Securitization and Other Instruments for

Transferring Risk to the Capital Markets

Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D.Actuarial Science Program

University of Illinois at Urbana-Champaign

Washington, DCJuly, 2003

Agenda

• Historical background of securitization

• Definition and evolution of insurance securitization

• Types of securitized insurance instruments

• Recent activity

• Issues for the future

Terminology and Tools

• Financial terminology– We need to learn to quack before we can be a duck– Financial practitioners say things like

“BB undefeased subordinated debenture at 6mLIBOR+350bps”

• Financial tools– Financial practitioners use tools with names like

“options,” “swaps,” “swaptions”

Securitization inHistorical Perspective

• Home mortgage market: funding shortfall in the late 1970s

• Market response:– Change tax laws: no double taxation on cash flow

pass-throughs– Modernized investment technology– FNMA, Freddie Mac

• Other asset-backed securities developed subsequently– Auto loans– Credit card receivables– David Bowie albums

The Securitization Process

• Participants– Demanders of funds

• Homeowner / borrower of funds• Bank / Loan originator

– Special purpose entity / trust– Suppliers of funds

• Underwriter / investment bank• Capital markets / investors

• Some of the Benefits– Liquidity– Market values– Lower cost

Mortgage-Backed Securities (MBSs)

• Originated in response to mortgage funding shortfall

• Mortgages are “securitized” by packaging mortgage loans and selling the cash flows as securities

• The mortgage-backed securities represent ownership in the mortgages

• Mortgages generally have an embedded option: to prepay the mortgage (in event of interest rates falling, mortgage-holder moving, etc.)

Mortgage-Backed Securities (cont.)

• Investors receive the monthly mortgage payments (principal and/or interest) paid by the mortgage borrowers

• With MBSs, the prepayment risk is transferred to the capital market investors

• Investors are compensated for this risk by sufficiently high yields on the securities

What is “Securitization of Insurance Risk”?

• Insurance company transfers underwriting risks to the capital markets by transforming underwriting cash flows into tradable financial securities

• Cash flows (e.g., repayment of interest and/or principal) are contingent upon an insurance event / risk

Evolution of the Insurance Industry

“Affronts” to Traditional Insurance

• Self-insurance• Captives• Risk retention groups and purchasing

groups• Insurance securitization• Portfolio insurance

Factors Affecting the Recent Development of Insurance Securitization

• Recent catastrophe experience– Reassessment of catastrophe risk

– Demand for and pricing of reinsurance

– Reinsurance supply issues

• Capital market developments– Development of new asset classes and asset-backed

markets

– Search for yield and diversification

• Restructuring of insurance industry

Possible Reasons for Securitizing Insurance Risks

• Capacity– Risk of huge catastrophe losses– Would severely impair P/C industry capital– Capital markets could handle

• Investment– Catastrophe exposure is uncorrelated with

overall capital markets– Thus, uncorrelated with existing portfolios– Diversification potential

Risks Which P/C Insurers Face

• Underwriting– Loss experience: frequency and severity– Underwriting cycle– Inflation– Payout patterns– Catastrophes

• Investment– Interest rate risk– Capital market performance

All of these risks can prevent a company from meeting its objectives

What to Securitize?

• Homeowners? Auto? Health?• “Homeowners is not a problem for the insurance

industry. Auto is not a problem for the insurance industry. We know how to manage those risks…. How about catastrophes?”

- Dennis Chookaszian (a 1992

comment, quoted in Best’s

Review, 4/99)

Types of Insurance Instruments

• Those that transfer risk– Reinsurance– Exchange-traded derivatives– Swaps– Catastrophe bonds

• Those that provide contingent capital– Letter of credit– Contingent surplus notes– Catastrophe equity puts

Exchange-Traded Derivatives

• Chicago Board of Trade– Option spreads ~ reinsurance– PCS: daily index values– Nine geographic products

• Bermuda Commodities Exchange– Binary options– Guy Carpenter Catastrophe Index– Seven geographic products

Risk Exchanges and Swaps

• CATEX New York

– Electronic bulletin board

– Intermediary

• CATEX Bermuda

– Joint venture: CATEX and Bermuda Stock

Exchange

• Swaps

Some Early Successful Bond Issues

• USAA: company’s hurricane losses

• Swiss Re: industry’s California E/Q losses

• Tokio Marine & Fire: Tokyo E/Q magnitude

• Centre Re: company’s Florida hurricane losses

• Yasuda Fire & Marine: typhoon losses

Early Successes• USAA / Residential Re

– Size: $477M, in two tranches– Trigger: hurricane losses to company– Coverage: 80% of $500M x/s $1B co. loss– A-1: rated AAA

• $163.8M, of which $77M placed in a defeasance account to fund principal repayment

• Only interest at risk• Coupon: LIBOR + 282 bps

– A-2: rated BB• $313.2M• Both principal and interest at risk• Coupon: LIBOR + 575 bps

Early Successes (cont.)• Swiss Re

– Size: $137M, in three classes

– Trigger: losses to industry from CA E/Q; industry insured loss, from a single event, greater than $18.5B triggers principal write-downs

– 40% of Class A proceeds to defeasance account

– Coupon:• A-1: LIBOR + 255 bps

• A-2: 8.645%

• B: 10.493%

• C: 12%

Early Successes (cont.)• Tokio / Parametric Re

– Size: $100M, in two tranches– Trigger: Tokyo earthquake magnitude; a Japanese

Meteorological Association magnitude rating of 7.1 or more involves loss of part or all of principal

– Half of $20M proceeds from A and all of $80M proceeds from B are risk capital

– Ten-year term – Coupon:

• A: LIBOR + 206 bps• B: LIBOR + 430 bps

Early Successes (cont.)

• Centre / Trinity Re– Size: $84M, in two tranches

– Trigger: FL hurricane losses to company

– Class A-1 notes ($22M in proceeds) provide for full principal repayment in event of a loss

– Coupon:• A-1: LIBOR + 182 bps

• A-2: LIBOR + 436 bps

Early Successes (cont.)

• Yasuda Fire and Marine– Typhoon losses– $80 million offering– 5-7 years– Attachment point recalculated every year with

exposure model -- constant 0.94% chance of loss to investors

– Guaranteed limits and pricing for a second event

Generally Common Traits of Early Successful Issues

• Involve catastrophe risk

• High levels of protection

• Relatively short maturities

• Some protection of principal included

• High coupon rates

Trend is now toward longer (e.g.,3-year versus annual)

Associated with “newness”

“Costs” of Cat Bonds

• High yields– Default premiums may be high for a time

• Setting up SPV

• Investment banking fees– Advising

– Spread

• Legal fees

Contingent Capital

• Contingent surplus notes– Option to borrow, contingent upon some event

or trigger

– Right to issue surplus notes

• Catastrophe equity puts– Put option (right to sell)

– Right to issue shares of stock, contingent upon some event or trigger

Very Recent Activity

• Approximately $1.22 billion issued in the 2002 cat bond market– Versus $1.14 billion in 2000

• Notable transactions:– USAA / Residential Re: Sixth consecutive year

– Vivendi / Studio Re: First direct-corporate issue on US peril

• Several catastrophe bond investment funds

Issues Regarding the Potential “Success” of Insurance Securitization

• Need to understand two markets– Capital markets– Insurance markets

• Separation of insurance and finance functions in many companies

• Information and technology• Pricing challenges• Cost (vs. cat. reinsurance market)• Legal / tax / accounting issues