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Financial Risk Products: Case Study Perspective

Financial Risk Products: Case Study Perspective. Discussion Topics. Insurance Linked Securities Case Study I - Hypothetical ILS Transaction Case Study II - Basis Risk Transaction. 4. 2. 1. 3. Investment Earnings. Cash Proceeds. Reinsurance Premium. Principal & Interest.

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Financial Risk Products: Case Study Perspective

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  1. Financial Risk Products: Case Study Perspective

  2. DiscussionTopics • Insurance Linked Securities • Case Study I - Hypothetical ILS Transaction • Case Study II - Basis Risk Transaction

  3. 4 2 1 3 Investment Earnings Cash Proceeds Reinsurance Premium Principal & Interest Contingent Claim Payment Cash Proceeds Investment Earnings Scheduled Interest Securitization - Overview Investments Investors Re-insurer SPV Swiss Re Financial Products

  4. 1 2 3 Reinsurance Premium Contingent Claim Payment Fixed Amounts Fixed Amounts Floating Rate Amounts Floating Rate Amounts Swap - Overview Re-insurer Swap Transaction based on notional amount Investors Swiss Re Swiss Re Financial Products

  5. Case Study I - Overview Elements of a Capital Market solution • Understanding of situation • Risk mapping • Exposure • Structuring issues • Delivery mechanism

  6. Case Study I: Risk Source Earthquake (EQ) risks in California Source: United States Geological Survey, National Earthquake Information Center, www.neic.cr.usgs.gov

  7. Case Study I - Situation Analysis • ABC is global leader in the microchip industry • Its factory is based in Palo Alto, California • California is highly exposed to EQ risks • Therefore, ABC seeks for protection against a potential profit drop resulting from a devastating EQ harming its microchip production • Because of the current market conditions there is no cover available on the traditional insurance market; ABC approaches you to propose a Capital Market solution

  8. Intensity map epicenter Fault plane focus (hypocenter) Case Study I - Risk mapping, definition of EQ Magnitude (M) • Measurement of energy release • Richter Scale (and others) • M max: ~8.5 • Damage: M>=5.0 Intensity (MMI) • Observation of effects • Modified Mercalli Scale - MMI (and others) • MMI 12 degrees: I to XII • Damage: MMI >=VI MMI = Modified Mercalli Shaking Intensity, average soil conditions Source: Swiss Re Reinsurance & Risk, RN/CP, SNAP EQ

  9. Case Study I - Exposure In USD m Turnover Net profit Source: Annual Reports

  10. Case Study I - Risk mapping, return periods p.a.

  11. Case Study I - Structuring issues • Issuer’s Needs vs. Investor’s Demand • Loss Basis • Risk Profile • Triggering Event • Coverage Period • Other Structuring Considerations

  12. Case Study I - Delivery mechanism • Structured Note • Onshore vs. Offshore Issuer • Defeased vs. Non-defeased • Fixed vs. Floating Rate • Public vs. Private • Single vs. Multiple Traches • Derivative Instrument • Swap vs. Option • ISDA regs • Targeted Buyers

  13. Case Study II Basis Risk Swap Transactions

  14. Basis Risk Transaction • Exchange of cash flows based on two variable indices • Amount you pay and receive will change according to the movements in two separate indices • Basis Swaps • Common capital markets instrument • Capital Markets Indices • London Interbank Offer Rate (LIBOR) • Commercial Paper (CP) • F/X rates • S&P 500 • Etc.

  15. 6.80% 6.60% 6.40% 6.20% 6.00% 5.80% 5.60% 5.40% Year 1 Year 2 Year 3 Year 4 Year 5 Example: LIBOR versus CP • Domestic interest rates tend to move in the same direction • However, the difference between different interest rates will vary over time LIBOR CP

  16. Example: LIBOR versus CP • Company A issues commercial paper and invests in floating rate notes at L + 50bps • Company A does not wish to take the risk that CP rates will increase faster than LIBOR or decrease slower than LIBOR • Company A approaches Swiss Re Financial Products (SRFP) and enters into a basis swap • Company A pays LIBOR to SRFP • SRFP pays CP + 10 to Company A • Company A locks in 60 bps spread

  17. Floating Rate Notes LIBOR + 50 LIBOR Company A CP + 10 Commercial Paper Example: LIBOR versus CP Company A Receives from FRN: LIBOR + 50 Pays to SRFP: LIBOR Net: + 50 Receives from SRFP: CP + 10 Pays to investors: CP Net + 10 Total + 60 SRFP

  18. Basis Risk Transactions in Insurance • Potential Loss Tiggers in Re/Insurance Markets • Actual losses • Industry Losses • Loss ratios • Losses on different perils • Value of Basis Swap Transactions • To hedge a position already taken (reduce risk profile) • To arbitrage a market inefficiency (get cheaper overall pricing) • To be an innovator • To speculate

  19. Outside Source Indexed Protection Basis Transaction SRNM Corporate/ Insurer/ Reinsurer Basis Transaction #1 • Client gets indexed cover from outside source • Client enters into basis transaction with SRNM • Client pays to SRNM any recoveries made on indexed cover • SRNM pays client for actual losses incurred

  20. Indexed Reinsurance or Security or Swap or Option SRNM Corporate/ Insurer/ Reinsurer Indemnity Agreement Basis Risk Investors Basis Transaction #2 • Client gets indemnity cover from SRNM • SRNM issues indexed paper to the market • SRNM keeps the basis risk

  21. Portfolio Swap Indexed Reinsurance or Security or Swap or Option SRNM Corporate/ Insurer/ Reinsurer Basis Risk Outside Source Cal. quake Japan quake Basis Transaction #3 • Client receives return on a portion of SRNM’s California earthquake book of business • SRNM receives return on a portion of Client’s Japan earthquake book of business • SRNM may or may not enter into a transaction to hedge itself • Client’s overall book of business is better diversified

  22. Basis Swap Example • A XYZ Reinsurer is attempting to get windstorm coverage for Florida, Texas, and the East Coast • XYZ Re wants to pay 7% • No offers • XYZ Re approaches SRNM for alternative solutions • SRNM analyses XYZ Re’s book of business and determines the level of industry losses equivalent to the layer XYZ Re wants reinsured • XYZ Re purchases ILW for 6% from an insurer / CM investor(s) and enters into basis transaction with Swiss Re for 1%

  23. Basis Swap Example (cont.) • Basis risk transaction • XYZ Re pays claims to Swiss Re based on industry losses • Any claims XYZ Re must pay to Swiss Re it will receive from Insurer as part of ILW • Swiss Re pays claims to XYZ Re based on losses on XYZ Re’s reinsurance book • If Windstorm occurs and industry losses are large relative to XYZ Re’s book, Swiss Re receives payment • If XYZ Re’s losses are large relative to the industry, Swiss Re makes a payment

  24. 10 mm ILW XYZ Re Swiss Re Reinsurance 20 million - 50% QS Basis Swap Structure Basis Risk - Sell Reinsurance Buy ILW XYZ Re Receives from Ins. / Investor: Industry Losses Pays industry losses to SR: Industry Losses Receives payment from SR: Actual Losses Net: Actual Losses Insurer / Investor Texas to Maine ILW XYZ Re Swiss Re Basis Risk

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