Insurance Securitization

Rick Gorvett, FCAS, MAAA, ARM, Ph.D.

Actuarial Science Program
University of Illinois
at Urbana-Champaign

International Association of Consulting Actuaries

Hershey, PA
June 2000
 Risk and Response

• Risk
– Recent catastrophes
– Resulting insolvencies and financial
impairment
– Potential for even greater impact
• Response
– Development of securitized insurance
products
 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
 Securitization in
Historical Perspective
• Home mortgage market: funding shortfall in the
late 1970s
• Market response: mortgage-backed securities
• Other asset-backed securities developed
subsequently
– Auto loans
– Credit card receivables
– David Bowie albums
 Securitization Process
• Participants
– Borrower
– Loan originator
– Special purpose trust
– Underwriter
– Investors
• Some of the Benefits
– Liquidity
– Market values
– Lower cost
– Improved credit rating
 Evolution of the Insurance
Industry
“Affronts” to Traditional Insurance

• Self-insurance and captives

• Risk retention groups

• Insurance securitization

• Portfolio insurance
 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
Insurance Securitization in Context:
Managing Risks

• Insurance securitization is one of many

financial risk management (FRM) techniques
• Building blocks of FRM:
– Stocks and bonds
– Forwards and futures
– Options
– Swaps
 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
 Issues Regarding the Potential
Success of Insurance Securitization
• Difficult to understand
– Capital markets
– Insurance markets
• Separation of insurance and finance functions in
many companies
• Information and technology
• Difficult to price
• Expensive (vs. cat. reinsurance market)
• Legal / tax / accounting issues
 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
– Catastrophe exposure swaps
• CATEX Bermuda
– Joint venture: CATEX and Bermuda Stock
Exchange
• Swaps
 Catastrophe Bonds:
The Trigger Issue
• Basis risk
– How closely do the company’s losses follow the
industry index?
• Moral hazard
– Increased losses to company may decrease the debt
obligations

Trade-off between basis risk and moral hazard

Direct versus industry versus event triggers
 Types of Bond Triggers
• Direct: based on company losses
– E.g., USAA catastrophe bond
– No basis risk
• Industry: based on an index
– E.g., Swiss Re; CBOT PCS option spreads
– Essentially no moral hazard
• Event
– E.g., Tokio Marine & Fire
– Earthquake magnitude
 Types of Catastrophe Bond
Risk-Taking

• Risk of losing some or all of your principal

– Defeasement of principal with U.S. Treasuries?
• Risk of diminished or lost interest payments
• Often, several “tranches” with different
yields and ratings
 Typical Catastrophe Bond
Issuance Structure

• Insurance company sets up an SPV (Special

Purpose Vehicle) -- offshore reinsurer
• Company purchases reinsurance contract
from SPV
• Company issues bonds to capital markets
through SPV
 Some 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
• Swiss Re: “basis swap” with reinsurer
 Generally Common Traits of
Successful Bond Issues

• Involve catastrophe risk

• High levels of protection
• Relatively short maturities
• Some protection of principal included
• High coupon rates
 “Costs” of Catastrophe 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
 The Future of Insurance
Securitization

• Will it survive and grow?

– Cost relative to insurance and reinsurance
– Time and technology
• Will it replace or supplement traditional
transactions?
• How will it affect reinsurance?
 The Future of Insurance
Securitization (cont.)

• Capacity versus other reasons

• Catastrophe risks versus traditional
insurance lines
• Historically, markets for other forms of
securitizations have taken some time to
develop and mature
 The Future of Insurance
Securitization (cont.)

• Legal and tax issues

– Are securitization instruments insurance?
– Bermuda Insurance Amendment Act (1998):
insurance derivatives are “investment contracts”
– Different tax implications:
• Protect income statement
• Protect balance sheet
 The Future of Insurance
Securitization (cont.)
• Insurer FRM can take a variety of forms
– Asset hedges
• Reinsurance
• Derivatives
– Liability hedges
• Debt forgiveness
– Asset-liability management
– Contingent financing
– Post-loss financing and recapitalization
 Personal Info

• Web page:

http://www.math.uiuc.edu/~gorvett

• E-mail:

gorvett@uiuc.edu