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.


Getting started	4
A brief peek into the past	4
Setting the pace	5
The inside story	6
Catastrophe bonds	12
Advantage for developing countries like India	12
Trends in insurance securitisation in the year 2003-2004	13

Appendix	16
References	17

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 capital markets."

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 industry.

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.

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 it.

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.

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 group.

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 transaction costs.

The expected payment to the bondholder, averaged over the event distribution = (110)(0.98) + (0)(0.02) = 107.8

We should 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) = 101.69

This should be the price of bond X. The event states and cash flows of bond X are as shown in Figure 2.

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

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.

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 year.

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.

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.

Similar to 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 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, 2000).

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.

Figure 8: Exposure of Risk Securitisation over last 5 years (Source: Lane Financial, L.L.C)

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.

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.

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 Risk”.

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