The Rationale for the Securitization of Insurance Risk

Presented by

Richard D. PhillipsBruce A. Palmer Professor of Risk Management and Insurance

Georgia State University

Presented to

Annual Congress of ActuariesJune 21, 2007Paris France

Outline

• Introduction to Securitization

• Discuss the Drivers of Demand for Securitization• Market and regulatory factors• A changing business model

• Quick Update of Current Market Conditions

Introduction

• Securitization - a mechanism whereby contingent and deterministically scheduled cash flow streams arising out of a transaction are unbundled and traded as separate financial instruments that appeal to different classes of investors.

• Important elements• Cash flows traditionally were held on balance sheet or earned/paid over

time• Cash flows are predictable and/or can be modeled• Assets and risk are usually transferred between parties• Assets associated with the transaction must be bankruptcy remote

• Accomplished using Special Purpose Entities (SPE’s) • “brain dead”

Simple Example

• Option 1 – Firm wants to purchase an asset• Borrow money from the bank

• Book loan as liability on balance sheet• Repay principal and interest over time• Claim interest expense for tax purposes

• Purchase asset• Book asset on balance sheet• Depreciate asset over working lifetime • Face risk asset loses or gains value over time

Securitization Option

• Option 2 – Synthetic Lease• Firm establishes bankruptcy remote SPE

• SPE raises funds from investors and purchases asset• SPE leases asset to the firm in return for lease payments• SPE can borrow funds at lower rates than the firm – why?

• At the end of the lease, firm can decide to • Renew the lease• Purchase property for pre-determined price, or• Force the SPE to sell the property

• Advantages• Firms faces risk of loss or gain at the time of sale so firm is considered “virtual

owner”• Firm claims depreciation and interest expenses for tax purposes

• As long as lease payments are less than some threshold values of the asset fair value, there is no asset (and therefore liability) on the balance sheet for accounting purposes.

Sources of Demand for Securitization

• Efficient Demand• Demand that would exist in the absence of serious market

imperfections

• Inefficient demand• Driven by “RRATs” – Regulatory, Rating agency, Accounting and

Tax factors

Why Securitization Creates Value GenerallyEfficient Demand

• Lower cost of funds

• Source of liquidity

• Diversify funding sources

• Off-balance sheet assets and liabilities

• Accelerate earnings

Why Securitization Creates Value for InsurersEfficient Demand

• Traditionally, investing in insurance risks was possible primarily by buying insurer stocks• But what drives insurer stocks?

• Underwriting risks (mortality, accident rates)• Investment risks• Regulatory risks• Agency costs and mismanagement risks

• Securitization creates value by creating “pure play” or primitive securities that are removed from the usual firm-wide risks facing insurers• Enable investors to improve portfolio efficiency • To the extent transparency is achieved, costs of

informational asymmetries are reduced• Pure costs of securitized risk transfer may be

• Less than cost of capital of an insurer• Less than cost of traditional hedging & financing mechanisms such as

reinsurance

“RATs” Demand for New Instruments

• Tax motives • Minimization of taxes due to convexity of tax schedules and

“loop-holes”

• Regulatory motives • Compliance with regulatory rules such as risk-based capital• Accounting motives

• E.g., securitizing deferred acquisition expenses • Improve regulatory balance sheet• Achieve higher financial ratings

• “Cleansing” financial statements prior to entering the mergers & acquisitions market

Changing Business ModelsWarehousing vs. Intermediation

• Traditional roles• Investment banking – intermediaries

• Insurance/reinsurance – risk warehousers

Traditional Insurer ModelRisk-Warehousing and Risk-Bearing

Risk Warehouse

Retain Liabilities

Risk-BearingEquity Capital

Hedging Firms

and PH’s

Premium

Contingent Payoff

Capital Market

Capital

Dividends

Reinsurer Premium

Contingent Payment

Why Risk Warehouses Developed

• Insurance is characterized by informational asymmetries • Insurer is “opaque”

• Debt claimant cannot judge overall risk exposure, reserve adequacy, etc.• Opaqueness is partially mitigated if insurer holds equity & diversifies over

a wide range of risks• Reduces income volatility and solvency risk, but also• Helps assure debt claimants that probability of bad outcomes has been

minimized• Requires insurer to keep risks on balance-sheet

• Opacity and market experience generate private information for the (re)insurer

• E.g., ability to estimate insurance claims distributions• Information on portfolios and underwriting quality of specific clients (what did

we call this?)• Opacity creates “economic rents”

Investment Bank ModelRisk Intermediation

Risk Intermediary:

(Investment Bank)

Hedge Premium

Contingent Hedge Payoff

Owners

Capital/ Expertise

Compensation

Equity Capital

Capital Market

Risk-BearingContingent

Payment

Risk Premium

Hedging Firms

Combining the Intermediary and Warehouse Model

WarehouseRetain Liabilities

Risk-BearingEquity Capital

Hedging Firms

and PH’s

Premium

Contingent Payoff

Capital Market

Capital

Dividends

Reinsurer Premium

Contingent Payment

IntermediarySecuritize Liabilities

Capital Market

RiskPremium

Contingent Payment

Evolving Towards Securitization

• Securitization forces the firm to identify where the value chain creates the most value• Occurs when reduced financing or hedging costs more than offset the loss

of economic rents from reducing opacity• Securitization leverages the insurers/reinsurer’s information advantage –

but for who?• Insurer/Reinsurer’s new role

• Originate pools of risks• Underwrite to create viable tranches• Repackage for sale in securities markets

• Increased recognition equity capital is costly BEYOND systematic risk costs• Improvements in capital allocation methods• Solvency II

ILS Prices Declining Over Time(At least they were)

Source: Lane (2006)

0%

2%

4%

6%

8%

10%

12%

14%

Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06

Quarter

Perc

ent

0

1

2

3

4

5

6

7

8

Yiel

d/Ex

pect

ed L

oss

Expected LossYieldYield/Expected Loss

Catastrophe Bond Issues: 1996 – 2006*

Catastrophe Bonds Outstanding

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

$ M

illio

ns

Outstanding 306 305 804 1,454 1,853 2,204 3245 3285 4275New Issue 725 825 1,122 967 990 2,132 1143 2138 4259

1998 1999 2000 2001 2002 2003 2004 2005 2006*

* - Through November 2006Source: Goldman Sachs (2006) and Swiss Re (2006).

Perils Securitized

Japan Wind, 2%

U.S. Wind, 25%

Europe Wind, 7%

California EQ, 15%Central US

EQ, 2%

Other EQ, 13%

Multiperil, 36%

Total: $14 billion

2004* (USD 4 billion market

)

1999 (USD 1 billion

market)

Primary Insurer30%

Money Manager

30%

Dedicated Cat Fund5%

Reinsurer25%

Hedge Fund5%

Bank5%

Primary Insurer

3%

Money Manager

40%

Dedicated Cat Fund33%

Reinsurer4%

Hedge Fund16%

Bank4%

Who buys these bonds?

Bill DubinskyAugust 2004ARIA Annual Meeting*As of July 23 2004

• The Dedicated Cat Fund segment has increased from 5% to 33%• The Money Manager segment has increased from 30% to 40%

Design Consideration: The Triggering Event

• Examples of Trigger• Indemnity trigger

• Loss experience of one insurer• Modeled Loss• Industry trigger

• Industry loss warranties• The PCS call options traded on

the CBOT • Parametric index

• Pure index• Magnitude of earthquake• Windspeed of hurricane

• Multiple parameters• Payoff is a function of various

transparent parameters

Indemnity

Basis Risk to SponsorTr

ansp

aren

cy to

Inve

stor

Modeled Loss

Industry Index

Parametric

What Else Can Be Securitized? Life Insurer Balance Sheet

Assets Traded assets Long-term Short-termNon-traded assets Policy acquisition costs Other receivables Other non-traded

Liabilities Policy reserves Life insurance Annuity Premium reserves Equity capital

What Else Can Be Securitized?Life Insurance Cash Flows

• Inflows• Premiums• Annuity considerations• Investment income• Investment sales and maturities• Fee income (e.g., asset

management fees on variable products)

• Outflows• Policy death benefits• Annuity payments• Surrenders (disintermediation)• Expense payments

• Origination costs• Ongoing costs

• Capital expenditures• Taxes

Conclusions

• Vast amounts of assets and liabilities remain “on balance sheet” in the insurance industry

• To realize full potential for securitization• Overcome informational opacities • Develop better indices for index linked products• Reduce regulatory obstacles• Educate insurers and investors

• Tremendous potential to change insurance industry business model

Conclusions II

• Important to reduce costs of informational asymmetries• May require insurers to sacrifice some “private

information”• Asymmetry costs can be mitigated by structuring

• Informationally sensitive tranches that appeal to investors with information advantages

• Informationally insensitive tranches for less well informed investors

• Development of a public market needed to achieve full potential

• Solvency II will further drive demand to “accelerate” the balance sheet