Risk Securitization 101 2000 CAS Special Interest Seminar

1
Risk Securitization 1012000 CAS Special
Interest Seminar

• David Na, FCAS, MAAA
• Deloitte Touche, Bermuda

2
Background
3
Background

• Merging of Financial and Insurance Markets
• Travelers Citicorp CitiGroup?
• Insurance Industry Scared by Events Such as
  Hurricane Andrew
• 18 billion? 60-80 billion??
• Recent Activity - New Companies/Transactions
• Arrow Re (Goldman Sachs)
• Lehman Re (Lehman Brothers)

4
Background

• Effects of Natural Catastrophes in Late 80s
  Early 90s
• Decreased Insurance/Reinsurance Capacity
• Increased Demand for Reinsurance
• Realization of Inadequate Pricing
• Increased Awareness re Insurers Exposures

5
Background

• Comparison of Capitalization of Insurance and
  Capital Markets...
• Estimated Capital of US P/C Ins. Industry 338
  billion
• Size of the Capital Markets
• Total Capitalization 34 trillion
• Average Daily Fluctuation 200 billion
• 100 billion loss 1/3 of 1 of market capital

6
What is Risk Securitization?

• Packaging/Transferring of insurance underwriting
  risks to the capital markets through the issuance
  of a financial security
• 2 Important Aspects
• Transformation of U/W Cash flows into tradable
  securities
• Transfer of U/W Risk through the trading of those
  securities
• Investment Return is contingent upon underwriting
  experience

7
Types of Transactions/Triggers

• Indemnified Notes
• Indexed Notes
• Parametric Notes

8
Indemnified Notes

• Responds Directly to Ceding Companys Specific
  Exposures Actual Losses
• Provides the Most Precise Coverage for Cedant
• Reflects Cedants U/W Claim Settlement
  Processes
• Long Development Patterns Investors may need to
  Wait for Their Return
• Sample Transaction Alpha Wind

9
Indexed Notes

• Linked to Industry or Geographic Index (e.g. PCS)
• Cedant Exposed to Significant Basis Risk, if
  Index is not Consistent with Cedants Actual
  Losses
• Shorter Development Period (Generally Easier to
  Predict the Index than Individual Company Losses)
• Synthetic Indemnification Mathematical
  Attempt to Replicate the Cedants Underlying Book
  of Business
• Sample Transaction Seismic Re.

10
Parametric Notes

• Linked to Quantities Associated with Pertinent
  Events Generally Physical Attributes of an
  Event
• Magnitude, Intensity, Epicenter of EQ
• Wind Speed, Forward Velocity, County of
  Landfall of Hurricane
• Removes Risks Associated with Modeling the Ceding
  Companys Exposures or Changes in Exposures
• Virtually Eliminates Development Period
• Sample Transaction Concentric Ltd.

11
Investor Risks Returns

• No Standard Approach
• Principal Protection sometimes
• Various Tranches
• Varying Terms (e.g. Tokio EQ is 10 years)
• Returns based on Risk

12
Other Examples of Securitization

• Mortgage Backed Securities
• Similarly created by excess demand
• However, high volume, stable asset was
  securitized
• Auto Loans Credit Card Receivables
• David Bowie (offering securitized by future sales
  of CDs)
• NFL (offering securitized by 18 billion TV deal)
• subsequently withdrawn

13
Perspective

• Think of as any other security...
• Its all about Risk v. Return...
• Here, the risk happens to be insurance related

14
Types of Insurance Linked Securities (ILSs)
15
Types of ILSs

• Catastrophe Bonds - Will Discuss in Detail...
• Catastrophe Risk Exchange (CATEX) Swaps
• Insurance Related Derivatives/Options
• Catastrophe Equity Puts (CAT-E-Puts)
• Contingent Surplus Notes
• Weather Derivatives

16
Types of ILSs

• CATEX Swaps NY Bermuda
• Electronically swap CAT exposures (e.g.
  geographic location, property type, etc.)
• Insurance Related Derivatives/Options
• Chicago Board of Trade Options Based on
  aggregate industry CAT losses (Property Claim
  Services)
• Bermuda Commodities Exchange CAT Options Based
  on Guy Carpenter Catastrophe Index (ratio of
  losses to housing values)

17
Types of ILSs

• Catastrophe Equity Puts (CAT-E-Puts) - Insurer
  has the option to sell equity (e.g. preferred
  shares) at pre-determined price, contingent upon
  a specific event
• Contingent Surplus Notes - Option to borrow
  contingent upon the occurrence of a specific
  event (contingent funds held in trust)
• Weather Derivatives - Insurance or derivative
  contract which pays based on weather related
  events

18
Generic ILS Structure
Portfolio Return Premium
Premium
InsurerorReinsurer
SPV
Investors
Reimbursement Payment (Event Contingent)
Loss of Value (Event Contingent)
Portfolio Return
Liquidation of Assets (Event Contingent)
Invested Proceeds - Trust Account
19
Advantages - Investor

• Above average yield relative to other securities
  (e.g. corporate bonds) of similar risk
• Outstanding diversification effect - Unlike
  investments in insurance company stocks, CAT
  events are generally uncorrelated with an
  investors portfolio
• Allows non-insurance investors to participate in
  insurance related transactions
• Preparation for convergence of Insurance Banking

20
Advantages - Issuer

• Capacity - Access the Capital of the Financial
  Markets
• Greater Flexibility in Terms of Coverage
• Reinsurance Protection Fully Collateralized, No
  Credit Risk
• More Stable Pricing - Insulated from U/W cycles
• High aggregate level risk transfer
• Innovation/Prestige - Cutting Edge

21
Issues

• Requires understanding of both Capital and
  Insurance Markets (Investors as well as Issuers)
• Historical separation of Capital and Insurance
  Markets (e.g. Regulatory Issues)
• Uncertainty involved in pricing high layer or
  catastrophic events (Reliance on Modeling)
• Issuers Costs (Relative to Purchase of
  Reinsurance)
• Investors Return (Relative to Comparably Risky
  Securities)
• Accounting, Legal, Regulatory, Tax, etc.

22
The USAA/Residential Re. Transaction
23
USAA/Residential Re.

• Placed in 1997 (with subsequent renewals)
• Reinsurance coverage of 80 of 500M x 1B
• Covers Category 3, 4, or 5 Hurricanes along the
  East or Gulf Coasts of the US
• 477 M in bonds issued
• Residential Re. Domiciled in Cayman

24
USAA/Residential Re.

• Tranche A-1 (164 M)
• AAA rated
• Only interest at risk
• Coupon paid LIBOR 2.82
• Tranche A-2 (313 M)
• BB rated
• Principal Interest at risk
• Coupon paid LIBOR 5.75
• Investor Appeal
• Principal Protection AAA Rating
• Favorable risk/return

25
USAA/Residential Re.
Why did it work in 1997?

• Market timing lack of investors appetite for
  risk in 1996 in 1997, risk/return more
  attractive
• Rating agency concerns (1996 not investment
  grade)
• Protection of principal
• 1997 issue had short duration conservative loss
  trigger (USAAs losses from Andrew 555 M)

26
Risk Securitization 1012000 CAS Special
Interest Seminar

• David Na, FCAS, MAAA
• Deloitte Touche, Bermuda