Using IFEX Event Linked Futures Imperial College, Tanaka Business School Workshop on Insurance-linked Securities Friday Oct

2 Why IFEX Event Linked Futures? HURRICANE KATRINA

3 What IFEX Can Do For You IFEX EVENT LINKED FUTURES GIVE IMPROVED ACCESS TO THE REINSURANCE ASSET CLASS It’s only necessary to open an account with a clearing member of the Chicago Climate Futures Exchange Positions can be continuously adjusted – ‘dynamic reinsurance hedging’ when liquidity develops Forward contracting is possible on IFEX in insurance risk – effectively impossible in the insurance industry otherwise

4 What Are IFEX Event Linked Futures IFEX EVENT LINKED FUTURES ARE EXCHANGE TRADED BINARY FUTURES CONTRACTS MODELLED ON ILW REINSURANCE POLICIES Contracts for Difference Although Event Linked Futures (ELFs) are similar to ILW (Industry Loss Warranty) reinsurance policies, they are contracts for difference and NOT reinsurance policies as they are not contracts of indemnity Futures ELFs give the right to receive payments when insured losses caused by specific events reach pre-specified amounts during a particular calendar year risk period Binary ELFs are binary or digital contracts Event Based ELFs are currently listed as First, Second, Third and Fourth Event contracts for 2008 and 2009 Exchange Traded and Cleared Trading in ELFs is exchange traded and cleared. ELFs are margined and guaranteed by the Clearing Corporation

5 Event Linked Futures: US T&P, Florida and US Gulf Coast IFEX EVENT LINKED FUTURES: US T&P TROPICAL WIND IFEX Event Linked Futures are triggered by insured losses as calculated by Property Claims Services part of the Insurance Services Organisation The covered territories are US Territories and Possessions (T&P), i.e.: –The 50 US states (including Hawaii and Alaska) –Washington DC –Puerto Rico and the US Virgin Islands The Loss Trigger Levels are for: –$10bn, $20bn, $30bn, $40bn and $50bn IFEX ELFs: FLORIDA AND US GULF COAST IFEX Florida ELF covers losses in the state of Florida IFEX US Gulf Coast ELF covers losses in Alabama, Mississippi, Louisiana and Texas IFEX Florida and Gulf Coast ELFs have the same Loss Trigger Levels and event structure as the main IFEX US Tropical Wind contracts.

6 IFEX Event Linked Futures are Event Based EVENT DEFINITION The definition of event followed by the IFEX Event Linked Futures contracts follows that of conventional ILW reinsurance policies Each Loss Trigger Level represents a discrete ELF contract For example, the 2008 First Event $10bn Loss Trigger Level (LTL) represents: ‘The first tropical wind catastrophe in 2008 causing insured losses in excess of $10bn’ Thus a second 2008 tropical wind catastrophe causing insured losses in excess of $20bn would trigger the Second Event $10bn LTL and the First Event $20bn LTL IFEX currently trades First, Second, Third and Fourth Event 2008 and 2009 contracts

7 IFEX ELF Contracts are Margined (1) IFEX ELF MARGIN IFEX ELF contracts are margined as futures contracts Because of the margining system, the security of ELF contracts is excellent Margin is of two types: – Variation Margin –Maintenance Margin Variation Margin reflects day-by-day the mark to market value of the contract. If the price of a contract falls the buyer pays and the seller receives variation margin The protection buyer pays the premium through the erosion of the value of the contract if there is no claim. The protection seller receives the premium from the fall in the erosion of the value of the contract if there is no claim If a LTL is triggered (a claim made) variation margin will flow to the full value of the contract from the seller to the buyer

8 IFEX ELF Contracts are Margined (2) Maintenance Margin is payable either by accumulated variation margin and/or by deposits of cash, high grade fixed interest securities or Letters of Credit Before and after the North Atlantic (and Eastern Pacific) hurricane season (June 1 – November 30) Maintenance Margin is $200 per contract (2% of its notional value or ‘limit’) for buyers and $800 for sellers During the hurricane season Maintenance Margin increases to $600 for the buyer and $2,400 for the seller If a hurricane or tropical storm poses an ‘moderate’ or ‘severe’ threat margin increases as follows: –Moderate Threat: Buyer $3,000 and Seller $3,000 –Severe Threat: Buyer $8,000 and Seller $2,000 Maintenance Margin requirements are assessed for ‘moderate’ or ‘severe’ on the $10bn and $20bn LTLs and the $30bn, $40bn and $50bn LTLs separately

9 Trading Platform, Clearing, Data and Ownership The trading platform is provided by the Chicago Climate Futures Exchange The central counter-party is the Clearing Corporation IFEX is a subsidiary of Climate Exchange PLC (CLE)(AIM quoted). Other subsidiaries include the European Climate Exchange, the Chicago Climate Exchange and the Chicago Climate Futures Exchange Property Claims Services (PCS), part of Insurance Services Organisation, supplies estimates of insurance industry losses PCS is the benchmark provider of information supplied to the property casualty insurance industry

10 Types of Trading IFEX OFFERS TYPES OF TRADING PREVIOUSLY IMPOSSIBLE OR INCONVENIENT OR EXPENSIVE Insurance price risk trading before the hurricane season – January of one year to June/July inclusive of the following year Insurance risk trading during the hurricane season - June to November inclusive significant risk during (August to October inclusive) ‘Live cat’ trading when a tropical storm or hurricane is running ‘Dead cat’ trading after a significant hurricane has made landfall and whether it will hit a particular Loss Trigger Level

11 Trading so Far….. (1) IFEX ELF CONTRACTS WERE FIRST LISTED IN SEPTEMBER 2007 Over $76m of limit equivalent exchanged – Open interest around $45m of limit

12 Trading So Far….. (2) PARTICIPANTS IN THE PUBLIC DOMAIN –Deutsche Bank –Swiss Re –Nephila –BRIT –Hiscox Other participants actual and potential include: –Hedge funds –Investment banks –Chicago locals / Lloyd’s investors –Two more Lloyd’s managing agencies

13 Trading so Far….. (3) OPEN INTEREST: 2008 Contracts

14 Trading so far..… (4) OPEN INTEREST 2009 CONTRACTS

15 Prices (1)

16 Prices (2) PRICES

17 Prices (3) PRICES

18 ‘Dead Cat’ Trading on Ike DEAD CAT TRADING ON IKE

19 Trading Strategies: Price Trading THE REINSURANCE PRICE ASSET CLASS IFEX ELFs traded out of the (effective) hurricane season (August to October inclusive) form a separate and new reinsurance price risk asset class. Prices can be volatile – after KRW prices US wind ILW prices tripled in the space of six months The price of the IFEX 2008 First Event US TW $10bn moved up from 33.6% RoL equivalent in late September 2007 to 39.95% RoL equivalent at the end of July 2007 – and to 41.6% RoL in mid-August

20 Trading Strategies: Carrying Insurance Risk CARRYING INSURANCE RISK THE EASY WAY IEX ELF contracts can be used to carry insurance risk in a cheap and convenient way – just open a account with a Chicago Climate Futures Exchange clearing member (FCM). There is no need to form an insurance or reinsurance company. Positions can be unwound and traded – ‘dynamic reinsurance’ hedging Positions are capital efficient for both longs and shorts – margin is low until there is a threat of a LTL being triggered

21 Trading Strategies: Hedging HEDGING CAN BE BOTH LONG AND SHORT Long positions can be used to manage the US wind exposures of: Cat bonds, cat bond portfolios, sidecars, Lloyd’s Special Purpose Syndicates, portfolios of reinsurance shares Short positions can be used to lock in attractive renewal rates in advance – a reinsurance version of the classic short hedge. ELF prices may be proxies for (re)insurance prices generally

22 Trading Strategies: Pre-positioning Following a Super Catastrophes IFEX TROPICAL WIND EVENT LINKED FUTURES CAN BE USED TO HEDGE AGAINST ANY CATASTROPHE THAT CAUSES SERIOUS LOSS TO THE INTERNATIONAL INSURANCE INDUSTRY Any catastrophe which causes major losses to the international insurance industry will lead to a very large increase in the price of US Tropical Wind protections for the subsequent year Thus a participant seeking protection for such a super catastrophe would buy the 2009 US Tropical Wind ELF for the $50bn Loss Trigger Level Should such a very large (perhaps $80bn insured loss) super catastrophe occur, the price of the $50bn 2009 ELF might increase from, say, a Rate on Line equivalent of 8% to 24% In the absence of a major catastrophe, the cost of the hedge might be limited to the bid-offer spread, or possibly negative if the price of the 2009 ELFs rose (perhaps as the result of a smaller catastrophe) IFEX ELFs can be used to hedge against any super-catastrophe not just US windstorms

23 ‘Reinsurance Security’ ‘REINSURANCE SECURITY’ OF IFEX CONTRACTS IFEX ELF contracts are traded on the Chicago Climate Futures Exchange (CCFE). They are fully margined by the Clearing Corporation and marked to market twice daily. Accounts are segregated and clearing members are often large banks or their subsidiaries The plans to move the CDS market on exchange point to the security and transparency offered by Clearing Corporation and CCFE ‘Reinsurance security’ is thus excellent

24 Summary IFEX ELF CONTRACTS ARE AN IMPORTANT NEW MEANS OF CARRYING AND MANAGING INSURANCE RISK ELF contracts can be used to: manage US Tropical Wind exposures of insurance portfolios hedge US Tropical Wind cat exposures hedge against non-US wind super catastrophes that severely affect insurance and reinsurance markets increase insurance capital to exploit a hard market following a major catastrophe ELF contracts offer: the equivalent of excellent reinsurance security

25 CONTACTS Neil Eckert T: E: Robert Miller T: E: Website: IFEX Hasilwood House, 62 Bishopsgate, LONDON EC2N 4AW

26 Climate Exchange PLC Group of Companies Climate Exchange Plc is a holding company whose subsidiaries are principally engaged in owning, operating and developing exchanges to facilitate trading in environmental financial instruments including emissions reduction credits in both voluntary and mandatory markets. The two main businesses are the Chicago Climate Exchange (CCX) which operates a voluntary but legally binding cap and trade system including an exchange for CO2 emissions as well as SOx and NOx contracts in the US and internationally, and the European Climate Exchange (ECX) which operates an exchange focussed on compliance certificates for the mandatory European Emissions Trading Scheme. CCX is a financial institution whose objectives are to apply financial innovation and incentives to advance social, environmental and economic goals. CCX is the world's first and North America's only legally binding rules-based greenhouse gas emissions allowance trading system, as well as the world's only global system for emissions trading based on all six greenhouse gases. CCX members are leaders in greenhouse gas management and represent all sectors of the global economy, as well as public sector innovators. Reductions achieved through CCX are the only reductions in North America being achieved through a legally binding compliance regime, providing independent third party verification provided by NASD and price transparency. The founder, Chairman and CEO of CCX is economist and financial innovator Dr. Richard L. Sandor, who was named a Hero of the Planet by Time magazine for his founding of CCX. For a full list of CCX members, daily prices and other exchange information, see CCX, a US corporation, launched its trading platform in In 2005, CCX launched the European Climate Exchange (ECX), now the leading exchange operating in the European Union Emissions Trading Scheme. CCX also launched the Chicago Climate Futures Exchange (CCFE), a CFTC-regulated futures exchange for U.S. SO2 allowances and U.S. NOx Ozone Season allowances, the world's first environmental derivatives exchange. Since 2006, CCX, ECX and CCFE have been owned by Climate Exchange Plc, a publicly traded company listed on the AIM of the London Stock Exchange. The European Climate Exchange (ECX) manages product development and marketing of Carbon Financial Instruments (CFI) futures and options contracts on CO2 EU allowances traded under the EU Emissions Trading Scheme. ECX CFI contracts are listed and traded on the ICE Futures electronic platform, offering a central marketplace for emissions trading in Europe with standard contracts and clearing guarantees provided by LCH.Clearnet. ECX/ ICE Futures is the most liquid, pan-European Exchange for carbon emissions trading. More than 80 leading global businesses have signed up for membership to trade ECX products. In addition, several hundred clients can access the market via banks and brokers.

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