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  • Insurance Securitization: Rick Gorvett, FCAS, MAAA, ARM, PH.D

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    Rick Gorvett presented on insurance securitization at a conference in 2000. He discussed how insurance companies can transfer underwriting risks to capital markets by transforming cash flows from insurance policies into tradable securities. This allows insurers to gain liquidity, improve credit ratings, and access new sources of capital. Gorvett also examined different insurance securitization products like catastrophe bonds and derivatives, and considered issues around their development and potential future impacts on the insurance industry.

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    Rick Gorvett presented on insurance securitization at a conference in 2000. He discussed how insurance companies can transfer underwriting risks to capital markets by transforming cash flows from insurance policies into tradable securities. This allows insurers to gain liquidity, improve credit ratings, and access new sources of capital. Gorvett also examined different insurance securitization products like catastrophe bonds and derivatives, and considered issues around their development and potential future impacts on the insurance industry.

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    16 views27 pages

    Insurance Securitization: Rick Gorvett, FCAS, MAAA, ARM, PH.D

    Uploaded by

    routraykhushboo
    Rick Gorvett presented on insurance securitization at a conference in 2000. He discussed how insurance companies can transfer underwriting risks to capital markets by transforming cash flows from insurance policies into tradable securities. This allows insurers to gain liquidity, improve credit ratings, and access new sources of capital. Gorvett also examined different insurance securitization products like catastrophe bonds and derivatives, and considered issues around their development and potential future impacts on the insurance industry.

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    of 27

    Insurance Securitization

    Rick Gorvett, FCAS, MAAA, ARM, Ph.D.


    Actuarial Science Program
    University of Illinois
    at Urbana-Champaign

    International Association of Consulting Actuaries


    Hershey, PA
    June 2000
    Risk and Response

    • Risk
    – Recent catastrophes
    – Resulting insolvencies and financial
    impairment
    – Potential for even greater impact
    • Response
    – Development of securitized insurance
    products
    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
    Securitization in
    Historical Perspective
    • Home mortgage market: funding shortfall in the
    late 1970s
    • Market response: mortgage-backed securities
    • Other asset-backed securities developed
    subsequently
    – Auto loans
    – Credit card receivables
    – David Bowie albums
    Securitization Process
    • Participants
    – Borrower
    – Loan originator
    – Special purpose trust
    – Underwriter
    – Investors
    • Some of the Benefits
    – Liquidity
    – Market values
    – Lower cost
    – Improved credit rating
    Evolution of the Insurance
    Industry
    “Affronts” to Traditional Insurance

    • Self-insurance and captives

    • Risk retention groups

    • Insurance securitization

    • Portfolio insurance
    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
    Insurance Securitization in Context:
    Managing Risks

    • Insurance securitization is one of many


    financial risk management (FRM) techniques
    • Building blocks of FRM:
    – Stocks and bonds
    – Forwards and futures
    – Options
    – Swaps
    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
    Issues Regarding the Potential
    Success of Insurance Securitization
    • Difficult to understand
    – Capital markets
    – Insurance markets
    • Separation of insurance and finance functions in
    many companies
    • Information and technology
    • Difficult to price
    • Expensive (vs. cat. reinsurance market)
    • Legal / tax / accounting issues
    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
    – Catastrophe exposure swaps
    • CATEX Bermuda
    – Joint venture: CATEX and Bermuda Stock
    Exchange
    • Swaps
    Catastrophe Bonds:
    The Trigger Issue
    • Basis risk
    – How closely do the company’s losses follow the
    industry index?
    • Moral hazard
    – Increased losses to company may decrease the debt
    obligations

    Trade-off between basis risk and moral hazard


    Direct versus industry versus event triggers
    Types of Bond Triggers
    • Direct: based on company losses
    – E.g., USAA catastrophe bond
    – No basis risk
    • Industry: based on an index
    – E.g., Swiss Re; CBOT PCS option spreads
    – Essentially no moral hazard
    • Event
    – E.g., Tokio Marine & Fire
    – Earthquake magnitude
    Types of Catastrophe Bond
    Risk-Taking

    • Risk of losing some or all of your principal


    – Defeasement of principal with U.S. Treasuries?
    • Risk of diminished or lost interest payments
    • Often, several “tranches” with different
    yields and ratings
    Typical Catastrophe Bond
    Issuance Structure

    • Insurance company sets up an SPV (Special


    Purpose Vehicle) -- offshore reinsurer
    • Company purchases reinsurance contract
    from SPV
    • Company issues bonds to capital markets
    through SPV
    Some 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
    • Swiss Re: “basis swap” with reinsurer
    Generally Common Traits of
    Successful Bond Issues

    • Involve catastrophe risk


    • High levels of protection
    • Relatively short maturities
    • Some protection of principal included
    • High coupon rates
    “Costs” of Catastrophe 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
    The Future of Insurance
    Securitization

    • Will it survive and grow?


    – Cost relative to insurance and reinsurance
    – Time and technology
    • Will it replace or supplement traditional
    transactions?
    • How will it affect reinsurance?
    The Future of Insurance
    Securitization (cont.)

    • Capacity versus other reasons


    • Catastrophe risks versus traditional
    insurance lines
    • Historically, markets for other forms of
    securitizations have taken some time to
    develop and mature
    The Future of Insurance
    Securitization (cont.)

    • Legal and tax issues


    – Are securitization instruments insurance?
    – Bermuda Insurance Amendment Act (1998):
    insurance derivatives are “investment contracts”
    – Different tax implications:
    • Protect income statement
    • Protect balance sheet
    The Future of Insurance
    Securitization (cont.)
    • Insurer FRM can take a variety of forms
    – Asset hedges
    • Reinsurance
    • Derivatives
    – Liability hedges
    • Debt forgiveness
    – Asset-liability management
    – Contingent financing
    – Post-loss financing and recapitalization
    Personal Info

    • Web page:

    http://www.math.uiuc.edu/~gorvett

    • E-mail:

    [email protected]

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