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Risk Securitisation: A Few Notes
This paper is an attempt to
explain briefly the phenomenon risk
securitisation in its broadest sense. It starts with an introduction to
securitisation in general. Then it explains the structure of risk securitisation
transactions before discussing in detail how risk securitisation actually works.
The trends in insurance securitisation in the year 2003-04 are also given so
that one gets an idea of what is happening currently in the world of
securitisation. Lastly, in the appendix, details of an interesting mortality
risk bond issued in 2003 are given.
Actuarial Society of India
A brief peek into the past
Setting the pace
The inside story
Advantage for developing countries like India
Trends in insurance securitisation in the year
Securitisation is one of the
interesting things that have happened to the financial world. It roughly means
"the bundling or repackaging of rights to future cash flows for sale in
Before we get into specifics,
let us give a fair idea about securitisation. Suppose you want to buy land and
grow crops and you do not have money. What would you do? You will take a loan,
buy land, grow crops and then repay the loan over a period of time with the
profits from the harvests. Imagine doing the same thing in another way. You show
people that you have a means for future cash flows in the form of returns from
harvests if you own land, the purchase of which is only possible if investors
give you money to buy the land. In the first case, investors will be giving you
loan on the land. But in the second case, the investors fund the future cash
flows of harvest profits which will be possible as you buy land with the money
they have given you i.e. they have directly invested on future cash flows. This
makes more sense since they are more interested in the profit from the land
rather than the land itself. This is securitisation.
It is ideal if the investor base
is large and diverse which is possible if securitised products are sold in
capital markets. Marketability of the product is required which necessitates the
instrument to be packaged into homogenous lots. Credit rating is also required
which necessitates following quality procedures and rules.
Taking the logic further, even
risk can be securitised. The perceived risk can be packaged as risk bonds which
pay higher than normal return to the bondholders. This transferring of risk in
the form of securitised bonds is part of alternate risk transfer (ART).
Alternate risk market refers to the marketplace for those entities that seek
risk transfer and risk retention solutions outside the traditional reinsurance
A brief peek into the past:
The hard market conditions from
1975 through 1978 served as the catalyst to the development of alternate market.
Mortgaged-backed securities (MBS) was followed by asset-backed securities (ABS)
which soon included automobile loans, credit card receivables, commercial
mortgage loans, home equity loans, etc. In 1988, risk securitisation involving
insurers was applied to sales of rights to emerging profits from blocks of life
insurance policies and annuities. Since early-1990s, futures contracts and
securities are being issued to securitise the risk of loss that may happen due
to natural calamities like earthquakes and hurricanes. USAA is the most
prominent player in this market currently.
Pure risk transfer securitisations are also being used to protect an originating insurer against adverse mortality risk in the case of life insurance or adverse longevity risk in the case of annuity and pension products. Alternate risk markets are also evolving for weather, space launch, aviation, oil platform risk, etc.
Setting the pace:
Structure of risk securitisation
consists of four important entities: retail customers, originator, Special
Purpose Vehicle (SPV) and investors.
Customers are those who buy
policies from the insurer or originator. The present value of the principal and
interest payments i.e. the insurance policy and annuity (rights of cash flows)
constitute the asset of the originator. Securitisation moves the asset off the
balance sheet. For this, the passive financial entity SPV is created just for
the purpose of housing the asset and issuing tradable securities with the asset
as the collateral. Investors buy these securities, contributing funds to the SPV.
The SPV, in return, remits all or part of the proceeds from the bond issue to
the originator. SPV may act only as a simple conduit or as an active
intermediate for reshaping the cashflows arising from the assets transferred to
Sometimes it is desirable for an SPV to pay a floating rate of interest to bondholders even though the assets held by the SPV give a fixed rate of interest. So normally, the SPV enters a swap transaction, either over-the-counter or through an exchange, whereby the fixed rate of interest from the assets is swapped for a floating rate tied to a widely used index like LIBOR.
Figure 1: Basic structure of a risk-based securitisation
Why does not the originator
itself issue bonds instead of doing it through the SPV? Since securitisation
involves a transfer of diverse receivables from the originator to diverse
ever-changing set of investors, it is highly undesirable to transfer the
receivables directly to the investors. Also, the use of SPV eliminates the need
for the insurer to carry debt on its balance sheet. As mentioned before, SPV
houses assets and liabilities, off-balance-sheet of the originator, resulting in
favourable capital structure implications for the originator.
The way in which the originator
conducts its business should also be tracked since all of the risk factors which
can affect the SPV need to be understood. Since most life insurance asset and
liability accounts are complex and opaque, securitisation poses relatively
difficult problems for these cash flows in comparison with the thriving
securitised markets for assets such as mortgages (Cummins, 2004).
A rating normally questions
whether entire money can be paid back to the investors and whether the money
that is paid is on time. These refer to the credit risk and the liquidity risk.
How effectively the assets have been transferred by the originator to the issuer
has a bearing on the credit quality of the bond. The asset transfer should
survive the insolvency of the originator. The SPV continues to have an
obligation to repay the bonds it sold to the investors. By collateralizing the
transaction the counter-party risk or the risk of default is eliminated. If the
title is not effectively transferred, then the assets remain available to the
originator’s general creditors, inadvertently reducing the credit quality of
the asset to that of the originator itself. The rating of the pooled assets
depends on their quality and the statistical certainty of the income that they
generate. “Principal-protected” tranches usually qualify for higher credit
ratings from rating companies which naturally expands the market for these types
of tranches to institutional investors who have a high tendency to invest only
in higher rated forms of debt.
Sooner than later Value Added
Tax (VAT) will be a reality in India. Then it should be ensured that issuer does
not become responsible for the VAT liabilities of the rest of the originator’s
The inside story:
One must be wondering how
investors can be compelled to buy “risk”. It is obvious that investors will
not buy risk as long as it is profitable. And if it is profitable for the
investors to buy risk, what is the price the insurance companies have to pay so
that they can sell risk to the investors. How is this cost of selling risk to
investors more beneficial to the insurance companies than to retain the risk
themselves? Securitisation of risk is more efficient as the risk can be hedged
at a lower cost than under traditional reinsurance methods and produce adequate
returns to the risk-bearers. Let us look at a very simplified hypothetical
scenario to really understand how this all works.
Consider the “happening of an
event”, defined by the occurrence of certain pre-agreed parameters, as the
risk. The event can be a calamity or an adverse situation or any condition which
acts as a risk to one’s line of business. Let the market interest rate on
risk-free securities be a constant 6% per year. Since the interest rate is
constant, there is no interest rate risk. Let us design a bond X whose face
value is 100 and annual coupon rate is 10%. The entire principal and the
interest of the bond is said to be under risk of happening of the event. If the
event occurs in the 1-year time period of the bond, it triggers a default on
both the principal and the coupon. If the event does not occur, then 110 is paid
to the bondholder at the end of the year. Let us assume that it is proved by
statistical modeling that the probability of this event is 0.02. Ignore
payment to the bondholder, averaged over the event distribution =
(110)(0.98) + (0)(0.02) =
discount the interest rate on risk-free securities from this value to get the
amount at the starting of the 1-year period i.e. (1/1.06) (107.8) =
This should be the price of bond X. The event states and cash flows of bond X are as shown in Figure 2.
Figure 2: One-Period Bond X Cash Flow
Also consider a risk-free bond
which has future cash flow of 110 in a year’s time. The annual coupon rate is
6% (same as the market rate on risk-free securities). This type of bond is
called a straight bond. The amount at
the starting of the 1-year period by discounting the interest rate on risk-free
securities from the future cash flow value of 110 is (1/1.06) (110) = 103.77
Figure 3: One-Period Straight Bond Cash Flow
Now the insurer issues bond X and buys the straight bond at the same time. Since the straight bond is costlier, this costs the insurer 103.77 – 101.69 = 2.08 per 100 of face value. This is the price the insurer pays to avert risk from the event. How? If there is an event, then the insurer receives the straight bond principal (100) and the coupon (10). This amount (110) is for the insurer himself since he need not pay the bond X principal and coupon (100 + 10) to the investors of bond X. But if there is no event, then he just has to pay the investors of bond X the amount he gets from the straight bond.
Equivalently, the insurer has purchased a one-year reinsurance bond which pays 10 in case the event occurs during the time period. The insurer can then use this 10 to pay for the claims of its customers. We can see that this increases the insurer’s capacity to sell insurance by 110 at the cost of 2.08 per 100 of bond face value.
The event states and net cash flows are as shown in Figure 4.
Figure 4: One-Period Net Cash Flow
There can be many variations to
this model. The interest rate, which we have assumed to be a constant, can be
variable. We can have “principal protected” bonds wherein only the coupon or
coupon and a fraction of the principal is lost by the investors, when the event
occurs. Instead of 1-year bond we can have a bond that is for a number of years.
Unlike a single period bond, we can also have a multiple period bond with terms
that are different for each period. We have assumed here that the bond defaults
if the event occurs at anytime during the 1-year time period. But the bond deed
instead can specify that only the future principal and coupon payments to the
bondholders are to be forfeited from the time the event occurs. There can also
be varying degrees of occurring of the event and the occurrence of multiple
events. The bonds may also have multiple classes of risk (or tranches).
Different tranches help make the bonds appealing to diverse investors. Tranches
carrying higher risk may offer a higher yield to bondholders than lower-risk
tranches offering lower yield. Contingent bonds (second event bonds) provide no
protection for the first adverse event but any subsequent adverse event is
covered. It is ideal if an insurance company is confident that it can withstand
the first adverse event without difficulty but needs protection for any
subsequent adverse event to save itself from bankruptcy. Since occurrence of two
events is rare, the cost to protect only against the second event is low for the
insurance companies. It is the variations, designed to suit the requirements of
the investors, which add to the complexity of an actual bond issue.
The example above uses a single
period model. Let us consider another simple two-period model for bond Y in
which only the coupons are at risk i.e. if an event occurs, then the investor
forfeits his expected coupon and not his bond principal. A coupon of 10 per bond
face value of 100 is paid to the bondholder at the end of the first year if the
event does not occur. Else, no coupon is paid at the end of the first year. And
again the coupon of 10 is paid to the investor at the end of the second year if
no event occurs during the second year. If the event occurs during the second
year, then no coupon is paid at the end of the second year. It should be noted
that the bondholder always gets back his principal 100 at the end of the second
The expected payment, averaged
over the event distribution, to the bondholder for the first year is (10) (0.98)
+ (0) (0.02) = 9.8 and that for the second year is 100 + 9.8 = 109.8
We should discount the interest
rate on risk-free securities from this value to get the amount at the starting
of the 2-year period i.e. (1/1.06) [9.8 + 109.8 (1/1.06)] = 106.96
This should be the price of bond Y. The event states and cash flows of bond Y are as shown in Figure 5.
Figure 5: Two-Period Bond Y Cash Flow
Also consider a risk-free
straight bond which has future cash flow of 10 in a year's time and 110 at the
end of the second year. The annual coupon rate is 6% (same as the market rate on
risk-free securities). The amount at the starting of the 1-year period by
discounting the interest rate on risk-free securities from the future cash flow
is (1/1.06) [10 + 110 (1/1.06)] = 107.33
This should be the price of the straight bond. The event states and cash flows of the straight bond are as shown in Figure 6.
Figure 6: Two-Period Straight Bond Cash Flow
before, the insurer issues bond Y and buys the straight bond at the same time.
Since the straight bond is costlier, this costs the insurer 107.33 - 106.96 =
0.37 per 100 of face
value which provides 10 units of coverage per period. In either of the two
future periods, if there is an event, then the insurer receives the straight
bond coupon (10). The straight bond coupon is for the insurer itself since it
need not pay the bond Y coupon (10) to the bondholders. But if there is no
event, then it just has to pay the investors of bond Y the amount it gets from
the straight bond i.e. its net cash flow this time is zero.
Equivalently, the insurer has
purchased a two-year reinsurance bond which pays 10 in case the event occurs
during either period. The insurer can then use this 10 to pay for the claims of
its customers. We can see that this increases the insurer's capacity to sell
insurance for each of the next two years by 10 at the cost of 0.37 per 100 of
bond face value.
The event states and net cash flows are as shown in Figure 7.
Figure 7: Two-Period Net Cash Flow
Some of the advantages of these bonds are:
The insurance industry will be
strained by a major catastrophe, say a $50 billion hurricane loss, but the
capital markets could withstand it with relative calm. Securitisation is
ideal for covering low frequency, high severity risks like catastrophes.
Catastrophic (CAT) securities also enable insurers exposed to CAT risk to hedge
losses exceeding the capacity of the international insurance and reinsurance
markets and avoid the market disruptions caused by reinsurance price and
availability cycles (Cummins and Weiss 2000).
CAT bonds can be considered as
“zero-beta” assets since their payoffs are generally uncorrelated with the
economy or for that matter any existing investment avenues. This is because
little correlation exists between stocks and catastrophic events such as
earthquakes and floods. Assets with low correlation and high return and high
returns are valuable for both portfolio diversification and yield enhancement.
Hence, CAT bonds boost the performance of the portfolio provided their expected
return is more than any lower risk rate (which is the case so) (Litzenberger,
Beaglehole and Reynolds, 1996).
It is known that securitisation
provides customized contracting for the hedging of risks. It is known that
hedging with contracts that are sold at mark-ups over the expected loss is less
efficient than hedging using contracts sold at actuarially fair prices. Even at
the current markups in the CAT securities market, insurance-linked securities
are competitive with traditional reinsurance when it comes to price and hedging
effectiveness. And since it is expected that the markups in the CAT securities
are set to decline as investors gain more experience with these bonds and as
markets become more liquid, it is obvious that in time to come, CAT bonds are
the logical choice over traditional reinsurance (Cummins, Lalonde and Phillips,
developing countries like India:
If disasters and adverse economic conditions occur in developing countries, it takes far more time for them to effectively handle the situation and return to functioning societies. In developed countries, a large measure of restitution is provided by private insurance markets. But in developing countries, help is crucial from international reconstruction agencies like IMF and World Bank, charity organizations and donor governments. It should be noted that here insurance markets contribute very little. This is because developing countries usually are unable to afford the premiums. Also repayment to reconstruction loans from international agencies acts as a burden to economic rebound. Hence cost-effective securitisation of risk insurance is very desirable in developing countries.
Securitisation has the potential to play a very important role in India for further economic robustness. But it is still in a nascent-stage here. The structure of catastrophe risk securitisation that has evolved in hurricane-prone US and earthquake-prone Japan may not be suitable in its entirety for India since many economic zones have low calamity incidence. But still, apart from ABS and MBS securities, we can still develop risk bonds on catastrophe and mortality that are tailor-made for India’s needs and concerns. But the greatest hurdle right now is the lack of clarity with regard to this instrument among the originators and general investors alike. There is still an absence of appropriate legislation and legal clarity despite enacting the Securitisation Bill in 2000. Even the transaction duties are high and are not uniform across various states in India. But the major hurdle is the lack of awareness of this instrument.
insurance securitisation in the year 2003-2004
2003-04 was an excellent year for insurance securitisation:
An estimated $1.9 billion of securities were issued which represents a 50% increase over the previously most active year to date (1999).
Innovative deals explored new risk exposures like terrorism risk. It is a welcome sign in growth since till now most of the securitisation happened in catastrophe bonds.
"Life" risks (mortality risk, embedded value and life versus annuity arbitrage) appeared on the scene for the first time. Traditional life market is huge compared to calamity market and successful inroads into this crucial market can significantly boost insurance securitisation.
In a departure from past practice, no bonds were issued with 12 month term. The securitisation market has evolved from the traditional reinsurance market where annual renewals are the norm. Since longer maturities save issuance costs and spreads coverage costs, this departure was expected.
Some issues covered second events. For example, Phoenix Quake Wind covers any typhoon losses or earthquake losses that occur after a first earthquake event.
Transferring mortality risk to the capital markets is no longer a concept but is now a reality. The first known mortality risk securitisation was issued by Swiss Re in 2003. A brief description of the deal is provided in the appendix.
Securitisation in various risk exposures over the years is shown in figure 8. It can be seen that the issues now are more diversified.
Figure 8: Exposure of Risk Securitisation over last 5 years (Source: Lane Financial, L.L.C)
A major trend that can be discerned is price compression has taken place. As indicated in figure 9 for catastrophe bonds, spreads have begun to drop in the face of added supply. Lower spread and greater demand for securities suggests that the insurers should now find it much cheaper to get their coverage in the capital markets than in the traditional markets.
Figure 9: Changes in Average Secondary Market Cat Bond Spreads (Source: Lane Financial, L.L.C)
But still, the transactions presently are complex and costly. Investment banking, modeling and rating agency fees all add up the final cost. Also, reinsurance is preferable to capital markets for messy, complicated risks and for risks where capacity needs are small. One should understand that reinsurance is also an efficient tool which is tried and tested. Capital markets will complement the existing reinsurance capacity that is available to the originator rather than completely replacing them. Securitisation goes a long way in making the insurance cover cheaper for the common man. And finally, despite all the trends emerging, it should be noted that the trend towards insurance securitisation is more of an evolution than of a revolution.
Ltd., Mortality Risk Bond
Transferring mortality risk to
the capital markets is no longer a concept but is now a reality. The first known
mortality risk securitisation, which covers the insurer for higher than expected
mortality, was issued by Swiss Re in 2003. It is triggered by adverse mortality
index. The special purpose vehicle, Vita Capital Ltd., issued mortality index
notes carrying a premium of 135 basis points over LIBOR. The maturity period is
for three and half years. Original issue size was $250 million but the structure
allows for up to $400 to be issued. Vita Capital executed a swap transaction to
swap Swiss Re's fixed premium payment for LIBOR. Swiss Re gets a call option on
the proceeds in the SPV since it pays a premium to Vita Capital. The mortality
index is based on general population mortality in the US, UK, France,
Switzerland and Italy with weights given in the index being 70%, 15%, 7.5%, 5%
and 2.5% respectively. The basic structure is as shown in figure 10. If
mortality is between 130% and 150% of the actual number of deaths in the indexed
pool, Swiss Re would be permitted proportionate payments from Vita Capital. The
full amount will flow to Swiss Re if mortality reached 150% or more of the
actual number of deaths. Hence this issue is like a call option with 130% being
the lower 7strike price and 150% being the upper strike price.
This issue is interesting because of its simplicity. Instead of cash flows of entire life insurance policies, this transaction directly considers mortality risk. Moreover, it never needed a third-party guarantee to obtain A+ credit rating. It is reasoned that these bonds are suited for large, diversified multinational insurers and reinsurers.
Figure 10: Vita Capital Mortality Risk Bond
Cummins, David, 2004,
“Securitisation of Life Insurance Assets and Liabilities”, working paper,
The Wharton Financial Institutions Center.
Cox, Samuel H., Joseph R.
Fairchild, and Hal W. Pedersen, “Economic Aspects of Securitisation of
Lane Financial, LLC, 2004,
“Review of Trends in Insurance Securitisation”.
Kothari, Vinod, “Securitisation – a primer”.