Risk Securitization CAS Special Interest Seminar David Na, FCAS, MAAA Deloitte & Touche, Bermuda

Background

Merging of Financial and Insurance Markets  Travelers + Citicorp = CitiGroup? Insurance Industry “Scared” by Events Such as Hurricane Andrew  $18 billion? $60-80 billion?? Recent Activity - New Companies/Transactions  Arrow Re (Goldman Sachs)  Lehman Re (Lehman Brothers)

Background Effects of Natural Catastrophes in Late 80’s & Early 90’s:  Decreased Insurance/Reinsurance Capacity  Increased Demand for Reinsurance  Realization of Inadequate Pricing  Increased Awareness re: Insurer’s Exposures

Background Comparison of Capitalization of Insurance and Capital Markets... Estimated Capital of US P/C Ins. Industry ~ $338 billion Size of the Capital Markets  Total Capitalization ~ $34 trillion  Average Daily Fluctuation ~ $200 billion  $100 billion loss ~ 1/3 of 1% of market capital

What is Risk Securitization? Packaging/Transferring of insurance underwriting risks to the capital markets through the issuance of a financial security 2 Important Aspects: –Transformation of U/W Cash flows into tradable securities –Transfer of U/W Risk through the trading of those securities Investment Return is contingent upon underwriting experience

Types of Transactions/Triggers Indemnified Notes Indexed Notes Parametric Notes

Indemnified Notes Responds Directly to Ceding Company’s Specific Exposures & Actual Losses Provides the Most Precise Coverage for Cedant Reflects Cedant’s U/W & Claim Settlement Processes Long Development Patterns – Investors may need to Wait for Their Return Sample Transaction: Alpha Wind

Indexed Notes Linked to Industry or Geographic Index (e.g. PCS) Cedant Exposed to Significant Basis Risk, if Index is not Consistent with Cedant’s Actual Losses Shorter Development Period (Generally Easier to Predict the Index than Individual Company Losses) “Synthetic Indemnification” – Mathematical Attempt to Replicate the Cedant’s Underlying Book of Business Sample Transaction: Seismic Re.

Parametric Notes Linked to Quantities Associated with Pertinent Events – Generally Physical Attributes of an Event:  Magnitude, Intensity, & Epicenter of EQ  Wind Speed, Forward Velocity, & County of Landfall of Hurricane Removes Risks Associated with Modeling the Ceding Company’s Exposures or Changes in Exposures Virtually Eliminates Development Period Sample Transaction: Concentric Ltd.

Investor Risks & Returns No Standard Approach Principal Protection… sometimes Various Tranches Varying Terms (e.g. Tokio EQ is 10 years) Returns based on Risk

Other Examples of Securitization Mortgage Backed Securities –Similarly created by excess demand –However, high volume, stable asset was securitized Auto Loans & Credit Card Receivables David Bowie (offering securitized by future sales of CD’s) NFL (offering securitized by $18 billion TV deal) –[subsequently withdrawn]

Perspective Think of as any other security... It’s all about Risk v. Return... Here, the risk happens to be insurance related

Types of Insurance Linked Securities (ILS’s)

Types of ILS’s Catastrophe Bonds - Will Discuss in Detail... Catastrophe Risk Exchange (CATEX) Swaps Insurance Related Derivatives/Options Catastrophe Equity Puts (CAT-E-Puts) Contingent Surplus Notes Weather Derivatives

CATEX Swaps – NY & Bermuda –Electronically swap CAT exposures (e.g. geographic location, property type, etc.) Insurance Related Derivatives/Options –Chicago Board of Trade Options: Based on aggregate industry CAT losses (Property Claim Services) –Bermuda Commodities Exchange CAT Options: Based on Guy Carpenter Catastrophe Index (ratio of losses to housing values) Types of ILS’s

Catastrophe Equity Puts (CAT-E-Puts) - Insurer has the option to sell equity (e.g. preferred shares) at pre- determined price, contingent upon a specific event Contingent Surplus Notes - Option to borrow contingent upon the occurrence of a specific event (contingent funds held in trust) Weather Derivatives - Insurance or derivative contract which pays based on weather related events Types of ILS’s

Generic ILS Structure Insurer or Reinsurer SPVSPV InvestorsInvestors Invested Proceeds - Trust Account Invested Proceeds - Trust Account PortfolioReturn Liquidation of Assets (Event Contingent) ReimbursementPayment Loss of Value (Event Contingent) Premium Portfolio Return + Premium

Advantages - Investor Above average yield relative to other securities (e.g. corporate bonds) of similar risk Outstanding diversification effect - Unlike investments in insurance company stocks, CAT events are generally uncorrelated with an investor’s portfolio Allows non-insurance investors to participate in insurance related transactions Preparation for convergence of Insurance & Banking

Advantages - Issuer Capacity - Access the Capital of the Financial Markets Greater Flexibility in Terms of Coverage Reinsurance Protection – Fully Collateralized, No Credit Risk More Stable Pricing - Insulated from U/W cycles High aggregate level risk transfer Innovation/Prestige - “Cutting Edge”

Issues Requires understanding of both Capital and Insurance Markets (Investors as well as Issuers) Historical separation of Capital and Insurance Markets (e.g. Regulatory Issues) Uncertainty involved in pricing high layer or catastrophic events (Reliance on Modeling) Issuer’s Costs (Relative to Purchase of Reinsurance) Investor’s Return (Relative to Comparably Risky Securities) Accounting, Legal, Regulatory, Tax, etc.

The USAA/Residential Re. Transaction

USAA/Residential Re. Placed in 1997 (with subsequent renewals) Reinsurance coverage of 80% of $500M x $1B Covers Category 3, 4, or 5 Hurricanes along the East or Gulf Coasts of the US $477 M in bonds issued Residential Re. Domiciled in Cayman

USAA/Residential Re. Tranche A-1 ($164 M): –AAA rated –Only interest at risk –Coupon paid LIBOR % Tranche A-2 ($313 M): –BB rated –Principal & Interest at risk –Coupon paid LIBOR % Investor Appeal –Principal Protection & AAA Rating –Favorable risk/return

USAA/Residential Re. Market timing; lack of investors’ appetite for risk in 1996; in 1997, risk/return more attractive Rating agency concerns (1996 not investment grade) Protection of principal 1997 issue had short duration & conservative loss trigger (USAA’s losses from Andrew ~ $555 M) Why did it work in 1997?

Risk Securitization CAS Special Interest Seminar David Na, FCAS, MAAA Deloitte & Touche, Bermuda