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Investing in Insurance Risk: Insurance-Linked Securities - A Practitioner's Perspective

  • ID: 1346069
  • Book
  • June 2010
  • Incisive Media
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The rapid growth of the market for insurance-linked securities has highlighted the need for information on the types of these securities and the issues involved in their structuring, pricing, trading, and managing on a portfolio basis.

Insurance-linked securities and certain reinsurance instruments provide the ability to invest in insurance directly, as opposed to investing in equities or debt issued by insurance and reinsurance companies. The “pure” insurance risk component of these investments can range from that of property catastrophe to longevity, all of which provide limited correlation with the investment performance of traditional asset types.

Securitisation of insurance risk has also become an important tool for risk and capital management that can be utilised by insurance companies alongside the more traditional approaches. It offers insurance and reinsurance companies additional flexibility at a time when the landscape keeps changing and the ability to respond to changes quickly is a critical source of competitive advantage.

Investing in Insurance Risk by Alex Krutov looks at all of the issues involved in investing in insurance risk and insurance securitisation. It examines the various types of insurance-linked securities now available to investors, along with techniques for their analysis. In addition, the book explains the considerations insurance companies face in transferring insurance risk to the capital markets.

The book is somewhat provocatively titled Investing in Insurance Risk to emphasize that investing always involves the potential of both return and risk. This is particularly clear in a field such as insurance-linked securities, where risk transfer—rather than simply raising capital—is often the primary driver for issuing these securities. The ability to analyze the risk-return profile of these investments is essential for both issuing and investing in them.

The book is designed to serve as a valuable resource to those active in the insurance-linked securities marketplace, while also aiding basic understanding of the topics for those new to the field. The author offers a clear practitioner’s perspective as opposed to an academic one; this hands-on approach is particularly important in a market that is new and still evolving.
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1 Investing in Insurance Risk
Investing in risk
Insurance risk
Insurance markets
Securities issued by insurance companies
Insurance-linked securities
Investing in insurance risk

2 Insurance-Linked Securities
Insurance-linked securities defined
Types of insurance-linked securities
Yield and diversification offered by insurance-linked securities
Market dynamics


3 Property Catastrophe Bonds
Securitisation of property insurance risk
Motivation for transferring natural catastrophe risk to the capital markets
Historical perspective
Risk transfer in insurance
Catastrophe bond structure
Default triggers
Number and types of perils
Quantitative analysis
Investment performance of cat bonds
Market stability and growth
More on the sponsor and investor perspectives
Modelling property catastrophe insurance risk
Cat bonds: trends and expectations

4 Modelling Catastrophe Risk
The challenge of modelling catastrophe events
Importance of catastrophe modelling to investors
Modelling catastrophe insurance risk of insurance-linked securities
The science of catastrophes
Earthquake frequency and severity
Earthquake location
More on earthquake modelling
Historical frequency of hurricanes threatening the US
Seasonality of the hurricane risk in insurance-linked securities
Landfall frequency in peak regions
Hurricane frequency effects over various time horizons
Investor views on macro-scale frequency effects
Evolution of investor views on catastrophe modelling
Elements of hurricane modelling
Damage modelling
Financial loss modelling
Catastrophe model structure
Modelling terrorism risk
Modelling pandemic flu risk
Practical modelling of catastrophe risk
Data quality
Investor and catastrophe modelling
Catastrophe bond remodelling
Hurricane forecasting
Climate change
Sponsor perspective on modelling
Modelling as a source of competitive advantage to investors
Modelling as a source of competitive disadvantage to investors
Trends and expectations

5 Catastrophe Derivatives and ILWs
Index-linked contracts
Role of an index
Catastrophe derivatives defined
Industry loss warranties defined
Market size
Key indexes
Modelling industry losses
The ILW market
ISDA US wind swap confirmation template
IFEX catastrophe derivatives
CME hurricane derivatives
Eurex hurricane futures
More unusual products
Comments on pricing
Credit risk
Basis risk
The use of transformers
Investor universe
Mortality and longevity derivatives
Investor and hedger perspectives
Trends and expectations

6 Reinsurance Sidecars and Securitised Reinsurance
Securitisation of reinsurance
Reinsurance sidecars
Sidecar structure
Investor perspective
Sponsor perspective
Sidecar types
Investor universe
Considerations in investment analysis
Trends and expectations

7 Credit Risk in Catastrophe Bonds and Other ILS
Credit risk
Credit risk and ILS
Traditional solutions
The need for new solutions
Solutions to credit risk issues in insurance-linked securities
Triparty repo arrangement
Customised puttable notes
Use of US Treasury money market funds as collateral
Collateral options in collateralised reinsurance
Trends and expectations

8 Weather Derivatives
The broader definition of insurance-linked securities
Weather derivatives defined
Heating and cooling degree days
Other types of weather derivatives
Payout on standard options
Exchange-traded weather derivatives
Pricing models for weather derivatives
Practical challenges in pricing
Investing in weather derivatives
Emissions trading
Trends and expectations


9 Funding Excess Insurance Reserves
Excess insurance reserves
Some examples
“Excess” reserves
Funding solutions
Embedded-value and value-in-force securitisation
Market fluidity
RBC requirements leading to “unnecessary” capital strain
Regulation XXX reserve funding
Letter-of-credit facility for funding regulation XXX reserves
Securitisation of Regulation XXX reserves
Other solutions
Additional considerations for investors
Funding AXXX reserves
Loss portfolio transfer

10 Embedded-Value Securitisation
Rationale for embedded-value securitisations
Embedded value and value-in-force defined
Direct monetisation versus true securitisation
Closed block
Investor perspective
Specific structures
Stress scenarios
Ratings of EV securitisations
Examples of EV securitisation
Gracechurch/Barclays EV securitisation
Trends and expectations


11 Securitisation of Extreme-Mortality Risk
The risk of extreme mortality
Securitisation of extreme-mortality risk
The groundbreaking Vita securitisation
Other securitisations of extreme-mortality risk
Basis risk
Credit enhancement
Investor types
Extreme-mortality risk quantification and pricing
Current modelling approaches
Mortality derivatives
Additional considerations for investors
Extreme mortality securitisation: trends and expectations

12 Life Insurance Settlements
Insurance policy as a tradable asset
Life settlements
Life settlement securitisations
Legal and ethical issues
Market participants
Current and future market size
Regulatory issues
The link between investor risk and consumer protection
Tax issues
Insurable interest
Investor- or stranger-originated life insurance policies
Trust structures and investor due diligence
The use of not-for-profit organisations in life settlements
Investor perspective
Insurance industry perspective
Risks to insurers

13 Mortality and Longevity Models in Insurance-Linked Securities
Mortality and longevity
Mortality rates
Mortality tables
Population mortality tables
Mortality dynamics
Select and ultimate tables
Credibility theory approach
Longevity improvements
Lee–Carter and related methods
Markov process of mortality and morbidity
Direct age transform mortality modelling
Mortality and longevity shocks

14 Valuation of Life Settlements and Other Mortality-Linked Securities
Modelling investment performance of life settlements
Life expectancy
Methodology changes in the calculation of life expectancy
Underwriting concepts
Choice of mortality table
2008 valuation basic table
Relative risk ratios
Underwriting for older ages
Choosing the LE
LE shopping
Assumed premiums
Being paid for the risk

15 Longevity Risk Transfer and Longevity-Linked Securities
Longevity risk
Need to transfer longevity risk
Longevity improvements
Natural hedges
Primary mechanisms of longevity risk transfer
Longevity swaps
Mortality forwards and survivor forwards
Longevity bonds
More on other solutions for longevity risk management in a DB pension fund
Indexes of longevity
Investors in longevity
Market developments
Extension risk in traded policies
Trends and expectations


16 Managing Portfolios of Catastrophe Risk
Portfolio construction
Exotic beta
How catastrophe risk is different
Measures of return and risk
Managing a portfolio of cat risk by a (re)insurance company
Managing a portfolio of catastrophe insurance-linked securities
Types of instrument
Portfolio constraints
Standard tools and the modelling of individual securities
Portfolio optimisation
Pitfalls of standard optimisation techniques
Remodelling and portfolio optimisation
Sensitivity analysis and scenario testing
Additional considerations
Performance measurement

17 Managing Portfolios of Multiple Types of ILS
Types of insurance-linked securities
Rationale for combining different types of ILS in the same portfolio
Correlation among different types of ILS
Tenor and liquidity
Portfolio optimisation
The argument against combining ILS of multiple types in the same portfolio
Portfolio valuation issues
Performance measurement
Investment management policy
Risk management

18 Conclusion
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Alex Krutov is Managing Director of Century Atlantic Capital Management, where he developed an investment strategy across all types of insurance-linked securities (ILS) and collateralized reinsurance, as well as portfolio optimization and risk management techniques for ILS and reinsurance. Prior to joining the firm, he was President of Navigation Advisors LLC, a New York management-consulting firm focused on the insurance industry, capital markets, and general management. Prior to founding Navigation Advisors, Alex Krutov was employed in a variety of roles, including officer-level positions, at companies such as Transatlantic Reinsurance Company, American International Group, Reliance Group, UBS Warburg, and AXA Financial.

Alex Krutov’s primary expertise and experience involve the products that bridge the gap between (re)insurance and capital markets. He has strong expertise in insurance securitisation, alternative risk transfer, reinsurance and insurance underwriting, portfolio issues in investing in insurance-linked securities, risk analysis, pricing of catastrophe (re)insurance risk, and general management.

Alex Krutov is a member of the American Academy of Actuaries, the Casualty Actuarial Society, and the Society of Actuaries. He chairs the Risk-Based Capital Committee of the American Academy of Actuaries. In addition to his actuarial credentials, Alex Krutov holds an MBA in Management and Finance from the Columbia University Graduate School of Business. He also holds an MS in Physics.
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