the value of catastrophe securitization · 2011-06-10 · the value of catastrophe securitization...

The Value of Catastrophe Securitization

Bobby Bierley, Jim Hilliardand Rob Hoyt

Institutstag – IVW an der Uni Köln6. Juni 2011

The Georgia RMI Program• #2 RMI Program nationally in the U.S.

News Rankings

• Largest RMI Program in the U.S. – Risk Management Magazine – 129 graduates last year

• Risk management and insurance emphasis in the MBA program

• Significant Ph.D. program

Agenda• Introduction• Catastrophe Bond Design & Structure• The Study

– Purpose & Motivation– Data, Methodology, & Variables– Results– Conclusions

Introduction

Annual Catastrophe Bond Transactions Volume

$1,729.8

$2,700.0$3,400.0

$4,800.0

$966.9

$7,329.6

$4,693.4

$1,991.1

$1,142.8$1,219.5$846.1$984.8$1,139.0$633.0

$0$1,000

$2,000$3,000

$4,000$5,000

$6,000$7,000

$8,000

97 98 99 00 01 02 03 04 05 06 07 08 09 10

Ris

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apita

l Iss

ues

($ M

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5

10

15

20

25

30

35

Num

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f Iss

uanc

es

Risk Capital Issued Number of Issuances

Source: MMC Securities Guy Carpenter, A.M. Best; Insurance Information Institute.

Catastrophe bond issuance soared in the wake of

Hurricanes Katrina and the hurricane seasons of

2004/2005, but retrenched during the financial crisis of

2008

Q1 2011 - $1 billion v. $650 million in

Q1 2010

Literature Review

Literature Review• Corporate Demand for Insurance

• Mayers and Smith (1982, 1990)• Demand for Insurance is a function of:

– tax structure– expected bankruptcy and financial distress costs – ownership structure– investment incentives– information asymmetry– comparative advantage in real services

• Securitization is an alternative (or complement) to standard insurance, useful if it provides the advantages of insurance at a lower cost or with capacity unavailable in the insurance markets

Categories of Literature

• The Market & History– Cummins (2007, 2008), McGhee et al. (2007, 2008),

Cummins (1999), and Froot (2001)

• Design & Structure– Tynes (2000), Ali (2000), Borden and Sarkar (1996)

• Technical Discussion– Chichilnisky and Heal (1998), Cummins (2004)

• Our Contribution: Add to limited empirical research on catastrophe securitization

Catastrophe Bond Design & Structure

What is “Catastrophe Securitization”?

• Def: Catastrophe Bonds are fully collateralized debt securities that pay off on the occurrence of a defined catastrophic event.

• Catastrophe Bonds typically cover specified perils (earthquakes, hurricanes, typhoons) within specific geographic areas (California, Gulf of Mexico, East Coast, Japan, Europe, etc.)

Why are Catastrophe Bonds Used?

• CAT Bonds have been utilized primarily to provide risk transfer capacity for the Sponsor/Cedent entity’s layer of loss that attaches excess of a one-in-100 year event (prob = 1%) and aggregates at the one-in-250 year event (prob < .4%)

• Why is this done?1. Counterparty credit issues of reinsurers at this level

2. Reinsurance is often uneconomical at this level

USAA – May 2009 issue for 1-in-500 year event

Basic Structure

Source: MMC Securities and Guy Carpenter.

Quality and duration had been a problem in some deals – higher quality and matched

durations now common

Monthly evaluations

– now weekly or

daily

Risk Trade-offs• Basis risk

– mismatch between the risk outcomes and the payoffs on the hedge

• Moral hazard– intentional actions by the “insured” that

make the payoff more likely or larger

Typical Catastrophe Bond Components

• Bond Term: Usually 2 to 4 years

• Multi-Peril vs. Single Peril

• Payout Triggers (3 Categories):– Indemnity Triggers

– Index Triggers (parametric, industry loss, and modeled loss)

– Hybrid Triggers

Advantages of Catastrophe Bonds Compared to Reinsurance

• Potential losses are fully collateralized (reinsurance cycling not a factor)

• Able to lock in a price and capacity for multiple years (usually 3 years)

• Open up an area of new risk capital

• Minimize the impact of insurance market shocks from market cycles

• Availability in higher risk layers

The Study

Purpose & Motivation• To determine whether catastrophe security

issuances follow the theoretical explanations for the corporate demand for risk management (do they add value?)

• To examine which firm- and issue-specific factors explain the firm value impacts observed upon issuance

Data, Methodology & Variables

• Sample: 90 combined catastrophe securitization transactions between 1997 and 2011 – combined because some transactions included multiple tranches being announced on the same announcement date

• Source: Market Reports, Moody’s, WRDS, CRSP, Factiva, Business Source Elite, Global Insight, Company Websites

• Removed: 1) M&A transactions when stock was not listed, 2) Takedowns, 3) Conflicting data with regard to event date or issuers, and 4) Non-cat non-life issuances e.g. motor insurance

Data, Methodology & Variables (con’t)

• Methodologies: Event Study and OLS Regression

• Foundation: Efficient Market Theory (CAPM)

• Event: Catastrophe Bond Issuances– Estimation Period: t-175 to t-20– Various Event Windows: including (-10,+10), (-5,+5),

(-1,0) and (-1,+1)

– Event: (earliest of press releases, news releases, or ratings announcements)

Empirical Model (Part 1)Market Model Event Study:

– Cumulative Abnormal Returns

– Test Statistics:

1. Rank Test z

2. Standardized Cross-sectional z Test

3. Generalized z Test.

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Empirical Model (Part 2)OLS Regression:

– Cumulative Abnormal Returns (Dependent Variable):

– Independent Variables and Predictions:• Market Cycle (-)• Firm Size (-)• U.S. Issuer (+/-)• Non-insurer Issuer (+)• Relative Issue Size (+/-)• Trigger Type (-)

with higher basis risk or moral hazard

• Single Peril (+/-)

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Market Model Results(all issuers, n=90)

Days CAAR StdCsect z Generalized Sign z Rank Test Z

(-10,+10) 1.69% 0.977 0.804 0.899

(-5,+5) 0.70% 0.051 0.804 0.291

(-1,0) -0.10% -0.584 0.593 -0.169

(-1,+1) 0.03% 0.106 -0.461 -0.014

* Significant at the 10% level** Significant at the 5% level*** Significant at the 1% level

Market Model Results(first issuers, n=29)

Days CAAR StdCsect z Generalized Sign z Rank Test Z

(-10,+10) 4.28% 2.880*** 2.230** 2.644***

(-5,+5) 1.21% 0.251 0.744 0.657

(-1,0) -0.12% -0.335 0.372 0.063

(-1,+1) 0.30% 0.582 -0.371 0.246

* Significant at the 10% level** Significant at the 5% level*** Significant at the 1% level

Categorical Variables in the Model

Variable N% of

Issues

Non-Insurer 2 2.2%Trigger Type:

Parametric 16 25.0%Industry Index 24 41.7%Indemnity 12 5.6%

Single Peril 40 44.4%Swiss Re 26 28.9%First Issue 29 33.3%

(-10,+10) (-5,+5) (-1,+1)

Intercept 0.01299 0.01537 0.03487 0.03294 0.00007 0.00144

Market Cycle -0.00466 -0.00419 -0.01683 -0.01721 -0.00718 -0.00691

Firm Size 0.0001 0.00001 -0.00004 -0.0004 -0.0001 -0.0001

US Firm -0.0361 * -0.03774 * -0.02928 ** -0.02794 ** -0.00601 -0.00696

Non-insurer 0.16115 * 0.16075 * 0.0943 * 0.09462 * -0.00219 -0.00242

Reliatve Issue Size 416.9847 408.7924 222.4761 229.1352 26.49945 21.79793

Parametric Trigger -0.02466 -0.02513 -0.02635 -0.02597 0.000474 0.000203

Industry Index Trigger -0.02475 -0.02476 -0.03012 ** -0.03012 ** 0.00242 0.00241

Indemnity Trigger -0.03963 ** -0.0411 ** -0.03065 ** -0.02946 ** 0.00164 0.000795

Single Peril 0.02004 0.02008 0.01072 0.01068 0.00972 * 0.00975

First Issue 0.03368 ** 0.03262 ** 0.00362 0.00449 -0.00138 -0.00199

Swiss Re -0.00465 0.00378 -0.00267

Adjusted R-Square 13.75% 12.70% 8.03% 6.91% -2.46% -3.57%

Cross-Sectional Model Results (N=90)

Conclusions- Catastrophe bond market appears to be on a path

to continued growth (recent disasters have not dampened the interest in this market)

- Current securities regulation dictates that bond prospectuses for privately placed bonds can only be distributed to accredited investors as defined by the SEC (creates difficulty for researchers)

- Evidence of positive returns that are statistically significant and economically meaningful for first issuers

Conclusions (con’t)

- U.S. insurer is significant and negative - May reflect higher spreads for catastrophe bond issuances

in this market

- Non-insurer issuer variable was significant and positive- issuance by non-insurance firms may be perceived as

innovative by investors and only routine by insurance firms

- Indemnity and Industry Index triggers are significant and negative relative to modeled loss trigger- Better balance of basis risk and moral hazard

Future Developments to Watch• Solvency II and other regulatory capital

frameworks are likely to generate more focus on capital requirements for tail risks

• Possible role for catastrophe bonds in addressing these new capital needs

• Issues faced by governments in addressing catastrophe risks

• Flood and coastal wind risks in U.S. (NFIP)

• Natural catastrophe exposures in developing and under-developed countries (World Bank)

Contact Information for the Risk Management and Insurance Program

at the University of Georgia

• Department Head, Rob Hoyt– Brooks Hall 206– rhoyt@terry.uga.edu

• Our web site– www.terry.uga.edu/insurance