Canadian Institute of Actuaries L’Institut canadien des actuaires 2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008

Reinsurance: cat bond process and risk management Pierre G. Laurin, FCAS, FCIA, MAAA September 25, 2008 Montréal (QC)

Contents Risk management issues Index linked securities Cat bond Side-car market PCS index trigger ILS over time Trends

Risk management issues Reinsurance is a source of contingent capital Reduction of volatility of results on a excess of loss basis Reduction of actual capital on a quota share basis Same concepts for primary insurers as for reinsurers who use retro-cessions Need to ensure quality of such capital

Canadian context Source: AM Best data

Risk management issues Availability of reinsurance Increase quality of capital Diversification of capital sources Cash flow issues Multi year covers

Securitised cat cover Cat Bond Collaterised layers Traditional Reinsurance Layers Retention

Historical context Index linked securities started in 1992 Response to risk management issues Alternative to hard reinsurance markets Need to find alternative sources of capital

Development Purpose: Increase reinsurance capacity Reduce earnings volatility Reduce capital volatility Diversification of source of capital Overall: Increasingly important strategic component for insurers & reinsurers Alternative to traditional reinsurance entities for private investors Can be customized to handle any type of insurance risk (e.g, workers comp.)

Index linked securities Cat bonds Indemnity Parametric Hybrids Side cars PCS index trigger

Overview of Nat Cat Trigger Types Source: Swiss Re

Cat bonds characteristics One sponsor Event based Only modeled exposures are covered Fully collaterised Non-indemnity cover (trigger based) Regular reset of attachment point Strict disbursements of proceeds High basis risk High yield

Catastrophe bonds – basic structure (diagram) Interest = LIBOR + Premiums Sponsor/ Originator Insurance Company Premiums Issuer Bankruptcy Remote Special Purpose Vehicle Investors (Qualified Institutional Buyers) Principal at maturity and liquidation Reinsurance Contract Note Proceeds/Funding Remaining funds at maturity Note Proceeds LIBOR Trust Account Highly Rated Short-Term Investments LIBOR Swap Counterparty Investment Income

Securitised cat cover Attachment point reset based on pre-determined excedence probability Cat Bond Collaterised layers Traditional Reinsurance Layers Retention

Reset of attachment point Timing is essential Renewal dates should be coordinated with traditional program Pre-event Initial attachment point determined prior renewal Final attachment point determined mid-year Potential gap in coverage Post-event Attachment point revised depending on date of event

Compared to traditional reinsurance Utilizes normal reinsurance agreements Typically excess of loss Fully collaterised Different source of capital Defined perils coverage Consolidation issues

Stakeholder perspectives Debt investor Relatively higher yield than corporate bonds Ability to customize terms & conditions Clearly defined risk categories & parameters Strong diversification of investments

Stakeholder perspectives Sponsor perspective Addresses risk management issues Diversification of capital Collaterisation of cover Certainty of coverage Multi year cover

Cat bonds Indemnity Based on company actual losses No basis risk Paid as losses get paid Parametric Trigger on modeled data Higher basis risk Can be paid immediately

Cat bonds requirements High level of sophistication in reinsurance thought process High investment of time Typically cost more than traditional reinsurance Good medium to address risk management issues

Historical context side cars “Traditionally” new reinsurers in market post large event Capital available Current players wanting to increase writings Strong pressures from rating agencies Uncertainty with catastrophe models results

Lessons learned From prior promotions Many new entrants have short time horizon Opportunistic perspective Need to change capital structure if reinsurer intends to continue operations Many IPOs on survivors

Side-car characteristics One sponsor Typically portfolio based While strong model based, include coverage of unmodeled exposures Indemnity cover No real reset of attachment points but capacity resets strict disbursements of proceeds Low basis risk High yield for bond holder but somewhat lower than cat bond Short tail lines of business Some commercial lines Actuarial opinion required Some pay-back mechanism

Quota Share Reinsurance Premium less Brokerage & Commission Structure (diagram) Proceeds Side-Car Holding Co. Debt Investors Notes: P&I Proceeds Equity Investors Shares $ Capital Dividends Reinsurer Quota Share Reinsurance Side-Car Reins. Co. Premium less Brokerage & Commission $ Contribution held for benefit of Cedant Distribution (Debt Interest, Profits) Payment for Losses Collateral Trust

Structure How they operate: Newly created holding company funded by private equity investors Usually hedge funds and other institutional investors Typically funded by debt & equity financing Assumes risk & premiums; pay claims to ceding company

Analytic issues – legal structure Review of legal & structural documents Quota share reinsurance agreement Collateral trust agreement Debt prospectus & covenants Structural soundness Legal enforceability

Analytic issues – business profile Review business profile Ceding company’s operations Underwriting management of insurance portfolio Risk tolerance levels Ability to avoid adverse selection Insufficient premium Excessive losses

Analytic issues – portfolio & modeling techniques Analysis of portfolio Develop default probability Can be multiple tranches Rating reflects ability to; Pay claims (side-car Reinsurer) Principal & interest (side-car holding company debt) Catastrophe loss modeling techniques employed Quality of assets in collateral trust Analytics similar to evaluating catastrophe bonds & other structured financings

Compared to traditional reinsurance Utilizes normal reinsurance agreements Typically quota share Depends on ceding company for reserving & claims practices Performance of side-car a result of underwriting & claims-settling capabilities of ceding company Typically private ownership Limited lifetime (not a going concern) Highly structured & limited purpose Typically limited to single cedant and/or contract Absence of active management team Cash disbursement tightly controlled by collateral trust agreement

Stakeholder perspectives Equity investor Opportunistic investment during hard markets Access to underwriting expertise Limited exposure to operating and legacy risks Relatively low cost to establish Can be established relatively quickly Allows for relatively easy exit Typically automatic winding down

Stakeholder perspectives Debt investor Relatively high yield Ability to customize terms & conditions Clearly defined risk categories & parameters Side-car is not a going concern Not likely to be recapitalized after a loss

Stakeholder perspectives Ceding company perspective Cedant can customize terms & conditions to meet needs Ability to capture market share during hard market Potential to obtain management fee & profit commission Allows for relatively easy exit of excess capital Diversification of source of capital

PCS index securities Bonds pay if the market loss is above a certain threshold Threshold determined by market loss Largest basis risk Very liquid Very popular alternative investment

P&C securization growth Source: Guy Carpenter, 2007

Risk capital by specific peril Source: Guy Carpenter, 2007

Risk Capital / Transactions by Trigger Type Source: Guy Carpenter, 2007

Trends - US Increase use of shelf offering Softening in the terms and conditions (multi perils and locations) More investment grade ILS Primary insurers are getting more in the game, where reinsurers were the principal driver of ILS Consolidation issues IFRS:SIC 12 vs US GAAP:FIN 46R

Trends - Canada Availability of quality reinsurance market Limits generally lower in Canada vs US Few cat bonds covering Canadian exposures (Merna Re) Cat models not truly tested Increased awareness of ILS