Transcript Document 7548128

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Issues Related to Insurance Securitization
Dan Isaac
Swiss Re Investors, Inc.
Presented:
2000 CAS Special Interest Seminar
October 16, 2000
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Basis risk:
The risk that the derivative security does not move
precisely with the underlying “hedged” security; the
risk arising from the uncertainty regarding the future
basis. For an insurer using a securitization as a
hedge, it is the risk that the “coverage” does not
change precisely with the catastrophe experience of
the insurer.
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Three Basic Dimensions
• Basis of Coverage
• Trigger Mechanism
• Payment Type
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Basis of Coverage
• Company’s Exposure
• Industry’s Exposure
• Event Parameters
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Basis of Coverage
Company’s Exposure
• Advantages:
 Limited Basis Risk
 Easiest to Model Benefits
 Directly Comparable to Other Reinsurance Treaties
 Disadvantages:
 Highest Disclosure Standard
 Less Marketable
Example: USAA CAT Bond (96-98)
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Basis of Coverage
Industry’s Exposure
• Advantages:
 Manageable Basis Risk
 More Marketable
 Less Subject to Manipulation by Company
• Disadvantages:
 Harder to Model Benefits
 Fewer Benchmark Prices
Example: CBOT Options
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Basis of Coverage
Event Parameters
• Advantages:
 Little or No Disclosure
 Most Marketable
 No Reliance on “Black Boxes”
 Fastest Settlement
 Disadvantages:
 Largest Basis Risk
 No Benchmark Prices
Example: Parametric Re (97)
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Trigger Mechanism
• Actual Results
• Modeled Results
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Trigger Mechanism
Actual Results
• Advantages:
 Less Basis Risk
 Fits Well With Traditional Coverage
• Disadvantages:
 Harder to Extend to Multi-Year
 Can be “Gamed”
 Requires Long Development Period
Example: CEA Bond (96)
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Trigger Mechanism
Modeled Results
• Advantages:
 Faster Settlement
 Eliminates Model Bias Concern
 Easily Extended
• Disadvantages:
 Potentially Large Basis Risk
 May Fail Reinsurance and/or Hedge Accounting Rules
Example: Golden Eagle Capital (99)
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“Payment” Type
• Cash
• Equity
• Loan



Line of Credit
Surplus Notes
Bond
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“Payment” Type
Cash
• Advantages:
 Loss Payment Ends Contract
 Most Accounting Flexibility
 No Limitations on Recovery
• Disadvantages:
 Costly
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“Payment” Type
Equity
• Advantages:
 Cheaper
 Can Include Options to Further Lower Cost
 Usually Includes a Call Feature
• Disadvantages
 Only Protects Balance Sheet, not Income Statement
 Loss of Control
Example: LaSalle Re CatEPut (97)
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“Payment” Type
Loan
• Advantages:
 Cheapest, by Far
• Disadvantages
 Doesn’t Improve Either Balance Sheet or Income
Statement
 Coverage is Usually Limited/Eliminated for Largest
Events
Example: Nationwide Surplus Notes (95)
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Other Considerations
Desired Accounting
Options
• Reinsurance
• Hedge
• Mark to Market
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Other Considerations
Desired Accounting
Impacts
• Where benefits appear
 Underwriting Insurance
 Investment Income
 Balance Sheet
• When benefits appear
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FAS 113 - Accounting for Reinsurance
Conditions for Reinsurance Accounting (Paragraph 9)
• Reasonably Possible that Reinsurer will Lose Money
• Reinsurer Assumes Substantial Insurance Risk
• Relates to Underlying Exposure
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FAS 113 - Accounting for Reinsurance
Conditions for Indemnity (Paragraph 62)
• Payments Vary Directly with Cedants Results
• Applies to Both Timing and Amount of Payments
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ISTF - Insurance Securitization Task Force
• Formed in Conjunction with Protected Cell Legislation
• Focused on Defining Bounds of “Acceptable” Coverages

Specifically, non-indemnity covers
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Statistics Originally Reviewed
• Change in expected policyholder deficit (EPD)
• Change in Value at Risk (VaR)
• Change in standard deviation
• Coverage ratio
• Correlation
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Statistics Proposed
• Change in Tail Value at Risk (TVaR)
• Melding of the EPD and VaR measures
above.
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Graphical Explanation
G
6
F E
5H
C
B
$
4
3
2
1
A
D
99%
100%
0
0%
20%
40%
60%
80%
Cumulative Probability
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Statistics Proposed
• Change in Tail Value at Risk (TVaR)
• Melding of the EPD and VaR measures
above.
• Change in standard deviation (StD)
• Similar to the above measure except that it
is modified to include the cost of the hedge
and as a result measures the potential for
investment gain.
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Reduction of Risk
Reduction in TailVaR1
= -
Post-Hedge TailVaR
Pre-Hedge TailVaR
Reduction in StdDev1
= -
Post-Hedge StdDev
Pre-Hedge StdDev
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Conclusions
Based on the research completed we believe that if it can
be shown that both, the change in TVaR and StD (PostHedge – Pre-Hedge), are less than 0 then the transaction
is effective.
If one or both record positive values then transaction has
a high potential of producing returns that exceed the
hedged exposure and should be considered an
investment.
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ISTF - Insurance Securitization Task Force
• http://www.casact.org/research/istf/istfindex.htm
• Easier way:

Go to CAS Website

Click on RESEARCH (in right column)

Under Committee/Task Force Projects and Web Sites,
click on Work of the Index Securitization Task Force
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Bifurcation:
The act of notionally splitting one contract into two
(or more) equivalent contracts for accounting
purposes. For insurance, this usually results in
splitting a contract into an indemnity contract (which
gets reinsurance accounting) and a “basis risk”
contract (which gets mark to market accounting).
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Bifurcation
Industry Exposure Based Coverage can be Split into:
• An Approximate Company Based Coverage
• e.g. Adjust Attachment Point and Limit by Company’s
Market Share in Coverage Region
• A “Basis Risk” Swap
• Company Pays Based on Their Own Results
• Company Receives Based on Industry’s Results
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Other Considerations
Transaction Format
Options
• Reinsurance
• Swap
• Catastrophe Bond
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Other Considerations
Transaction Format:
Impacts
 Cost and time of setting up transacations
 Eligible investors
 Security of recoverables
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