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Risk Securitization 101 2000 CAS Special Interest Seminar

Risk Securitization 101 2000 CAS Special Interest Seminar. David Na, FCAS, MAAA Deloitte & Touche, Bermuda. Background. Background. Merging of Financial and Insurance Markets Travelers + Citicorp = CitiGroup? Insurance Industry “Scared” by Events Such as Hurricane Andrew

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Risk Securitization 101 2000 CAS Special Interest Seminar

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  1. Risk Securitization 1012000 CAS Special Interest Seminar David Na, FCAS, MAAA Deloitte & Touche, Bermuda

  2. Background

  3. Background • Merging of Financial and Insurance Markets • Travelers + Citicorp = CitiGroup? • Insurance Industry “Scared” by Events Such as Hurricane Andrew • $18 billion? $60-80 billion?? • Recent Activity - New Companies/Transactions • Arrow Re (Goldman Sachs) • Lehman Re (Lehman Brothers)

  4. Background • Effects of Natural Catastrophes in Late 80’s & Early 90’s: • Decreased Insurance/Reinsurance Capacity • Increased Demand for Reinsurance • Realization of Inadequate Pricing • Increased Awareness re: Insurer’s Exposures

  5. Background • Comparison of Capitalization of Insurance and Capital Markets... • Estimated Capital of US P/C Ins. Industry ~ $338 billion • Size of the Capital Markets • Total Capitalization ~ $34 trillion • Average Daily Fluctuation ~ $200 billion • $100 billion loss ~ 1/3 of 1% of market capital

  6. What is Risk Securitization? • Packaging/Transferring of insurance underwriting risks to the capital markets through the issuance of a financial security • 2 Important Aspects: • Transformation of U/W Cash flows into tradable securities • Transfer of U/W Risk through the trading of those securities • Investment Return is contingent upon underwriting experience

  7. Types of Transactions/Triggers • Indemnified Notes • Indexed Notes • Parametric Notes

  8. Indemnified Notes • Responds Directly to Ceding Company’s Specific Exposures & Actual Losses • Provides the Most Precise Coverage for Cedant • Reflects Cedant’s U/W & Claim Settlement Processes • Long Development Patterns – Investors may need to Wait for Their Return • Sample Transaction: Alpha Wind

  9. Indexed Notes • Linked to Industry or Geographic Index (e.g. PCS) • Cedant Exposed to Significant Basis Risk, if Index is not Consistent with Cedant’s Actual Losses • Shorter Development Period (Generally Easier to Predict the Index than Individual Company Losses) • “Synthetic Indemnification” – Mathematical Attempt to Replicate the Cedant’s Underlying Book of Business • Sample Transaction: Seismic Re.

  10. Parametric Notes • Linked to Quantities Associated with Pertinent Events – Generally Physical Attributes of an Event: • Magnitude, Intensity, & Epicenter of EQ • Wind Speed, Forward Velocity, & County of Landfall of Hurricane • Removes Risks Associated with Modeling the Ceding Company’s Exposures or Changes in Exposures • Virtually Eliminates Development Period • Sample Transaction: Concentric Ltd.

  11. Investor Risks & Returns • No Standard Approach • Principal Protection… sometimes • Various Tranches • Varying Terms (e.g. Tokio EQ is 10 years) • Returns based on Risk

  12. Other Examples of Securitization • Mortgage Backed Securities • Similarly created by excess demand • However, high volume, stable asset was securitized • Auto Loans & Credit Card Receivables • David Bowie (offering securitized by future sales of CD’s) • NFL (offering securitized by $18 billion TV deal) • [subsequently withdrawn]

  13. Perspective • Think of as any other security... • It’s all about Risk v. Return... • Here, the risk happens to be insurance related

  14. Types of Insurance Linked Securities (ILS’s)

  15. Types of ILS’s • Catastrophe Bonds - Will Discuss in Detail... • Catastrophe Risk Exchange (CATEX) Swaps • Insurance Related Derivatives/Options • Catastrophe Equity Puts (CAT-E-Puts) • Contingent Surplus Notes • Weather Derivatives

  16. Types of ILS’s • CATEX Swaps – NY & Bermuda • Electronically swap CAT exposures (e.g. geographic location, property type, etc.) • Insurance Related Derivatives/Options • Chicago Board of Trade Options: Based on aggregate industry CAT losses (Property Claim Services) • Bermuda Commodities Exchange CAT Options: Based on Guy Carpenter Catastrophe Index (ratio of losses to housing values)

  17. Types of ILS’s • Catastrophe Equity Puts (CAT-E-Puts) - Insurer has the option to sell equity (e.g. preferred shares) at pre-determined price, contingent upon a specific event • Contingent Surplus Notes - Option to borrow contingent upon the occurrence of a specific event (contingent funds held in trust) • Weather Derivatives - Insurance or derivative contract which pays based on weather related events

  18. Generic ILS Structure Portfolio Return + Premium Premium InsurerorReinsurer SPV Investors Reimbursement Payment (Event Contingent) Loss of Value (Event Contingent) Portfolio Return Liquidation of Assets (Event Contingent) Invested Proceeds - Trust Account

  19. Advantages - Investor • Above average yield relative to other securities (e.g. corporate bonds) of similar risk • Outstanding diversification effect - Unlike investments in insurance company stocks, CAT events are generally uncorrelated with an investor’s portfolio • Allows non-insurance investors to participate in insurance related transactions • Preparation for convergence of Insurance & Banking

  20. Advantages - Issuer • Capacity - Access the Capital of the Financial Markets • Greater Flexibility in Terms of Coverage • Reinsurance Protection – Fully Collateralized, No Credit Risk • More Stable Pricing - Insulated from U/W cycles • High aggregate level risk transfer • Innovation/Prestige - “Cutting Edge”

  21. Issues • Requires understanding of both Capital and Insurance Markets (Investors as well as Issuers) • Historical separation of Capital and Insurance Markets (e.g. Regulatory Issues) • Uncertainty involved in pricing high layer or catastrophic events (Reliance on Modeling) • Issuer’s Costs (Relative to Purchase of Reinsurance) • Investor’s Return (Relative to Comparably Risky Securities) • Accounting, Legal, Regulatory, Tax, etc.

  22. The USAA/Residential Re. Transaction

  23. USAA/Residential Re. • Placed in 1997 (with subsequent renewals) • Reinsurance coverage of 80% of $500M x $1B • Covers Category 3, 4, or 5 Hurricanes along the East or Gulf Coasts of the US • $477 M in bonds issued • Residential Re. Domiciled in Cayman

  24. USAA/Residential Re. • Tranche A-1 ($164 M): • AAA rated • Only interest at risk • Coupon paid LIBOR + 2.82% • Tranche A-2 ($313 M): • BB rated • Principal & Interest at risk • Coupon paid LIBOR + 5.75% • Investor Appeal • Principal Protection & AAA Rating • Favorable risk/return

  25. USAA/Residential Re. Why did it work in 1997? • Market timing; lack of investors’ appetite for risk in 1996; in 1997, risk/return more attractive • Rating agency concerns (1996 not investment grade) • Protection of principal • 1997 issue had short duration & conservative loss trigger (USAA’s losses from Andrew ~ $555 M)

  26. Risk Securitization 1012000 CAS Special Interest Seminar David Na, FCAS, MAAA Deloitte & Touche, Bermuda

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