S ec uritis e T his

Jon Tindall

Outline1. Background2. Securitisation Markets3. Structuring Securitisations4. Pricing Securitisations5. Lehman Brothers6. AXA Motor Securitisation7. What next?

B ac kground

Market B ac kground• First securitisations early 1970’s in US mortgage markets

» Funding shortfalls in residential mortgage markets.» State backed lenders.

• Government National Mortgage Association (GNMA) “Ginnie Mae” (1970), Freddie Mac (1970), Fannie Mae (1981).

• First Asset Backed Securities (ABS) 1985 – Computer loans• ILS Markets took first big steps after series of catastrophes in early

1990’s»Hurricane Andrew»Northbridge earthquake

What is S ec uritis ation?• Some common features of securitisations:

» The consolidation of cash flows into a single, trade-able asset;

» The transfer of risk between parties.» The creation of a Special Purpose Vehicle (SPV) to act between the parties involved in the transaction.

» A tax-beneficial structure.

Ins uranc e S ec uritis ation• Similar in structure with one major distinction:

Cedant generally remains liable to the policyholder

• Convergence of capital and insurance markets» Financial institutions seeking to diversify risk profiles;» Capacity constraints of traditional insurance markets;» Requirement for an integrated approach to risk and ERM practices.

Why S ec uritis e?• Range of reasons why an Originator would securitise:

» Lower cost of capital» Locking in profits from a block of business» Transferring unwanted risks to wider capital markets

• Increased hedging opportunities• Provides flexibility in new business and M&A activities

AR T vs T raditional R eins uranc e

0

50

100

150

200

250

300

350

400

450

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

RO

L in

dex

Source: Guy Carpenter

• Alternative risk transfer mechanisms become popular after spikes in RI premiums

• Generally follow shortages in global reinsurance capital

• Acts to put downwards pressure on RI premiums

Rate On Line (ROL) index

S ec uritis ation Markets

IL S Markets

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Val

ue

(US

$m)

0

5

10

15

20

25

30

Nu

mb

er o

f T

ran

sact

ion

s

New IssuesOutstanding @ year endnumber

• Market peaked in 2007.

• New issuance dropped by nearly 2/3 post GFC

• 2010 was 2nd

largest new issuance, behind 2007.

Source: Willis Capital Markets ILS Update - Q4 2010

IL S Markets• High issuance in 2010

covering US risks.• Primarily wind coverage,

some earthquake• Australia – no recent

transactions.– Earthquake bonds,

Australis, introduced by Swiss Re in 2006.

Transaction Size Sponsor Perils Trigger Maturity

Johnston Re $305m Munich Re US Wind Indemnity May-13

Lodestone Re $420m National Union Fire US Wind, US Earthquake PCS May-13

Merna Reinsurance $350m State Farm US Earthquake Midwest Indemnity Apr-13

Foundation Re $180m Hartford US Wind PCS Feb-14

Successor $90m Swiss ReUS Wind, Japan Earthquake, Europe Wind Hybrid Apr-13

Green Valley $134m Swiss Re Europe Wind Parametric Jan-12

Blue Fin $150m Allianz US Wind, US Earthquake Modelled Loss May-13

Ibis Re $150m Assurant US Wind PCS Apr-13

R ec apitilis ation

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Andrew September 11th Katrina et al

Shar

e of

New

Cap

ital

Cat Bonds

Sidecars

Start Ups

Recapitilisation

Alternative forms of capital have become increasingly important in the recapitalisation of insurance markets following natural disasters.

Inves tor Mix

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1999 2009

Money ManagersHedge FundsCAT FundsBanksInsurers

• Specialist CAT and hedge funds now dominate.

• Less than 10% now retained within the insurance industry.

S truc turing S ec uritis ations

B as ic S truc ture

Swap Counterparty

CapitalMarketsSPVOriginator

TrustOriginator: The institution providing the securitised assets.

SPV: The vehicle that issues securities to the capital markets and provides coverage to the originator.

Capital Markets: The purchasers of securities offered by the SPV.

Trust: Generally set up as a charitable trust. Provides independence of the SPV.

Swaps: TRS, credit risk, liquidity risk.

C as h F lows – F inanc ial C los e

Swap Counterparty

CapitalMarketsSPVOriginator

Trust

Securitised assets / liability

Deposit / Obligation

Setup Costs

Capital

Securities, bonds, equity

Swap Obligation

Swap fee

• SPV offers securities to capital markets.

• Proceeds held within the SPV and invested via a mandate.

• Deposit / Obligation is provided to the Originator by the SPV

• Swaps are entered into

C as h F lows – Operation

Swap Counterparty

CapitalMarketsSPVOriginator

Trust

Premium

Operating Costs

BBSW + margin%

Fixed rate

Variable rate

• Originator pays ongoing premium to SPV. Sometimes collateralised upfront.

• SPV pays BBSW + margin% in accordance with securities offered.

• Swap arrangements – hedging, liquidity payments.

• SPV generally pays for operation of the structure.

C as h F lows – Maturity

Swap Counterparty

CapitalMarketsSPVOriginator

Trust

Trigger payment

Principal

Break fee

• If not triggered – SPV returns the principal to note holders.

• If trigger event then payment made to Originator based on payment mechanism.

• Trigger event may or may not cause maturity

• Swap and liquidity account break fees are paid depending on term to maturity.

T rigger T ypes• The trigger defines the payment mechanism for the securitisation

transaction.• The type of trigger determines where the structure sits on the basis-

risk / moral-hazard spectrum.» Matching the payout of the derivative to the incurred losses» Moral hazard can increase at claims approach attachment level

• Multiple peril triggers are popular – especially post GFC

T rigger T ypes• Types of common triggers:

» Indemnity: Based on the actual losses incurred by the insurer. Contains no basis risk but high moral risk.

» Modelled Loss: Combination of indemnity and parametric triggers. Insurers exposure + Loss model maintained by 3rd

party.» Industry Loss: Based on total loss to the industry.» Parametric: Payments based on reference to some index. Eliminates moral risk but contains the largest basis risk.

S truc tural E nhanc ements• Subordination: SPV issues a variety of securities of varying credit qualities

via a series of ‘tranches’. • Spread accounts: more recent transactions use credit derivatives to

achieve this and to transfer the credit exposure to wider capital markets.• Collateralised accounts: Feature of most insurance transactions.

Percentage (often 100%) of the outstanding liability is collateralised in cash (or equivalent) within the SPV.

• Over collateralisation: Placing more capital in the SPV than is required to back the liabilities.

• Liquidity account: Added to provide security around the timely payment of dividends.

‘T ranc hing’• ‘Tranching’ of liabilities allows different quality securities to be issued.

Margins can range from +20bps to over +800bps

• Senior debt generally have largest volumes

• Equity tranche – often purchased by the sponsor

Tranche C

Tranche B

Tranche A

Debt

AAA+$250m

Equity

SPV Funding

AA$80m

BB+$40m

Preference Shares$10m

P ric ing and R is k Management Applic ations

P ric ing S ec uritis ationsPricing of the offered securities:

The spread can be broken into:

• Credit risk priced via traditional means.• Default risk is the risk due to the securitised asset / liability – i.e. the

catastrophe in a CAT bond. Determined by integrated CAT models.

%Spread%BBSW%Coupon +=

%inProfitMarg%DefautRisk%CreditRisk%Spread ++=

P ric ing S ec uritis ations• Ultimate Loss:

Major drawback is that effective maturity can be very early on. No further upside possible

• Periodic Loss:

Loss of principal in one period doesn’t affect subsequent periods

∑=

−=N

i

rti eXS

1

)(.

tt

tttt P

Ll

,1

,1,1

−

−− =

L ehman’s Impac t

$20

$30

$40

$50

$60

$70

$80

$90

$100

$110

30-Aug 14-Sep 29-Sep 14-Oct 29-Oct 13-Nov

Mar

ket V

alue

Ajax

Carillion A-1

New ton Re 2008

Willow Re

• Lehman Brothers was the counterparty in 4 Total Return Swaps (TRS) for CAT bond at the time of their collapse

• Returns to note holders could no longer be guaranteed

QL D F loods• Massive uninsured infrastructure losses.• Who should pay for these costs? Flood levy? QLD?

Australia? • Or offload the risk to broader capital markets

» Independent MP, Nick Xenophon» Swiss Re – call for use of CAT bonds

J apan E arthquake

Issue Size (US$) Sponsor TriggerMontana Re $250m Flagstone Re ParametricVega $106m Swiss Re ParametricAtlas Capital VI $50m SCOR ParametricSuccessor X $120m Swiss Re ParametricAtlas Capital VI $50m SCOR ParametricTopiary Capital $200m Platinum Underwriters ParametricVega $150m Swiss Re Modelled LossValais Re $104m Flagstone Re IndemnityMuteki $300m Munich Re ParametricMidori $260m Munich Re Parametric

• Exposures to the earthquake are still being evaluated.

Insured losses ~ US$35 billion

Total cost ~ US$310 billion

• A range of CAT bonds involved.• Several triggers will be breachedMontana ReTopiary Capital

QL D F loods• Massive uninsured infrastructure losses.• Who should pay for these costs? Flood levy? QLD?

Australia? • Or offload the risk to broader capital markets

» Independent MP, Nick Xenophon» Swiss Re – call for use of CAT bonds

AXA Motor S ec uritis ation

First Securitisation of a retail GI portfolio• €200m of bonds issued in 2006

» Approximately 3 million French vehicles.» Around €1 billion in premiums

• €475m in 2007.

AXA Motor S ec uritis ation

Class A - AAA€91.5m

Class B - A€220.0m

Class C – BBB-€100.1m

Equity - €24.2 AXA

Capital Markets

Loss ratio

Class D - BB€39.2m

72.5%69.0% 74.3% 78.9% 89.0% 93.2%

Pro

babi

lity

Equity Class AClass CClass D Class B

AXA Motor S ec uritis ation

• We don’t know what the equity attachment level was in first issue, x%

• Class C notes rated BBB which is around a one in 200 year event.

Raises a few questions:» So how muck risk was actually being transferred?» Would AXA have sought traditional reinsurance coverage this far in the tail?

AXA Motor S ec uritis ation

• Benefits to AXA include:» Attractive pricing (15, 37, 59 bps over EURIBOR)» Elimination of credit risk from the protection» Pricing pressure on traditional reinsurance providers

• Benefits to investors:» A wide range of securities in terms of risk/return profile.

» An asset with very low correlation to other securities

Where to from here?• Market is bouncing back from post GFC

» Structural enhancements» Increased transparency

• 2010 second largest new issuance for ILS• Significant opportunities in Australia given exposure to natural

perils» Flood, Earthquake, Cyclone, Terrorism

• Securitisation of non-cat risks

T hankyou

J on T indall

jon.tindall@ finity.c om.au