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Insurance Abstract
A method and apparatus of securitizing insurance, reinsurance and
retrocession risk is provided. The system provides a vehicle whereby
investors may directly participate in such risk. The system includes
establishing a limited-life business entity. Capital is raised through
the sale of common and/or preferred shares in the business entity.
The capital is invested against which the business entity assumes
premium and risk liability. After a first predetermined period of
time (i.e., an underwriting phase), the business entity stops underwriting
risks for premium and gives investors options to liquidate shares
in the business entity for cash or in the form of a roll over to
a similar business entity. The business entity then runs off remaining
risk liabilities during a second predetermined period of time (i.e.,
a runoff phase). Upon completion of the runoff phase, the business
entity distributes all its remaining assets to its shareholders
and/or rolls over their equity to another similar business entity,
and the original business entity is wound up.
Insurance Claims
1. A method of securitizing risk comprising: establishing a business
entity with a predetermined period of existence, the predetermined
period including an underwriting phase of a first predetermined
duration followed by a runoff phase of a second predetermined duration;
raising capital through a sale of securities of the business entity;
actively underwriting and assuming a plurality of risks in exchange
for premium during the underwriting phase, the plurality of risks
including at least one of an insurance risk, a reinsurance risk,
and a retrocessionary risk; ending the active underwriting and assumption
of risks at an end of the underwriting phase; giving an investor
a first option at the end of the underwriting phase, the first option
including at least one option for (i) requiring a redemption by
the business entity of shares in the business entity, (ii) rolling
over equity in the business entity to a second business entity,
and (iii) remaining invested in the business entity; purchasing
reinsurance-to-close to discharge risk of the business entity proportional
to the shares being redeemed by the investor and to shares utilized
to roll over equity in the business entity to the second business
entity; discharging risk during the runoff phase remaining after
the purchase of reinsurance-to-close; and ending the existence of
the business entity at an end of the runoff phase.
2. The method of claim 1, wherein actively underwriting and assuming
the plurality of risks comprises actively underwriting and assuming
the plurality of risks at a plurality of times.
3. The method of claim 1, wherein the second business entity comprises
a limited-life business entity embodying another underwriting phase
of a third predetermined duration followed by another runoff phase
of a fourth predetermined duration.
4. The method of claim 3, wherein rolling over equity in the business
entity to the second business entity comprises a tax-free transfer
of assets.
5. The method of claim 3, wherein the reinsurance-to-close proportionally
allocable to redeemed shares is purchased from the second business
entity.
6. The method of claim 3, wherein the reinsurance-to-close proportionally
allocable to rolled over shares is purchased from the second business
entity.
7. The method of claim 3, wherein the investor exercises the first
option by redeeming a first portion of shares in the business entity
and by rolling over a second portion of shares in the business entity
to the second business entity.
8. The method of claim 1, further comprising making at least one
interim cash distribution to the investor during the runoff phase.
9. The method of claim 3, further comprising giving an investor
a second option at the end of the runoff phase, the second option
including at least one option for (i) receiving a final distribution
in liquidation of the business entity and (ii) rolling over equity
in the business entity to a third limited life business entity that
embodies yet another underwriting phase of a fifth predetermined
duration followed by yet another runoff phase of a sixth predetermined
duration.
10. The method of claim 9, wherein rolling over equity in the business
entity to the third business entity comprises a tax-free transfer
of assets.
11. The method of claim 9, further comprising discharging risk
proportionally allocable to rolled over shares by purchasing reinsurance-to-close.
12. The method of claim 11, wherein the reinsurance-to-close proportionally
allocable to rolled over shares is purchased from the second business
entity.
13. The method of claim 9, wherein the investor exercises the second
option by redeeming a first portion of shares in the business entity
and by rolling over a second portion of shares in the business entity
to the second business entity.
14. The method of claim 1, wherein ending the existence of the
business entity comprises winding up the business entity by distributing
assets of the business entity at an end of the business entity's
predetermined period of existence.
15. The method of claim 1, wherein the business entity comprises
a first business entity and the first business entity transfers
assets to a second business entity in exchange for securities in
the second business entity, the securities to be distributed to
the shareholders of the first business entity.
16. The method of claim 15, wherein the first business entity further
transfers liabilities to the second business entity.
17. The method of claim 1, wherein actively underwriting and assuming
the plurality of risks during the underwriting phase comprises assuming
progressively shorter tail risks during the underwriting phase.
18. The method of claim 1, wherein the underwriting phase does
not assume only a single risk.
19. The method of claim 1, wherein the underwriting phase does
not assume only a single package of risks.
20. The method of claim 1, wherein substantially all underwriting
risk and associated opportunity for income are transferred by the
business entity to a third party through the use of derivatives.
21. The method of claim 20, wherein all of the underwriting risk
and associated opportunity for income are transferred by the business
entity to the third party through the use of derivatives.
22. The method of claim 1, wherein substantially all investment
risk and associated opportunity for income are transferred by the
business entity to a third party through the use of derivatives.
23. The method of claim 22, wherein all of the investment risk
and associated opportunity for income are transferred by the business
entity to the third party through the use of derivatives.
24. The method of claim 1, further comprising establishing underwriting
guidelines defining types and quality of risks the business entity
is authorized to assume.
25. The method of claim 1, further comprising establishing requirements
for diversification of risk by the business entity.
26. The method of claim 1, further comprising establishing a predefined
premium to net worth ratio cap, wherein the business entity seeks
to limit its written premium to the net worth ratio cap.
27. The method of claim 1, wherein the business entity seeks to
limit its aggregate loss reserves to a predefined ratio to net worth.
28. The method of claim 1, further comprising investing capital
raised by the sale of securities in the business entity and writing
the premium based on the capital.
29. The method of claim 28, further comprising increasing a net
worth of the business entity by reinvesting net underwriting income
and net investment income and gain and writing additional premium
based on the increased net worth.
30. The method of claim 1, wherein discharging remaining risk includes
at least one of paying losses, commuting existing risk obligations,
and purchasing reinsurance-to-close.
31. The method of claim 1, wherein raising capital comprises a
sale of common shares in the business entity and at least one of
preferred shares in the business entity, surplus notes, and other
debt instruments.
32. The method of claim 1, wherein raising capital include a sale
of derivatives.
33. The method of claim 1, wherein the business entity is a special
purpose corporation.
34. The method of claim 33, wherein the special purpose corporation
is an off-shore corporation.
35. A method of selling at least one of insurance, reinsurance,
and retrocessional risk in capital markets comprising: establishing
a business entity with at least the following parameters being fixed
at a time the business entity is established: (i) an underwriting
phase having a first predetermined duration during which the business
entity actively underwrites and assumes a plurality of risks; (ii)
a runoff phase to occur after the underwriting phase, the runoff
phase having a second predetermined duration during which the business
entity discharges risks assumed during the underwriting phase and
does not assume any additional risk; and (iii) a first investor
option to redeem shares in the business entity at an end of the
underwriting phase, the redemption of shares being proportionally
allocable to a discharge of risk by a reinsurance-to-close purchase;
and selling securities in the business entity.
36. The method of claim 35, wherein actively underwriting and assuming
the plurality of risks comprises actively underwriting and assuming
the plurality of risks at a plurality of times.
37. The method of claim 35, wherein the underwriting phase and
the runoff phase define a predetermined overall limited life of
the business entity.
38. The method of claim 35, further comprising a second investor
option to roll over equity in the business entity to another business
entity.
39. The method of claim 38, wherein the second investor option
to roll over equity in the business entity to another business entity
comprises a tax-free transfer of assets.
40. The method of claim 35, wherein the underwriting phase does
not assume only a single risk.
41. The method of claim 35, wherein the underwriting phase does
not assume only a single package of risks.
42. The method of claim 35, wherein substantially all underwriting
risk and associated opportunity for income are transferred by the
business entity to a third party through the use of derivatives.
43. The method of claim 42, wherein all of the underwriting risk
and associated opportunity for income are transferred by the business
entity to the third party through the use of derivatives.
44. The method of claim 35, wherein substantially all investment
risk and associated opportunity for income are transferred by the
business entity to a third party through the use of derivatives.
45. The method of claim 44, wherein all of the investment risk
and associated opportunity for income are transferred by the business
entity to the third party through the use of derivatives.
46. A method of investing in at least one of insurance, reinsurance
and retrocessional risk by an investor comprising: purchasing securities
of a business entity established with (i) an underwriting phase
having a first predetermined duration during which the business
entity actively underwrites and assumes a plurality of risks; (ii)
a runoff phase to occur after the underwriting phase, the runoff
phase having a second predetermined duration during which the business
entity discharges risks assumed during the underwriting phase and
does not assume any additional risk; and (iii) a first investor
option to redeem shares in the business entity at an end of the
underwriting phase, the redemption of shares being proportionally
allocable to a discharge of risk by a reinsurance-to-close purchase;
and exercising the investor option at the end of the underwriting
phase.
47. The method of claim 46, wherein actively underwriting and assuming
the plurality of risks comprises actively underwriting and assuming
the plurality of risks at a plurality of times.
48. The method of claim 46, wherein the underwriting phase and
the runoff phase define a predetermined overall limited life of
the business entity.
49. The method of claim 46, further comprising a second investor
option to roll over equity in the business entity to another business
entity.
50. The method of claim 49, wherein the second investor option
to roll over equity in the business entity to another business entity
comprises a tax-free transfer of assets.
51. The method of claim 46, wherein the underwriting phase does
not assume only a single risk.
52. The method of claim 46, wherein the underwriting phase does
not assume only a single package of risks.
53. The method of claim 46, wherein substantially all underwriting
risk and associated opportunity for income are transferred by the
business entity to a third party through the use of derivatives.
54. The method of claim 53, wherein all of the underwriting risk
and associated opportunity for income are transferred by the business
entity to the third party through the use of derivatives.
55. The method of claim 46, wherein substantially all investment
risk and associated opportunity for income are transferred by the
business entity to a third party through the use of derivatives.
56. The method of claim 55, wherein all of the investment risk
and associated opportunity for income are transferred by the business
entity to the third party through the use of derivatives.
57. An apparatus comprising: a controller; an input/output device
coupled to the controller; and a memory coupled to the controller,
the memory storing a software program for execution by the controller,
the software program being structured to cooperate with the input/output
device to facilitate: establishing a business entity with a predetermined
period of existence, the predetermined period including an underwriting
phase of a first predetermined duration followed by a runoff phase
of a second predetermined duration; raising capital through a sale
of securities of the business entity; actively underwriting and
assuming a plurality of risks in exchange for premium during the
underwriting phase, the plurality of risks including at least one
of an insurance risk, a reinsurance risk, and a retrocessionary
risk; ending the active underwriting and assumption of risks at
an end of the underwriting phase; giving an investor a first option
at the end of the underwriting phase, the first option including
at least one option for (i) requiring a redemption by the business
entity of shares in the business entity, (ii) rolling over equity
in the business entity to a second business entity, and (iii) remaining
invested in the business entity; purchasing reinsurance-to-close
to discharge risk of the business entity proportional to the shares
being redeemed by the investor and to shares utilized to roll over
equity in the business entity to the second business entity; discharging
risk remaining after the purchase of reinsurance-to-close during
the runoff phase; and ending the existence of the business entity
at an end of the runoff phase.
58. The apparatus of claim 57, wherein actively underwriting and
assuming the plurality of risks comprises actively underwriting
and assuming the plurality of risks at a plurality of times.
59. The apparatus of claim 57, wherein rolling over equity in the
business entity to the second business entity comprises a tax-free
transfer of assets.
60. The apparatus of claim 57, wherein the software program is
further structured to facilitate giving an investor a second option
at the end of the runoff phase, the second option including at least
one option for (i) receiving a final distribution in liquidation
of the business entity and (ii) rolling over equity in the business
entity to the second business entity.
61. The apparatus of claim 57, wherein the underwriting phase does
not assume only a single risk.
62. The apparatus of claim 57, wherein the underwriting phase does
not assume only a single package of risks.
63. The apparatus of claim 57, wherein the software program is
further structured to facilitate the transfer of substantially all
underwriting risk and associated opportunity for income by the business
entity to a third party through the use of derivatives.
64. The apparatus of claim 63, wherein all of the underwriting
risk and associated opportunity for income are transferred by the
business entity to the third party through the use of derivatives.
65. The apparatus of claim 57, wherein the software program is
further structured to facilitate the transfer of substantially all
investment risk and associated opportunity for income by the business
entity to a third party through the use of derivatives.
66. The apparatus of claim 65, wherein all of the investment risk
and associated opportunity for income are transferred by the business
entity to the third party through the use of derivatives.
67. The apparatus of claim 57, wherein the software program is
further structured to facilitate a conformance to underwriting guidelines
and promote a diversification of risks.
68. The apparatus of claim 67, wherein the software program is
further structured to facilitate an analysis of premium trends and
lost trends.
Insurance Description
TECHNICAL FIELD
[0001] The present system relates to methods and apparatus for
securitizing insurance, reinsurance and retrocessional risk, and
providing an equity security for investors to participate in such
risk.
BACKGROUND
[0002] Insurance and Reinsurance Market. The primary insurance
market provides financial protection against numerous types of risk.
In exchange for insurance premium, an insurer agrees to underwrite
the risks specified in the insurance policy. If the event insured
against occurs, the insurer is obligated to pay for all or a portion
of the financial loss incurred by the policyholder.
[0003] There are many types of insurance covering many kinds of
risks, broadly divided into (i) life and health; (ii) property and
casualty; and (iii) surety and guaranty. Policies may insure individuals,
groups, businesses, and governments, generally for a one-year period,
but sometimes for shorter or longer periods. Insurance had its beginnings
at the time of Hammurabi. It has developed with civilization to
address the needs of society, but its broad contours have not changed
substantially since Lloyds of London was formed over 300 years ago.
The system offered is a new method for conducting and financing
insurance and reinsurance operations, that attracts a broader base
of investors to participate in risk and reward.
[0004] Property and Casualty. Property and casualty is subdivided
into personal and commercial lines. Fire insurance protects against
the risk of damage to property from fire and allied risks. Homeowners
and renters insurance add a broad package of risks to basic fire
protection. Auto insurance protects against both damage to property
(collision and comprehensive) and injury to third parties (liability).
Professional errors and omissions (malpractice) insurance protects
against liability arising from negligent professional services,
especially legal, accounting and medical. Officer and director insurance
protects the insureds from mismanagement or breach of fiduciary
duty. Bankers' blanket bond protect financial institutions from
a variety of theft and fraud risks. Risks of transportation are
covered by marine and inland marine policies. These are but a sampling
of the numerous types of insurance and the variety of risks insured.
[0005] Most casualty and property policies are "occurrence"
policies, which insure against an event such as a fire or a collision.
Occurrence of the event triggers the insurance coverage. In contrast,
malpractice and director and officer policies usually are "claims
made," policies where coverage is triggered when a claim against
the insured is asserted.
[0006] When an insured purchases insurance to protect against a
specified property or casualty risk, the risk remains, but the financial
exposure from the risk is transferred in whole or part to the insurer.
By writing insurance contracts, the insurer accepts premium and
assumes risk liability. Fortunately, not all insured risks occur.
Most buildings do not burn. Most professionals do not commit malpractice.
By selective underwriting and realistic premium pricing, an insurer
can reasonably expect that the aggregate amount of premium received
will exceed the total amount that must be paid for losses, defense
of insureds, and operating expenses. If premium received exceeds
those costs, the insurer realizes an underwriting profit, and conversely,
an underwriting loss if the premium received is less than those
costs.
[0007] Upon entering into insurance contracts, the insurer must
be able to pay incurred losses. Since it is impossible to predict
when losses will occur, or their frequency and their severity, the
insurer must have adequate financial resources to pay claims as
losses occur. The insurer's net worth (capital and surplus), loss
reserves and premiums collected, provide these resources. These
funds are invested, and the investment earnings increase the resources
available to the insurer.
[0008] An insurer's or reinsurer's capacity to underwrite risks
directly depends on its net worth. The risk-based capital rules
adopted by all States in general have the effect of limiting the
amount of premium from 1 to 3 times net worth, primarily based on
the volatility or unpredictability of different categories of risk.
For example, more predictable personal lines may be underwritten
at a ratio of 4 to 1 of premium-to-net worth while volatile malpractice
risks may be limited to 1 to 1.
[0009] In contrast, professional liability insurance and environmental
contamination insurance are "long tail" risks. Such liability
often cannot be determined for years, even decades after the events
that eventually result in an insurance claim. With environmental
contamination, for example, it may take years for spilled toxins
to seep into the local ground water and pollute wells remote from
the original contamination site. It may take even longer to determine
the source of the toxins and still longer to determine who was responsible
for their presence. Only then can the cost of cleaning up the problem
be estimated. Thus, an insurer who insures against such risk is
potentially exposed to liability for an extended period of time,
and the amount of loss is highly variable. In general, short tail
risk is less volatile than long tail risk, making it much easier
to estimate losses in order to establish realistic premium rates.
[0010] Life and Health. Life underwriting involves an array of
life policies--term, ordinary life, universal life, endowments--and
annuity contracts. Many life companies (and some casualty companies)
underwrite both individual and group health coverages--medical,
hospital, prescription, accidental death and dismemberment, long-term
disability and long-term care.
[0011] Surety and Guaranty. These coverages include bonding, such
as surety and fidelity; performance guaranties such as for construction
or government contracts; and financial guaranties, such as for mortgages.
[0012] Reinsurance. The fundamental principle of insurance is the
transfer of risk. For a premium, financial risk is transferred from
the insured to the insurer. Even though premium rates are set to
produce an underwriting profit, this may not occur if there are
more claims than expected ("frequency risk") or if claims
are larger than projected ("severity risk").
[0013] All categories of insurance risk--property and casualty,
life and health, and surety and guaranty--can be passed off and
spread. Protection against primary insurance risk is known as reinsurance.
Primary insurers transfer a portion of their risk to reinsurers
through contracts called reinsurance "treaties" (in contrast
to primary insurance contracts called "policies"). In
a typical reinsurance treaty the primary insurer cedes a percentage
of its received premium, together with a corresponding portion of
its outstanding risk, to one or more reinsurers. The primary insurer
who cedes risk and premium is known as the ceding company, and the
party that assumes the risk is known as the reinsurer or cedant.
The further transfer of risk by a reinsurer to another reinsurer
is known as a retrocession. Most treaties are for one year, but
there are 2- and 3-year treaties and some longer terms.
[0014] Reinsurance treaties can transfer risk in many ways. For
example, in a "whole account" reinsurance treaty the insurer
cedes a portion of its risk from all of its lines of business, e.g.,
auto, homeowners, professional liability, directors and officers,
and others. Alternatively, a reinsurance treaty may be limited to
a single line, such as standard auto, or a group of related coverages.
[0015] Reinsurance treaties also may be distinguished by the manner
in which the primary insurer's risk is ceded. Quota share reinsurance
protects against the risk that a primary insurer will incur excessive
aggregate loss--whether caused by frequency or a combination of
frequency and severity--in its overall book of business (whole account)
or in a particular line. By such treaties, the primary insurer cedes
a specific percentage of its received premium with the related risk--e.g.,
20% of its received premium and 20% of the outstanding risk being
reinsured. However, the assuming reinsurers typically will accept
less than the aforementioned 20% to compensate the ceding insurer
for the cost of generating and underwriting the business. This allowance
is known as a ceding commission. Quota share treaties may be capped.
For example, a reinsurer may agree to pay 20% of all claims ceded
to it up to an aggregate limit of $25 million for all claims. The
coverage may be limited to a layer of risk--e.g., 20% of all losses
up to $2 million per claim.
[0016] Excess-of-loss reinsurance primarily protects against severity--e.g.,
large individual claims. In an excess-of-loss treaty the ceding
company cedes a percentage of risk above a defined threshold, such
as $10 million, known as the ceding company's retention, or a defined
layer such as between $10 and $25 million ($25 m excess of $10 m).
For an agreed premium, the reinsurer agrees to pay a portion of
any loss incurred by the insurer in excess of the ceding company's
retention or within the defined layer. If the loss exceeds the upper
limits of the coverage, the excess risk reverts to the ceding company
or is covered by a higher excess-of-loss layer purchased by the
ceding company. Ceding companies typically purchase excess-of-loss
reinsurance in multiple layers to protect against extremely large
claims. An excess-of-loss treaty may be subject to an aggregate
limit or cap.
[0017] There are numerous other variations in quota share and excess-of-loss
treaties, including commutation options, whereby the ceding company
has the option to cancel the treaty and receive a partial refund
of premium paid according to a pre-agreed formula; and numerous
forms of profit sharing and retrorating whereby the premium is increased
or decreased according to loss results. Although quota share and
excess-of-loss are the most common type of reinsurance treaties,
there are many other types.
[0018] Because the development of risk is unpredictable, primary
insurers often enter into a web of different types of reinsurance
treaties to protect against many loss scenarios, as is illustrated
by FIG. 1, which depicts a conventional reinsurance structure of
a malpractice insurance facility for large law firms. This is an
example of both frequency and severity exposures from long tail
liabilities in contrast to the more predictable short tail exposures
illustrated by FIGS. 3 thru 29.
[0019] The chart in FIG. 1 is divided both horizontally and vertically.
From the bottom up, the horizontal layers show the division of risk
for a single claim among the insureds: the primary insurer; the
first tier reinsurer, which is the insurer's parent; and commercial
market retrocessionaires. The vertical divisions show as the claim
amount increase, the allocation of risk, at each layer, retained
by the primary insurer, its parent reinsurer, and the further distribution
of the remaining risk between the U.S. and European retrocessionaires.
More than 60 reinsurers participated in this long tail and volatile
risk.
[0020] The bottom layer 12 represents the retentions available
to the insured large law firms--e.g., $100,000 to $1,000,000 of
each claim made against the firm. The higher the retention, the
lower the premium for the insurance.
[0021] The next layer 14 shows a $100,000 per claim retention by
the primary insurer.
[0022] The remaining layers, in ascending order, show 16 a quota
share layer and four layers 18, 20, 22, and 24 of excess-of-loss
treaties, providing an overall limit of $75 million per claim in
excess of the insured's retention. For a full $75 million loss in
excess of the insured retention, the primary insurer will be liable
for $100,000; its reinsuring parent will be liable for $10,249,000;
the quota share reinsurers $2,523,500; and the excess-of-loss reinsurers
$62,127,500.
[0023] Reinsurers may be "direct markets" with which
the ceding company negotiates directly. Other reinsurers are "broker
markets" which deal exclusively with licensed reinsurance brokers.
In this situation, the ceding company and its broker design a reinsurance
program, which the broker then attempts to place, depending on the
size of the risk, with a single, a few, or many reinsurers.
[0024] Inasmuch as brokers are paid commission based on performance,
it is in their interest to place treaties as quickly and efficiently
as possible. Accordingly, brokers will concentrate their efforts
on reinsurers having known willingness and the financial capacity
to take on the risk, especially if it involves a large amount of
coverage. For a reinsurer, it is highly valuable to see considerable
broker traffic attempting to place reinsurance. If a large number
of brokers are offering many different treaties, the reinsurer can
be more selective as to the type and quality of the risk it is willing
to assume.
[0025] Reinsurance Leverage. Reinsurers of property and casualty
risks usually maintain an overall premium-to-net worth (capital
plus surplus) ratio of between 1.5:1 and 3:1. Assume that a reinsurer
maintains a maximum premium-to-net worth ratio of 2.5:1. If the
reinsurer's premium-to-net worth ratio is 2:1, the reinsurer has
unused capacity to accept additional premium and assume the associated
risk. As its premium-to-net worth ratio approaches 2.5:1, the reinsurer's
ability to accept additional premium diminishes. A reinsurer can
increase its capacity by increasing its capital or reducing its
retained premium by ceding a portion of its premium and the associated
risk to other reinsurers. Such an arrangement is known as a retrocession.
A retrocession from a first reinsurer to a second reinsurer operates
exactly as a cession from a primary insurer to the first reinsurer,
except the first reinsurer becomes the ceding company instead of
the primary insurer. Retrocessions increase the reinsurer's capacity
by reducing its retained or net premium, thereby reducing its premium-to-net
worth ratio.
[0026] Investor Participation in Insurance, Reinsurance, and Retrocessional
Risk. At present, there are only two ways in which investors can
participate in insurance and reinsurance risk. The basic method
is to invest in a public insurance or reinsurance company, most
of which are very large, ongoing organizations writing many lines
of business. Because of the inherent difficulty in accurately estimating
losses not yet incurred, the investor is exposed to inadequately
booked liabilities when the investment is made. It is not rare for
a large public insurance company to increase its loss reserves by
$2 or $3 billion. There are only a few public insurance companies
that specialize in one or a few lines, so most investors must accept
across-the-board risk when they buy shares of a public company.
[0027] The polar alternative of an ongoing insurance or reinsurance
company is investment in a single treaty or a fixed package of treaties,
available to wealthy investors directly or through hedge funds.
The single treaty, which usually is for a property catastrophe risk
(hurricane or earthquake), concentrates rather than spreads risk.
A package of reinsurance treaties which is uncommon, may spread
the risk, but locks in the risk for the investment period. If the
package has a significant portion of deteriorating risks, the investor
cannot liquidate the investment without a large loss.
SUMMARY
[0028] The system disclosed herein relates to methods and apparatus
for securitizing risk and providing an equity security whereby investors
may participate in insurance, reinsurance and retrocessional risk.
According to the system, a limited-life business entity or special
purpose corporation ("SPC") is created. The SPC will actively
underwrite risk. Shares in the limited life SPC are marketed and
sold to investors. The capital raised through the sale of securities
is invested by the SPC in the equity and debt markets. The SPC leverages
its invested capital by writing premium for risk assumed at a multiple
of its capital and surplus. The risk assumed by the SPC may be primary
insurance, reinsurance, or retrocessional property and casualty,
life and health, or surety and guaranty risk.
[0029] In contrast to the existing modes of participating in insurance
and reinsurance risk--by investing in the shares of an insurance
or reinsurance company or by investing in a single catastrophe treaty
or a package of treaties--the newly-formed SPC wholly avoids the
detriment of unbooked prior loss; can be highly selective in underwriting;
and can readily adjust to changed market conditions to take advantages
of opportunities and reduce or avoid worsening risks. The dynamic
underwriting of the SPC distinguishes it from the static investment
in reinsurance risk through a single treaty or package of treaties.
Its partnership with insurers or reinsurers results in reduced operating
expense because the SPC is primarily using the underwriting facilities
of its partner. Furthermore, the SPC does not compete with traditional
reinsurers in that it has a specific finite purpose and does not
invest in marketing, staffing, perpetuation and infrastructure.
It is purely a financing vehicle to participation in the insurance
and reinsurance markets.
[0030] The SPC actively underwrites risk for premiums for a specified
limited period of time--e.g. 5 years, although it can be for a shorter
or longer period. In one embodiment of the system, the risk assumed
by the SPC during this active underwriting phase will be short-tail
casualty and property risk, with the tail progressively shortened
by writing a larger portion of property risk as the end of the active
underwriting phase approaches. By contracting the tail, the likelihood
is increased that residual risk liability can be fully runoff during
a passive runoff phase which follows the active underwriting phase.
The SPC manages the runoff for a predefined period of time--for
example, 5 years although it might be shorter or longer depending
on the tail of the risk assumed--during which it disposes of all
remaining risk liability by paying out losses, commuting reinsurance
treaties, or purchasing retrocession-to-close so that the SPC can
be wound up as scheduled. In support of this objective, the SPC
sets aside 3% of gross collected premium to pre-fund the reinsurance-to-close.
The durations of both the underwriting phase and the runoff phase
are fixed or fixed within narrow limits at the time the SPC is formed.
For example, each phase may be absolutely fixed at from 3 to 10
years, or each phase may be fixed within a range such as 5 to 7
years. The duration of the phases need not be the same. One could
be fixed and the other within a range.
[0031] Each investor has the choice of liquidating the investment
at the end of either the underwriting phase or the runoff phase.
At the end of the underwriting phase, investors may opt to redeem
their shares and receive a cash distribution of their proportionate
share of the SPC's net worth, less the cost of purchasing reinsurance-to-close
for risk of the SPC that is not fully matured. At that time, investors
may alternatively elect to transfer (i) their proportionate share
of the SPC's assets less the cost of reinsurance-to-close or (ii)
their proportionate share of the SPC's assets and liabilities, to
a new SPC in a tax-free transaction. If the cost of the reinsurance-to-close
is more than or less than a pre-funded amount set aside for such
reinsurance, there will be an additional charge assessed against
or credited to the shareholders receiving a cash distribution or
rolling over their investment into a new SPC.
[0032] Investors who retain shares in the SPC for the runoff period
will, at its end, receive their full share of the assets, without
a charge for reinsurance-to-close, assuming all of the SPC's liabilities
will have been resolved by that time. If there is any residual liability,
it will be discharged from their share of the special fund for purchasing
reinsurance-to-close, subject to an additional charge to them if
the fund is insufficient or an increased distribution if it is excessive.
[0033] A final option is that investors who remain with the SPC
until it is wound up may opt for a tax-free rollover of their proportionate
share of the SPC's assets and liabilities into a new SPC organized
and operated in the same manner. In this scenario, reinsurance-to-close
would be purchased for any residual risk liability not transferred
to the new SPC.
[0034] Additional features and advantages of the present system
are described in, and will be apparent from, the following detailed
description of the system and the proforma financial projections
for a model SPC illustrating one of the many possible embodiments
of the system.
DESCRIPTION OF THE FIGURES
[0035] Each of the Figures, listed below, are illustrations of
a model embodying the presently disclosed system.
[0036] FIG. 1 is a chart showing a typical reinsurance treaty structure.
[0037] FIG. 2 is a flowchart showing a method of securitizing risk
and providing a new equity security whereby investor can participate
in such risk.
[0038] FIG. 3 is a table describing the assumptions underlying
proforma financial projections of a model SPC organized and operated
according to the present system.
[0039] FIG. 4 is a multi-year balance sheet of the model SPC.
[0040] FIG. 5 is a multi-year income statement of the model SPC.
[0041] FIGS. 6A thru C is a table showing by month the assumed
gross premium of the model SPC.
[0042] FIG. 7 is a table showing by quarter gross assumed premium
of the model SPC.
[0043] FIG. 8 is a table showing by quarter funds set aside by
the model SPC for purchasing reinsurance-to-close.
[0044] FIG. 9 is a table showing by quarter net premium written
each quarter by the model SPC after the 3% setaside for reinsurance-to-close.
[0045] FIGS. 10A thru 10F form a table showing the timing between
the month that premium is written and when the premium is earned.
[0046] FIG. 11 is a table showing by quarter net earned premium
of the SPC.
[0047] FIG. 12 is a table showing by quarter unearned premium of
the SPC.
[0048] FIG. 13 is a table showing by quarter gross premium collections
by the SPC.
[0049] FIG. 14 is a table showing by quarter net premium collections
after the 3% setaside for reinsurance-to-close.
[0050] FIG. 15 is a table showing ceding commission incurred.
[0051] FIG. 16 is a table showing management fees incurred.
[0052] FIG. 17 is a table showing Federal excise tax incurred.
[0053] FIG. 18 is a table showing ceding commission paid.
[0054] FIG. 19 is a table showing management fees paid.
[0055] FIG. 20 is a table showing Federal excise tax paid.
[0056] FIG. 21 is a table showing incurred net losses and loss
adjustment expenses ("LAE").
[0057] FIGS. 22A thru F is a schedule of loss and LAE paid corresponding
to the quarter the loss was incurred.
[0058] FIG. 23 is a table showing by quarter net losses and LAE
paid.
[0059] FIG. 24 is a table showing cash flow from operations.
[0060] FIG. 25 is a table showing invested assets at the beginning
of each quarter and quarterly earned investment income.
[0061] FIG. 26 is a table showing by quarter investment income
received.
[0062] FIG. 27 is a table showing annual realized capital gains.
[0063] FIG. 28 is a table showing cash flow from investment and
operations.
[0064] FIG. 29 is a table showing projected returns to investors
in the model SPC.
[0065] FIG. 30 is a block diagram of an example communications
system.
[0066] FIG. 31 is a block diagram of an example computing device.
DETAILED DESCRIPTION OF EXEMPLARY EMBODIMENTS
[0067] The system comprises methods of securitizing insurance,
reinsurance and retrocessional risk through a new and unique type
of investment, through which investors may easily and efficiently
participate in the potential financial rewards from underwriting
such risks. Embodiments of the system may be tailored to special
applications for each of these levels of risk transfer.
[0068] Summary Description. FIG. 2 is an example of a flow chart
of a method for securitizing reinsurance risk. The method begins
by determining an underwriting program and capitalizing the SPC
(block 50). Questions that are typically resolved during this pre-organization
planning include: Will the SPC finance insurance, reinsurance or
retrocessional risk? Will it involve property and casualty, life
and health, or surety and guaranty risks? Within those categories,
what risks will be eligible and in what mix and with what diversification?
Will there be a single contract with one reinsurer, or will the
SPC enter into separate negotiations for each risk it assumes? The
foregoing decisions will result in a predetermination of the duration
of both the underwriting phase and the runoff phase, and therefore
the overall life of the SPC.
[0069] Next the limited-life SPC is created (block 51). The purpose
of the SPC is to participate in insurance, reinsurance or retrocessional
risk as chosen at block 50. The SPC has a limited life in that it
is established to exist for a predetermined duration, divided into
a predetermined period in which it actively underwrites and assumes
risk and a predetermined runoff period, at the end of which the
SPC will be wound up and dissolved. Once formed, the SPC raises
capital by marketing and selling common and preferred shares and
surplus notes and other debt instruments of the SPC to investors
(block 52). The equity and debt capital raised through the sale
of securities of the SPC provides resources to support the assumption
of risk by the SPC. The capital raised is then invested in capital
markets issues of debt and equity securities (block 53). Based on
this capital, the SPC underwrites insurance, reinsurance or retrocessional
risk by assuming premium and associate risk liability as a multiple
of its capital and according to its underwriting guidelines (block
54). After a pre-defined period of time referred to herein as the
active underwriting phase (e.g., 5 years), the SPC discontinues
underwriting (block 55). But the SPC continues to earn on its invested
net worth and loss reserves, and runs off the previously assumed
liability, referred to herein as the runoff phase (block 56). During
the runoff phase (e.g., 6 years), the SPC resolves its risk liability
by paying off losses, commuting treaties and purchasing reinsurance-to-close.
At the end of the runoff phase, the assets of the SPC are distributed
to the shareholders and/or to a newly organized SPC incident to
a tax-free transaction (block 57). Finally, the SPC is dissolved,
ending its legal existence (block 58).
[0070] Business entity. In an embodiment of the system, the SPC
is incorporated in Bermuda as a special purpose vehicle, licensed
by the government of Bermuda (although there are other suitable
venues) as an insurance or reinsurance company to assume a diversified
aggregation of insurance, reinsurance or retrocessional risk. Shares
in the SPC will be issued in one or more classes of common shares.
One or more classes of preferred shares may also be offered. Finally,
surplus notes, which are legally debt but are treated as capital
for regulatory purposes, and/or ordinary debt instruments may also
be offered by the SPC to investors. It is expected that the share
offerings of each SPC will normally range upwards from $100 million,
sometimes augmented by surplus notes or other debt, but an SPC might
be organized with less capital.
[0071] Operating Alternatives. According to various embodiments
of the system, the SPC may participate in reinsurance treaties either
by direct cessions from primary insurers or retrocessions from other
reinsurers. The principal customer base of these SPCs will include
small to mid-sized commercial stock company insurers and reinsurers;
mid-sized mutual insurance companies; subsidiaries of large insurance
companies; and group and single owner captives.
[0072] Two principal types of operating modes by the SPC are contemplated.
Under the first type, the SPC will contract with a reinsurer to
participate with the reinsurer in new and renewal treaties. By this
arrangement, the SPC will stand shoulder-to-shoulder with that reinsurer
in assuming cessions directly from primary insurers or other reinsurers.
Although it may assume a smaller percentage of the placements, the
SPC typically will assume a share of the ceded risk equal to that
retained by the reinsurer. This effectively doubles the reinsurer's
line capacity without incurring the cost of raising capital. This
added capacity makes the reinsurer more attractive to brokers, which
will lead to increased broker traffic, enabling the reinsurer to
be more selective as to the quality and type of risk it assumes,
thereby increasing its potential for increased underwriting profits.
In this arrangement, the SPC essentially delegates its pen to the
reinsurer, signing onto the treaties entered by the reinsurer, subject
only to the SPC's underwriting guidelines and individual approval
of each risk assumed.
[0073] The second operating mode is participations negotiated,
directly or through a broker, in numerous treaties with several
or many ceding reinsurers. These may be direct cessions by a primary
insurer or an assumption by a reinsurer with a concurrent retrocession
to the SPC.
[0074] Underwriting Guidelines. The SPC will disclose to potential
cedants and brokers, as well as to investors, the types of risks
it will assume. In one embodiment of the system, the SPC will accept
only cessions involving non-volatile property and short tail casualty
risk of personal and commercial lines. In order to ensure sound
underwriting by the cedant, the SPC will require that the cedant
retain risk from each cession at least equal to that ceded to the
SPC. Volatile lines such as high risk product liability, environmental,
catastrophic property and long-tail casualty risks, would not be
accepted. Currently, medical and large accounting firm malpractice
risks would be excluded. Some lines, such as professional liability
for small accounting firms, would be underwritten with high selectivity.
The acceptability of risks will be continuously monitored for volatility
and profitability based on loss experience, prevailing loss trends,
existing market premium rates, and current premium trends. Individual
assumptions of risk normally would be limited so that premium received
from a transaction will never represent more than 5% to 7% of the
SPC's expected total annual premium. Because of the objective that
the ceded risk be short tail, assumptions principally will be of
"working layer" quota share treaties, which develop more
quickly and are inherently less volatile than excess-of-loss treaties
involving more severe but less frequent losses. Treaties will be
widely diversified by line of insurance and by geography as well.
Multi-year treaties will be acceptable when practical. Finally,
for purposes of limiting residual risk, commutable treaties will
be favored over non-commutable ones. Overarching the foregoing objectives
of assuming short tail risk and diversification will be to seek
and disproportionately be free of any remaining liabilities of the
SPC. The second option is for investors to transfer their share
of the SPC's assets and liabilities, or to transfer only assets
after reinsurance-to-close is purchased to cover their share of
risk liabilities, to a newly formed SPC in a tax-free transition.
Investors who do not exercise either of these options will hold
their shares to the end of the run-off phase, at which time the
SPC will distribute all its assets, resolve its liabilities, and
be wound up. At the end of the run-off phase, the third option is
for the remaining investors to receive cash after purchasing any
necessary reinsurance-to-close. The fourth option is for the remaining
investors to transfer their share of assets and liabilities or to
transfer only assets after reinsurance-to-close is purchased to
cover their share of risk liabilities, in a tax-free transaction
to a new SPC.
[0075] To illustrate the benefits of investing in an SPC according
to the present system, proforma financial projections of a model
SPC are provided by FIGS. 3 thru 29. This model is a "middle
case" example among an infinite number of possibilities. FIG.
3 describes the assumptions upon which the model SPC is based. Summary
proforma financial projections include a balance sheet (FIG. 4);
and an income statement (FIG. 5). Supporting tables are provided
in FIGS. 6 thru 28, which illustrate how the values of the financial
statements are derived. The tables will be described as necessary
to provide a detailed description of the performance of the model
SPC based on the underlying assumptions.
[0076] The starting point is an examination of the assumptions
listed in FIG. 3. All of the assumptions on which the present model
is based are realistic moderate to conservative estimates of what
can be expected of the model SPC's operations. In this example,
the SPC will be capitalized at $100 million. The funds are deemed
raised in assume risk from primary insurers or reinsurers having
superior long-term underwriting track records.
[0077] Illustrative Financial Model. The foregoing underwriting
guidelines and diversification requirements are one model illustrated
by FIGS. 3 thru 29. Another SPC could adopt much more conservative
or more liberal guidelines based on investor interest or, market
conditions. This could include highly volatile lines, modulated
by selective reinsurance, to seek a higher return.
[0078] According to the system, the initial phase of the SPC will
include active underwriting to assume risk liability. This underwriting
phase will last for a predetermined period of years--for example
5 years--after which the SPC will enter a passive phase to run off
then existing obligations. During the run-off phase, the SPC will
continue to earn investment and underwriting income, and continue
to pay losses on the risk that it assumed during its underwriting
phase. The run-off phase also will last a predetermined period of
time--for example, 5 years. If any non-matured risk remains at the
end of this phase, it can be closed out by commuting open treaties
and/or purchasing reinsurance-to-close or transferred to a new SPC
as part of a tax-free merger or other type of combination. If no
such corporate combination occurs, the SPC will be dissolved after
all its assets have been distributed and liabilities resolved.
[0079] According to an embodiment of the system, investors in the
SPC will have four options for realizing on their investment in
addition to holding it to maturity. The first option is to redeem
their shares at the end of the underwriting phase--e.g., the fifth
year. Investors who choose this option will receive their percentage
share of the net worth of the SPC, less a charge for purchasing
reinsurance-to-close to cover their share of the remaining liability
from the SPC's active underwriting phase, so that they will 2004,
and operations begin at the outset of 2005. The example SPC's funds
will be invested in the capital markets according to the asset allocation
shown in FIG. 3, namely 60% in bonds and 40% of equities, which
is based on State insurance regulation. Expected investment income
and capital gains, both based on historical averages, are shown
in FIG. 3. It is assumed that funds invested in bonds will produce
a 5% annual yield and equities 1%. Bonds are expected to realize
capital gains of 1% per year and equities 6%. The SPC will incur
an annual investment advisory fee each year in the amount of 40
basis points (0.4%) of the fair market value of the portfolio.
[0080] FIG. 3 also describes regulatory limitations that affect
the financial statements. The SPC will leverage its net worth (capital
and surplus) by writing insurance and/or reinsurance premium as
a multiple of such net worth. The model SPC will write premium at
a maximum leverage of 2.5:1 of premium-to-net worth. Underwriting
and other factors may cause this ratio to vary from 2.5:1, but the
ratio will be maintained as close as feasible to this target. A
fund will be accumulated to purchase reinsurance-to-close by annually
setting aside 3% of gross collected premium to cover residual liability
(i) of investors who opt to redeem their shares at the end of the
fifth year and (ii) when the SPC is being wound up. The model projects
that the SPC will be required to pay ceding commission of 23% of
assumed gross premium. Each year the SPC will pay a 1% Federal excise
tax and a 1% management fee measured by assumed gross premium.
[0081] Additional premium related factors are described in FIG.
3. The model assumes that the SPC will not immediately write its
full capacity of premium (2.5 times net worth) as of January 1,
but that seasonal adjustment factors will influence when premium
is written throughout the year. FIG. 3 includes a schedule of such
adjustment factors. Estimates of the total written premium each
year are multiplied by the appropriate seasonality factor to determine
the amount of premium that will be written each month. For example,
the schedule shows that 15% of the yearly total will be written
in January, 5% will be written in February, and so forth. For simplicity's
sake, it is assumed that all annual treaties are effective as of
the first day of the year. Finally, FIG. 3 includes incurred loss
and loss payment timing projections. The model assumes losses and
loss adjustment expenses (LAE) of 72% of net earned premium. Incurred
losses will be paid over 20 consecutive quarters beginning in the
quarter the loss arises.
[0082] These assumptions underlie the detailed financial projections
contained in the model. FIG. 29 is a table showing the high returns
to investors from an investment in an SPC organized and operated
according to the present system.
[0083] The proforma projections assume that the SPC was created
and capitalized in 2004 and that it began active operations in 2005.
Referring first to the balance sheet, FIG. 4, the total assets of
the SPC at the close of 2004 are $100,000,000. This represents the
aggregate amount invested by investors who purchased shares in the
SPC. This is reduced by $5,000,000 for start-up costs associated
with forming the corporation, raising capital and beginning operations
(brokerage fees, marketing and legal fees). These costs, which appear
as a liability on the balance sheet, are conservatively expensed
in 2005 rather than be capitalized and amortized over the life of
the SPC. The remaining $95,000,000 of shareholder equity represents
the funds with which the SPC begins operations in 2005.
[0084] These funds are invested 60% bonds and 40% equities according
to the asset allocation described in FIG. 3. Thus, at the beginning
of 2005, $57,000,000 are invested in bonds and $38,000,000 in equities.
These investments begin earning interest and dividend income immediately
at the start of 2005. Before calculating investment income and capital
gains earned, it is necessary to examine how the model accounts
for the ongoing process of writing and collecting premium and paying
losses. From this, it can be projected how operating cash flows
will increase invested funds that will directly increase investment
returns.
[0085] As the SPC began operations in 2005 with a $95,000,000 net
worth, it can write $237,500,000 worth of premium during 2005 while
staying within the limits of the desired 2.5 premium-to-net worth
ratio. However, this value ignores the fact that as the year progresses,
income is being earned both from operations and from investment
of the funds. This increase the SPC's net worth, thereby increasing
the SPC's ability to write premium. This is calculated in the model
by multiplying the surplus at the beginning of each year by an adjustment
factor and is identified as the "Pegged GAAP surplus"
on the Balance Sheet. The Pegged GAAP surplus is then used as the
basis for determining the total premium that can be written for
the year. Start up factors are expected to delay premium collections
in the first year and limit the initial growth of the surplus. Accordingly,
the surplus adjustment factor for the first year is limited to 3%.
For each subsequent year, however, the surplus adjustment factor
is 20%.
[0086] Since net worth at the end of 2004 is $95,000,000, application
of the 3% growth factor for 2005 results in a Pegged GAAP surplus
of $97,850,000. Multiplying this amount by 2.5 determines the SPC's
capacity to write $244,625,000 ($97,850,000.times.2.5) during 2005.
The model assumes that the SPC will write premium to its full capacity
each year.
[0087] Premium written each year is spread throughout the year.
The amount of premium written each month will vary according to
the seasonality factors shown in FIG. 3. FIG. 6 shows a table of
premium written each month by the SPC. The values are derived from
the total written premium for the year multiplied by the appropriate
seasonality factors shown in the left-hand margin of FIG. 6. This
is equivalent to assumed gross premium, broken out by quarter in
the table shown in FIG. 7, along with calendar year-to-date and
the cumulative totals. Summing the quarterly totals for 2005 confirms
that $244,625,000 of assumed gross premium is written in 2005. The
2005 income statement (FIG. 5) shows $237,286,500, which is net
of the cost of reinsurance-to-close.
[0088] Not all of the premium the SPC writes each year is treated
as income. As indicated in the assumptions of FIG. 3, each year
the SPC sets aside 3% of gross written premium for the purpose of
funding the purchase of reinsurance-to-close to cover residual losses
for those investors who opt to redeem their shares after five years
and of such reinsurance-to-close when the SPC is wound up. FIG.
8 is a table showing the amount set aside each quarter for purchasing
reinsurance-to-close. FIG. 9 in turn, is a table showing the net
premium written each quarter after the 3% setaside is subtracted
from the gross written premium. As shown in FIG. 8, the total setaside
for reinsurance-to-close in 2005 is $7,338,750. This also appears
as a liability on the Balance Sheet (FIG. 4). The resulting net
premium written for 2005 is $237,286,250.
[0089] Writing premium is not immediately taken into income by
the SPC. According to the accounting method applied by the present
model, written premium is earned as the underlying obligations are
discharged. Insurance policies and reinsurance treaties are typically
written for one year. Premium written on July 1 incurs risk liability
that extends through June 30 of the next year. The present model
uses straight-line amortization to account for premium that is earned
over the course of a year. The total net premium written in a given
month is divided into 24 equal parts, of which 1/24th is earned
in the month the premium is written on the assumption that the "average"
policy is written at mid-month; 2/24ths ( 1/12th) of the total is
earned each month thereafter for the next 11 months; and the final
1/24th is earned in the thirteenth month after the premium is written.
FIGS. 10A thru F show a schedule of net premium earned each month
corresponding to the underlying month in which the premium was written.
FIG. 11 shows the total net earned premium by quarter. FIG. 12 shows
the remaining written but unearned premium by quarter. Total earned
premium is a line item on the income statement (FIG. 5), which amounts
to $125,465,105 for 2005. This value can be found in the year-to-date
entry for the quarter ending December 2005 in the table shown in
FIG. 11. The total written but unearned premium for 2005 is found
as the entry for the quarter ending December 2005 in FIG. 12. This
amount, $111,821,145, appears as a liability on the Balance Sheet
in FIG. 4.
[0090] FIG. 13 is a table showing gross premium collected by quarter.
The timing of premium collections is important because collections,
less loss and expense payments, determine the actual growth of the
SPC's funds. The totals for gross premium collected correspond to
assumed gross premium written (FIG. 9), except that each entry is
offset by one calendar quarter because collections are delayed 45
days from the time the written premium is booked. Premium written
in the first half of a quarter will be collected in the same quarter,
whereas premium written in the second half of the quarter will be
collected in the next quarter. Accordingly, comparing the table
in FIG. 13 to that in FIG. 7, we see that the $66,048,750 of assumed
gross premium written in the quarter ending March 2005 is booked
as being collected in the quarter ending June 2005. Similarly, the
$58,710,000 of assumed gross premium written in the quarter ending
June 2005 is booked as being collected in the quarter ending September
2005 and so forth. The quarterly, year-to-date, and cumulative totals
are adjusted to reflect the 45 day delay in premium collections.
FIG. 14 is a table similar to the table in FIG. 13 except that FIG.
14 shows net collections by quarter after the 3% setaside reinsurance-to-close
has been subtracted.
[0091] Operating expenses and loss payouts also impact the growth
of the surplus. According to the present model, the SPC's operating
expenses include 23% ceding commission, a 1% annual management fee,
and a 1% Federal excise tax, all measured by gross premium. These
expenses are booked in the same quarter in which the underlying
gross premium is written. FIG. 15 is a table showing ceding commission
incurred each quarter; FIG. 16 is a table showing management fees
incurred; and FIG. 17 is a table showing Federal excise tax incurred.
Each of the tables in FIGS. 15, 16 and 17 are by calendar quarter.
The model assumes that ceding commission, management fees and Federal
excise tax will be paid the quarter after they are incurred. Accordingly,
FIG. 18 is a table showing ceding commission paid; FIG. 19 is a
table showing management fees paid; and FIG. 20 is a table showing
Federal excise tax paid.
[0092] In addition to premium collections and operating expenses,
the growth of the SPC's funds also depends on payouts of incurred
losses. When such losses occur and when they are paid have a major
effect on cash flow, and therefore on the growth of the SPC's net
worth. As shown in FIG. 3, the present model assumes a 72% loss
ratio. The model further assumes that losses will be incurred in
the same quarter the associated premium is earned. Accordingly,
the incurred losses and LAE amount to 72% of the net premium earned
in the same quarter. FIG. 21 is a table that shows losses and LAE
incurred each quarter. Each quarterly entry corresponds to 72% of
the net earned premium for the same quarter as set out in the table
shown in FIG. 11.
[0093] Although losses and LAE are deemed incurred in the same
quarter the associated premium is earned, actual payment is later.
Reporting delays, claim adjusting procedures, reinsurance notification
requirements, and other factors will delay the time at which losses
are actually paid. A schedule of loss payouts is shown in FIG. 3.
According to the model, payouts for losses incurred in a given quarter
will be spread out over the next twenty quarters. Of these losses
and LAE, 5% will be paid out the first quarter in which the loss
occurs, 10% will be paid out the second quarter, 12.5% the third
quarter, and so forth according to the schedule. FIGS. 22A thru
F show a loss payout schedule for losses incurred each quarter.
Working forward from the table in FIG. 11, net earned premium for
the quarter ending March 2005 is $9,590,319. From the table in FIG.
21 net losses and LAE accruing that same quarter is $6,905,030 (i.e.,
72% of $9,590,319). From the schedule shown in FIGS. 22A, $345,251
of this total (5%) is paid out in the quarter ending March 2005,
and $690,503 (10%) is paid in the quarter ending June 2005. Such
payments continue through the quarter ending December 2009 according
to the loss payout schedule of FIG. 3. Adding all the values in
the first row to be checked of the loss and LAE payment schedule
horizontally, 6,905,030 or 100% of the losses and LAE incurred in
the quarter ending March 2005 are paid out by the quarter ending
December 2009 (FIGS. 22A and B). The total losses paid out each
quarter are determined by adding the columns of the schedule in
FIGS. 22A thru C vertically. This shows that the total net loss
and LAE payouts for the quarter ending March 2005 are $345,261.
Payouts for the quarter ending June 2005 are $1,544,733 and so forth.
Total quarterly net losses and LAE payouts are tabulated in FIG.
23.
[0094] With the schedules of quarterly premium collections (FIG.
14), losses and LAE payments (FIG. 23) and other expenses (FIGS.
18, 19 and 20) are consolidated in the table in FIG. 24, which shows
quarterly cash flows from operations. For the quarter ending June
2005, $95,403,750 of gross premium is collected (FIG. 13). For the
same quarter, $21,942,863 of ceding commission is paid (FIG. 18);
$660,488 in Federal excise taxes are paid (FIG. 19); $660,498 in
management fees are paid (FIG. 20); and $345,251 in losses and LAE
are paid (FIG. 23). These collections and payments result in a net
cash inflow from operations of $71,794,661 for the quarter ending
June 2005. Similar calculations show a cash inflow of $44,842,282
for the quarter ending September 2005, $40,869,144 for the quarter
ending December 2005, and so forth. In the year 2010, after the
SPC has ceased writing additional premium, the cash inflow switches
to outflow as losses and expenses continue to be paid while no additional
premium is collected.
[0095] In addition to quarterly cash flows from operations are
cash flows from investment. Knowledge of cash flows from operations
is necessary for calculating investment cash flows because cash
inflows from operations are added to the invested funds which produce
investment income and realized capital gains. FIG. 25 is a table
showing total invested assets at the beginning of each quarter.
The assumptions described in FIG. 3 are that assets are allocated
60% in bonds and 40% in equities throughout the life of the SPC.
The SPC raised $100 million in capital in 2004, paid $5,000,000
in startup costs, and began operations in 2005 with $95,000,000
in surplus funds. Based on the asset allocation referred to above,
the opening balance for the SPC's first quarter of operations is
$57,000,000 in bonds in $38,000,000 in equities.
[0096] The model assumes 5% annual interest income from bonds and
1% annual dividend income from equities. Bonds are assumed to realize
1% capital gains per year and equities 6%. According to the model,
investment income is received every quarter, while capital gains
are realized only at the end of each calendar year. FIG. 26 is a
table showing quarterly earned investment income. FIG. 27 is a table
showing annual realized capital gains. Net investment income for
the quarter ending March 2005, after one fourth of the 0.04% (40
basis points) annual investment advisory fee has been paid, is $706,800
from bonds, and $91,200 from equities, for a total of $798,000.
The model assumes that one-half of the investment income earned
in a quarter is received in the same quarter while the other half
is received the next quarter. FIG. 28 presents quarterly investment
income received. Since only one half of all investment income is
received in the quarter it is earned, only $353,400 (one half of
$706,800) of investment income is received in the first quarter
of 2005 from bonds and $91,200 is received from equities. Total
investment income receipts for the quarter ending March 2005 are
$444,600. This amount is reinvested in bonds and equities respectively
according to the assumed 60%/40% asset allocation rule. Thus, with
these first quarter investment receipts the investment earnings
for the second quarter of 2005 will be based not on the initial
balances of $57,000,000 and $38,000,000, but rather on the increased
balances of $57,266,760 and $38,177,840.
[0097] FIG. 28 is a table which combines quarterly cash flows from
operations and from investment. Reference back to FIG. 25 shows
that invested assets at the beginning of each quarter include the
beginning balance from the previous quarter plus the previous quarter's
investment cash flows plus the previous quarter's cash flows from
underwriting operations. Thus, the opening balances for third quarter
investments are $100,823,605 in bonds and 67,215,737 in equities
for a total of $168,039,342, which is equal to the opening investment
balance from the second quarter $95,444,600, as increased by the
second quarter investment cash flows of $800,081, and underwriting
operations cash flow of $71,794,661. At the end of the fourth quarter,
the year's realized capital gains from both bonds and equity investments
are also added to the total invested assets.
[0098] The information in the Tables in FIGS. 6 thru 28 is the
input for the amounts on the Balance Sheet and Income Statement,
shown in FIGS. 4 and 5. For example, the Income Statement shows
that the total premium written in 2005 is $237,286,250. This value
is derived from the table in FIG. 9, and represents the net premium
written after 3% of gross premium written is set aside for funding
the future purchase of reinsurance-to-close. The total premium earned
for 2005 is $125,465,105. This is the annual total of net earned
premium for 2005, which is found in the year-to-date entry for the
fourth quarter of 2005 in the net earned premium table shown in
FIG. 11. Investment income earned for 2005 is $4,259,452 from bonds
and $549,607 from equities, for a total of $4,809,000. These numbers
are derived from the Investment Income Earned table of FIG. 26.
Premium and investment income earned in 2005 result in total income
of $130,274,164.
[0099] On the expense side, from the net loss and LAE incurred
table of FIG. 21 losses incurred for 2005 are $90,334,875. The ceding
commission incurred table of FIG. 15 shows such expense of $56,263,750;
the management fees incurred table of FIG. 16 shows such fees of
$2,446,250; and the Federal excise tax incurred table of FIG. 17
shows such taxes of $2,446,250. FIG. 4 shows premium acquisition
costs of $25,718,863, which are deferred from the first year. All
of this results in total expenses of $125,772,262 for 2005. Subtracting
total expenses from the total income leaves $4,501,902 of net operating
income for 2005. Adding to this, the $5,041,180 in realized gains
on investments in 2005 produces net income of $9,543,082 for the
first year of operations.
[0100] The balance sheet (FIG. 4) shows that at the close of 2005,
the SPC has total assets of $309,265,831. These include $21,190,641
of net premiums receivable, $796,166 in accrued investment income;
and $25,718,863 in deferred acquisition costs. Liabilities at the
end of 2005 include $111,821,145 in unearned premium; $84,462,041
in loss reserves; $7,338,750 set aside for the future purchase of
reinsurance-to-close; and $1,100,834 of accrued expenses and startup
costs, for total liabilities of $204,722,749. This results in net
income for 2005 of $9,543,082, which increases shareholder equity
from $95 million at the beginning of 2005 to $104,543,082 at the
end of the year. Total liabilities and equity at the end of 2005
are $309,265,831.
[0101] Net income of $9,543,082 represents the only change in shareholder
equity for 2005. No dividends are paid and no redemptions are made
in 2005. Thus, shareholder equity increases that year from $95,000,000
to $104,543,082.
[0102] Based on the detailed description of the first year of operation
of the model SPC, the financial projections through 2009 can be
readily traced. The SPC operates in substantially the same manner
from 2005 to 2009, investing surplus, writing premium, and paying
losses and expenses. The only change in the SPC's operations is
that as the end of 2009 approaches, the SPC will accept risk having
a gradually shortened tail.
[0103] After 2009, however, the SPC stops underwriting and accepting
premium. As can be seen on the Income Statement, no premium appears
in 2010 and thereafter. There is some residual premium earned in
2010, ($312,982,903) based on premium written in 2009. After 2010,
however, and no premium is written or earned, so that after 2010,
all of the SPC's income is derived from invested funds. The SPC
continues to pay losses on risk assumed in previous years.
[0104] In the present model, investors are given the option of
cashing out of the SPC at the end of the fifth year (2009) by redeeming
their shares or remaining shareholders in the SPC until 2015 when
it is wound up. At both times, investors have the further option
of a tax-free rollover of their investment into another SPC with
similar operations.
[0105] In most instances, reinsurance-to-close will be purchased
to discharge liability allocable to those shareholders redeeming
shares and/or rolling over their investment at the end of the fifth
year. Reinsurance-to-close may also be purchased prior to final
distribution to shareholders and/or rollover of their equity at
the end of the SPC's existence. At both times, the reinsurance-to-close
will be purchased from the 3% setaside and if necessary from other
funds of the SPC. FIG. 8 shows that the funds available for purchasing
reinsurance-to-close and the discounted value of future earnings
on loss reserves being transferred. Together these represent 22%
of the loss reserves being reinsured and so should be sufficient
to purchase the necessary reinsurance-to-close.
[0106] The present model assumes that the SPC's loss reserves will
exactly cover the residual risk, both at the end of the underwriting
phase and at the end of the runoff phase. In practice, it is almost
certain that the loss reserves will either exceed the residual risk
or will be insufficient. In both cases, an adjustment is necessary,
either by crediting excess loss reserves to the SPC's surplus, or
charging surplus for the shortfall.
[0107] The model assumes that 70% of the initial investors will
opt to redeem or roll over their shares at the end of 5 years. Accordingly,
the Balance Sheet (FIG. 4) shows a cash distribution of $212,367,219
paid in 2010, representing 70% of shareholder equity at the close
of 2009. This assumes that 705 of the 3% setaside for reinsurance-to-close
is sufficient to purchase that reinsurance. If it were not, the
$212,367,219 distribution would be reduced by the shortfall. The
investors who cash out the fifth year forgo any residual interest
in the 3% setaside for purchasing reinsurance-to-close. Thus, they
have no liability for the residual non-mature risk that the remaining
investors in the SPC retain. Receipt of the $212,367,215 dividend
ends their involvement with the SPC. This distribution for a five-year
investment represents a 24.9% annual return on the investors' initial
$70,000,000 investment.
[0108] The 30% of investors who are assumed to remain invested
in the SPC after the fifth year benefit from the continuing investment
income and capital gain earned both on the SPC's investment portfolio
and on the remainder of the 3% setaside, as well as the premium
earned in 2010. Thus, the remaining investors' equity continues
to grow. After 2010, the SPC's income is limited to investment income
and capital gains. Losses continue to be paid from the loss reserves
which are effectively depleted in 2015 when all outstanding risk
has either matured and losses paid out, or residual risk has been
discharged by commutation of treaties and/or the purchase of reinsurance-to-close.
If the cost of the reinsurance-to-close is greater or lesser than
the 3% setaside, the remaining shareholders' final distribution
will be correspondingly reduced or increased. Thus, in 2015 when
all residual liability has been run out or is otherwise disposed
of, shareholder equity stands at $394,833,592. This represents a
26.4% annual rate of return on the $30,000,000 invested by the 30%
of investors who hold shares for the life of the SPC.
[0109] According to the model, investors enjoy very favorable returns
whether they elect to cash out at the end of 5 years (24.9% annually)
or whether they remain until the SPC is wound up (26.4% annually).
See comparative investor return data in FIG. 29. Thus, a limited
life SPC organized and operated as described provides an attractive
vehicle for investment in underwriting insurance, reinsurance and
retrocessional risk.
[0110] Another significant advantage of the present system is that
SPCs may be used for numerous and varied purposes. The foregoing
example shows an SPC may be organized to participate in property
and casualty reinsurance directly with another reinsurer. In this
model the SPC receives retrocessions from the reinsurer pursuant
to an underwriting contract. Such participation on the part of the
SPC may be on a whole account basis, or on selected lines. Similarly,
an SPC may be established for property and casualty market reinsurance
individually negotiated participations with, and retrocessions from,
one or more reinsurers not under contract with the SPC. Such participations
also may be on a whole account or selected lines basis. Participations
need not be limited to property and casualty. SPCs may be created
for life and health reinsurance participations with and retrocessions
from reinsurers, either under contract or by an individual transaction
negotiation, and on a whole account or selected lines basis. The
same holds true for surety and guaranty reinsurance risks.
[0111] All the foregoing embodiments can be replicated to finance
primary insurance risk--property and casualty, life and health,
and surety and guaranty.
[0112] SPCs may be created for financing the purchase of a book
of insurance or reinsurance business, or the acquisition of an insurance
or reinsurance company. SPCs can finance finite risk reinsurance
treaties. An SPC can assume highly volatile natural catastrophe
risks such as hurricanes and earthquakes in lieu of catastrophe
bond issues now offered in the capital market.
[0113] Finally, the SPC may utilize derivatives to transfer from
the SPC all or substantially all underwriting risk and reward or
investment risk and reward. The purpose of transferring investment
risk would be to create a more highly leveraged security exclusively
for underwriting risk which would have the potential for greater
return associated with increased risk to investors. The use of derivatives
to transfer underwriting risk from the SPC would have the opposite
effect of reducing risk and potential return to investors.
[0114] These numerous alternative embodiments will produce returns
to investors that likely could vary, perhaps substantially, from
those projected by the model. As a general proposition, the greater
the risk assumed, the greater the potential for high returns as
well as loss.
[0115] Computer Implemented Embodiments. Any of the above teachings
may be implemented by a computing device in a networked environment.
A high level block diagram of an exemplary network communications
system 100 is illustrated in FIG. 30. The illustrated system 100
includes one or more client devices 102 and one or more servers
104. Each of these devices may communicate with each other via a
connection to one or more communications channels 108 such as the
Internet or some other data network, including, but not limited
to, any suitable wide area network or local area network.
[0116] The server 104 stores a plurality of files, programs, and/or
web pages in one or more databases 110 for use by the clients 102.
The databases 110 may be connected directly to the server 104 and/or
via one or more network connections. The databases 110 store information
used by the server 104.
[0117] One server 104 may interact with a large number of clients
102. Accordingly, each server 104 is typically a high end computer
with a large storage capacity, one or more fast microprocessors,
and one or more high speed network connections. Conversely, relative
to a typical server 104, each client device 102 typically includes
less storage capacity, a single microprocessor, and a single network
connection.
[0118] A more detailed block diagram of a client device 102 is
illustrated in FIG. 31. The client device 102 may include a personal
computer (PC), a personal digital assistant (PDA), an Internet appliance,
a cellular telephone, or any other suitable communication device.
The client device 102 includes a main unit 202 which preferably
includes one or more processors 204 electrically coupled by an address/data
bus 206 to one or more memory devices 208, other computer circuitry
210, and one or more interface circuits 212. The processor 204 may
be any suitable processor, such as a microprocessor from the INTEL
PENTIUM.RTM. family of microprocessors. The memory 208 preferably
includes volatile memory and non-volatile memory. Preferably, the
memory 208 stores a software program that interacts with the other
devices in the system 100. This program may be executed by the processor
204 in any suitable manner. The memory 208 may also store digital
data indicative of documents, files, programs, web pages, etc. retrieved
from a server 104 and/or loaded via an input device 214.
[0119] The interface circuit 212 may be implemented using any suitable
interface standard, such as an Ethernet interface and/or a Universal
Serial Bus (USB) interface. One or more input devices 214 may be
connected to the interface circuit 212 for entering data and commands
into the main unit 202. For example, the input device 214 may be
a keyboard, mouse, touch screen, track pad, track ball, isopoint,
and/or a voice recognition system.
[0120] One or more displays, printers, speakers, and/or other output
devices 216 may also be connected to the main unit 202 via the interface
circuit 212. The display 216 may be a cathode ray tube (CRTs), liquid
crystal displays (LCDs), or any other type of display. The display
216 generates visual displays of data generated during operation
of the customer computer 102. For example, the display 216 may be
used to display web pages received from the server 104. The visual
displays may include prompts for human input, run time statistics,
calculated values, data, etc.
[0121] One or more storage devices 218 may also be connected to
the main unit 202 via the interface circuit 212. For example, a
hard drive, CD drive, DVD drive, and/or other storage devices may
be connected to the main unit 202. The storage devices 218 may store
any type of data used by the customer computer 102.
[0122] The client device 102 may also exchange data with other
network devices 220 via a connection to the network 108. The network
connection may be any type of network connection, such as an Ethernet
connection, digital subscriber line (DSL), telephone line, coaxial
cable, etc. Users of the system 100 may be required to register
with the server 104. In such an instance, each user may choose a
user identifier (e.g., e-mail address) and a password which may
be required for the activation of services. The user identifier
and password may be passed across the network 108 using encryption
built into the user's browser. Alternatively, the user identifier
and/or password may be assigned by the server 104.
[0123] While various embodiments of the system have been described,
it will be apparent to those of ordinary skill in the art that many
more embodiments are possible within the scope of the system. Accordingly,
the invention is not to be restricted except in light of the attached
claims and their equivalents. |