Risk Securitization 101

2000 CAS Special Interest Seminar

David Na, FCAS, MAAA

Deloitte & Touche, Bermuda

Background

Background

• Merging of Financial and Insurance Markets Travelers + Citicorp = CitiGroup?

• Insurance Industry “Scared” by Events Such as Hurricane Andrew $18 billion? $60-80 billion??

• Recent Activity - New Companies/Transactions Arrow Re (Goldman Sachs) Lehman Re (Lehman Brothers)

Background

• Effects of Natural Catastrophes in Late 80’s & Early 90’s: Decreased Insurance/Reinsurance Capacity

Increased Demand for Reinsurance

Realization of Inadequate Pricing

Increased Awareness re: Insurer’s Exposures

Background

• Comparison of Capitalization of Insurance and Capital Markets...

• Estimated Capital of US P/C Ins. Industry ~ $338 billion

• Size of the Capital Markets Total Capitalization ~ $34 trillion Average Daily Fluctuation ~ $200 billion $100 billion loss ~ 1/3 of 1% of market capital

What is Risk Securitization?

• Packaging/Transferring of insurance underwriting risks to the capital markets through the issuance of a financial security

• 2 Important Aspects:– Transformation of U/W Cash flows into tradable

securities– Transfer of U/W Risk through the trading of those

securities• Investment Return is contingent upon

underwriting experience

Types of Transactions/Triggers

• Indemnified Notes

• Indexed Notes

• Parametric Notes

Indemnified Notes

• Responds Directly to Ceding Company’s Specific Exposures & Actual Losses

• Provides the Most Precise Coverage for Cedant

• Reflects Cedant’s U/W & Claim Settlement Processes

• Long Development Patterns – Investors may need to Wait for Their Return

• Sample Transaction: Alpha Wind

Indexed Notes

• Linked to Industry or Geographic Index (e.g. PCS)

• Cedant Exposed to Significant Basis Risk, if Index is not Consistent with Cedant’s Actual Losses

• Shorter Development Period (Generally Easier to Predict the Index than Individual Company Losses)

• “Synthetic Indemnification” – Mathematical Attempt to Replicate the Cedant’s Underlying Book of Business

• Sample Transaction: Seismic Re.

Parametric Notes

• Linked to Quantities Associated with Pertinent Events – Generally Physical Attributes of an Event: Magnitude, Intensity, & Epicenter of EQ Wind Speed, Forward Velocity, & County of Landfall of

Hurricane

• Removes Risks Associated with Modeling the Ceding Company’s Exposures or Changes in Exposures

• Virtually Eliminates Development Period

• Sample Transaction: Concentric Ltd.

Investor Risks & Returns

• No Standard Approach

• Principal Protection… sometimes

• Various Tranches

• Varying Terms (e.g. Tokio EQ is 10 years)

• Returns based on Risk

Other Examples of Securitization

• Mortgage Backed Securities– Similarly created by excess demand– However, high volume, stable asset was securitized

• Auto Loans & Credit Card Receivables

• David Bowie (offering securitized by future sales of CD’s)

• NFL (offering securitized by $18 billion TV deal)– [subsequently withdrawn]

Perspective

• Think of as any other security...

• It’s all about Risk v. Return...

• Here, the risk happens to be insurance related

Types of Insurance Linked Securities (ILS’s)

Types of ILS’s

• Catastrophe Bonds - Will Discuss in Detail...

• Catastrophe Risk Exchange (CATEX) Swaps

• Insurance Related Derivatives/Options

• Catastrophe Equity Puts (CAT-E-Puts)

• Contingent Surplus Notes

• Weather Derivatives

• CATEX Swaps – NY & Bermuda

– Electronically swap CAT exposures (e.g. geographic location, property type, etc.)

• Insurance Related Derivatives/Options– Chicago Board of Trade Options: Based on

aggregate industry CAT losses (Property Claim Services)

– Bermuda Commodities Exchange CAT Options: Based on Guy Carpenter Catastrophe Index (ratio of losses to housing values)

Types of ILS’s

• Catastrophe Equity Puts (CAT-E-Puts) - Insurer has the option to sell equity (e.g. preferred shares) at pre-determined price, contingent upon a specific event

• Contingent Surplus Notes - Option to borrow contingent upon the occurrence of a specific event (contingent funds held in trust)

• Weather Derivatives - Insurance or derivative contract which pays based on weather related events

Types of ILS’s

Generic ILS Structure

InsurerInsureroror

ReinsurerReinsurer

InsurerInsureroror

ReinsurerReinsurerSPVSPVSPVSPV InvestorsInvestorsInvestorsInvestors

InvestedInvestedProceeds - Proceeds -

Trust AccountTrust Account

InvestedInvestedProceeds - Proceeds -

Trust AccountTrust Account

PortfolioPortfolioReturnReturnLiquidation Liquidation

of Assetsof Assets(Event (Event Contingent)Contingent)

ReimbursementReimbursementPayment Payment (Event (Event Contingent)Contingent)

Loss of ValueLoss of Value(Event (Event Contingent)Contingent)

PremiumPremium

Portfolio Portfolio ReturnReturn

+ Premium+ Premium

Advantages - Investor

• Above average yield relative to other securities (e.g. corporate bonds) of similar risk

• Outstanding diversification effect - Unlike investments in insurance company stocks, CAT events are generally uncorrelated with an investor’s portfolio

• Allows non-insurance investors to participate in insurance related transactions

• Preparation for convergence of Insurance & Banking

Advantages - Issuer

• Capacity - Access the Capital of the Financial Markets

• Greater Flexibility in Terms of Coverage• Reinsurance Protection – Fully Collateralized, No

Credit Risk• More Stable Pricing - Insulated from U/W cycles• High aggregate level risk transfer• Innovation/Prestige - “Cutting Edge”

Issues

• Requires understanding of both Capital and Insurance Markets (Investors as well as Issuers)

• Historical separation of Capital and Insurance Markets (e.g. Regulatory Issues)

• Uncertainty involved in pricing high layer or catastrophic events (Reliance on Modeling)

• Issuer’s Costs (Relative to Purchase of Reinsurance)• Investor’s Return (Relative to Comparably Risky

Securities)• Accounting, Legal, Regulatory, Tax, etc.

The USAA/Residential Re. Transaction

USAA/Residential Re.

• Placed in 1997 (with subsequent renewals)

• Reinsurance coverage of 80% of $500M x $1B

• Covers Category 3, 4, or 5 Hurricanes along the East or Gulf Coasts of the US

• $477 M in bonds issued

• Residential Re. Domiciled in Cayman

USAA/Residential Re.

• Tranche A-1 ($164 M):– AAA rated– Only interest at risk– Coupon paid LIBOR + 2.82%

• Tranche A-2 ($313 M):– BB rated– Principal & Interest at risk– Coupon paid LIBOR + 5.75%

• Investor Appeal– Principal Protection & AAA Rating– Favorable risk/return

USAA/Residential Re.

• Market timing; lack of investors’ appetite for risk in 1996; in 1997, risk/return more attractive

• Rating agency concerns (1996 not investment grade)

• Protection of principal• 1997 issue had short duration & conservative loss

trigger (USAA’s losses from Andrew ~ $555 M)

Why did it work in 1997?

Risk Securitization 101

2000 CAS Special Interest Seminar

David Na, FCAS, MAAA

Deloitte & Touche, Bermuda