Derivatives for Risk Management

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Derivatives for Risk Management

• Trent Cooksley
• FIN 340
• Dr. Gasper
• December 3, 2001

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Convergence of Capital and Insurance Markets

• More and more increasingly the capital markets
  and the insurance markets are integrating
  together.
• Many professionals believe that the industry is
  growing more and more capable of handling current
  and future risk.

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But Why? Major disasters have caused us to
re-asses our risk management objectives

• Hurricane Hugo
• Hurricane Fran

• San Francisco Earthquake
• Terrorist Attacks

• US insurance industry has approximately 265
  billion of available capital which it must use to
  cover 25-30 trillion of property risk
• There is also casualty risk associated with a 7
  trillion dollar economy
• Capital Markets are worth approximately 30
  trillion
• Investors in the liquid capital markets can
  accept risk from the insurance industry, making
  reinsurance much easier

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Derivatives markets

• Futures
• Options
• Swaps

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Based on asset liability management problems in

• Protecting asset yields
• Creating inflation indexed products
• Liability hedging vehicles for underwriters to
  manage loss ratios in general insurance

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OTC products

• Catastrophe Bonds
• Contingent Surplus Notes
• Catastrophe Swaps

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Exchange Traded Products

• Chicago Board of Trade, Bermuda Commodity
  Exchange, Catastrophe Risk Exchange, New York
  Mercantile Exchange
• Exchanges act as intermediaries between buyers
  and sellers, the buyers and sellers are unaware
  of each others identity
• All exchanges offer standardized insurance risk
  management products and provide liquid markets
  for buyers and sellers

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Chicago Board of Trade contracts

• Catastrophe options
• Standardized contracts that give the purchaser
  the right to a cash payment if a specified index
  of catastrophe losses for a specific period reach
  a certain level
• A loss estimate is formulated by the Property
  Claims Service
• There are 5 separate regions in the US as well as
  one national contract

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How catastrophe options work

• Sep 5, 1996-Hurricane Fran threatens the east
  coast
• Catastrophe option sellers provide buyers with
  6.6 million in supplementary, last minute
  coverage
• PCS 3rd quarter eastern contract was at the 40/60
  price level. With a 40/60 strike, the call
  4 billion in aggregate industry losses in excess
  of 6 billion.
• If actual losses fall between 4 billion and 6
  billion, the buyer of the 40/60 call is
  compensated for the difference between the strike
  and the index at settlement

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• If the index settles at 50, representing 5
  billion in losses, the buyer receives 2,000 per
  spread for the 10-point penetration into the
  40/60 level
• If the losses exceed 6 billion, the buyer
  receives a total of 4,000 per spread
• The price of these options is formulated from the
  market, what the buyers and sellers agree is a
  fair price
• As Hurricane Fran set in the bid (price which
  buyers will pay) began to rise but the ask (price
  which sellers are willing to sell) stayed steady,
  the ask stayed at a rate because sellers who were
  mindful of 1989s Hurricane Hugo felt that their
  ask was the lowest acceptable compensation for
  assuming the risk posed by the storm
• The contract settled at 17.5 or 1.75 billion in
  aggregate industry losses, well below the 4
  billion strike price.
• Hurricane Fran did not cause the damage expected,
  therefore speculators who were selling options
  kept the premium that the buyers paid after the
  contract expired (and made money) if the damages
  had been higher the sellers of the contracts
  would have been obligated to pay 200 per point
  penetration into the 40/60 level.

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Why look to derivatives for risk management?

• Derivatives allow for much more innovation
• Derivatives allow risk managers to smooth
  revenues by finding different options for
  garnering insurance
• Companies can adjust their risk portfolio as
  opposed to being locked into a multi-year
  agreement with a specific counterparty
• Derivatives advantages over traditional insurance
  products include
• Much more ease of use
• High degree of liquidity
• High degree of leverage ability

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Thank youQuestions?