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Financial Risk Products: Case Study Perspective. Discussion Topics. Insurance Linked Securities Case Study I - Hypothetical ILS Transaction Case Study II - Basis Risk Transaction. 4. 2. 1. 3. Investment Earnings. Cash Proceeds. Reinsurance Premium. Principal & Interest. - PowerPoint PPT Presentation
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1
Financial Risk Products: Case Study Perspective
Swiss Re Capital Markets 2
Discussion Topics
• Insurance Linked Securities
• Case Study I - Hypothetical ILS Transaction
• Case Study II - Basis Risk Transaction
Swiss Re Capital Markets 3
Securitization - Overview
SPVRe-insurer Investors
Investments
Swiss ReFinancialProducts
Principal& Interest
Cash Proceeds
ReinsurancePremium
ContingentClaim Payment
Cash Proceeds
InvestmentEarnings
ScheduledInterest
InvestmentEarnings
1 2
3
4
Swiss Re Capital Markets 4
Swiss Re Swiss Re Financial Products
Investors
Swap Transaction based on notional amount
Floating RateAmounts
Re-insurer
ContingentClaim Payment
ReinsurancePremium
Fixed Amounts
Floating RateAmounts
Fixed Amounts
Swap - Overview
1
2 3
Swiss Re Capital Markets 5
Case Study I - Overview
• Understanding of situation
• Risk mapping
• Exposure
• Structuring issues
• Delivery mechanism
Elements of a Capital Market solution
Swiss Re Capital Markets 6
Case Study I: Risk Source
Earthquake (EQ) risks in California
Source:United States Geological Survey, National Earthquake Information Center, www.neic.cr.usgs.gov
Swiss Re Capital Markets 7
Case Study I - Situation Analysis
• ABC is global leader in the microchip industry
• Its factory is based in Palo Alto, California
• California is highly exposed to EQ risks
• Therefore, ABC seeks for protection against a potential profit drop resulting from a devastating EQ harming its microchip production
• Because of the current market conditions there is no cover available on the traditional insurance market; ABC approaches you to propose a Capital Market solution
Swiss Re Capital Markets 8
Magnitude (M)• Measurement of energy release
• Richter Scale (and others)
• M max: ~8.5
• Damage: M>=5.0
Intensity (MMI)
• Observation of effects
• Modified Mercalli Scale - MMI (and others)
• MMI 12 degrees: I to XII
• Damage: MMI >=VI
Case Study I - Risk mapping, definition of EQ
MMI = Modified Mercalli Shaking Intensity, average soil conditionsSource: Swiss Re Reinsurance & Risk, RN/CP, SNAP EQ
focus (hypocenter)
epicenterFault plane
Intensity map
Swiss Re Capital Markets 9
Case Study I - Exposure
20002200
2400
3000
3500
4000
2850
400 450600
10001200
1500
850
0
1000
2000
3000
4000
1995 1996 1997 1998(E) 1999(E) 2000(E) Average
TurnoverNet profit
In USD m
Source: Annual Reports
Swiss Re Capital Markets 10
Case Study I - Risk mapping, return periods p.a.
0%
10%
20%
30%
40%
50%
60%
$billions of Insured Loss
Prob
abili
ty
Swiss Re Capital Markets 11
Case Study I - Structuring issues
• Issuer’s Needs vs. Investor’s Demand
• Loss Basis
• Risk Profile
• Triggering Event
• Coverage Period
• Other Structuring Considerations
Swiss Re Capital Markets 12
Case Study I - Delivery mechanism
• Structured Note
– Onshore vs. Offshore Issuer
– Defeased vs. Non-defeased
– Fixed vs. Floating Rate
– Public vs. Private
– Single vs. Multiple Traches
• Derivative Instrument
– Swap vs. Option
– ISDA regs
– Targeted Buyers
13
Case Study II
Basis Risk Swap Transactions
Swiss Re Capital Markets 14
Basis Risk Transaction
• Exchange of cash flows based on two variable indices
– Amount you pay and receive will change according to the movements in two separate indices
• Basis Swaps
– Common capital markets instrument
• Capital Markets Indices
– London Interbank Offer Rate (LIBOR)
– Commercial Paper (CP)
– F/X rates
– S&P 500
– Etc.
Swiss Re Capital Markets 15
Example: LIBOR versus CP
5.40%
5.60%
5.80%
6.00%
6.20%
6.40%
6.60%
6.80%
Year 1 Year 2 Year 3 Year 4 Year 5
LIBOR
CP
• Domestic interest rates tend to move in the same direction
• However, the difference between different interest rates will vary over time
Swiss Re Capital Markets 16
Example: LIBOR versus CP
• Company A issues commercial paper and invests in floating rate notes at L + 50bps
• Company A does not wish to take the risk that CP rates will increase faster than LIBOR or decrease slower than LIBOR
• Company A approaches Swiss Re Financial Products (SRFP) and enters into a basis swap
• Company A pays LIBOR to SRFP
• SRFP pays CP + 10 to Company A
• Company A locks in 60 bps spread
Swiss Re Capital Markets 17
Example: LIBOR versus CP
Company A
Receives from FRN: LIBOR + 50
Pays to SRFP: LIBOR
Net: + 50
Receives from SRFP: CP + 10
Pays to investors: CP
Net + 10
Total + 60
SRFPCompany A
FloatingRate Notes
LIBOR + 50
CommercialPaper
LIBOR
CP + 10
Swiss Re Capital Markets 18
Basis Risk Transactions in Insurance
• Potential Loss Tiggers in Re/Insurance Markets
– Actual losses
– Industry Losses
– Loss ratios
– Losses on different perils
• Value of Basis Swap Transactions
– To hedge a position already taken (reduce risk profile)
– To arbitrage a market inefficiency (get cheaper overall pricing)
– To be an innovator
– To speculate
Swiss Re Capital Markets 19
Basis Transaction #1
SRNMCorporate/
Insurer/Reinsurer
BasisTransaction
IndexedProtection
OutsideSource
• Client gets indexed cover from outside source
• Client enters into basis transaction with SRNM
– Client pays to SRNM any recoveries made on indexed cover
– SRNM pays client for actual losses incurred
Swiss Re Capital Markets 20
Basis Transaction #2
Corporate/Insurer/
Reinsurer
Indexed Reinsuranceor Security
or Swapor Option
InvestorsIndemnityAgreement
SRNMBasis Risk
• Client gets indemnity cover from SRNM
• SRNM issues indexed paper to the market
– SRNM keeps the basis risk
Swiss Re Capital Markets 21
Basis Transaction #3
• Client receives return on a portion of SRNM’s California earthquake book of business
• SRNM receives return on a portion of Client’s Japan earthquake book of business
– SRNM may or may not enter into a transaction to hedge itself
• Client’s overall book of business is better diversified
Corporate/Insurer/
Reinsurer
Indexed Reinsuranceor Security
or Swapor Option Outside
SourceSRNMBasis Risk
PortfolioSwap
Japan quake
Cal. quake
Swiss Re Capital Markets 22
Basis Swap Example
• A XYZ Reinsurer is attempting to get windstorm coverage for Florida, Texas, and the East Coast
– XYZ Re wants to pay 7%
– No offers
• XYZ Re approaches SRNM for alternative solutions
• SRNM analyses XYZ Re’s book of business and determines the level of industry losses equivalent to the layer XYZ Re wants reinsured
• XYZ Re purchases ILW for 6% from an insurer / CM investor(s) and enters into basis transaction with Swiss Re for 1%
Swiss Re Capital Markets 23
Basis Swap Example (cont.)
• Basis risk transaction
– XYZ Re pays claims to Swiss Re based on industry losses
• Any claims XYZ Re must pay to Swiss Re it will receive from Insurer as part of ILW
– Swiss Re pays claims to XYZ Re based on losses on XYZ Re’s reinsurance book
– If Windstorm occurs and industry losses are large relative to XYZ Re’s book, Swiss Re receives payment
– If XYZ Re’s losses are large relative to the industry, Swiss Re makes a payment
Swiss Re Capital Markets 24
Basis Swap Structure
XYZ Re
Receives from Ins. / Investor:Industry Losses
Pays industry losses to SR:Industry Losses
Receives payment from SR:Actual Losses
Net: Actual Losses
XYZ ReInsurer /Investor
Basis Risk - Sell Reinsurance
Buy ILW
Texas to MaineILW Swiss Re
Basis Risk
XYZ Re Swiss Re10 mm ILW
Reinsurance20 million - 50% QS