USAA: Catastrophe Risk Financing Harvard Case Solution & Analysis

  1. How much will a surplus note cost USAA currently for an equivalent amount of protection? Calculate how much a contingent surplus note will cost USAA currently? How will each impact the ROE of USAA?

ANSWER:

The below table shows the cost of surplus note and the cost of contingent surplus note of USAA for the proceeding years.

Cost

1993

1994

1995

1996

Surplus Note Cost

-2,782.70

-3001.8

-2585.2

-2665

Contingent Surplus Cost

-1,140.20

-1206.1

-1144.2

-1298

Probable Maximum Loss

-3,922.90

-4207.9

-3729.4

-3963

 

Cost of capital of a firm affected by the surplus note, and losses from catastrophes is detained under the undiscounted values on the balance sheet. If the number of insurance companies increase, then the unrecognized discount on interest in the loss surplus increases over time, and this reduces the earnings which are undervalued; in addition the return on surplus will also reduce, which will result as a reduction in the value of equity.

Contingent surplus notes have no affect on USAA’s return on equity as it is secondary to all claims made by policy holders; regardless of the amount of contingent surplus notes.

  • 2.      Describe how catastrophe options work. How will these instruments help an insurer? What will be its impact on an insurer's ROE?

ANSWER:

A call option for the protection of catastrophes’ losses is provided to large firms from the municipalities to redeem it when catastrophes occur. This option can be redeemed at par value. It provides insurance for the losses incurred by natural disasters. This low probability event occurs at extremely high cost and these insurances are excluded from the standard exposed insurance policies. These instruments help the insurer to insure uncertain losses and recover those losses by paying the premium price as a protection fee. The cat options not only insure the losses but it also increases the cost of capital. These costs of capital increase through payments of premium fees. To pay this premium, insurance firms reduce their retain earnings which increase the demand to raise capital in order to distribute dividends to shareholders. The return on equity will reduce in order to pay dividends.

3.      If USAA decides to use cat option, how much will it cost for an equivalent amount of protection, and what will be its impact on capital requirements and ROE?

ANSWER:

If USAA uses cat option, then the equivalent cost as premium for protection will be paid in amount as $330 million for the total of $4350 million.

  • 4.      Now consider the Cat Bond transaction. Describe how this transaction works, including its structure, and how it helps a traditional insurer. Why is co-insurance a feature of the Cat Bond structure? Why is Class A-1 securities needed?

ANSWER:

The Cat Bond transaction works through observing the Special Purpose Vehicle (SPV), in which the insurer makes an agreement with the insurance party who wants to insure its policies against catastrophes. The insurer receives premium from the insurance party in exchange of securing their risks against issuing securities.  Furthermore, securities are issued to investors through SPV, and these SPV receives principle amounts as returns. These returns are deposited into collateral accounts for further investment, and these investments are made in the money markets funds. Investors receive interest payments from these investments made in the money market funds and these investors pay premium to SPVs. If catastrophes occurred then these collaterals will be liquidated by the SPVs to reimburse investors’ loss according to the terms and conditions of the Cat Bonds. Class A-1 securities are needed in this because the returns on these classes of securities are more secured than Class 2 securities which ultimately generate the returns...................................

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