The palgrave handbook of unconventional risk transfer

THE PALGRAVE HANDBOOK OF UNCONVENTIONAL RISK TRANSFER Edited by Maurizio Pompella and Nicos A Scordis The Palgrave Handbook of Unconventional Risk Transfer Maurizio Pompella  •  Nicos A Scordis Editors The Palgrave Handbook of Unconventional Risk Transfer Editors Maurizio Pompella School of Economics and Management University of Siena Siena, Italy Nicos A Scordis Tobin College of Business St John’s University New York, New York, USA ISBN 978-3-319-59296-1    ISBN 978-3-319-59297-8 (eBook) DOI 10.1007/978-3-319-59297-8 Library of Congress Control Number: 2017947702 © The Editor(s) (if applicable) and The Author(s) 2017 This work is subject to copyright All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed The use of general descriptive names, registered names, trademarks, service marks, etc in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations Cover credit: travellinglight / Alamy Stock Photo Printed on acid-free paper This Palgrave Macmillan imprint is published by Springer Nature The registered company is Springer International Publishing AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland To Giuseppe Foreword There will always be risk It is one of the global economy’s certainties, alongside such self-evident ones as death and taxes For this reason alone, a volume covering any aspect of risk transfer is welcome, but a book that addresses unconventional risk transfer is rarer in the field of economic literature and hence still more welcome There is much fascinating detail in this book Perhaps a few words of context, within the confines of a foreword, may help set the scene for the reader Risk has always been with us it is true, but equally true is the fact that there are those who wish more, rather than less, of it This makes the market Consider that every time someone deals in an instrument as ubiquitous as the humble Eurodollar contract, that transaction represents the coming together of two parties with diametrically opposing views One person’s risk exposure is another’s risk opportunity Of course the conventional or “vanilla” methods of risk transfer are more than suitable for a majority of the world’s participants in finance, energy, commodities, weather and other “asset classes” But often large risk exposures that cannot be mitigated using vanilla methods but yet cannot for one reason or another be left unhedged require unconventional methods if they are to be dealt with And if one can find a ready and willing counterparty, it is inevitable in a free market that these methods will be developed and pursued In 2002, I was working in structured finance at JPMorgan Chase Bank when one of the deals we brought to the market was what we thought the world’s first synthetic Collateralised Debt Obligation (“Robeco CSO”), which utilised credit default swaps to transfer risk via a pooled vehicle; this was an unconventional risk transfer but at the same time an investment product, and the technology became quite commonplace within a year or two One year’s unconventional risk management approach is next year’s routine transaction (In fact I believe a firm called Dolmen Securities beat us to that “world’s first” vii viii  Foreword title with a transaction called “Blue Chip CDO”, but unfortunately that deal did not feature in Risk magazine like our one did!) This is a welcome feature of a globalised free market environment, where innovation thrives and, once in a while, produces genuine benefits for society There will always be innovation in finance, some of it very useful and some of it merely navel gazing, but in the whole, such practice produces value To use an obscure analogy from the world of military aviation, for every Supermarine Spitfire there was first a Boulton Paul Defiant It is a truism that only very rarely does one arrive at the quality product without sampling some duds along the way The asset classes described in this book are many and varied, and often it is the more esoteric products that call for unconventional methods to be applied This is understandable when one has a paucity of market players This is a specialised business, but often dealing in very important areas Without the unconventional approaches to risk management noted in this book, one would risk inefficiencies in production and delivery, with consequent knock-­­on impact on the customer So it is to be welcomed that innovation in risk transfer is something that, nearly ten years after the global financial crash of 2008, remains to the fore All good textbooks should present a solution as well as the problem I was particularly impressed to see the dissection of various approaches to structuring risk transfer across different product types, which forms the bulk of the latter parts of the book I am sure this material will be of value to practitioners But irrespective of one’s own background, for all true students of risk management, be they in the finance, insurance, weather or energy industry or elsewhere, this Handbook is a worthwhile addition to the economics literature The editors are to be commended for their work in bringing to our attention this collection of leading-edge thinking in the exotic world of unconventional risk transfer Kent Business School, University of Kent Canterbury, UK 30 January 2017 Moorad Choudhry Moorad Choudhry  is the former CEO of Habib Bank AG Zurich and was previously the Treasurer of Royal Bank of Scotland (RBS) Corporate Banking, Europe Arab Bank and KBC Financial Products He has over 30 years’ experience in the city and began his career at the London Stock Exchange Choudhry is a visiting professor at the University of Kent Business School, where he teaches on the MSc Finance programme He is a fellow of the Chartered Institute of Securities & Investment and of the London Institute of Banking and Finance He obtained his MBA at Henley Business School and his PhD from Birkbeck, University of London He is the author of The Principles of Banking (2012) Contents 1 Introduction   1 Maurizio Pompella and Nicos A Scordis Part I  Risk Management Strategies and Perspectives    5 2 A Theoretical Perspective on Risk Management   7 Richard Friberg 3 A Practical Perspective on Corporate Risk Management  35 Nicos A Scordis and Annette Hofmann Part II  Conventional vs Unconventional Transfer   55 4 Reinsurance, Insurability and the New Paradigms of Unconventional Risk Transfer  57 Maurizio Pompella 5 Enterprise Risk Management and the Risk Management Process 109 Greg Niehaus ix x  Contents 6 Credit Risk Transfer with Single-Name Credit Default Swaps 143 Christopher L Culp, Andria van der Merwe, and Bettina J Stärkle Part III  Risks by Class  187 7 Natural Hazards 189 Joanna Faure Walker 8 Anthropic Perils and Man-Made Risks 241 Gordon Woo 9 Mortality and Longevity Risk 269 Erzsébet Kovács and Péter Vékás 10 Country Risk: Case Study on Crises Examples and  Lessons Learnt   299 Vasily Solodkov and Yana Tsyganova Part IV Vulnerability, Market Solutions and Societal Implications  327 11 Disaster Vulnerability 329 Joern Birkmann, Linda Sorg, and Torsten Welle 12 Insurance-Linked Securities: Structured and Market Solutions 357 Annette Hofmann and David Pooser 13 Longevity Risk Transfer 375 Douglas Anderson and Steven Baxter  Contents     Part V  Risk Modelling and Stress Testing xi  435 14 Quantitative Man-Made Risks’ Modelling 437 Gordon Woo 15 Pandemic Risk Modelling 463 Dominic Smith 16 Assembling Individual ILS into an Optimal Portfolio 497 Morton Lane 17 Stress Testing with Bayesian Nets and Related Techniques: Meeting the Engineering Challenges 537 Riccardo Rebonato Index 577 .. .The Palgrave Handbook of Unconventional Risk Transfer Maurizio Pompella  •  Nicos A Scordis Editors The Palgrave Handbook of Unconventional Risk Transfer Editors Maurizio Pompella School of. .. firm keep the risk within the firm and thus implicitly the firm’s own investors pay for the risk Therefore, in our view, both risk transfer and risk retention are components of the firm’s risk financing... the term risk transfer to indicate that the managers of a firm pay an external group of investors to take on the firm’s risk We use the term risk retention’ to indicate that the managers of