Finance 431: Property-Liability Insurance Lecture 21: Securitization of Catastrophe Risk

Securitization of Catastrophe Risk Impetus Insurance Markets $400-500 Billion in Capital Financial Markets $50-60 Trillion in Capital in US $150-180 Trillion in Capital in World Catastrophe Potential $60-100 Billion Too Large for Insurance Markets Less than a 1% Impact on Financial Markets Need to Develop Mechanisms to Spread Catastrophe Risk More Widely 2

Securitization of Catastrophe Risk Three Basic Approaches Exchange Traded Derivatives CBOT Cat Insurance Futures and Options Bermuda Commodities Exchange Cat Options Contingent Capital Line of Credit Contingent Surplus Notes Catastrophe Equity Puts Risk Capital Catastrophe Bonds 3

Alternative Catastrophe Securitization Contingent Capital Insurer Could Buy Puts on Its Own Stock Moral Hazard Puts Not Traded for Most Insurers Cat-Equity- Puts At least 17 trades to date for $4.7 billion of contingent capital 12

Cat-E-Puts Written by AON Prenegotiated Option on a Firm’s Own Securities Triggered by a Catastrophic Event Buyer Pays Premium to Option Writer Option Writer Provides Post-event Equity Normally Written for 3 years 13

Benefits of Cat-E-Puts Allows the buyer to protect its balance sheet Rating agencies view this approach favorably Cost compares favorably with reinsurance 14

Alternative Catastrophe Securitization Risk Capital Typical case - pre-funded, fully collateralized Commonly termed Cat bonds Provides cedants 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 19

Issuers and Investors Sponsorship of transactions includes: Allianz, AGF, CEA, Gerling, Kemper, Mitsui, USAA , State Farm, Tokio, Winterthur, XL Capital, Yasuda, Zurich AXA Re, Hannover Re, Munich Re, Scor, St. Paul Re, Swiss Re Investors include: Reinsurers, Insurers, Banks, Investment Advisors/Mutual Funds, Hedge/ Proprietary Funds

Risks Covered Gulf Coast Hurricane California Earthquake Europe Wind Japan Earthquake Japan Typhoon Midwest Earthquake Northeast Hurricane Monaco Earthquake Puerto Rico Hurricane Europe Hail Hawaii Hurricane

Triggers Indemnity Parametric PCS Modeled Loss

Examples of Risk Capital USAA raised $477 million in June, 1997 Created Residential Re, Ltd. Covers East Coast Hurricane Risk Swiss Re raised $137 million in July, 1997 Created SR Earthquake Fund, Ltd. Covers California Earthquake Risk 20

USAA Catastrophe Bonds Residential Re raised $477 million in capital Two tranches A-1 Extendible Principal Protected Bonds Pay LIBOR + 273 basis points $163.8 million bonds plus option on $77 million invested in 10 year zero coupon bond Option protects principal, but not economic value A-2 Principal Variable Bonds Pay LIBOR + 576 basis points $313.2 million bonds 21

USAA Catastrophe Bonds Residential Re reinsures USAA Single East Coast hurricane causing in excess of $1 billion in insured losses to USAA Reinsurance is 80% of losses between $1 and $1.5 billion Stated maturity of bonds is 1 year If there is a loss, maturity can be extended 6 months Interest is payable during extension If a loss occurs on tranch A-1, maturity is extended to 10 years, but no interest will be paid 22

Swiss Re Catastrophe Bonds SR Earthquake Fund raised $137 million in 2 year notes Three tranches 1 - $42 million floating rate $20 million fixed rate 60% of principal at risk Ratings: Baa2 Moody’s, BBB- Fitch 2 - $60.3 million fixed rate all of principal is at risk Ratings: Ba1 Moody’s, BB Fitch 3 - $14.7 million Not rated 23

Swiss Re Catastrophe Bonds Triggers PCS index of industrywide losses Investors in first two tranches lose 1/3 of principal at each level $18.5 billion $21 billion $24 billion Lower triggers apply to the third tranch SR Earthquake Fund provides Swiss Re with $112.2 million reinsurance for a single California earthquake 24

Pricing of Risk Capital Comparison of interest rate differential between risky capital and risk free rate with the expected losses USAA Initial offer 9 times Current trading 6 times Swiss Re 6 times BB rated debt 2.2 times Emerging markets 1.3-2.7 times Problem: This approach ignores the loss distribution. Catastrophe coverage has greater chance of total loss of principal than other debt. 25

Additional Points Concerning Risk Capital Offshore subsidiary used to avoid taxation of interest Insurers using this approach should expect litigation after a loss. This is common practice after a default on high yield debt. 26

Summary Catastrophes can be so large that the insurance industry may be unable to handle them under traditional method Securitization can be an effective way to handle catastrophe and other insurance risks This field is just beginning to develop Expertise needed in both insurance and finance 27