OFOR Presentation May 2002 - Color

8/14/2019 OFOR Presentation May 2002 - Color

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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



Overview

• Use of derivatives by insurers

• Securitization of insurance risk



Use of Derivatives by InsurersBased on Cummins, Phillips, and Smith

North 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



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



Results (p.2)

•Life insurers used derivatives to manageinterest 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



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



Why Don’t Insurers Use Derivatives More?

• Unfamiliarity with derivatives

• Conservatism

• Derivative horror stories

• Regulatory resistance

• Lack of focus on financial risk management



Securitization of Insurance Risk

• Exchange Traded Derivatives

• Contingent Capital

• Risk Capital

• Recent insurance derivatives



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



Status of Exchange Traded

Derivatives• Trading volume was very low

• Large bid-ask spreads

• There is currently no viable market for

exchange traded derivatives



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



Risk Capital

Catastrophe Bonds

Typical case - pre-funded, fully collateralized

Provides insurers with additional capital and multiyear coverage for catastrophes

Provides investors with diversification and high yieldsInvestors include:

Mutual funds Hedge funds

Reinsurers Life insurers

Money managers



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



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



Documents

OFOR Presentation May 2002 - Color