Finance 431: Property-Liability Insurance Lecture 21: Securitization of Catastrophe RiskSecuritization of Catastrophe RiskSlide 3Alternative Catastrophe SecuritizationCat-E-Puts Written by AONBenefits of Cat-E-PutsAlternative Catastrophe SecuritizationSlide 8Issuers and InvestorsRisks CoveredTriggersExamples of Risk CapitalUSAA Catastrophe BondsSlide 14Swiss Re Catastrophe BondsSlide 16Pricing of Risk CapitalAdditional Points Concerning Risk CapitalSummaryFinance 431:Property-Liability InsuranceLecture 21: Securitization of Catastrophe RiskSecuritization of Catastrophe RiskImpetusInsurance Markets $400-500 Billion in CapitalFinancial Markets$50-60 Trillion in Capital in US$150-180 Trillion in Capital in WorldCatastrophe Potential $60-100 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 BondsAlternative 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 CapitalTypical case - pre-funded, fully collateralizedCommonly termed Cat bondsProvides cedants with additional capital and multiyear coverage for catastrophesProvides investors with diversification and high yieldsInvestors include:Mutual funds Hedge funds ReinsurersLife insurers Money managersIssuers and Investors•Sponsorship of transactions includes:–Allianz, AGF, CEA, Gerling, Kemper, Mitsui, USAA , State Farm, Tokio, Winterthur, XL Capital, Yasuda, Zurich–AXA Re, Hannover Re, Munich Re, Scor, St. Paul Re, Swiss Re•Investors include:–Reinsurers, Insurers, Banks, Investment Advisors/Mutual Funds, Hedge/ Proprietary FundsRisks Covered•Gulf Coast Hurricane •California Earthquake•Europe Wind•Japan Earthquake•Japan Typhoon•Midwest Earthquake•Northeast Hurricane•Monaco Earthquake•Puerto Rico Hurricane•Europe Hail•Hawaii HurricaneTriggers•Indemnity•Parametric•PCS•Modeled LossExamples of Risk CapitalUSAA raised $477 million in June, 1997Created 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 capitalTwo 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 Current 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 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.SummaryCatastrophes can be so large that the insurance industry may be unable to handle them under traditional methodSecuritization can be an effective way to handle catastrophe and other insurance risksThis field is just beginning to developExpertise needed in both insurance and