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Access reinsurance returns through Insurance Linked Futures (ILFs
- 1. TRANSPARENCY ◊ LIQUIDITY ◊ DIVERSIFICATION ◊ PERFORMANCE
- 2. “Securitization is coming…. insurance leaders thus have two choices, get in front of the trend or get run over by it.” Bernard L. Hengesbaugh Chairman, CNA Financial Securitized Insurance Risk--1997.
- 3. ILS Issuance and Risk Capital Outstanding 1997-2013
- 4. Uncorrelated ILS Returns Financial Crisis vs. Catastrophic Loss
- 5. WHAT IS THE NEXT TREND IN REINSURANCE?
- 6. WHAT IS THE NEXT TREND IN REINSURANCE? COMMODITIZED RISK TRANSFER WITH INSURANCE LINKED FUTURES
- 7. ILF Strategy 1. Create a reinsurance spot market SPV/sidecar of diverse-fully collateralized risk 2. Publish an ILF tracking index based on total return of sidecar 3. Form ILF exchange for cash settled index futures and options
- 8. ILF ECOSYSTEM Capital Markets Buy/sell ILF’s to access reinsurance returns. ILF EXCHANGE Index based futures and options ILF TRACKING INDEX Underwriting SYNDICATE Third Party Investors Third Party Investors Open Source Risk Pool SPV Members Members Expand platform to accept membership from other insurers/reinsurers as acceptance grows ILF Clearing Counterparty risk/margin and settlement
- 9. Capital Markets Buy/sell ILF’s to access reinsurance returns. ILF EXCHANGE ILF ECOSYSTEM Index based futures and options Index Index Index Rated members Levered Capital Third Party Investors Unrated/Unmodeled Fully collateralized Third Party Investors Unrated Fully collateralized Members SPV Members Indices tranched by yield/expected loss ILF Clearing Counterparty risk/margin and settlement Mezzanine Investment Grade Hi-Yield
- 10. BUILDING THE INDEX Ceded Premium ILF INDEX FORMULA Base 100 + Expected Loss (EL) -- Ultimate Loss (UL) -- Discounted Underwriting Profit (DUP) + Total Return of Fixed Income Portfolio (TR) Index = 100 + (EL-UL-DUP+TR)
- 11. BUILDING THE INDEX INDEX VALUE = 100 + (EL-UL-DUP+TR) Expected Loss (EL) = Combination of historical claims, industry loss trends and inflation data projects loss of 12-month cycle of pooled reinsurance contracts. (Includes allowance for IBNR adjustments from past cycles) Calculated and published with full transparency prior to the start of each cycle.
- 12. BUILDING THE INDEX INDEX VALUE = 100 + (EL-UL-DUP+TR) Ultimate Loss = Paid Claims + Case Reserves + IBNR. (IBNR = Claims incurred but not yet reported + future case reserve adjustments) Calculated and published weekly.
- 13. BUILDING THE INDEX INDEX VALUE = 100 + (EL-UL-DUP+TR) Discounted Underwriting Profit (DUP) = (Target Profit Margin/total # of days in cycle) * (# of days left in cycle). Creates a discount to par, like a cost of carry function which decays towards zero at expiration and compensates the long for bearing risk.
- 14. BUILDING THE INDEX INDEX VALUE = 100 + (EL-UL-DUP+TR) Total Return = Total Return of the fixed income portfolio of invested premiums and collateral for the underlying cycle. Accounts for accrued interest, coupon pmts, compounded returns and changes in value of principal. Calculated and published daily.
- 15. EX: PRICING THE INDEX 2014 Index 12-31-14 1-01-14 EL=UL 2014 Cycle Underlying sidecar/pool Day 1 of the cycle--EL is set equal to UL Final Settlement Third Friday Sep 2015 Base + 100 EL + 18 UL - 18
- 17. EX: PRICING THE INDEX 2014 Index 12-31-14 1-01-14 EL=UL 2014 Cycle Underlying sidecar/pool Day 1 of the cycle--EL is set equal to UL Final Settlement Third Friday Sep 2015 Base + 100 EL + 18 UL - 18
- 18. EX: PRICING THE INDEX 1-01-14 DUP =10% 2014 Cycle Underlying sidecar/pool DUP begins at 10% Decaying cost of carry Base + 100 EL + 18 UL - 18 DUP - 10 2014 Index Final Settlement Third Friday Sep 2015 DUP = 0 12-31-14
- 19. Example: Expiration and Settlement-PRICING THE INDEX 1-01-14 EL =18% UL= 18% 2014 Cycle Underlying sidecar At final settlement UL = 16.5% DUP decays to zero TR for the cycle was 1.2% Base + 100 EL + 18 UL - 16.5 DUP - 0 2014 Index Final Settlement Third Friday Sep 2015 DUP = 0 TR + 1.2 Final Settlement 2014 Index Price Calculation = 102.70 12-31-14
- 20. ILF Index Futures--Cash Settled $100,000 contract (fully collateralized reinsurance protection) $10 per .01 index point PAR=100 ILF INDICES Product Symbol (Hypothetical) March 2015 H June 2015 M Sept 2015 U Dec 2015 Z Hi-Yield RY RYH15 RYM15 RYU15 RYZ15 Mezzanine RM RMH15 RMM15 RMU15 RMZ15 Investment Grade RI RIH15 RIM15 RIU15 RIZ15
- 21. 1-01-14 Expiration and Rollover Dec 14’ expiry Mar 15’ expiry Jun 15’ expiry Sep 15’ expiry 12-month cycle 2014 sidecar 12-31-14 Serial futures contracts expiring in quarterly cycles 2014 Index
- 22. 1-01-14 Expiration and Rollover Dec 14’ expiry Mar 15’ expiry Jun 15’ expiry Sep 15’ expiry 12-month cycle 2014 sidecar 12-31-14 Serial futures contracts expiring in quarterly cycles Trailing claims data drives the index value until final settlement of the Sept contract 2014 Index
- 23. 1-01-14 Hedging Pool Exposure 12-month cycle 2014 sidecar 12-31-14 2014 Index Investors can fully hedge exposure by selling short 1 ILF per $100,000 pro-rata share of the sidecar This provides flexibility to book profits or reallocate capital for future sidecars if ROL go higher Dec 14’ 2014 Mar 15’ 2014 Jun 15’ 2014 Sep 15’ 2014
- 24. 1-01-14 Hedging Pool Exposure 12-month cycle 2014 sidecar 12-31-14 At expiration of each quarterly contract--the hedge can be easily rolled over until final cash settlement of the index(Sept.) 2014 Index Dec 14’ 2014 Mar 15’ 2014 Jun 15’ 2014 Sep 15’ 2014
- 25. 1-01-14 1-01-15 12-month cycle 2015 sidecar 12-month cycle 2014 sidecar Dec 14’ 2014 Mar 15’ 2014 Jun 15’ 2014 Sep 15’ 2014 Dec 15’ 2015 Mar 16’ 2015 Jun 16’ 2015 An allowance for adjustments in IBNR of current and past cycles will be priced into the EL of future cycles 2014 Index 2015 Index 2015 EL + allowance for 2014 IBNR Adj.
- 26. 1-01-14 1-01-15 12-month cycle 2015 sidecar 12-month cycle 2014 sidecar 1-01-16 Dec 14’ 2014 Mar 15’ 2014 Jun 15’ 2014 Sep 15’ 2014 Dec 15’ 2015 Mar 16’ 2015 Jun 16’ 2015 2015 index 2016 index 2015 EL + allowance for 2014 IBNR Adj. 2016 EL + allowance for 2014 + 2015 IBNR Adj. 2014 Index
- 27. Looking Beyond Cat Risk - By shortening risk duration of long tailed lines--new third party capital will be encouraged to participate
- 28. Looking Beyond Cat Risk - Creating an expansion of ILS capacity into Casualty, Longevity, Medical and Worker’s Comp
- 29. Driving Exchange Volume Options can hedge insurance risk and reduce the index to an interest rate derivative
- 30. Driving Exchange Volume Options can hedge insurance risk and reduce the index to an interest rate derivative Spread Trades VS Treasuries Eurodollars Deliverable Swap Futures
- 31. Example: Using Options to Create Interest Rate Arbitrage Long ILF Spread converges to zero at expiry Exp. Dec 2015 ILF Short IR Future Long UL Call ATM Strike Dec exp. Receive DUP Income 12-month cycle 2015 sidecar 1. If ILF is underpriced vs IR future--buy the ILF 2. Sell correct hedge ratio of IR futures (use DV01 method--dollar value of 1 basis point) 3. Purchase at-the-money strike (ATM) call options on UL component of ILF (hedges out the insurance risk and reduces ILF to an interest rate derivative) 4. Receive DUP carry income as time decays (offsets cost of call premium) 5. At expiration--the spread between long and short position converges to zero Profit = (# of basis points of the spread)+ (DUP – option premium)* (DVO1 of net position)
- 32. Option Strategies Create Crossover Markets • Yield Curve trading • Libor based credit spreads • Carry trades (DUP) • Peak risk calendar spreads • Tranched Index yield spreads
- 33. The ILF Strategy Execution 1. Create a reinsurance spot market 2. Publish an ILF tracking index based on total return of sidecar 3. Form ILF exchange for cash settled index futures and options