Evolution of Insurance Securitization

Stephen P. D’ArcyFellow of the Casualty Actuarial Society

Professor of FinanceUniversity of Illinois

UNSW Actuarial Studies Alumni Event2 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

– 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-PutsWritten 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 CapitalTypical 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 yieldsInvestors include:

Mutual funds Hedge funds ReinsurersLife insurers Money managers

Risks Covered• 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

• 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• 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