Swiss Re's Tom Skwarek clocks industry with a new idea: just-in-time capital: up to $500-million in new, regulatory capital can be triggered in the event of a major catastrophe

Risk & Insurance,  Sept 15, 2008  by Steve Yahn

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The highly innovative notion of CLOCS (Committed Long Term Capital Securities) grew out of Farmers Insurance Exchange rethinking its entire risk management strategy in the light of Hurricane Rita.

"Rita came very close to hitting the sweet spot of our book of business," said Ron Myhan, executive vice president of finance at Los Angeles-based Farmers Insurance. "We became worried about the possibility of Rita becoming a Category 5 hurricane that would have hit a very populated part of the coast of Texas. For us and a lot of other people, that's a really, really big event.

"Plus, after Katrina, we saw the computer models were potentially understating the amount of loss one could have from a hurricane," added Myhan.

So Farmers put out invitations to reinsurers and capital markets firms to make presentations on what type of financial instruments as well as reinsurance could be put together in light of these conditions. "Swiss Re under their capital markets leader Tom Skwarek was the only one who had a concept of this CLOCS structure," noted Myhan.

The core notion of Farmers' CLOCS offering, launched in July of 2007, is that Swiss Re and a syndicate of high-quality institutional investors agreed in advance to purchase surplus notes increasing regulatory capital in Farmers if a Katrina/Rita type hurricane occurred and caused substantial losses for Farmers.

The Farmers deal was the first broadly syndicated transaction to combine an insurance event, in this case a hurricane, with the issuance of regulatory capital. The concept created "just in time" capital that would be available if a major natural disaster loss occurred rather than holding additional, and expensive, equity on its balance sheet or purchasing more reinsurance to cover remote events.

"You can't put too much capital on your balance sheet because that costs a lot of money," noted Skwarek. "So having 'just in time' capital, or standby capital, is far more efficient than going out to raise equity. That was another big factor in creating this solution."

The trigger for CLOCS to go into action is after all of Farmers' reinsurance is taken, "so the probability of a catastrophic loss is relatively low," added Skwarek. "The banks liked this because we were diversifying them away from the corporate market and the financial conditions that were causing corporations to draw down on the loans banks were committed to provide to them."

"Most commercial banks lend from five to seven years," said Skwarek. "So we were able to convince the banks that Farmers' financial strength deserved their support. We also faced the challenge of convincing banks to take a subordinated risk in Farmers after a catastrophic hurricane. Again, although this was completely new for the banks, Farmers' fundamental financial strength was key to the banks' risk evaluation.

"With the support of our lead managers, Commerzbank, Citibank and Calyon, we ended up placing this primarily with commercial banks around the world."

In all, Farmers acquired the right to issue $500 million of regulatory, capital if it suffers a severe natural catastrophe loss in the Texas hurricane corridor in the next five years. According to the deal, if Farmers suffers a $2 billion-plus windstorm loss in Texas, the only place it has such a huge concentration of business, it has the right to use 10-year subordinated loan notes to major institutions to restore its capital base.

Swiss Re says the risk of drawing on the full $500 million would be in the range of a 1-in-a-250-year event.

Insiders noted that the cost of meeting the post-Rita challenge via more reinsurance would have been six percent annum and six to eight percent through eat bonds, whereas the cost of the Swiss Re et al solution was close to half of one percent per year.

But the deal might never have gotten done if Swiss Re did not have feet firmly planted in both the reinsurance and capital markets realms.

"The Swiss Re capital markets operation, I think, is the most successful group of professionals that I am familiar with at finding the meeting points between capital markets and insurance and reinsurance," said a senior vice president of a German public sector bank that participated in the Farmers deal.

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"They are with confidence able to talk to the traditional two sides of most insurance organizations, one is the treasury/CFO tract, and the other would be the risk manager," said this bank official.

"And because they have as their employees both insurance professionals and capital markets professionals I suspect there's much less of a disconnect than if there were just representatives of an investment bank or just representatives of another reinsurer," the banker added.

"The 'Eureka Moment' was to say we could do a large transaction for a major insurance company tapping into our eat bond experience and our understanding of capital and risk," said Skwarek