securitization and other instruments for transferring risk to the capital markets
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Securitization and Other Instruments for
Transferring Risk to the Capital Markets
Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D.Actuarial Science Program
University of Illinois at Urbana-Champaign
Washington, DCJuly, 2003
Agenda
• Historical background of securitization
• Definition and evolution of insurance securitization
• Types of securitized insurance instruments
• Recent activity
• Issues for the future
Terminology and Tools
• Financial terminology– We need to learn to quack before we can be a duck– Financial practitioners say things like
“BB undefeased subordinated debenture at 6mLIBOR+350bps”
• Financial tools– Financial practitioners use tools with names like
“options,” “swaps,” “swaptions”
Securitization inHistorical Perspective
• Home mortgage market: funding shortfall in the late 1970s
• Market response:– Change tax laws: no double taxation on cash flow
pass-throughs– Modernized investment technology– FNMA, Freddie Mac
• Other asset-backed securities developed subsequently– Auto loans– Credit card receivables– David Bowie albums
The Securitization Process
• Participants– Demanders of funds
• Homeowner / borrower of funds• Bank / Loan originator
– Special purpose entity / trust– Suppliers of funds
• Underwriter / investment bank• Capital markets / investors
• Some of the Benefits– Liquidity– Market values– Lower cost
Mortgage-Backed Securities (MBSs)
• Originated in response to mortgage funding shortfall
• Mortgages are “securitized” by packaging mortgage loans and selling the cash flows as securities
• The mortgage-backed securities represent ownership in the mortgages
• Mortgages generally have an embedded option: to prepay the mortgage (in event of interest rates falling, mortgage-holder moving, etc.)
Mortgage-Backed Securities (cont.)
• Investors receive the monthly mortgage payments (principal and/or interest) paid by the mortgage borrowers
• With MBSs, the prepayment risk is transferred to the capital market investors
• Investors are compensated for this risk by sufficiently high yields on the securities
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
Evolution of the Insurance Industry
“Affronts” to Traditional Insurance
• Self-insurance• Captives• Risk retention groups and purchasing
groups• Insurance securitization• Portfolio insurance
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
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
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
What to Securitize?
• Homeowners? Auto? Health?• “Homeowners is not a problem for the insurance
industry. Auto is not a problem for the insurance industry. We know how to manage those risks…. How about catastrophes?”
- Dennis Chookaszian (a 1992
comment, quoted in Best’s
Review, 4/99)
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
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
Risk Exchanges and Swaps
• CATEX New York
– Electronic bulletin board
– Intermediary
• CATEX Bermuda
– Joint venture: CATEX and Bermuda Stock
Exchange
• Swaps
Some Early 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
Early Successes• USAA / Residential Re
– Size: $477M, in two tranches– Trigger: hurricane losses to company– Coverage: 80% of $500M x/s $1B co. loss– A-1: rated AAA
• $163.8M, of which $77M placed in a defeasance account to fund principal repayment
• Only interest at risk• Coupon: LIBOR + 282 bps
– A-2: rated BB• $313.2M• Both principal and interest at risk• Coupon: LIBOR + 575 bps
Early Successes (cont.)• Swiss Re
– Size: $137M, in three classes
– Trigger: losses to industry from CA E/Q; industry insured loss, from a single event, greater than $18.5B triggers principal write-downs
– 40% of Class A proceeds to defeasance account
– Coupon:• A-1: LIBOR + 255 bps
• A-2: 8.645%
• B: 10.493%
• C: 12%
Early Successes (cont.)• Tokio / Parametric Re
– Size: $100M, in two tranches– Trigger: Tokyo earthquake magnitude; a Japanese
Meteorological Association magnitude rating of 7.1 or more involves loss of part or all of principal
– Half of $20M proceeds from A and all of $80M proceeds from B are risk capital
– Ten-year term – Coupon:
• A: LIBOR + 206 bps• B: LIBOR + 430 bps
Early Successes (cont.)
• Centre / Trinity Re– Size: $84M, in two tranches
– Trigger: FL hurricane losses to company
– Class A-1 notes ($22M in proceeds) provide for full principal repayment in event of a loss
– Coupon:• A-1: LIBOR + 182 bps
• A-2: LIBOR + 436 bps
Early Successes (cont.)
• Yasuda Fire and Marine– Typhoon losses– $80 million offering– 5-7 years– Attachment point recalculated every year with
exposure model -- constant 0.94% chance of loss to investors
– Guaranteed limits and pricing for a second event
Generally Common Traits of Early Successful Issues
• Involve catastrophe risk
• High levels of protection
• Relatively short maturities
• Some protection of principal included
• High coupon rates
Trend is now toward longer (e.g.,3-year versus annual)
Associated with “newness”
“Costs” of Cat Bonds
• High yields– Default premiums may be high for a time
• Setting up SPV
• Investment banking fees– Advising
– Spread
• Legal fees
Contingent Capital
• Contingent surplus notes– 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
Very Recent Activity
• Approximately $1.22 billion issued in the 2002 cat bond market– Versus $1.14 billion in 2000
• Notable transactions:– USAA / Residential Re: Sixth consecutive year
– Vivendi / Studio Re: First direct-corporate issue on US peril
• Several catastrophe bond investment funds
Issues Regarding the Potential “Success” of Insurance Securitization
• Need to understand two markets– Capital markets– Insurance markets
• Separation of insurance and finance functions in many companies
• Information and technology• Pricing challenges• Cost (vs. cat. reinsurance market)• Legal / tax / accounting issues
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