Swiss Re prepares credit derivatives strategy for China

China's huge external and domestic trade - along with demands placed on banks and insurers by Basle II - may drive the next phase of development of Swiss Re's business in the region, says the group. The Zurich-based reinsurer has been operating in Asia for many years, making inroads for its services and products in Japan and southeast Asia.

"There is intensive cooperation and exchange of know-how at various levels and institutions in order to hopefully start (the Chinese business drive) soon - if not at the end of 2006, then at the start of next year," said Peter Schmidt, head of credit solutions at Swiss Re, speaking at a media briefing in Hong Kong in early October.

"There is a focus for us on China because there is a lot still to be built," he said. "And our partners in China are interested to learn more about the credit environment and credit insurance."

Swiss Re will be helping promote creditworthy behaviour in domestic trade through training and know-how transfer, and introducing Chinese insurers to innovation in structured products.

Key legislation

Key to these developments is a new bankruptcy law, said Schmidt. The Law of the People's Republic of China on Enterprise Bankruptcy will come into force in June 2007.

He said alternative products are also available in the banking sector, such as letters of credit, but he does not see these as competition. "Banks and insurance companies cooperate in big markets to support exports to grow, to support the Chinese economy to grow," said Schmidt.

When all the legislation is in place, Swiss Re aims to discuss with its clients in China the use of securitisation to transfer credit insurance risk. One such transaction was the Crystal Credit transaction completed by the reinsurer in January, the first indemnity-based credit reinsurance securitisation ever completed.

The deal involved the issue of EUR252 million by Crystal Credit, a special-purpose vehicle, of variable-rate notes in three tranches with an average pre-tax coupon of three-month Euribor plus 3.93% a year, paid quarterly and with a scheduled maturity of three years and a legal final maturity of 6.5 years.

The underlying risk was linked to claims and reserves that Swiss Re will have on its credit reinsurance business for 2006, 2007 and 2008. Investors were hedge funds, banks and insurance firms. The indemnity trigger allowed Swiss Re to achieve capital relief at minimal basis risk. The indemnity is based on the firm's loss ratio (incurred losses divided by the earned premium for an accounting or treaty period), which is 74%, said Schmidt.

The Crystal Credit deal made formerly illiquid assets a transferable risk, said Schmidt. Such credit protection unites the areas of banking, insurance and capital markets, and the next step would be a convergence in pricing, he added.

In the past 10 years, there has been dramatic growth in the issue of insurance-linked securities. New issuance in the first eight months of 2006 was $7 billion, already well exceeding the figure for new issuance for the whole of 2005 of $5.7 billion, according to Swiss Re.

There is huge potential demand for credit risk transfer in China (see box). Among Swiss Re's potential clients are the China Export and Credit Insurance Corp (Sinosure), which is the only source of medium- to long-term insurance cover for Chinese exporters in the market, while insurers such as PICC and Ping An are also potential issuers of insurance-linked securities.

"Chinese companies with global risk are our potential clients," Schmidt said. "But the same concept can be applied to the domestic market, and this is something now in the build-up phase."

At this stage, Swiss Re can only instruct its Chinese clients on the concept and benefits of creating insurance-linked securities. In future, it plans to develop products tailored to those clients.