Insurance SecuritizationSecuritization of Catastrophe RiskCBOT Catastrophe Insurance Futures and OptionsInitial CBOT CAT Insurance FuturesPCS Catastrophe Insurance OptionsPCS Catastrophe Index ValuationCurrent Status of PCS OptionsProblems with the PCS OptionsAlternative Catastrophe SecuritizationCat-E-Puts Written by AONBenefits of Cat-E-PutsAlternative Catastrophe SecuritizationExamples of Risk CapitalUSAA Catastrophe BondsSlide 15Swiss Re Catastrophe BondsSlide 17Pricing of Risk CapitalAdditional Points Concerning Risk CapitalSecuritization of Other Insurance RisksSummaryInsurance SecuritizationImpetusInsurance Markets $200-250 Billion in CapitalFinancial Markets$10-15 Trillion in CapitalCatastrophe Potential $70-120 BillionToo Large for Insurance MarketsLess than a 1% Impact on Financial MarketsNeed to Develop Mechanisms to Spread Catastrophe Risk More WidelySecuritization of Catastrophe RiskThree Basic ApproachesExchange Traded DerivativesCBOT Cat Insurance Futures and OptionsBermuda Commodities Exchange Cat OptionsContingent CapitalLine of CreditContingent Surplus NotesCatastrophe Equity PutsRisk CapitalCatastrophe BondsCBOT Catastrophe Insurance Futures and OptionsCAT Insurance FuturesIntroduced in December, 1992National and Regional ContractsBased on ISO paid loss data adjusted to industry levelPerils included:Wind Hail Earthquake Riot FloodSettlement valueLoss Ratio x $25,000 ($50,000 cap)Initial CBOT CAT Insurance FuturesMinimal trading volume developedReasons:High risk for sellersBuyers not used to futuresMarking-to-marketBuyer loses money on the future if catastrophesare lowInsurance regulatory resistanceNewly created index, which may not correspond to catastrophe risk for a particular insurerReinsurance is available as an alternativePCS Catastrophe Insurance OptionsIntroduced in 1996Underlying is the PCS IndexEstimates of Insured Losses from CatastrophesNational and Regional ContractsTwo SizesSmall Cap (up to $20 Billion)Large Cap ($20 to $50 Billion)PCS Catastrophe Index ValuationPCS Loss Index = PCS Estimate/100 MillionValue is rounded to one decimal pointExample:PCS Loss Estimate = $7,328,340,000PCS Index = 73.3Current Status of PCS OptionsNo trading has taken place since December, 1999.Typical Trade: Option SpreadsBuyer purchases the lower strike price option and simultaneously sells the higher strike price option.Problems with the PCS OptionsLarge Bid/Ask SpreadsExample (11/28/97)National 5/25 Call Spread for December 1997Bid 1.7Ask 6.0Low LiquidityEntire day’s trading equals $500,000 of coverageAlternative Catastrophe SecuritizationContingent CapitalInsurer Could Buy Puts on Its Own StockMoral HazardPuts Not Traded for Most InsurersCat-Equity-PutsAt least 17 trades to date for $4.7 billion of contingent capitalCat-E-PutsWritten by AONPrenegotiated Option on a Firm’s Own SecuritiesTriggered by a Catastrophic EventBuyer Pays Premium to Option WriterOption Writer Provides Post-event EquityNormally Written for 3 yearsBenefits of Cat-E-PutsAllows the buyer to protect its balance sheetRating agencies view this approach favorablyCost compares favorably with reinsuranceAlternative Catastrophe SecuritizationRisk Capital$1.5 billion of risk capital raised since 1995Typical case - pre-funded, fully collateralizedProvides insurance company with additional capital and multiyear coverage for catastrophesProvides investors with diversification and high yieldsInvestors include:Mutual funds Hedge funds ReinsurersLife insurers Money managersExamples of Risk CapitalUSAA raised $477 million in June, 1997 and $450 million in June, 1998Created Residential Re, Ltd.Covers East Coast Hurricane RiskSwiss Re raised $137 million in July, 1997Created SR Earthquake Fund, Ltd.Covers California Earthquake RiskUSAA Catastrophe BondsResidential Re raised $477 million in capital in 1997Two tranchesA-1 Extendible Principal Protected Bonds Pay LIBOR + 273 basis points $163.8 million bonds plus option on $77 million invested in 10 year zero coupon bond Option protects principal, but not economic value A-2 Principal Variable Bonds Pay LIBOR + 576 basis points $313.2 million bondsUSAA Catastrophe BondsResidential Re reinsures USAASingle East Coast hurricane causing in excess of $1 billion in insured losses to USAAReinsurance is 80% of losses between $1 and $1.5 billionStated maturity of bonds is 1 yearIf there is a loss, maturity can be extended 6 monthsInterest is payable during extensionIf a loss occurs on tranch A-1, maturity is extended to 10 years, but no interest will be paidSwiss Re Catastrophe BondsSR Earthquake Fund raised $137 million in 2 year notesThree tranches1 - $42 million floating rate $20 million fixed rate 60% of principal at risk Ratings: Baa2 Moody’s, BBB- Fitch 2 - $60.3 million fixed rate all of principal is at risk Ratings: Ba1 Moody’s, BB Fitch3 - $14.7 million Not ratedSwiss Re Catastrophe BondsTriggersPCS index of industrywide lossesInvestors in first two tranches lose 1/3 of principal at each level$18.5 billion$21 billion$24 billionLower triggers apply to the third tranchSR Earthquake Fund provides Swiss Re with $112.2 million reinsurance for a single California earthquakePricing of Risk CapitalComparison of interest rate differential between risky capital and risk free rate with the expected lossesUSAAInitial offer 9 times Later trading 6 timesSwiss Re 6 timesBB rated debt 2.2 timesEmerging markets 1.3-2.7 timesProblem: This approach ignores the loss distribution. Catastrophe coverage has greater chance of total loss of principal than other debt.Additional Points Concerning Risk CapitalOffshore subsidiary (Special Purpose Vehicle) used to avoid taxation of interestInsurers using this approach should expect litigation after a loss. This is common practice after a default on high yield debt.Securitization of Other Insurance RisksPotential for Satellite insuranceMarine insurance (large vessels)Product liabilityInsurance related bonds issued by countries where insurance cannot be obtainedSummarySecuritization can be an effective way to handle catastrophe and other insurance risksField is just beginning to developExpertise needed in both insurance and