Final Case:USAA

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,

calculated using the formula,

ROL = Premium Paid/Limit=12.5%

Price= ROL/Actuarial probability – 1 = 12.5/4.5 -1=1.8

For layer 5, Losses that exceed 1000mm

ROL =5.5% (From Exhibit 5)

From Exhibit 4, Actuarial probability that losses will exceed 1000mm=0.96%

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.

After Hurricane Andrew in 1992, price of reinsurance increased to about 6.

Considered alternatives:

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

spread of 204 bp over comparable Treasury with a yield of 9.04%.

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

but unlike equity, on issuance of surplus notes, ownership is not diluted.

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.

Contingent Surplus Notes:

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

additional Interest that USAA has to pay the Investors.

Structure of contingent surplus notes:

Additional Interest Trust Cash Investors

Treasuries
USAA Notes + Interest
Option to sell
surplus notes

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

reinsurance for $392mm. This structure is equivalent to Credit default swaps.

So Price= ROL/Actuarial probability – 1 = 2.2/0.96 -1=1.3

Problem:

As the proceeds from issuing Trust notes are held as Treasuries there might be a small interest

rate risk.

PCS (Property Claim Services) Catastrophe Insurance options:

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

exercise price of Y. To get insured on a layer of losses (D),

No of contracts needed = (D/(Y—

—X))/200.

The pay off diagram for CAT options used in call option spreads is shown below.

Pay off

Y-X

X Y Losses in index

CAT options are zero-beta

beta assets as the underlying value is not the stock price which can be

attractive to few investors.

Problems:

PCS options market is not very liquid with few traders

traders. So the insurer might not be able to find

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.

Securitized Risk Transfer

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

Class A-2 – Ba2 rating - principal variable for $313 mm

As it is securitized, unlike contingency supply notes, it might be easy to find investors.

From exhibit 14,

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.

The calculation of ROL for cat bonds is shown below,

 Spread in
spread in bp Principal USD
Aaa 35 164 0.574
Ba 262 313 8.2006
Total =477 8.7746
ROL=8.7746/400
ROL = 2.19%

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

Class A-2 Prin Variable 313 250 262 6.55

Total 477 100.00% 569.4805 7.668182

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.