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 Some of the Benefits –Liquidity –Market values –Lower cost –Improved credit rating

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 asset- backed 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

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