Casualty Loss Reserve Seminar September 18, 2000 Minneapolis, MN Introduction to the Alternative Risk Transfer Market

Presenters André Lefebvre, FCAS, MAAA – Winterthur International – Waltham, MA Barbara Russo – Winterthur International – New York, NY Charlie Woodman, CPA – Marsh Risk Finance – Atlanta, GA

Agenda Brief Overview of CAS Activities Overview of the ART Market Definitions of ART Approaches Examples of some ART Transactions Some Actuarial Issues

CAS Task Force on Nontraditional Practice Areas Created in Purpose was to formulate recommendations as to how the CAS can better support its members that are currently working, or wish to work in the future, in nontraditional practices areas. Issued report to CAS Board of Directors in late 1999.

CAS Task Force on Nontraditional Practice Areas One of the recommendations was that the CAS should expand its education and research functions to support new, priority practice areas much as it did with DFA several years ago and it should concentrate on developing specific skill sets that have general applicability to a wide-range of practice areas, including Enterprise Risk Management.

CAS Advisory Committee on Enterprise Risk Management Established earlier this year as a result of the recommendation from the Task Force on Nontraditional Practice Areas. Purpose is to identify research and education that the CAS should undertake in the area of Enterprise Risk Management and recommend methods, priorities, and timetables to the Executive Council for implementing that research and education.

What is Enterprise Risk Management? Proposed working definition of ERM for CAS purposes: – “ERM is the discipline by which organizations in all industries assess, control, exploit, finance and monitor risks from all sources for the purpose of increasing the organization’s short- and long-term value to its stakeholders.”

What is Alternative Risk Transfer? Risk Financing Solution to ERM Definition of ART

It is universally agreed that there is no universal definition for the alternative risk marketplace or for alternative risk transfer.

Evolving Definition Originally, corporate customers who chose to finance substantial portions of their P&C risks through their own balance sheets. Historical ART tools: – Self-Insurance – Captives – Risk Retention Groups – Alternative Financing Facilities

Evolving Definition Hard market of mid-1980’s brought serious shortages in coverage and affordability problems. Financial reinsurance and capital markets products were developed in response to the need for significant risk-bearing capacity in the insurance industry.

Working Definition Risk financing methods applied to new and traditional risks which differ from classic risk transfer approaches. Risks other than those traditionally insured by the insurance industry, financed using insurance tools and techniques.

Growth of Alternative Market Overall domestic commercial market growth since mid -1980’s: 4% Traditional commercial market share: 3% Alternative market share: more than 6% annual compound rate of growth Source: A.M. Best

Market Scope

What’s Behind the Growth? Historically, reasons were defensive: – Lower and more manageable insurance costs. – More control over claims. – Greater incentives to perform effective risk management. These reasons still underlie clients decisions to adopt classic ART approaches.

Growth Continues... More recently, reasons have become more strategic: – Improved financial and risk management. – Customized insurance programs. – Direct access to worldwide reinsurance market. – Greater control over loss prevention.

Continuing Evolution Supply shifts: – Abundance of capital seeking effective deployment. – Convergence creating new tools to address risk. – Slow growth in traditional lines driving search for profit. Demand shifts: – Predictable earnings lead to higher stock market valuations. – Changing standards of corporate governance call for identification and mitigation of the corporation’s significant risks.

Organizational Change Chief Risk Officer – Identify, analyze, and quantify risks across corporation. – Determine optimum means of mitigating, absorbing, and transferring risk.

Chief Risk Officer CRO looks at risks formerly handled in separate silos: – Insurance - Hazard or P/C Risks – Treasury - Financial Risks – Audit - Compliance Risks – Trading - Market Risks

Drivers Behind CRO Approach Unforgiving stock market where missed earnings projections equate to significant drops in stock prices. Regulators have eliminated special accounting methods formerly used to manage earnings. FAS 133 complicates the hedging process.

Change Brings Opportunity Looking at risk on a broader basis will lead to standardization of tools and methods used to quantify risk. Overlap and sharing of knowledge and skills between actuaries and other financial quantitative analysts.

ART Approaches Multi-Line Multi-Year Integrated Risk Volatility Smoothing Securitization Credit Enhancement Project Finance

Multi-Line Multi-Year Definition: Aggregation of insurance lines usually sold individually into a single policy and spanning multiple years.

Multi-Line Multi-Year Multi-Line aspect allows Customers to purchase “less” coverage with more flexible terms. Multi-Year aspect provides administrative efficiency. Historically not very successful because: – Soft Insurance Market – Complex Transaction

Integrated Risk Similar to Multi-Line Multi-Year concept, but with the inclusion of other risks, such as: – Business Risks – Credit Risks – Liquidity Risks – Market or Financial Risks

Volatility Smoothing Definition: Management of fluctuating costs through the use of an off-balance sheet financing vehicle in order to achieve budget predictability.

Volatility Smoothing Companies have historically employed hedging strategies (where available) to manage volatile exposures. Hedging assumes the existence of an active, efficient market with buyers and sellers of risk. Insurance can be used to transfer risks where markets are either illiquid or nonexistent.

Securitization Definition: Transferring of Underwriting Risks to the Capital Markets through the creation and issuance of Financial Securities.

CAT Bonds Traditional Reinsurance Market can be characterized by cyclical pricing & fluctuating capacity. Some companies have turned to Capital Markets for pricing efficiency & capacity.

Credit Enhancement Definition: Credit Risk is the risk of default by a counterparty. This risk can be mitigated by the use of Credit Enhancement arrangements whereby the credit risk is “enhanced” by the substitution of a more credit-worthy party for the lesser one.

Types of Credit Enhancement Individual Counterparty Collateralized Bond Obligations (CBO) Collateralized Mortgage Obligations (CMO)

Project Finance Definition: Financing structure where the assets and the expected cash flow of a project are used to secure and repay the lenders. The credit risk facing the lenders can be mitigated by the substitution of a more credit-worthy party for the lesser one (type of Credit Enhancement arrangement).

Some Actuarial Issues Pricing – Moral Hazard/Alignment of Interest – Data/Modeling – Correlation Reserving – Extension of Pricing Capital Allocation – Multi-Year