1. Securitization and Other Instruments for Transferring Risk to the Capital Markets Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D. Actuarial Science Program University of Illinois at Urbana-Champaign Washington, DC July, 2003

2. Agenda Historical background of securitization Definition and evolution of insurance securitization Types of securitized insurance instruments Recent activity Issues for the future

3. Terminology and Tools Financial terminology –We need to learn to quack before we can be a duck –Financial practitioners say things like “BB undefeased subordinated debenture at 6mLIBOR+350bps” Financial tools –Financial practitioners use tools with names like “options,” “swaps,” “swaptions”

4. Securitization in Historical Perspective Home mortgage market: funding shortfall in the late 1970s Market response: –Change tax laws: no double taxation on cash flow pass-throughs –Modernized investment technology –FNMA, Freddie Mac Other asset-backed securities developed subsequently –Auto loans –Credit card receivables –David Bowie albums

5. The Securitization Process Participants –Demanders of funds Homeowner / borrower of funds Bank / Loan originator –Special purpose entity / trust –Suppliers of funds Underwriter / investment bank Capital markets / investors Some of the Benefits –Liquidity –Market values –Lower cost

6. Mortgage-Backed Securities (MBSs) Originated in response to mortgage funding shortfall Mortgages are “securitized” by packaging mortgage loans and selling the cash flows as securities The mortgage-backed securities represent ownership in the mortgages Mortgages generally have an embedded option: to prepay the mortgage (in event of interest rates falling, mortgage-holder moving, etc.)

7. Mortgage-Backed Securities (cont.) Investors receive the monthly mortgage payments (principal and/or interest) paid by the mortgage borrowers With MBSs, the prepayment risk is transferred to the capital market investors Investors are compensated for this risk by sufficiently high yields on the securities

8. 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

9. Alternatives to Capital “Insurers are discovering what bankers know as securitisation: the process of assembling mortgages, credit- card receivables or even business loans into securities that provide reasonably predictable income streams and principal repayments. This sort of financial engineering has been going on for decades in America.... Its big advantage is that, once the assets have been sold, the issuer need no longer set aside capital to cover potential losses; instead, the capital can be redeployed more profitably. Insurers are only now waking up to the potential benefits.” - “An Earthquake in Insurance,” Economist, 2/26/98

10. Evolution of the Insurance Industry “Affronts” to Traditional Insurance Self-insurance Captives Risk retention groups and purchasing groups Insurance securitization Portfolio insurance

11. 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

12. 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

13. 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

14. What to Securitize? Homeowners? Auto? Health? “Homeowners is not a problem for the insurance industry. Auto is not a problem for the insurance industry. We know how to manage those risks…. How about catastrophes?” - Dennis Chookaszian (a 1992 comment, quoted in Best’s Review, 4/99)

15. 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

16. 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

17. Risk Exchanges and Swaps CATEX New York –Electronic bulletin board –Intermediary CATEX Bermuda –Joint venture: CATEX and Bermuda Stock Exchange Swaps

18. Some Early Successful Bond Issues USAA: company’s hurricane losses Swiss Re: industry’s California E/Q losses Tokio Marine & Fire: Tokyo E/Q magnitude Centre Re: company’s Florida hurricane losses Yasuda Fire & Marine: typhoon losses

19. Generally Common Traits of Successful Issues Involve catastrophe risk High levels of protection Relatively short maturities Some protection of principal included High coupon rates

20. “Costs” of Cat Bonds High yields –Default premiums may be high for a time Setting up SPV Investment banking fees –Advising –Spread Legal fees

21. 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

22. Very Recent Activity Approximately $1.22 billion issued in the 2002 cat bond market –Versus $1.14 billion in 2001 Notable transactions: –USAA / Residential Re: Sixth consecutive year –Vivendi / Studio Re: First direct-corporate issue on US peril Several catastrophe bond investment funds

23. Issues Regarding the Potential “Success” of Insurance Securitization Need to understand two markets –Capital markets –Insurance markets Separation of insurance and finance functions in many companies Information and technology Pricing challenges Cost (vs. cat. reinsurance market) Legal / tax / accounting issues

25. The Future of Insurance Securitization A number of issues 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

26. CBOT Catastrophe Option Spreads European cash options Loss period: generally calendar quarter (except annual for Western and CA) PCS provides industry indexes daily Development period: 6 or 12 months Index Valuation: Each index point = $100 million in industry cat losses = $200 cash value Strike values: in multiples of 5 Tick size: one-tenth of a point (= $20)

27. CBOT Cat. Option Spreads (cont.) Underlying instrument: –National -- All states + DC –Eastern -- AL, CT, DE, DC, FL, GA, LA, ME, MD, MA, MS, NH, NJ, NY, NC, PA, RI, SC, VT, VA, WV –Northeastern -- CT, DE, DC, ME, MD, MA, NH, NJ, NY, PA, RI, VT –Southeastern -- AL, FL, GA, LA, MS, NC, SC, VA, WV –Midwestern -- AR, IL, IN, IA, KS, KY, MI, MN, MO, NE, ND, OH, OK, SD, TN, WI –Western -- AK, AZ, CA, CO, HI, ID, MT, NV, NM, OR, UT, WA, WY –California –Florida –Texas

28. CBOT Cat. Option Spreads (cont.) Example December 1997 30/50 TX Call Spread Essentially, this is a $2B x/s $3B layer on 4th-quarter 1997 industry Texas cat losses: [50-30] x $100M = $2B 30 x $100M = $3B If 4th-quarter TX cat losses = $4.5B: Call option spread value = [($4.5B/$100M)-30]x$200 = $3,000

29. Bermuda Commodities Exchange Catastrophe derivatives Guy Carpenter Catastrophe Index Single loss, second loss, and aggregate options Binary option: payoff either $0 or $5000 Two six-month risk periods each year Periodic settlement evaluations -- final is 13 months after end of risk period National, NE, SE, MW, Gulf, FL, TX

30. Uses of Exchange-Traded Options Hedge insurer’s catastrophic loss exposure –Proceeds from options potentially provide a cash flow which offsets cat. losses to some degree –Does not change likelihood or severity of a catastrophe -- but changes net impact on insurer Issues –Basis risk Depends on index which defines / triggers cash flows E.g., regional versus state versus zip code –Frequency of settlement and index calculation –Marketing and liquidity

31. Other Insurance Products Contingent surplus notes –Insurer has right to issue surplus notes (subordinated debt), contingent upon an event –Investment trust sells certificates to capital markets, and invests in liquid securities –If event occurs, insurer issues surplus notes in exchange for liquid securities

32. Other Insurance Products (cont.) Catastrophe equity puts –Insurer has right to issue equity (e.g., preferred stock), contingent upon an event –Insurer pays investors for the option to sell them shares –If event occurs, insurer receives cash from investors in exchange for its shares

33. Other Insurance Products (cont.) Catastrophe bonds –Insurer issues debt –Similar to a corporate bond –Provision for “contingent debt forgiveness” –If a specified event occurs, some / all of the principal / interest payment obligations of the insurer will be forgiven (sacrificed) by the investors

34. RECENT SUCCESSES USAA / Residential Re –Size: $477M, in two tranches –Trigger: hurricane losses to company –Coverage: 80% of $500M x/s $1B co. loss –A-1: rated AAA $163.8M, of which $77M placed in a defeasance account to fund principal repayment Only interest at risk Coupon: LIBOR + 282 bps –A-2: rated BB $313.2M Both principal and interest at risk Coupon: LIBOR + 575 bps

35. RECENT SUCCESSES (cont.) Swiss Re –Size: $137M, in three classes –Trigger: losses to industry from CA E/Q; industry insured loss, from a single event, greater than $18.5B triggers principal write-downs –40% of Class A proceeds to defeasance account –Coupon: A-1: LIBOR + 255 bps A-2: 8.645% B: 10.493% C: 12%

36. RECENT SUCCESSES (cont.) Tokio / Parametric Re –Size: $100M, in two tranches –Trigger: Tokyo earthquake magnitude; a Japanese Meteorological Association magnitude rating of 7.1 or more involves loss of part or all of principal –Half of $20M proceeds from A and all of $80M proceeds from B are risk capital –Ten-year term –Coupon: A: LIBOR + 206 bps B: LIBOR + 430 bps

37. RECENT SUCCESSES (cont.) Centre / Trinity Re –Size: $84M, in two tranches –Trigger: FL hurricane losses to company –Class A-1 notes ($22M in proceeds) provide for full principal repayment in event of a loss –Coupon: A-1: LIBOR + 182 bps A-2: LIBOR + 436 bps

38. RECENT SUCCESSES (cont.) USAA (1998) –$450 million, thru Residential Re –Company losses greater than $1B from Hurricane –A-1: LIBOR + 140 bps (compare with 282 bps in 1997) –A-2: LIBOR + 400 bps (compare with 575 bps in 1997)

39. RECENT SUCCESSES (cont.) Yasuda Fire and Marine –Typhoon losses –$80 million offering –5-7 years –Attachment point recalculated every year with exposure model -- constant 0.94% chance of loss to investors –Guaranteed limits and pricing for a second event

40. RECENT SUCCESSES (cont.) F&G Re –Aggregate x/s cover for a portfolio of catastrophe reinsurance contracts –$54 million offering –Through Mosaic Re X.L. Mid Ocean Re –Retrocessional hurricane and E/Q –$200 million offering –Competitive bidding process –Swap

41. RECENT SUCCESSES (cont.) Swiss Re –Basis swap with reinsurer (“ABC”) –Up to $10 million transferred –Two triggers: SE windstorm losses of ABC SE windstorm losses of industry (from PCS) Exceed trigger? ABCIndustryResult Y NSwiss Re pays N YABC pays N NNothing Y YPay each other

42. GENERALLY COMMON TRAITS OF SUCCESSFUL ISSUES Involve catastrophe risk High levels of protection Relatively short maturities Some protection of principal included High coupon rates

43. “COSTS” OF CAT BONDS High yields –Default premiums may be high for a time Setting up SPV Investment banking fees –Advising –Spread Legal fees

44. THE FUTURE OF INSURANCE SECURITIZATION Will it survive and grow? –Expensive –Time and technology Will it replace or supplement traditional transactions? How will it affect reinsurance?

45. 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

46. 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

47. THE FUTURE OF INSURANCE SECURITIZATION (cont.) What form will insurer FRM take? –Asset hedges Reinsurance Derivatives –Liability hedges Debt forgiveness –Asset-liability management –Contingent financing –Post-loss financing and recapitalization

48. Capacity: Is There a Shortfall? Estimate of total net worth of U.S. P/C industry: $300B + Capital exists to handle contingencies “Insurance density” is low in places New capital enters when rates of return are high (e.g., Bermuda cat insurers after Andrew)

49. CBOT PCS Catastrophe Option Spreads European cash options Loss period: generally calendar quarter (except annual for Western and CA) Development period: 6 or 12 months PCS provided industry indexes daily Index Valuation: Each index point = $100 million in industry cat losses = $200 cash value Strike values: in multiples of 5 Tick size: one-tenth of a point (= $20)

50. CBOT PCS Catastrophe Option Spreads (cont.) Example December 1997 30/50 TX Call Spread Essentially, this is a $2B x/s $3B layer on 4th- quarter 1997 industry Texas cat losses: [50 - 30] x $100M = $2B 30 x $100M = $3B If 4th-quarter TX cat losses = $4.5B: Call option spread value = [($4.5B / $100M) - 30] x $200 = $3,000

51. Bermuda Commodities Exchange Catastrophe Options Catastrophe derivatives Guy Carpenter Catastrophe Index Single loss, second loss, and aggregate options Binary option: payoff either $0 or $5000 Two six-month risk periods each year Periodic settlement evaluations -- final is 13 months after end of risk period National, NE, SE, MW, Gulf, FL, TX NotBut