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
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Borrower
Loan originator
Special purpose trust
Underwriter
Investors
• Some of the Benefits
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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
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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:
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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 assetbacked 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
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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