Download Evolution of Insurance Securitization

Evolution of Insurance Securitization
Stephen P. D’Arcy
Fellow of the Casualty Actuarial Society
Professor of Finance
University of Illinois
UNSW Actuarial Studies Alumni Event
2 July 2007
Sydney, Australia
Impetus for Securitization of
Insurance Risk
• One major catastrophe could eliminate most of
the world’s insurance capital
• The largest potential loss is less than the daily
fluctuation of total financial markets
• If insurance losses could be shifted to financial
markets, the risk would be manageable
Steps in Insurance Securitization
• Catastrophes
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Chicago Board of Trade Catastrophe Futures – 1992
PCS Catastrophe Options – 1996
Contingent Capital – 1996
Risk Capital – 1997
• Longevity
– Mortality Index Bonds – 2003
• Motor Insurance
– French Motor Insurance Portfolio – 2005
– Multinational Motor Insurance Portfolio - 2007
Catastrophe Insurance Securitization
• CBOT Catastrophe Futures
– Underlying index: Paid claims for 22 insurers
– Perils: Wind, Hail, Earthquake, Riot and Flood
– Settlement Value: Loss Ratio x $25,000
• PCS Catastrophe Option
– Underlying index: PCS Estimate/100 million
– All catastrophe claims (over $25 million)
– Small (up to $20 billion) and large ($20 to 50
billion) caps
Cat-E-Puts
Written by AON
Pre-negotiated Option on a Firm’s Own Securities
Triggered by a Catastrophic Event
Buyer Pays Premium to Option Writer
Option Writer Provides Post-event Equity
Normally Written for 3 years
Minimum net worth required to exercise put
Risk Capital
Typical case
Issue bonds with repayment and/or coupons
dependent on catastrophe losses
Provides cedents with additional capital and
multiyear coverage for catastrophes
Provides investors with diversification and high
yields
Investors include:
Mutual funds Hedge funds
Reinsurers
Life insurers
Money managers
Risks Covered
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U. S. Gulf Coast Hurricane
California Earthquake
Europe Wind
Japan Earthquake
Japan Typhoon
U. S. Midwest Earthquake
U. S. Northeast Hurricane
Monaco Earthquake
Puerto Rico Hurricane
Europe Hail
Hawaii Hurricane
Triggers
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Indemnity
Parametric
PCS
Modeled Loss
Examples of Risk Capital
USAA raised $477 million in June, 1997
Created Residential Re, Ltd.
Covers East Coast Hurricane Risk
Swiss Re raised $137 million in July, 1997
Created SR Earthquake Fund, Ltd.
Covers California Earthquake Risk
Online reference for many deals
http://www.artemis.bm/html/dealdir/index.htm
Longevity Risk
• Longevity risk is the risk of mortality rates
deviating from expected levels
• Over last century, mortality rates have steadily
declined, leading to longer life expectancies
• Significant improvement for most recent
period has been noted
• Primary concern for insurers and pension
funds is improvement for those age 60 and
older
Exposure to Longevity Risk
• Life insurance
– Risk is if mortality rates increase
– Coverage concentrated on particular ages (30-70)
– Recent concerns
• Catastrophic losses
• Pandemics
• Annuities and pension funds
– Risk is if mortality rates decline more than expected
– Annuities are concentrated on particular ages (60+)
Managing Longevity Risk
• Life insurers
– Could balance life insurance and annuity exposure
• Difficult to accomplish
– Reinsurance for sudden increased mortality
• Concentration of reinsurers
• Cost of coverage
• Pension funds
– Spreading losses forward under pension accounting
– Use of asset returns as discount rate
– Lower investment returns can no longer cover
increasing longevity
Longevity Derivatives
• First life insurance securitizations involved
offsetting premium loadings or reducing
reserve requirements
• Current securitizations involve securitizing
mortality risk
– Swiss Re (2003)
• Life insurance catastrophe bond
– EIB/BNP (2004)
• Long term longevity bond
Swiss Re Mortality Index Bond
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Issued December, 2003
$400 million in 3 year notes, quarterly coupons
Bond paid LIBOR + 135 basis points
Mortality rate was based on the weighted
average mortality of US, UK, France, Italy and
Switzerland
• Option to reduce repayment on bond if
mortality exceeds 130% of 2002 mortality rate
• Principal is reduced 5% for every 0.01 increase
in mortality over threshold
• Vita Capital was the Special Purpose Vehicle
Swiss Re Bond
• Ratings: A3/A+
• Fully subscribed
• Investors included pension funds
– High coupon
– Natural hedge
Motor Insurance Securitization
• AXA securitized French motor insurance – 2005
• Securitized European motor insurance – 2007
• Bonds pay variable rate based on underlying loss
experience
What’s Next?
• Catastrophes
– Exchange traded derivative
• Mortality
– Zero-coupon or deferred mortality bonds
– Mortality swaps
– Mortality futures and options
• Other coverages
– Securitizing runoff business
– Other lines besides motor insurance
Conclusions about Securitization
• Allows insurers to focus on writing policies
without having to retain all the risk
• Alternative to reinsurance and useful for
reinsurers
• Provides an attractive investment alternative for
institutional investors
• Allows market to solve risk aggregation issues
without relying on government
• Growth is very likely
• Will change the face of the insurance industry