Transcript The Catastrophic Risk Problem

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
• Discuss the Drivers of Demand for Securitization
• Market and regulatory factors
• A changing business model
• Quick Update of Current Market Conditions
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”
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
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.
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
Why Securitization Creates Value Generally
Efficient Demand
• Lower cost of funds
• Source of liquidity
• Diversify funding sources
• Off-balance sheet assets and liabilities
• Accelerate earnings
Why Securitization Creates Value for Insurers
Efficient 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
“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
Changing Business Models
Warehousing vs. Intermediation
• Traditional roles
• Investment banking – intermediaries
• Insurance/reinsurance – risk warehousers
Traditional Insurer Model
Risk-Warehousing and Risk-Bearing
Hedging
Firms
and PH’s
Premium
Risk
Warehouse
Retain Liabilities
Premium
Reinsurer
Contingent
Payment
Contingent
Payoff
Capital
Risk-Bearing
Equity Capital
Capital
Market
Dividends
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”
Investment Bank Model
Risk Intermediation
Hedge Premium
Hedging
Firms
Risk
Intermediary:
Risk
Premium
(Investment Bank)
Capital
Market
Risk-Bearing
Contingent
Hedge Payoff
Equity Capital
Capital/
Expertise
Contingent
Payment
Compensation
Owners
Combining the Intermediary and Warehouse Model
Risk
Premium
Intermediary
Hedging
Firms
and PH’s
Premium
Contingent
Payoff
Securitize
Liabilities
Warehouse
Retain Liabilities
Risk-Bearing
Contingent
Payment
Capital
Market
Premium
Reinsurer
Contingent
Payment
Capital
Capital
Market
Equity Capital
Dividends
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
ILS Prices Declining Over Time
(At least they were)
8
Expected Loss
Yield
Yield/Expected Loss
12%
10%
7
6
Percent
5
8%
4
6%
3
4%
2
2%
1
0%
0
Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06
Quarter
Source: Lane (2006)
Yield/Expected Loss
14%
Catastrophe Bond Issues: 1996 – 2006*
Catastrophe Bonds Outstanding
Perils Securitized
$9,000
$8,000
Japan Wind,
2%
$ Millions
$7,000
$6,000
U.S. Wind,
25%
Multiperil,
36%
$5,000
$4,000
$3,000
Europe
Wind, 7%
$2,000
$1,000
$0
1998 1999 2000 2001 2002 2003 2004 2005 2006*
Outstanding
306
305
New Issue
725
825
Other EQ,
Central US
13%
EQ, 2%
California
EQ, 15%
804 1,454 1,853 2,204 3245 3285 4275
1,122 967
990
2,132 1143 2138 4259
* - Through November 2006
Source: Goldman Sachs (2006) and Swiss Re (2006).
Total: $14 billion
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)
Bank
Hedge Fund 5%
5%
Primary Insurer
30%
Bill Dubinsky
August 2004
ARIA Annual Meeting
*As of July 23 2004
Hedge Fund
16%
Reinsurer
4%
Reinsurer
25%
Dedicated Cat
Fund
5%
2004*
(USD 4 billion market )
Money
Manager
30%
Dedicated Cat
Fund
33%
Primary
Bank Insurer
4%
3%
Money
Manager
40%
Design Consideration: The Triggering Event
• Examples of 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
Transparency to Investor
• Indemnity trigger
Parametric
Industry
Index
Modeled
Loss
Indemnity
Basis Risk to Sponsor
What Else Can Be Securitized?
Life Insurer Balance Sheet
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 Insurance Cash Flows
• 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
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
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