Presented to Annual Congress of Actuaries June 21, 2007 Paris France

Outline Introduction to Securitization Discuss the Drivers of Demand for Securitization Market and regulatory factors A changing business model Quick Update of Current Market Conditions

Introduction Securitization - a mechanism whereby contingent and deterministically scheduled cash flow streams arising out of a transaction are unbundled and traded as separate financial instruments that appeal to different classes of investors. Important elements Cash flows traditionally were held on balance sheet or earned/paid over time Cash flows are predictable and/or can be modeled Assets and risk are usually transferred between parties Assets associated with the transaction must be bankruptcy remote Accomplished using Special Purpose Entities (SPE’s) “brain dead”

Simple Example Option 1 – Firm wants to purchase an asset Borrow money from the bank Book loan as liability on balance sheet Repay principal and interest over time Claim interest expense for tax purposes Purchase asset Book asset on balance sheet Depreciate asset over working lifetime Face risk asset loses or gains value over time

Securitization Option Option 2 – Synthetic Lease Firm establishes bankruptcy remote SPE SPE raises funds from investors and purchases asset SPE leases asset to the firm in return for lease payments SPE can borrow funds at lower rates than the firm – why? At the end of the lease, firm can decide to Renew the lease Purchase property for pre-determined price, or Force the SPE to sell the property Advantages Firms faces risk of loss or gain at the time of sale so firm is considered “virtual owner” Firm claims depreciation and interest expenses for tax purposes As long as lease payments are less than some threshold values of the asset fair value, there is no asset (and therefore liability) on the balance sheet for accounting purposes.

Sources of Demand for Securitization Efficient Demand Demand that would exist in the absence of serious market imperfections Inefficient demand Driven by “RRATs” – Regulatory, Rating agency, Accounting and Tax factors

Why Securitization Creates Value Generally Efficient Demand Lower cost of funds Source of liquidity Diversify funding sources Off-balance sheet assets and liabilities Accelerate earnings

Why Securitization Creates Value for Insurers Efficient Demand Traditionally, investing in insurance risks was possible primarily by buying insurer stocks But what drives insurer stocks? Underwriting risks (mortality, accident rates) Investment risks Regulatory risks Agency costs and mismanagement risks Securitization creates value by creating “pure play” or primitive securities that are removed from the usual firm-wide risks facing insurers Enable investors to improve portfolio efficiency To the extent transparency is achieved, costs of informational asymmetries are reduced Pure costs of securitized risk transfer may be Less than cost of capital of an insurer Less than cost of traditional hedging & financing mechanisms such as reinsurance

“RATs” Demand for New Instruments Tax motives Minimization of taxes due to convexity of tax schedules and “loop-holes” Regulatory motives Compliance with regulatory rules such as risk-based capital Accounting motives E.g., securitizing deferred acquisition expenses Improve regulatory balance sheet Achieve higher financial ratings “Cleansing” financial statements prior to entering the mergers & acquisitions market

Changing Business Models Warehousing vs. Intermediation Traditional roles Investment banking – intermediaries Insurance/reinsurance – risk warehousers

Traditional Insurer Model Risk-Warehousing and Risk-Bearing Risk Warehouse Retain Liabilities Risk-Bearing Equity Capital Hedging Firms and PH’s Premium Contingent Payoff Capital Market Capital Dividends Reinsurer Premium Contingent Payment

Why Risk Warehouses Developed Insurance is characterized by informational asymmetries Insurer is “opaque” Debt claimant cannot judge overall risk exposure, reserve adequacy, etc. Opaqueness is partially mitigated if insurer holds equity & diversifies over a wide range of risks Reduces income volatility and solvency risk, but also Helps assure debt claimants that probability of bad outcomes has been minimized Requires insurer to keep risks on balance-sheet Opacity and market experience generate private information for the (re)insurer E.g., ability to estimate insurance claims distributions Information on portfolios and underwriting quality of specific clients (what did we call this?) Opacity creates “economic rents”

Investment Bank Model Risk Intermediation Risk Intermediary: (Investment Bank) Hedge Premium Contingent Hedge Payoff Owners Capital/ Expertise Compensation Equity Capital Capital Market Risk-Bearing Contingent Payment Risk Premium Hedging Firms

Combining the Intermediary and Warehouse Model Warehouse Retain Liabilities Risk-Bearing Equity Capital Hedging Firms and PH’s Premium Contingent Payoff Capital Market Capital Dividends Reinsurer Premium Contingent Payment Intermediary Securitize Liabilities Capital Market Risk Premium Contingent Payment

Evolving Towards Securitization Securitization forces the firm to identify where the value chain creates the most value Occurs when reduced financing or hedging costs more than offset the loss of economic rents from reducing opacity Securitization leverages the insurers/reinsurer’s information advantage – but for who? Insurer/Reinsurer’s new role Originate pools of risks Underwrite to create viable tranches Repackage for sale in securities markets Increased recognition equity capital is costly BEYOND systematic risk costs Improvements in capital allocation methods Solvency II

ILS Prices Declining Over Time (At least they were) Source: Lane (2006)

Catastrophe Bond Issues: 1996 – 2006* * - Through November 2006 Source: Goldman Sachs (2006) and Swiss Re (2006). Total: $14 billion

2004* (USD 4 billion market ) 1999 (USD 1 billion market) Primary Insurer 30% Money Manager 30% Dedicated Cat Fund 5% Reinsurer 25% Hedge Fund 5% Bank 5% Primary Insurer 3% Money Manager 40% Dedicated Cat Fund 33% Reinsurer 4% Hedge Fund 16% Bank 4% Who buys these bonds? Bill Dubinsky August 2004 ARIA Annual Meeting *As of July The Dedicated Cat Fund segment has increased from 5% to 33% The Money Manager segment has increased from 30% to 40%

Design Consideration: The Triggering Event Examples of Trigger Indemnity trigger Loss experience of one insurer Modeled Loss Industry trigger Industry loss warranties The PCS call options traded on the CBOT Parametric index Pure index Magnitude of earthquake Windspeed of hurricane Multiple parameters Payoff is a function of various transparent parameters Indemnity Basis Risk to Sponsor Transparency to Investor Modeled Loss Industry Index Parametric

What Else Can Be Securitized? Life Insurer Balance Sheet Assets Traded assets Long-term Short-term Non-traded assets Policy acquisition costs Other receivables Other non-traded Liabilities Policy reserves Life insurance Annuity Premium reserves Equity capital

What Else Can Be Securitized? Life Insurance Cash Flows Inflows Premiums Annuity considerations Investment income Investment sales and maturities Fee income (e.g., asset management fees on variable products) Outflows Policy death benefits Annuity payments Surrenders (disintermediation) Expense payments Origination costs Ongoing costs Capital expenditures Taxes

Conclusions Vast amounts of assets and liabilities remain “on balance sheet” in the insurance industry To realize full potential for securitization Overcome informational opacities Develop better indices for index linked products Reduce regulatory obstacles Educate insurers and investors Tremendous potential to change insurance industry business model

Conclusions II Important to reduce costs of informational asymmetries May require insurers to sacrifice some “private information” Asymmetry costs can be mitigated by structuring Informationally sensitive tranches that appeal to investors with information advantages Informationally insensitive tranches for less well informed investors Development of a public market needed to achieve full potential Solvency II will further drive demand to “accelerate” the balance sheet