Z Securitization Stephen Philbrick © 1999, Swiss Re Investors All Rights Reserved.

Z 1 Swiss Re Investors Note I’ve added commentary to the notes section of most slides. If you are viewing this as a slide show, you will miss the commentary. Switch to the notes page view to see the commentary

Z 2 Swiss Re Investors Roadmap Risk Management Response to Loss Major Types of Securitization More detail on Bonds AAA activity regarding accounting treatment

Z 3 Swiss Re Investors Risk Management Response to Loss Capital (“I’ll pay the loss”) Debt (“You pay the loss, I’ll pay you back”)  Contingent Surplus Notes Equity (“You pay the loss, I’ll give you a piece of the company”)  Contingent Equity (e.g. CatEPuts SM ) Payment (“You pay the loss”)  Reinsurance  Exchange-Traded Catastrophe Options  Bonds

Z 4 Swiss Re Investors Definition “Insurance securitization” can be defined as the transferring of underwriting risks to the capital markets through the creation and issuance of financial securities. In other words, securitization involves a transfer of risk outside the industry

Z 5 Swiss Re Investors Critical Elements The transformation of underwriting cash flows into tradable financial securities. The transfer of underwriting risks to the capital markets through the trading of those securities.

Z 6 Swiss Re Investors Securitization Responses Capital Debt  Contingent Surplus Notes Equity  Contingent Equity (e.g. CatEPuts SM ) Payment Reinsurance  Exchange-Traded Catastrophe Options  Bonds

Z 7 Swiss Re Investors History The concept of “insurance securitization” originated with an article published some twenty-five years ago, in which insurance derivatives (specifically, reinsurance futures) were first speculated upon. * *[Richard W. Gorvett, Insurance Securitization : The Development Of A New Asset Class, 1999 Casualty Actuarial Society “Securitization of Risk”Discussion Paper Program]

Z 8 Swiss Re Investors Why Now? 1) Recent catastrophe experience Hurricane Andrew in 1992 Northridge earthquake in ) Capital market developments 3) Structure of the insurance industry

Z 9 Swiss Re Investors Capital Is current level (  350 Dec 98) too high or too low Yes Too high, because industry return on surplus falls below desired levels Too low, because surplus is not high enough to cover major catastrophes and have enough for other exposures

Z 1010 Swiss Re Investors Bond Securitization Indemnity - Based upon actual losses Parametric - Based upon an index

Z 1 Swiss Re Investors Comparison Basis RiskNoYes Disclosure RequirementsExtensiveModest Claim Development PeriodRequiredNot Required Co-insuranceRequiredNot Required IndemnityParametric

Z 1212 Swiss Re Investors 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 catastrophe options as a hedge, it is the risk that the cat option position does not change precisely with the catastrophe experience of the insurer.

Z 1313 Swiss Re Investors Reinsurance - free of Basis Risk? No! Co-insurance and Reinstatement premiums (arguable) Industry Loss Warranties (ILW)

Z 1414 Swiss Re Investors Why is basis risk important? Reinsurance enjoys favorable statutory accounting treatment. Securitization does not. Consequently, securitization normally occurs off-shore. Model law legislation in progress to allow favorable accounting treatment for certain types of securitization

Z 1515 Swiss Re Investors Protected-cell legislation Will apply to “Indemnity trigger” transactions Will apply to “non-indemnity trigger” transactions if they meet a hedging effectiveness requirement Goal - avoid providing reinsurance accounting treatment to pure investments

Z 1616 Swiss Re Investors 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

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Z 1919 Bibliography Example Bibliography Listing Borden, Sara and Asani Sarkar, 1998, "Securitizing Property Catastrophe Risk",

Z 2020 Swiss Re Investors Statistics Originally Reviewed Change in expected policyholder deficit (EPD) Change in Value at Risk (VaR) Change in standard deviation Coverage ratio Correlation

Z 2121 Swiss Re Investors Statistics Proposed Change in Tail Value at Risk (TVaR) – this is a melding of the EPD and VaR measures above. Change in standard deviation (StD) – this is 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.

Z 2 Swiss Re Investors Reduction of Risk Post-Hedge TailVaR Reduction in TailVaR1 Pre-Hedge TailVaR  Post-Hedge StdDev Reduction in StdDev1 Pre-Hedge StdDev 

Z 2323 Swiss Re Investors Graphical Explanation 99% AD C H B F E G

Z 2424 Swiss Re Investors 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.