risk securitization 101 2000 cas special interest seminar david na, fcas, maaa deloitte &...
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Risk Securitization 101
2000 CAS Special Interest Seminar
David Na, FCAS, MAAA
Deloitte & Touche, Bermuda
Background
• Merging of Financial and Insurance Markets Travelers + Citicorp = CitiGroup?
• Insurance Industry “Scared” by Events Such as Hurricane Andrew $18 billion? $60-80 billion??
• Recent Activity - New Companies/Transactions Arrow Re (Goldman Sachs) Lehman Re (Lehman Brothers)
Background
• Effects of Natural Catastrophes in Late 80’s & Early 90’s: Decreased Insurance/Reinsurance Capacity
Increased Demand for Reinsurance
Realization of Inadequate Pricing
Increased Awareness re: Insurer’s Exposures
Background
• Comparison of Capitalization of Insurance and Capital Markets...
• Estimated Capital of US P/C Ins. Industry ~ $338 billion
• Size of the Capital Markets Total Capitalization ~ $34 trillion Average Daily Fluctuation ~ $200 billion $100 billion loss ~ 1/3 of 1% of market capital
What is Risk Securitization?
• Packaging/Transferring of insurance underwriting risks to the capital markets through the issuance of a financial security
• 2 Important Aspects:– Transformation of U/W Cash flows into tradable
securities– Transfer of U/W Risk through the trading of those
securities• Investment Return is contingent upon
underwriting experience
Indemnified Notes
• Responds Directly to Ceding Company’s Specific Exposures & Actual Losses
• Provides the Most Precise Coverage for Cedant
• Reflects Cedant’s U/W & Claim Settlement Processes
• Long Development Patterns – Investors may need to Wait for Their Return
• Sample Transaction: Alpha Wind
Indexed Notes
• Linked to Industry or Geographic Index (e.g. PCS)
• Cedant Exposed to Significant Basis Risk, if Index is not Consistent with Cedant’s Actual Losses
• Shorter Development Period (Generally Easier to Predict the Index than Individual Company Losses)
• “Synthetic Indemnification” – Mathematical Attempt to Replicate the Cedant’s Underlying Book of Business
• Sample Transaction: Seismic Re.
Parametric Notes
• Linked to Quantities Associated with Pertinent Events – Generally Physical Attributes of an Event: Magnitude, Intensity, & Epicenter of EQ Wind Speed, Forward Velocity, & County of Landfall of
Hurricane
• Removes Risks Associated with Modeling the Ceding Company’s Exposures or Changes in Exposures
• Virtually Eliminates Development Period
• Sample Transaction: Concentric Ltd.
Investor Risks & Returns
• No Standard Approach
• Principal Protection… sometimes
• Various Tranches
• Varying Terms (e.g. Tokio EQ is 10 years)
• Returns based on Risk
Other Examples of Securitization
• Mortgage Backed Securities– Similarly created by excess demand– However, high volume, stable asset was securitized
• Auto Loans & Credit Card Receivables
• David Bowie (offering securitized by future sales of CD’s)
• NFL (offering securitized by $18 billion TV deal)– [subsequently withdrawn]
Perspective
• Think of as any other security...
• It’s all about Risk v. Return...
• Here, the risk happens to be insurance related
Types of ILS’s
• Catastrophe Bonds - Will Discuss in Detail...
• Catastrophe Risk Exchange (CATEX) Swaps
• Insurance Related Derivatives/Options
• Catastrophe Equity Puts (CAT-E-Puts)
• Contingent Surplus Notes
• Weather Derivatives
• CATEX Swaps – NY & Bermuda
– Electronically swap CAT exposures (e.g. geographic location, property type, etc.)
• Insurance Related Derivatives/Options– Chicago Board of Trade Options: Based on
aggregate industry CAT losses (Property Claim Services)
– Bermuda Commodities Exchange CAT Options: Based on Guy Carpenter Catastrophe Index (ratio of losses to housing values)
Types of ILS’s
• Catastrophe Equity Puts (CAT-E-Puts) - Insurer has the option to sell equity (e.g. preferred shares) at pre-determined price, contingent upon a specific event
• Contingent Surplus Notes - Option to borrow contingent upon the occurrence of a specific event (contingent funds held in trust)
• Weather Derivatives - Insurance or derivative contract which pays based on weather related events
Types of ILS’s
Generic ILS Structure
InsurerInsureroror
ReinsurerReinsurer
InsurerInsureroror
ReinsurerReinsurerSPVSPVSPVSPV InvestorsInvestorsInvestorsInvestors
InvestedInvestedProceeds - Proceeds -
Trust AccountTrust Account
InvestedInvestedProceeds - Proceeds -
Trust AccountTrust Account
PortfolioPortfolioReturnReturnLiquidation Liquidation
of Assetsof Assets(Event (Event Contingent)Contingent)
ReimbursementReimbursementPayment Payment (Event (Event Contingent)Contingent)
Loss of ValueLoss of Value(Event (Event Contingent)Contingent)
PremiumPremium
Portfolio Portfolio ReturnReturn
+ Premium+ Premium
Advantages - Investor
• Above average yield relative to other securities (e.g. corporate bonds) of similar risk
• Outstanding diversification effect - Unlike investments in insurance company stocks, CAT events are generally uncorrelated with an investor’s portfolio
• Allows non-insurance investors to participate in insurance related transactions
• Preparation for convergence of Insurance & Banking
Advantages - Issuer
• Capacity - Access the Capital of the Financial Markets
• Greater Flexibility in Terms of Coverage• Reinsurance Protection – Fully Collateralized, No
Credit Risk• More Stable Pricing - Insulated from U/W cycles• High aggregate level risk transfer• Innovation/Prestige - “Cutting Edge”
Issues
• Requires understanding of both Capital and Insurance Markets (Investors as well as Issuers)
• Historical separation of Capital and Insurance Markets (e.g. Regulatory Issues)
• Uncertainty involved in pricing high layer or catastrophic events (Reliance on Modeling)
• Issuer’s Costs (Relative to Purchase of Reinsurance)• Investor’s Return (Relative to Comparably Risky
Securities)• Accounting, Legal, Regulatory, Tax, etc.
USAA/Residential Re.
• Placed in 1997 (with subsequent renewals)
• Reinsurance coverage of 80% of $500M x $1B
• Covers Category 3, 4, or 5 Hurricanes along the East or Gulf Coasts of the US
• $477 M in bonds issued
• Residential Re. Domiciled in Cayman
USAA/Residential Re.
• Tranche A-1 ($164 M):– AAA rated– Only interest at risk– Coupon paid LIBOR + 2.82%
• Tranche A-2 ($313 M):– BB rated– Principal & Interest at risk– Coupon paid LIBOR + 5.75%
• Investor Appeal– Principal Protection & AAA Rating– Favorable risk/return
USAA/Residential Re.
• Market timing; lack of investors’ appetite for risk in 1996; in 1997, risk/return more attractive
• Rating agency concerns (1996 not investment grade)
• Protection of principal• 1997 issue had short duration & conservative loss
trigger (USAA’s losses from Andrew ~ $555 M)
Why did it work in 1997?