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Derivatives in the Insurance

Market
Stephen P. D’Arcy
Professor of Finance
University of Illinois
http://www.cba.uiuc.edu/~s-darcy/

First Annual OFOR Symposium
May 16, 2002
Overview
• Use of derivatives by insurers
• Securitization of insurance risk
Use of Derivatives by Insurers
Based on Cummins, Phillips, and Smith
North American Actuarial Journal January 1997

• 1994 annual statements filed with NAIC
• 1,760 life insurers and 2,707 P-L insurers
• Schedule DB Derivative Instruments
• Categories of derivatives included:
– Options, caps, and floors owned
– Options, caps, and floors written
– Collars, swaps, and forward agreements
– Futures contracts
Results
• 12% of life insurers and 7% of P-L insurers used
derivatives sometime during the year
• Stock insurers use derivatives more
– Life insurers: 16% of stock companies, 7% of mutuals
– P-L insurers: 10% of stock companies, 4% of mutuals
• Larger companies used derivatives more
– For largest size quartile, 34% of life and 21% of P-L
insurers used derivatives
Results (p.2)
• Life insurers used derivatives to manage
interest rate risk
– Caps/floors
– Interest rate swaps
– Options and/or futures positions on bonds
• P-L insurers have a higher percentage of
assets in equities
– Use of equity options, both calls and puts
• P-L insurers used FX forwards
Conclusion
• Most insurers did not use derivatives as of 1994
• Even for those that did use derivatives, the
volume was low
– For users, average notional value of open positions
• $661 million for life insurers
• $90 million for property-liability insurers
Why Don’t Insurers Use Derivatives More?

• Unfamiliarity with derivatives
• Conservatism
• Derivative horror stories
• Regulatory resistance
• Lack of focus on financial risk management
Securitization of Insurance Risk
• Exchange Traded Derivatives
• Contingent Capital
• Risk Capital
• Recent insurance derivatives
Exchange Traded Derivatives
• First proposed by Goshay and Sandor – 1973
• CBOT Catastrophe futures and options – 1992
– Underlying: small sample of companies reported paid
losses
• CBOT PCS Catastrophe Insurance Options – 1995
– Underlying: estimate of industry wide incurred losses
• Bermuda Commodities Exchange Catastrophe
Options
– Binary options
– Trigger: Guy Carpenter Catastrophe Index
Status of Exchange Traded
Derivatives
• Trading volume was very low
• Large bid-ask spreads
• There is currently no viable market for
exchange traded derivatives
Contingent Capital
• Line of credit
• Contingent surplus note
• Cat-Equity-Put
– Insurer contracts with counterparty to purchase put options
– Options can only be exercised in the event of a catastrophe
– Minimum post catastrophe net worth requirement
– Warranties on reinsurance, management control, etc.
– Exposure period 1-10 years
– Annual premiums
– Buyback provisions
Risk Capital
Catastrophe Bonds
Typical case - pre-funded, fully collateralized
Provides insurers with additional capital and multiyear
coverage for catastrophes
Provides investors with diversification and high yields
Investors include:
Mutual funds Hedge funds
Reinsurers Life insurers
Money managers
Examples of Catastrophe Bonds
• USAA – 1997
– East coast hurricane
• Swiss Re – 1997
– California earthquake
• Munich Re – 2001
– Hurricane, earthquake and European windstorm
• Syndicate 33 of Lloyd’s of London – 2002
– St. Agatha Re
Recent Insurance Derivatives
• Catastrophe risk swap
– Swiss Re and Tokio Marine and Fire – 2001
• Japan earthquake for California earthquake
• Japan typhoon for Florida hurricane
• Japan typhoon for France storm
• Earthquake derivative
– Munich Re and Berkshire Hathaway – 2001
• Earthquakes affecting World Cup Soccer
• Parametric trigger
Future of Securitization
• Major insurers and reinsurers will expand use
• Markets will grow with increased availability
• Additional sources of risk could be covered
• Trend will drive insurers to additional
financial risk management