Derivatives in the Insurance Market

Stephen P. D’ArcyProfessor of FinanceUniversity of Illinois

http://www.cba.uiuc.edu/~s-darcy/

First Annual OFOR SymposiumMay 16, 2002

Overview

• Use of derivatives by insurers

• Securitization of insurance risk

Use of Derivatives by InsurersBased on Cummins, Phillips, and Smith

North American Actuarial Journal January 1997

• 1994 annual statements filed with NAIC• 1,760 life insurers and 2,707 P-L insurers• Schedule DB Derivative Instruments• Categories of derivatives included:

– Options, caps, and floors owned– Options, caps, and floors written– Collars, swaps, and forward agreements– Futures contracts

Results

• 12% of life insurers and 7% of P-L insurers used derivatives sometime during the year

• Stock insurers use derivatives more– Life insurers: 16% of stock companies, 7% of mutuals– P-L insurers: 10% of stock companies, 4% of mutuals

• Larger companies used derivatives more– For largest size quartile, 34% of life and 21% of P-L

insurers used derivatives

Results (p.2)• Life insurers used derivatives to manage

interest rate risk– Caps/floors– Interest rate swaps– Options and/or futures positions on bonds

• P-L insurers have a higher percentage of assets in equities– Use of equity options, both calls and puts

• P-L insurers used FX forwards

Conclusion

• Most insurers did not use derivatives as of 1994

• Even for those that did use derivatives, the volume was low– For users, average notional value of open positions

• $661 million for life insurers

• $90 million for property-liability insurers

Why Don’t Insurers Use Derivatives More?

• Unfamiliarity with derivatives

• Conservatism

• Derivative horror stories

• Regulatory resistance

• Lack of focus on financial risk management

Securitization of Insurance Risk

• Exchange Traded Derivatives

• Contingent Capital

• Risk Capital

• Recent insurance derivatives

Exchange Traded Derivatives

• First proposed by Goshay and Sandor – 1973• CBOT Catastrophe futures and options – 1992

– Underlying: small sample of companies reported paid losses

• CBOT PCS Catastrophe Insurance Options – 1995– Underlying: estimate of industry wide incurred losses

• Bermuda Commodities Exchange Catastrophe Options– Binary options– Trigger: Guy Carpenter Catastrophe Index

Status of Exchange Traded Derivatives

• Trading volume was very low

• Large bid-ask spreads

• There is currently no viable market for exchange traded derivatives

Contingent Capital• Line of credit

• Contingent surplus note

• Cat-Equity-Put– Insurer contracts with counterparty to purchase put options

– Options can only be exercised in the event of a catastrophe

– Minimum post catastrophe net worth requirement

– Warranties on reinsurance, management control, etc.

– Exposure period 1-10 years

– Annual premiums

– Buyback provisions

Risk CapitalCatastrophe Bonds

Typical case - pre-funded, fully collateralizedProvides insurers with additional capital and multiyear coverage for catastrophesProvides investors with diversification and high yieldsInvestors include:

Mutual funds Hedge fundsReinsurers Life insurersMoney managers

Examples of Catastrophe Bonds

• USAA – 1997– East coast hurricane

• Swiss Re – 1997– California earthquake

• Munich Re – 2001– Hurricane, earthquake and European windstorm

• Syndicate 33 of Lloyd’s of London – 2002– St. Agatha Re

Recent Insurance Derivatives

• Catastrophe risk swap– Swiss Re and Tokio Marine and Fire – 2001

• Japan earthquake for California earthquake

• Japan typhoon for Florida hurricane

• Japan typhoon for France storm

• Earthquake derivative– Munich Re and Berkshire Hathaway – 2001

• Earthquakes affecting World Cup Soccer

• Parametric trigger

Future of Securitization

• Major insurers and reinsurers will expand use

• Markets will grow with increased availability

• Additional sources of risk could be covered

• Trend will drive insurers to additional financial risk management