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

2. Securitization of Catastrophe Risk
Impetus
Insurance Markets
$ Billion in Capital
Financial Markets
$50-60 Trillion in Capital in US
$ Trillion in Capital in World
Catastrophe Potential $ 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

3. 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

4. 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

5. 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

6. 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

7. 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

9. 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

10. 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

11. Triggers
Indemnity
Parametric
PCS
Modeled Loss

12. 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

13. USAA Catastrophe Bonds
Residential Re raised $477 million in capital
Two tranches
A-1 Extendible Principal Protected Bonds
Pay LIBOR 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 basis points
$313.2 million bonds 21

14. 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

15. 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

16. 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

17. 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 times
Problem: This approach ignores the loss distribution. Catastrophe coverage has greater chance of total loss of principal than other debt. 25

18. 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

19. 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