Transcript Financial Risk Products: Case Study Perspective 1

Financial Risk Products:
Case Study Perspective
1
Discussion Topics
• Insurance Linked Securities
• Case Study I - Hypothetical ILS Transaction
• Case Study II - Basis Risk Transaction
Swiss Re
Capital Markets
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Securitization - Overview
Investments
1
Investment
Earnings
3
Cash
Proceeds
Reinsurance
Premium
Principal
& Interest
Re-insurer
Investors
SPV
Contingent
Claim Payment
Cash
Proceeds
Investment
Earnings
Scheduled
Interest
Swiss Re
Financial
Products
Swiss Re
Capital Markets
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4
3
Swap - Overview
Re-insurer
Reinsurance
Premium
Contingent
1
Claim Payment
Fixed Amounts
Swiss Re
Floating Rate
Amounts
2
Swiss Re
Capital Markets
Swap Transaction based
on notional amount
Swiss Re
Financial
Products
Fixed Amounts
Investors
Floating Rate
Amounts
3
4
Case Study I - Overview
Elements of a Capital Market solution
• Understanding of situation
• Risk mapping
• Exposure
• Structuring issues
• Delivery mechanism
Swiss Re
Capital Markets
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Case Study I: Risk Source
Earthquake (EQ)
risks in California
Source:
United States Geological Survey,
National Earthquake Information
Center, www.neic.cr.usgs.gov
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Capital Markets
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Case Study I - Situation Analysis
• ABC is global leader in the microchip industry
• Its factory is based in Palo Alto, California
• California is highly exposed to EQ risks
• Therefore, ABC seeks for protection against a potential profit drop
resulting from a devastating EQ harming its microchip production
• Because of the current market conditions there is no cover available on
the traditional insurance market; ABC approaches you to propose a
Capital Market solution
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Capital Markets
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Case Study I - Risk mapping, definition of EQ
Magnitude (M)
Intensity (MMI)
•
Measurement of energy release
•
Observation of effects
•
Richter Scale (and others)
•
•
M max: ~8.5
Modified Mercalli Scale - MMI (and
others)
•
Damage: M>=5.0
•
MMI 12 degrees: I to XII
•
Damage: MMI >=VI
Intensity map
Fault plane
epicenter
focus
(hypocenter)
MMI = Modified Mercalli Shaking Intensity, average soil conditions
Source: Swiss Re Reinsurance & Risk, RN/CP, SNAP EQ
Swiss Re
Capital Markets
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Case Study I - Exposure
In USD m
4000
4000
3500
3000
3000
2850
2400
2200
2000
2000
1500
1200
1000
1000
400
Turnover
Net profit
Source: Annual Reports
Swiss Re
Capital Markets
450
850
600
0
1995
1996
1997
1998(E) 1999(E) 2000(E) Average
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Case Study I - Risk mapping, return periods p.a.
60%
Probability
50%
40%
30%
20%
10%
20
22
.5
15
17
.5
10
12
.5
7.
5
5
2.
5
0
0%
$billions of Insured Loss
Swiss Re
Capital Markets
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Case Study I - Structuring issues
• Issuer’s Needs vs. Investor’s Demand
• Loss Basis
• Risk Profile
• Triggering Event
• Coverage Period
• Other Structuring Considerations
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Capital Markets
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Case Study I - Delivery mechanism
• Structured Note
– Onshore vs. Offshore Issuer
– Defeased vs. Non-defeased
– Fixed vs. Floating Rate
– Public vs. Private
– Single vs. Multiple Traches
• Derivative Instrument
– Swap vs. Option
– ISDA regs
– Targeted Buyers
Swiss Re
Capital Markets
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Case Study II
Basis Risk Swap Transactions
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Basis Risk Transaction
• Exchange of cash flows based on two variable indices
– Amount you pay and receive will change according to the
movements in two separate indices
• Basis Swaps
– Common capital markets instrument
• Capital Markets Indices
– London Interbank Offer Rate (LIBOR)
– Commercial Paper (CP)
– F/X rates
– S&P 500
– Etc.
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Capital Markets
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Example: LIBOR versus CP
6.80%
6.60%
6.40%
6.20%
LIBOR
CP
6.00%
5.80%
5.60%
5.40%
Year 1
Year 2
Year 3
Year 4
Year 5
• Domestic interest rates tend to move in the same direction
• However, the difference between different interest rates will
vary over time
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Capital Markets
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Example: LIBOR versus CP
• Company A issues commercial paper and invests in floating rate
notes at L + 50bps
• Company A does not wish to take the risk that CP rates will
increase faster than LIBOR or decrease slower than LIBOR
• Company A approaches Swiss Re Financial Products (SRFP)
and enters into a basis swap
• Company A pays LIBOR to SRFP
• SRFP pays CP + 10 to Company A
• Company A locks in 60 bps spread
Swiss Re
Capital Markets
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Example: LIBOR versus CP
Company A
Floating
Rate Notes
Receives from FRN: LIBOR + 50
Pays to SRFP:
LIBOR
Net:
+ 50
LIBOR + 50
LIBOR
Company A
SRFP
CP + 10
Commercial
Paper
Swiss Re
Capital Markets
Receives from SRFP:CP + 10
Pays to investors:
CP
Net
+ 10
Total
+ 60
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Basis Risk Transactions in Insurance
• Potential Loss Tiggers in Re/Insurance Markets
– Actual losses
– Industry Losses
– Loss ratios
– Losses on different perils
• Value of Basis Swap Transactions
– To hedge a position already taken (reduce risk profile)
– To arbitrage a market inefficiency (get cheaper overall pricing)
– To be an innovator
– To speculate
Swiss Re
Capital Markets
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Basis Transaction #1
Outside
Source
Indexed
Protection
SRNM
Basis
Transaction
Corporate/
Insurer/
Reinsurer
• Client gets indexed cover from outside source
• Client enters into basis transaction with SRNM
– Client pays to SRNM any recoveries made on indexed
cover
– SRNM pays client for actual losses incurred
Swiss Re
Capital Markets
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Basis Transaction #2
Corporate/
Insurer/
Reinsurer
Indemnity
Agreement
Basis Risk
SRNM
Indexed Reinsurance
or Security
or Swap
or Option
Investors
• Client gets indemnity cover from SRNM
• SRNM issues indexed paper to the market
– SRNM keeps the basis risk
Swiss Re
Capital Markets
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Basis Transaction #3
Portfolio
Swap
Corporate/
Insurer/
Reinsurer
Basis Risk
Cal. quake
Japan quake
Indexed Reinsurance
or Security
or Swap
or Option
SRNM
Outside
Source
• Client receives return on a portion of SRNM’s California earthquake
book of business
• SRNM receives return on a portion of Client’s Japan earthquake book
of business
– SRNM may or may not enter into a transaction to hedge itself
• Client’s overall book of business is better diversified
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Capital Markets
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Basis Swap Example
• A XYZ Reinsurer is attempting to get windstorm coverage for
Florida, Texas, and the East Coast
– XYZ Re wants to pay 7%
– No offers
• XYZ Re approaches SRNM for alternative solutions
• SRNM analyses XYZ Re’s book of business and determines
the level of industry losses equivalent to the layer XYZ Re
wants reinsured
• XYZ Re purchases ILW for 6% from an insurer / CM
investor(s) and enters into basis transaction with Swiss Re
for 1%
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Capital Markets
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Basis Swap Example (cont.)
• Basis risk transaction
– XYZ Re pays claims to Swiss Re based on industry losses
• Any claims XYZ Re must pay to Swiss Re it will receive from
Insurer as part of ILW
– Swiss Re pays claims to XYZ Re based on losses on XYZ Re’s
reinsurance book
– If Windstorm occurs and industry losses are large relative to XYZ
Re’s book, Swiss Re receives payment
– If XYZ Re’s losses are large relative to the industry, Swiss Re
makes a payment
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Capital Markets
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Basis Swap Structure
XYZ Re
Basis Risk Sell Reinsurance
Buy ILW
Insurer /
Investor
Texas to Maine
ILW
XYZ Re
Swiss Re
Receives from Ins. / Investor:
Industry Losses
Pays industry losses to SR:
Industry Losses
Receives payment from SR:
Actual Losses
Basis Risk
10 mm ILW
XYZ Re
Net:
Actual Losses
Swiss Re
Reinsurance
20 million - 50% QS
Swiss Re
Capital Markets
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