capital market reinsurance solutions july 9, 2001 philip kane, acas tel: +1 212 723 5851
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Capital Market Reinsurance Solutions July 9, 2001 Philip Kane, ACAS Tel: +1 212 723 5851 Philippe Joly Tel: +1 212 723-6461. Derivatives are any financial instrument which “derives” its value from some “underlying” asset or another derivative - PowerPoint PPT PresentationTRANSCRIPT
Capital Market Reinsurance Solutions
July 9, 2001
Philip Kane, ACASTel: +1 212 723 5851
Philippe Joly
Tel: +1 212 723-6461
Page 2
Insurance Derivatives and Reinsurance
• Derivatives are any financial instrument which “derives” its value from some “underlying” asset or another derivative
• The increase in the sophistication of the reinsurance market has paralleled the development of the derivatives market.
• Insurance Derivatives relate to those derivatives which are concerned with insurance risks, placed with insurers, or use insurance techniques and structures.
• Insurance Derivatives are used as an alternative to reinsurance transactions and as a new source of risk taking opportunities. But often they involve the blending of insurance and derivative structures.
• Insurance Derivative groups have been formed at all the major Investment Banks. At Citigroup, we are a 10 year old group with 8 professionals directly attached to insurance derivatives and handling transactions in excess of over $20 billion notional a year.
Page 3
Capital Market Risk Transfer Opportunities for the Reinsurance Market
• Risk Classes:
–Credit Risk
–Future Flows
–Project Finance
–Private Equity
–Basis Risks
–Residual Value
–Sovereign/Political Risk
–Plant Outage
–Volatility Risks
–Correlation Risks
–Weather Risks
Page 4
Risk Transfer Opportunities for the Reinsurance Market
• Reasons for Reinsurance Risk Transfer
–Relationships
–Unique Risk Appetites (Class and level)
–Analytical Expertise
–Flexible Mandates
–RAT (Regulatory, Accounting, Tax)
Page 5
Synthetic CDO Example
• CDO= Collateralized Debt Obligation
• CDO’s represent a class of financial instruments each composed of a portfolio of loans, bonds, or other debt form representing the obligations of underlying third parties to pay.
• These third parties are referred to as “names” and are pooled for diversity: there can be as many as 150 or more in a single CDO
• CDO’s are tranched in layers of risk:
–The first tranche or layer represents the first set of default losses between 0-5% of the notional and therefore is the riskiest. It is often referred to as the equity layer.
–The next tranche is the mezzanine tranche which represents the next losses between 5-10% of the notional.
–The remaining obligations are the last to default, and this layer is considered the least risky, and therefore named the senior tranche.
Page 6
Credit Default Swap
• The Synthetic qualifier represents the use of derivatives transfer the risk of the losses to third parties without the debt notionals changing hands. This is done through Credit Default Swaps.
• Credit Default Swap: Two parties enter into an agreement whereby one party pays the other a fixed periodic coupon (premium) for the specified life of the agreement. The other party makes no payments unless a specified credit event occurs (floating payer). Credit events are typically defined to include a material default, bankruptcy, or debt restructuring for a specified reference asset.
• Upon a credit event the floating payer either pays the market value of the asset (physical settlement) or the difference between par and such market value (cash settlement).
Page 7
CDO: Sample Capital Structure
AAA+
BBB
B/BB
Senior: 90% of notional
Mezzanine: 7% of notional
Equity: 3% of notional
Page 8
Binomial Model of CDO’s
• Moody’s is leading ratings provider for tranches
• Basic Rating model divides names into industry/country groups and reduces the total number of names to an index based on the notional in each group: this index is termed a diversity score
• This diversity score is used as the n for a binomial model
• Given the average rating, and historical defaults, a frequency can be determined for default.
• Assuming a recovery rate under each obligation one can determine the number of defaults necessary to provide losses to a tranche. This can be used to determine the expected loss within a tranche by assigning probability to each number of defaults
• Probability of a specific number (x) of defaults =
n! / [x! (n-x)!] * (p)x(1-p) n-x
Page 9
Default Probabilities: Moody’s
The tables below provide Moody’s estimates of the cumulative and marginal defaultrates, during the period 1970-1996, given a particular initial rating:
MOODY’S CUMULATIVE DEFAULT RATES (%) 1970-1996
Long-Term Rating 1 yr 2 yrs 3 yrs 4 yrs 5 yrs
Aaa 0.00 0.00 0.00 0.04 0.13Aa 0.03 0.05 0.10 0.25 0.40A 0.01 0.07 0.22 0.39 0.57
Baa 0.12 0.39 0.76 1.27 1.71Ba 1.36 3.77 6.29 8.88 11.57B 7.27 13.87 19.94 25.03 29.45
MOODYS’ MARGINAL DEFAULT RATES (%) 1970-1996
Long-Term Rating 1 yr 2 yrs 3 yrs 4 yrs 5 yrs
Aaa 0.00 0.00 0.00 0.04 0.09Aa 0.03 0.02 0.05 0.15 0.15A 0.01 0.06 0.15 0.17 0.18
Baa 0.12 0.27 0.37 0.51 0.44Ba 1.36 2.41 2.52 2.59 2.69B 7.27 6.60 6.07 5.09 4.42
Page 10
Historical Recovery Rates
T h e tab le b elo w p r o v id es aver age r eco ver ies o n d efau l ted d eb t g iven th e lega l sta tu so f each ca tego ry o f d eb t.
W h i le th ese fi gu r es w o u ld ap p ea r cr i ti ca l to p r o p er p r i c in g o f cr ed i t r i sk , th ei r u t i l i tyi s d im in i sh ed a g r ea t d ea l w h en acco u n t i s tak en o f th ei r va r iab i l i ty , a s o b ser ved inth e h i sto g r am b elo w ( d er ived fr o m a lead in g stu d y o f b an k lo an s) :
S e n i o r i t y A v e r a g e R e c o v e r y R a t e
S en io r secu r ed 6 4 .5 9 %S en io r u n secu r ed 4 8 .3 8S en io r su b o r d in a ted 3 9 .7 9S u b o r d in a ted 3 0 .0 0J u n io r su b o r d in a ted 1 6 .3 3
R e c o v e r ie s
0 %
5 %
1 0 %
1 5 %
2 0 %
2 5 %
3 0 %
0-2.5
%
2.5%
-12.5
%
12.5%
-22.5
%
22.5%
-32.5
%
32.5%
-42.5
%
42.5%
-52.5
%
52.5%
-62.5
%
62.5%
-72.5
%
72.5%
-82.5
%
82.5%
-92.5
%
92.5%
-100
%
P e r c e n ta g e
Page 11
Synthetic CDO Expected Loss Calculation using Binomial Model
• From previous slides we assume a diversity score of 20, a 5 year average life, and an average Baa rating, producing a default frequency of 1.71%. We also assume a Recovery Rate of 50%.
• We are interested in determining the Expected Loss (and the rating) of Tranche, say, [4% , 8%]
• Using the binomial model we can produce the following distribution of defaults:
Number of Net Loss to Loss toProbability Defaults Default Loss Tranche Tranche (%)70.82502% 0 0% 0% 0% 0% E[Loss to Tranche] (%)24.64356% 1 5% 3% 0% 0% 1.424%4.07299% 2 10% 5% 1% 25%0.42516% 3 15% 8% 4% 88%0.03144% 4 20% 10% 4% 100%0.00175% 5 25% 13% 4% 100%0.00008% 6 30% 15% 4% 100%0.00000% 7 35% 18% 4% 100%0.00000% 8 40% 20% 4% 100%
Page 12
CDOs: Note on Correlation
An intuitive way of understanding the concept of Loss to a tranche is to realize that the E(Loss) to a small tranche dx is equal to the Probability of Attachment at x.
This explains why the E(Loss) to a bottom tranche is essentially determined by the probability of attachment at the portfolio level.
And the E(Loss) to a top tranche is essentially determined by the probability of Exhaustion at the portfolio Level.
0%
100%
a
b
0% 100%a b
Probabilityof Exceedence
E ( L[a,b] )
b
aba dxxLPab
LE )(1
)( ],[
Page 13
Synthetic CDO Market
• Market was originally driven by Bank Regulatory Capital Relief
• Banks’ capital charge of 8% of notional on non-OECD bank debt; but only 1.6% for OECD banks and VAR (economic) charges for trading book. Therefore, banks with trading books can provide capital relief to non-trading book banks, and buy protection in the form of derivatives.
• Additional volume provided by non-bank Credit Derivative Trading volume
• Synthetic CDO Market has traded in excess of $400,000,000,000 of notional.
• Reinsurance Market has been attracted to the risk and structure of synthetic CDO’s due to actuarial pricing methodology and regulatory needs of end-buyers
• Credit-Default Swaps are also be treated as insurance policies for insurance regulatory purposes in certain jurisdictions (eg, Bermuda), allowing insurance entities to be providers of protection and the booking of insurance premiums
Page 14
CDO: Actual Deal
PaymentThreshold
2.00%
ReliefSeekingBank
OTC Market
CorporateLoan &Bonds
OECD BANK
OECD BANK
CITIBANK
CIT
IBA
NK
OEC
D B
AN
K
JuniorDefault Swap
MezzanineDefault Swap
SeniorDefault Swap
Super SeniorDefault Swap
Credit LinkedNote
OTC MarketCredit Default
Swap
Page 15
Synthetic CDO Market
Capital Relief
Seeking Bank
Counterparty Bank’s
Trading Book
Premium
Losses
Credit Default Swap Market
Premium
Losses
Reinsurance and Bank Market
Page 16
Synthetic CDO Accounting
• Market traded risks, even if in insurance form, should be marked to market based on US GAAP
• If blended with insurance or other risks, bifurcation should take place
• Insurance, weather, and other natural risks are specifically excluded from FASB 133
• Credit risk is marked to market as a derivative but not as insurance.
• Insurers who choose to take credit risk in insurance form do not have to mark portfolio if the form meets GAAP criteria as a financial guarantee (identifiable failure to pay) but default swap providers do, regardless of jurisdiction .
• Currently, banks haven’t accepted insurance policies in trading books.
• The use of Transformers has been common to address this problem.
Page 17
In order to qualify for the scope exception in paragraph 10(d), a
financial guarantee contract must require, as a precondition for
payment of a claim, that the guaranteed party be exposed to a loss
on the referenced asset due to the debtor's failure to pay when
payment is due both at inception of the contract and over its life. If the
terms of a financial guarantee contract require payment to the
guaranteed party when the debtor fails to pay when payment is due,
irrespective of whether the guaranteed party is exposed to a loss on
the referenced asset, the contract does not qualify for the scope
exception in paragraph 10(d). Even if, at the inception of the contract,
the guaranteed party actually owns the referenced asset, the scope
exception in paragraph 10(d) does not apply if the contract does not
require exposure to and incurrence of a loss as a precondition for
payment. Furthermore, to qualify for the scope exception in paragraph
10(d), the compensation paid under the contract cannot exceed the
amount of the loss incurred by the guaranteed party.
Accounting: Statement 133 Implementation Issue No. C7
Page 18
The guaranteed party's exposure to and incurrence of a loss on the
referenced asset can arise from owning the referenced asset or from
other contractual commitments, such as in a back-to-back guarantee
arrangement. The application of the scope exception to financial
guarantee contracts under which the guaranteed party incurs a loss
resulting from the debtor's failure to pay either because it owns the
referenced asset or because of other contractual commitments is
consistent with the reasoning for Statement 133's scope exception for
certain insurance contracts. Paragraph 281, which relates to the
exclusion of certain insurance contracts from the scope of Statement
133, indicates that those contracts are excluded from the scope
because they entitle the holder to compensation only if, as a result of
an identifiable insurable event (other than a change in price), the
holder incurs a liability or there is an adverse change in the value of a
specific asset or liability for which the holder is at risk.
Accounting: Statement 133 Implementation Issue No. C7(Continued)
Page 19
Capital Market Alternatives to Reinsurance
• Reinsurance Transactions often address financial issues that can also be addressed by the capital markets
–Property Catastrophe risk linked notes
–Life Reinsurance may transfer interest rate risks which can be addressed by the interest rate swap market
–Life and P/C Surplus Relief could be structured with an SPV supported by a securitization of the profits
–Contingent Capital can be securitized in form of a note with different spreads pre- and post- contingency/exercise.
–Dual Risk Covers: Cat Protection contingent on equity index move
–Aggregate Stop Losses can include financial risks such as interest rate risks
Page 20
Combined Aggregate Stop Loss Example
• Stop Loss which combines both losses on asset and liability side
• By converting asset risk into a formula using duration, notional, and interest rates, can generate losses on asset side derived from interest rate movements
• Covered losses under reinsurance would include indexed interest rate losses as above
• When these losses and insurance losses exceeded attachment point, reinsurer pays, up to limit.
• Usual duration is one year, covering all lines of insurance business as well.
• Catastrophe losses are usually capped as well.
Page 21
Combined Aggregate Stop Loss Pricing
• Aggregate Loss Models are available for insurance risks and are usually based on stochastic models of losses
• Insurance risks are generally modeled with statistical models and insurance risk only stop losses are generally priced using Monte Carlo simulation
• Issues are generally correlations, event losses (catastrophe), trended and untrended expected loss ratios, growth rates, etc….
• Transaction models combining asset risk with insurance risks have generally added these risks as another stochastic variable.
• For liquid risks such as short interest rates there can be great divergence between insurance pricing and Capital Markets pricing.
• For illiquid risks, the pricing results tend to converge due to the lack of liquid markets for these risks. These risks get treated as event risks in the capital markets much like insurance pricing rather than continuous risks.
Page 22
Insurance Pricing vs. Derivatives Pricing
Typical Insurance Pricing: ‘Call Contract’
S=100
S=110
S=90Option Value = 0
Option Value = 10Probability: p = 55%
Probability: 1-p = 45%
Interest Rate: r = 5%
Option Price: S= [ p.10 + (1-p).0 ] / (1+r) = 10p / (1+r) = 5.24
Page 23
Insurance Pricing vs. Derivatives Pricing
Derivatives Pricing: Call Option
S=100
S=110
S=90Option Value = 0
Option Value = 10Probability: p = 55%
Probability: 1-p = 45%
Interest Rate: r = 5%
Pricing is determined by the construction of a replicating portfolio, not by actual probabilities
Page 24
Insurance Pricing vs. Derivatives Pricing
Derivatives Pricing: Building a Replicating Portfoliomade of x bonds and y underlying securities
S=100
S=110
S=90Option Value = 0
Option Value = 10Probability: p = 55%
Probability: 1-p = 45%
Interest Rate: r = 5%
Portfolio = ( -0.42 Bonds , 0.5 securities)Portfolio Value = -0.42*105 + 0.5 * 110
= 110
Portfolio = ( -0.42 Bonds , 0.5 securities)Portfolio Value = -0.42*105 + 0.5 * 90
= 0
The option and the Porfolio have the same final value in all cases, therefore they should have the same price at time 0
Option Price = -0.42 * 100 + 0.5 * 100 = 7.14
Page 25
Insurance Pricing vs. Derivatives Pricing
Derivatives Pricing: Using Risk-Neutral Probabilities
If we calculate the probability p* satisfying
100 * (1.05) = 110 p* + 90 (1- p*)
p* = 0.75,
then we can check that
[ 10 p* + 0 (1- p*) ] / (1+r) = 7.14 = Call Price
S=100
S=110
S=90Option Value = 0
Option Value = 10Probability: p = 55%
Probability: 1-p = 45%
Interest Rate: r = 5%
Page 26
Combined Aggregate Stop Loss Pricing
• We will assume for each .005% change in interest rates, the bond portfolio moves a value equal to 1% of premium.
• We will also assume no correlation between a move in interest rates during the year and the resulting accident year loss ratio.
• The cover will be 20% in excess of 70%, with a sublimit of 10% on asset losses due to interest rate moves
Interest Rate Move
Effective Pure Loss Ratio Attachment
Effective Pure Loss Limit
Required Reinsurance Premium on Pure Losses
Interest Rate Option Payoff
0.00% 0.7 20.00% 4.00% 0.00%0.50% 0.69 20.00% 4.99% 0.99%1.00% 0.68 20.00% 6.01% 2.01%1.50% 0.67 20.00% 7.06% 3.06%2.00% 0.66 20.00% 8.16% 4.16%2.50% 0.65 20.00% 9.31% 5.31%3.00% 0.64 20.00% 10.52% 6.52%3.50% 0.63 20.00% 11.80% 7.80%4.00% 0.62 20.00% 13.16% 9.16%4.50% 0.61 20.00% 14.59% 10.59%5.00% 0.6 20.00% 16.10% 12.10%
Page 27
Combined Aggregate Stop Loss Pricing
Interest Rate Option Payoff
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
Interest Rate Movements
Inte
res
t R
ate
Op
tio
n P
ay
off
Page 28
Combined Aggregate Stop Loss Pricing
• The interest rate option payoff is based on the cumulative change in the required premium from the pure loss (no interest rate moves) premium.
• The Premium changes as the effective loss ratio attachment drops due to interest rate losses.
• Assuming this option cost 1.5% and the pure stop loss cost 4%, the total upfront premium would be 5.5%.
• With this payoff we can arrange an interest rate only option for a reinsurer to be able to bind a combined aggregate stop loss delivering the necessary premium to underwrite the loss risk.
• This could also be done for “finite” stop loss covers and multi-year stop loss covers.
Page 29
Combined Aggregate Stop Loss Accounting
• There is no explicit accounting pronouncements on Combined Aggregate Stop Loss Covers.
• There have been FAS clarifications of combined insurance and financial risks.
• There would be merit to NOT bifurcating the interest rate option embedded in the trade.
• This is because a pure loss ratio in excess of 60% is required for any interest rate losses to be covered, and this is not certain.
• The insured must also actually experience the interest rate losses, much like the actual loss requirement of industry loss covers.
Page 30
Only those contracts for which payment of a claim is triggered only by a
bona fide insurable exposure (that is, contracts comprising either solely
insurance or both an insurance component and a derivative instrument)
may qualify for the exception under paragraph 10(c). In order to qualify,
the contract must provide for a legitimate transfer of risk, not simply
constitute a deposit or form of self-insurance. A property and casualty
contract that provides for the payment of benefits/claims as a result of
both an identifiable insurable event and changes in a variable would in its
entirety qualify for the insurance exclusion in paragraph 10(c)(2) of
Statement 133 (and thus not contain an embedded derivative instrument
that is required to be separately accounted for as a derivative instrument)
provided all of the following conditions are met:
1.Benefits/claims are paid only if an identifiable insurable event
occurs (for example, theft or fire) pursuant to the requirements of
paragraph 10(c)(2) of Statement 133.
Accounting: Statement 133 Implementation Issue No. B26
Page 31
Accounting: Statement 133 Implementation Issue No. B26 (Continued)
2.The amount of the payment is limited to the amount of the
policyholder’s incurred insured loss.
3.The contract does not involve essentially assured amounts of
cash flows (regardless of the timing of those cash flows) based on
insurable events highly probable of occurrence because the
insured would nearly always receive the benefits (or suffer the
detriment) of changes in the variable. If there is an actuarially
determined minimum amount of expected claim payments (and
those cash flows are indexed to or altered by changes in a
variable) that are the result of insurable events that are highly
probable of occurring under the contract and those minimum
payment amounts are expected to be paid each policy year (or on
another predictable basis), that "portion" of the contract does not
qualify for the insurance exception.
Page 32
Conclusions
• Convergence is here!!
• Capital Markets are sourcing risks for the Reinsurance market as well providing solutions to insurance problems
• Be cautious when underwriting liquid risks, but look for structural exploitations.
• In illiquid risk markets there are many opportunities for savvy players and Reinsurers are a major player.
• Re/insurance has unique regulatory, accounting, and tax implications that can work to the advantage or disadvantage of transactions.