Financial risk products case study perspective
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Financial Risk Products: Case Study Perspective. Discussion Topics. Insurance Linked Securities Case Study I - Hypothetical ILS Transaction Case Study II - Basis Risk Transaction. 4. 2. 1. 3. Investment Earnings. Cash Proceeds. Reinsurance Premium. Principal & Interest.

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Financial Risk Products: Case Study Perspective

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Financial risk products case study perspective

Financial Risk Products: Case Study Perspective


Discussion topics

DiscussionTopics

  • Insurance Linked Securities

  • Case Study I - Hypothetical ILS Transaction

  • Case Study II - Basis Risk Transaction


Securitization overview

4

2

1

3

Investment

Earnings

Cash

Proceeds

Reinsurance

Premium

Principal

& Interest

Contingent

Claim Payment

Cash

Proceeds

Investment

Earnings

Scheduled

Interest

Securitization - Overview

Investments

Investors

Re-insurer

SPV

Swiss Re

Financial

Products


Swap overview

1

2

3

Reinsurance

Premium

Contingent

Claim Payment

Fixed Amounts

Fixed Amounts

Floating Rate

Amounts

Floating Rate

Amounts

Swap - Overview

Re-insurer

Swap Transaction based

on notional amount

Investors

Swiss Re

Swiss Re

Financial

Products


Case study i overview

Case Study I - Overview

Elements of a Capital Market solution

  • Understanding of situation

  • Risk mapping

  • Exposure

  • Structuring issues

  • Delivery mechanism


Case study i risk source

Case Study I: Risk Source

Earthquake (EQ) risks in California

Source:

United States Geological Survey, National Earthquake Information Center, www.neic.cr.usgs.gov


Case study i situation analysis

Case Study I - Situation Analysis

  • ABC is global leader in the microchip industry

  • Its factory is based in Palo Alto, California

  • California is highly exposed to EQ risks

  • Therefore, ABC seeks for protection against a potential profit drop resulting from a devastating EQ harming its microchip production

  • Because of the current market conditions there is no cover available on the traditional insurance market; ABC approaches you to propose a Capital Market solution


Case study i risk mapping definition of eq

Intensity map

epicenter

Fault plane

focus (hypocenter)

Case Study I - Risk mapping, definition of EQ

Magnitude (M)

  • Measurement of energy release

  • Richter Scale (and others)

  • M max: ~8.5

  • Damage: M>=5.0

Intensity (MMI)

  • Observation of effects

  • Modified Mercalli Scale - MMI (and others)

  • MMI 12 degrees: I to XII

  • Damage: MMI >=VI

MMI = Modified Mercalli Shaking Intensity, average soil conditions

Source: Swiss Re Reinsurance & Risk, RN/CP, SNAP EQ


Case study i exposure

Case Study I - Exposure

In USD m

Turnover

Net profit

Source: Annual Reports


Case study i risk mapping return periods p a

Case Study I - Risk mapping, return periods p.a.


Case study i structuring issues

Case Study I - Structuring issues

  • Issuer’s Needs vs. Investor’s Demand

  • Loss Basis

  • Risk Profile

  • Triggering Event

  • Coverage Period

  • Other Structuring Considerations


Case study i delivery mechanism

Case Study I - Delivery mechanism

  • Structured Note

    • Onshore vs. Offshore Issuer

    • Defeased vs. Non-defeased

    • Fixed vs. Floating Rate

    • Public vs. Private

    • Single vs. Multiple Traches

  • Derivative Instrument

    • Swap vs. Option

    • ISDA regs

    • Targeted Buyers


Case study ii

Case Study II

Basis Risk Swap Transactions


Basis risk transaction

Basis Risk Transaction

  • Exchange of cash flows based on two variable indices

    • Amount you pay and receive will change according to the movements in two separate indices

  • Basis Swaps

    • Common capital markets instrument

  • Capital Markets Indices

    • London Interbank Offer Rate (LIBOR)

    • Commercial Paper (CP)

    • F/X rates

    • S&P 500

    • Etc.


Example libor versus cp

6.80%

6.60%

6.40%

6.20%

6.00%

5.80%

5.60%

5.40%

Year 1

Year 2

Year 3

Year 4

Year 5

Example: LIBOR versus CP

  • Domestic interest rates tend to move in the same direction

  • However, the difference between different interest rates will vary over time

LIBOR

CP


Example libor versus cp1

Example: LIBOR versus CP

  • Company A issues commercial paper and invests in floating rate notes at L + 50bps

  • Company A does not wish to take the risk that CP rates will increase faster than LIBOR or decrease slower than LIBOR

  • Company A approaches Swiss Re Financial Products (SRFP) and enters into a basis swap

  • Company A pays LIBOR to SRFP

  • SRFP pays CP + 10 to Company A

  • Company A locks in 60 bps spread


Example libor versus cp2

Floating

Rate Notes

LIBOR + 50

LIBOR

Company A

CP + 10

Commercial

Paper

Example: LIBOR versus CP

Company A

Receives from FRN:LIBOR + 50

Pays to SRFP:LIBOR

Net:+ 50

Receives from SRFP:CP + 10

Pays to investors:CP

Net+ 10

Total+ 60

SRFP


Basis risk transactions in insurance

Basis Risk Transactions in Insurance

  • Potential Loss Tiggers in Re/Insurance Markets

    • Actual losses

    • Industry Losses

    • Loss ratios

    • Losses on different perils

  • Value of Basis Swap Transactions

    • To hedge a position already taken (reduce risk profile)

    • To arbitrage a market inefficiency (get cheaper overall pricing)

    • To be an innovator

    • To speculate


Basis transaction 1

Outside

Source

Indexed

Protection

Basis

Transaction

SRNM

Corporate/

Insurer/

Reinsurer

Basis Transaction #1

  • Client gets indexed cover from outside source

  • Client enters into basis transaction with SRNM

    • Client pays to SRNM any recoveries made on indexed cover

    • SRNM pays client for actual losses incurred


Basis transaction 2

Indexed Reinsurance

or Security

or Swap

or Option

SRNM

Corporate/

Insurer/

Reinsurer

Indemnity

Agreement

Basis Risk

Investors

Basis Transaction #2

  • Client gets indemnity cover from SRNM

  • SRNM issues indexed paper to the market

    • SRNM keeps the basis risk


Basis transaction 3

Portfolio

Swap

Indexed Reinsurance

or Security

or Swap

or Option

SRNM

Corporate/

Insurer/

Reinsurer

Basis Risk

Outside

Source

Cal. quake

Japan quake

Basis Transaction #3

  • Client receives return on a portion of SRNM’s California earthquake book of business

  • SRNM receives return on a portion of Client’s Japan earthquake book of business

    • SRNM may or may not enter into a transaction to hedge itself

  • Client’s overall book of business is better diversified


Basis swap example

Basis Swap Example

  • A XYZ Reinsurer is attempting to get windstorm coverage for Florida, Texas, and the East Coast

    • XYZ Re wants to pay 7%

    • No offers

  • XYZ Re approaches SRNM for alternative solutions

  • SRNM analyses XYZ Re’s book of business and determines the level of industry losses equivalent to the layer XYZ Re wants reinsured

  • XYZ Re purchases ILW for 6% from an insurer / CM investor(s) and enters into basis transaction with Swiss Re for 1%


Basis swap example cont

Basis Swap Example (cont.)

  • Basis risk transaction

    • XYZ Re pays claims to Swiss Re based on industry losses

      • Any claims XYZ Re must pay to Swiss Re it will receive from Insurer as part of ILW

    • Swiss Re pays claims to XYZ Re based on losses on XYZ Re’s reinsurance book

    • If Windstorm occurs and industry losses are large relative to XYZ Re’s book, Swiss Re receives payment

    • If XYZ Re’s losses are large relative to the industry, Swiss Re makes a payment


Basis swap structure

10 mm ILW

XYZ Re

Swiss Re

Reinsurance

20 million - 50% QS

Basis Swap Structure

Basis Risk -

Sell Reinsurance

Buy ILW

XYZ Re

Receives from Ins. / Investor:Industry Losses

Pays industry losses to SR:Industry Losses

Receives payment from SR:Actual Losses

Net:Actual Losses

Insurer /

Investor

Texas to Maine

ILW

XYZ Re

Swiss Re

Basis Risk


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