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Presented to Annual Congress of Actuaries June 21, 2007 Paris France

The Rationale for the Securitization of Insurance Risk Presented by Richard D. Phillips Bruce A. Palmer Professor of Risk Management and Insurance Georgia State University . Presented to Annual Congress of Actuaries June 21, 2007 Paris France. Outline. Introduction to Securitization

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Presented to Annual Congress of Actuaries June 21, 2007 Paris France

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  1. The Rationale for the Securitization of Insurance RiskPresented byRichard D. PhillipsBruce A. Palmer Professor of Risk Management and InsuranceGeorgia State University Presented to Annual Congress of Actuaries June 21, 2007 Paris France

  2. Outline • Introduction to Securitization • Discuss the Drivers of Demand for Securitization • Market and regulatory factors • A changing business model • Quick Update of Current Market Conditions

  3. Introduction • Securitization - a mechanism whereby contingent and deterministically scheduled cash flow streams arising out of a transaction are unbundled and traded as separate financial instruments that appeal to different classes of investors. • Important elements • Cash flows traditionally were held on balance sheet or earned/paid over time • Cash flows are predictable and/or can be modeled • Assets and risk are usually transferred between parties • Assets associated with the transaction must be bankruptcy remote • Accomplished using Special Purpose Entities (SPE’s) • “brain dead”

  4. Simple Example • Option 1 – Firm wants to purchase an asset • Borrow money from the bank • Book loan as liability on balance sheet • Repay principal and interest over time • Claim interest expense for tax purposes • Purchase asset • Book asset on balance sheet • Depreciate asset over working lifetime • Face risk asset loses or gains value over time

  5. Securitization Option • Option 2 – Synthetic Lease • Firm establishes bankruptcy remote SPE • SPE raises funds from investors and purchases asset • SPE leases asset to the firm in return for lease payments • SPE can borrow funds at lower rates than the firm – why? • At the end of the lease, firm can decide to • Renew the lease • Purchase property for pre-determined price, or • Force the SPE to sell the property • Advantages • Firms faces risk of loss or gain at the time of sale so firm is considered “virtual owner” • Firm claims depreciation and interest expenses for tax purposes • As long as lease payments are less than some threshold values of the asset fair value, there is no asset (and therefore liability) on the balance sheet for accounting purposes.

  6. Sources of Demand for Securitization • Efficient Demand • Demand that would exist in the absence of serious market imperfections • Inefficient demand • Driven by “RRATs” – Regulatory, Rating agency, Accounting and Tax factors

  7. Why Securitization Creates Value GenerallyEfficient Demand • Lower cost of funds • Source of liquidity • Diversify funding sources • Off-balance sheet assets and liabilities • Accelerate earnings

  8. Why Securitization Creates Value for InsurersEfficient Demand • Traditionally, investing in insurance risks was possible primarily by buying insurer stocks • But what drives insurer stocks? • Underwriting risks (mortality, accident rates) • Investment risks • Regulatory risks • Agency costs and mismanagement risks • Securitization creates value by creating “pure play” or primitive securities that are removed from the usual firm-wide risks facing insurers • Enable investors to improve portfolio efficiency • To the extent transparency is achieved, costs of informational asymmetries are reduced • Pure costs of securitized risk transfer may be • Less than cost of capital of an insurer • Less than cost of traditional hedging & financing mechanisms such as reinsurance

  9. “RATs” Demand for New Instruments • Tax motives • Minimization of taxes due to convexity of tax schedules and “loop-holes” • Regulatory motives • Compliance with regulatory rules such as risk-based capital • Accounting motives • E.g., securitizing deferred acquisition expenses • Improve regulatory balance sheet • Achieve higher financial ratings • “Cleansing” financial statements prior to entering the mergers & acquisitions market

  10. Changing Business ModelsWarehousing vs. Intermediation • Traditional roles • Investment banking – intermediaries • Insurance/reinsurance – risk warehousers

  11. Traditional Insurer ModelRisk-Warehousing and Risk-Bearing Premium Risk Warehouse Retain Liabilities Reinsurer Premium Hedging Firms and PH’s Contingent Payment Contingent Payoff Capital Risk-Bearing Equity Capital Capital Market Dividends

  12. Why Risk Warehouses Developed • Insurance is characterized by informational asymmetries • Insurer is “opaque” • Debt claimant cannot judge overall risk exposure, reserve adequacy, etc. • Opaqueness is partially mitigated if insurer holds equity & diversifies over a wide range of risks • Reduces income volatility and solvency risk, but also • Helps assure debt claimants that probability of bad outcomes has been minimized • Requires insurer to keep risks on balance-sheet • Opacity and market experience generate private information for the (re)insurer • E.g., ability to estimate insurance claims distributions • Information on portfolios and underwriting quality of specific clients (what did we call this?) • Opacity creates “economic rents”

  13. Investment Bank ModelRisk Intermediation Risk Intermediary: (Investment Bank) Risk Premium Hedge Premium Capital Market Risk-Bearing Hedging Firms Contingent Hedge Payoff Contingent Payment Equity Capital Capital/ Expertise Compensation Owners

  14. Combining the Intermediary and Warehouse Model RiskPremium Capital Market Intermediary Securitize Liabilities Premium Hedging Firms and PH’s Contingent Payment Contingent Payoff Premium Warehouse Retain Liabilities Reinsurer Contingent Payment Capital Risk-Bearing Equity Capital Capital Market Dividends

  15. Evolving Towards Securitization • Securitization forces the firm to identify where the value chain creates the most value • Occurs when reduced financing or hedging costs more than offset the loss of economic rents from reducing opacity • Securitization leverages the insurers/reinsurer’s information advantage – but for who? • Insurer/Reinsurer’s new role • Originate pools of risks • Underwrite to create viable tranches • Repackage for sale in securities markets • Increased recognition equity capital is costly BEYOND systematic risk costs • Improvements in capital allocation methods • Solvency II

  16. ILS Prices Declining Over Time(At least they were) Source: Lane (2006)

  17. Catastrophe Bond Issues: 1996 – 2006* Total: $14 billion * - Through November 2006 Source: Goldman Sachs (2006) and Swiss Re (2006).

  18. Who buys these bonds? • The Dedicated Cat Fund segment has increased from 5% to 33% • The Money Manager segment has increased from 30% to 40% 1999 (USD 1 billion market) 2004* (USD 4 billion market ) Primary Insurer Bank Bank 5% Hedge Fund 4% 3% Hedge Fund 5% 16% Primary Insurer 30% Reinsurer Money Reinsurer 4% 25% Manager 40% Dedicated Cat Dedicated Cat Fund Money Fund 5% Manager 33% 30% Bill Dubinsky August 2004 ARIA Annual Meeting *As of July 23 2004

  19. Design Consideration: The Triggering Event • Examples of Trigger • Indemnity trigger • Loss experience of one insurer • Modeled Loss • Industry trigger • Industry loss warranties • The PCS call options traded on the CBOT • Parametric index • Pure index • Magnitude of earthquake • Windspeed of hurricane • Multiple parameters • Payoff is a function of various transparent parameters Parametric Industry Index Transparency to Investor Modeled Loss Indemnity Basis Risk to Sponsor

  20. Assets Traded assets Long-term Short-term Non-traded assets Policy acquisition costs Other receivables Other non-traded Liabilities Policy reserves Life insurance Annuity Premium reserves Equity capital What Else Can Be Securitized? Life Insurer Balance Sheet

  21. Inflows Premiums Annuity considerations Investment income Investment sales and maturities Fee income (e.g., asset management fees on variable products) Outflows Policy death benefits Annuity payments Surrenders (disintermediation) Expense payments Origination costs Ongoing costs Capital expenditures Taxes What Else Can Be Securitized?Life Insurance Cash Flows

  22. Conclusions • Vast amounts of assets and liabilities remain “on balance sheet” in the insurance industry • To realize full potential for securitization • Overcome informational opacities • Develop better indices for index linked products • Reduce regulatory obstacles • Educate insurers and investors • Tremendous potential to change insurance industry business model

  23. Conclusions II • Important to reduce costs of informational asymmetries • May require insurers to sacrifice some “private information” • Asymmetry costs can be mitigated by structuring • Informationally sensitive tranches that appeal to investors with information advantages • Informationally insensitive tranches for less well informed investors • Development of a public market needed to achieve full potential • Solvency II will further drive demand to “accelerate” the balance sheet

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