Swiss Re Investors, Inc. Z Z Issues Related to Insurance Securitization Dan Isaac Swiss Re Investors, Inc. Presented: 2000 CAS Special Interest Seminar October 16, 2000

Swiss Re Investors, Inc. Z Basis risk: The risk that the derivative security does not move precisely with the underlying “hedged” security; the risk arising from the uncertainty regarding the future basis. For an insurer using a securitization as a hedge, it is the risk that the “coverage” does not change precisely with the catastrophe experience of the insurer.

Swiss Re Investors, Inc. Z Three Basic Dimensions Basis of Coverage Trigger Mechanism Payment Type

Swiss Re Investors, Inc. Z Basis of Coverage Company’s Exposure Industry’s Exposure Event Parameters

Swiss Re Investors, Inc. Z Basis of Coverage Advantages: Limited Basis Risk Easiest to Model Benefits Directly Comparable to Other Reinsurance Treaties  Disadvantages: Highest Disclosure Standard Less Marketable Example: USAA CAT Bond (96-98) Company’s Exposure

Swiss Re Investors, Inc. Z Basis of Coverage Advantages: Manageable Basis Risk More Marketable Less Subject to Manipulation by Company Disadvantages: Harder to Model Benefits Fewer Benchmark Prices Example: CBOT Options Industry’s Exposure

Swiss Re Investors, Inc. Z Basis of Coverage Advantages: Little or No Disclosure Most Marketable No Reliance on “Black Boxes” Fastest Settlement  Disadvantages: Largest Basis Risk No Benchmark Prices Example: Parametric Re (97) Event Parameters

Swiss Re Investors, Inc. Z Trigger Mechanism Actual Results Modeled Results

Swiss Re Investors, Inc. Z Trigger Mechanism Advantages: Less Basis Risk Fits Well With Traditional Coverage Disadvantages: Harder to Extend to Multi-Year Can be “Gamed” Requires Long Development Period Example: CEA Bond (96) Actual Results

Swiss Re Investors, Inc. Z Trigger Mechanism Advantages: Faster Settlement Eliminates Model Bias Concern Easily Extended Disadvantages: Potentially Large Basis Risk May Fail Reinsurance and/or Hedge Accounting Rules Example: Golden Eagle Capital (99) Modeled Results

Swiss Re Investors, Inc. Z “Payment” Type Cash Equity Loan Line of Credit Surplus Notes Bond

Swiss Re Investors, Inc. Z “Payment” Type Advantages: Loss Payment Ends Contract Most Accounting Flexibility No Limitations on Recovery Disadvantages: Costly Cash

Swiss Re Investors, Inc. Z “Payment” Type Advantages: Cheaper Can Include Options to Further Lower Cost Usually Includes a Call Feature Disadvantages Only Protects Balance Sheet, not Income Statement Loss of Control Example: LaSalle Re CatEPut (97) Equity

Swiss Re Investors, Inc. Z “Payment” Type Advantages: Cheapest, by Far Disadvantages Doesn’t Improve Either Balance Sheet or Income Statement Coverage is Usually Limited/Eliminated for Largest Events Example: Nationwide Surplus Notes (95) Loan

Swiss Re Investors, Inc. Z Other Considerations Options Reinsurance Hedge Mark to Market Desired Accounting

Swiss Re Investors, Inc. Z Other Considerations Impacts Where benefits appear Underwriting Insurance Investment Income Balance Sheet When benefits appear Desired Accounting

Swiss Re Investors, Inc. Z FAS Accounting for Reinsurance Conditions for Reinsurance Accounting (Paragraph 9) Reasonably Possible that Reinsurer will Lose Money Reinsurer Assumes Substantial Insurance Risk Relates to Underlying Exposure

Swiss Re Investors, Inc. Z FAS Accounting for Reinsurance Conditions for Indemnity (Paragraph 62) Payments Vary Directly with Cedants Results Applies to Both Timing and Amount of Payments

Swiss Re Investors, Inc. Z ISTF - Insurance Securitization Task Force Formed in Conjunction with Protected Cell Legislation Focused on Defining Bounds of “Acceptable” Coverages Specifically, non-indemnity covers

Swiss Re Investors, Inc. Z Statistics Originally Reviewed Change in expected policyholder deficit (EPD) Change in Value at Risk (VaR) Change in standard deviation Coverage ratio Correlation

Swiss Re Investors, Inc. Z Statistics Proposed Change in Tail Value at Risk (TVaR) Melding of the EPD and VaR measures above.

Swiss Re Investors, Inc. Z Graphical Explanation 99% AD C H B F E G

Swiss Re Investors, Inc. Z Statistics Proposed Change in Tail Value at Risk (TVaR) Melding of the EPD and VaR measures above. Change in standard deviation (StD) Similar to the above measure except that it is modified to include the cost of the hedge and as a result measures the potential for investment gain.

Swiss Re Investors, Inc. Z Reduction of Risk Post-Hedge TailVaR Reduction in TailVaR1 Pre-Hedge TailVaR  Post-Hedge StdDev Reduction in StdDev1 Pre-Hedge StdDev 

Swiss Re Investors, Inc. Z Conclusions Based on the research completed we believe that if it can be shown that both, the change in TVaR and StD (Post- Hedge – Pre-Hedge), are less than 0 then the transaction is effective. If one or both record positive values then transaction has a high potential of producing returns that exceed the hedged exposure and should be considered an investment.

Swiss Re Investors, Inc. Z ISTF - Insurance Securitization Task Force Easier way: Go to CAS Website Click on RESEARCH (in right column) Under Committee/Task Force Projects and Web Sites, click on Work of the Index Securitization Task ForceWork of the Index Securitization Task Force

Swiss Re Investors, Inc. Z Bifurcation: The act of notionally splitting one contract into two (or more) equivalent contracts for accounting purposes. For insurance, this usually results in splitting a contract into an indemnity contract (which gets reinsurance accounting) and a “basis risk” contract (which gets mark to market accounting).

Swiss Re Investors, Inc. Z Bifurcation Industry Exposure Based Coverage can be Split into: An Approximate Company Based Coverage e.g. Adjust Attachment Point and Limit by Company’s Market Share in Coverage Region A “Basis Risk” Swap Company Pays Based on Their Own Results Company Receives Based on Industry’s Results

Swiss Re Investors, Inc. Z Other Considerations Options Reinsurance Swap Catastrophe Bond Transaction Format

Swiss Re Investors, Inc. Z Other Considerations Impacts  Cost and time of setting up transacations  Eligible investors  Security of recoverables Transaction Format: