Securitization of
Catastrophe Risk:
A USAA Example
Presentation to:
The CAS Seminar on
Financial Risk Management
April 12, 1999
Presented by: Rhonda K. Aikens
Executive Director, Financial Actuary
USAA
1
Objective of Briefing
To summarize the Residential Re
transaction and its implications
for USAA, the P&C Insurance Industry
and investors.
2
How will USAA insulate itself
from the next mega-hurricane?
3
Hurricane Andrew made landfall in South Dade County Florida devastating
Homestead Air Force Base. 4
1992 Hurricane Andrew
USAA Industry
$620,000,000 $17,900,000,000
5
Miami
40 miles
north
A storm
the size
of Andrew
just 40 mi.
HAFB north would
have resulted
in insured
losses of
over
$50 billion
6
Exposure to Mega-Hurricane
Estimated U.S. Insured Losses (1/500 Yr.)
$21 Billion
Hurricane
Northeast Region
$17 Billion
Hurricane
Southeast Region
$22 Billion
Hurricane
Houston-Galveston $76 Billion
Hurricane
Florida Region
Source: Risk Management Solutions, Inc.; Insurance Services Office, Inc.
7
Strategic Challenge:
Industry Perspective
Since 1989, a series of natural disasters has resulted in variability in
insurance losses.
Prior to Hurricane Hugo, the insurance industry had never suffered
losses from a single disaster over $1 Billion.
Since then, 11 natural disasters have exceeded this amount.
Traditional reinsurance mechanisms are limited in capacity.
Recent events have caused the insurance industry to reconsider its
approach in handling low frequency, high severity occurrences.
The questions have centered around the following:
— What steps can we take to reduce losses from future disasters?
— What steps can we take to reduce variability in insurer results
from future disasters?
8
Strategic Challenge:
USAA Perspective
Serving members who live in catastrophe-prone
areas requires maintenance of a high level of
capitalization and liquidity.
If such exposures could be mitigated, then
transferred or separately securitized, USAA
could more efficiently deploy its capital resources.
9
Options Considered By USAA
To Address
The Strategic Challenge
Expanded Traditional Reinsurance
Catastrophe Bonds
Catastrophe Options
Surplus Notes and Contingent Surplus Notes
Contingent Equity
Catastrophe Swaps
10
Options’ Issue:
Financing vs. Hedging
Financing Hedging
Surplus Notes Reinsurance
Instrument
Contingent Surplus Notes Cat Bonds
Contingent Equity CBOT
Risk Transfer No Yes
Impact on:
PML No Yes
Surplus Yes Yes
Liquidity Yes Yes
Balance Sheet Yes * Yes
* Contingent type can be kept off balance sheet until exercised.
11
USAA Preferred Hedging
Strategy
Security Permanence Reinsurance
Markets
Risk Transfer
USAA
Capital
Capacity Cost Markets
- Competitive.
- Financially Strong.
- Highly Rated.
- No regulatory concerns.
12
Hedging Design Field
Moral Hazard
Re- C. B. O. T.
C insurance
r R
e i
d s
i k
t Cat Bond Cat Bond
Indemnity Index
Basis Risk
Source: “Financial Risk Management For Catastrophes”- Neil Doherty
13
Capital Market Contracts:
Index vs. Indemnity Approaches
Index Approach Indemnity Approach
1. Index based payment 1. Actual loss based payment
2. Speculative 2. Non-speculative
3. May/may not transfer risk 3. Risk transfer
4. Basis risk 4. No basis risk
5. Accounted as investment 5. Accounted as reinsurance
6. Low transaction cost 6. Transaction cost material
7. Very small capacity 7. Medium capacity for now
14
Selected Hedging
Instruments
Expanded Traditional Reinsurance
Catastrophe Bonds
15
Characteristics Of
Catastrophe Bonds
Rated security
Renewable process
Supplement to traditional reinsurance
Objective risk assessment
Potentially attractive to investors
16
Special Purpose Reinsurer
How it Works
Reinsurance
Reg 114 Trust
Company SPR Account
Premium To secure obligations
under the Reinsurance
Agreement
Investor
17
The Reinsurance Agreement
Obligates Residential Reinsurance to pay USAA
for the claims in the layer between $1.0 billion
and $1.5 billion resulting from a single Class 3, 4
or 5 hurricane in the Covered States during a 12
month claims period.
USAA will retain not less than 10% of the risk.
18
Catastrophe Bond
Transaction Timeline
June 1, 1999 -
June 15, 1998 - May 31, 1999 Dec 1, 1999
Extended
Risk Period Claims
Period
June 1 Dec 1 June 1 Dec 1
Typical Hurricane Season
19
Key Issues Encountered
Federal Tax
– SPR off-shore
– Debt vs. equity interest
Regulatory
– Recognition that investors are not in the business
of insurance
Securities
– Public vs. private offering
Bond Structure
– Principal at risk vs. principal protected
– Single year vs. multi-year transaction
20
The Investor’s
Perspective
21
Why Do I Buy?
Before Increase Yield
After
Reduce Portfolio
Variability
Portfolio Return
Porfolio Risk
22
What Do
Do II Need
Need To
To Know?
Know?
Questions
Questions that
that need
need to
to be
be answered
answered from
from Investor’s
Investor’s Perspective
Perspective
How do I assess the risk ?
How credible is the risk assessment ?
When do I feel that I have become educated enough to buy ?
Is this the first transaction of this kind?
Is there a pipeline of future deals to further increase diversification ?
Why have they bypassed the reinsurance market ?
Can I afford to lose all my principal ?
What are the regulatory impacts (especially for life insurers and
pensions funds) ?
Isn’t one year too short; wouldn’t a multi-year commitment improve
the utility of this instrument ?
23
Who Are The Investors?
Bottom line: 90 - 95% of the money is new to the P&C Insurance
Industry. This is “found money”; capital that would never have
been applied to the problem of catastrophe protection through
either investment in primary insurers or reinsurers.
24
Categories Of Investors:
This is a Global Market
Life Insurers
Pension Funds
Reinsurers
Hedge Funds
Banks
Investment Advisors
25
Wall Street Journal
June 18, 1997
26
THE NEW YORK TIMES
AUGUST 6, 1997
Even
Even Nature
Nature
Can
Can Be
Be Turned
Turned
Into
Into aa Security
Security
High
HighYield
Yieldand
andBig
BigRisk
Risk
With
WithCatastrophe
CatastropheBonds
Bonds
27
Observations
Traditional reinsurance capacity is plentiful, but limited.
Capital markets offer the potential to supply additional capacity.
USAA’s success in renewing its transaction at reduced cost is evidence
that:
1. Securitization of catastrophe risk on a large scale is possible and
sustainable.
2. Improving efficiency and cost is also possible; multi-year transaction
could help in this regard.
Note: There have been about 21 capital market risk transfer
securitizations to date.
28
Observations
Continued
Continued
Growth of capital markets reinsurance will be slow due to:
1. Lack of expertise, basis risk/low risk transfer/speculative
nature of investment, accounting and regulatory restrictions
(index options)
2. High transactions costs, tax issues/offshore nature, need for
more investor education (indemnity catastrophe bonds)
3. Soft traditional reinsurance market with large capacity
and declining reinsurance prices.
Significant growth in capital market reinsurance will require:
1. Addressing the issues mentioned above.
2. NAIC adopting changes to support securitization of insurance.
3. Changes at the Federal level and removal of tax disincentives so these
SPR transactions can take place on-shore.
29
Conclusion
This pioneering (and now renewed), mutually
beneficial transaction fulfills the strategic purposes of:
– Tapping into the vast pool of capital for capacity.
– Introducing a new asset class which supplements
reinsurance.
– Providing a vehicle for investors to increase yield,
while reducing portfolio risk through
diversification.
30
Insulating
InsulatingUSAA
USAA
from
fromthe
the
Financial
FinancialImpact
Impact
of
ofaa
Mega-Catastrophe
Mega-Catastrophe
31