1. CARe Seminar on Reinsurance Marriott Inner Harbor, Baltimore, MD
Economic Rationale of Combining (Re)Insurance with Financial Risk Hedges
CARe Seminar on Reinsurance
Marriott Inner Harbor, Baltimore, MD
June 6-8, 1999
Presented by
David Koegel

2. Separate vs. Blended Coverage Triggers Conditional Variation
Dual Risk Approach
Separate vs. Blended Coverage Triggers
Financial
Loss
Insurance
Combined Risk,
Dual Trigger or
Conditional Variation
Coverage
Insurance
Loss
Financial
Loss
(Re)Insurance
Policy
Derivative
Instrument
Blended
Retention
Separate
Retention

3. Dual Risk Approach
Importance of Preserving Capital Under Simultaneous Occurrence of Insurance and Financial Events
Catastrophe Loss (Insurance Event)
Forced Realization of Capital Loss
Asset Price Decline (Financial Event)

4. Distinction Between Combined Risk, Dual Trigger and Conditional Variation Coverages
Coverage responds if the blended retention (sum of retentions on previously purchased Individual Risk coverage) is exceeded due to occurrence of either or both insurance and financial events (i.e., higher expected retained loss per individual risk)
Dual Trigger
Coverage responds if the blended retention is exceeded due to occurrence of both insurance and financial events (i.e, significantly higher expected retained aggregate losses)
Conditional Variation
Coverage responds if the blended retention is exceeded due to occurrence of the insurance event, but the limit varies based on movements in a specified market variable (e.g., interest rate)

5. Combined Risk Coverage
Example:
Effective July 1, 1999 through June 30, 2000.
Two Individual Risk covers of up to $10,000,000 losses excess of $1,000,000 for each of:
(a) insured property damage; and
(b) a drop in S&P 500 Equity Index.
ROL for Property Cat cover = 10%; price = $1,000,000.
ROL for S&P 500 Index put option spread = 20%;
price = $2,000,000. [e.g., trade one thousand 1300/1200 spreads]

6. Combined Risk Coverage (cont’d)
Example (cont’d):
Replace Individual Risk covers with Combined Risk coverage for (a) and (b) of up to $20,000,000 losses in excess of $2,000,000
Coverage triggered by losses under either or both (a) & (b)
Assume losses equal to full limit + retention
(i.e., $11,000,000 under each coverage section).
Assuming no correlation, pricing is:
[(10% x (1 - 20%) + (20% x (1 - 10%))] x ($11,000,000 - $2,000,000) +
[10% x 20% x ($22,000,000 - $2,000,000)] = $2,740,000.

7. Combined Risk Coverage (cont’d)
Example (cont’d):
Net price reduction of $260,000 (roughly 9% savings relative to $3,000,000 premium for two separate covers) due to increase in retention.
Appropriate when company is willing to keep $2,000,000 of losses and allocates retention to different risks. Get substantially the same protection at a discounted price.

8. Dual Trigger Coverage Example:
Effective July 1, 1999 through June 30, 2000.
Up to $20,000,000 for catastrophe losses in excess of $2,000,000
Contingent on S&P 500 Index being below July 1, value as of June 30, 2000 close.

9. Dual Trigger Coverage (cont’d)
Example (cont’d):
ROL for S&P 500 Index put option spread = 20%;
price = $2,000,000.
ROL for Cat cover = 10%; price = $1,000,000.
Assuming no correlation: Dual Trigger Price around
20% x 10% x $20,000,000 = $400,000 (roughly 13% of the price for two separate covers, i.e., 2% ROL Vs. 15% ROL)
Rational approach if the company ordinarily has S&P 500 equity gains that can readily be used to offset cat losses.
Dual Trigger coverage is extremely valuable if such gains
are not available for offset when cat event does occur.

10. Other Examples of Dual Triggers
Electrical Utility:
shutdown of the plant
price of electricity above a certain strike
rainfall exceeding a specified number of inches
extra maintenance expenses associated with a storm
Hospital:
medical malpractice claims exceeding policy limits
negative returns on the equity portfolio
Insurance Company:
property catastrophe loss exceeding a specified amount

11. Example of a Triple Trigger
Electrical Utility:
boiler breakdown
price of electricity above a certain strike price
number of days during which temperature exceeds a certain threshold

12. Conditional Variation Coverage
Fixed upfront premium
Limit varies by formula based on a constant value multiplied by movements in an underlying market variable such as a stock price, interest rate or commodity price
Recoverables available only when event occurs and market variable movement is in a direction unfavorable to buyer as stipulated in the contract (e.g., a catastrophe occurs during a rise in interest rates)
Optimal efficiency achieved as coverage vacillates during the term on an as needed basis

13. Review of Coverage Types
Alternative Approaches to Combining
(Re)Insurance with Financial Risk Hedges
Combined Risk
Dual Trigger
Conditional Variation

14. Funded Approaches to Dual Trigger Coverage
Contingent Surplus Replenishment with Recourse
Statutory:
Surplus Notes
Unearned Premium Reserve Transfers
Loss Reserve (Portfolio) Transfers
Statutory and GAAP:
Equity Puts
Multi-Year Aggregate Stop Loss Covers
Reverse Securitizations

15. Summary Alternative Approaches to Combining
(Re)Insurance with Financial Risk Hedges
Combined Risk
Dual Trigger
Conditional Variation
Funded or Finite Risk