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Integrating the New Infinity Empire

When SunGard Data Systems acquired Infinity Financial Technology last November, players in the derivatives software industry gasped and then quickly set their tongues wagging in an effort to guess how SunGard president Cristobal Conde would ever merge such markedly different companies. After all, SunGard

Capital Markets and Renaissance Software—another recent acquisition—frequently competed with Infinity on the lucrative multimillion dollar systems contracts at the high end of the business.

Last month, the company announced that all three subsidiaries would be merged under the name Infinity. "For the first time, a company in the financial risk management area has reached critical mass,” said Roger Lang, former CEO of Infinity, who will have the same title in the new company.

Conde named three market trends that he hoped to capitalize on: the explosive growth in volume, complexity and diversity of financial instruments; the intensifying regulatory scrutiny; and the increasing shift from proprietary to vendor solutions.

Although he claimed the programs had "complementary strengths,” Conde's chief technical problem will be remapping SunGard and Renaissance products into Infinity's data model. Companies usually start with a data model and develop applications on top of it. But the new company will have to integrate existing applications into the new data model. "You just don't rip out a data model and stick in somebody else's,” notes one industry competitor. "It will take six to nine months or longer to change all reads and writes to make it all compatible.” In the interim, he says, the renegade systems are likely to write to their own database and "shadow” to the new Infinity standard data model. "It's not a step forward, it's a step back.”

Integrating senior management may prove even harder. Infinity managers will likely be senior-most in the pecking order, and there may be a flight of quality people from the firms that are not sitting at the top of the organizational chart. Infinity's competitors hope that the focus on reorganization will distract Infinity sufficiently to give them time to build up the functionality of their own programs.

Another competitor speculates that the new Infinity may garner substantial savings over running separate development efforts. It could also enjoy the substantial edge in marketing that a large sales team can bring. "It's another example of consolidation that's long overdue,” he says. "It's happening first at the top, with the big systems vendors, and then it will move downward.”

A New Take on Cat Options

With the launch of catastrophe insurance options in 1995, the Chicago Board of Trade established itself as the leading exchange in insurance derivatives. Last year, its Property Claims Services' (PCS) cat option reached record volume numbers, and since then the CBOT has looked for ways to expand its product line.

Sometime during the first quarter of this year, the CBOT will do just that, when it launches its single-event catastrophe options. The new products, like regular PCS cat options, cover disasters in California, Texas and Florida as well as five regions—the Northeast, the Southeast, the East, the Midwest and the West—and the United States in general. But whereas PCS cat options are useful for protecting insurers in aggregate during fixed intervals, paying out at expiration when triggered, single-cat options will protect insurers from specific atmospheric or seismic disasters and are exercised and delivered immediately.

The benefits of such a product are clear. "In the Western part of the United States,” says L.P. Hemond, product manager at the CBOT, "since history's been written, there's been no hurricane that's landed in that area, so there's no need for single-event atmospheric options. Similarly, in the East there's less need for single-event earthquakes. So some regions will have both types, others will have one, and the national contracts will cover everyone.”

The new products will offer protection in increments of five PCS index points. In the event that, say, an earthquake in California causes $5 billion in damages, options with a strike price of five points on the PCS will trigger and pay out immediately, but options with a strike price of 10 points will stay on the board. And insurers will have the option of buying options behind the first event at the five-point level, so if an event triggers the first option, it will be cleared and the second option will become the first.

This adds up to a great deal of flexibility for insurers. The PCS cat options allow insurers to recoup their losses from single events only after expiry, while the single-event options will offer immediate payout. "Losses come with every event,” says Hemond. "These options are designed to correlate better with what's actually happening in the industry—with the kind of risks that end-users will be facing in regions where they have exposure.” And since single-event options are far less expensive than reinsurance for second and third events, insurers are able to protect against multiple events for a fraction of the cost.

Hemond views the new products as another step in the evolution of insurance derivatives. "Our second vice chairman, Richard Sandor, has been talking about the securitization of insurance risk for years,” says Hemond. "He said this is a market that's going to wake up and want to ‘derivatize' its risk. And it's happening.”

Cat Fever
Two ivory tower articles praise catastrophe-linked options.

By Robert Hunter

Like most areas of derivatives, insurance derivatives have followed a developmental path much like the history of England—evolution, rather than revolution, has been the rule. Richard Sandor, chairman of Hedge Financial Products and second vice chairman at the Chicago Board of Trade, has sung the praises of insurance derivatives for years, and in the latest edition of the Journal of Applied Corporate Finance, he and coauthors Michael Cantor and Joseph Cole turn the song into a quasi-religious paean. Elsewhere in the same issue, Neil Doherty, professor at the University of Pennsylvania's Wharton School, sings praises only slightly less exultant.

Since 1992, Sandor et. al. point out, the insurance industry has paid out more than $60 billion in losses, and the fledgling reinsurance industry, with a total of just $6.5 billion of capital, is woefully inadequate to protect insurers from future catastrophes such as hurricane Andrew, which alone caused $16 billion in property damages in 1992. "Nontraditional forms of reinsurance capacity such as hedge funds, pension funds and commodity funds need to be tapped,” they argue. "For this to occur, insurance risks must be transformed into securities and derivatives that an investor can understand and can therefore include in an investment portfolio. These financial instruments must also be effective hedging and risk management tools that the insurance industry is willing to use.” Catastrophe-linked options, they say, are powerful and effective hedging tools that offer price discovery and efficiency benefits as well.

Cat bonds will benefit insurers in another way, they say: as risk is transferred to the capital markets, the reinsurance industry will see increased capacity, which will reduce reinsurance rates and make them less volatile. Moreover, they should appeal to portfolio managers increasingly in coming years, offering a mechanism for diversification from equity markets. The authors predict that future cat options on the Property Claims Services' (PCI) index will be zero-beta assets, meaning they are virtually uncorrelated to the Standard & Poor's 500. And the market is already showing "promising signs,” most notably in the over-the-counter bond market, where a $477 million hurricane note issued by USAA and a $137 million earthquake bond issued by Swiss Re last year catapulted the insurance and capital markets closer to convergence, attracting investors "because of their price, rating and size.”

The nascent insurance derivatives market, they assert, is heating up, and as a result, "the insurance industry may change the way it chooses to hedge its risk for the first time in well over 300 years.”

Neil Doherty of the Wharton School jumps on the cat bandwagon in the Journal with "Financial Innovation in the Management of Catastrophe Risk.” He argues that reinsurance, the traditional hedge for primary insurers, commands high transaction costs, while the continued development of catastrophe risk as an asset class is providing insurers with less costly hedging alternatives that, not coincidentally, can provide investors with high rates of return.

Nevertheless, after evaluating both traditional and evolving methods of hedging credit risk, basis risk and the "moral hazard” that attends the insurance industry, Doherty concludes that both reinsurance and cat options and bonds are here for the long haul, and will combine to provide insurers with more flexible and less costly hedging mechanisms in coming years.

Fed Defends New Capital Regs

By Robert Hunter

When the Federal Reserve decided last year to change bank capital requirements to account for what it calls "market risk,” many risk managers and compliance officers viewed the plan as an attempt to sock it to banks with high risk exposures in equity markets.

Not so, says the Fed in a December 1997 defense of its plan entitled "Bank Capital Requirements for Market Risk: The Internal Models Approach,” published in the New York Fed's Economic Policy Review. "The [new] approach will lead to regulatory capital charges that conform more closely to banks' true risk exposures…[and] the information generated…will allow supervisors and financial market participants to compare risk exposures over time and across institutions,” it explains. The requirements took full effect on New Year's Day, affecting 15 U.S. banks.

The plan was an outgrowth of the Basel Committee on Banking Supervision's 1996 proposal, which called for an adjustment of capital requirements for international banks based on a set of value-at-risk calculations measuring market risk exposures.

It differed from the Basel Committee's proposal in one important respect: While the Basel plan called for a standardized approach to VAR measurement, the Fed's plan called for an internal models approach, in which banks use their own VAR models to produce compliance data. The Fed's plan, it argued, was more precise than a standardized measure and easier to administer. Yet many U.S. banks complained that the requirements of the Fed's plan were too stringent and would lead to underperformance. Bankers Trust was the only bank to begin implementing the new requirements during the voluntary compliance period, which lasted until January 1.

The requirements call for a 10-day, 99th percentile VAR estimate, meaning a particular bank would expect to lose more than a certain amount of money on only one day in 100 10-day periods. The VAR estimates, moreover, are to be calculated on a daily basis using at least a one-year historical observation period. The capital charge takes the average VAR estimate over the previous 60 trading days and multiplies this by a "scaling factor” of three.

In addition, the new plan differs in its treatment of specific risk, or the risk of negative price movements of a security as a result of specific events affecting the issuer of the security (unrelated to general risk factors, such as interest rate moves and so on). Under the old capital requirements, long-term debt and equity positions were subject to capital charges that ranged from 0 percent for government securities to 8 percent for corporate debt and equity. The new plan allows banks to measure their specific risk using their VAR models, and the results are scaled by a factor of four until banks can show that their specific risk VAR estimates adequately account for "idiosyncratic” market behavior.

To deter banks from intentionally cooking their VAR numbers to lower their capital requirements, the Fed imposes stiff penalties for inaccurate modeling. The Fed confirms bank-provided data by a process of backtesting, in which it compares a bank's VAR numbers with its actual trading outcomes—that is, the number of days that a bank's losses actually exceeded the targeted amount. Banks with five or more discrepancies between the VAR data and actual trading results during the previous 250 trading days are subject to a higher scaling factor. The scaling factor increases to a maximum of four for banks with 10 or more exceptions.

Critics complained that the 10-day holding period is too conservative, that the year-long observation period is much too long and that the scaling factor undermines the benefits of the internal approach for banks with accurate VAR measures. By scaling the results, they argued, banks that provide accurate VAR figures are unfairly penalized.

The Fed has dismissed these arguments, asserting that the changes in capital requirements for the banks affected by the new rules are "likely to be quite small.” It estimates that banks' capital requirements would increase by only 1.5 percent to 7.5 percent. And when specific risk is included in the mix, the overall increase may even be smaller than that. "Given the significant positions that some institutions hold in instruments that will become subject to the specific risk capital requirements,” it says, "the [specific risk] carve out may well result in a net reduction in required capital levels for some institutions.”

Even under this rosy scenario, banks likely won't reap the benefits of the new plan for long. Evidently the Fed isn't through tinkering with capital requirement procedures just yet. When it unveiled the new plan in 1996, chairman Alan Greenspan said it was already "on the verge of obsolescence,” and that a "precommitment approach” will be the wave of the future.

To get a copy of the publication, call the Federal Reserve Bank of New York at 212-720-6134.