A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence Casualty Actuarial Society Seminar on Reinsurance 2003 June 2, 2003 Philadelphia, Pennsylvania Athula Alwis, ACAS, MAAA, American Re

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence Surety Defined - One who at the request of another, and for the purpose of securing to him a benefit, becomes responsible for the performance by the latter of some act in favor of a third person, or hypothecates property as security therefor. One who undertakes to pay money or to do any other act in event that his principal fails therein. A person who is primarily liable for payment of debt or performance of obligation of another. One bound with his principal for the payment of a sum of money or for the performance of some duty or promise and who is entitled to be indemnified by some one who ought to have paid or performed if payment or performance be enforced against him. Term includes a guarantor. Black's Law dictionary 6th edition.

OBLIGEE PRINCIPALSURETY SURETY DEFINED A joint undertaking with the Principal and the Surety to fulfill a contractual obligation.

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Current Status The convergence of the insurance and financial markets changes the way we need to look at credit and surety: –Products have become more sophisticated, requiring new risk management procedures (both risk quantification and exposure management) –Insureds have become more sophisticated, dramatically increasing the risk of anti-selection and requiring new pricing methods –Regulators, rating agencies and investors have become more vocal about their concerns

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  The spectrum of products is growing –Contract surety –Commercial surety –Financial guaranty –Credit insurance –Credit derivatives –Structured credit solutions The possibility that the risk transfer being sold in the market is a mixture of these products is increasingly high.

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Clients are getting more sophisticated Example: –Eastern Power sells $100mm of electricity to Western Power, payable in advance. –Western Power then sells the same electricity back to Eastern Power for $105mm, payable in arrears and insured with a power delivery bond. –Combined, the two form a $100mm loan from Western to Eastern at 5% interest with the credit risk stripped out.

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Market forces are driving evolution –Insureds increasingly are unable to purchase enough credit protection through traditional channels, driving them to the new & non-traditional products –Insurers generally are unable to adequately monitor credit aggregations across all of their products, resulting in them putting out too much total capacity –Differences between insurance and financial markets pricing create arbitrage opportunities

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Insurers are being forced to change –Insurers originally welcomed the new products because they wanted top-line growth, and they tried tapping into the financial market’s revenues –Insurers have since learned that credit is a catastrophe prone risk, and it must be managed accordingly –Both insurers and insureds have learned that insurance is very different from finance, even if the risks look similar –Regulators, rating agencies and investors have begun demanding greater transparency and better quantification & control of credit risk exposures

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Insurance Pricing Theory Surety is considered a Property line of business: –Rates are a function of the exposure (bond) size and classification –Usually based on loss experience Weaknesses: –Does not adequately capture the credit cycle –Does not adequately reflect changes in credit quality –Does not adequately differentiate risks

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Financial Market Pricing Theory Surety E[L] =  (Financial Instrument E[L],  ) –  = Probability of Loss as a Surety Product / Probability of Default as a Financial Instrument –Financial Instrument E[L] = Notional Amount x Default Rate x (1 – Recovery Rate) x Correlation Factor

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Calculation of E(Loss) [for a single principal] (1) Principal XYZ Inc. (2) Credit RatingBaa3 (3) IndustryPower (4) Exposure25,000,000 (5) Duration5 [A single payment of $25mm is due in 5 years.] (6) Moody's Default Rate3.05% (7) Average Recovery Rate10% [Default value for high risk bonds] (8)  100% [Bond is a no-recourse demand obligation.] (9) Expected Loss686,250 = (4) x (6) x [1 - (7)] x (8) (10) Discount 5%)0.784 (11) PV(Expected Loss)537,695 = (9) x (10) Correlation Factor is 1.0 because this is a single principal

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Calculation of E(Loss) [for a multiple principals] –The calculations for a portfolio of primary or reinsurance risks can be achieved similarly. –An advanced and more realistic method is to the calculations using a simulation model –Loss scenarios are simulated based on credit ratings while the recovery rates and the volatility around recovery rates are factored in using a beta function. Then, a correlation matrix is brought into the picture using calibrated multi-variate normal copula approach.

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Risk Management Techniques –Concentration limits –Orderly exit strategy –Collateral covenants –Reinsurance –Credit derivatives –Diversification with non-credit

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Risk Management Requirements –A sophisticated inventory system, tracking both assumed and ceded exposures, in a consistent manner, for all products & investments –A credit catastrophe model (similar to the nat-cat models) –A capacity allocation/management process (similar to the nat-cat processes) –Integration of the risk management and pricing systems –Understanding why the insured is buying protection

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Conclusion –The traditional insurance methods for evaluating and managing surety risks have become out-dated. Insurance companies who do not change are at risk of being anti-selected against. The consequences of writing these product with the old methods are severe. –We strongly believe that following the lead of financial markets could help the surety industry quantify and manage Credit & Surety risks more effectively and more efficiently. This will ensure the long-term availability of sufficient capital, and thus capacity, for this line of business.

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Question and Answer

A Paradigm Shift Based on the paper: Credit & Surety Pricing and the Effects of Financial Market Convergence  Contact Information Athula Alwis: