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Derivatives in the Insurance Market. Stephen P. D’Arcy Professor of Finance University of Illinois http://www.cba.uiuc.edu/~s-darcy/ First Annual OFOR Symposium May 16, 2002. Overview. Use of derivatives by insurers Securitization of insurance risk.

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derivatives in the insurance market

Derivatives in the Insurance Market

Stephen P. D’Arcy

Professor of Finance

University of Illinois

http://www.cba.uiuc.edu/~s-darcy/

First Annual OFOR Symposium

May 16, 2002

overview
Overview
  • Use of derivatives by insurers
  • Securitization of insurance risk
slide3
Use of Derivatives by InsurersBased on Cummins, Phillips, and SmithNorth American Actuarial Journal January 1997
  • 1994 annual statements filed with NAIC
  • 1,760 life insurers and 2,707 P-L insurers
  • Schedule DB Derivative Instruments
  • Categories of derivatives included:
    • Options, caps, and floors owned
    • Options, caps, and floors written
    • Collars, swaps, and forward agreements
    • Futures contracts
results
Results
  • 12% of life insurers and 7% of P-L insurers used derivatives sometime during the year
  • Stock insurers use derivatives more
    • Life insurers: 16% of stock companies, 7% of mutuals
    • P-L insurers: 10% of stock companies, 4% of mutuals
  • Larger companies used derivatives more
    • For largest size quartile, 34% of life and 21% of P-L insurers used derivatives
results p 2
Results (p.2)
  • Life insurers used derivatives to manage interest rate risk
    • Caps/floors
    • Interest rate swaps
    • Options and/or futures positions on bonds
  • P-L insurers have a higher percentage of assets in equities
    • Use of equity options, both calls and puts
  • P-L insurers used FX forwards
conclusion
Conclusion
  • Most insurers did not use derivatives as of 1994
  • Even for those that did use derivatives, the volume was low
    • For users, average notional value of open positions
      • $661 million for life insurers
      • $90 million for property-liability insurers
why don t insurers use derivatives more
Why Don’t Insurers Use Derivatives More?
  • Unfamiliarity with derivatives
  • Conservatism
  • Derivative horror stories
  • Regulatory resistance
  • Lack of focus on financial risk management
securitization of insurance risk
Securitization of Insurance Risk
  • Exchange Traded Derivatives
  • Contingent Capital
  • Risk Capital
  • Recent insurance derivatives
exchange traded derivatives
Exchange Traded Derivatives
  • First proposed by Goshay and Sandor – 1973
  • CBOT Catastrophe futures and options – 1992
    • Underlying: small sample of companies reported paid losses
  • CBOT PCS Catastrophe Insurance Options – 1995
    • Underlying: estimate of industry wide incurred losses
  • Bermuda Commodities Exchange Catastrophe Options
    • Binary options
    • Trigger: Guy Carpenter Catastrophe Index
status of exchange traded derivatives
Status of Exchange Traded Derivatives
  • Trading volume was very low
  • Large bid-ask spreads
  • There is currently no viable market for exchange traded derivatives
contingent capital
Contingent Capital
  • Line of credit
  • Contingent surplus note
  • Cat-Equity-Put
    • Insurer contracts with counterparty to purchase put options
    • Options can only be exercised in the event of a catastrophe
    • Minimum post catastrophe net worth requirement
    • Warranties on reinsurance, management control, etc.
    • Exposure period 1-10 years
    • Annual premiums
    • Buyback provisions
risk capital catastrophe bonds
Risk CapitalCatastrophe Bonds

Typical case - pre-funded, fully collateralized

Provides insurers with additional capital and multiyear coverage for catastrophes

Provides investors with diversification and high yields

Investors include:

Mutual funds Hedge funds

Reinsurers Life insurers

Money managers

examples of catastrophe bonds
Examples of Catastrophe Bonds
  • USAA – 1997
    • East coast hurricane
  • Swiss Re – 1997
    • California earthquake
  • Munich Re – 2001
    • Hurricane, earthquake and European windstorm
  • Syndicate 33 of Lloyd’s of London – 2002
    • St. Agatha Re
recent insurance derivatives
Recent Insurance Derivatives
  • Catastrophe risk swap
    • Swiss Re and Tokio Marine and Fire – 2001
      • Japan earthquake for California earthquake
      • Japan typhoon for Florida hurricane
      • Japan typhoon for France storm
  • Earthquake derivative
    • Munich Re and Berkshire Hathaway – 2001
      • Earthquakes affecting World Cup Soccer
      • Parametric trigger
future of securitization
Future of Securitization
  • Major insurers and reinsurers will expand use
  • Markets will grow with increased availability
  • Additional sources of risk could be covered
  • Trend will drive insurers to additional financial risk management