Casualty Actuarial Society – Chicago, IL November 2007 Actuarial Skills in the Financial Markets Phil Kane – Director: Securitized Credit Casualty Actuarial Society – Chicago, IL November 2007

How do Investment Banks Organize Themselves? Investment Banking Advisory and Relationship Management Valuations Capital Structure Advice Acquisition/Spin-Off Strategies Equity Research Markets Securities & Derivatives - Sales and Trading Security Transactions Cat Bonds ALM – Hedging Secondary Insurance Policy Transactions XXX Securitizations Credit Research Risk Management Portfolio Credit Derivative Transactions and CDOs DCM ECM Structuring

CDOs as Credit Reinsurance? Andrew event ≈ Subprime Mortgage event Like Reinsurance, CDOs re-tranche risk portfolios to re-distribute it different risk appetites Catastrophe Risk Placement CDO Tranching Sleep Tight protection Super Senior Excess of Loss Senior Mezz Working Layer Junior Mezz Retention First Loss

CDOs : An Actuarial Role? Much like Actuaries at the forefront of driving reinsurance transaction pricing and execution, Structurers model and execute CDO transactions… CDO pricing transparency recently questioned but limiting discussion to Credit Derivative CDOs, pricing models have become widely accepted and have actuarial analogues. Risk premiums are typically arbitrage free; two way markets allow for the assumption that spreads are the best measure of default risk In addition, ratings models usually have similar engine to pricing models, but rely on agency statistics rather than market inputs

Portfolio Credit Derivative Models Default Risk ≈ Similar to insurance Event Risk If event happens, loss; no event, no loss Spread Risk ≠ Insurance Premium Risk No Mark to Market for Insurance Premiums (yet….) Simple default models are typically based on binomial models for defaults; With correlations between 0 and 1, Gaussian Copulas have become standard model In Credit, as in the markets as a whole, individual risks are NOT independent

Marked to Market Risk Trading desk hold statistical reserves for counterparty risks, “gap” risks, and model risks. These are typically monitored by Risk Management (analogue to Reserving Actuaries). Trading Desks though are also exposed to Marked to Market as well, for example, basis risk on hedges: (using CDX example with recent levels:) CDX Tranches 30-100% [8.25]bps running 15-30% [14.5]bps running CDX Index [61]bps 10-15% [32.5]bps running 7-10% [73]bps running 3-7% [213]bps running 0-3% [18.55]% running = [75.9]bps running expected total Expected Basis approximately of [15]bps; can move though, +/- 5bps

Many roles for dedicated Insurance Knowledge Summary Many roles for dedicated Insurance Knowledge Actuarial Skills are directly transferable to Insurance Related Investment Banking. Life Actuaries have been successful migrated to ALM, asset sales, and securitization products. In markets, Portfolio Credit Derivatives behave in a many ways like Reinsurance In addition, to transact in the Credit Derivative Markets, one must firmly grasp Market to Market Risks as well. But, in general the modeling skills of an actuary can be successfully used in CDOs of all asset classes.

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