DFA and Securitization
Presentation to the Casualty Actuarial Society
July 13, 1998
Global New Derivatives
Agenda
 The “Non-” Construction
 Capital Markets Context
 Uses of DFA
 Developments in Securitization
Global New Derivatives
Capital Markets Context
 Measuring Risk and Return
 Psychology
 History
 Defining “Beta”
 Trading in Low Beta Risks
 Range of Risks
 Appeal to Investors
 Benefits to Issuers
Global New Derivatives
Volatility of Earnings
50
40
30
20
10
0
-10
-20
-30
-40
Global New Derivatives
Risk and Return
25%
Drugs
Return on Equity
20%
Cosmetics
Soft Drinks
Restaurant
S&P 500
Retail Food Chains
15%
Oil Well Services
Life
P&C
10%
Metals
Railroads
5%
Airlines
Machine Tools
Steel
0%
0%
2%
4%
6%
8%
10%
12%
Standard Deviation of Returns
14%
16%
18%
Global New Derivatives
Defining Beta
100%
Return on Small Cos.
80%
60%
Y =  + x
40%
 = Cov(xy) / SD(x)2
20%
Ra = Rf +  (Rm - Ra)
0%
-20%
-40%
-40%
-20%
0%
20%
Return on DJIA
40%
60%
Global New Derivatives
Defining Beta
Return on Low Beta Trades
100%
80%
60%
40%
20%
0%
-20%
-30%
-20%
-10%
0%
10%
20%
Return on DJIA
30%
40%
50%
60%
Global New Derivatives
Low Beta Risks
 Natural Catastrophes
 earthquake, volcano, tsunami, flood, landslide, subsidence
 hurricane, windstorm, tornado, brush fire
 Weather
 degree-days, freeze, precipitation
 Industry
 infrastructure and project finance
 drilling, mining, aviation, satellite, nuclear efficacy
 maintenance, obsolescence, residual value
 GDP
Global New Derivatives
Investor Perspective
30%
Annual Return
25%
20%
15%
10%
5%
4%
6%
8%
10%
12%
14%
16%
18%
Risk (Standard Deviation)
Data Used: S&P 500, Merrill Lynch Bond Index B0A0, Historical Reinsurance Industry Returns for Low Beta Asset
20%
Global New Derivatives
Issuer Perspective
 Efficient Markets
 Match risks to investor preferences
 Aggregate “basket” / avoid over-hedging
 Tax
 Deductibility
 Leverage
 Firm partitions
 Ratings and Regulation
Global New Derivatives
Issuer Perspective
 Deadweight Cost of Ruin
 Capacity
 Additional capacity for conventional risks
 Handle unconventional risks
 Integrated View of Capital
Global New Derivatives
Uses of DFA
 Price an individual risk
 Price a portfolio of liabilities
 Allocate assets
 Optimize the capitalization
 equate a pound of equity, a yard of debt, a gallon of reinsurance
 Trade individual and aggregate risks
Global New Derivatives
DFA: Outcomes
Model all the risks to get the full profile
Cumulative Probability
100%
80%
Expected Gain
60%
40%
Potential Loss of Ratings
20%
0%
-10
-8
-6
-4
-2
0
2
4
Earnings per Share
6
8
10
12
14
16
Global New Derivatives
Challenges to Insurers
 Paradox of Capital
 Disintermediation
 Clients’ perspective - articulate the benefits
 Non-intermediation
 12% / 88%
 The risks already exist, but fall to the common equity
 Mission
 Underwriting is the real value-added
 Handle a much wider range of risks, adopt a trading perspective
 Cost of capital is key
Global New Derivatives
Retrospective
Pre 1994
1994
•“Alternate Risk”
•Premium Trust
•“Financial
Reinsurance”
•“Cat Note”
•Surplus notes
•ABS Market
Innovations
1995
•“Contingent”
Surplus Notes
1996
•Cat Swaps &
Bonds
•“Contingent”
Equity
1997/8
•Indemnity Cat Bond
•Non-Cat Swaps
Global New Derivatives
Historical Context
The development of the market for
Low Beta risks is part of the
broader sweep of events. Viewed in
historical context, the future is part
of a trend and may well be
predictable.
 Late 1970’s start of the mortgage-backed securities
market
 Derivatives warehouses in early 80’s
 High yield securities bring trading to commercial
banking
 First credit card and automobile loan securitizations in
1985-6
 Derivatives extend to commodities, credit, and other
categories in early 90’s
 MBS, ABS, and high yield all as established asset classes.
In 1998, each will be several hundred billion dollars in
the US public markets
Global New Derivatives
Vision of the Future
The transformation that has
occurred in the US financial services
sector may well occur in the
insurance and reinsurance
industries.
 Broad investor familiarity with the insurance business
 New equity market valuations, optimized capital
 Warehousing joint ventures with Wall Street firms
 Combinations with institutional money managers
 Proliferation of start-up reinsurers with access to public
capital
 Increase in competition from other financial intermediaries
 Growth of sophisticated analytics and a new trading
perspective
 Commoditization of some products, disintermediation of
some participants