s biggest reinsurer by premiums. “Being No. 1 isn’t important,” insists Aigrain. “What matters is profitability.”

Yet for all Aigrain’s energetic optimism, many analysts and fund managers remain deeply skeptical of the industry’s long-term profitability. “Returns in the past for reinsurance firms have been almost as abysmal as those for some automobile companies,” says Jennifer Norris, a London-based insurance industry buy-side analyst at AllianceBernstein, which manages more than $700 billion.

According to a September 2006 report by Standard & Poor’s, global reinsurers posted average annual returns on revenues of just 5.3 percent from 1988 through 2005. In only two of those years did the industry’s ROR hit double digits — reaching 10.3 percent in 1997, and 11 percent in 2003. Besides such major events as the 2001 global stock market meltdown and the 9/11 terrorist attacks, investors must brace themselves every summer for the hurricane season. Then, when profits turn upward, competition sets in and premiums head south. “All of this leads to a perception among investors that reinsurance is a sector in which you can trade, but that you are better off elsewhere for long-term investments,” says Jürgen Hawlitzky, Frankfurt-based senior analyst for global insurance at Allianz Global Investors, which has E320 million ($432 million) in reinsurance company holdings among its E1.28 trillion in assets.

Swiss Re enjoyed a banner year in 2006. Net income nearly doubled, to Sf4.56 billion ($3.63 billion) from Sf2.3 billion in 2005. Like other insurers, Swiss Re benefited from an absence of catastrophes; by contrast, it suffered losses of Sf2.99 billion from Hurricanes Katrina, Rita and Wilma in 2005. The combined ratio of the company’s property/casualty business, a key metric that compares the cost of claims plus expenses to premium income, fell to a lucrative 90.4 from 112.3 a year earlier. Premiums rose 10 percent last year, to Sf29.5 billion, reflecting a contribution of Sf3.5 billion from GEIS after its purchase was completed in June 2006. With securities markets strong last year, net investment income rose 14 percent, to Sf6.99 billion; bonds generated income of Sf5.58 billion and equities just Sf249 million. The remainder came from alternatives such as real estate, private equity and funds of funds. Overall, the company’s return on equity rose to 16.3 percent from 10.3 percent in 2005.

The good results continued in the first half of 2007, with net rising 63 percent from a year earlier, to Sf2.52 billion, and return on equity edging up to 16.8 percent. The combined ratio ticked up modestly to 92.8, reflecting a rise in flood claims in Australia, Indonesia and the U.K. Net investment income jumped 40.6 percent, to Sf4.58 billion, reflecting the addition of the GEIS portfolio.

Still, Aigrain concedes his industry is “rightly criticized for having a lower-than-appropriate return on capital and disappointing its shareholders.” That includes Swiss Re’s own share price, which had risen a modest 18.8 percent, to Sf116.50 in mid-June from Sf98.08 a decade earlier; the Swiss market index gained 75.2 percent during the same period. The share price tumbled over the following two months, to Sf96.25 in mid-August, as global market turmoil hit financial stocks. In an effort to bolster returns and satisfy shareholders, Swiss Re in March boosted its dividend by 36 percent, to Sf3.4 a share for 2006 from Sf2.5 for 2005; it also said it would buy back as much as Sf6 billion of its shares over the next three years.

Following in Swiss Re’s footsteps, archrival Munich Re responded to shareholder pressure by announcing plans in early May to return E8 billion to shareholders by the end of 2010 through buybacks and higher dividends. “The big problem with insurers and reinsurers is that they accumulate capital in good times, and then waste it away in falling premiums and misplaced risk, creating the next down cycle,” says Patrick Macaskie, head of research at Odey Asset Management. The London-based hedge fund took a stake of less than 1 percent in Munich Re to pressure it for even higher buybacks and dividends.

Few investors believe Swiss Re or Munich Re are vulnerable to a leveraged buyout in the short term. Capital requirements set by regulators and ratings agencies make it difficult to load debt onto an insurer or reinsurer, says Allianz Global Investors’ Hawlitzky. Nevertheless, he adds, “There is no question that the insurance industry is focusing more on capital efficiency, buybacks and boosting returns.”

Swiss Re says its announcement of buybacks and higher dividends preceded reports of pressure on the industry from activists. “We had our strategy and have continued to pursue it,” says Alms, the company spokesman.

Besides its recent largesse toward shareholders, Swiss Re trumpets its commitment to insurance-linked securities as a driver of capital efficiency and higher returns. The company declines to disclose how much it earns from securitization, either in terms of underwriting fees or in capital savings, but analysts estimate that it contributes well below 10 percent to the bottom line.

The real contribution of securitization lies elsewhere. The uneven pattern of natural catastrophes injects volatility into the reinsurance business. Such disasters cost insurers a relatively modest $15 billion last year, compared with a record $80 billion in 2005, which included the cost of Katrina. By transferring peak risks to the capital markets to smooth out that volatility, insurance-linked securities have “clearly reinforced the quality and sustainability of our earnings,” Aigrain says.

In March Swiss Re estimated that hedging instruments could knock off as much as $2.18 billion from hypothetical claims of $4.95 billion triggered by North Atlantic hurricanes, European windstorms and earthquakes in California and Japan. Securitizations would account for more than half of those savings.

The growth of insurance-linked securities, although they promise to dampen earnings volatility, poses new risks to Swiss Re, some analysts and investors say. After all, if primary insurers were to use the capital markets directly to protect themselves against risk or to free up capital, they would need to buy less reinsurance. “If anything, this emphasis on securitization only adds to the market’s suspicion that Swiss Re is doing itself out of its core reinsurance business,” says AllianceBernstein’s Norris.

Furthermore, as securitization becomes increasingly profitable, Swiss Re is likely to face stiff underwriting competition from investment banks. “Why can’t Goldman Sachs do the same thing — and more efficiently?” asks Markus Engels, senior insurance analyst at Frankfurt-based Cominvest Asset Management, which oversees $75 billion in assets. Engels declines to disclose his fund’s reinsurance holdings but says, “We are definitely underweight.”

Goldman is indeed targeting insurance-linked securities. The firm had underwritten a total of $6.5 billion in ILSs by the end of last year, more than any other rival; Lehman Brothers was a close second with $5.8 billion.

Although Swiss Re ranked only third as an underwriter, it’s status as a trailblazing issuer gives it a strong claim to market leadership. “They have been more innovative than anybody else,” says John Brynjolfsson, fund manager at Pacific Investment Management Co., a Newport Beach, California–based fixed-income specialist with more than $680 billion in assets under management, including more than $1 billion worth of cat bonds.

An example of its innovation is Swiss Re’s largest securitization to date — the $1.19 billion Successor cat bond program issued in June 2006. It provided Swiss Re protection against the industry’s four major catastrophe scenarios — U.S. hurricanes, California earthquakes, European storms and Japanese earthquakes. Most cat bonds are designed to pay out only when outsize cataclysms occur, but Successor was structured to provide returns at lower “attachment points” — that is, even if hurricanes or quakes cause relatively modest damage. Risks are reflected in the different Successor tranches, which offer notes with one- to two-year maturities at interest rates that range from 5.25 percent to 39.25 percent over LIBOR.

According to Swiss Re, about one third of investors in Successor were traditional money managers, another third were hedge funds that specialize in ILSs, and the remainder were large macro hedge funds that have strategies across all product areas. “We learned to target each investor individually,” says Christian Mumenthaler, Swiss Re’s chief risk officer.

Cat bonds account for about three quarters of the insurance-linked securities that Swiss Re has originated or underwritten, but it hasn’t ignored life bonds, which represent a majority of the overall securitization market. The company has arranged some of the most cutting-edge life bonds, including a $442 million offering of securities for French insurer AXA in November 2006. The bonds, dubbed Osiris, were designed to protect the insurer against a sharp rise in mortality among policyholders in France, Japan and the U.S., possibly stemming from natural disasters, terrorism or pandemics. Swiss Re pioneered this type of life bond for itself with its Vita 1 and Vita 2 programs in 2003 and 2004.

Osiris included two single-A-rated tranches, one for E100 million and the other for E50 million, as well as a $150 million, triple-B-rated tranche and a $100 million double-B-rated offering. All four issues mature in January 2010; interest rates vary from less than one percentage point over Euribor to five points above LIBOR. If mortality in any given year exceeds the combined index of historical mortality in France, Japan and the U.S. by 30 percent, part of the Osiris bond proceeds will be diverted to AXA and investors will lose some of their principal. If mortality exceeds the three-country index by 50 percent, investors will lose all of their principal. According to Dan Ozizmir, Swiss Re’s head of insurance securitization, U.S. hedge funds focused on the lower-rated bonds, whereas European and Asian money managers preferred the higher-rated tranches.

“With Osiris, the big difference was that investors showed a very significant tolerance for riskier tranches and wider spreads,” says Ozizmir.

This financial engineering seems light years removed from the company’s origins. Swiss Re was founded in 1863 by the Helvetia General Insurance Co., Credit Suisse and Basler Handelsbank to provide fire, marine and life reinsurance to Swiss and foreign insurance firms. Swiss Re found it difficult to penetrate foreign markets until the San Francisco earthquake and fire of 1906. The company’s losses on that disaster amounted to roughly half of its overall annual fire premiums, but by settling claims promptly, it gained global recognition and enjoyed a sharp rise in business.

Swiss Re benefited from Switzerland’s neutrality during World War II and emerged in better shape than its European rivals to capitalize on the Continent’s postwar economic boom. The company expanded into primary insurance as well but eventually abandoned that business in 1994 to concentrate on reinsurance. Over the next four years, it purchased the Alhermij Group in the Netherlands for an undisclosed sum, Mercantile & General Re in the U.K. for $2.7 billion and Life Re in the U.S. for $1.8 billion to become the largest life and health reinsurer in the world and the second-largest overall reinsurer after Munich Re.

But by the late 1990s, it had become apparent to Swiss Re that the industry’s profitability was lagging, especially compared with the spurt forward in banking, where securitization was taking hold. Then–chief executive officer Walter Kielholz, who today serves as vice chairman of Swiss Re and chairman of Credit Suisse, predicted at the time that securitization would play an increasing role in reinsurance.

Momentum for securitization built under Kielholz and his successor, John Coomber, a British-born insurance executive who joined Swiss Re as an actuary in 1983 and rose to the top post in 2003. Coomber is credited with turning the company around after its Sf91 million loss in 2002, when it was found liable for $875 million in claims from the destruction of the World Trade Center and saw its investment returns hit by the global stock market collapse in 2001. By the end of 2004, sharp increases in reinsurance premiums and a recovery in investment returns helped the company post net income of Sf2.5 billion. But rightly or wrongly, because of Aigrain’s investment banking background, the push for securitization at Swiss Re is most identified with him rather than Coomber, who currently sits on the supervisory board of Euler Hermes, the credit insurance subsidiary of Germany’s Allianz. “Aigrain is certainly more aggressive than Coomber was — he’s more a banker than an insurance type,” says Colin Simpson, a London-based insurance industry analyst for Bear, Stearns & Co.

During his 20 years at JPMorgan, the Paris-born Aigrain rose to chairman of JP Morgan et Cie, and led a restructuring of operations in France from 1996 to 1998. For the next two years, he shuttled between Paris and New York as co-head of mergers and acquisitions and head of investment banking for the industrial sectors. In the months before joining Swiss Re, he was co-head of investment banking client coverage for JPMorgan in New York.

Former colleagues at the bank describe him as “bullheaded but displaying Gallic charm” and “fiercely ambitious.” But with the merger of J.P. Morgan & Co. and Chase Manhattan Corp., the center of gravity at JPMorgan Chase moved toward retail banking and Aigrain hit a glass ceiling. “Jacques wanted to run whatever company he worked for, and it became clear to him that he wasn’t going to be the CEO of Morgan Chase,” says Bill Winters, the London-based, co–chief executive officer at JPMorgan Investment Bank.

Still, Aigrain’s decision to move to Swiss Re as deputy CEO in 2001, with a promise of promotion to the top, surprised his former colleagues. In his years at JP Morgan, Aigrain had made his reputation as an industrial — especially, chemical industry — M&A expert. He didn’t deal with insurance or securitization or derivatives.

“He was about as unqualified to run an insurance business as any banker we’ve got — except that he is a leader, and I’m sure that’s what Swiss Re saw in him,” says Winters. “Well, he got his wish to run his own show. But reinsurance is a big, lumbering, unexciting, capital-intensive business, unless Jacques manages to aggressively transform it.”

Aigrain has made two key appointments to put his stamp on top management: George Quinn, the chief financial officer in the Americas division, was named CFO for all Swiss Re in early 2007, replacing Ann Godbehere, who had held the post since 2003 and has left the company; and Roger Ferguson, a former vice chairman of the U.S. Federal Reserve Board, was made head of Swiss Re Financial Services, which oversees asset management, securitization and credit risk. The post had been occupied since 2003 by John Fitzpatrick, who left the company in early 2006 when Aigrain made himself acting head of financial services.

Even before taking the top job, Aigrain helped to reshape Swiss Re by leading the negotiations to buy GE Insurance Solutions. The acquisition — the biggest ever by a reinsurance company — vaulted the company past longtime market leader Munich Re in terms of premiums.

The addition of Kansas City, Missouri–based GEIS vastly enlarges Swiss Re’s U.S. footprint, giving it a bounty of medium-size clients in the Midwest to go with its existing client base among big primary insurers on the East and West Coasts. “It has clearly made us the largest player in the U.S.,” says Pierre Ozendo, CEO of Swiss Re’s Americas division. “We don’t aspire just for size, but Insurance Solutions gives us the opportunity to be the most profitable reinsurer.”

Ozendo plans to use Swiss Re’s enhanced U.S. position to emphasize facultative reinsurance, which allows a client to buy a single policy to cover a variety of large and unusual risks — say, a tsunami in Asia, windstorms and floods in Europe and hurricanes in the U.S. — that are usually covered by separate contracts with different companies. Facultative reinsurance tends to be a small portion of business for most reinsurers because it requires a lot of personnel and attention, but, says Ozendo, “we see it as a tremendous growth area for us.”

Still, many analysts remain skeptical about the deal. GE had been shopping Insurance Solutions for three years, and Swiss Re had looked the company over twice before finally purchasing it. GEIS lost $700 million between 2000 and 2005 and saw its premiums shrink from $9.6 billion in 2003 to $6.2 billion in 2005. Although the deal has made Swiss Re larger, doubts persist that the insurer can escape the industry’s cycle of volatility. “The question is: Can Swiss Re use its market share to demand better terms and conditions for itself, better pricing, and perform better than the market — or is its performance just going to be the industry average?” says Laline Carvalho, an insurance credit analyst at Standard & Poor’s in New York who follows Swiss Re’s Americas division.

What keeps the industry’s performance low is the ease with which new players can enter the market. The Insurance Information Institute, a New York–based trade industry association, estimates that in the wake of Katrina, some $30 billion of new capital entered the industry — with only about $10 billion of that coming from existing insurers and reinsurers. “It’s basically a classical exercise in capitalism,” says Robert Hartwig, president and chief economist of the Insurance Information Institute. “All this money came at a time when risks and rewards were high.” In 2006 returns were as high as 40 percent for some investors, but many analysts and investors worry that the latest inflow of capital will erode returns, as in previous cycles.

In addition to extending his reach, Aigrain is bolstering profitability by reining in costs. In July 2006 he announced a restructuring to reduce the enlarged company’s 11,500 payroll by 2,000 jobs, or 17 percent, by the end of 2007 and save $300 million a year. The cuts will be roughly equally divided between GEIS and Swiss Re. He also sold the company’s iconic London building, known locally as the Gherkin, to German property company IVG Immobilien for £600 million ($1,172 million) in February, generating a £200 million gain. Swiss Re remains the principal tenant.

Swiss Re achieved further savings in June 2006, when it sold Fox-Pitt, Kelton — the investment bank it acquired seven years earlier to help build up its financial services expertise — for an undisclosed price to an investor group led by Fox-Pitt’s management and J.C. Flowers & Co., a New York–based investment fund.

Insurance-linked securities are key to Aigrain’s plans to grow the business. The theoretical foundations for new types of securities are laid out in Zurich, where Thomas Hess, the company’s chief economist and head of research, describes his job as figuring out ways to “insure the uninsurable.” The process begins with data collection. “It’s easy enough to gather data on the risks posed by a consumer product that is frequently used and then judge what the price should be for a bond,” says Hess. Natural disasters, on which there is a growing body of research, are also increasingly insurable. “But for something like terrorism, we have too little standardized information to be able to determine if the price for such a bond is acceptable,” he says. The only large-scale insurance for acts of terror is provided by government programs such as the Terrorism Risk Insurance Act, under which the U.S. government will pay up to 90 percent of insured losses for damages caused by a terrorist attack.

Swiss Re and Credit Suisse did arrange a E400 million cat bond on behalf of the Fédération Internationale de Football Association, soccer’s governing body, to protect its investment in the 2006 World Cup in Germany from the risk of terrorism. But that offering covered simply the risk of revenue losses if the event were called off rather than the loss of life or property damage. Although terror remains largely uninsurable by the private sector, Swiss Re continues to expand the limits of securitizing the risk of natural catastrophes. One lesson of Katrina was the need for better computer models to more accurately predict the frequency of hurricanes and the damage they cause. For that Swiss Re turned to a specialty firm, Risk Management Solutions, in Newark, California.

After poring over $21 billion in insurance claims resulting from the 2004 and 2005 hurricane seasons, RMS concluded that hurricane activity would probably remain elevated for at least the next ten to 15 years as a result of global warming. “Landfall activity is likely to be 25 to 30 percent higher than we previously believed,” says Josh Darr, director of North American climate hazard modeling at RMS. The company also devised models to identify the risks that storms pose to individual properties, such as schools, stores and office buildings. Previously, insurers aggregated all such risks in their pricing. “With a cat bond, you want to make sure you have the best risk analysis possible because it’s what investors look at before deciding to buy,” says Darr.

Norman Menachem Feder, a partner at Tel Aviv, Israel–based law firm Caspi & Co. who advises clients on cat bonds, urges them to be cautious about securities that are more familiar to the issuer than the investor. “Reinsurers know a lot more about what’s going on,” says Feder. “So the first question my client should be asking is: ‘Why is the reinsurer laying off this risk on me?’” If the reinsurer is issuing bonds for balance-sheet purposes, investors might well want to consider investing, he says.

For some investors the main attraction of cat bonds is that their performance isn’t linked to the capital markets. “I happen to think it’s easier to predict the randomness of an earthquake or hurricane than the behavior of the economy, capital markets and CEOs,” says Pimco’s Brynjolfsson.

Of course cat bonds can go sour. “I do have some battle scars,” concedes Brynjolfsson. On August 14, 2005, just two weeks before Katrina struck the Gulf Coast, Swiss Re arranged a $190 million, 5.43 percent cat bond on behalf of Zurich Financial Services. Pimco’s Real Return Fund bought $5 million worth of bonds, but damage claims slashed their value to just $3,000 by September 30, 2006.

Nonetheless, in Katrina’s aftermath Swiss Re has gone on to issue ever-larger cat bonds and appears to be gaining a competitive advantage. In June the company introduced a basket of three cat bond indexes to improve market transparency and attract a wider range of investors. “From now on, securitization deals will become easier and cheaper for Swiss Re because the more deals it does, the more economies of scale it can gain from them,” says Bear Stearns’ Simpson. By contrast, Munich Re issued its first cat bond — a $150 million offering covering risks from any hurricane generating a loss in excess of $35 billion in the eastern and southern U.S. — only in May. The transaction was led by Morgan Stanley and Munich American Capital Markets, a unit of the German reinsurer.

Fending off investment banks with deeper pockets and broader distribution networks may prove more difficult, however. “Swiss Re obviously has the technical expertise and the franchise in insurance-linked securities for now,” says Ben Cohen, a London-based insurance industry analyst at UBS. “But if the market gets big enough, what is going to stop UBS or Credit Suisse from hiring away a dozen people to do insurance securitization?”

So far there has been no such poaching, and Aigrain expresses few worries about competitive risks. In his view the industry — and Swiss Re — have barely begun to tap the potential of securitization. “The insurance industry today is still primarily about you as the insured giving me your risk and having me place it on my balance sheet — and that’s it,” he says. “If we can make the same transformation as the banking world — and that’s what securitization is all about — we should be in a position to substantially improve the economics of this industry.”

If not, Swiss Re’s bottom line will remain at the mercy of the elements — the frequency and costs of floods, windstorms and earthquakes that make or break a reinsurer’s year.