Evolution of Insurance Securitization Stephen P. D’Arcy Fellow of the Casualty Actuarial Society Professor of Finance University of Illinois UNSW Actuarial Studies Alumni Event 2 July 2007 Sydney, Australia

Impetus for Securitization of Insurance Risk One major catastrophe could eliminate most of the world’s insurance capital The largest potential loss is less than the daily fluctuation of total financial markets If insurance losses could be shifted to financial markets, the risk would be manageable

Steps in Insurance Securitization Catastrophes –Chicago Board of Trade Catastrophe Futures – 1992 –PCS Catastrophe Options – 1996 –Contingent Capital – 1996 –Risk Capital – 1997 Longevity –Mortality Index Bonds – 2003 Motor Insurance –French Motor Insurance Portfolio – 2005 –Multinational Motor Insurance Portfolio

Catastrophe Insurance Securitization CBOT Catastrophe Futures –Underlying index: Paid claims for 22 insurers –Perils: Wind, Hail, Earthquake, Riot and Flood –Settlement Value: Loss Ratio x $25,000 PCS Catastrophe Option –Underlying index: PCS Estimate/100 million –All catastrophe claims (over $25 million) –Small (up to $20 billion) and large ($20 to 50 billion) caps

Cat-E-Puts Written by AON Pre-negotiated 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 Minimum net worth required to exercise put

Risk Capital Typical case Issue bonds with repayment and/or coupons dependent on catastrophe losses Provides cedents with additional capital and multiyear coverage for catastrophes Provides investors with diversification and high yields Investors include: Mutual fundsHedge fundsReinsurers Life insurersMoney managers

Risks Covered U. S. Gulf Coast Hurricane California Earthquake Europe Wind Japan Earthquake Japan Typhoon U. S. Midwest Earthquake U. S. 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 Online reference for many deals

Longevity Risk Longevity risk is the risk of mortality rates deviating from expected levels Over last century, mortality rates have steadily declined, leading to longer life expectancies Significant improvement for most recent period has been noted Primary concern for insurers and pension funds is improvement for those age 60 and older

Exposure to Longevity Risk Life insurance –Risk is if mortality rates increase –Coverage concentrated on particular ages (30-70) –Recent concerns Catastrophic losses Pandemics Annuities and pension funds –Risk is if mortality rates decline more than expected –Annuities are concentrated on particular ages (60+)

Managing Longevity Risk Life insurers –Could balance life insurance and annuity exposure Difficult to accomplish –Reinsurance for sudden increased mortality Concentration of reinsurers Cost of coverage Pension funds –Spreading losses forward under pension accounting –Use of asset returns as discount rate –Lower investment returns can no longer cover increasing longevity

Longevity Derivatives First life insurance securitizations involved offsetting premium loadings or reducing reserve requirements Current securitizations involve securitizing mortality risk –Swiss Re (2003) Life insurance catastrophe bond –EIB/BNP (2004) Long term longevity bond

Swiss Re Mortality Index Bond Issued December, 2003 $400 million in 3 year notes, quarterly coupons Bond paid LIBOR basis points Mortality rate was based on the weighted average mortality of US, UK, France, Italy and Switzerland Option to reduce repayment on bond if mortality exceeds 130% of 2002 mortality rate Principal is reduced 5% for every 0.01 increase in mortality over threshold Vita Capital was the Special Purpose Vehicle

Swiss Re Bond Ratings: A3/A+ Fully subscribed Investors included pension funds –High coupon –Natural hedge

Motor Insurance Securitization AXA securitized French motor insurance – 2005 Securitized European motor insurance – 2007 Bonds pay variable rate based on underlying loss experience

What’s Next? Catastrophes –Exchange traded derivative Mortality –Zero-coupon or deferred mortality bonds –Mortality swaps –Mortality futures and options Other coverages –Securitizing runoff business –Other lines besides motor insurance

Conclusions about Securitization Allows insurers to focus on writing policies without having to retain all the risk Alternative to reinsurance and useful for reinsurers Provides an attractive investment alternative for institutional investors Allows market to solve risk aggregation issues without relying on government Growth is very likely Will change the face of the insurance industry