27 60. As a further alternative to the use of SPV's or protected cells in insurance-linked securitizations, the Chicago-based INEX exchange offers special purpose limited syndicates ("SPLSs"). The INEX Board of Trustees and the Illinois Department of Insurance must approve each transaction and each exercises oversight over INEX transactions. An insurer can launch a securitization by transferring the particular risks to a full member INEX syndicate. That syndicate then retrocedes the risks to an SPLS, which in turn sets up a collateral trust account to secure its obligations. 61. The minimum capitalization of the SPLS is $30,000. While subject to U.S. federal and state income taxes, the SPLS is not subject to premium taxes. Under regulations issued by the Illinois Department of Insurance, investors are not in the business of insurance solely for investing in this type of a transaction. The trust must be administered in Illinois and all assets must be located in Illinois. In 2000, Vesta Fire Insurance Corp. securitized a $50 million layer of property loss exposures. The following is a description of the transaction: An INEX illustration: The Vesta transaction: In March of 2000, the Inex Insurance Exchange announced the formation of Vesta Capital Insurance Syndicate, Inc. (hereinafter "Vesta Capital"), a new underwriting syndicate member owned by Vesta Insurance Group (hereinafter "Vesta"). The INEX Board of Trustees and the Illinois Department of Insurance had approved Vesta Capital for membership. Vesta Capital was capitalized at $30 million. In July of 2000, Vesta Fire Insurance Company, a wholly-owned subsidiary of Vesta Insurance Group, completed a $50 million securitization of property loss exposures to Northeastern United States hurricane exposures and Hawaiian storms. A SPLS named NeHi Re facilitated the transaction, which involved $8.5 million in equity investments and $41.5 million in ILSs. NeHi Re's obligations are fully secured by a fully funded trust agreement. Payments are triggered by computer modeling done by Applied Insurance Research and risks and attachment points are recalculated each year of a threeyear term. 29 62. The trigger is probably the single most significant design feature of a CAT bond. It determines how the originator of the transaction recovers its losses after a catastrophic event. While a reinsurance contract generally indemnifies a cedent for actual losses, CAT bonds can be structured with non-indemnity types of triggers such as parametric or industry-wide loss triggers. 63. In designing a particular trigger for an intended transaction, an originator must consider two types of risks: (i) "Tail risk" arises because claims can continue to develop and increase above the amount paid and reserved at the end of a loss development period. Investors usually limit that loss development period to no more than 18 months by providing for a commutation of all losses thereafter to the originator. The Northridge earthquake provides an excellent example of how significant tail risk can be. In February of 1994 for instance, industry losses from the quake were estimated at $7.3 billion. By July of 1995, the final estimate had reached $12.5 billion. (ii) "Basis risk" is associated with differences between the originator's actual losses and the amount of losses indicated by the trigger. This type of risk exists only in transactions that apply a non-indemnity type of trigger. The two types of risk can of course work either for or against an originator. 64. There are methods for an originator to mitigate, but not eliminate, tail risk and basis risk. To mitigate tail risk, an originator can proceed in one of two ways: (i) The firm can enter into a reinsurance contract of unlimited duration with a reinsurer. Most likely, that reinsurer would then wish transform that risk by securitizing all or a portion thereof with an indemnity 30 (ii) Alternatively, an originator can enter into a specific tail risk reinsurance contract with an SPV in conjunction with its own indemnity-triggered securitization. 65. To mitigate basis risk, an originator can either: (i) Purchase indemnity reinsurance from a transformer or a fronting reinsurer, which then proceeds with an indextriggered securitization of the associated risk; or (ii) Proceed with a direct index securitization with additional reinsurance for basis risk. Regardless of the type of trigger, each and every securitization involves a further type of risk, namely "model risk”. Modeling methodologies and technologies of an extremely complex nature are an essential part of each of these transactions. Hence, the assumptions regarding the model's choice of variables for specification, the sensitivities of these variables to various assumed conditions, and the existing correlations among these variables, are of vital importance to matching the model with the reality of catastrophic loss for a particular originator. One might add that thoughtful, careful, and thorough modeling under a wide variety of conditions and assumptions is also an excellent way to minimize excessive basis risk. Indemnity triggers 66. An “indemnity" trigger links recovery to the actual loss incurred by the originator. The bond's attachment, defined as the point where insured losses exceed an amount certain, determines when the principal invested begins to be tapped. The exhaustion point is reached when the principal has been fully tapped. The entire process is modeled of course so as to generate investor interest. Hence, an indemnity trigger creates model risk and tail risk but no basis risk. As will be seen shortly, indemnity triggers, while seemingly simple and attractive from an originator's point of view, actually also entail an additional risk: an indemnity trigger adds a potential liability risk because of certain disclosure requirements. 67. A further drawback to an indemnity trigger is the potential for adverse selection. Since the particular risk zones that are part of the 84-418 D-7 31 securitization are typically selected and agreed upon in advance, while of course an ongoing flow of risks in and out of the zones in to the normal course of business continues, investors tend to become concerned about the quality of the business flow. Moreover, investors tend to have concerns regarding the claims settlement process. Indeed, with an indemnity trigger, incentives favoring moral hazard or sloppy claims handling might in fact created. Claims can be inflated or at least not carefully scrutinized when losses reach into the layer covered by the securities. Hence, it is common to find investors demanding shared participation by the originator in the transaction so as to align the interests of the two parties. 10% plus from attachment to exhaustion usually satisfies investors' concerns. LET'S PROVIDE A DETAILED DESCRIPTION OF AN Index triggers 68. Instead of an indemnity trigger, a securitization can be structured with an "index" trigger. The trigger links the monies recovered by an originator from investors after a catastrophe to an insurance index (e.g., the Property Claims Service index, the Guy Carpenter index). Complex modeling is used to establish a significant correlation between the behavior of the index and losses that can be expected from the originator's portfolio of risks after a specified event. The idea is establish a match between the actual losses likely to be incurred by the originator after the event, the amount to be recovered from investors, and the distribution of losses by firms that make up the index. In order to achieve such a match, the originator's distribution of business must bear some similarity to the distribution of business for the firms within the index. Index triggers generate both tail risk and basis risk. 69. Lloyd's syndicate 33, Hiscox, has recently securitized a $33 million bond via an SPRV called St. Agatha Re. The bond would cover losses from earthquake in either California or the New Madrid region. The trigger consists of two parts: firstly a low level parametric trigger, and secondly a modeled trigger. The Qualifying Event trigger is parametric but the purpose of this is merely to set a realistic trigger for a loss |