Professional Documents
Culture Documents
Vivek Durairaj
FNCE488
Traditional Reinsurance:
Traditionally, reinsurance was purchased in layers for different amounts that would be triggered
by a catastrophic event. USAA by June 1997 had purchased reinsurance to protect against 90%
of losses between $450mm and $600mm. So USAA would be covered for $135 mm for losses
exceeding $450mm. Cost of this coverage, also called Rate on Line, was 12.5% for layer 2,
So price=5.5/0.96-1=4.72
After a catastrophe, the reinsurers’ capital gets depleted. This results in the price of reinsurance
being high and the availability of reinsurance being low just after the catastrophe.
Surplus Notes:
Surplus Notes are basically subordinate notes that have a maturity 10-30 years with a callable
protection. From exhibit 9 it is seen that the recent 30 yr surplus notes issued in 1997 have a
This is less than 12.5% ROL of the traditional reinsurance for layer 2.
Surplus notes only increase the statutory capital not the GAAP capital. It has the features of both
debt and equity. As surplus notes are subordinate to all other obligations, it is almost like equity
Problems:
Investors might not be willing to invest in surplus notes just after a catastrophe and so the needed
capital might not be available when needed the most. ROL is only slightly less than that of
traditional reinsurance.
Insurer uses an investment bank to create a trust to issue notes to investors and buy treasuries
from the proceeds. Trust has to pay the interest from treasuries and some additional interest to
the investors. This additional interest is paid by the insurer to the Trust, which is also considered
to be fee for the option to sell surplus notes in exchange of the Treasuries if a catastrophe occurs.
So the investors assume the credit risk on the surplus notes and the cost of reinsurance is the
Treasuries
USAA ON contingency Trust
Surplus Notes
From exhibit 9, it is seen that Nationwide issued contingent surplus notes with 10 year maturity
for a principal of $392 mm with a spread of 220bp over the treasuries. This 220bp is the cost of
Problem:
As the proceeds from issuing Trust notes are held as Treasuries there might be a small interest
rate risk.
CAT options open the private capital markets for reinsurance. The catastrophe loss indices are
based on estimation of the losses that occurred during the loss period by Property Claim Service.
The loss periods are in quarters and the development periods during which the losses will be
estimated are in six months or twelve months. Index valuation is calculated by dividing the
estimated losses during the loss period by 1100 mm. PCS option cash equivalent of each index
point is $200. Generally CAT options are used in call option spreads.
A call option can bought with an exercise price of X and a call option can be written with an
The pay off diagram for CAT options used in call option spreads is shown below.
Pay off
Y-X
X Y Losses in index
Problems:
the needed size of reinsurance. Also as the CAT options are not tailor made and cover a wide a
range of catastrophes, it might not be sufficient to cover an insurer’s risks. But PCS options can
be used as a fill gap in case the traditional reinsurance is not sufficient enough. Pay off is based
on the estimated losses and not the actual losses of the company giving an imperfect coverage.
USAA will be buying reinsurance from a SPV which in turn will issue two types of securities
1)principal variable security and 1) principal protected security. The proceeds from the sale of
these securities will be held as short term investments in the SPV. In the event of a catastrophe,
SPV will sell the short term investments and pay USAA for the covered losses. In case of
principal variable securities, investors would lose some or all of their investments In case of
principal protected securities, the payment of the principal will be delayed but the interest would
not be paid. USAA needs coverage for 80% of 500 mm in excess of 1 billion or 400 mm.
Class A-1 – Aaa rating - a) principal protected for $77 mm b) principal variable for $87 mm
market 10 yr 1 yr def
Rating spread def rate rate
Baa 77bp 5% 0.51%
Ba 262bp 18.20% 1.99%
Market spread for Baa security is 77bp. So market spread for Aaa security can be assumed to be
around 35bp.
For USAA, probability that losses will be greater than 1Billion = 0.96%
Price=2.19/0.96-1
price = 1.29
The cat bond has slightly lower price than that of the contingent surplus notes. This makes cat
bonds desirable. It also provides more granularity with securitization making it easier for small
investors. As the proceeds are held as commercial paper, the interest rate risk is minimal.
Problem:
Cat bonds cover only one occurrence of catastrophe that exceeds the lower limit of the
reinsurance coverage.
Proposed Alternative:
By changing the principal amounts of class A-1 and class A-2 issued, price of the reinsurance
can be further decreased. By issuing more class A-1 securities and less A-2 securities, the price
of reinsurance can be effectively decreased. The new proposed structure is shown in the table
below.
Spread in Spread in
Previous New bp USD
Class A-1 Prin Variable 77 46.95% 150
Prin Protected 87 53.05% 169.4805
319.4805 35 1.118182
ROL=7.668/400
ROL = 1.92%
Price=1.92/0.96-1
Price = 1.00
It is seen from above calculations that the price of reinsurance is considerably lower.