Securitization and Other Instruments for Transferring Risk to the Capital Markets

1. Securitization and Other Instruments for Transferring Risk to the Capital Markets Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D. Actuarial Science Program University of Illinois at Urbana-Champaign Washington, DC July, 2003

2. Agenda • Historical background of securitization • Definition and evolution of insurance securitization • Types of securitized insurance instruments • Recent activity • Issues for the future

3. Terminology and Tools • Financial terminology • We need to learn to quack before we can be a duck • Financial practitioners say things like “BB undefeased subordinated debenture at 6mLIBOR+350bps” • Financial tools • Financial practitioners use tools with names like “options,” “swaps,” “swaptions”

4. Securitization inHistorical Perspective • Home mortgage market: funding shortfall in the late 1970s • Market response: • Change tax laws: no double taxation on cash flow pass-throughs • Modernized investment technology • FNMA, Freddie Mac • Other asset-backed securities developed subsequently • Auto loans • Credit card receivables • David Bowie albums

5. The Securitization Process • Participants • Demanders of funds • Homeowner / borrower of funds • Bank / Loan originator • Special purpose entity / trust • Suppliers of funds • Underwriter / investment bank • Capital markets / investors • Some of the Benefits • Liquidity • Market values • Lower cost

6. Mortgage-Backed Securities (MBSs) • Originated in response to mortgage funding shortfall • Mortgages are “securitized” by packaging mortgage loans and selling the cash flows as securities • The mortgage-backed securities represent ownership in the mortgages • Mortgages generally have an embedded option: to prepay the mortgage (in event of interest rates falling, mortgage-holder moving, etc.)

7. Mortgage-Backed Securities (cont.) • Investors receive the monthly mortgage payments (principal and/or interest) paid by the mortgage borrowers • With MBSs, the prepayment risk is transferred to the capital market investors • Investors are compensated for this risk by sufficiently high yields on the securities

8. 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

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

10. 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

11. 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

12. 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

13. What to Securitize? • Homeowners? Auto? Health? • “Homeowners is not a problem for the insurance industry. Auto is not a problem for the insurance industry. We know how to manage those risks…. How about catastrophes?” - Dennis Chookaszian (a 1992 comment, quoted in Best’s Review, 4/99)

14. 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

15. 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

16. Risk Exchanges and Swaps • CATEX New York • Electronic bulletin board • Intermediary • CATEX Bermuda • Joint venture: CATEX and Bermuda Stock Exchange • Swaps

17. Some Early 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

18. Early Successes • USAA / Residential Re • Size: $477M, in two tranches • Trigger: hurricane losses to company • Coverage: 80% of $500M x/s $1B co. loss • A-1: rated AAA • $163.8M, of which $77M placed in a defeasance account to fund principal repayment • Only interest at risk • Coupon: LIBOR + 282 bps • A-2: rated BB • $313.2M • Both principal and interest at risk • Coupon: LIBOR + 575 bps

19. Early Successes (cont.) • Swiss Re • Size: $137M, in three classes • Trigger: losses to industry from CA E/Q; industry insured loss, from a single event, greater than $18.5B triggers principal write-downs • 40% of Class A proceeds to defeasance account • Coupon: • A-1: LIBOR + 255 bps • A-2: 8.645% • B: 10.493% • C: 12%

20. Early Successes (cont.) • Tokio / Parametric Re • Size: $100M, in two tranches • Trigger: Tokyo earthquake magnitude; a Japanese Meteorological Association magnitude rating of 7.1 or more involves loss of part or all of principal • Half of $20M proceeds from A and all of $80M proceeds from B are risk capital • Ten-year term • Coupon: • A: LIBOR + 206 bps • B: LIBOR + 430 bps

21. Early Successes (cont.) • Centre / Trinity Re • Size: $84M, in two tranches • Trigger: FL hurricane losses to company • Class A-1 notes ($22M in proceeds) provide for full principal repayment in event of a loss • Coupon: • A-1: LIBOR + 182 bps • A-2: LIBOR + 436 bps

22. Early Successes (cont.) • Yasuda Fire and Marine • Typhoon losses • $80 million offering • 5-7 years • Attachment point recalculated every year with exposure model -- constant 0.94% chance of loss to investors • Guaranteed limits and pricing for a second event

23. Generally Common Traits of Early Successful Issues • Involve catastrophe risk • High levels of protection • Relatively short maturities • Some protection of principal included • High coupon rates Trend is now toward longer (e.g., 3-year versus annual) Associated with “newness”

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

25. 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

26. Very Recent Activity • Approximately $1.22 billion issued in the 2002 cat bond market • Versus $1.14 billion in 2000 • Notable transactions: • USAA / Residential Re: Sixth consecutive year • Vivendi / Studio Re: First direct-corporate issue on US peril • Several catastrophe bond investment funds

27. Issues Regarding the Potential “Success” of Insurance Securitization • Need to understand two markets • Capital markets • Insurance markets • Separation of insurance and finance functions in many companies • Information and technology • Pricing challenges • Cost (vs. cat. reinsurance market) • Legal / tax / accounting issues