Catastrophes, Capital
markets, and Risk Securitization
Funding catastrophes: Reinsurance? Bonds?
1. NAIC and use of cat modeling in rate-making
2. Risk Securitization courtesy of David Na, FCAS,
MAAA, Deloitte & Touche, Bermuda
3. Risk Securitization 101 – courtesy of Kymn
Astwood, CA, Arrow Reinsurance Company,
Limited, (A Goldman Sachs Group Company)
4. Slides from CEA, FHCF, TWIA - Federal role?
States?
NAIC Catastrophe Computer
Modeling Handbook
Purpose of the Handbook
“What on Earth do we need this for?”
The purpose of the Catastrophe Modeling
Handbook is to explore in some detail catastrophe
computer models and to discuss issues that have
arisen or can be expected to arise from their use.
Used by insurance regulators to review models
primarily used in underwriting, rate-making and
solvency procedures.
3
User Perspectives of Models
“Well here’s what we think...”
Insurers’ Perspective:
– Old rate making methods underestimate the cost of
insuring catastrophe prone areas.
Consumers’ Perspective:
– Modelers must disclose input and output so independent
tests can be run to assure that results are reasonable.
4
User Perspectives of Models (continued)
Regulators’ Perspective:
– Must learn to replace traditional models with a
methodology that is in its relative infancy in terms of
producing consistently reliable results.
– Must work with modelers to provide enough disclosure
to make informed decisions while preserving the
confidentiality of proprietary details.
5
Components of the Model
“The whole is greater than the sum of its parts.”
Science Module:
– Physical characteristics about the catastrophe (factors
include: wind speeds, landfall location, magnitude,
location of fault, liquefaction potential).
Engineering Module:
– Estimates the effect of catastrophic events on
different types of structures (factors include: age of
structure, construction type, attachment anchoring).
Insurance Module:
– Estimates the insured damage at a location (factors
include: guaranteed replacement cost multiplier,
deductible, reinsurance limits). 6
Risk Securitization 101
2000 CAS Special Interest Seminar
David Na, FCAS, MAAA
Deloitte & Touche, Bermuda
Background
• Effects of Natural Catastrophes in Late 80’s &
Early 90’s:
Decreased Insurance/Reinsurance Capacity
Increased Demand for Reinsurance
Realization of Inadequate Pricing
Increased Awareness re: Insurer’s Exposures
Types of ILS’s
• Catastrophe Bonds - Will Discuss in Detail...
• Catastrophe Risk Exchange (CATEX) Swaps
• Insurance Related Derivatives/Options
• Catastrophe Equity Puts (CAT-E-Puts)
• Contingent Surplus Notes
• Weather Derivatives
Advantages - Investor
• Above average yield relative to other securities
(e.g. corporate bonds) of similar risk
• Outstanding diversification effect - Unlike
investments in insurance company stocks, CAT
events are generally uncorrelated with an investor’s
portfolio
• Allows non-insurance investors to participate in
insurance related transactions
• Preparation for convergence of Insurance &
Banking
Advantages - Issuer
• Capacity - Access the Capital of the Financial
Markets
• Greater Flexibility in Terms of Coverage
• Reinsurance Protection – Fully Collateralized, No
Credit Risk
• More Stable Pricing - Insulated from U/W cycles
• High aggregate level risk transfer
• Innovation/Prestige - “Cutting Edge”
Issues
• Requires understanding of both Capital and
Insurance Markets (Investors as well as Issuers)
• Historical separation of Capital and Insurance
Markets (e.g. Regulatory Issues)
• Uncertainty involved in pricing high layer or
catastrophic events (Reliance on Modeling)
• Issuer’s Costs (Relative to Purchase of Reinsurance)
• Investor’s Return (Relative to Comparably Risky
Securities)
• Accounting, Legal, Regulatory, Tax, etc.
Casualty Actuarial Society
―Risk Securitisation 101”
Kymn Astwood, CA
Arrow Reinsurance Company, Limited
(A Goldman Sachs Group Company)
16th October, 2000
Slide 14
Agenda
1 Insurance and the Capital Markets are Converging
2 Risk Transfer vs Risk Financing
3 Overview of the Risk-linked Securities Sector
4 Benefits of Risk-linked Securities
5 Structure of Risk-linked Securities
6 Weather Derivatives and Other Alternatives
Slide 15
Insurance and Capital Markets are
Converging
Corporations,
Traditional
New Capital
Insurance and
Risk Markets
Reinsurance
Instruments
Markets
Pricing and volatility for Concern over
insurance and correlation – particularly
reinsurance Legal and Risk in down markets
1999 – second worst Regulatory Assessment Desire for more
catastrophe year for the Infrastructure Technology concrete risk
P&C industry assessment
Weather hedging driven ―Alpha-driven‖ investing
Securities rulings Modeling firms
by utility deregulation
and opinions
Academic and
Portfolio credit hedging
Standard government-
driven by BIS rules,
documentation sponsored research
cyclical considerations
SVO rating Internet-based data
Availability of coverage
guidelines accessibility
for high capacity/new
exposures Rating agency
expertise
Slide 16
Overview of Coverage Types
Types of Coverage
———————Risk Financing Options ——————
Risk Transfer Coverage Pre-Funded Coverage Post-Funded Coverage
A premium is paid Premiums paid at Payout determined
in advance equaling levels exceeding the and paid post-event.
the market price of market price of risk. It is repaid over time.
risk Excess builds up in a There may be a small
fund which is returned option premium paid
if there is no loss in advance
Slide 17
9
Impact of Market Forces
Securitization will become increasingly cost competitive with
reinsurance because of the forces driving both the markets
Securitization
Reinsurance Stable spreads with
Hardening of retrocessional markets respect to BB
Problems in Australian insurance corporate bonds
market Lower transaction
Earthquakes in Turkey, Taiwan, Greece, costs
Mexico Increased investor
Hurricanes in U.S. and Central America comfort with the
Higher satellite and aviation losses asset class
Problems with workers compensation
market due to Unicover-managed pool
Pressure to increase premiums to
restore investor confidence in
insurance/reinsurance stocks
Industry consolidation
Slide 18
Benefits of Risk Securitization
Issuer Perspective
Diversification of sources of risk protection
Additional capacity for certain risks / geographic areas
No credit risk due to full-collateralization of securities
Prompt claims payment following a loss event
Clearly defined trigger reduces disputes regarding
covered claims
Multi-year coverage at a fixed cost may be locked in at
inception
Market perception as an innovator and industry leader
Slide 19
Benefits of Risk Securitization
Investor Perspective
Uncorrelated Diversification can be achieved due to low
correlation with equity and fixed income investments
Attractive Risk/Return Profile compared with similarly
rated corporate bonds
Sophisticated Risk Analysis is performed by independent
catastrophe-modeling firms
Liquidity is provided by the growing secondary market
trading of risk-linked securities
Tim Richison
Chief Financial Officer
CAS Catastrophe Seminar
The Challenges of Dealing with Natural Catastrophes
October 7 - 8, 2002
CEA Financial Structure - Proposed at 1/1/03 CEA Financial Structure - at 12/31/01
$7,003M* $7,172M*
Second Industry Second Industry
Assessment Layer Assessment Layer
$1,456M $5,716M
$1,456M
$5,547M
$338M Fourth Reinsurance Layer
$5,209M $538M Second Reinsurance Layer
$200M Transformer Reinsurance Layer
$5,009M $5,178M
$616M Line of Credit – Interim $717M CCC Layer** -
GRB Financing Interim GRB Financing
$4,393M $100M Pre-Event General Revenue Bond
$4,461M
Layer
$4,293M $400M Second Reinsurance Layer
First Reinsurance Layer
$3,893M $1,434M
$600M First Reinsurance Layer
$3,293M $3,027M
First Industry
First Industry
Assessment Layer
Assessment Layer
$2,183M
$2,183M
$717M*** $844M
$1,110M Capital and Retained $844M Capital and Retained
Earnings Earnings
$350M Minimum Statutory Capital $350M Minimum Statutory Capital
*Excluding the $350 million Minimum Statutory Capital, total claim-paying capacity at 12/31/01 is $7.172 billion;
proposed claims-paying capacity at 1/1/03 is $7.003 billion.
21
Florida Hurricane
Catastrophe Fund
Texas Windstorm/Hail
Conference
November 17, 2004
22
Florida Property
Insurance Marketplace
Private
Reinsurers
(approximately 140)
FHCF
$616.2 million FHCF Premium
(about 11.6% of residential premium)
Insurers - 226 FIGA
Florida
(includes Citizens) Insurance
$5.3 billion residential Guarantee
Association
premium (estimated)
Residential
Policyholders
(5.8 million policies) 23
Initial Season Capacity For the 2004 Hurricane Season
(October 2004 Estimate)
Maximum
53 year Emergency
return Assessment --
time* $15 Billion Capacity $1.608 billion
(only $595.5
$21.4 B $8.880 B Bonding Capacity million
Overall (Includes Loss Adjustment Expense) needed)
Industry 2.22%
Loss
$6.120 B Projected 2004
Year-end Cash Balance
$4.5 B Industry Aggregate Retention 24
Not Drawn to scale.
*Return time not adjusted for premium/exposure growth.
Current
Financial
Structure
25
Current
Structure
and
Bonds
26
Protected
CRTF
27