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SECURITIZATION 101
 

SECURITIZATION 101

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    SECURITIZATION 101 SECURITIZATION 101 Presentation Transcript

    • 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
        • Borrower
        • Loan originator
        • Special purpose trust
        • Underwriter
        • Investors
      • Some of the Benefits
        • 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
        • 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:
        • 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 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
    • 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
        • 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:
      • [email_address]