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, DC
July, 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 in
Historical 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
Alternatives to Capital
“Insurers are discovering what bankers know as
securitisation: the process of assembling mortgages, creditcard receivables or even business loans into securities that
provide reasonably predictable income streams and
principal repayments. This sort of financial engineering
has been going on for decades in America.... Its big
advantage is that, once the assets have been sold, the issuer
need no longer set aside capital to cover potential losses;
instead, the capital can be redeployed more profitably.
Insurers are only now waking up to the potential benefits.”
- “An Earthquake in Insurance,” Economist, 2/26/98
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
Generally Common Traits of
Successful Issues
• Involve catastrophe risk
• High levels of protection
• Relatively short maturities
• Some protection of principal included
• High coupon rates
“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 2001
• 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
The Future of Insurance
Securitization
• A number of issues
• 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
CBOT Catastrophe Option Spreads
• European cash options
• Loss period: generally calendar quarter (except
annual for Western and CA)
• PCS provides industry indexes daily
• Development period: 6 or 12 months
• Index Valuation: Each index point
= $100 million in industry cat losses
= $200 cash value
• Strike values: in multiples of 5
• Tick size: one-tenth of a point (= $20)
CBOT Cat. Option Spreads (cont.)
• Underlying instrument:
– National -- All states + DC
– Eastern -- AL, CT, DE, DC, FL, GA, LA, ME, MD, MA, MS,
NH, NJ, NY, NC, PA, RI, SC, VT, VA, WV
– Northeastern -- CT, DE, DC, ME, MD, MA, NH, NJ, NY, PA,
RI, VT
– Southeastern -- AL, FL, GA, LA, MS, NC, SC, VA, WV
– Midwestern -- AR, IL, IN, IA, KS, KY, MI, MN, MO, NE, ND,
OH, OK, SD, TN, WI
– Western -- AK, AZ, CA, CO, HI, ID, MT, NV, NM, OR, UT, WA,
WY
– California
– Florida
– Texas
CBOT Cat. Option Spreads (cont.)
Example
• December 1997 30/50 TX Call Spread
• Essentially, this is a $2B x/s $3B layer on
4th-quarter 1997 industry Texas cat losses:
[50-30] x $100M = $2B
30 x $100M = $3B
• If 4th-quarter TX cat losses = $4.5B:
Call option spread value =
[($4.5B/$100M)-30]x$200 = $3,000
Bermuda Commodities Exchange
•
•
•
•
•
•
Catastrophe derivatives
Guy Carpenter Catastrophe Index
Single loss, second loss, and aggregate options
Binary option: payoff either $0 or $5000
Two six-month risk periods each year
Periodic settlement evaluations -- final is 13
months after end of risk period
• National, NE, SE, MW, Gulf, FL, TX
Uses of Exchange-Traded Options
• Hedge insurer’s catastrophic loss exposure
– Proceeds from options potentially provide a cash
flow which offsets cat. losses to some degree
– Does not change likelihood or severity of a
catastrophe -- but changes net impact on insurer
• Issues
– Basis risk
• Depends on index which defines / triggers cash flows
• E.g., regional versus state versus zip code
– Frequency of settlement and index calculation
– Marketing and liquidity
Other Insurance Products
• Contingent surplus notes
– Insurer has right to issue surplus notes
(subordinated debt), contingent upon an event
– Investment trust sells certificates to capital markets,
and invests in liquid securities
– If event occurs, insurer issues surplus notes in
exchange for liquid securities
Other Insurance Products (cont.)
• Catastrophe equity puts
– Insurer has right to issue equity (e.g., preferred
stock), contingent upon an event
– Insurer pays investors for the option to sell them
shares
– If event occurs, insurer receives cash from
investors in exchange for its shares
Other Insurance Products (cont.)
• Catastrophe bonds
– Insurer issues debt
– Similar to a corporate bond
– Provision for “contingent debt forgiveness”
– If a specified event occurs, some / all of the
principal / interest payment obligations of the
insurer will be forgiven (sacrificed) by the
investors
RECENT 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
RECENT 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%
RECENT 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
RECENT 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
RECENT SUCCESSES (cont.)
• USAA (1998)
– $450 million, thru Residential Re
– Company losses greater than $1B from
Hurricane
– A-1: LIBOR + 140 bps (compare with 282
bps in 1997)
– A-2: LIBOR + 400 bps (compare with 575
bps in 1997)
RECENT 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
RECENT SUCCESSES (cont.)
• F&G Re
– Aggregate x/s cover for a portfolio of
catastrophe reinsurance contracts
– $54 million offering
– Through Mosaic Re
• X.L. Mid Ocean Re
–
–
–
–
Retrocessional hurricane and E/Q
$200 million offering
Competitive bidding process
Swap
RECENT SUCCESSES (cont.)
• Swiss Re
– Basis swap with reinsurer (“ABC”)
– Up to $10 million transferred
– Two triggers:
• SE windstorm losses of ABC
• SE windstorm losses of industry (from PCS)
Exceed trigger?
ABC
Industry
Y
N
N
Y
N
N
Y
Y
Result
Swiss Re pays
ABC pays
Nothing
Pay each other
GENERALLY COMMON TRAITS
OF SUCCESSFUL ISSUES
• Involve catastrophe risk
• High levels of protection
• Relatively short maturities
• Some protection of principal included
• High coupon rates
“COSTS” OF CAT BONDS
• High yields
– Default premiums may be high for a time
• Setting up SPV
• Investment banking fees
– Advising
– Spread
• Legal fees
THE FUTURE OF INSURANCE
SECURITIZATION
• Will it survive and grow?
– Expensive
– 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.)
• What form will insurer FRM take?
– Asset hedges
• Reinsurance
• Derivatives
– Liability hedges
• Debt forgiveness
– Asset-liability management
– Contingent financing
– Post-loss financing and recapitalization
Capacity: Is There a Shortfall?
• Estimate of total net worth of U.S. P/C industry:
$300B +
• Capital exists to handle contingencies
• “Insurance density” is low in places
• New capital enters when rates of return are high
(e.g., Bermuda cat insurers after Andrew)
CBOT PCS Catastrophe Option
Spreads
• European cash options
• Loss period: generally calendar quarter (except
annual for Western and CA)
• Development period: 6 or 12 months
• PCS provided industry indexes daily
• Index Valuation: Each index point
= $100 million in industry cat losses
= $200 cash value
• Strike values: in multiples of 5
• Tick size: one-tenth of a point (= $20)
CBOT PCS Catastrophe Option
Spreads (cont.)
Example
• December 1997 30/50 TX Call Spread
• Essentially, this is a $2B x/s $3B layer on 4thquarter 1997 industry Texas cat losses:
[50 - 30] x $100M = $2B
30 x $100M = $3B
• If 4th-quarter TX cat losses = $4.5B:
Call option spread value =
[($4.5B / $100M) - 30] x $200 = $3,000
Bermuda Commodities Exchange
Catastrophe Options
•
•
•
•
Catastrophe derivatives
Guy Carpenter Catastrophe Index
Single loss, second loss, and aggregate options
Binary option: payoff either $0 or $5000
Not
But
• Two six-month risk periods each year
• Periodic settlement evaluations -- final is 13
months after end of risk period
• National, NE, SE, MW, Gulf, FL, TX