Derivatives in the Insurance Market

1. Derivatives in the Insurance Market Stephen P. D’Arcy Professor of Finance University of Illinois http://www.cba.uiuc.edu/~s-darcy/ First Annual OFOR Symposium May 16, 2002

2. Overview • Use of derivatives by insurers • Securitization of insurance risk

3. Use of Derivatives by InsurersBased on Cummins, Phillips, and SmithNorth American Actuarial Journal January 1997 • 1994 annual statements filed with NAIC • 1,760 life insurers and 2,707 P-L insurers • Schedule DB Derivative Instruments • Categories of derivatives included: • Options, caps, and floors owned • Options, caps, and floors written • Collars, swaps, and forward agreements • Futures contracts

4. Results • 12% of life insurers and 7% of P-L insurers used derivatives sometime during the year • Stock insurers use derivatives more • Life insurers: 16% of stock companies, 7% of mutuals • P-L insurers: 10% of stock companies, 4% of mutuals • Larger companies used derivatives more • For largest size quartile, 34% of life and 21% of P-L insurers used derivatives

5. Results (p.2) • Life insurers used derivatives to manage interest rate risk • Caps/floors • Interest rate swaps • Options and/or futures positions on bonds • P-L insurers have a higher percentage of assets in equities • Use of equity options, both calls and puts • P-L insurers used FX forwards

6. Conclusion • Most insurers did not use derivatives as of 1994 • Even for those that did use derivatives, the volume was low • For users, average notional value of open positions • $661 million for life insurers • $90 million for property-liability insurers

7. Why Don’t Insurers Use Derivatives More? • Unfamiliarity with derivatives • Conservatism • Derivative horror stories • Regulatory resistance • Lack of focus on financial risk management

8. Securitization of Insurance Risk • Exchange Traded Derivatives • Contingent Capital • Risk Capital • Recent insurance derivatives

9. Exchange Traded Derivatives • First proposed by Goshay and Sandor – 1973 • CBOT Catastrophe futures and options – 1992 • Underlying: small sample of companies reported paid losses • CBOT PCS Catastrophe Insurance Options – 1995 • Underlying: estimate of industry wide incurred losses • Bermuda Commodities Exchange Catastrophe Options • Binary options • Trigger: Guy Carpenter Catastrophe Index

10. Status of Exchange Traded Derivatives • Trading volume was very low • Large bid-ask spreads • There is currently no viable market for exchange traded derivatives

11. Contingent Capital • Line of credit • Contingent surplus note • Cat-Equity-Put • Insurer contracts with counterparty to purchase put options • Options can only be exercised in the event of a catastrophe • Minimum post catastrophe net worth requirement • Warranties on reinsurance, management control, etc. • Exposure period 1-10 years • Annual premiums • Buyback provisions

12. Risk CapitalCatastrophe Bonds Typical case - pre-funded, fully collateralized Provides insurers with additional capital and multiyear coverage for catastrophes Provides investors with diversification and high yields Investors include: Mutual funds Hedge funds Reinsurers Life insurers Money managers

13. Examples of Catastrophe Bonds • USAA – 1997 • East coast hurricane • Swiss Re – 1997 • California earthquake • Munich Re – 2001 • Hurricane, earthquake and European windstorm • Syndicate 33 of Lloyd’s of London – 2002 • St. Agatha Re

14. Recent Insurance Derivatives • Catastrophe risk swap • Swiss Re and Tokio Marine and Fire – 2001 • Japan earthquake for California earthquake • Japan typhoon for Florida hurricane • Japan typhoon for France storm • Earthquake derivative • Munich Re and Berkshire Hathaway – 2001 • Earthquakes affecting World Cup Soccer • Parametric trigger

15. Future of Securitization • Major insurers and reinsurers will expand use • Markets will grow with increased availability • Additional sources of risk could be covered • Trend will drive insurers to additional financial risk management