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Insurance Securitization

Insurance Securitization. Rick Gorvett, FCAS, MAAA, ARM, Ph.D. Actuarial Science Program University of Illinois at Urbana-Champaign International Association of Consulting Actuaries Hershey, PA June 2000. Risk and Response. Risk Recent catastrophes

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Insurance Securitization

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  1. Insurance Securitization Rick Gorvett, FCAS, MAAA, ARM, Ph.D. Actuarial Science Program University of Illinois at Urbana-Champaign International Association of Consulting Actuaries Hershey, PA June 2000

  2. Risk and Response • Risk • Recent catastrophes • Resulting insolvencies and financial impairment • Potential for even greater impact • Response • Development of securitized insurance products

  3. 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

  4. 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

  5. Securitization Process • Participants • Borrower • Loan originator • Special purpose trust • Underwriter • Investors • Some of the Benefits • Liquidity • Market values • Lower cost • Improved credit rating

  6. Evolution of the Insurance Industry “Affronts” to Traditional Insurance • Self-insurance and captives • Risk retention groups • Insurance securitization • Portfolio insurance

  7. 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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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

  14. Risk Exchanges and Swaps • CATEX New York • Electronic bulletin board • Catastrophe exposure swaps • CATEX Bermuda • Joint venture: CATEX and Bermuda Stock Exchange • Swaps

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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

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

  22. 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

  23. 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?

  24. 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

  25. 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

  26. 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

  27. Personal Info • Web page: http://www.math.uiuc.edu/~gorvett • E-mail: gorvett@uiuc.edu

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