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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
