Seismic Limited Case Study LEHMNABROTHER S John Kiernan August 15, 2000

LEHMNABROTHER S 2 Convergence of the Insurance and Capital Markets Catastrophe Securitization – Why? Traditional reinsurance markets today Traditional reinsurance markets today  Cyclical pricing and fluctuating capacity Andrew/Northridge Andrew/Northridge  Large losses for reinsurers  Significant increases in premium rates  Reduction of catastrophe reinsurance coverage available to primary insurance companies Insurance companies turned to capital markets Insurance companies turned to capital markets  Efficiency and capacity

LEHMNABROTHER S 3 Insurance Risk as an Asset Class Catastrophe Securitization – Why? Insurance risk has become next major asset class absorbed by Capital Markets Insurance risk has become next major asset class absorbed by Capital Markets Corporate bond market replaced traditional practice of long-term bank lending to corporations Corporate bond market replaced traditional practice of long-term bank lending to corporations S&Ls used to originate and hold mortgage risk, now supplanted by mortgage bond market S&Ls used to originate and hold mortgage risk, now supplanted by mortgage bond market Following this pattern, the capital markets are transforming the traditional reinsurance market Following this pattern, the capital markets are transforming the traditional reinsurance market

LEHMNABROTHER S 4 Alternative and Supplement to Traditional Reinsurance Why Do Insurance Companies Care? Limited number of highly-rated reinsurers Limited number of highly-rated reinsurers  Credit risk : concern particularly for upper-layers  Capital markets easily addresses this concern Capital markets capacity and pricing efficiency makes them attractive Capital markets capacity and pricing efficiency makes them attractive Desirable characteristics that don’t exist in traditional market Desirable characteristics that don’t exist in traditional market  Flexibility in terms of maturity Keeps traditional market providers honest Keeps traditional market providers honest

LEHMNABROTHER S 5 CAT Bonds Offer Attractive Returns on a Risk- Reward Basis Why Do Investors Care? Valuing a CAT bond Valuing a CAT bond  Based on pure expectation hypothesis, investor should be compensated for expected loss  Expected loss - average loss to a CAT bond as determined by independent third party through multi- year simulation  CAT bonds usually trade at a multiple, usually 6:1 to 7:1 of expected loss

LEHMNABROTHER S 6 Why Do CAT Bonds Trade As a Multiple to Expected Loss? Why Do Investors Care? Concentration of risk in reinsurance hands leads to “cheap” pricing of risk Concentration of risk in reinsurance hands leads to “cheap” pricing of risk Liquidity concerns Liquidity concerns Concern over “accuracy” of modeled expected losses Concern over “accuracy” of modeled expected losses “Fat Tails” “Fat Tails” Extreme aversion to “lose everything” scenario Extreme aversion to “lose everything” scenario

LEHMNABROTHER S 7 #1 Problem Faced by Portfolio Managers Is Lack of Diversification When They Need It Most Why Do Investors Care? The correlation among existing asset classes The correlation among existing asset classes  High Grade/High Yield Corporate Bonds  Mortgage-backed Securities  Emerging Markets  Equities can rise dramatically when just a small sector of the global economy, even regionally or market specific, takes a downturn

LEHMNABROTHER S 8 Excess Returns in Stressful Times Are Negative and Highly Correlated Why Do Investors Care? *Excess returns over similar duration U.S. Treasuries **All long duration mortgages ***Excess return over 30-year U.S. Treasury Bond

LEHMNABROTHER S 9 CAT Bonds Are Uncorrelated to Other Capital Markets Risks Why Do Investors Care? CAT bonds are securities whose trigger events are based upon uncorrelated phenomena CAT bonds are securities whose trigger events are based upon uncorrelated phenomena  Occurrence of earthquakes  Extreme temperature variations This is an asset class whose trigger events are truly independent of economic factors such as: This is an asset class whose trigger events are truly independent of economic factors such as:  Interest Rates  Foreign Exchange Rates  Risk Premia for Credit Spreads  GDP  Market Perception of Economy

LEHMNABROTHER S Seismic Limited – Case Study Problem Lehman Re has substantial California Earthquake exposure Lehman Re has substantial California Earthquake exposure Looking for retro capacity Looking for retro capacity

LEHMNABROTHER S Seismic Limited – Case Study Which Way Do I Go? Difficult to obtain California earthquake reinsurance of significant size from highly rated counterparties Capital Markets Reinsurance Industry Hungry for high yielding, low risk securities that are easy to understand Solution: Create a California earthquake CAT bond with losses tied to an index

LEHMNABROTHER S Seismic Limited – Case Study Seismic Limited-March 2000 US $150,000,000 exposed to insured losses in California from earthquakes and fires following US $150,000,000 exposed to insured losses in California from earthquakes and fires following Payment of principal, interest, and dividends on Securities linked to Property Claim Services’ (PCS) reported Cumulative Estimated Insured Losses over 22 month Risk Period Payment of principal, interest, and dividends on Securities linked to Property Claim Services’ (PCS) reported Cumulative Estimated Insured Losses over 22 month Risk Period First securitization involving Lehman Re Ltd., the reinsurance subsidiary of Lehman Brothers Holdings Inc. First securitization involving Lehman Re Ltd., the reinsurance subsidiary of Lehman Brothers Holdings Inc. Risk assessment performed by Risk Management Solutions Risk assessment performed by Risk Management Solutions Only single risk California Earthquake Catastrophe Bond currently in market Only single risk California Earthquake Catastrophe Bond currently in market

LEHMNABROTHER S Seismic Limited– Case Study Swap Counterparty Securityholders Seismic Ltd. Collateral Account Lehman Re PeriodicPayments Counterparty Contract LIBOR InvestmentEarnings LIBOR LIBOR $150M Net Principal Amount Payout if Trigger Overview (1) Notes (2) Preference Shares

LEHMNABROTHER S Seismic Limited – Case Study Structural Motivations:Lehman Re/Lehman Brothers Create a product that is easy to understand Create a product that is easy to understand Seismic closely resembles Industry Loss Warranties (ILWs) Seismic closely resembles Industry Loss Warranties (ILWs) Capacity constraints lessened Capacity constraints lessened Arbitrage between traditional and capital markets Arbitrage between traditional and capital markets Value of full collateralization Value of full collateralization

LEHMNABROTHER S Seismic Limited – Case Study Structural Motivations: Investor Attractive risk/reward Attractive risk/reward Value of purchasing non-correlated asset Value of purchasing non-correlated asset Only single risk, California only CAT Bond in market Only single risk, California only CAT Bond in market Like index based nature of loss measurement - addresses moral hazard Like index based nature of loss measurement - addresses moral hazard ILW nature of security provides a pricing back-stop in case of capital markets disruption ILW nature of security provides a pricing back-stop in case of capital markets disruption Transparency of structure promotes liquidity Transparency of structure promotes liquidity

LEHMNABROTHER S Seismic Limited – Case Study Basis Risk Issues A unique characteristic of Seismic is the role of Lehman Re A unique characteristic of Seismic is the role of Lehman Re Lehman Re is able to hold and manage risk, thus allowing it to tailor products that Capital Market participants want Lehman Re is able to hold and manage risk, thus allowing it to tailor products that Capital Market participants want CatastrophicCaliforniaEarthquakeRisk Basis Risk SecuritizableRisk Lehman Re CAT Bonds (Indemnity) (Index)

LEHMNABROTHER S Seismic Limited – Case Study Sources of Basis Risk Residential vs. Residential/Commercial Residential vs. Residential/Commercial Fire Following Fire Following General correlation between industry losses & losses on specific reinsurance treaty General correlation between industry losses & losses on specific reinsurance treaty Lehman opinion: Market pays you handsomely for assumption of basis risk Lehman opinion: Market pays you handsomely for assumption of basis risk

LEHMNABROTHER S Seismic Limited – Case Study Basis Risk Retention : The Future If catastrophic securitization is to grow dramatically, Seismic is a template for such growth If catastrophic securitization is to grow dramatically, Seismic is a template for such growth Current issues holding back market growth Current issues holding back market growth  Cedents: speed to market, pricing  Investors: complexity, moral hazard, lack of transparency Solution: Intermediary (broker, cedent, underwriter) takes basis risk Solution: Intermediary (broker, cedent, underwriter) takes basis risk Market gets simpler deals, faster execution, better liquidity = more investors Market gets simpler deals, faster execution, better liquidity = more investors Investor willingness to “pay” for transparency - differential between structures apparent in secondary trading of outstanding deals Investor willingness to “pay” for transparency - differential between structures apparent in secondary trading of outstanding deals

LEHMNABROTHER S Seismic Limited – Case Study Rating Agency Issues Have expressed dismay over structural complexity of recent insurance-linked transactions. Have asked for more transparency Have expressed dismay over structural complexity of recent insurance-linked transactions. Have asked for more transparency Strong preference for index or parametric deals over indemnity Strong preference for index or parametric deals over indemnity Relied on both internal models and quality of RMS model to assess the validity of expected loss calculations Relied on both internal models and quality of RMS model to assess the validity of expected loss calculations Developed “comfort” with PCS’s ability to accurately reflect aggregate industry losses in California Developed “comfort” with PCS’s ability to accurately reflect aggregate industry losses in California Moral hazard concerns largely eliminated by virtue of industry- wide loss measurement Moral hazard concerns largely eliminated by virtue of industry- wide loss measurement

LEHMNABROTHER S Why PCS? Seismic Limited - Case Study Industry Gold Standard Industry Gold Standard Long history of providing catastrophic loss measurements Long history of providing catastrophic loss measurements Usage of PCS loss estimates in ILW contracts underscores legitimacy of index in eyes of investors Usage of PCS loss estimates in ILW contracts underscores legitimacy of index in eyes of investors

LEHMNABROTHER S Seismic Limited – Case Study Why RMS? Investors require detailed analysis of risk associated with the bonds including attachment and exhaustion probabilities and expected losses Investors require detailed analysis of risk associated with the bonds including attachment and exhaustion probabilities and expected losses Rating agencies and investors have developed a level of “comfort” with the analysis provided by these companies Rating agencies and investors have developed a level of “comfort” with the analysis provided by these companies RMS was used for the Seismic deal because of its knowledge and background in the study and assessment of California earthquake risk RMS was used for the Seismic deal because of its knowledge and background in the study and assessment of California earthquake risk RMS plays a critical role in marketing as supplier of independent analysis and is also available to address investor questions RMS plays a critical role in marketing as supplier of independent analysis and is also available to address investor questions

LEHMNABROTHER S Summary of RMS Analysis Annualized Aggregate Probabilities* Seismic Limited– Case Study * As measured by RMS

LEHMNABROTHER S Seismic Limited – Case Study Term Sheet

LEHMNABROTHER S Seismic Limited – Case Study

LEHMNABROTHER S Trigger Amount Schedule

LEHMNABROTHER S Seismic Limited– Case Study Investor Demand

LEHMNABROTHER S Seismic Limited– Case Study Increase in money managers participation - more stable capacity Increase in money managers participation - more stable capacity General increase in recognition of value of non-correlated nature of risk General increase in recognition of value of non-correlated nature of risk Shift toward lower yielding single peril deals and away from “kitchen sink” retro deals Shift toward lower yielding single peril deals and away from “kitchen sink” retro deals Recent issuance has led to ability to create portfolio of non- correlated CAT risks, bringing previously “on-the-fence” accounts into CAT bond markets Recent issuance has led to ability to create portfolio of non- correlated CAT risks, bringing previously “on-the-fence” accounts into CAT bond markets Recognition that liquidity is much better than skeptics contend Recognition that liquidity is much better than skeptics contend Investor Trends

LEHMNABROTHER S Seismic Limited– Case Study Seismic oversubscribed and well traded in secondary market Seismic oversubscribed and well traded in secondary market  Transparency  Simplicity  Lack of moral hazard  Liquidity  Reinsurance market backstop At same time, Lehman Re (Cedent) achieves objectives At same time, Lehman Re (Cedent) achieves objectives  Big capacity  Fully collateralized  Attractive pricing adjusted for basis risk Conclusions

LBEHM N A R O THER S