1 ZSwiss Re New Markets
INSURITIZATION
Presentation to
CAS CARe Seminar
Nick Giuntini, FCAS
August 15, 2000
2 ZSwiss Re New Markets
AGENDA
Insuritization
What is the Opportunity
Why Does it Exist
General Underwriting ApproachPossible Pricing Pitfalls / Issues
3 ZSwiss Re New Markets
1) Definition
Insuritizition Placing risks that originate in the capital markets into the (re)insurance markets.
- e.g. wrapped bonds (credit enhancement)
<<vs.>>
Securitization Placing risks that would otherwise reside with (re)insurance companies into the
capital markets- e.g. cat bonds
4 ZSwiss Re New Markets
1) Opportunities
Types of Risks where Insuritization has been/can be used:
Municipal Bond Insurance
CDOs
Project Finance
Royalty Streams
•film
•franchise
•drug
•music
NEW, ESOTERIC OR UNDERSERVED ASSET CLASSES ARE REAL OPPORTUNITIES FOR (RE)INSURERES.
5 ZSwiss Re New Markets
Coupon - Decomposition
Coupon
Spread
Risk-free rate
Risk premium
Novelty Premiu
mCompensating the default risk of a non risk-free investment
Bonus for investing in a new asset class (novelty premium) - decrease over time
1) Capital Markets Pricing
6 ZSwiss Re New Markets
1) Capital Markets Pricing
BBB / BB Spreads: New Assets verses Established Assets
-
50.00
100.00
150.00
200.00
250.00
300.00
350.00
400.00
450.00
500.00
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Sp
re
ad
to
Lib
or
CORP
ABS
N-ABS
7 ZSwiss Re New Markets
150
60
175
70
350
240
325
270
0
50
100
150
200
250
300
350
400
Ca
t R
isk
An
nu
al
E(l
os
s)=
70
bp
s
Re
sid
ua
lV
alu
e o
f O
ilP
latf
orm
An
nu
al
E(l
os
s)=
20
bp
s
Au
to R
es
idu
al
Va
lue
An
nu
al
E(l
os
s)=
75
bp
s
PE
ME
X O
ilR
ev
en
ue
sE
(lo
ss
)=2
0b
ps
Insurance Market Distribution
Capital Markets Distribution
Sp
read
to
L
IBO
R
1) Pricing Comparison - Examples
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1) Why is Capital Markets Pricing Higher for Certain Risks?
Illiquid Small Volumes of Risk Traded New Asset Class Lack of Coverage / Interest Uncertainty About Risk / Loss Estimates
Accumulating vs. Diversifying Risks (1 Sided vs. 2 Sided)
9 ZSwiss Re New Markets
1) Accumulating vs. Diversifying Risks
Diversifying Risks 2 Sided Risks Natural Longs & Shorts Capital is not needed for risk if you can match up longs & shorts Generally most efficiently handled through Capital Markets e.g. Foreign Exchange Risk, Interest Rate Risk.
Accumulating Risks 1 Sided Risks Society is overall long in these risks Society net needs capital for these risks Generally most efficiently handled by entities that can diversify their
capital exposure with other accumulating risks (i.e. Insurance Cos.) e.g. Property Cat risk
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1) (Re)insurer’s Competitive Advantages
Ability to underwrite & price difficult underlying risks, while separating or mitigating the risks that cannot be underwritten effectively
Ability to manage the risk within a diversified risk portfolio
High quality Ratings (i.e. AAA)
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1) SRNM Risk Screening Process
Criteria for underwriting of Asset Backed Risks
Strong deal economics - lack of an efficient alternative market for the risk
Access to expertise, or ability to acquire needed expertise
Accepted model for the risk
Quality data that can be used to define the expected distribution
Low management risk or moral hazard risk
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Un-Funded Solution
Derivative Transaction
Liquidity Facility
Surety
Financial Guarantee Policy
Insurance of Underlying Risks
Monoline Company as a Front
Funded Solutions
On-Balance Sheet
Off-Balance Sheet - Conduit, Repo, Total Return Swaps, Rented CP Facilities
1) Form of Risk Transfer
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2) POTENTIAL PRICING PITFALLS / ISSUES
Alignment of Interests / Moral HazardTrend or Cycle?Too Little Data“Too Much” DataChange in Underlying Process Inappropriate DataOver-Reliance on Linear Regression“Trending, Developing & On-levelling”others...
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2) Alignment of Interests - Moral Hazard
“We wouldn’t have done these deals had they not been insured”
- John Miller, Managing Director - Chase Securities
In reference to insured film loans where claim have been filed against the insurers. The insurer’s, however, claim that they were relying on Chase’s track record of historically successful film lending.
WSJ - July 20, 2000
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2) Trend or Cycle?
Are current oil prices part of a trend or just a temporary peak?
Annual (June) Oil Prices
10
15
20
25
30
35
1983 1985 1987 1989 1991 1993 1995 1997 1999
Year
Price
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2) Too Little Data
Largest US Cat Loss per Year
-
5.0
10.0
15.0
20.0
25.0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
Year
Tot
al In
sure
d Lo
ss in
199
9 U
SD
, Billi
on
17 ZSwiss Re New Markets
2) “Too Much” Data
“We used 17,500 data points to predict the price of electricity.”
This will show the price of electricity as a function of gas prices, temperature, generating capacity, time of day, and day of week.
However, these data points are only 2 years worth of information (hourly observations).
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2) Change in Underlying Process
California WC C/Rs
80%
90%
100%
110%
120%
130%
140%
150%
1988 1990 1992 1994 1996 1998 2000
Accident Year
Com
bine
d R
atio
@ 1
2/31
/99
Start of
Open Rating
19 ZSwiss Re New Markets
2) Inappropriate Data
Stock Price Movements
25
30
35
40
45
50
55
60
65
19-Jul-99 07-Sep-99 27-Oct-99 16-Dec-99 04-Feb-00 25-Mar-00 14-May-00 03-Jul-00
Year
Pric
e
Ford ATT
Correlation between daily price movements is 2%.
However, correlation when Ford is down at least 3% is 24%.
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2) Over-Reliance on Linear Regression
Regression estimate would have dramatically overestimated new stores.
Annual Store Openings - Restaurant Chain
0
50
100
150
200
250
1978 1983 1988 1993 1998
Year
Nu
mb
er
o f
Ne
w S
tore
s
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2) “Trending, Developing & On-Leveling”
Mortgage Portfolio Delinquency Rates
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
1992 1993 1994 1995 1996 1997 1998 1999 2000
Year
as a
% o
f Out
stan
ding
Por
tfolio
Data not adjusted for economy or increasing size of portfolio.
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CONCLUSION
Big Opportunities for (Re)Insurers
Risk Understanding & Quantitative Analysis Crucial Be Careful Make Informed Judgements Where Uncertainty Exists - Be “Conservative” Include both Insurance & Finance Perspective