Insurance Securitization Rick Gorvett, FCAS, MAAA, ARM, Ph.D. Actuarial Science Program University...

Insurance Securitization

Rick Gorvett, FCAS, MAAA, ARM, Ph.D.Actuarial Science Program

University of Illinois

at Urbana-Champaign

International Association of Consulting ActuariesHershey, PA

June 2000

Risk and Response

• Risk– Recent catastrophes– Resulting insolvencies and financial

impairment– Potential for even greater impact

• Response– Development of securitized insurance

products

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

Securitization inHistorical Perspective

• Home mortgage market: funding shortfall in the late 1970s

• Market response: mortgage-backed securities

• Other asset-backed securities developed subsequently– Auto loans– Credit card receivables– David Bowie albums

Securitization Process

• Participants– Borrower– Loan originator– Special purpose trust– Underwriter– Investors

• Some of the Benefits– Liquidity– Market values– Lower cost– Improved credit rating

Evolution of the Insurance Industry

“Affronts” to Traditional Insurance

• Self-insurance and captives

• Risk retention groups

• Insurance securitization

• Portfolio insurance

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

Insurance Securitization in Context:Managing Risks

• Insurance securitization is one of many financial risk management (FRM) techniques

• Building blocks of FRM:– Stocks and bonds– Forwards and futures– Options– Swaps

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

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

Issues Regarding the Potential Success of Insurance Securitization

• Difficult to understand– Capital markets– Insurance markets

• Separation of insurance and finance functions in many companies

• Information and technology• Difficult to price• Expensive (vs. cat. reinsurance market)• Legal / tax / accounting issues

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

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

Risk Exchanges and Swaps

• CATEX New York

– Electronic bulletin board

– Catastrophe exposure swaps

• CATEX Bermuda

– Joint venture: CATEX and Bermuda Stock

Exchange

• Swaps

Catastrophe Bonds:The Trigger Issue

• Basis risk– How closely do the company’s losses follow the

industry index?

• Moral hazard– Increased losses to company may decrease the debt

obligations

Trade-off between basis risk and moral hazard

Direct versus industry versus event triggers

Types of Bond Triggers

• Direct: based on company losses– E.g., USAA catastrophe bond– No basis risk

• Industry: based on an index– E.g., Swiss Re; CBOT PCS option spreads– Essentially no moral hazard

• Event– E.g., Tokio Marine & Fire– Earthquake magnitude

Types of Catastrophe BondRisk-Taking

• Risk of losing some or all of your principal– Defeasement of principal with U.S. Treasuries?

• Risk of diminished or lost interest payments

• Often, several “tranches” with different yields and ratings

Typical Catastrophe Bond Issuance Structure

• Insurance company sets up an SPV (Special Purpose Vehicle) -- offshore reinsurer

• Company purchases reinsurance contract from SPV

• Company issues bonds to capital markets through SPV

Some 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

• Swiss Re: “basis swap” with reinsurer

Generally Common Traits of Successful Bond Issues

• Involve catastrophe risk

• High levels of protection

• Relatively short maturities

• Some protection of principal included

• High coupon rates

“Costs” of Catastrophe Bonds

• High yields– Default premiums may be high for a time

• Setting up SPV

• Investment banking fees– Advising

– Spread

• Legal fees

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

The Future of Insurance Securitization

• Will it survive and grow?– Cost relative to insurance and reinsurance

– Time and technology

• Will it replace or supplement traditional transactions?

• How will it affect reinsurance?

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

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

The Future of Insurance Securitization (cont.)

• 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

Personal Info

• Web page:

http://www.math.uiuc.edu/~gorvett

• E-mail:

gorvett@uiuc.edu