Derivatives in the Insurance Market Stephen P. D’Arcy Professor of Finance University of Illinois First Annual OFOR Symposium May 16, 2002

Overview Use of derivatives by insurers Securitization of insurance risk

Use of Derivatives by Insurers Based on Cummins, Phillips, and Smith North American Actuarial Journal January 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 manage interest 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 yields Investors include: Mutual fundsHedge funds ReinsurersLife 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

Future of Securitization Major insurers and reinsurers will expand use Markets will grow with increased availability Additional sources of risk could be covered Trend will drive insurers to additional financial risk management