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Fi n a n ce i n PersPec tive Issue 1 October 2007

Insurance upheaval...Sarbanes Oxley...Harry Alverson...Black Swans...Rajat Gupta...William Keegan...Trading platforms...Petrochemicals...Capital Concepts

Issued by Qatar Financial Centre Authority




Reality check / 5

There is nothing new about financial storms in the run-up to World Bank and International Monetary Fund annual meetings, says William Keegan.

capital expansion / 8 stoRm waRning / 22

James White, in a three-part special, examines the structural upheaval in the insurance industry.

The insurance industry has been forced to develop new and more sophisticated mechanisms in response to a spate of natural and man-made disasters. Christopher Owen reports.

out of the box / 28

Measures like the Sarbanes Oxley financial regulation will force alternative investment management to consider relocating away from established centres. By Marc Miles and Jack Anderson.

equity fiRst / 39

In a major interview Harry Alverson, of the Carlyle Group, explains private equity's phenomenal growth. By David Smith.



platfoRm one / 46

Globalisation, economic prosperity and the rise of the internet has sparked a revolution in the structure and ownership of trading platforms. By Prabhu Guptara.

positive eneRgy / 53

Nassim Nicholas Taleb explains to David Smith how random and unpredictable events can be turned to advantage.

capital JuDgement / 56



For the first time in history, says Aaron Brown, the amount of capital in the system is close to being determined rationally.

fuelling the boom / 60

The global petrochemical industry's centre of gravity is about to shift with the Middle East poised to play a leading role. Hilfra Tandy reports.

paRtneRship pays / 64

Rajat Gupta insists that the adversarial relationship between business and politics is out of date: only co-operation and joint working can aid the cause of international development.

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Rajat Gupta is the Senior

Partner Emeritus of McKinsey & Company, where he served as Global Managing Director from 1994 to 2003. He is a member of the board of the Qatar Financial Centre Authority. He is now Chair of the Board of the Global Fund to Fight AIDS, Tuberculosis and Malaria.

James White has 13 years

experience working for global communications consultancies within the professional and financial services sectors. Under the banner Whitenoise Consulting, he currently writes numerous white papers and articles, particularly on key insurance and corporate reputation issues.

Dr Marc Miles is a global

economist and former director of The Center for International Trade and Economics, The Heritage Foundation and Editor, Heritage Foundation/Wall Street Journal Index of Economic Freedom.

Professor Prabhu Guptara

is Executive Director of Organisation Development, at Wolfsberg (a subsidiary of UBS), Switzerland. He has contributed this article in a personal capacity and the article has no relationship with any of the organisations with which he is or has in the past been connected.

Jack Anderson is an

international US and European Tax Attorney, Director of Fairvest ICX, Forbes Global Tax Editor, and author of the Global Tax Misery Index.

William Keegan is the senior economics commentator of

the London Observer, with more than a quarter of a century's experience covering international business and finance developments. In this capacity he has interviewed many of the world's leading financial decision makers.

Christopher Owen is a London-based journalist and editor

who specialises in international fiscal, legal and regulatory issues. A regular contributor to national and specialist newspapers, he was the launch editor for Offshore Red, the Offshore Financial Law Reports and Private Wealth Advisor.

Aaron Brown is risk manager

at AQR Capital Management. He is the author of The Poker Face of Wall Street and has contributed to or co-authored several other books including a forthcoming history of financial speculation. He has been a trader, head of mortgage securities, as well as a finance professor.

Hilfra Tandy has been writing about the international

chemical industry since 1975, joining the London Financial Times in 1980 where she founded and launched Chemical Matters which subsequently became an independent publication.

David Smith has been Economics Editor of the London

Sunday Times since 1989, where he writes a weekly column. He is the author of several books, including `The Rise and Fall of Monetarism, ­ and most recently `The Dragon and the Elephant: China, India and the New World Order.'

QUANTUM FINANCE IN PERSPECTIVE. TM TRADEMARK REGISTRATION IN PROGRESS. © QATAR FINANCIAL CENTRE AUTHORITY 2007. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic or otherwise, without the prior permission of the copyright holder. Quantum magazine is published quarterly by Camel5 Publishing of London ("the Company") on behalf of the Qatar Financial Centre Authority ("QFCA").Whilst the Company makes all reasonable effort to ensure that information contained in articles ("information") is accurate, complete and not misleading, no warranty, representation or undertaking of any kind whatsoever is given by the Company or QFCA. The Company, QFCA and its representatives shall not be liable, directly, indirectly or howsoever for any loss or damage suffered or incurred by any party using or relying upon the information. Further, no liability whatsoever is accepted for any errors, omissions or statements contained in the information. Accordingly, all third parties accessing, using and/or relying upon the information expressly undertake to carry out their own due diligence and independent verification of the accuracy and completeness of the information.


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Challenges and Opportunities

z The emerging markets crash of 1997... the dotcom boom and bust...

the sub-prime mortgage crisis in the United States. It becomes ever more apparent that crises that not so long ago could be confined to a geographical area or a particular sector now have a global impact ­ and that this impact can happen with breathtaking speed. At the same time, markets are changing and the structure of trading platforms ­ not to mention their ownership ­ is being transformed in ways that were unimaginable only a few years ago. The penalty for those who fail to understand what is happening is considerable, though there are also unprecedented opportunities for those who make the right call and are prepared to be innovative. Those legislators who fail to provide the right balance between proper controls and allowing their markets to prosper will also suffer, as financial institutions and businesses will look beyond traditional jurisdictions if they are not satisfied with the way their own markets are regulated. Our goal in Quantum, Finance in Perspective, a quarterly magazine published on behalf of the Qatar Financial Centre Authority, is to examine the world's markets today, what is likely to happen and, most importantly, the implications for the corporate and financial sector. In this issue, we report on the insurance sector, which is in the midst of a period of unprecedented upheaval. We examine whether capital markets can ­ and should ­ take over the management of risk in this area; the convergence of healthcare and financial services; and the development of the captive insurance market in the Middle East. There is also a detailed technical analysis of alternative risk transfer. We interview Harry Alverson of the Carlyle Group, who defends the role of private equity investors, and profile the guru Nassim Nicholas Taleb, who explains his `black swan theory' on the impact of the unexpected. We intend to keep a close eye on the behaviour of politicians and regulators and the way their decisions impact on the financial sector. In this issue we look at the impact of the Sarbanes Oxley legislation on hedge funds in New York. Indeed, the relationship between politicians and the private sector is vital. Rajat Gupta, Senior Partner Emeritus at McKinsey & Company, argues that business and government should not be rivals because, as partners, they can be a strong engine of development. We are confident that you will find the arguments presented in these articles thought provoking. But we do not expect you to agree with everything ­ and hope that you will stimulate further debate by contributing to our letters page. Q


Rajat Gupta Lord Jacob Rothschild Sir Graham Boyce Sir Kenneth Warren


Sarah MacInnes [email protected] +44 7879 473 221


Nigel Dudley [email protected] +44 208 670 1922


Steve Martin [email protected] +974 496 7777 Shashank Srivastava [email protected] +974 496 7777


Marcus Baron


Hannah Lawrence

For subscription please visit our website

Quantum - Finance In Perspective - Issue 1


Facilitating the development of Qatar as a major player in the global insurance industry

Progressing the Vision


This page: Professor J.K. Galbraith Next page (clockwise): Alan Greenspan, Jean Claude Trichet (President of the European Central Bank), Ben Bernanke (chairman of the Federal Reserve Board)

By William Keegan

Lessons from History

z The ink (conventional or designed specifically for

computer print-outs) had hardly dried on the International Monetary Fund's summer economic forecasts before it became apparent that the size and ramifications of the US "sub-prime" mortgage problem were potentially far more serious than initially expected. One London-based commentator rather arrogantly explained the US "sub-prime" mortgage market as "loans to borrowers with dodgy credit histories". No doubt many borrowers were not credit worthy. But the bigger problem ­ and very much a sign of the times ­ was that so many of the lenders, or middlemen proffering financial advice, could be described as having indulged in "dodgy" behaviour themselves by promoting these loans and not explaining the dangers and implications of much higher interest rates

(in the UK there has been longer experience of the pros and cons of what are known here as "variable rate mortgages"). The defaults naturally had an impact on financial markets, with much-publicised losses at the Wall Street firm Bear Stearns, which had led the fashion for "bonds backed by high-risk mortgages". The italics are mine. Professor J. K. Galbraith, who died only last year, would have relished the ironies of recent financial market behaviour, not least because of such wonders, as described by the Economist, as "covenant-lite" loans, under which lenders give up their rights to monitor the behaviour of the borrower; or "payment-in-kind notes", which allow borrowers to substitute more IOUs for interest payments. There is nothing new about financial crises in the run-up to the annual meetings of the World Bank and the International Monetary Fund. Memories were jogged of the Asian financial crisis in the summer of 1997, the pain caused by the Russian default the following summer and the crisis at Long-Term Capital Management (LTCM) shortly afterwards. Indeed, one should not forget that the IMF and other Bretton Woods institutions (the World Bank and the General Agreement on Tariffs and Trade ­ now the World Trade Organisation) were themselves born at the end of the 1939-1945 world war, in reaction to the anarchic regime of chronic financial and economic crises which bedevilled the years between the end of the First World War in 1918 and the outbreak of the Second. Recollection of those years should serve to remind us that the achievement of low inflation is not the be-all and end-all of macro-economic policy. Indeed, the ultimate

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manifestation of the conquest of inflation, i.e. deflation, can presage economic and social disaster. The statutory objectives of the US Federal Reserve ­ price stability and maximum employment ­ recognise this. The present chairman of the Federal Reserve Board, Ben Bernanke, studied the Great Depression at some length, and, in the period before he succeeded Alan Greenspan, published a paper on the lessons of the Japanese deflation of the 1990s. Bernanke's conclusion, as the Fed reacted to the bursting of the dot com bubble of the 1990s, was that, although the likelihood of outright deflation in the US was not great, the consequences of such a risk materialising were such that policy should err on the side of expansion. This indeed is what Greenspan contrived before Bernanke took over in 2006, notwithstanding the former's famous warning in 1996 of the dangers of "irrational exuberance" in the financial markets. Broadly speaking, this "bias towards expansion" has been evident in much of the industrialised ­ and newly industrialised ­ world, with the exception of the eurozone, where the emphasis is on price stability, from which it is hoped that all economic good will follow. But the US economy has recently been slowing down, not least because the sheer vigour of the economy for much of the decade made Bernanke's risk of deflation even more remote. The Fed duly embarked on the series of counter-inflationary increases in interest rates which have precipitated, but not necessarily caused, the sub-prime mortgage crisis. The interesting thing about the IMF's upward revisions to its growth forecasts in late July ­ by 0.3 percentage points from the spring, to a heady 5.2 per cent real growth for the 6

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world economy this year ­ is that stronger growth in China, India and Russia was deemed to be more than sufficient to counteract the effect of slower growth in the US. Nevertheless, the financial markets became very nervous in July and August. There was quite a shake-out, and the widening of spreads (the gap between the returns on topquality bonds and the rest) caused all sorts of trouble for the hedge funds, private equity concerns and many of those operators in the financial markets who had been dependant on the assumption that credit was freely available. The optimistic interpretation of this summer's shenanigans in the financial markets was that they constituted what Jean-Claude Trichet, President of the European Central Bank, called a "normalisation" of risk assessment.


the question of how far the devaluation of the dollar still had to go; and "whither the oil price and its effects?". The US had for some years been importing one and a half times more than it was exporting, and it did not require a PhD in advanced mathematics to recognise the longterm unsustainability of its position. But, notwithstanding the passionate feelings in Congress about the substantial undervaluation of the Chinese yuan, progress in adjusting the foreign exchange value of the yuan has been pitifully slow, so that much of the impact of the declining dollar has been concentrated on the euro and the pound sterling. As the dollar fell in the course of the first half of this year, the Organisation for the Petroleum Exporting Countries (OPEC) were anxious to recoup some of their currency losses (oil being priced in dollars), just as they were in 1973 before the Yom Kippur War brought the first "oil shock". They turned a deaf ear to western calls for increased production, as the price reached levels (in real terms) close to what was experienced in the early 1980s through the combination of the first (1973-74) and second (1979-80) oil shocks. So, as this October's annual meetings of the World Bank and IMF approached, the optimists cited official forecasts for record world economic growth for 2007, and rationalised events in the financial markets as necessary adjustments. The pessimists worried about the impact of a possible "credit crunch" on the real economy, and the consequences for the eurozone's competitiveness of a continuing fall in the dollar. The pessimists also fretted about how long the international economy could sustain such impressive growth rates against the background of high oil prices and potential uncertainties about the reliability of continuing sources of energy supply. Subdued optimists consoled themselves with the thought that if recent events did presage an economic slowdown, that would at least ease the pressure on the price of oil. But, for this observer, perhaps the most interesting financial development between last year's annual meetings in Singapore and this year's in Washington has been the dawning realisation among practitioners (or players as they like to call themselves) in the financial community that by spreading risk you do not eliminate it. Although central banks are now more enlightened than they were as portrayed in Galbraith's `The Great Crash' in 1929, I fear that the behaviour of the financial markets in recent years has been all reminiscent of the antics so brilliantly described by Galbraith all those years ago. No wonder that great book by that great man has never been out of print. Q

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Above: IMF Logo

Indeed, for several years the world's leading central bankers have been concerned about the behaviour of the financial genie let out of the bottle. Perhaps the most vociferous and persuasive prophet of potential doom has been Bill White, the Canadian chief economist at the Bank for International Settlements (BIS) in Basle. In the annual BIS report, and in several influential academic papers, White has questioned whether satisfaction with the way modern, independent central banks control inflation is enough. In common with a number of academic economists, White has been concerned about asset prices, and has advocated a broader and more forward-looking anticipatory approach to making policy than has recently been fashionable. Again, Trichet probably epitomised the mood of the leading central bankers who meet in Basle most months when he said on 2 August: "We were calling for an orderly and smooth re-appreciation of risks and we asked markets and investors to be as keen as possible to avoid sharp and abrupt corrections". Thus, in theory, the scares and adjustments in asset prices, credit ratings and market appraisals of risk during the summer months constituted a return to down-to-earth reality. But even necessary and/or desirable adjustments in the financial markets are bound to be painful for many; and there is always a danger that they will damage the entire system, as opposed to certain errant players, and provoke outright recession. Fears of a credit crunch and an over-reaction arose against the background of two other major uncertainties:



Managing Risk

z Whilst insurance and reinsurance risks have been

offloaded onto capital markets over the last decade, innovation has been slow. According to ratings agency Fitch, reasons have historically included a lack of enthusiasm from insurance originators, regulatory hurdles, deal complexity, lack of a sufficient investor base and high transaction costs. The driver behind recent capital market development was the devastating hurricane season in 2005, which inflicted an $80 billion loss on the insurance and reinsurance markets. Insurers with exposure to US hurricanes saw rising costs which meant that, in some cases, traditional reinsurance was 8

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The last few years have seen the strong convergence of the insurance sector and capital markets, a trend that has not only resulted in new market entrants to the insurance market, such as hedge funds, but also a gradual change in the way the insurance industry approaches risk. Capital markets are here to stay, says James White.


Capital markets have significantly greater capacity than the insurance markets. The removal of counterparty credit risk (the vehicle already holds a pool of capital). Increases the diversification of protection sources and offers multi-year protection. Improves cost of capital i.e. the reduction in the cost of capital achieved through securitisation is greater than the cost of servicing the securitisation structure.

Deutsche Bank is experimenting with markets in "event-loss swaps". According to Fitch, bonds linked to life insurance and mortality rates and sold to hedge funds and pension funds reached $5.4 billion last year from a zero level a few years ago. "Derivatives have made the world a better place," says Roger Ferguson, head of financial services at Swiss Re. "Allowing risk to be sliced and priced more finely, therefore getting it to the hands of those who can bear the risks, has got to be a positive development." In a catastrophe bond market that has seen huge growth in a relative period of calm, he does however add a note of caution: "The current scale of derivatives has not been fully tested in the most stressful circumstances, " he says. Investment banks are looking to offer tailored derivatives solutions to the trustees of pension funds via longevity bonds, a challenge given that trustees are inherently conservative and cautious about capital markets. Caitlin Long at Credit Suisse is convinced that capital markets will soon develop to trade longevity and mortality risk, arguing that there is simply not enough capital in the life insurance industry to absorb the entire longevity exposure in pension plans. This position is supported by David Blake, professor of pensions economics at Cass Business School, who believes that a new market will emerge in 2007 and will outstrip credit derivatives ­ which is already worth $26,000 billion. Perhaps more importantly, the convergence of capital markets and insurance is enabling parties to reassess the nature of risk. As the world becomes an increasingly uncertain place for companies, there is a drive for companies to re-examine the way they manage risks. Some insurers and reinsurers have been forced to limit the cover for companies with operations exposed to natural perils. Companies have faced the storm season with less cover than they would have liked, whilst others have been forced to take on more risk themselves through higher deductibles. Capital markets allow insurers and reinsurers to think differently about acceptance, retention and hedging of insurance and reinsurance liabilities. Stephen May, chief executive at Heritage Mutual Management, says that the new capital markets role allows organisations to better separate out risk and mitigate it. "Before, when you bought traditional insurance, you received an off-the-shelf solution, at a market-driven rather than justifiable rate. Capital market emergence means that organisations don't have to buy traditional insurance anymore and can carry out risk mitigation ­ it has changed

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either unavailable or too expensive. Capital markets stepped into the breach by providing insurers and reinsurers with an alternative way to pass on risk via securitised assets. The traditionally slow-moving reinsurance market has been navigated by hedge funds which, tempted by the large returns to be made from high reinsurance rates, brought with them aggressive capital market instruments. Hedge fund capital has provided much needed capacity by acquiring insurance-linked securities or backing insurance vehicles. Since the volume issued amounts to a fraction of the $3,000 billion worth of asset-backed securities worldwide, it is clear that there is plenty more opportunity for an insurance-based market to develop. Swiss Re forecasts the market for insurance-backed bonds to increase from $25 billion now to at least $150 billion by 2015. More innovative securitisation products are now being launched. For example, Axa's recent $606 million securitisation of its European car insurance book breaks new insurance ground, as securitisation was previously used in offloading catastrophe risks. Denis Duverne, Axa's Chief Financial Officer, sees the transaction as an "efficient risk and capital management tool for the insurance industry, as well as a new attractive asset class for investors". Investment banks have also been busy. ABN Amro last year led a collateral debt obligation (CDO) which packaged the natural catastrophe risks of the insurer Catlin ­ and



June 07: Axa sells risk of insuring 6m drivers from four European countries into the international capital markets in $606m transaction. June 07: Swiss Re issues $100m cover to protect against earthquake risk in Mediterranean countries. April 07: Swiss Re issues $150m bonds to cover Thames flood risk. Feb 07: Hannover Re launches via a collateralised debt obligation (Merlin CDO1) to protect itself against losses in the insurance and reinsurance industry.


Will these startling growth rates in insurancelinked securities issuance continue over the next few years? Insurance experts believe securitisation will gather pace as climate change demands that insurers spread risks onto a wider pool of investors. It will not necessarily proceed at the same pace, according to Tim Roberts, head of McKinsey's financial institutions practice in London. "There is a collective agreement that the capital markets have been slow to deliver to the insurance industry" and points to catastrophe bonds which were under discussion for 10 years before really taking off. Mark Hvidsten, Chief Executive Officer at Willis Capital Markets believes the convergence is set to continue. "If you analyse developments in the last three to four years, it looks like it's here to stay." The next step could be a partial commoditisation of the CAT bond market. "Partial commoditisation and tailor-making certain parameters for sponsors could be a great thing."


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Luca Albertini, head of European insurancelinked securities at Swiss Re does not believe the capital markets will ever replace insurance. "But there are things for which insurance is best and things for which capital markets can provide a solution. Having a bit of both is the ideal." Stephen Catlin, Chief Executive Officer at Catlin, a Lloyds insurer, believes that capital markets will increasingly be used for risk transfer by insurers. The advantage for insurers is in being able to transfer the risk for three years rather than the single year of traditional reinsurance contracts, as well as the attractiveness of the pricing. Geoff Bromley at Guy Carpenter expects 2007 to be a record year of catastrophe bond issuance. "In the first four months of this year, around $2bn of CAT bonds were issued with several more due to hit the market. The convergence of our marketplace is a fact and sponsors now expect their programmes to be presented to the capital markets."



USD bn 24 20 16 12 8 4 0 98 99 00 01 02 03 04 05 06*

* data through August 25 2006 Source: Swiss Re Capital Markets

New Issues Outstanding from previous years

the way companies think about insurance and helped them to take control," he says. Accompanying this new mindset is a focus on the importance of data, a far cry from the way major underwriting decisions in the reinsurance industry were once taken. Previously, it used to be about people and relationships. In the new world, information is king, as well as the ability to segment risks in order to better understand them. The more the data can be taken apart and turned into meaningful information, the better indices can be created for capital markets risk-transfer. Stephen May continues: "The data and modelling is becoming more available and, as convergence develops, I have no doubt that the demand for data will be satisfied. Emerging markets such as the Middle East are particularly interesting because they are starting from a different position, a `blank page', and using state-of-the-art risk modelling techniques." Until recently most traditional debt investors were wary of catastrophe bonds. Now pension funds and others have been desperately seeking derivatives that offer a decent return in a low-yield world. The more aggressive hedge funds are increasingly willing to buy the riskier portions of the debt and trade them, ensuring market liquidity.

Maren Josefs, at rating agency S&P's insurance division, sees investors split into two types. The first is experienced and sophisticated with resources to manage insurance risks, such as catastrophe bond funds and hedge funds. The second, such as pension funds, is more receptive to guidance from the rating agencies. Some fear that investor appetite will diminish with higher interest rates, since "standard" debt instruments will look more attractive. But most believe that since insurancelinked securities are unrelated to other financial assets, they can be a useful addition to any investment portfolio. So how will investors respond to a series of disasters and the affliction of heavy losses? Josefs does not envisage a huge change in investor appetite, on the basis that some investors, such as hedge funds, are more familiar with digesting losses. "2006 showed that, although there were huge losses in the industry following a series of hurricanes the previous year, money from the capital markets poured into the reinsurance industry attracted by the high prices on offer," she says. There are barriers to growth, however. The reinsurance market is softening, with prices dropping by 20 per cent as hurricane losses in 2006 and capital market competition kick in. "The reinsurance industry is undergoing a seminal change. The competitors are no longer merely other

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reinsurers. The competitors are capital markets, local governments, residual markets and self insurance," says Peter Hearn, chief executive of Willis Re. Hearn believes that the softening rates may support a move back to more traditional insurance, leading to a brief delay in the development of innovative reinsurance capital market products. Should it happen, this pause will surely be brief. A further factor affecting the market is that the European Union intends to adopt a framework directive in 2007 aligned to the actual risks of the insurance industry, and has set a timeframe for implementation by 2012. The framework will ensure appropriate risk controls in running an insurance business and means that the need for sophisticated operational risk management tools has never been greater. The industry has been lobbying for the directive to cover securitisation and, in July this year, the European Commission announced that Solvency II will take account of asset-side risk as well, creating a total balance sheet regime. In practice, this means that insurers will be able to use securitisation, reinsurance and derivatives to transfer risk, and also invest in start-ups and venture capital and non-listed companies. The Group of Thirty, a private, non-profit international body composed of private and public sectors and academia, released its Reinsurance and International Financial Markets report last year, highlighting a number of challenges. Along with progress towards greater standardisation of transactions and the need to improve the deal economics through increased deal sizes, the report noted that the industry needs to identify, measure and manage the risks involved in securitisation more effectively. Most importantly, it identified the need to develop robust risk-based models that analyse the basis risk arising from the fact that securitisation is unlikely to transfer exactly the same risks to the capital markets as the insurer has written. Such models should also describe the nature of the cash flows to be acquired by investors and need to be understood and accepted by regulators and ratings agencies. The reality is that for the insurance industry, capital markets are here to stay and will continue to develop and innovate both in deal size and asset class. Whilst the pace of the change will always be influenced by investor appetite within the capital markets, which can sometimes fluctuate, key factors will be the degree of mindset change within insurance and reinsurance companies, and on details of the forthcoming Solvency II. Q 12

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By James White

Captive Audience

Historically, captives have been used by risk managers as a way to capture commercial insurance premiums, allowing the large multinational company to self-insure various lines of coverage such as general liability, workers' compensation, employee benefits and property insurance. With favourable claims experience, self-insurance becomes another profit centre.

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600 Captive License Dates by Region 500 400 300 200 100 0 1980 Source: Aon, June 2007 1985 1990 Americas 1995 EMEA 2000 2005 Asia Pacific

z It is no longer a preserve of the large conglomerate. An and potential investment returns. Since captives can be

estimated 600 captives will be incorporated during 2007, and more than half of those will be formed by middlemarket businesses. The range of activities performed by captives has grown in recent years, as has the market in which they operate. Recent captives research undertaken by Aon, the insurance broker, has also dispelled the popular belief that the market is saturated.The `Global 1500: A Captive Insight' report, published in June 2007, points to an underdeveloped market, with more than half (53 per cent) of the global 1500 companies not currently owning a captive. These companies are missing out on better quality of cover, as well as potential savings of 10-15 per cent of their reinsurance programme costs. Cost savings are made through economies of scale, efficient use of capital and senior management time; the most guilty sectors are manufacturing and communications, where only 55 per cent and 62 per cent of the global 1500 companies have captives. Those who do take full advantage of the opportunities include large group companies. They use captives to complement the services and coverage provided by traditional insurers and reinsurers, thereby providing their owners with specific financial and strategic benefits ­ this is often a key component of an overall company risk management framework. Some of these benefits include lower insurance costs, greater coverage flexibility, improved price stability, 14

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structured in a focused way to address clearly defined issues, they allow a company to adopt a tailored approach to risk management. In addition, they are designed to be a long-term solution for providing insurance coverage that is not entirely dependent upon insurance company swings in the market-place. Captives can take several forms, varying on the basis of their number of parents (single parent vs. multi-parent), risk diversity (homogeneous vs. heterogeneous), and type of ownership and/or management (3rd party vs. self managed and/or owned). A feasibility study is typically carried out to analyse the benefits and structures that may best fit a particular organisation. Stephen Cross, chief executive of Aon captive services group, says: "People that are not thinking towards the alternative market still tend to buy their coverage on an each-line basis. However, carrying various lines of business in a captive will create a portfolio effect for firms, so even if one area of the captive does not perform particularly well, it is balanced out to some degree by the performance of other areas". The increasing ability of captives to write specialist risks, as well as traditional casualty and property lines, means that captives now have a closer fit with organisations' unique risk profiles and requirements. Captives are an effective tool in providing a tailored approach to risk management. Some of the most eager users of the captive market are firms where capacity for the risks involved is shrinking, or



Unavailable insurance cover 2%

To transfer risks 1%

To generate profits 14%

} } }


Other reasons (access to additional markets, facilitating risk management processes) 36%


To reduce cost of risk 47%

Source: Marsh, April 2007

firms trying to avoid being hit for a number of small but high-frequency claims. For this reason, many firms in the manufacturing, energy and pharmaceutical sectors turn to the captive market. Insurance broker Marsh surveyed risk managers early in 2007 and identified the reasons they were choosing to set up captives. The overwhelming response was to reduce the cost of risk at 47% followed by other reasons such as access to additional markets and facilitating risk management processes at 36% (see figure above). The report also found captives are frequently used for low-severity, high-frequency events, and "accordingly each and every limit is moderately low ­ more than half the companies have a limit below $4 million. More than half of the 55 companies with an aggregate cap in place have it set either at or below £10 million". However, a number of captives also take significant aggregate exposures, with at least 20 per cent taking more than $100 million in exposure, though with energy companies representing 12 per cent of the group surveyed, this relatively high level is not unexpected. The Marsh study also purports to explode the myth that most captives are created to access the reinsurance market. The finding that 59 per cent of the captives surveyed did not purchase reinsurance, against 41 per cent that did, is linked with the fact that many captives are actively involved in high-frequency, low-severity risks that would not typically be of interest to the reinsurance market. But the captives market is set to change, as companies are increasingly considering captive formation, and it is

noteworthy that, whilst this approach was previously a response to hardening insurance rates, it is now driven by a desire to fulfil broader strategic management aims and to address the total cost of risk. In the wide choice of domiciles, regional trends are starting to be seen. There has been strong demand from US companies for captives that are domiciled onshore, partly driven by a more negative perception attributed to the concept of offshore jurisdictions, coupled with a focus on corporate transparency following a succession of well-documented corporate failures. This has led to the emergence of new US onshore domiciles and explains the rapid growth of Vermont, which is catching up with Bermuda as the capital of the captives market. European companies are increasingly setting up new captives in Europe rather than Bermuda and other traditional destinations. The new domiciles are competing with traditional rivals on the issues of proximity and market access, as well as communications and language advantages. Some believe that there is now an oversupply of domiciles. Andrew Tunnicliffe at Aon is emphatic: "There are close to 30 places that claim to have captive-domicile legislation, and that is oversupply. Frankly, there are now too many places". Another consideration is the business culture of the domicile itself. Malcolm Cutts-Watson, head of Willis European Captive Practice, says: "Ireland is Europe's most mature onshore domicile, but the problem it has is that they want to gold-plate any regulation to be absolutely certain there are not going to be any insolvencies. But that makes

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Domicile 1980 1985 1990 1995 2000 2005

Bermuda Vermont Luxembourg Guernsey Ireland

Source: Aon, June 2007

it a hard environment in which to do business. Whereas the new jurisdictions have shown themselves to be more flexible, the large multinationals will still pick Ireland for its reputation". According to Aon, the Asian market is earmarked for significant growth (only 17 per cent of Asian G1500 companies have captives). What is needed in these markets to provide a catalyst for growth? Aon's Andrew Tunnicliffe calls for more client education, especially in Asia, to explain how the process actually works and to gradually change the corporate mindset. "The large broking organisations will be the people who will make that market happen", he adds. The Middle East market saw its first captive formation at the end of 2006. Similar to Asia, domiciles in the Middle Eastern region will see the large majority of business coming from local parent companies, in a trend set to be one of the few certainties globally in an unpredictable market. Whilst Bahrain has led the way in captive legislation, Dubai and Qatar are not far behind, with Dubai in particular seeing a lot of activity with local companies keen to support the introduction of legislation. As more domicile options appear, the decision for parent companies about where to set up a captive becomes largely a matter of taste. As hard markets bite and captive insurance becomes increasingly more mainstream, it is likely that more companies will turn to it as an option, and be prompted to look in the first instance by rising premiums.



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} } } } } }

48 2 0 3 0 55 11 3 5 0 70 39 38 24 3 90 70 67 44 26 212 120 76 68 52 256 192 100 95 91

It is not all about premiums, however. As the market hardens, deductibles are also likely to rise while the terms and conditions of the cover in place may also deteriorate. Many firms will start questioning whether they are getting `value for money' and, on further investigation, will realise they could provide their own cover at a more competitive price and continue to do so into the future. So who are the people to educate companies about the benefits of captives? The largest brokers, Aon, Marsh and Willis, all have their own captive management offering and have serious experience at structuring this vehicle. According to Charles Allen, managing director at Heritage Insurance Management, another key influencer is the independent captive manager, with no ties to an insurer, broker or other service provider. Allen says, "Adaptation to change is accepting the fact that selfinsurance is a very useful tool, for many businesses. It fulfils a number of objectives. It allows them to write policies that perhaps they find it quite difficult to place in the open/retail market, thereby accessing the reinsurance markets behind some form of captive retention or other involvement. It also allows them to look at wordings and the extent to which certain types of coverage are excluded in the market". In the coming years, however, it seems the impact of insurance market conditions will lessen as the captive movement gathers momentum and increasingly firms begin to see the captive market as a viable option and not simply the preserve of the largest corporations. Q



At the end of 2006, Tabreed, a district cooling company, became the first captive insurance company to be domiciled in the Middle East region. "We are in a capital-intensive business requiring large amounts of investments," said Mohamed Saif Al Mazrouei, Chairman of Tabreed. "The long-term, asset-intensive nature of our business requires that we excel in financial planning and risk management." The captive set-up is managed by Ensurion, an independent Middle East captive management company. Youssef Al Kareh, General Manager of Ensurion, said: "This is a significant milestone in the regional insurance industry's development. Captives have been used since the 1950s by Fortune 500 companies and other large insurance buyers around the world. It is high time that the Middle East also began to benefit from such structures. "Insurance procurement has been centralised into Tabreed's captive, optimised with the support of an international panel of distinguished re-insurers and structured to provide the company with significant cost savings and controls. Since Tabreed has been set up, the supply side is increasing resources to the brokerage and the demand side is sitting up and taking notice. "The Middle East is not a litigious environment, so there is less scope than in the US and Europe for environmental or malpractice liabilities. It is very plain vanilla covers that are needed for companies with multi-billion dollar assets. "We have a number of new clients in the pipeline, mainly in petrochemicals, logistics and marine. There are distinct advantages to Middle Eastern companies in having a captive domiciled in the region. It is more cost effective from a geographic and logistical point of view to hold local board meetings. The costs for a Saudi company of holding a board meeting in Bermuda, for instance, are huge in comparison to being able to meet in their own backyard. In addition, they are often more comfortable doing business

Below: Manama, Bahrain

in the region and having more affinity with a local regulator. "Bahrain, where Tabreed is domiciled, was the first jurisdiction in the region with a captive regime, but it has been followed by Dubai and Qatar. Ensurion deals with the region and has no preference about domicile other than to explain the issues to a client. Sharia sensitivities do not discriminate against captives, and sharia-compliant captives are our radar screen but it is not necessarily important to the larger corporates that we are dealing with. "I can envisage between 10 and 15 captives being domiciled in the Gulf region in the next five years. When we talk to companies about the captive concept, they are interested but many are cautious because this new area is out of their comfort zone. But I'm confident that, as the region's regulatory frameworks in each of its financial centres develops, the resistance to change will lessen".

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James White examines the convergence of healthcare and financial services, the movement towards defined contribution schemes and the impact on the insurance industry.

Customising Healthcare

z The healthcare insurance market is on the brink of a in the US's largest benefit plan, the Federal Employees

seismic shift in the way it operates, driven by a spiralling of health benefit costs. Its future will see a movement towards defined contribution schemes and the opening up, according to management consultancy Booz Allen & Hamilton, of a $1 trillion opportunity for US financial services companies alone, with the creation of 50-100 million new retail investment healthcare accounts. US total healthcare spend is expected to rise from $1.4 trillion in 2001 to $2.4 trillion in 2010. Inevitably, North American employers are starting to convert direct benefit programmes to direct contribution programmes. This move towards healthcare consumerism, complemented by developments in e-commerce infrastructure and product innovations, is resulting in a convergence of financial services and healthcare benefits. Employers such as Medtronic and Motorola are already providing defined contribution plans, initially to management personnel. Retail portals are being marketed by firms like Definity Health and SimplyHealth, where employees can select coverage, networks and other critical health plan features. Defined contribution features are already included 18

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Health Benefit Program, through which federal employees can make healthcare choices online. According to Booz Allen & Hamilton, the projected $1 trillion growth will be privately funded, and whilst healthcare has traditionally been managed outside the confines of the investment system, the use of individual healthcare accounts in the US will deliver on short-term and long-term financial management needs. Alternatively, health benefits can be viewed in two ways: a subsidy for predictably routine expenses and an insurance fund against unforeseen risks and longer-term security. This opportunity for insurers is supported by McKinsey, which believes that by 2011, $550-$600 billion of premiums will be in the hands of individual decision makers rather than employers or the government. Furthermore, whilst a similar shift from direct benefit to direct contribution has taken place in the retirement savings market, dramatically changing the asset management landscape, the early signs are that the pace of change is likely to be faster in healthcare. Booz Allen & Hamilton envisages a direct contribution model built around a website, where employees make


choices using a voucher, with options to increase coverage and features with their own funds. Initially, today's employerspecific risk pools will be maintained, but new aggregation and risk models will emerge in the long term. Yet alongside this trend to a consumer-driven healthcare model, governments around the world are imposing standards of care on employers. For example, in the UK, recent Health & Safety Executive guidelines to employers provide a checklist for managing stress in the workplace. Whilst it has no statutory power, this guidance serves as a reminder that a healthcare onus will continue to be placed on the employer. The US healthcare corporate default position, whereby employers provide employees with a full refund on healthcare costs, is clearly unsustainable. As nanotechnology starts to deliver new treatments, the costs are likely to increase (certainly in the case of recent cancer drug breakthroughs). Since the default "full refund" position will not support such high costs, Alex Bennett at Aon Consulting believes that a hybrid system may evolve; a combination of consumer control and reduced employer funding as their scope of responsibilities becomes ever wider. Mike Williams, a consultant at employee benefits consultancy Watson Wyatt, agrees that a new model is likely to emerge from the US, where there is already consumer empowerment through individual health savings accounts. In the UK, he does not see employers unduly concerned about healthcare costs, which are cheaper than the US and seen as a "duplication of the National Health Service". He adds: "We are already seeing greater consumer control, a flexible environment and more product choice, all managed through the internet. But it must be stressed, in the UK at least, this is a gradual movement". Whatever shape the future model takes, a switch to direct contribution plans in healthcare is arguably more politically sensitive than in retirement plans. Employers may be nervous about introducing radical change in a competitive employment market, but rising healthcare costs may leave them with little choice. Naturally they will face criticism that direct contribution shifts responsibility away from employers and towards employees. A consumer-driven system is expected to develop, and the online model will become a self-service healthcare environment for the employee, providing convenience as well as lower administrative costs for the employer. As healthcare goes retail, from growing interest in the US in health savings accounts to the proliferation of minute clinics,


Individuals, not groups, are the decision makers, with emphasis on first-class service. Insurers need to adopt a retail approach, as well as continue a traditional wholesale approach. Pricing risk needs to be developed to the different customer segments, so customer insight is vital. Consolidation of health insurance, benefits administration and financial services companies as they compete for market share.

a significant change of approach and mindset is required for both consumers and insurance companies. Consumers are likely to resist direct contribution plans at first, but product innovation could change their outlook and lead to more rational consumption decisions. It requires a dramatic change of consumer perception of health benefits, away from envisaging healthcare as a free good to be consumed "as frequently as possible" towards the concept of a lifelong stream of annuity payments, to be managed for maximum value today and security for what may happen tomorrow. McKinsey believes that as costs are being passed onto individuals, they will soon expect first-class service, in line with what they expect in other consumer-facing industries such as retail and banking. They will also expect 100 per cent accuracy and convenience of contact, as well as demanding greater levels of advice and support, given the complexity of healthcare insurance products. Employers will continue to play a critical role, since they select a menu of products and fund much of the plan, as well as aggregating risk to provide affordable coverage for older workers and those with an existing problem.

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Furthermore, according to Marco Bannerman, head of corporate sales at UK-based healthcare insurer BUPA, employers still want to retain a mandate so they can be regarded as "caring". He says: "To play no role in the healthcare environment of employees would be to provide your peer companies with a competitive advantage. However, employers are asking insurance companies to add more value to the scheme, which is evolving into providing positive health support among staff". A more consumer-driven healthcare model will force insurers to have sharper consumer insights. In addition, as the industry becomes more retail focused, insurers are likely to face serious competitive threats from potential new entrants. The insurers will need to develop retail expertise whilst at the same time managing the traditional wholesale business. McKinsey see this as a significant challenge for large parts of the industry, companies whose "competencies, organisational structure and mindsets are directed at businesses not individual customers". To "go retail", these companies need not only to develop better insight about the consumer but also to improve product management, retail distribution, customer service, risk management and consumer-orientated medical management. Already, financial services providers are building strategies to integrate lifelong funding for healthcare risk with retirement, and then linking them with routine retail banking services. Not only are innovators developing approaches that transform healthcare funding while involving consumers in their own healthcare decisions, but products are being designed for which actuarial studies show that, over time, significant surpluses will be accumulated by most people. This is beneficial as it will allow a cushion for critical lifestages, times when needs are greater such as childcare and middle age. This potential to build a long-term fund for lifelong healthcare security should lead to consumers becoming more active participants not only in their own medical decisions but also their own lifestyle. For example, patients with cardiovascular disease tend towards surgical treatment. If these patients could accumulate and invest unused healthcare money, then it could lead them to try diet and exercise regimes and medicine before going for surgery. According to Phillip Taylor, managing director of Preferred Medical, many people in the UK are monitoring their health and going to the doctor earlier than they used to as a result of the trend towards preventative medicine throughout the insurance industry and the medical profession. The 20

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fact that there is a lack of "wellness services" available on the state-funded National Health Service provides insurers and advisers with a niche opportunity. He adds: "Wellness products are becoming popular, and they reward people for staying healthy. As a result, premiums are coming down". Positive health is the natural evolution to the healthcare model, and insurers are stepping into the breach to drive preventative initiatives themselves. For example, BUPA has launched a Positive Health scheme which provides members with online assessment in four key health areas ­ sleep, stress, nutrition and fitness ­ alongside support and advice. This "retailisation" of corporate healthcare brings additional challenges for insurers. Firstly, there is a need to persuade corporate employers of the value of such preventative schemes, though this is perhaps surprising, given that there is clear evidence that a healthier workforce correlates with a more productive workforce. In addition, a major challenge will be to engage the approximately 70 per cent of employees who have no cause to utilise their healthcare scheme. In the UK, Prudential has responded by rewarding employees in a scheme with a rebate if they use a gym membership. Those who want to succeed will have to adapt. McKinsey has outlined areas where insurers will need to strengthen: product innovation, retail distribution, customer service and risk management. Large insurers do not place enough emphasis on product innovation as a source of competitive advantage and tend to follow desires of employers or benefits


­ insurers offering health benefits through supermarkets, pharmacies or online portals; affinity marketing ­ use of third-party segment groups; partnership with financial institutions ­ to provide opportunities to use partner branch networks; and work sites ­ given the insurer's strong relationship with employers, this channel is perhaps the most important one. Worksite marketing will be a major purchase criterion for large employers who want to migrate to direct contribution health plans. As a starting point, the insurer needs to define the consumer segments it wishes to pursue and choose the approach that fits. Some consumers will want a trusted advisor who can make decisions for them, while others prefer to use information to make their own decisions. Choosing a partner is a key factor in positioning the insurer brand. For example, offering a product via a value-orientated retailer may cement the perception that the product is competitive on cost. The level of insurers' retail expertise differs in each regional market. "In the UK, the insurers already have a strong retail brand," according to David Costain at Axa PPP. "As insurers become more involved in employee assistance services, there will simply be a greater leaning towards a retail focus." The classic insurer approach to the consumer experience has previously focused on servicing consumers as efficiently as possible. This approach is not sufficient for the retail market, where the customer experience needs to add value. The aim must be to develop loyal and committed customers who would recommend the insurer to friends and family. In order to price correctly, insurers must understand not only the risk profiles of individual customers but also the true cost to serve, which varies by segment and channel. Turning this into an opportunity, insurers need to combine insights about consumer behaviours with actuarial methods to create a competitive advantage. As the healthcare model moves towards a focus on individuals, insurers need to respond with improved insights about customers which will underpin the capabilities with which it will compete. Even insurers with some background of dealing with consumers will still have cultural challenges in adopting new operating models. In the years ahead, health insurance, benefits administration and financial services industries will compete fiercely for market share which will lead to partnerships and mergers and acquisitions as the market converges. Those companies that understand and exploit the emerging market will enjoy significant profit opportunities. Q

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As the healthcare model moves towards a focus on individuals, insurers need to respond with improved insights about customers which will underpin the capabilities with which they will compete.

consultants. The result is that the product often ignores the consumer needs and preferences. Not only will insurers need to produce genuine insight on consumer attitudes and "lifestages" to provide appropriate products, they will also need to be nimble in bringing a tailored product suite to market. The winners will provide an expanded product portfolio of innovative health insurance products, as well as ancillary products and services. Insurers will need to adopt a mixand-match approach in their product, offering, for example, individual health, dental and life insurance. In addition, operational features such as billing and customer services will need to be integrated to allow one point of contact for the customer. Insurers, which historically focus on product coverage levels and the design of benefits, now also have to deal with the service experience, the network and clinical programmes. They will have to design, launch and manage products quickly from concept to market in a way that keeps a range of different stakeholders contented. As consumers take greater control over healthcare, insurers need to generate sales via direct dealings with the consumer. Whether via intermediary or directto-consumer distribution, additional emphasis will need to be placed on building distinctive branding and marketing to create a brand the consumer can trust. McKinsey says there are five types of retail channels: direct response channel ­ includes a captive sales force, call centres, internet, direct mail and advertising; retail channels


Risk Business

Weathering the Storm

Christopher Owen analyses changes in how the insurance industry has set itself to cope with the ever more prevalent risk of disaster.

z The increased prevalence of natural and man-made

disasters over the past two decades has triggered a sea change in the way the insurance industry handles catastrophe. Businesses, hit by higher premiums or the inability of insurance companies to cover high-impact risks, have increasingly sought other options.Their principal destination has been the Alternative Risk Transfer (ART) market, which has reacted swiftly to provide a range of innovative solutions. These products are designed to support businesses in the face of mounting risks at the "high end" of the risk profile. In other words, low-frequency but high-severity events. To the extent that they fill in where traditional insurance is unable or unwilling to provide coverage, ART products may be complementary to traditional insurance. But the potential clearly exists that these supplements represent a new, more complex and widespread challenge to traditional insurance mechanisms, and, in time, may grow to replace them. The insurance industry uses the term catastrophe to label events that exceed a certain dollar threshold in claims payouts. In 1997 the catastrophe definition was raised from $5 million to $25 million. But the cost of some catastrophes, both natural and man-made, can now be in the tens of billions of dollars.


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Risk Business


Four events in particular have helped to shape the ART market. Hurricane Andrew in 1992 and the Northridge earthquake of 1994 proved to be far more destructive than most experts had predicted, and led to a shortage of catastrophe reinsurance capacity in the US. This prompted insurers, reinsurers, investment banks and others to look for new ways to spread the risk of natural disasters. Increasingly, the capital markets came to be viewed as a large resource that could be tapped to cover claims at the higher levels, after reinsurance had been exhausted, in cases where there was a low probability of loss. Equally significant was the terrorist attack on the World Trade Centre in 2001, which changed insurers' assumptions about man-made risks worldwide. It was also one of the catalysts for the Sarbanes-Oxley Act, which introduced new statutory requirements for senior managers of US public companies to certify that their companies have adequate internal controls. This led many companies to adopt a more strategic, comprehensive approach to risk management, and effectively removed the traditional barriers between companies' treasury and insurance-buying operations. Finally there was Hurricane Katrina in 2005. At least 1,836 people lost their lives in the storm and in the subsequent floods, making it the deadliest US hurricane since 1928. The hurricane was estimated to have been responsible for $81.2 billion in damage ­ the costliest natural disaster in US history. It served to intensify discussions about the way disasters, natural and man-made, should be managed and also strengthened the conviction that the frequency of such events is increasing and that the consequent hardening of property and casualty markets may be a permanent adjustment. All these drivers have prompted executives to seek out risk mitigation alternatives, and a consensus is emerging that the global capital markets have capacity far exceeding that of the insurance markets and consequently can handle ­ at a lower cost and with less shock to the system ­ the occurrence of natural disasters and other severe risks. The ART market has therefore developed as the insurance and capital markets find ways to work together to resolve longstanding capacity concerns.

Above: Hurricaine Katrina

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Risk Business

The first wave of alternatives was based on loss retentions and their primary support mechanism, the single-parent captive. Captive insurance companies have become the fulcrum of risk-financing programmes in many businesses, they are likely to play an ever more substantial role as companies move increasingly into enterprise risk management. The next crop of alternatives is based on a number of capital market products and is aimed more at capacity than at cost. Among the available alternatives to insurance products are credit securitisations, CAT bonds, sidecars, weather derivatives and finite risk products. Many of these instruments are products of the capital markets. The principal advantage to investors is diversification. Catastrophe losses are unrelated to the usual speculative risks, which are generally economic. This de-correlation means that ART products can provide investors with returns even during cyclical financial market downturns. While the number of transactions involving the capital markets is still relatively small, it is fast expanding. A report by Conning Research & Consulting last September, for instance, found that alternative market mechanisms now cover about 30 per cent of the US commercial insurance market (traditional insurance companies cover the remaining 70 per cent). Utilisation of securitisations within the insurance industry is a relatively new idea that started in the 1990s, but it has steadily gained favour with the capital market investors. Assets subject to credit risk, such as receivables, are transferred to specially created investment vehicles, which then sell on securities "backed" by the assets transferred. The proceeds are remitted to the transferor of the assets ­ the entity 24

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Above and previous page: The Chicago Mercantile exchange

that otherwise would have purchased insurance ­ and the purchasers of the securities assume the risk. Swiss Re, the Zurich-based reinsurance company, estimates the current outstanding volume of insurance-linked securities at about $23 billion. But they note that issuance is accelerating fast, and their current projections are for growth to reach a range of $150 billion to $350 billion by 2018. By far the most enthusiastic users of securitisation have been life insurers, who can significantly reduce their capital requirements ­ and thereby increase their capacity to write new business ­ by selling risks to investors. For property and casualty insurers, dealing with high-severity, low-

frequency events, securitisations have principally centred on CAT bonds, which were one of the first ART products to take advantage of the convergence of the insurance and capital markets. Properly known as catastrophe bonds, these are risk-linked securities designed to transfer a specified set of risks from the issuer to investors. CAT bonds are usually structured as corporate bonds, but repayment of the principal is waived if certain specified conditions, generally linked to a defined catastrophic event like a hurricane, are triggered. If no hurricane strikes, the investors enjoy a return on their investment through interest payments, as well as the principal repayment over

Risk Business

worldwide reinsurance market. The next time premiums for any business line harden, as they are now doing for the property catastrophe business, it is likely that sidecars will be used to make up capacity. Finite risk products have also become more prevalent. Unlike standard insurance contracts, which usually have a 12-month duration, finite risk products are typically multiyear insurance contracts. In exchange for the payment of a premium approximating to the liability estimate, the insured and its insurer agree to share the investment income generated by the premium. The insured would also be entitled to deduct the premium paid at the outset of the transaction and, if the insured risk does not materialise during the term of the contract, would receive back a substantial portion of the premium paid. The products above have generally been applied to high-severity, lowfrequency situations. In contrast, weather derivatives are designed primarily for events that are less dramatic but which could have an equally devastating effect on companies' balance sheets. Variable weather affects supply and demand in almost every industry. It is most influential in sectors such as energy or agriculture but can also have a significant impact upon sectors like retail, clothing, tourism and entertainment. The concept underlying weather derivatives is based on "degree days" ­ that is, a temperature-based measurement calculated as the deviation of the average daily temperature from a predetermined base. The two most popular measurements are heating degree days (HDD) and cooling degree days (CDD). The Chicago Mercantile Exchange (CME) has listed futures on

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For property and casualty insurers, dealing with highseverity, low-frequency events, securitisations have principally centred on CAT bonds, which were one of the first ART products to take advantage of the convergence of the insurance and capital markets.

the life of the bond. But if the triggering event occurs, then the investors may lose their rights to a portion of or the entire principal, which is retained by the issuer to pay the loss. Another recent innovation has been "reinsurance sidecars". These are structured to attach to an existing reinsurer to provide additional capacity with the existing underwriter. Sidecars are generally much smaller deals than CAT bonds, and are constructed as private placements rather than tradable securities. They are usually formed as small, tailored reinsurance companies, with just a few investors covering the upper layers of the insurance contract or the highest-loss events. The sidecar concept became

prominent among investors, particularly hedge funds, after Hurricane Katrina. They can be set up and capitalised in a matter of weeks and therefore offer a quick way to participate in the risk/return of the hard reinsurance market, without investing either in existing reinsurers, who might have past liabilities that would undermine returns, or in new reinsurers that would take time to build reserves. So far these vehicles have only been used to reinsure property catastrophe exposures, but theoretically any risk can be reinsured, provided the premium is sufficient to attract investors. It is therefore likely that they will play an important role in the


Risk Business

these references since 1999. Weather derivatives are now routinely used as a hedge against adverse weather conditions around the world. The size of the weather derivatives market has grown sharply, from practically nothing in 1997 to a $40 billion notional market value in 2005. This growth can be attributed not just to increased awareness of the risk posed by the weather to businesses, but also to the empirical data showing that the weather itself has become more changeable. More than 5,000 contracts were traded in 2005 between 40 market participants, mainly in the US, Europe and Japan, with some strong interest also reported from India and South America. Significant growth is expected in the future. This list of risk financing alternatives is by no means exhaustive and, as the insurance and capital markets continue to work together to resolve long standing capacity concerns, new and more sophisticated alternative risk financing products will likely emerge. The build up of pressure on the property insurance segment has provided the main driving force to date and, with more volatile weather events predicted for the future, it would seem that the industry will go on looking to the ART market to fashion its response. Capital markets experts will seek to expand their role in the market, and insurers will need to adjust their strategies accordingly. In the meantime these new products and applications will undoubtedly be taken up in more and more geographies around the world. Q


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Risk Business


ART structures may not have arrived yet in the Middle East, but they are moving ever closer. On 1 June this year Swiss Re closed the first Mediterranean earthquake risk bond, worth $100 million. The bonds transfer serious earthquake risk in five Mediterranean countries from Swiss Re to Medquake, a Cayman Islands-based special-purpose vehicle. Medquake issued the notes, which buy protection on policies in Turkey, Greece, Israel, Portugal and Cyprus, for a period of three years from May 2007 through May 2010. Swiss Re Capital Markets, the investment banking arm of Swiss Re, structured, placed and underwrote the bonds, which were based on a parametric index, representing a weighted measure of earthquake activity in the region. These notes will pay the coupon unless the index exceeds the trigger level. Luca Albertini, head of the European Insurance Linked Securities and Asset Backed Securities team at Swiss Re's Capital Management and Advisory (CMA), explains the reationale behind the deal: "We assembled some of our exposures to quakes in different regions. This made sense from a cost point of view because it diversifies exposure for the investors. Also the advantage of placing this type of risk into capital markets is the speed of payment." While securities laws prevent public discussion of specific deals, he added that Swiss Re is looking at the Middle East with a view to supporting clients with CAT bond structures in the region by the end of this year. "The Middle East is a new market," said Albertini. "The reason we have not been focused on the region is because there is still so much to do in traditional markets. When you go to a new market, you have to analyse all the exposures, work out the modelling, the legal issues, and then put together the structure. But we are currently working on the modelling and the legal structure will follow. Certainly there is a lot of interest in taking exposure in the Middle East because it will provide investors with diversification." But it is unlikely that the SPV will be based in the Middle East. Cayman is the industry's favoured location because it is a cost-effective option that also offers a high degree of investor protection and confidence. Most European SPVs are currently being set up in Ireland for similar reasons. "Precedence and confidence are important because the research and development required for new locations is expensive. Unless there are compelling legal or tax reasons, sponsors will go back to the Cayman Islands, Bermuda or Ireland," said Mr Albertini. "If a government is really committed to establishing a successful regime, it needs more than just the legislation. It should also sponsor its own structure, with a domestic SPV, to provide investors with confidence."

Above: Doha, Qatar

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Boxed in?


The Sarbanes Oxley financial regulation, and proposed new taxes on hedge fund and private equity firms in the US and UK are having a negative impact. Marc Miles and Jack Anderson examine how these businesses are responding to this political attack and what criteria they will use when they examine alternative financial centres in which to operate.

z The history of the financial markets

is one of movement and change. Darwinian evolutionary process is at work with new financial tools being developed and global financial centres always on the move. In the 18th and 19th centuries the hub of financial activity moved from Paris to London and New York. In the 20th century the Nixon administration's 10 per cent tax withholding on US and foreign residents saw the centre of the international bond market shift from New York to London. Today the widely acknowledged over-regulation of Sarbanes-Oxley, combined with instant access to

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information, is pushing the equity markets out of New York to London and other locations. This should concern those responsible for New York's markets, not least because its current position is far from strong. London already exceeds it in all but alternative investment management's hedge funds and private equity firms' assets. London has a chance to win even there, but London, too, is at risk. For the reality today is that no country or city has a dependable David Laro has authoritatively said "Taxes are an essential consideration in an executive's decision to invest capital. As little as a two percent change in tax rates can be a sufficient motivation in relocation of assets". The shift to electronic markets and high-speed connections has made financial markets portable. This ease of movement means governments can no longer act in a vacuum. Studies by bodies including The Economist Intelligence Unit, the World Economic at the very time that financial markets are becoming even more mobile. Once again we are seeing Congressional reaction to crises collide with the law of unintended consequences, and the desire to regulate clashing with the realities of global markets. Congressmen repeatedly forget the economic truth that the more you regulate an activity, the less of it will occur, and the corollary that taxes are an invitation for people to find some way around them ­ or at


% share of financial-services markets, latest available


Cross-border bank lending Foreign equities turnout Foreign-exchange turnover Over-the-counter derivatives turnover Marine insurance net premium income International bonds (secondary market)

Source: International Financial Services London

United States

9 34 18 24 11 na


8 nil 8 3 12 na

France Germany Others

9 nil 3 10 6 na 10 3 5 3 8 na 44 23 34 17 43 na

} } } } } }

20 40 32 43 20 70

monopoly on financial transactions. The enhanced mobility of financial markets due to electronic trading, computerisation and growing stability in many countries allows managers and traders to choose where they can maximise the after-tax returns to themselves and their clients. The reality of global competition is that managers are no longer loyal to a particular location ­ and one of the key factors affecting their decision is regulatory or tax changes, both personal and corporate, introduced by governments. US Tax Court Judge 30

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Forum and Ernst and Young show that companies in the US and Europe are relocating in search of lower costs, local markets and a more congenial regulatory and tax environment. The importance of regulation and tax in choosing where to carry out business should be self-evident. However, it is not obvious to those trying to maximise something other than profits on alternative investment management: the 110th US (Democratic) Congress or the British (Labour) government. Western financial centres are under governmental attack

least to minimise their impact. In short, what legislators aim to do may be a far cry from what actually happens. The intent of Sarbanes-Oxley (Sarbox) was clear ­ to prevent a repetition of the horrific losses suffered by stockholders and employees of Enron and Worldcom. However, regulations are just another form of tax, which raises the cost of doing business and produces unintended behaviour. There is no doubt that Enron and Worldcom officials lied and hid the truth of tenuous financial situations and encouraged employees to buy


more doomed stock for their retirement accounts, even as the officers were selling theirs at inflated prices. When the truth was eventually exposed, the stock was worthless, burning investors and leaving employees to watch their once promising retirement nest eggs evaporate. The media became preoccupied with stories of the extent of misery wrought by this egregious scandal. Congress was urged to "do something" to prevent future scandals and punish the miscreants; no matter that the actions of Enron and Worldcom officials were already illegal under existing law, and that they were eventually convicted. The attorney representing the judge in the bankruptcy of Enron, Neal Batson, searched over 30 million documents to ferret out what really happened, as well as the stash of over $5 billion in hidden assets. He concluded that the Enron crimes were already covered by existing law and that the burden imposed by Sarbox would have no additional impact in stopping the next Enron. Instead, investors should realise that the next crime could be for Congress or the Security and Exchange Commission (SEC) to apply Sarbox to alternative investment management and its sophisticated, affluent and qualified investors. Such steps would hasten the decline of American financial markets. It is one thing to spread the costs of implementing Sarbox across a corporation the size of Exxon or Worldcom. It is quite another to impose the same costs on a start-up entrepreneurial business. The unintended consequence was that new initial public offerings (IPOs) increasingly shifted to venues in London and other global markets with less onerous regulations and penalties.


The Sarbanes-Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 (Sarbox), was Congress's answer to the public outcr y that followed a series of financial scandals, including those involving Enron and Worldcom. The legislation is wide-ranging and establishes new or enhanced standards for all US public company boards, management, and public accounting firms. Under this complex law, a public company with more than 300 shareholders must establish extensive internal controls to monitor and report all financial transactions of the company. An outside auditor overseen by the company's audit committee must verify the controls, and the chief executive and chief financial officer of the corporation must vouch in writing that the financial statements are entirely correct and comply with all securities laws. If the auditors give them incorrect figures, too bad ­ the CEO and CFO are still subject to criminal penalties. Critics say that there are huge additional costs on corporations, not to mention new federal crimes and penalties ­ and a tantalising opportunity for litigious shareholders or attorney generals with political aspirations.

Michael Oxley, Vice-Chairman of NASDAQ

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TOP 20 IPO'S IN 2006

Name Domicile Country Industry Proceeds (US $M) Primary Exchange


1. 2. 3. 4. 5. 6. 7. 8. 9. Industrial & Commercial Bank of China-ICBC Bank of China Ltd Rosneft Natixis Standard Life Assurance Co Lotte Shopping Ltd Aozora Bank Ltd Saras Spa MasterCard Inc 10. China Communications Construction Co Ltd 11. Petroplus Holdings AG 12. Kazmunaigas Exploration & Production 13. China Coal Energy Co Ltd 14. Debenhams Ltd 15. Daqin Railway Co Ltd 16. Symrise AG 17. Reliance Petroleum Ltd 18. SMS Reaal Groep NV 19. Biffa Plc 20. Spirit Aerosystems Holdings Inc

Source: Ernst & Young Strategic Growth Markets Network

Russian Federation France United Kingdom South Korea Japan Italy United States China Switzerland Kazakhstan China United Kingdom China Germany India Netherlands United Kingdom United States


China China

Energy and Power Financials Financials Retail Financials Energy and Power Consumer Products and Services Industrials Energy and Power Energy and Power Materials Retail Industrials Consumer Staples Energy and Power Financials Energy and Power Industrials


Financials Financials

} }

21,929 11,186 10,656 5,296 4,444 3,738 3,218 2,637 2,579 2,379 2,318 2,255 1,945 1,924 1,921 1,846 1,832 1,724 1,691 1,647 Hong Kong Hong Kong London Euronext London Korea Tokyo Milan NYSE Hong Kong Zurich London Hong Kong London Shanghai Frankfurt Bombay Euronext London NYSE


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Many small American companies, with the help of new consultants, chose to register outside the country. Only one of the twenty top international IPOs last year was under the buttonwood tree on the NYSE, while the value of IPOs in both Hong Kong and London exceeded that in NewYork City and the value of initial US private placements (not subject to Sarbox) exceeded domestic IPOs as well. New York's share of global IPOs dropped from 50 per cent in 1999 to about 7 per cent last year. The NYSE globalisation with the NYSE-Euronext merger is only a partial solution. The message is starting to get through. Officials from Treasury Secretary Henry Paulson down, are worried. In January, Mayor Michael Bloomberg and Senator Charles Schumer issued a report warning of New York's potential decline as the financial capital of the world. They specifically pointed to the Sarbox regulatory hurdles and potential

litigation as barriers to doing business there. The chief beneficiaries have been financial centres like London, which is already the hedge fund capital of Europe, home to 38 of the top 50 companies in this sector. A June survey assessed London as superior to New York, particularly because of lower regulations and threats of litigation. This concern was underlined by former financial community indicter turned New York governor Eliot Spitzer, who issued an executive order creating the New York State Commission to Modernise the Regulation of Financial Services. This panel will focus on streamlining regulation and includes Lloyd Blankfein of Goldman Sachs, Charles Prince of Citi and Stephen Cutler of JP Morgan Chase. But the bigger risk is at the federal, not state, level. Treasury Secretary Paulson and SEC chief Christopher Cox have both warned of new potential

federal regulatory problems. Does this mean there will be a solution? Don't count on it. Congress has been considering extending Sarbox-type regulations to alternative investment management. Potentially more damagingly, Congress might next pick up on the arguments of Germany's Finance Minster, Peer Steinbrûck, for government regulation through a code of conduct for alternative investment management ("locusts", as he calls them). The sub-prime loan crisis may be Congress' excuse to regulate. Congress should instead examine the evidence produced over the years by the Heritage Foundation/ Wall Street Journal's annual Index of Economic Freedom. Ten factors measure, for about 160 countries, the degree to which markets are open, governments do not meddle in the affairs of people, and the rule of law exists. The message is that as countries move closer to "economic freedom", they tend to grow more rapidly. The

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more economies are free to adjust to global competition, the better they do. This evidence should also be setting off alarm signals about the potential impact of the "crisis" atmosphere in Washington. For example, the SEC has proposed regulating hedge funds much as it regulates other financial assets and funds. And in the Senate, leading finance committee members are considering reversing the game rules and cutting off tax benefits to hedge fund and private equity owners. The mood is not investor friendly in Congress, where Democrats have called for the repeal of the capital gains reduction. More ominously, the proposal for increases in tax rates for hedge funds and private equity firms is coming from both sides of the aisle. There are three sets of proposals, which are a reaction to the recent explosion of hedge funds and particularly to the public outcry over the well-publicised mega-payout to partners from the Blackstone Group 34

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Today the over-regulation of SarbanesOxley, combined with instant access to information, is pushing the equity markets out of New York to London and other locations.

Left: Henry M. Paulson, Jr. Treasury Secretary Below Left: Bernard J. Ebbers, former CEO of WorldCom

IPO. No one has ever declared that using existing tax rules to qualify for the 15 per cent rate is illegal. The only charge is that it is unfair or wrong. Of course, few mention that the same proposals would also affect venture capital firms, real estate partnerships and many oil and gas companies. This hysteria overshadows the fact that hedge funds are a risky business. On the same day that Blackstone made its killing in the IPO market, headlines also focused on Bear Stearns bailing out two of its hedge funds to the tune of $3.2 billion. No wonder that the payouts to the lucky winners are large. Of the estimated 9-10,000 hedge funds, only a small fraction consistently outperform the S&P index, net of fees. And fees can be quite substantial. Funds typically charge 2 per cent annually to manage money and demand 20 per cent of any profits. A fund has to perform very well for investors to see above average returns.

The first of these proposals attacks a longstanding and accepted treatment that the at-risk equity investment of a fund manager is taxed at capital gains rates. In general, the 2 per cent fixed fee ­ based on the asset size of the fund that managers of hedge funds receive for their services ­ is taxable as ordinary income, at a 35 per cent rate (in New York the combined federal/ state/city rate is 46 per cent). However, both hedge fund and private equity fund managers also invest their own money into the fund's transactions, which results in their participating in the potential capital gains of the fund, called a "carried interest". This is generally 20 per cent of the total gain of the fund, if any, on liquidation of the investment. This capital gain is then taxed at a 15 per cent rate (in New York as much as 26 per cent). The first proposal would increase the tax on this gain to 35 per cent. However, this gain is fully an

"at risk" investment due solely to managers' market successes. The amount of such capital gains accruing to fund managers over the past few years has been almost $50 billion; a tempting target for a tax-hungry Congress. But the reality is that such a change to one of the key factors encouraging success may actually reduce tax revenues by stimulating the international flight of funds and their managers. Can the US global taxation basis and anti-corporate inversion rules stop such flight despite unfavourable changes? In short, no. The second proposal is to impose a corporate tax on alternative investment management partnerships that go public and expose them to double taxation ­ even though high tax rates are already a competitiveness issue for the US. The 35 per cent US corporate tax rate is already the third highest in the world, and when combined with the New York State/City corporate tax

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Germany's failure to understand the impact of tax and regulation on behaviour dates back to 1989 when it repeated President Nixon's error by imposing a 10 per cent withholding tax on interest for Germans, resulting again in a shift of assets to new markets. Following a massive cash exodus, within a few months the withholding tax was revoked because of damage to Germany as a financial centre. The Germans did not learn the lesson, deciding in 1993 to impose a 30 per cent withholding tax on interest income. All they achieved was doing neighbouring Luxembourg a favour, as Germans began showing up in banks there clutching large bundles of Deutschmarks. Soon more German money was flowing into Luxembourg funds than German funds. It was not so much the tax itself ­ withholding tax did not apply to foreigners and applied to only a fraction of Germans ­ that affected behaviour. What mattered was that the actions of 1989 and 1993 telegraphed that the tax environment could change at any time, thus adding new risk to investing in Germany and making German markets that much less attractive. German regulators must also face the reality of modern global financial markets ­ that greater tax bites and regulations are doomed to failure. Institute local withholding and funds fly to neighbouring states. Institute EU-wide withholding and funds escape to lower-taxed regions beyond the EU's grasp. Even the attempt by the OECD in 2000 to corral global tax competition by blacklisting smaller countries as "tax havens" and threatening financial retaliation has failed miserably. Ever y small countr y tr ying to expand its financial centre knows that by holding out it will receive more than its share of the tax-fleeing money. Investors like not only lower costs, but also faith that a government will not significantly change the rules of the game.

rate, it becomes the highest. In June 2007 Blackstone, one of the largest private equity firms, successfully went public on the New York Stock Exchange. Blackstone wisely carried this out as a partnership using "blocking corporations" in order to be treated for tax purposes as a pass-through, with taxes paid at individual rates. Thus Blackstone partners avoided the punitive US corporate double taxation, taxing first at corporate rate and a second time at the individual rate as income is distributed. The proposed law change would treat Blackstone as a corporation in order to increase tax rates to the same 35 per cent they want on individuals, plus the second tax that results when managers and investors receive their payouts. The current proposal for an initial five-year phase-in now looks like it will be substantially shortened in the negotiation of the bill. This attack on public offerings of alternative investment management is targeted and applies to a limited group, but it is equally discouraging to the financial community as a whole. Supporters of this second attack on alternative investment management argue that the mere act of going public transforms Blackstone from a partnership into a "corporation". This proposal would affect the other almost 100 publicly traded partnerships listed on US stock exchanges for many years. Existing tax law dating back 20 years to 1987 specifically allows partnerships to go public and exempts them from corporate tax ­ as long as 90 per cent of their income is from interest, dividends, rents, royalties and capital gains. This is exactly the type of income earned by alternative investment managers and Blackstone.


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The third proposal is that US pension funds, as well as hospital and university endowment funds that invest through offshore subsidiaries and "blocking corporations" of US hedge funds, be subject to tax on this "unearned" income. Such a rule would reduce the cash available for endowment funds to pay US retirees, hospitals and universities. These proposals may never become law, but the possibility that US taxes may rise and regulations get tougher is enough to remind hedge funds and private equity fund managers that they have a choice. And they know that in a globally competitive market, they cannot afford to deliver lower returns to their investors than funds anywhere else in the world. The first alternative for managers is Belgravia and Mayfair in London, which is now the largest financial market for cross-border bank lending, foreign equities, foreign-exchange, derivatives, marine insurance, international bonds ­ though it is still only second to the

US and New York, for the moment, in hedge fund and private equity fund assets. This past migration of financial markets is why New York politicians and Treasury Secretary Paulson are concerned that London may take over these latter markets. London won its dominant position due to earlier regulatory and tax missteps in the US and New York. But is the UK now about to repeat the same mistakes? Earlier this year, some members of the private equity community proposed a doubling of their UK taxes from 10 per cent to 20 per cent, and, for certain nondomiciles, from even lower levels to 20 per cent, in response to fears that the Labour government might increase these taxes to 40 per cent. Prime Minister Gordon Brown, as Chancellor, had used the emotionally charged words "justice and integrity" in reference to the fiscal matters of alternative investment management. Yet he also recognises the importance of the financial community to London,

a lesson he learned a decade ago when he tried to eliminate the favourable tax treatment of financial managers not domiciled in the UK. He may again pull back to save London's advantage. The fear that the British government might overreact to public hostility to private equity companies has led some US firms, such as Highland Capital, to choose Switzerland rather than London or New York. Highland appears to be happy in tax-secure Switzerland, with a favourable and certain tax ruling and no capital gains tax on personal asset sales. These advantages outweigh a relatively unfavourable ordinary income tax rate for individuals employed and selling business assets. But hedge funds and private equity firms are not limited to the US, London or even Switzerland. Many have already chosen to incorporate in even more tax and regulatory friendly spots like the Cayman Islands. In a couple of weeks and for less than $40,000 (a fraction of the time and money

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needed to set up shop in the corporate friendly state of Delaware), they can set up a Cayman-based corporation or partnership, yet can operate from almost anywhere in the world where personal taxation is favourable. Even American owners, subject to taxation on a global basis, can benefit from incorporation elsewhere. Under technical rules of the dealer exception or where the corporation is not more than majority controlled by 10 per cent US shareholders, taxation can be delayed indefinitely until the earnings actually return to the US. If new legislation raises the regulatory tax of operating in the US, the scales tip toward more operations abroad. New York City suffers, others gain. Of course there are caveats. Other financial services firms could benefit from these proposals. Recently introduced exchange traded funds (ETFs) which track hedge fund performance offer another avenue to circumvent at least some of the new restrictions. Charging a fraction of the hedge fund fees, the promoters 38

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of these new vehicles promise returns roughly equal to that of the average hedge fund. The difference is that after-tax returns would be larger and, regardless of Congressional changes, will continue to be taxed as capital gains as long as the one-year holding period is met. Shifting to non-US markets could just mean increased issuance of these ETFs by financial institutions in London or elsewhere. All this indicates that alternative investment management will be looking further and further from the traditional locations for its managers and corporate legal location. The Cayman Islands already have 75 per cent of the world's offshore corporate hedge funds and is competing against Isle of Man, Guernsey, the British Virgin Islands and Bermuda for the remainder. While incorporated offshore, managers for these funds have remained along the gold coast of Connecticut, New York, Chicago, Belgravia and Mayfair. But the threatened tax increases

to those simply managing in these locations are provoking questions about whether to relocate physically to a more favourable tax and regulatory environment, where US citizens or green-card holder managers can get tax deferral and non-US managers can get low or no taxation. Part of the decision of where to locate is whether there is also a substantial local market of funds available for investment to compliment their already global market of clients. As long as one is moving, why not go to where you have a good chance of picking up more clients and assets locally as well as long distance through modern communications. Global mobility and alternatives such as Switzerland, the GCC and other new global locations are not for everyone. But with tax rate hikes threatened in the US and UK, those who thought they would retire at the age of 40 to enjoy their wealth or to fund their charitable foundation may now be forced to defer to age 50 or even 65 in order to reach their financial goals. Q

Harry Alverson

Private equity is the growth business market in the 21st century. David Smith analyses the strengths and weaknesses of this phenomenon and talks to Harry Alverson, a managing director of the Carlyle Group, one of the most successful companies in this sector.

Advocating Private Equity

Above: Harry Alverson

z Private equity, dubbed the `face billion of private equity invested since

of capitalism in the 21st century', is a phenomenon. It has swept America, Europe and Asia ­ and now the Middle East and North Africa (MENA) is set to be its fourth global conquest. Last year more than 1,000 quoted US companies were taken private ­ in deals worth more than $400 billion ­ compared with just over 300 five years ago. European private equity deals also boomed, totalling $231 billion in 2006, a 41 per cent increase on 2005. Now global private equity firms have their eyes on the $1,000 billion of MENA oil wealth generated since 2002, and believe their expertise can play a vital role in driving the region's economic diversification. They also see an untapped market, with less than $4 2002. The MENA economy, with a combined weight that makes it a world leader and a population 40 per cent bigger than the United States, is ripe for private equity, experts believe. Rapid economic growth ­ the Economist Intelligence Unit predicts that MENA expansion will outstrip that of the global economy through to 2010 ­ maturing capital markets, and, in particular, liberalisation and privatisation offer huge opportunities. Prominent privatisations in Qatar include a range of projects in healthcare, education and tourism. In Bahrain (Bahrain Financial Harbour and Bahrain Telecommunications), Kuwait (Kuwait Airways, Boubyan Islamic Bank, Al Jazeera Airways), Oman, the

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Harry Alverson

"In respect of Qatar, particularly, I would say you have a place that is the wealthiest country in the world in terms of GDP per capita; a very wealthy place. There the need is more for expertise than capital. To the extent that groups like ourselves can come in and assist in downstream petrochemical projects... and specialised logistics and shipping, there will be opportunities in a place like Qatar."

UAE, and Saudi Arabia the expansion is similarly notable. Nobody is better placed to offer an insight into the potential for private equity in the Middle East than Harry Alverson, one of the Carlyle Group's managing directors. Carlyle, one of the biggest and most successful private equity firms, has more than $75.6 billion under management in 55 funds under four investment disciplines ­ buyouts, venture & growth capital, real estate and leveraged finance ­ and retains more than 900 investment professionals operating out of offices in 21 countries. From his Washington office, Alverson is responsible for Carlyle's investor relations and fund-raising. But he also has strong ties and 40

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long experience in the region. Before joining Carlyle, he was responsible as a vice-president in the Global Asset Management Group of Chase Manhattan Bank based in New York for Chase's European and Middle East institutional and private corporate investment clients. Before that Alverson was responsible for the Middle East Corporate Finance Group of Bankers Trust Company based in London, concentrating on acquisition financing and cross-border advisory work. He also started Bankers Trust's Energy Merchant Bank, with responsibility for Central Europe and the Middle East. Alverson serves on the board of directors of the Arab Bankers Association of North America and is a founding member of the US

Qatar Business Council. In a rare interview, Alverson provides some key insights into the benefits private equity is set to bring to the Middle East. "The main benefits are to make companies more efficient, improving their competitiveness and of course providing liquidity," he says. "This is because increasingly, firms that are seeking to sell a division or subsidiary, or firms that are for sale, are turning to private equity as a source for liquefying their company, in addition to other options such as going public or strategic sales." Private equity is a spur to efficiency, he says, forcing companies to focus on what it is that drives the business. "Private equity tends to force companies to focus on their core competences and

Harry Alverson


Private equity is eyeing up investment opportunities in the Middle East at a time when it has come up against criticism, not just on its home patch in the United States but also in Europe. The returns that Harry Alverson, a managing director of the Carlyle Group, regards as the norm have been attacked as excessive, and private equity partners have been criticised for not paying their fair share of tax. How does he respond to such criticisms? Quite robustly, it turns out. "Private equity is a type of investment that most closely aligns the interests of the management of the investment and the limited partners ­ the investors," he says. "To the extent that private equity firms are making a lot of money at this time, it only means the investors are making a multiple of that. "If the investors don't make money, the private equity firms and the owners of the private equity firms don't make money. It's hard for me to fathom why people criticise what people like Steve Schwarzman [chairman, CEO and co-founder of The Blackstone Group] are making because, although he's a tremendously well-paid individual, he has made an awful lot of money for his investors. "Most of the money that goes into private equity comes from pension funds, investment authorities such as the QIA (Qatar Investment Authority), university endowments and so forth. Thus, the substantial returns that are being made are benefiting state employees, universities, funds for future generations and so on. The benefits spread much beyond a small group of large investors. The large investors are investing on behalf of a much broader swathe of the population than I think many people tend to focus on."

principal activities. That all helps make them more efficient and typically more profitable, and often results in growing these companies more rapidly than would otherwise be the case. This is true, even if private equity will, once it acquires a company, spin off or sell off these non-core activities. Those non-core activities can then end up with someone who can grow those businesses more rapidly." Trade unions in some countries have criticised private equity for its effect on jobs, the charge being that workers suffer when efficiency gains are pushed through. Alverson does not pretend that the employment impact of private equity deals is always benign. But he maintains that the picture is more varied than the critics suggest.

Left: Steve Schwarzman (chairman, CEO and cofounder of The Blackstone Group)

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Harry Alverson


Deutsche Telekom and Blackstone

One of the great challenges for the German economy has been how to achieve flexibility and improve corporate efficiency without provoking a political backlash against "Anglo-Saxon" style economic reforms. The case of Deutsche Telekom and Blackstone, the US hedge fund group, provides an insight into the way this was achieved. During 2005 Stephen Schwarzman, Blackstone's chairman and chief executive, heard that the German government was considering selling part of its stake in Deutsche Telekom, owner of the mobile phone operator T-Mobile and a market darling at the height of the technology boom in 2000. Schwarzman went straight to the top, arranging a meeting with Angela Merkel, the German chancellor. It could have been a difficult meeting ­ the Social Democrats, Merkel's coalition partners, had criticised hedge funds as "locusts" ­ and many people in Germany saw little distinction between hedge funds and private equity. Schwarzman pointed out that there was a significant difference and, to his surprise, found himself pushing at an open door. The German government would not stand in the way of changes at Deutsche Telekom, even if they resulted in job losses. A few months later Blackstone acquired a 4.5 per cent stake in the German telecoms giant, paying $3.5 billion. It followed a typical private equity pattern. The shares had fallen to a seventh of their 2000 peak and this offered value in Blackstone's view. Blackstone's influence, some would say, can already be seen. Deutsche Telekom is engaged in a process of cutting 32,000 jobs and focusing on core activities. Fat is being cut at a rapid rate. But the process is taking time. The underlying state of the business was, it seemed, worse than Blackstone had realised, with profit warnings and a loss of traditional fixedline customers following the acquisition of its stake. There have been departures at the top. The timetable for returning the company to profit has been extended to 2013 from 2009. Blackstone may have to stay for the long term.

Above: Deutsche Telekom Logo

"Some companies acquired by private equity firms grow very rapidly and increase employment, but that's not always the case," he agrees. Carlyle remains a leading player despite the recent rapid expansion of the private equity business. "We have the largest global network by far among private equity firms," says Alverson. "We are operating in every major region. With that comes an ability to identify add-on acquisitions for portfolio companies that we control. It gives us keener insight into the value of what we own, because we can compare valuations around the world in similar sectors. "We have a high degree of operational experience and strength since we tend to focus on investing


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Harry Alverson

the United States. The conditions for success in private equity differ from country to country, but there are certain fundamental requirements, says Alverson. "Clearly, well-developed capital markets and a well-developed regulatory framework for business are helpful. Private equity in its modern incarnation was essentially invented in the United States back in the 1970s. KKR [Kohlberg, Kravis, Roberts & Co, the firm founded in 1976 by Henry Kravis and George Roberts] is the only large, major player still extant from that era. "Private equity grew as an American business, and was exported relatively early on in the 1980s to Europe where, I think, the perception was that the regulations weren't as friendly. It was more fragmented in the sense that you didn't yet have the `United States of Europe' that is gradually coming together; you didn't have a common currency. The inefficiencies created by that fragmentation were thought at the time to create some interesting opportunities. "Notwithstanding the fact that there are some very large, indigenous European private equity shops such as CVC Partners, Doughty Hanson and so on, the business of global private equity has been dominated by the American firms. There is virtually no European firm that has a significant presence in the largest private equity market, the United States. US firms are very active in Europe, are the largest firms in Asia and are now branching into what some might call emerging markets, such as Latin America and the Middle East." So what does private equity have to offer to the Middle East, and why is the industry increasingly turning its attentions to the region? Alverson argues that a model that has worked around the world can bring the same general benefits to the Middle East. There are also, however, some specific benefits, as he explains. "The Middle East is not a uniform area. The opportunities are going to be different from region to region. We look at the Middle East as being composed as the GCC (Saudi Arabia, Qatar, the UAE, Kuwait, Oman, Qatar); Egypt and North Africa; and Turkey and the Levant. Jordan, the Lebanon and Syria really don't offer as many large opportunities. "The opportunity set in each of those three larger regions ­ Egypt and North Africa, Turkey and the GCC ­ is going to be different. In the GCC, what has happened over the years is that markets there are very fragmented because they've been highly protected. So you had businesses that started off in one sector, perhaps as a GM distributor, which would saturate that market, but be unable to take that business to another country and grow regionally. They'd add on other unrelated businesses, perhaps becoming an air-conditioning distributor, become the agent for Bechtel, for Halliburton and so on. "It's not clear that there were lots of benefits from this kind of conglomerisation. Some of these businesses have gone as far as they can, even in that kind of horizontal diversification, so in order for them to expand, they're going to have to move outside their country and perhaps even outside their region. This is where private equity generally can be helpful to them." But what needs to happen on the legislative and economic front in the Middle East to improve the environment for private equity? Alverson starts by saying that private equity firms will adapt to circumstances ­ "one operates

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in five or six industries and buy into those same industries over and over again. We have a very strong tradition in aerospace, defence, telecommunications, healthcare, certain types of transportation and industrial investments and, more recently, in consumer products and branded retailtype investments. "We have a strong cadre of people with key operational skills in these industries. We also have a large group of former CEOs and former directors of portfolio companies that we have owned or controlled who are prepared on relatively short notice to help us with acquisitions." When people look at the private equity scene, they notice that it developed first and most rapidly in


Harry Alverson

like aerospace, defence, telecommunications, healthcare, and certain types of transportation ­ those in which it has comparative advantage ­ the ones it will expect to specialise in when it comes to private equity in the Middle East? Alverson suggests, initially at least, firms will need to be adaptable. "I think in the Middle East one is going to have to be much more opportunistic. In things like telecommunications, yes, health, yes, transportation, perhaps, and we have a very large energy private equity operation which has been successful: that is exportable. But not everything is perfectly transferable to the MENA region. "We will have perhaps to be prepared to undertake greenfieldtype projects, where we are actually developing projects from the ground up rather than buying an existing firm and trying to improve it. We don't typically engage in greenfield projects outside the real-estate area in any other part of the world. One has to be a little bit more nimble, a little bit more flexible." With that proviso, how confident is he that private equity can succeed in the Middle East? The central question, in his view, is not whether private equity can work, but whether it can succeed on the kind of scale that has become the norm in other parts of the world. "I'm confident it can work," he insists. "The real question is whether you can generate the kind of returns in the region commensurate with the risks one is taking; returns that would justify the exercise. At the end of the day, if private equity is done intelligently ­ and I'm talking about private equity here as distinct from venture capital ­ it is frankly hard to lose money. "The level of risk I would see is that private equity firms are targeting

in the environment that is available". But, he adds, there are certain changes that could usefully take place. "The things that would make life a little easier for private equity ­ and indeed for all business development ­ are not necessarily things that would be easy to achieve," he says. "For example, I've long been a proponent of more liberalisation of ownership regulations. The ownership rules that currently apply are opaque. They are changing in a way that is untried for the most part but, by and large, they are still quite protective of local nationals within each country, much less other GCC nationals. So it may be difficult for other GCC nationals, say somebody from the Emirates or from Saudi, to buy a business in Qatar, even moreso a European or an American firm. "On the real-estate front things are liberalising a little more rapidly ­ but only really in little islands of development. There are certain developments 44

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in Dubai, for example, that permit foreign ownership. Sometimes they are long-term leaseholds, and sometimes freeholds are available. Similar things are being developed now in certain specific projects in Oman and Abu Dhabi. I understand the same thing is going to occur in Doha. If there was more liberalisation of ownership rules and a clearer regime of who could own what, that would be helpful." Just as Europe's adoption of the euro has stimulated private equity activity, so he believes that a common currency for the GCC would make a big difference. He notes: "You have six countries with small populations with the exception of Saudi Arabia. These are relatively small economies and yet everyone jealously holds on to their respective dinars, riyals and so forth. It would be helpful if the GCC would finally get its act together and have one common currency". Are Carlyle's strongest areas

Harry Alverson

25 per cent per annum rates of return in general. But what if you end up generating an 8 per cent, 9 per cent or 14 per cent per annum rate of return? That is the kind of risk parameter you are assuming. What remains to be seen is whether one can generate the kind of returns that one would want to see in undertaking private equity in the region; and, on top of that, what the risk perceptions and the rewards expectations are of both non-Middle East investors and Middle East investors in investing in the region." There is another difference he highlights with regard to the Middle East. It is not just a question of investments within the region but, increasingly, the outward-looking investment activities of Middle East investors. "In respect of Qatar, particularly, you have a place that is the wealthiest country in the world in terms of GDP per capita; a very wealthy place," he says. "There the need is more for expertise than capital. To the extent that groups like ourselves can come in and assist in downstream petrochemical projects ­ such as spin-offs from the gas-to-liquids projects and so forth ­ and specialised logistics and shipping, there will be opportunities in a place like Qatar. "But I would also say that the most important opportunities in a place like Qatar would be for firms like ours to partner with organisations or with the government itself in order to make strategic acquisitions outside the country. As you know, Qatar has been linked with EADS, Thames Water, Sainsbury and had real-estate projects and other overseas investments. Firms like ours, that have industry expertise in Europe or the US, may be of real value in working in partnership with Qatar to help buy into industries that are of strategic importance to the country." Q


Carlyle and Hertz

Hertz is perhaps the best known name in vehicle rental around the world. What is less well know is that until two years ago Hertz was a wholly-owned subsidiary of the Ford Motor Company, until it was acquired in a private equity deal led by Carlyle. Hertz consists of two divisions, Hertz Rent-A-Car, the largest global car rental brand, with 7,400 owned, licensed or franchised locations in 150 countries across the world, and Hertz Equipment Rental Corporation, which rents a range of industrial and construction equipment, including earth movers, aerial equipment, cranes, electrical equipment, pumps, trucks and other general use equipment from more than 340 branches in North America, France and Spain. In September 2005, an acquisition vehicle formed by Carlyle, Clayton Dubilier & Rice (CD&R) and Merrill Lynch Global Private Equity (MLGPE) entered into a purchase agreement to acquire 100% of the capital stock of Hertz from Ford. By the time the transaction was completed on December 21 2005, Hertz had a capital structure with $2.3 billion in equity contributed in approximately equal amounts by affiliates of CD&R, Carlyle and MLGPE. It also had $5.6 billion of corporate debt as well as $4.8 billion of US fleet debt, and $2.1 billion of international fleet debt. George W. Tamke, a CD&R Operating Partner and Chairman of the Hertz Board of Directors, said, "The capital structure that has been put in place for Hertz will provide significant flexibility for the company, and will allow the business to build on the very strong foundation that has been established". In November 2006, the new owners floated part of their holding of Hertz with an IPO on the New York Stock Exchange, raising $1.3 billion.

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Floor Wars

Floor Wars

Trading Places

Around the world, the number of "trading platforms" is mushrooming. Prabhu Guptara analyses the essential components of a trading platform, how they have evolved from stock exchanges, their impact on business and what the future holds for them.

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Floor Wars

z The confluence of globalisation, character and began to demutualise merged in 1998 with the Stockholm

economic prosperity and internet technology has sparked a revolution in the structure and ownership of trading platforms. It began with the creation of the first electronic platform, NASDAQ, in 1971, but it has accelerated in the last decade with a plethora of mergers and takeovers. NASDAQ, owned initially by a few individuals, was the first entity to take trading beyond stock exchange-type clubs and oligopolies to the general public. It set a trend soon followed by the major stock exchanges, as they started losing their club-like by offering their shares to the public. Control passed from the hands of the exchange's founders, who were also usually the biggest customers, to outside investors interested primarily not in running a club but in making a profit. As a consequence, these longestablished stock exchanges themselves have now started being bought and sold, even across national boundaries, in a way that would have been unimaginable only a few years ago. OMX became the world's first publicly-listed exchange in 1987, Stock Exchange, and in 2003 with the HEX Group ­ the Helsinki Exchange Group, which had acquired the Tallinn stock exchange in 2001 and then the Riga Stock Exchange, as well as the central securities depositories of both Estonia and Latvia. The ever-growing OMX continued to go further along its acquisitive way by taking over the Vilnius Stock Exchange in 2004, the Copenhagen Stock Exchange in 2005, and the Iceland Stock Exchange in 2006, only to be itself swallowed up in its turn by NASDAQ, for $3.7 billion in May this year. In other major cross-border developments over the last year or so, the LSE acquired the Borsa Italiana for 1.6 billion euros ($2.15 billion), and Deutsche Börse bought the US International Securities Exchange for $2.8 billion. In one of the most ground-breaking deals, NYSE recently acquired Euronext for $11 billion to create the world's first global stock market, making it possible to have continuous trading of stocks and derivatives over a 21-hour time span. With the merger, NYSE Euronext (as the combined exchange is called) brings together six cash equities exchanges in five countries and six derivatives exchanges, and is a world leader for listings, for the distribution of market data, and for trading in cash equities, equity and interest rate derivatives and bonds. It is worth noting that the NYSE is a relatively old-style exchange and that Euronext's attraction was not only that it is large and pan-European, but also that it brought with it advanced electronic trading ability. The route is now open for trading multiple asset classes across national borders and

Floor Wars

regulatory frameworks on a single global cash and derivatives trading platform. To achieve this grand objective, NYSE Euronext has committed itself to completing an unprecedented global integration project: six trading platforms will be reduced to two, 10 data centres to four and four networks to one. The complexity of linking multiple-trading venues subject to different trading rules, currencies and regulatory regimes will be vital experience for whenever NYSE Euronext is able to acquire a partner in the Far East, as it has signalled its intention to do. If and when that happens, 24-hour trading will become possible on NYSE Euronext. Companies founded as primarily electronic trading arms ­ such as OMX ­ have linked up with traditional stock exchanges, while such exchanges ­ such as NYSE ­ have also acquired electronic providers, or exchanges with well-integrated electronic providers. There are grounds for scepticism over how well traditional exchanges will integrate with primarily electronic entities, and I am rather more confident of the prospects for primarily electronic entities incorporating traditional exchanges ­ though history is not on my side on this point. If one looks to telecoms, for example, it is clear that few of the new challengers have matched the established utilities. It remains to be seen if history is a reliable guide for the new world of trading platforms. While globalised business does need global exchanges, and transnational consolidation has been creating such giants, the danger of the establishment of a global monopoly has been a concern. European and US authorities have tried to address this, the USA with a regulation


By the 1970s, stock exchanges were comfortable monopolies or oligopolies. But just when the situation looked stable, this structure was threatened by globalisation and most particularly by the rise of information technology. IT lowered the operating costs of the back office of individual stock exchanges but, as the initial development costs of any IT system are substantial, it led to these exchanges (or the developers of the IT solutions) seeking to recoup some of the development costs, or adding to their profits, by selling to other exchanges. Moreover, once IT "platforms" were developed for electronic trading of financial services, it rapidly became obvious to everyone that the size of the deal was in principle irrelevant to the capacity to execute it. In other words, from the perspective of the back office, it would cost as little to transact a deal worth one dollar as it would to transact a deal worth billions. So it no longer made sense, as had been the case until then, to set a respectably hefty minimum value for transactions. And it now became possible to develop technological solutions to the challenge of establishing the creditworthiness of organisations and individuals. Without the need for individually establishing the creditworthiness of potential trading partners, and without the need for massive amounts of money before you can deal, the essential logic for stock exchanges disappeared. There are, though, certain advantages that traditional "on the `phone" or "online stock exchange-style dealing" still offer ­ which is of course the reason (apart from market inertia) why stock exchanges still exist.

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Floor Wars

on equity securities (Reg NMS), and the European Union with the Markets in Financial Instruments Directive (MiFiD), due to be fully implemented by November 2007. The latter dispenses with the idea that share trading must be carried out only through exchanges. Although not all EU states have accepted this step forward, the laggards may find themselves left on the European and global sidelines. MiFiD's "non-concentration" rule is intended to open national stock exchange monopolies to competition, for example by the establishment of Multilateral Trading Facilities (MTF): systems which bring together operators who buy and sell financial interests, so that groups of companies can trade with each other as if they are exchanges. The resulting contraction of business will mean that smaller European exchanges will be swallowed up more quickly than would otherwise have been the case, though this trend was in any case inevitable. Several initiatives to create alternative trading and market data platforms have already been announced which, should they see the light of day, will challenge all established exchanges. Such initiatives include: Turquoise, a pan-European alternative trading system; Instinet-ChiX, an equities MTF; Project Boat, a market data provider; and Equiduct, a panEuropean retail trading platform registered as a "regulated market" under MiFID, and thus governed by slightly different standards from an MTF, but with the same de-monopolising effect on the marketplace. Stock exchanges are being disintermediated by trading platforms, including those run by banks, which are themselves being 50

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disintermediated by trading platforms built by hedge funds. All these are being disintermediated by attempts to allow what is called Direct Market Access (DMA) ­ making it possible, for example, for asset managers, hedge funds and proprietary traders to access money without having to go through a brokerage firm's execution desk. The most extreme form of DMA allow companies and institutions to sell directly to the public without any intermediating institutions at all. As companies have begun to issue shares directly to the public via the Internet, this form of DMA is clearly already in being. The way is now open for more companies to run markets in their own shares, and for individuals to create their own financial strategies and invest in companies without going through brokers, stock exchanges, hedge funds and the rest. So far as financial intermediaries are concerned, however, the rise of IT has resulted in the creation of many platforms devoted to niche and even sub-niche financial markets, and there are now trading platforms for buying or selling almost every kind of financial entity: shares, bonds, commodities, futures, alternative investments, foreign exchange, interest rates, derivatives, index arbitrage, carbon trading, photovoltaics. There is even a trading platform for minutes on VoIP (voice conversations on the Internet). These kinds of initiatives are affecting not only Europe and the USA, traditionally the leaders in financial innovation, but also the Middle East, Asia and the Far East, Latin America, and even Africa. Japan pioneered the equities trading platform Chi-X; the People's Bank of China threatens to develop a genuine trading platform for the yuan; and the Korea Exchange

(KRX) has not only developed its own electronic bond trading system but has also won a deal to supply and implement it for Bursa Malaysia Berhad (Bursa Malaysia). Customised for the Malaysian bond market, it will include order-matching, trade negotiation, trade reporting, surveillance and price dissemination functions aimed at improving the liquidity of the secondary bond market. Meanwhile, Bursa Malaysia had launched its own new derivatives trading engine, Bursa Trade; and KRX and Bursa Malaysia have now announced that they intend to collaborate on developing the bond market in the whole of the APAC region, in addition to working together on financial derivatives products. Following completion of the Malaysian project ­ expected by the end of 2007 ­ KRX says that it, along with its IT subsidiary Koscom, will target firms in Central Asia, the Middle East and South America. Consider, too, Kenya's premier trading platform, Bonanza, which is a retail trading system that uses mobile phones to transfer money from retail goods buyers to sellers. Or think of BusyLab, a software research and development business based in Ghana, which has developed a suite of tools that will target the agriculture sector across Africa with TradeNet, allowing users to sign-up for SMS alerts for whatever commodities they are interested in. Users can request prices, which are provided in real time on the network, from enumerators active throughout 380 markets spread across the African continent. Users can also indicate their particular geographical areas of business and receive instant SMS alerts for offers to buy or sell as soon as anyone else on the network

Floor Wars

submits an offer ­ via their mobile of course. Thus another result of the rise of IT has been the emergence of competition, not only from established and developed markets, but from a range of unlikely sources and through the latest manifestation of IT's convergence with telecoms and media. So what has been the impact of such developments on industry? Whether it be globalising and merging stock exchanges, or niche operators in unexpected locations, the overall result has been positive from the perspective of the customer. Financial services are becoming commoditised, transaction costs and sizes are lower, settlement of deals has become faster and more efficient, the market has greater transparency, more ordinary people can participate in the market, more money has become available for investment, and (at least in the commoditised sector) there is lower risk. The emergence of electronic trading has not only shaken up the national monopolies and ways of doing business, but also created new possibilities. One such is commoditised cross-asset class trading (dealing not just in one asset class at a time but in multiple-asset classes). Another is algorithmic trading, also known as automated trading, black box trading, or "robo-trading". This was defined by Harrell Smith of Celent in his company's May 2005 Report as "any quantitative model that automatically executes a specific order according to the parameters of the given algorithm, as well as any user-defined constraints that can be imposed at the time of execution". Specifically, algorithms analyse an order and determine the timing, size and destination of

Floor Wars

Dealing in multiple currencies imposes unnecessary exchange costs ­ a burden which led to the rise of the Euro and has incentivised the rulers of other regions (such as the Asia Pacific) to pursue their own single currency. Moreover, the major currencies (the dollar, euro and yen) have been converging in value anyway, and minor currencies (e.g. the Indian rupee), have been appreciating ­ to the extent that at least one player has recently asked for a long-term contract to be signed in Indian rupees rather than in dollars! By contrast, the Chinese government insists on keeping the value of its currency as low as possible for as long as possible, for the simple reason that a cheap yuan is the key to continuing expansion of Chinese exports. However, while currencies ­ with the exception of the yuan ­ are converging globally at one level, a host of niche currencies has emerged, from Travel Miles to Luncheon Vouchers. More seriously, Professor Margit Kennedy, a leading consultant, has been arguing the case for complementary currencies, sectoral currencies and regional currencies, such as the saber in Brazil and the chiemgauer in southern Germany. My own view is that a global currency would entail factoring in all the risks associated with that currency, and that the world is much safer if there are several currencies, including such complementary, sectoral and regional examples. Similarly, in the world of stock exchanges and trading platforms, a global monopoly would be the key danger. Guarding against this is, however, made easier by the rise of the Internet and its convergence with telecoms and the media, and the resulting plethora of newer and newer trading platforms. Q

its constituent trades. With speed and accuracy ever more essential components of any trading strategy, algorithmic trading offers significant advantages. So what are we to make of the future of the chaotic world created

disintermediating and transparencycreating tendency of technology on one hand, and traditional stock exchanges and other intermediary institutions on the other. These institutions still have credibility because they offer expertise not possessed by every investor, as

"My own view is that a global currency would entail factoring in all the risks associated with that currency, and that the world is much safer if there are several currencies, including such complementary, sectoral and regional examples."

by the new electronic platforms? As technology marches on, ever more sophisticated trading platforms will be created. Legislation and regulation will struggle to keep pace. However, it is clear that the world is locked in a struggle between the democratising, 52

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well as relative safety, trustworthiness and reliability. Will stock exchanges win out over the Internet, or vice versa? I see a parallel with the future of currencies. In theory, a genuinely globalised economy needs only one currency.

Black Swan

Paint it Black

David Smith talks to Nassim Nicholas Taleb whose book Black Swan is one of the surprise publishing hits of 2007, reaching beyond a business audience to the upper echelons of the New York Times bestseller list and its equivalents in other countries. Like his earlier book, Fooled by Randomness, it deals with the impact of the improbable.

z "It's a Black Swan event" has

become one of the corporate phrases of the year, its impact reflected by the fact that it is not only familiar to the business community but has entered common parlance. A Black Swan event is, according to the concept's creator Nassim Nicholas Taleb, "a highly improbable event with three principal characteristics: its unpredictability; its massive impact; and, after it has happened, our desire to make it appear less random and more predictable. The astonishing success of Google was a Black Swan; so was 9/11."

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Black Swan

"On the positive side, the biggest Black Swan is the rise of the internet over the past 20 years. Negative Black Swans happen faster; the positive ones tend to creep up on you. My house in Lebanon was blown up in a couple of minutes but it took three years to rebuild. Crashes in markets happen quickly; rises happen more slowly."

Taleb, born in 1960 in the Lebanon, made his reputation as a top trader on Wall Street before realising that some of the lessons he was learning in the financial markets had far wider implications. He is now Dean's Professor in the Sciences of Uncertainty at the University of Massachusetts. "The Black Swan is an illustration of exception, an image," he says. "We thought that all swans were white because nobody had ever seen a black one [until black swans were discovered by colonisers in Australia]. However, my Black Swan is not a bird, it is an event and has one additional attribute: it is of high consequence." So 9/11 was a Black Swan event, though many have tried to claim 54

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subsequently that it was entirely predictable. Was it the biggest such event? He insists not. "Of course I don't want to play down the deaths of so many people, but it certainly was not the biggest Swan," he says. "That was the First World War. It was highly unpredictable: people thought the world had become very civilised after a century of peace, and it wasn't in the data. It is only now that people claim it was to be expected; that's what I call the retrospective distortion. "When the war started, it lasted longer than anybody predicted, and then we had another one. That's the big Black Swan for me on the negative side. One that did not happen, but which would have dwarfed September 11, was Cuba and the Bay of Pigs."

It is easy to think of Black Swans as being what economists would call negative shocks; events that are essentially harmful in their impact, the more so because nobody was prepared for them. For Taleb, however, that would be to miss out half the picture. There are both negative and positive Black Swans. "On the positive side, the biggest Black Swan is the rise of the internet over the past 20 years," he says. "Negative Black Swans happen faster; the positive ones tend to creep up on you. My house in Lebanon was blown up in a couple of minutes, but it took three years to rebuild. Crashes in markets happen quickly; rises happen more slowly." Historians are subject to the

Black Swan

"retrospective distortion" he talks about. In some senses their role is to devise logical explanations for what may, in fact, be random events. But nobody likes to be caught out. Economists and market pundits rarely admit to being taken entirely by surprise, and neither do businesses. "Business provides us with a beautiful laboratory to see how fooled people can be, how much they can fool themselves," says Taleb. "People convince themselves they have illusory skills all the time, and reap the rewards. You only see the winners, you don't see the losers, and the winners have this high testosterone, high drive, which convinces them it is the cause of their success. Skills and hard work are necessary but not sufficient."

That is a fair criticism ­ but what determines whether businesses, when faced with uncertainty and random events, can make the best of it? "It is random whether you get a winning lottery ticket; it isn't random how you exploit it,"Taleb says. "The people who do very well are those who multiply their exposure to serendipidity, to positive Black Swan events. Once you identify how random the world can be, you can go about making it less random. The most successful people I speak to are those who are aware that it is all random out there. "Successful people don't stick to a regular schedule. If something comes in they go for it; they cancel their lunch appointments. They understand that opportunity doesn't grow on trees.

They also minimise their exposure to negative Black Swans. Most people are going to be suckers sometime; a lot of people are sceptical about small things but not the big things. Successful people are very sceptical in the large; they don't waste that scepticism on the small." Multi-millionaires demonstrate successful exploitation of Black Swan events more exactly than billionaires, he suggests. For every billionaire who has made it to the top by aggressive, risky behaviour, there are hundreds of others who have crashed and burned. Multi-millionaires are much more likely to have followed a path of minimising randomness in their lives. There's a lesson there, perhaps, for all of us. Q

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New Order

Aaron Brown examines the way a reassessment of the concept of capital is driving change in the financial sector and concludes that rational calculations of risk and capital are important steps to making things work better: not only are they likely to be more accurate than traditional rules, but the rationality includes the ability to learn.

Capital Values

z Everyone agrees that financial asset. A pen I use at work to write are a million bushels of corn available

markets are changing rapidly, and that those changes are driving further changes in business, trade and society at large. But that is where the consensus ends. Some fear the new order, some welcome it. Some point to derivatives as the cause, or hedge funds, or new international regulations like Basel II, or the breakdown of traditional regulations due to globalisation of capital markets. But the fundamental agent of change is nothing less than a reassessment of the concept of capital. "Capital" is money or other assets that are used to make money. If I own a car to drive around, it is an asset, but not a capital asset. If I use it to go into the taxi business, it becomes a capital 56

Quantum - Finance In Perspective - Issue 1

down a telephone number is a capital asset, but an identical pen I use in my house to write a grocery list is not. A key parameter in any economy is the proportion of assets that are capital assets; that is, the proportion of valuable things used in further production versus the proportion set aside for consumption or left unused. We know that devoting more resources to production means that the economy grows faster, but that devoting more to consumption means people live better today. Presented that way, as it is in many introductory economics texts, it sounds like a pure trade-off. Finance offers a way to eat our cake and have it too ­ we can use the same assets at the same time for consumption and production. Suppose, for example, that there

in the spring, and these are enough to feed everyone for one year. Individuals might be unwilling to sell corn to be used as seed because, if the price of corn goes up, they will not be able to use their money to buy enough corn to survive the next winter. If there is a forward exchange market, it is a different story. Individuals can sell half their corn stocks at the spot price, and use part of the money they receive to buy the same amount of corn back for forward delivery in the fall. Since the forward price is less than the spot price (corn is cheaper at harvest time), individuals make a profit doing this. Half the economy's corn is freed up from consumption to be used for production. Assets held by individuals for consumption are not reduced,


New Order

however, they are just changed in form from physical assets (corn) to financial assets (money and forward contracts). Banks do something similar. One person deposits one piece of gold in a bank. The bank lends out the gold to someone to use in a business. The borrower uses it to buy something; the seller deposits the gold back in the bank. The bank lends it out again, and the cycle continues. Physical assets formerly held for consumption are now dedicated to production, but the sellers do not feel less wealthy, they now have bank deposits instead of physical assets. Even rudimentary markets are more complicated than this, but it is the simple idea that is important. Consumers do not need to hoard assets. Physical assets not immediately needed for consumption can be exchanged

for financial assets, those financial assets can be used to repurchase physical assets when needed. The consumer avoids the storage costs and depreciation of physical assets, and earns a return on the financial assets. However, the consumer must accept the risk than the financial claims will not be honoured. The economy as a whole faces the same trade-off. Lots of financial assets mean consumers feel rich and spend a lot, which frees up a lot of assets for production. High consumer spending and easy credit helps business produce the economic growth to validate the subjective wealth of consumers. Unfortunately, even a small disruption in the production process can cause a crash in the financial assets, causing both shortages of physical assets needed for consumption and a

collapse of business activity. For most of human history, the practice of finance has been treated with suspicion. It seems fraudulent to use the same asset many times, and to create paper assets that might not be honoured in the future. But societies that embraced these mysteries saw their economies grow rapidly.Their people became rich, their merchants became powerful. However successful they were, though they seemed to be subject to periodic pain: panics, recessions, depressions, bank runs, mass defaults, liquidity crises, bubbles and crashes. Slowly, mainly by trial and error, societies discovered ways to combine acceptable levels of prosperity with tolerable amounts of disaster. The key seemed to be to make sure there was enough capital of the right kind, distributed in the right places, to keep the system stable and flexible. The knowledge acquired over the years opened up the possibility that the economy could be regulated rationally, rather than by trial and error leading to boom and bust (what engineers call "bang-bang" controls). It is fair to say that today ­ for the first time in history ­ the amount of capital in the financial system is close to being determined rationally. This does not mean there will be no more disasters. Rational does not mean perfect, or even wise. It means that smart people weighed the risk of disaster against the cost of prudence and made a conscious decision about the correct trade-off. These people had the data and tools to do it, and political appointees, academics and practising bankers all had a voice in the process. Their decisions may be wrong, even foolish, but they will no longer be wild guesses. Well, not quite. One of the byQuantum - Finance In Perspective - Issue 1


New Order

products of all the regulation was to increase the attractiveness of avoiding rules. A lot of financial activity moved to offshore locations, or organised itself to escape the rules (primarily by avoiding any dealings with the public). Hedge funds have been around for 60 years, but they have only become a major force in the market in the last 20 years, and they only became a significant fraction of risk capital in the last decade. I am using a very broad definition of "hedge funds" here, including things like private equity partnerships and commodity trading advisors. The key is, these are financial intermediaries whose capital levels are limited by their investors and trading partners, not by regulators. Before continuing to discuss the differences between hedge funds and more regulated financial intermediaries, I want to make an important point. Both hedge funds and regulated banks have a capital requirement set by risk management principles. Hedge funds may not invest using Value-atRisk, but the people who lend them money (their "prime brokers") and their trading counterparties require Value-at-Risk based margining, or other systems based on the volatility of the fund's assets. Hedge-fund investors demand to see Value-at-Risk reports. So we still have rational determination of capital levels, it is just that hedge-fund levels are determined in private by interested parties, while regulatory standards are determined in public with broader participation. When capital levels are set by tradition rather than science, they might be too low or too high. If they are too low, disaster will wipe away the entity. Therefore, the traditional survivors, 58

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Hedge-fund investors demand to see Value-at-Risk reports. So we still have rational determination of capital levels, it is just that hedge-fund levels are determined in private by interested parties, while regulatory standards are determined in public with broader participation.

on average, will have too much capital (but what is true of the average may not be true of an individual entity). Therefore the first effect of risk management, on average, is to reduce the amount of capital needed, which means more real business activity can take place with the same amount of capital assets. That, in turn, raises the profit from shifting assets from consumption to production (from an individual's standpoint, from holding more financial and fewer physical assets). It puts a premium on legal and other institutions defining and administering property rights (which sometimes, unfortunately, results in property rights being taken from the inattentive or helpless and given to the clever and powerful). Now the distinction between

regulated entities and hedge funds becomes important. Regulators do not seem inclined to reduce the average capital levels for financial companies. So regulated entities will reallocate capital to its most profitable uses under the new, risk-based calculations. Since they cannot shed capital, they will instead expand operations that have low risk under modern, scientific (but possibly flawed) calculations, at the expense of operations that were traditionally favoured. Among other changes, I expect less interest in lending to governments and big companies, and more interest in global diversification. Hedge-funds are not required to maintain capital levels, so can be expected to hedge-fund leverage increase. Their cost of capital is higher than regulated financial entities ­ which have explicit and implicit

New Order

government guarantees and access to cheap public capital. So they do best in strategies that regulation discourages, such as holding illiquid assets and high-frequency trading. Ironically, one of the most attractive businesses for regulated financial institutions under the new framework is lending to hedge funds. When you put it altogether, it makes sense. Hedge-funds are playing at the edges of the financial markets with assets that are newly placed into production, or in some cases, newly defined; and also with innovative strategies that exploit existing capital assets in new ways. As the funds gain experience with the asset classes and strategies, they can lever up their bets to increase profit.This brings regulated financial entities into the game, first as lenders then, as they

learn the business, as direct participants. Eventually the asset class or strategy can be incorporated into low-cost index products available to everyone. I am a big believer in low-cost index products, but it takes financial engineering to transform raw physical assets and ideas into securities suitable for indexing. Hedge-funds are like the simple life-forms that grow back first in a new ecosystem created by, say, an earthquake, fire or volcano. They change the environment to make it suitable for more complex organisms, and the process continues until the area is integrated into the global environment. Rational capital rules allow each kind of entity to flourish where it can do good, and gracefully yield to successor entities when the time is right.

People are not as smart as nature, so don't expect this to work perfectly. But rational calculations of risk and capital are important steps to make things work better. Not only are rational amounts of capital likely to be more accurate than traditional rules, rationality includes the ability to learn. If you have a traditional rule it either works, in which case you keep it, or it doesn't, in which case you're stuck. Since there's nothing to compare it to, it's not even clear when it's working and when it's not. A rational rule can be adjusted, in fact, must be adjusted continuously. It's a new financial world out there, and it will cause a lot of changes. For good or ill, the genie is out of the bottle. We should be careful what we wish for, because we will probably get it. Q

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Fuelling The Boom

forecast that a "monsoon" of Middle East petrochemical exports would flood Europe. The then ICI chairman and president of the European federation of chemical producers reflected the trepidation then felt by producers in North America and Japan. He was right ­ but at least 25 years premature. Despite the enormous development within the region in the last couple of decades ­ spearheaded by Saudi Arabia's petrochemical sector ­ the GCC nations and Iran are only now poised to exploit their intrinsic competitive advantages. What is happening now is a historic shift of the world's petrochemical industry's centre of gravity from the West to the East. In particular, the Middle East is becoming the focal point of petrochemicals production growth. will see its output of petrochemical building-block ethylene surpass European capacity levels during 2009 and North American levels by 2012. Petrochemicals emerged as the lead sector in Middle Eastern project finance during 2006, worth US$14.5 billion, up $10 billion from 2005 levels, according to Project Finance International (PFI). Total activity last year rose to $33.4 billion from 2005's $31.6 billion. PFI's latest interim figures for 2007 indicate that the region's project finance market is still booming. The power sector is currently topping the league table at a mid-year level of $9.3 billion, followed by petrochemicals at $3.3 billion. Overall volumes have slipped from 2006's interim $25.7 billion to $15.8 billion ­ primarily reflecting a tail-off in petrochemicals

By Hilfra Tandy

The Middle East is spearheading a huge expansion in production of petrochemical products and project financing which will result in a historic shift in the industry world-wide.

z In 1985 Sir John Harvey-Jones Announced projects in the region activity,

caused by escalating contractor costs which are forcing delays as producers and their sponsors review procurement strategies. Aside from what is likely to be a temporary slowdown in petrochemicals activity, growth in the regions' project finance market has been extraordinary. In 2003 volume was a whisker under $8 billion ­ then a record in itself ­ and in 2004 more than doubled to $18.5 billion. Overall, 2007 volumes could stay in the $30 billion range, with sizeable petrochemical and refinery projects in the offing along with independent water and power projects. The magnet of high energy prices has motivated lenders, and 2005 marked the point at which Western bank liquidity became a force in the Middle East. Trend-setting deals are being negotiated in the petrochemicals 61

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sector. The $760 million Qatofin and $1.48 billion Q-Chem 11 project financings closed simultaneously on November 16 2005. Those were landmark deals insofar as they marked the first time that two distinct project financings ­ sharing common infrastructure ­ simultaneously sourced funds from the bank market. Qatar Petroleum (QP), shareholder in both projects, was a pivotal coordinating focus. Earlier this year Euromoney Magazine's 2006 Middle East Petrochemicals "deal of the year" title was awarded to Sabic's Yanbu National Petrochemical Company (Yansab). Its chairman, and Sabic chief financial officer, Mutlaq AlMorished acknowledged that the SR13.125 billion (US$3.5 billion) project financing "stood out for a number of reasons" as a "greenfield" development. Yansab is the first Saudi Arabian company to have successfully closed an initial public offering at the inception stage. The Yansab IPO was also awarded "IPO of the Year" by the Banker's Magazine. The Yansab deal includes the largest-ever Islamic finance tranche of SR3.176 billion ($847 million) in any multi-sourced project financing globally. Sabic and ABN Amro, the sole financial advisor and underwriter, achieved a level of Islamic participation significantly higher than for any previous project financing in Saudi Arabia. During 2006 Sabic raised $11bn via IPO, bank debt, Eurobond and Sukuk. Al-Morished, speaking at last December's Gulf Petrochemicals and Chemicals Association (GPCA) conference, noted that there has never been a default on a petrochemical project in the GCC. In his presentation he observed that banks view the 62

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GCC with a high "comfort level". The region's trump card is its access to the world's keenest-priced natural gas. This was the overriding attraction to the Western oil and chemical majors and a Japanese consortium that became joint venture partners in Saudi Arabia in the late 1970s/early 1980s ­ natural gas is available in Saudi Arabia and North Africa at $0.75 per million Btus (mBtus). The contemporary increase in energy and raw material price levels, particularly in the USA, has further enhanced the region's attraction to petrochemical majors in the West and Japan. "Dow spends $12 billion a year in energy costs in the US. If we moved our US plants to Germany, we would spend $7 billion a year. If we moved them all to the Middle East, we would pay $1.5 billion a year," says Andrew Liveris, Dow Chemical's chief executive. The role of national governments has become pivotal. BASF board member Dr John Feldmann, responsible for plastics, oil and gas, reviewing the company's plastics strategy this year, noted that "85 per cent of all oil assets are state-owned ­ 40 years ago it was 15 per cent". BASF,

the world's largest chemical company, is pursuing an alternative strategy to those majors planning to remain dominant forces in the commodity petrochemical business, focussing on higher-margin specialised plastics and polymers. The Middle East can also tap into relatively competitive labour resources. As a recent McKinsey report noted: "The GCC states have the advantage of cheap labour, largely from India, Pakistan and the Philippines. Although employment costs will rise as Gulf governments reform the labour market to create higher-paying jobs for their own citizens, this development will do little to erode the cost advantages based primarily on the price of energy." It is important to put development to date into a wider context. In 2006 the chemical industry in Africa and the Middle East accounted for just $110 billion of the $2.85 trillion ($2,847 billion) generated by the global chemical industry, including pharmaceuticals and its exports trailed those of its major competitors. The Middle East is though poised to become the epicentre of the global petrochemicals industry. Saudi Arabia is consolidating its position as the


Price $ billion


Africa and the Middle East China The United States Western Europe

Source: American Chemistry Council

31 33.4 135 733


region's premier producer. It now accounts for 80 per cent of the GCC's petrochemicals capacity ­ investing more than $25bn in the next five years. Overall, $40bn will pour into the GCC's petrochemical sector by 2010. Given China's unprecedented industrialisation, and linked voracious appetite for petrochemicals, the primary target of Middle East petrochemical derivative exports is the Middle Kingdom. However, China is expanding its own petrochemical capacity. Four major complexes are scheduled to be built between now and 2010, adding almost 5mt of ethylene capacity. So, echoing 1985, respected sector analysts are wary. For example Pat Rooney, managing director of Chemical Market Associates Inc. Middle East, estimates that the step-change in Middle East exports from 2009 will "eliminate 15 per cent of the currently available Asian market" for Asian, North American and European petrochemical exporters. Rooney forecasts a 13m tonnes global surplus of ethylene by 2011 ­ equivalent to 10 per cent of annual consumption. This spells bad news for the old triad. For operators in the Middle East profits will be, Rooney says, "well above re-investment levels". Mark Gambrell, executive vicepresident of Dow Chemical, has a clear view of how the market will develop. "Today the `global assembly line' is this: Middle East oil and petrochemicals, on to China converters, processors and OEMs and on to end-use markets in North America and Europe,' he says. `But as we say in the US, why not cut out the middle-man? Why not shorten the global assembly line, to make the end-use products here in the Middle East, and ship directly to consumer markets?" Q

Middle East Investment

In Saudi Arabia alone, the current tranche of investment will enhance the role of the private sector, and by 2010 it will be operating an estimated 15-20 per cent of the country's petrochemical plants. In June 2006 King Abdullah opened the first phase of the 1,950 hectare, SR2.54 billion Jubail-11 project, which is expected to attract investment projects worth SR220 billion ($59 billion) and provide a framework for the industrialisation of the city for the next 25 to 30 years. Qatar, which shares the world's largest non-associated gas field and has proven reserves estimated at more than 900 trillion cubic feet, has nudged Indonesia off the top slot to become the world's premier LNG supplier. Qatar was the first LNG producer to build 3.3m tonne-per-year production trains, the first to build 4.7mtpa trains and is the first to build 7.8mtpa trains ­ innovations that significantly reduce the unit cost of producing LNG. By 2011 it is scheduled to become the world's gas-to-liquids (GTL) capital. In the next five years an eye-watering $146bn according to MEED Projects (as of Jan 2007) is being invested in Qatar, $80bn of that in energy and industry projects and of that around $12bn is being piled into its petro/chemicals sector. The country, with its access to huge resources, is capitalising on its gas reserves by focusing on an array of huge LNG and GTL projects. Qatar is developing four major projects that will quintuple its ethylene capacity ­ from 2006's 1mt-a-year to 5.7mt by 2012/13. A fifth major mix-feed joint venture cracker project (1.3mt ethylene) with Total Petrochemicals is under discussion. Each of the projects is being headed by Qatar Petroleum. Foundation stone ceremonies for the 1.3m-1.6m tonnes-ayear Ras Laffan cracker and the $1.2bn Qatofin project were held on May 18 and May 22 2006, respectively. The Qatofin plant will process about 422,000 tonnes of ethylene ­ piped from the Ras Laffan cracker ­ and 38,000 of butane, supplied by Q-Chem 11 under a long-term supply agreement. H.E. Abdullah Bin Hamad Al-Attiyah, Qatar's Deputy Prime Minister and Minister of Energy and Industry as well as Qatar Petroleum chairman, presided at the heads of agreement (HOA) signing with ExxonMobil Chemical president Michael Dolan last October. Qatar's other two announced ventures are with South Korea's Honam Petrochemical, at Mesaieed, and with Shell Chemicals at Ras Laffan.

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Developing in Partnership.

Business and politics should be allies in the battle against global poverty and disadvantage. Publicprivate partnerships can be a strong engine for development says Rajat Gupta.

z Human well-being and social prosperity have enjoyed civil society. When these powerful forces concentrate their

unprecedented gains in the last two decades, as the strong global economy has lifted hundreds of millions of people out of chronic poverty. The market economy, driving brisk growth worldwide since the fall of the Berlin Wall, has begun to fulfil its promise of bringing economic development to the millions, indeed billions, who had once been excluded from any chance of sharing in the world's wealth. International development has been spurred by market forces, surpassing anything that government planning or multilateral lending had ever been able to deliver. Yet the sustainability of the recent growth trend is now in question. In the near term, a slowing economy in the wealthy western and northern nations may soon reduce their consumption, thus limiting the growth potential for the poorer southern hemisphere. In the longer term, an anxious populist backlash in the wealthy West against further globalisation may close off some pathways for the impoverished billions who still aspire to join the global middle-class. Amid these risks, the cause of promoting international development will increasingly require the talent and the creativity of the very best minds that society can mobilise. I have spent much of my life participating in a dialogue among business, government, non-profit institutions and 64

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creativity in public-private partnerships, our world works better. Yet all too often, mistrust and misunderstanding impede us from joining forces. When our efforts are fragmented, we all lose: business loses opportunity, government loses credibility ­ and society loses most of all, as further economic opportunities are closed off for those who need them most. Economic growth and our hopes for the eradication of poverty depend upon the drive and creativity of commerce, in concert with the social consensus building that must be led by governments and civil society. Most public-sector and non-profit-sector leaders have come to realise that any effective development strategy will rely on the energies unleashed by business, which remains the engine of global growth. Business can kick-start a virtuous economic cycle: when developing nations integrate their local economies into global commerce, new enterprises are formed, new jobs are created, new skills are gained, and higher incomes are generated. As growth and productivity expand, intensified innovation and efficiency soon follow. New economic opportunities provide people with opportunity, dignity and empowerment.


government-guided economic programmes can be successful on their own. Governments certainly have a crucial role to play in creating the economic and social conditions that allow the virtuous cycle of development to take hold: by setting the frameworks that allow local businesses to become linked with international markets, that allow local entrepreneurs and institutions to develop, and that spur national competitiveness. Government leaders who instinctively mistrust the private sector should elevate their expectations of what business is capable of delivering: of how business can not only bring investment but also assert expertise and strengthen capabilities. The organisational skills of business can help governments build infrastructure and deliver public goods. Development that fails to leverage the best of business, or that fails to mobilise the best of government, is development that aims too low. Our statesmen, in both the private and public sectors, need to build a new accord that re-energises the partnership between business and government. Over the course of my career, I have had the privilege of being active in many areas that have helped promote international development: by consulting with major companies, by counselling government institutions, by serving non-profit agencies, and by conferring with international organisations. I have seen that my fellow business leaders must bear a greater responsibility than ever before, because the inexorable global forces affecting our society demand intricate decisions, made on the basis of an information-flow that is both instantaneous and imperfect. Society needs to mobilise its most talented minds ­ drawing on the insights of the private sector as well as the public sector ­ to help cope with a range of global forces that pose both imminent dislocations and long-range dilemmas. All of us need to raise our game. I know that the change in mind-set that I advocate involves business risk and political change ­ and such an evolution never comes easily. But with business statesmanship and political leadership, I feel confident that all of our institutions ­ in the private, public, non-profit and civil-society spheres ­ can move beyond the tired old partisan mind-sets that threaten effective cooperation. We must embrace the opportunity to act in our common interest, working together in genuine partnership to accomplish the goal we all share: lifting the world's hungry billions out of poverty, and building a humane, far-sighted and sustainable framework to support the ideal of stronger international development. Q

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Government, civil society and the business community must be united in their commitment to continuing this virtuous circle. Yet all too often ­ even after the decades of gains driven by public-private cooperation ­ government and business fall back into their outdated habit of operating as partisans. Because they feel at odds with each other or misunderstand each other's values, they fail to explore potential avenues of co-operation. It is a failure of mind-sets, and a failure of vision. When our understanding falters, we fail to see the simple truth: there is no hope for development without business and, in the long run, there is no hope for business without development. Companies that take a short-sighted view make the moral mistake of seeing profits but not people ­ and they make the management mistake of investing only where they can calculate a precise short-term return. Enlightened selfinterest should send business leaders to the development table to be co-architects of development strategies, to join in public-private partnerships, and to engage, as appropriate, in civic philanthropy. Governments that take an adversarial position make equally short-sighted errors. They short-change their own people of hope for continued development by distrusting the civic-minded intent of business and by imagining that


Issued by Qatar Financial Centre Authority


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