Securitization of Insurance Risks

1
Securitization of Insurance Risks

• RMI 4700
• Insurance Operations
• Robert Klein

2
Securitization of Liabilities

• Involves creating a financial instrument (e.g.,
  cat bond) that effectively diversifies or hedges
  a primary insurers underwriting risk.
• Designed to use large capacity of financial
  markets to diversify risks where conventional
  reinsurance is less efficient and/or capacity
  constrained.
• Some risks more suitable for securitization than
  others.
• Catastrophe options and bonds have been primary
  instruments.

3
Catastrophe Call Option Spread

• CBOT exchange-traded contracts that settle on
  loss indices developed by PCS.
• Index (x a) 100 M 1 point
• Example 20/40 call spread
• If event caused 30B in losses, each contract
  would pay 2,000 (100 points x 20).

0 for x lt a (x a) for a ltx ltb (b
a) for x gt b
b
f(x)
f(x)
x industry losses
a
B
20
40
4
Limited Volume of Cat Options Traded
5
Catastrophe Bond

• Insurer issues bonds with interest equal to
  risk-free rate risk premium 350-600 basis
  points (for 1 probability loss).
• Investors receive principal plus interest if no
  event.
• All or portion of interest and principal forgiven
  if event occurs.

6
Typical Structure of Catastrophe Bond with
Special Purpose Reinsurer
Insurer
Principal and/or Interest given a trigger event
Premium Payment
Single Purpose Reinsurer
Contingent Principal and/or Interest payment
Principal
Investors
7
Moral Hazard vs. Basis Risk

• Basis risk refers to disconnect between payout
  on contract ceding insurers losses.
• Tying payout to ceding insurers losses raises
  moral hazard risk.

• Non-Parametric Triggers
• Tied to cedant loss
• Lowers basis risk, but increases moral hazard.

• Parametric Triggers
• Not tied to cedant loss
• Based on physical event, e.g., storm or
  earthquake intensity.
• Or, total industry losses.
• Depending on trigger, high basis risk potential.

• Dual Triggers
• Parametric Non-Parametric

8
Reinsurance vs. Securitization

• Reinsurance
• Basis risk tends to be minimized to extent treaty
  based on losses of ceding insurer.
• Moral hazard has to be controlled through
  contract terms and monitoring by reinsurer.
• Tail risk easier to handle in reinsurance.
• Reinsurer provides other services, e.g., risk
  assessment.
• But, capacity constrained for catastrophes high
  risk premium.
• Securitization
• Each investor can efficiently take a small
  portion of a large risk ? reduces risk premium
  required, ample capacity.
• Basis risk vs. moral hazard addressed through
  triggers and other devices.

9
Issues in Future of Securitization

• Insurer demand
• Investor knowledge and acceptance.
• Transaction costs.
• Regulatory treatment.
• Most securitizations have been done offshore to
  avoid taxes.
• NAIC adopted model legislation that would
  facilitate onshore SPRVs Protected Cells.
• Some reinsurers fighting onshore SPRVs and
  proposal for favorable tax treatment.
• It will take time for securitization vehicles to
  be refined and market to develop.