Gerling Global Financial Products Pricing Structured Finance, Project Finance and Credit Enhancement Paul R. Hussian, FCAS Seminar on Reinsurance June 15, 2000

Gerling Global Financial Products Transaction Examples Trade Receivables Debt pools: Bonds (CBO), Bank Loans (CLO) Entertainment: Film Receivables Real estate finance: Commercial and residential mortgages (MBS)...

Gerling Global Financial Products Corporate Debt Ratings

Gerling Global Financial Products Structure Structure 1Structure 2

Gerling Global Financial Products Two Pricing Perspectives Actuarial/Insurance –premium Capital Markets –yield spread: over Treasuries/LIBOR

Gerling Global Financial Products Actuarial/Insurance Pricing Identify assets/cash flows Identify risk(s) Gather data Build cash flow model Run cash flows through deal structure Determine Premium, Profit, ROE

Gerling Global Financial Products Assets / Cash Flows ReceivablesCollection cycle CBO/CLOPools of debt (bonds, bank loans) EntertainmentFilm receipts Real estateCommercial/residential property

Gerling Global Financial Products Risks (Quantitative) Receivables Credit defaults, price/volume CBO/CLOBond/loan defaults, interest rates EntertainmentFilm performance Real estateProperty value, rent income All transactionsCorrelation to economy

Gerling Global Financial Products Data Sources CommoditiesCommodities futures exchange, Bloomberg, company CBO/CLOMoody’s, S&P, sponsoring bank/company EntertainmentMPAA, company Real estateCompany, FHA, FDIC, private industry study All transactionsOffering Memorandum

Gerling Global Financial Products Cash Flow Modeling – Common Challenges Company’s business model / economics of industry Stochastic modeling / simulation –mean, standard deviation, distribution of key variable(s) Scenario testing –stress tests; where is deal’s “break point”? –effect of recession Correlations –between variables –between assets/cash flows –to economy (cyclical, counter-cyclical, recession-proof)

Gerling Global Financial Products Receivables - Cash Flows Credit defaults on receivables –historical ratio: defaults  receivables –strength of obligors Price/volume of commodity being produced –range of price fluctuation –effect of recession on price, volume –obligor concentration risk

Gerling Global Financial Products Sample Receivables Loss Data Historically 3%, stable Historically 3%, volatile Increasing Loss Trend

Gerling Global Financial Products Receivables – Sample Average Monthly Price Data (Heavy Crude Oil)

Gerling Global Financial Products CBO/CLO – Cash Flows (Default Rates) Default Rate (frequency) = % of bonds/loans defaulting –Annual, multi-year Moody’s/S&P credit ratings of bonds/loans in portfolio (Aaa, Aa1, …) Correlation between bonds/loans –Diversity Score: translate portfolio into homogeneous, independent debt securities Binomial distribution

Gerling Global Financial Products CBO/CLO – Cash Flows (Severity) Severity = 1 - Recovery Rate Recovery Rate= post-default market value  par value Moody’s/S&P credit ratings of portfolio notes (Aaa, Aa1, …) Normal, Lognormal distribution Correlation between frequency, severity Loss rate = Default rate x Severity

Gerling Global Financial Products One-Year Default Rates by Year and Rating

Gerling Global Financial Products Average Cumulative Default Rates by Rating

Gerling Global Financial Products CBO/CLO – Historical Recovery Rates

Gerling Global Financial Products CBO/CLO – Moody’s Diversity Score Avg default rate = p, Diversity score = n, Recovery rate = r –p = weighted avg of individual bond default rates n selected to equate loss variance Decreasing n  increasing volatility & correlation –binomial C.V. = –n depends on industry concentration S&P method: increase p with industry concentration, assume independence

Gerling Global Financial Products CBO/CLO - Example

Gerling Global Financial Products Entertainment – Cash Flows (Film Co.) Coverage ratio = film revenue  production cost –mean –standard deviation Box office, licensing, pay-per-view, international Film revenue stream Correlation between films

Gerling Global Financial Products Real Estate – Cash Flows Occupancy rates Average rents Capital structure (debt, equity) Property value –cash flow discount rate Mortgages unrated, use industry data (FHA, FDIC) Strong correlation to economy

Gerling Global Financial Products Modeling Deal Structure Tranched (layered) vs Syndicated (pari passu) securities Cash flow waterfall Equity, subordination structure Early amortization triggers Indemnification provisions Floating rates Impact on insurer’s profit & risk

Gerling Global Financial Products Capital Markets Pricing Premium vs. yield spread between unwrapped notes and insurer credit rating Insurance vs. levered investment in unwrapped securities (insurer = investor)

Gerling Global Financial Products Current Spreads Over Treasuries (Financials)

Gerling Global Financial Products Example  5-yr bond:par value = $100M insurer rating = Aa1145 b.p. over T unwrapped notes = Ba3 415 b.p. over T insurer premium = (415 – 145) b.p. x $100M = $2.7M/yr present value = $10.1M

Gerling Global Financial Products Example

Gerling Global Financial Products Model Metrics Debt service coverage ratios = cash flow / debt service Balance sheet: equity, debt –% collateralization (value of collateral / full limits loss) –CBO collateral/CBO principal –loan/value (real estate, mortgages) Default probability & Loss rate (principal, interest, premium) – compare to Moody’s ratings Transaction break point Insurer present value profit/(loss) Relative risk/reward of tranches (IRR)

Gerling Global Financial Products CBO Example

Gerling Global Financial Products Model Output