Market Stephen P. D’Arcy Professor of Finance University of Illinois http://www.cba.uiuc.edu/~s-darcy/
First Annual OFOR Symposium
May 16, 2002 Overview • Use of derivatives by insurers • Securitization of insurance risk Use of Derivatives by Insurers Based on Cummins, Phillips, and Smith North American Actuarial Journal January 1997
• 1994 annual statements filed with NAIC
• 1,760 life insurers and 2,707 P-L insurers • Schedule DB Derivative Instruments • Categories of derivatives included: – Options, caps, and floors owned – Options, caps, and floors written – Collars, swaps, and forward agreements – Futures contracts Results • 12% of life insurers and 7% of P-L insurers used derivatives sometime during the year • Stock insurers use derivatives more – Life insurers: 16% of stock companies, 7% of mutuals – P-L insurers: 10% of stock companies, 4% of mutuals • Larger companies used derivatives more – For largest size quartile, 34% of life and 21% of P-L insurers used derivatives Results (p.2) • Life insurers used derivatives to manage interest rate risk – Caps/floors – Interest rate swaps – Options and/or futures positions on bonds • P-L insurers have a higher percentage of assets in equities – Use of equity options, both calls and puts • P-L insurers used FX forwards Conclusion • Most insurers did not use derivatives as of 1994 • Even for those that did use derivatives, the volume was low – For users, average notional value of open positions • $661 million for life insurers • $90 million for property-liability insurers Why Don’t Insurers Use Derivatives More?
• Unfamiliarity with derivatives
• Conservatism • Derivative horror stories • Regulatory resistance • Lack of focus on financial risk management Securitization of Insurance Risk • Exchange Traded Derivatives • Contingent Capital • Risk Capital • Recent insurance derivatives Exchange Traded Derivatives • First proposed by Goshay and Sandor – 1973 • CBOT Catastrophe futures and options – 1992 – Underlying: small sample of companies reported paid losses • CBOT PCS Catastrophe Insurance Options – 1995 – Underlying: estimate of industry wide incurred losses • Bermuda Commodities Exchange Catastrophe Options – Binary options – Trigger: Guy Carpenter Catastrophe Index Status of Exchange Traded Derivatives • Trading volume was very low • Large bid-ask spreads • There is currently no viable market for exchange traded derivatives Contingent Capital • Line of credit • Contingent surplus note • Cat-Equity-Put – Insurer contracts with counterparty to purchase put options – Options can only be exercised in the event of a catastrophe – Minimum post catastrophe net worth requirement – Warranties on reinsurance, management control, etc. – Exposure period 1-10 years – Annual premiums – Buyback provisions Risk Capital Catastrophe Bonds Typical case - pre-funded, fully collateralized Provides insurers with additional capital and multiyear coverage for catastrophes Provides investors with diversification and high yields Investors include: Mutual funds Hedge funds Reinsurers Life insurers Money managers Examples of Catastrophe Bonds • USAA – 1997 – East coast hurricane • Swiss Re – 1997 – California earthquake • Munich Re – 2001 – Hurricane, earthquake and European windstorm • Syndicate 33 of Lloyd’s of London – 2002 – St. Agatha Re Recent Insurance Derivatives • Catastrophe risk swap – Swiss Re and Tokio Marine and Fire – 2001 • Japan earthquake for California earthquake • Japan typhoon for Florida hurricane • Japan typhoon for France storm • Earthquake derivative – Munich Re and Berkshire Hathaway – 2001 • Earthquakes affecting World Cup Soccer • Parametric trigger Future of Securitization • Major insurers and reinsurers will expand use • Markets will grow with increased availability • Additional sources of risk could be covered • Trend will drive insurers to additional financial risk management