Insurance Securitization

Rick Gorvett, FCAS, MAAA, ARM, Ph.D.

Actuarial Science Program University of Illinois at Urbana-Champaign International Association of Consulting Actuaries Hershey, PA June 2000

Risk and Response

Risk
Recent catastrophes Resulting insolvencies and financial impairment Potential for even greater impact

Response
Development of securitized insurance products

What is Securitization of Insurance Risk?

Insurance company transfers underwriting risks to the capital markets by transforming underwriting cash flows into tradable financial securities Cash flows (e.g., repayment of interest and/or principal) are contingent upon an insurance event / risk

Securitization in Historical Perspective

Home mortgage market: funding shortfall in the late 1970s Market response: mortgage-backed securities Other asset-backed securities developed subsequently
Auto loans Credit card receivables David Bowie albums

Securitization Process
Participants
Borrower Loan originator Special purpose trust Underwriter Investors Liquidity Market values Lower cost Improved credit rating

Some of the Benefits

Evolution of the Insurance Industry

Affronts to Traditional Insurance
Self-insurance and captives Risk retention groups Insurance securitization Portfolio insurance

Risks Which P/C Insurers Face

Underwriting
Loss experience: frequency and severity Underwriting cycle Inflation Payout patterns Catastrophes

Investment
Interest rate risk Capital market performance

All of these risks can prevent a company from meeting its objectives

Insurance Securitization in Context: Managing Risks

Insurance securitization is one of many financial risk management (FRM) techniques Building blocks of FRM:
Stocks and bonds Forwards and futures Options Swaps

Factors Affecting the Recent Development of Insurance Securitization

Recent catastrophe experience
Reassessment of catastrophe risk Demand for and pricing of reinsurance Reinsurance supply issues

Capital market developments

Development of new asset classes and assetbacked markets Search for yield and diversification

Restructuring of insurance industry

Possible Reasons for Securitizing Insurance Risks

Capacity
Risk of huge catastrophe losses Would severely impair P/C industry capital Capital markets could handle

Investment
Catastrophe exposure is uncorrelated with overall capital markets Thus, uncorrelated with existing portfolios Diversification potential

Issues Regarding the Potential Success of Insurance Securitization

Difficult to understand
Capital markets Insurance markets

Separation of insurance and finance functions in many companies Information and technology Difficult to price Expensive (vs. cat. reinsurance market) Legal / tax / accounting issues

Types of Insurance Instruments

Those that transfer risk
Reinsurance Exchange-traded derivatives Swaps Catastrophe bonds

Those that provide contingent capital

Letter of credit Contingent surplus notes Catastrophe equity puts

Exchange-Traded Derivatives
Chicago Board of Trade
Option spreads ~ reinsurance PCS: daily index values Nine geographic products

Bermuda Commodities Exchange

Binary options Guy Carpenter Catastrophe Index Seven geographic products

Risk Exchanges and Swaps

CATEX New York
Electronic bulletin board Catastrophe exposure swaps

CATEX Bermuda
Joint venture: CATEX and Bermuda Stock Exchange

Swaps

Catastrophe Bonds: The Trigger Issue

Basis risk
How closely do the companys losses follow the industry index?

Moral hazard
Increased losses to company may decrease the debt obligations

Trade-off between basis risk and moral hazard Direct versus industry versus event triggers

Types of Bond Triggers

Direct: based on company losses
E.g., USAA catastrophe bond No basis risk

Industry: based on an index

E.g., Swiss Re; CBOT PCS option spreads Essentially no moral hazard

Event
E.g., Tokio Marine & Fire Earthquake magnitude

Types of Catastrophe Bond Risk-Taking

Risk of losing some or all of your principal
Defeasement of principal with U.S. Treasuries?

Risk of diminished or lost interest payments Often, several tranches with different yields and ratings

Typical Catastrophe Bond Issuance Structure

Insurance company sets up an SPV (Special Purpose Vehicle) -- offshore reinsurer Company purchases reinsurance contract from SPV Company issues bonds to capital markets through SPV

Some Successful Bond Issues

USAA: companys hurricane losses Swiss Re: industrys California E/Q losses

Tokio Marine & Fire: Tokyo E/Q magnitude

Centre Re: companys Florida hurricane losses Yasuda Fire & Marine: typhoon losses Swiss Re: basis swap with reinsurer

Generally Common Traits of Successful Bond Issues

Involve catastrophe risk High levels of protection

Relatively short maturities

Some protection of principal included

High coupon rates

Costs of Catastrophe Bonds

High yields
Default premiums may be high for a time

Setting up SPV Investment banking fees

Advising

Spread

Legal fees

Contingent Capital
Contingent surplus notes
Option to borrow, contingent upon some event or trigger

Right to issue surplus notes

Catastrophe equity puts

Put option (right to sell) Right to issue shares of stock, contingent upon some event or trigger

The Future of Insurance Securitization

Will it survive and grow?
Cost relative to insurance and reinsurance

Time and technology

Will it replace or supplement traditional transactions? How will it affect reinsurance?

The Future of Insurance Securitization (cont.)

Capacity versus other reasons Catastrophe risks versus traditional insurance lines Historically, markets for other forms of securitizations have taken some time to develop and mature

The Future of Insurance Securitization (cont.)

Legal and tax issues
Are securitization instruments insurance? Bermuda Insurance Amendment Act (1998): insurance derivatives are investment contracts Different tax implications:
Protect income statement Protect balance sheet

The Future of Insurance Securitization (cont.)

Insurer FRM can take a variety of forms
Asset hedges
Reinsurance Derivatives

Liability hedges
Debt forgiveness

Asset-liability management
Contingent financing Post-loss financing and recapitalization

Personal Info
Web page: http://www.math.uiuc.edu/~gorvett

E-mail: gorvett@uiuc.edu