Transcript 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,

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, DC
July, 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 in
Historical 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
Trend is now toward longer (e.g.,
3-year versus annual)
• Relatively short maturities
• Some protection of principal included
• High coupon rates
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