SECURITIZATION 101

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Securitization and Other Instruments for Transferring Risk to the Capital Markets Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D. Actuarial Science Program University of Illinois at Urbana- Champaign Washington, DC July, 2003

Transcript of SECURITIZATION 101

Page 1: SECURITIZATION 101

Securitization and Other Instruments for

Transferring Risk to the Capital Markets

Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D.Actuarial Science Program

University of Illinois at Urbana-Champaign

Washington, DCJuly, 2003

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Agenda

• Historical background of securitization

• Definition and evolution of insurance securitization

• Types of securitized insurance instruments

• Recent activity

• Issues for the future

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Terminology and Tools

• Financial terminology– We need to learn to quack before we can be a duck– Financial practitioners say things like

“BB undefeased subordinated debenture at 6mLIBOR+350bps”

• Financial tools– Financial practitioners use tools with names like

“options,” “swaps,” “swaptions”

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Securitization inHistorical Perspective

• Home mortgage market: funding shortfall in the late 1970s

• Market response:– Change tax laws: no double taxation on cash flow

pass-throughs– Modernized investment technology– FNMA, Freddie Mac

• Other asset-backed securities developed subsequently– Auto loans– Credit card receivables– David Bowie albums

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The Securitization Process

• Participants– Demanders of funds

• Homeowner / borrower of funds• Bank / Loan originator

– Special purpose entity / trust– Suppliers of funds

• Underwriter / investment bank• Capital markets / investors

• Some of the Benefits– Liquidity– Market values– Lower cost

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Mortgage-Backed Securities (MBSs)

• Originated in response to mortgage funding shortfall

• Mortgages are “securitized” by packaging mortgage loans and selling the cash flows as securities

• The mortgage-backed securities represent ownership in the mortgages

• Mortgages generally have an embedded option: to prepay the mortgage (in event of interest rates falling, mortgage-holder moving, etc.)

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Mortgage-Backed Securities (cont.)

• Investors receive the monthly mortgage payments (principal and/or interest) paid by the mortgage borrowers

• With MBSs, the prepayment risk is transferred to the capital market investors

• Investors are compensated for this risk by sufficiently high yields on the securities

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What is “Securitization of Insurance Risk”?

• Insurance company transfers underwriting risks to the capital markets by transforming underwriting cash flows into tradable financial securities

• Cash flows (e.g., repayment of interest and/or principal) are contingent upon an insurance event / risk

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Alternatives to Capital

“Insurers are discovering what bankers know as securitisation: the process of assembling mortgages, credit-card receivables or even business loans into securities that provide reasonably predictable income streams and principal repayments. This sort of financial engineering has been going on for decades in America.... Its big advantage is that, once the assets have been sold, the issuer need no longer set aside capital to cover potential losses; instead, the capital can be redeployed more profitably. Insurers are only now waking up to the potential benefits.”

- “An Earthquake in Insurance,” Economist, 2/26/98

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Evolution of the Insurance Industry

“Affronts” to Traditional Insurance

• Self-insurance• Captives• Risk retention groups and purchasing

groups• Insurance securitization• Portfolio insurance

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Factors Affecting the Recent Development of Insurance Securitization

• Recent catastrophe experience– Reassessment of catastrophe risk

– Demand for and pricing of reinsurance

– Reinsurance supply issues

• Capital market developments– Development of new asset classes and asset-backed

markets

– Search for yield and diversification

• Restructuring of insurance industry

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Possible Reasons for Securitizing Insurance Risks

• Capacity– Risk of huge catastrophe losses– Would severely impair P/C industry capital– Capital markets could handle

• Investment– Catastrophe exposure is uncorrelated with

overall capital markets– Thus, uncorrelated with existing portfolios– Diversification potential

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Risks Which P/C Insurers Face

• Underwriting– Loss experience: frequency and severity– Underwriting cycle– Inflation– Payout patterns– Catastrophes

• Investment– Interest rate risk– Capital market performance

All of these risks can prevent a company from meeting its objectives

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What to Securitize?

• Homeowners? Auto? Health?• “Homeowners is not a problem for the insurance

industry. Auto is not a problem for the insurance industry. We know how to manage those risks…. How about catastrophes?”

- Dennis Chookaszian (a 1992

comment, quoted in Best’s

Review, 4/99)

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Types of Insurance Instruments

• Those that transfer risk– Reinsurance– Exchange-traded derivatives– Swaps– Catastrophe bonds

• Those that provide contingent capital– Letter of credit– Contingent surplus notes– Catastrophe equity puts

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Exchange-Traded Derivatives

• Chicago Board of Trade– Option spreads ~ reinsurance– PCS: daily index values– Nine geographic products

• Bermuda Commodities Exchange– Binary options– Guy Carpenter Catastrophe Index– Seven geographic products

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Risk Exchanges and Swaps

• CATEX New York

– Electronic bulletin board

– Intermediary

• CATEX Bermuda

– Joint venture: CATEX and Bermuda Stock

Exchange

• Swaps

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Some Early Successful Bond Issues

• USAA: company’s hurricane losses

• Swiss Re: industry’s California E/Q losses

• Tokio Marine & Fire: Tokyo E/Q magnitude

• Centre Re: company’s Florida hurricane losses

• Yasuda Fire & Marine: typhoon losses

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Generally Common Traits of Successful Issues

• Involve catastrophe risk

• High levels of protection

• Relatively short maturities

• Some protection of principal included

• High coupon rates

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“Costs” of Cat Bonds

• High yields– Default premiums may be high for a time

• Setting up SPV

• Investment banking fees– Advising

– Spread

• Legal fees

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Contingent Capital

• Contingent surplus notes– Option to borrow, contingent upon some event

or trigger

– Right to issue surplus notes

• Catastrophe equity puts– Put option (right to sell)

– Right to issue shares of stock, contingent upon some event or trigger

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Very Recent Activity

• Approximately $1.22 billion issued in the 2002 cat bond market– Versus $1.14 billion in 2001

• Notable transactions:– USAA / Residential Re: Sixth consecutive year

– Vivendi / Studio Re: First direct-corporate issue on US peril

• Several catastrophe bond investment funds

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Issues Regarding the Potential “Success” of Insurance Securitization

• Need to understand two markets– Capital markets– Insurance markets

• Separation of insurance and finance functions in many companies

• Information and technology• Pricing challenges• Cost (vs. cat. reinsurance market)• Legal / tax / accounting issues

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The Future of Insurance Securitization

• A number of issues• Insurer FRM can take a variety of forms

– Asset hedges• Reinsurance• Derivatives

– Liability hedges• Debt forgiveness

– Asset-liability management– Contingent financing– Post-loss financing and recapitalization

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CBOT Catastrophe Option Spreads

• European cash options• Loss period: generally calendar quarter (except annual for

Western and CA)• PCS provides industry indexes daily• Development period: 6 or 12 months• Index Valuation: Each index point

= $100 million in industry cat losses

= $200 cash value• Strike values: in multiples of 5• Tick size: one-tenth of a point (= $20)

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CBOT Cat. Option Spreads (cont.)

• Underlying instrument:

– National -- All states + DC

– Eastern -- AL, CT, DE, DC, FL, GA, LA, ME, MD, MA, MS, NH, NJ, NY, NC, PA, RI, SC, VT, VA, WV

– Northeastern -- CT, DE, DC, ME, MD, MA, NH, NJ, NY, PA, RI, VT

– Southeastern -- AL, FL, GA, LA, MS, NC, SC, VA, WV

– Midwestern -- AR, IL, IN, IA, KS, KY, MI, MN, MO, NE, ND, OH, OK, SD, TN, WI

– Western -- AK, AZ, CA, CO, HI, ID, MT, NV, NM, OR, UT, WA, WY

– California

– Florida

– Texas

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CBOT Cat. Option Spreads (cont.)

Example• December 1997 30/50 TX Call Spread

• Essentially, this is a $2B x/s $3B layer on 4th-quarter 1997 industry Texas cat losses:

[50-30] x $100M = $2B

30 x $100M = $3B

• If 4th-quarter TX cat losses = $4.5B:

Call option spread value =

[($4.5B/$100M)-30]x$200 = $3,000

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Bermuda Commodities Exchange

• Catastrophe derivatives

• Guy Carpenter Catastrophe Index

• Single loss, second loss, and aggregate options

• Binary option: payoff either $0 or $5000

• Two six-month risk periods each year

• Periodic settlement evaluations -- final is 13 months after end of risk period

• National, NE, SE, MW, Gulf, FL, TX

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Uses of Exchange-Traded Options

• Hedge insurer’s catastrophic loss exposure– Proceeds from options potentially provide a cash flow which

offsets cat. losses to some degree– Does not change likelihood or severity of a catastrophe -- but

changes net impact on insurer

• Issues– Basis risk

• Depends on index which defines / triggers cash flows• E.g., regional versus state versus zip code

– Frequency of settlement and index calculation– Marketing and liquidity

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Other Insurance Products

• Contingent surplus notes– Insurer has right to issue surplus notes

(subordinated debt), contingent upon an event– Investment trust sells certificates to capital markets,

and invests in liquid securities– If event occurs, insurer issues surplus notes in

exchange for liquid securities

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Other Insurance Products (cont.)

• Catastrophe equity puts– Insurer has right to issue equity (e.g., preferred

stock), contingent upon an event

– Insurer pays investors for the option to sell them shares

– If event occurs, insurer receives cash from investors in exchange for its shares

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Other Insurance Products (cont.)

• Catastrophe bonds– Insurer issues debt

– Similar to a corporate bond

– Provision for “contingent debt forgiveness”

– If a specified event occurs, some / all of the principal / interest payment obligations of the insurer will be forgiven (sacrificed) by the investors

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RECENT SUCCESSES• USAA / Residential Re

– Size: $477M, in two tranches– Trigger: hurricane losses to company– Coverage: 80% of $500M x/s $1B co. loss– A-1: rated AAA

• $163.8M, of which $77M placed in a defeasance account to fund principal repayment

• Only interest at risk

• Coupon: LIBOR + 282 bps

– A-2: rated BB• $313.2M

• Both principal and interest at risk

• Coupon: LIBOR + 575 bps

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RECENT SUCCESSES (cont.)

• Swiss Re– Size: $137M, in three classes– Trigger: losses to industry from CA E/Q; industry insured

loss, from a single event, greater than $18.5B triggers principal write-downs

– 40% of Class A proceeds to defeasance account– Coupon:

• A-1: LIBOR + 255 bps

• A-2: 8.645%

• B: 10.493%

• C: 12%

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RECENT SUCCESSES (cont.)• Tokio / Parametric Re

– Size: $100M, in two tranches– Trigger: Tokyo earthquake magnitude; a Japanese

Meteorological Association magnitude rating of 7.1 or more involves loss of part or all of principal

– Half of $20M proceeds from A and all of $80M proceeds from B are risk capital

– Ten-year term – Coupon:

• A: LIBOR + 206 bps

• B: LIBOR + 430 bps

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RECENT SUCCESSES (cont.)

• Centre / Trinity Re– Size: $84M, in two tranches

– Trigger: FL hurricane losses to company

– Class A-1 notes ($22M in proceeds) provide for full principal repayment in event of a loss

– Coupon:• A-1: LIBOR + 182 bps

• A-2: LIBOR + 436 bps

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RECENT SUCCESSES (cont.)

• USAA (1998)– $450 million, thru Residential Re– Company losses greater than $1B from

Hurricane– A-1: LIBOR + 140 bps (compare with 282

bps in 1997)– A-2: LIBOR + 400 bps (compare with 575

bps in 1997)

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RECENT SUCCESSES (cont.)

• Yasuda Fire and Marine– Typhoon losses– $80 million offering– 5-7 years– Attachment point recalculated every year with

exposure model -- constant 0.94% chance of loss to investors

– Guaranteed limits and pricing for a second event

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RECENT SUCCESSES (cont.)

• F&G Re– Aggregate x/s cover for a portfolio of catastrophe

reinsurance contracts

– $54 million offering

– Through Mosaic Re

• X.L. Mid Ocean Re– Retrocessional hurricane and E/Q

– $200 million offering

– Competitive bidding process

– Swap

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RECENT SUCCESSES (cont.)• Swiss Re

– Basis swap with reinsurer (“ABC”)– Up to $10 million transferred– Two triggers:

• SE windstorm losses of ABC• SE windstorm losses of industry (from PCS)

Exceed trigger?ABC Industry Result Y N Swiss Re pays N Y ABC pays N N Nothing Y Y Pay each other

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GENERALLY COMMON TRAITS OF SUCCESSFUL ISSUES

• Involve catastrophe risk

• High levels of protection

• Relatively short maturities

• Some protection of principal included

• High coupon rates

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“COSTS” OF CAT BONDS

• High yields– Default premiums may be high for a time

• Setting up SPV

• Investment banking fees– Advising

– Spread

• Legal fees

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THE FUTURE OF INSURANCE SECURITIZATION

• Will it survive and grow?– Expensive

– Time and technology

• Will it replace or supplement traditional transactions?

• How will it affect reinsurance?

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THE FUTURE OF INSURANCE SECURITIZATION (cont.)

• Capacity versus other reasons

• Catastrophe risks versus traditional insurance lines

• Historically, markets for other forms of securitizations have taken some time to develop and mature

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THE FUTURE OF INSURANCE SECURITIZATION (cont.)

• Legal and tax issues– Are securitization instruments insurance?

– Bermuda Insurance Amendment Act (1998): insurance derivatives are “investment contracts”

– Different tax implications:• Protect income statement

• Protect balance sheet

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THE FUTURE OF INSURANCE SECURITIZATION (cont.)

• What form will insurer FRM take?– Asset hedges

• Reinsurance

• Derivatives

– Liability hedges• Debt forgiveness

– Asset-liability management

– Contingent financing

– Post-loss financing and recapitalization

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Capacity: Is There a Shortfall?

• Estimate of total net worth of U.S. P/C industry:

$300B +

• Capital exists to handle contingencies

• “Insurance density” is low in places

• New capital enters when rates of return are high

(e.g., Bermuda cat insurers after Andrew)

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CBOT PCS Catastrophe Option Spreads

• European cash options• Loss period: generally calendar quarter (except

annual for Western and CA)• Development period: 6 or 12 months• PCS provided industry indexes daily• Index Valuation: Each index point

= $100 million in industry cat losses= $200 cash value

• Strike values: in multiples of 5• Tick size: one-tenth of a point (= $20)

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CBOT PCS Catastrophe Option Spreads (cont.)

Example

• December 1997 30/50 TX Call Spread• Essentially, this is a $2B x/s $3B layer on 4th-

quarter 1997 industry Texas cat losses:

[50 - 30] x $100M = $2B

30 x $100M = $3B• If 4th-quarter TX cat losses = $4.5B:

Call option spread value =

[($4.5B / $100M) - 30] x $200 = $3,000

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Bermuda Commodities Exchange Catastrophe Options

• Catastrophe derivatives• Guy Carpenter Catastrophe Index• Single loss, second loss, and aggregate options• Binary option: payoff either $0 or $5000

• Two six-month risk periods each year• Periodic settlement evaluations -- final is 13

months after end of risk period• National, NE, SE, MW, Gulf, FL, TX

Not But