financial risk products: case study perspective

1

Financial Risk Products: Case Study Perspective

Swiss Re Capital Markets 2

Discussion Topics

• Insurance Linked Securities

• Case Study I - Hypothetical ILS Transaction

• Case Study II - Basis Risk Transaction


Securitization - Overview

SPVRe-insurer Investors

Investments

Swiss ReFinancialProducts

Principal& Interest

Cash Proceeds

ReinsurancePremium

ContingentClaim Payment

Cash Proceeds

InvestmentEarnings

ScheduledInterest

InvestmentEarnings

1 2

3

4


Swiss Re Swiss Re Financial Products

Investors

Swap Transaction based on notional amount

Floating RateAmounts

Re-insurer

ContingentClaim Payment

ReinsurancePremium

Fixed Amounts

Floating RateAmounts

Fixed Amounts

Swap - Overview

1

2 3


Case Study I - Overview

• Understanding of situation

• Risk mapping

• Exposure

• Structuring issues

• Delivery mechanism

Elements of a Capital Market solution


Case Study I: Risk Source

Earthquake (EQ) risks in California

Source:United States Geological Survey, National Earthquake Information Center, www.neic.cr.usgs.gov


Case Study I - Situation Analysis

• ABC is global leader in the microchip industry

• Its factory is based in Palo Alto, California

• California is highly exposed to EQ risks

• Therefore, ABC seeks for protection against a potential profit drop resulting from a devastating EQ harming its microchip production

• Because of the current market conditions there is no cover available on the traditional insurance market; ABC approaches you to propose a Capital Market solution


Magnitude (M)• Measurement of energy release

• Richter Scale (and others)

• M max: ~8.5

• Damage: M>=5.0

Intensity (MMI)

• Observation of effects

• Modified Mercalli Scale - MMI (and others)

• MMI 12 degrees: I to XII

• Damage: MMI >=VI

Case Study I - Risk mapping, definition of EQ

MMI = Modified Mercalli Shaking Intensity, average soil conditionsSource: Swiss Re Reinsurance & Risk, RN/CP, SNAP EQ

focus (hypocenter)

epicenterFault plane

Intensity map


Case Study I - Exposure

20002200

2400

3000

3500

4000

2850

400 450600

10001200

1500

850

0

1000

2000

3000

4000

1995 1996 1997 1998(E) 1999(E) 2000(E) Average

TurnoverNet profit

In USD m

Source: Annual Reports


Case Study I - Risk mapping, return periods p.a.

0%

10%

20%

30%

40%

50%

60%

$billions of Insured Loss

Prob

abili

ty


Case Study I - Structuring issues

• Issuer’s Needs vs. Investor’s Demand

• Loss Basis

• Risk Profile

• Triggering Event

• Coverage Period

• Other Structuring Considerations


Case Study I - Delivery mechanism

• Structured Note

– Onshore vs. Offshore Issuer

– Defeased vs. Non-defeased

– Fixed vs. Floating Rate

– Public vs. Private

– Single vs. Multiple Traches

• Derivative Instrument

– Swap vs. Option

– ISDA regs

– Targeted Buyers

13

Case Study II

Basis Risk Swap Transactions


Basis Risk Transaction

• Exchange of cash flows based on two variable indices

– Amount you pay and receive will change according to the movements in two separate indices

• Basis Swaps

– Common capital markets instrument

• Capital Markets Indices

– London Interbank Offer Rate (LIBOR)

– Commercial Paper (CP)

– F/X rates

– S&P 500

– Etc.


Example: LIBOR versus CP

5.40%

5.60%

5.80%

6.00%

6.20%

6.40%

6.60%

6.80%

Year 1 Year 2 Year 3 Year 4 Year 5

LIBOR

CP

• Domestic interest rates tend to move in the same direction

• However, the difference between different interest rates will vary over time



• Company A issues commercial paper and invests in floating rate notes at L + 50bps

• Company A does not wish to take the risk that CP rates will increase faster than LIBOR or decrease slower than LIBOR

• Company A approaches Swiss Re Financial Products (SRFP) and enters into a basis swap

• Company A pays LIBOR to SRFP

• SRFP pays CP + 10 to Company A

• Company A locks in 60 bps spread



Company A

Receives from FRN: LIBOR + 50

Pays to SRFP: LIBOR

Net: + 50

Receives from SRFP: CP + 10

Pays to investors: CP

Net + 10

Total + 60

SRFPCompany A

FloatingRate Notes

LIBOR + 50

CommercialPaper

LIBOR

CP + 10


Basis Risk Transactions in Insurance

• Potential Loss Tiggers in Re/Insurance Markets

– Actual losses

– Industry Losses

– Loss ratios

– Losses on different perils

• Value of Basis Swap Transactions

– To hedge a position already taken (reduce risk profile)

– To arbitrage a market inefficiency (get cheaper overall pricing)

– To be an innovator

– To speculate


Basis Transaction #1

SRNMCorporate/

Insurer/Reinsurer

BasisTransaction

IndexedProtection

OutsideSource

• Client gets indexed cover from outside source

• Client enters into basis transaction with SRNM

– Client pays to SRNM any recoveries made on indexed cover

– SRNM pays client for actual losses incurred



Corporate/Insurer/

Reinsurer

Indexed Reinsuranceor Security

or Swapor Option

InvestorsIndemnityAgreement

SRNMBasis Risk

• Client gets indemnity cover from SRNM

• SRNM issues indexed paper to the market

– SRNM keeps the basis risk



• Client receives return on a portion of SRNM’s California earthquake book of business

• SRNM receives return on a portion of Client’s Japan earthquake book of business

– SRNM may or may not enter into a transaction to hedge itself

• Client’s overall book of business is better diversified

Corporate/Insurer/

Reinsurer

Indexed Reinsuranceor Security

or Swapor Option Outside

SourceSRNMBasis Risk

PortfolioSwap

Japan quake

Cal. quake


Basis Swap Example

• A XYZ Reinsurer is attempting to get windstorm coverage for Florida, Texas, and the East Coast

– XYZ Re wants to pay 7%

– No offers

• XYZ Re approaches SRNM for alternative solutions

• SRNM analyses XYZ Re’s book of business and determines the level of industry losses equivalent to the layer XYZ Re wants reinsured

• XYZ Re purchases ILW for 6% from an insurer / CM investor(s) and enters into basis transaction with Swiss Re for 1%


Basis Swap Example (cont.)

• Basis risk transaction

– XYZ Re pays claims to Swiss Re based on industry losses

• Any claims XYZ Re must pay to Swiss Re it will receive from Insurer as part of ILW

– Swiss Re pays claims to XYZ Re based on losses on XYZ Re’s reinsurance book

– If Windstorm occurs and industry losses are large relative to XYZ Re’s book, Swiss Re receives payment

– If XYZ Re’s losses are large relative to the industry, Swiss Re makes a payment


Basis Swap Structure

XYZ Re

Receives from Ins. / Investor:Industry Losses

Pays industry losses to SR:Industry Losses

Receives payment from SR:Actual Losses

Net: Actual Losses

XYZ ReInsurer /Investor

Basis Risk - Sell Reinsurance

Buy ILW

Texas to MaineILW Swiss Re

Basis Risk

XYZ Re Swiss Re10 mm ILW

Reinsurance20 million - 50% QS

financial risk products: case study perspective

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