Securitization and Other Instruments for Transferring Risk to the Capital Markets

1
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

2
Agenda

• Historical background of securitization
• Definition and evolution of insurance
  securitization
• Types of securitized insurance instruments
• Recent activity
• Issues for the future

3
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 6mLIBOR350bps
• Financial tools
• Financial practitioners use tools with names like
• options, swaps, swaptions

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Securitization inHistorical 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

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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

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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.)

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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

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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

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Alternatives to Capital

• Insurers are discovering what bankers know as
  securitisation the process of assembling
  mortgages, credit-card 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

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Evolution of the Insurance Industry

• Affronts to Traditional Insurance
• Self-insurance
• Captives
• Risk retention groups and purchasing groups
• Insurance securitization
• Portfolio insurance

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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

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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

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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

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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 Bests
• Review, 4/99)

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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

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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

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Risk Exchanges and Swaps

• CATEX New York
• Electronic bulletin board
• Intermediary
• CATEX Bermuda
• Joint venture CATEX and Bermuda Stock Exchange
• Swaps

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Some Early Successful Bond Issues

• USAA companys hurricane losses
• Swiss Re industrys California E/Q losses
• Tokio Marine Fire Tokyo E/Q magnitude
• Centre Re companys Florida hurricane losses
• Yasuda Fire Marine typhoon losses

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Generally Common Traits of Successful Issues

• Involve catastrophe risk
• High levels of protection
• Relatively short maturities
• Some protection of principal included
• High coupon rates

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Costs of Cat Bonds

• High yields
• Default premiums may be high for a time
• Setting up SPV
• Investment banking fees
• Advising
• Spread
• Legal fees

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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

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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

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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

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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

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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)

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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

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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)-30x200 3,000

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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

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Uses of Exchange-Traded Options

• Hedge insurers 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

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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

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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

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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

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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

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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

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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

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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

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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)

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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

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RECENT SUCCESSES (cont.)

• FG 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

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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 Result
• Y N Swiss Re pays
• N Y ABC pays
• N N Nothing
• Y Y Pay each other

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GENERALLY COMMON TRAITS OF SUCCESSFUL ISSUES

• Involve catastrophe risk
• High levels of protection
• Relatively short maturities
• Some protection of principal included
• High coupon rates

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COSTS OF CAT BONDS

• High yields
• Default premiums may be high for a time
• Setting up SPV
• Investment banking fees
• Advising
• Spread
• Legal fees

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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?

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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

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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

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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

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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)

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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)

50
CBOT PCS Catastrophe 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

51
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
• 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

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