1. Insurance Securitization
Rick Gorvett, FCAS, MAAA, ARM, Ph.D.
Actuarial Science Program
University of Illinois
at Urbana-Champaign
International Association of Consulting Actuaries
Hershey, PA
June 2000

2. Risk and Response Risk Response Recent catastrophes
Resulting insolvencies and financial impairment
Potential for even greater impact
Response
Development of securitized insurance products

3. 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

4. Securitization in Historical 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

5. Securitization Process
Participants
Borrower
Loan originator
Special purpose trust
Underwriter
Investors
Some of the Benefits
Liquidity
Market values
Lower cost
Improved credit rating

6. Evolution of the Insurance Industry
“Affronts” to Traditional Insurance
Self-insurance and captives
Risk retention groups
Insurance securitization
Portfolio insurance

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. Risk Exchanges and Swaps
CATEX New York
Electronic bulletin board
Catastrophe exposure swaps
CATEX Bermuda
Joint venture: CATEX and Bermuda Stock Exchange
Swaps

15. 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

16. 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

17. Types of Catastrophe Bond Risk-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

18. 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

19. 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

20. 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

21. “Costs” of Catastrophe Bonds
High yields
Default premiums may be high for a time
Setting up SPV
Investment banking fees
Advising
Spread
Legal fees

22. Contingent Capital Contingent surplus notes Catastrophe equity puts
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

23. 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?

24. 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

25. 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

26. 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

27. Personal Info Web page: http://www.math.uiuc.edu/~gorvett E-mail: