Financial Risk Management of Insurance Enterprises

Securitization of Catastrophe Risk

Securitization of Catastrophe RiskImpetus

Insurance Markets $400-500 Billion in CapitalFinancial Markets$50-60 Trillion in Capital in US$150-180 Trillion in Capital in World

Catastrophe Potential $60-100 BillionToo Large for Insurance MarketsLess than a 1% Impact on Financial Markets

Need to Develop Mechanisms to Spread Catastrophe Risk More Widely

Carayannopoulos, Kovacs and LeadbetterInstitute for Catastrophic Loss Reduction - 2003

Securitization of Catastrophe Risk

Three Basic ApproachesExchange traded securitiesCBOT Catastrophe Futures and OptionsContingent CapitalCat-E-PutsRisk CapitalCatastrophe Bonds

CBOT Catastrophe Insurance Futures and Options

CAT Insurance FuturesIntroduced in December, 1992Quarterly contractsNational, Eastern, Midwestern and Western regionsBased on ISO paid loss data for 22 insurers, adjusted to industry levelPerils included:Wind Hail Earthquake Riot FloodSettlement valueLoss Ratio x $25,000 ($50,000 cap)

Initial CBOT CAT Insurance Futures

Minimal 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 alternative

PCS Catastrophe Insurance OptionsIntroduced in 1996Underlying is the PCS IndexNine Geographic Areas

National Five Regions Three States

Two SizesSmall Cap (up to $20 Billion)Large Cap ($20 to $50 Billion)

Development Period to Value PCS Index Six MonthsTwelve Months

PCS Catastrophe Index Valuation

PCS Loss Index = PCS Estimate/100 MillionValue is rounded to one decimal pointExample:

PCS Loss Estimate = $7,328,340,000PCS Index = 73.3

PCS Option PricingPCS Option prices are quoted in points and tenths of a point. Each point equals a cash value of $200.Example:On 11/28/97, 50 Western Region 1998 Annual Calls with a Strike Price of 150 traded at 2.5. The cost of each option was $500. If losses in 1998 exceed $15 billion (150x100 million), each option will be worth $200 for each $100 million of losses in excess of $15 billion. Since this is a small cap option, the maximum value of each option is $10,000 ($5 billion/100 million x $200). Thus, for a total cost of $25,000, the buyer of these 50 options purchased $500,000 of catastrophe coverage.

Status of PCS OptionsOpen Interest 16,793 (as of 11/28/97)Daily Trading Volume: Low

Week of 11/24: 310 OptionsWeek of 11/17: No tradesWeek of 11/10: 40 Options

Typical Trade: Option SpreadsBuyer purchases the lower strike price option and simultaneously sells the higher strike price option.

Problems with the PCS Options

Large Bid/Ask SpreadsExample (11/28/97)

National 5/25 Call Spread for December 1997Bid 1.7Ask 6.0

Low LiquidityEntire day’s trading equals $500,000 of coverage

PCS Options

No longer traded

Alternative Catastrophe Securitization

Contingent 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 capital

Cat-E-PutsWritten by AON

Prenegotiated Option on a Firm’s Own Securities

Triggered by a Catastrophic EventBuyer Pays Premium to Option WriterOption Writer Provides Post-event EquityNormally Written for 3 years

Benefits of Cat-E-Puts

Allows the buyer to protect its balance sheetRating agencies view this approach favorablyCost compares favorably with reinsurance

Components of Cat-E-PutsPut Option Terms

Face amount of securities to be issued (with minimum)Exposure period: 1-10 yearsAnnual option premiumTrigger and post event term option can be exercisedEstablishes minimum net worth the company must have to exercise the option to assure option writer that the company is viable after the lossWarranties regarding maintenance of reinsurance, aggregate ratios and change in management control

Components of Cat-E-PutsEquity Security Terms

Type of securityCommon stockConvertible debtTermConversion detailsYieldVoting interests and board representationConditions for buying back the issue to avoid long term dilution of interests

Hypothetical Cat-E-Put ExamplePrimary insurer contracts with investment bank to obtain contingent financing in the event of a single aggregate industry loss (measured by PCS) in excess of $5 billion over the next 3 years. For an annual payment of $4 million, the insurer can sell up to 1 million shares of restricted common stock to the investment bank at $50 per share within 90 days of the loss, with a minimum issue of 400,000 shares. Insurer has the right to buy back the stock over the following three years at a price representing a 15% annual return to the bank. This option cannot be exercised if the statutory surplus of the insurer is less than $60 million. The agreement is void if the insurer fails to maintain a set amount of reinsurance or incurs a change in management control.

Hypothetical Cat-E-Put ExampleIf the industry does not experience a $5 billion loss within the next 3 years, the bank gets a total of $12 million in premiums and does not buy the insurer’s stock. If there is a loss of that magnitude, the insurer may decide not to exercise the put option if its stock price exceeds the strike price or if it does not need the additional capital. If the loss is so large that it bankrupts (or severely impairs) the insurer, the option cannot be exercised. If the insurer does exercise the put option, it may buy the stock back from the bank when it regains its financial position. In the worst case, the bank ends up owning a significant portion of this insurer, which it can then sell when the buy-back option period expires.

Alternative Catastrophe SecuritizationRisk Capital

$23 billion of risk capital raised since 199731 Cat risk transactions in 2007Typical case - pre-funded, fully collateralizedProvides cedants with additional capital and multiyear coverage for catastrophesProvides investors with diversification and high yieldsInvestors include:Mutual funds Hedge funds ReinsurersLife insurers Money managers

Issuers 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 Funds

Risks Covered• Gulf Coast Hurricane • California Earthquake• Europe Wind• Japan Earthquake• Japan Typhoon• Midwest Earthquake• Northeast Hurricane• Monaco Earthquake• Puerto Rico Hurricane• Europe Hail• Hawaii Hurricane• Great Britian Flood

Triggers• Indemnity

– Insurer’s own losses• Parametric

– Earthquake magnitude– Storm severity (category 3 hurricane)

• PCS– Estimates of industrywide losses paid after a catastrophe occurs

• Modeled Loss– Measures of a catastrophe’s intensity are input into a model to

estimate the impact of that loss on the industry

Issues Related to Triggers• Indemnity trigger

– Potential for moral hazard– No basis risk for insurer

• Parametric or modeled loss– No moral hazard– Very significant basis risk for insurer

• PCS– Slight moral hazard– Significant basis risk for insurer

• Modeled loss– No moral hazard– Basis risk depends on what is modeled

Early Examples of Risk Capital

USAA raised $477 million in June, 1997Created Residential Re, Ltd.Covers East Coast Hurricane Risk

Swiss Re raised $137 million in July, 1997Created SR Earthquake Fund, Ltd.Covers California Earthquake Risk

USAA Catastrophe BondsResidential Re raised $477 million in capitalTwo tranches

A-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 bonds

USAA Catastrophe BondsResidential Re reinsures USAA

Single East Coast hurricane causing in excess of $1 billion in insured losses to USAAReinsurance is 80% of losses between $1 and $1.5 billion

Stated 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 paid

Swiss Re Catastrophe BondsSR Earthquake Fund raised $137 million in 2 year notes

Three 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 rated

Swiss Re Catastrophe BondsTriggers

PCS 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 tranch

SR Earthquake Fund provides Swiss Re with $112.2 million reinsurance for a single California earthquake

Recent Example of Risk CapitalAllianz Global issue – April 2007Covers flood in Great Britain and earthquake in Canada and US

(excluding California)$150 million of bondsIssued by Blue Wings, Ltd, Cayman IslandReturn of 315 basis points over LIBORRating of BB+ from S&PInsurance risk 0.54% per year (RMS)Triggers:

Earthquake based on modeled lossesFlood based on parametric indexFlood levels at 50 locations around country

Pricing of Risk CapitalComparison of interest rate differential between risky capital and risk free rate with the expected losses

USAAInitial offer 9 times Current trading 6 timesSwiss Re 6 timesAllianz Global 6 timesBB rated debt 2.2 timesEmerging markets 1.3-2.7 times

Problem: This approach ignores the loss distribution. Catastrophe coverage has greater chance of total loss of principal than other debt.

Additional Points Concerning Risk Capital

Offshore subsidiary used to avoid taxation of interest

Insurers using this approach should expect litigation after a loss. This is common practice after a default on high yield debt.

Summary

Insurers and reinsurers are developing new ways to transfer risk. Some of these techniques will be modeled after other financial securities, such as options, futures, and CDOs. Actuaries will need to play a role in this process, which will necessitate learning about non-traditional financial instruments. This represents an opportunity for actuaries of the third kind.