SECURITIZATION 101

593 views

Published on

0 Comments
1 Like
Statistics
Notes
  • Be the first to comment

No Downloads
Views
Total views
593
On SlideShare
0
From Embeds
0
Number of Embeds
2
Actions
Shares
0
Downloads
8
Comments
0
Likes
1
Embeds 0
No embeds

No notes for slide

SECURITIZATION 101

  1. 1. Insurance Securitization <ul><li>Rick Gorvett, FCAS, MAAA, ARM, Ph.D. </li></ul><ul><li>Actuarial Science Program </li></ul><ul><li>University of Illinois </li></ul><ul><li>at Urbana-Champaign </li></ul><ul><li>International Association of Consulting Actuaries </li></ul><ul><li>Hershey, PA </li></ul><ul><li>June 2000 </li></ul>
  2. 2. Risk and Response <ul><li>Risk </li></ul><ul><ul><li>Recent catastrophes </li></ul></ul><ul><ul><li>Resulting insolvencies and financial impairment </li></ul></ul><ul><ul><li>Potential for even greater impact </li></ul></ul><ul><li>Response </li></ul><ul><ul><li>Development of securitized insurance products </li></ul></ul>
  3. 3. What is “Securitization of Insurance Risk”? <ul><li>Insurance company transfers underwriting risks to the capital markets by transforming underwriting cash flows into tradable financial securities </li></ul><ul><li>Cash flows (e.g., repayment of interest and/or principal) are contingent upon an insurance event / risk </li></ul>
  4. 4. Securitization in Historical Perspective <ul><li>Home mortgage market: funding shortfall in the late 1970s </li></ul><ul><li>Market response: mortgage-backed securities </li></ul><ul><li>Other asset-backed securities developed subsequently </li></ul><ul><ul><li>Auto loans </li></ul></ul><ul><ul><li>Credit card receivables </li></ul></ul><ul><ul><li>David Bowie albums </li></ul></ul>
  5. 5. Securitization Process <ul><li>Participants </li></ul><ul><ul><li>Borrower </li></ul></ul><ul><ul><li>Loan originator </li></ul></ul><ul><ul><li>Special purpose trust </li></ul></ul><ul><ul><li>Underwriter </li></ul></ul><ul><ul><li>Investors </li></ul></ul><ul><li>Some of the Benefits </li></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Market values </li></ul></ul><ul><ul><li>Lower cost </li></ul></ul><ul><ul><li>Improved credit rating </li></ul></ul>
  6. 6. Evolution of the Insurance Industry <ul><li>“ Affronts” to Traditional Insurance </li></ul><ul><li>Self-insurance and captives </li></ul><ul><li>Risk retention groups </li></ul><ul><li>Insurance securitization </li></ul><ul><li>Portfolio insurance </li></ul>
  7. 7. Risks Which P/C Insurers Face <ul><li>Underwriting </li></ul><ul><ul><li>Loss experience: frequency and severity </li></ul></ul><ul><ul><li>Underwriting cycle </li></ul></ul><ul><ul><li>Inflation </li></ul></ul><ul><ul><li>Payout patterns </li></ul></ul><ul><ul><li>Catastrophes </li></ul></ul><ul><li>Investment </li></ul><ul><ul><li>Interest rate risk </li></ul></ul><ul><ul><li>Capital market performance </li></ul></ul><ul><li>All of these risks can prevent a company from meeting its objectives </li></ul>
  8. 8. Insurance Securitization in Context: Managing Risks <ul><li>Insurance securitization is one of many financial risk management (FRM) techniques </li></ul><ul><li>Building blocks of FRM: </li></ul><ul><ul><li>Stocks and bonds </li></ul></ul><ul><ul><li>Forwards and futures </li></ul></ul><ul><ul><li>Options </li></ul></ul><ul><ul><li>Swaps </li></ul></ul>
  9. 9. Factors Affecting the Recent Development of Insurance Securitization <ul><li>Recent catastrophe experience </li></ul><ul><ul><li>Reassessment of catastrophe risk </li></ul></ul><ul><ul><li>Demand for and pricing of reinsurance </li></ul></ul><ul><ul><li>Reinsurance supply issues </li></ul></ul><ul><li>Capital market developments </li></ul><ul><ul><li>Development of new asset classes and asset-backed markets </li></ul></ul><ul><ul><li>Search for yield and diversification </li></ul></ul><ul><li>Restructuring of insurance industry </li></ul>
  10. 10. Possible Reasons for Securitizing Insurance Risks <ul><li>Capacity </li></ul><ul><ul><li>Risk of huge catastrophe losses </li></ul></ul><ul><ul><li>Would severely impair P/C industry capital </li></ul></ul><ul><ul><li>Capital markets could handle </li></ul></ul><ul><li>Investment </li></ul><ul><ul><li>Catastrophe exposure is uncorrelated with overall capital markets </li></ul></ul><ul><ul><li>Thus, uncorrelated with existing portfolios </li></ul></ul><ul><ul><li>Diversification potential </li></ul></ul>
  11. 11. Issues Regarding the Potential Success of Insurance Securitization <ul><li>Difficult to understand </li></ul><ul><ul><li>Capital markets </li></ul></ul><ul><ul><li>Insurance markets </li></ul></ul><ul><li>Separation of insurance and finance functions in many companies </li></ul><ul><li>Information and technology </li></ul><ul><li>Difficult to price </li></ul><ul><li>Expensive (vs. cat. reinsurance market) </li></ul><ul><li>Legal / tax / accounting issues </li></ul>
  12. 12. Types of Insurance Instruments <ul><li>Those that transfer risk </li></ul><ul><ul><li>Reinsurance </li></ul></ul><ul><ul><li>Exchange-traded derivatives </li></ul></ul><ul><ul><li>Swaps </li></ul></ul><ul><ul><li>Catastrophe bonds </li></ul></ul><ul><li>Those that provide contingent capital </li></ul><ul><ul><li>Letter of credit </li></ul></ul><ul><ul><li>Contingent surplus notes </li></ul></ul><ul><ul><li>Catastrophe equity puts </li></ul></ul>
  13. 13. Exchange-Traded Derivatives <ul><li>Chicago Board of Trade </li></ul><ul><ul><li>Option spreads ~ reinsurance </li></ul></ul><ul><ul><li>PCS: daily index values </li></ul></ul><ul><ul><li>Nine geographic products </li></ul></ul><ul><li>Bermuda Commodities Exchange </li></ul><ul><ul><li>Binary options </li></ul></ul><ul><ul><li>Guy Carpenter Catastrophe Index </li></ul></ul><ul><ul><li>Seven geographic products </li></ul></ul>
  14. 14. Risk Exchanges and Swaps <ul><li>CATEX New York </li></ul><ul><ul><li>Electronic bulletin board </li></ul></ul><ul><ul><li>Catastrophe exposure swaps </li></ul></ul><ul><li>CATEX Bermuda </li></ul><ul><ul><li>Joint venture: CATEX and Bermuda Stock Exchange </li></ul></ul><ul><li>Swaps </li></ul>
  15. 15. Catastrophe Bonds: The Trigger Issue <ul><li>Basis risk </li></ul><ul><ul><li>How closely do the company’s losses follow the industry index? </li></ul></ul><ul><li>Moral hazard </li></ul><ul><ul><li>Increased losses to company may decrease the debt obligations </li></ul></ul><ul><li>Trade-off between basis risk and moral hazard </li></ul><ul><li>Direct versus industry versus event triggers </li></ul>
  16. 16. Types of Bond Triggers <ul><li>Direct : based on company losses </li></ul><ul><ul><li>E.g., USAA catastrophe bond </li></ul></ul><ul><ul><li>No basis risk </li></ul></ul><ul><li>Industry : based on an index </li></ul><ul><ul><li>E.g., Swiss Re; CBOT PCS option spreads </li></ul></ul><ul><ul><li>Essentially no moral hazard </li></ul></ul><ul><li>Event </li></ul><ul><ul><li>E.g., Tokio Marine & Fire </li></ul></ul><ul><ul><li>Earthquake magnitude </li></ul></ul>
  17. 17. Types of Catastrophe Bond Risk-Taking <ul><li>Risk of losing some or all of your principal </li></ul><ul><ul><li>Defeasement of principal with U.S. Treasuries? </li></ul></ul><ul><li>Risk of diminished or lost interest payments </li></ul><ul><li>Often, several “tranches” with different yields and ratings </li></ul>
  18. 18. Typical Catastrophe Bond Issuance Structure <ul><li>Insurance company sets up an SPV (Special Purpose Vehicle) -- offshore reinsurer </li></ul><ul><li>Company purchases reinsurance contract from SPV </li></ul><ul><li>Company issues bonds to capital markets through SPV </li></ul>
  19. 19. Some Successful Bond Issues <ul><li>USAA : company’s hurricane losses </li></ul><ul><li>Swiss Re : industry’s California E/Q losses </li></ul><ul><li>Tokio Marine & Fire : Tokyo E/Q magnitude </li></ul><ul><li>Centre Re : company’s Florida hurricane losses </li></ul><ul><li>Yasuda Fire & Marine : typhoon losses </li></ul><ul><li>Swiss Re : “basis swap” with reinsurer </li></ul>
  20. 20. Generally Common Traits of Successful Bond Issues <ul><li>Involve catastrophe risk </li></ul><ul><li>High levels of protection </li></ul><ul><li>Relatively short maturities </li></ul><ul><li>Some protection of principal included </li></ul><ul><li>High coupon rates </li></ul>
  21. 21. “ Costs” of Catastrophe Bonds <ul><li>High yields </li></ul><ul><ul><li>Default premiums may be high for a time </li></ul></ul><ul><li>Setting up SPV </li></ul><ul><li>Investment banking fees </li></ul><ul><ul><li>Advising </li></ul></ul><ul><ul><li>Spread </li></ul></ul><ul><li>Legal fees </li></ul>
  22. 22. Contingent Capital <ul><li>Contingent surplus notes </li></ul><ul><ul><li>Option to borrow, contingent upon some event or trigger </li></ul></ul><ul><ul><li>Right to issue surplus notes </li></ul></ul><ul><li>Catastrophe equity puts </li></ul><ul><ul><li>Put option (right to sell) </li></ul></ul><ul><ul><li>Right to issue shares of stock, contingent upon some event or trigger </li></ul></ul>
  23. 23. The Future of Insurance Securitization <ul><li>Will it survive and grow? </li></ul><ul><ul><li>Cost relative to insurance and reinsurance </li></ul></ul><ul><ul><li>Time and technology </li></ul></ul><ul><li>Will it replace or supplement traditional transactions? </li></ul><ul><li>How will it affect reinsurance? </li></ul>
  24. 24. The Future of Insurance Securitization (cont.) <ul><li>Capacity versus other reasons </li></ul><ul><li>Catastrophe risks versus traditional insurance lines </li></ul><ul><li>Historically, markets for other forms of securitizations have taken some time to develop and mature </li></ul>
  25. 25. The Future of Insurance Securitization (cont.) <ul><li>Legal and tax issues </li></ul><ul><ul><li>Are securitization instruments insurance ? </li></ul></ul><ul><ul><li>Bermuda Insurance Amendment Act (1998): insurance derivatives are “investment contracts” </li></ul></ul><ul><ul><li>Different tax implications: </li></ul></ul><ul><ul><ul><li>Protect income statement </li></ul></ul></ul><ul><ul><ul><li>Protect balance sheet </li></ul></ul></ul>
  26. 26. The Future of Insurance Securitization (cont.) <ul><li>Insurer FRM can take a variety of forms </li></ul><ul><ul><li>Asset hedges </li></ul></ul><ul><ul><ul><li>Reinsurance </li></ul></ul></ul><ul><ul><ul><li>Derivatives </li></ul></ul></ul><ul><ul><li>Liability hedges </li></ul></ul><ul><ul><ul><li>Debt forgiveness </li></ul></ul></ul><ul><ul><li>Asset-liability management </li></ul></ul><ul><ul><li>Contingent financing </li></ul></ul><ul><ul><li>Post-loss financing and recapitalization </li></ul></ul>
  27. 27. Personal Info <ul><li>Web page: </li></ul><ul><li>http://www.math.uiuc.edu/~gorvett </li></ul><ul><li>E-mail: </li></ul><ul><li>[email_address] </li></ul>

×