1. Canadian Institute of Actuaries L’Institut canadien des actuaires
2008 Seminar for the Appointed Actuary
Colloque pour l’actuaire désigné 2008

2. Reinsurance: cat bond process and risk management
Pierre G. Laurin, FCAS, FCIA, MAAA September 25, 2008 Montréal (QC)

3. Contents Risk management issues Index linked securities Cat bond
Side-car market
PCS index trigger
ILS over time
Trends

4. Risk management issues
Reinsurance is a source of contingent capital
Reduction of volatility of results on a excess of loss basis
Reduction of actual capital on a quota share basis
Same concepts for primary insurers as for reinsurers who use retro-cessions
Need to ensure quality of such capital

5. Canadian context
Source: AM Best data

6. Risk management issues
Availability of reinsurance
Increase quality of capital
Diversification of capital sources
Cash flow issues
Multi year covers

7. Securitised cat cover Cat Bond Collaterised layers Traditional
Reinsurance
Layers
Retention

8. Historical context Index linked securities started in 1992
Response to risk management issues
Alternative to hard reinsurance markets
Need to find alternative sources of capital

9. Development Purpose: Increase reinsurance capacity
Reduce earnings volatility
Reduce capital volatility
Diversification of source of capital
Overall:
Increasingly important strategic component for insurers & reinsurers
Alternative to traditional reinsurance entities for private investors
Can be customized to handle any type of insurance risk (e.g, workers comp.)

10. Index linked securities
Cat bonds
Indemnity
Parametric
Hybrids
Side cars
PCS index trigger

11. Overview of Nat Cat Trigger Types
Source: Swiss Re

12. Cat bonds characteristics
One sponsor
Event based
Only modeled exposures are covered
Fully collaterised
Non-indemnity cover (trigger based)
Regular reset of attachment point
Strict disbursements of proceeds
High basis risk
High yield

13. Catastrophe bonds – basic structure (diagram)
Interest = LIBOR + Premiums
Sponsor/ Originator
Insurance Company
Premiums
Issuer
Bankruptcy Remote Special Purpose Vehicle
Investors
(Qualified Institutional Buyers)
Principal at maturity and liquidation
Reinsurance Contract
Note Proceeds/Funding
Remaining funds at maturity
Note
Proceeds
LIBOR
Trust Account
Highly Rated Short-Term Investments
LIBOR
Swap
Counterparty
Investment Income

14. Securitised cat cover Attachment point reset based on
pre-determined excedence probability
Cat Bond
Collaterised layers
Traditional
Reinsurance
Layers
Retention

15. Reset of attachment point
Timing is essential
Renewal dates should be coordinated with traditional program
Pre-event
Initial attachment point determined prior renewal
Final attachment point determined mid-year
Potential gap in coverage
Post-event
Attachment point revised depending on date of event

16. Compared to traditional reinsurance
Utilizes normal reinsurance agreements
Typically excess of loss
Fully collaterised
Different source of capital
Defined perils coverage
Consolidation issues

17. Stakeholder perspectives
Debt investor
Relatively higher yield than corporate bonds
Ability to customize terms & conditions
Clearly defined risk categories & parameters
Strong diversification of investments

18. Stakeholder perspectives
Sponsor perspective
Addresses risk management issues
Diversification of capital
Collaterisation of cover
Certainty of coverage
Multi year cover

19. Cat bonds Indemnity Based on company actual losses No basis risk
Paid as losses get paid
Parametric
Trigger on modeled data
Higher basis risk
Can be paid immediately

20. Cat bonds requirements
High level of sophistication in reinsurance thought process
High investment of time
Typically cost more than traditional reinsurance
Good medium to address risk management issues

21. Historical context side cars
“Traditionally” new reinsurers in market post large event
Capital available
Current players wanting to increase writings
Strong pressures from rating agencies
Uncertainty with catastrophe models results

22. Lessons learned From prior promotions
Many new entrants have short time horizon
Opportunistic perspective
Need to change capital structure if reinsurer intends to continue operations
Many IPOs on survivors

23. Side-car characteristics
One sponsor
Typically portfolio based
While strong model based, include coverage of unmodeled exposures
Indemnity cover
No real reset of attachment points but capacity resets
strict disbursements of proceeds
Low basis risk
High yield for bond holder but somewhat lower than cat bond
Short tail lines of business
Some commercial lines
Actuarial opinion required
Some pay-back mechanism

24. Quota Share Reinsurance Premium less Brokerage & Commission
Structure (diagram)
Proceeds
Side-Car
Holding Co.
Debt Investors
Notes: P&I
Proceeds
Equity Investors
Shares
$ Capital
Dividends
Reinsurer
Quota Share Reinsurance
Side-Car Reins. Co.
Premium less Brokerage & Commission
$ Contribution held for benefit of Cedant
Distribution (Debt Interest, Profits)
Payment for Losses
Collateral Trust

25. Structure How they operate:
Newly created holding company funded by private equity investors
Usually hedge funds and other institutional investors
Typically funded by debt & equity financing
Assumes risk & premiums; pay claims to ceding company

26. Analytic issues – legal structure
Review of legal & structural documents
Quota share reinsurance agreement
Collateral trust agreement
Debt prospectus & covenants
Structural soundness
Legal enforceability

27. Analytic issues – business profile
Review business profile
Ceding company’s operations
Underwriting management of insurance portfolio
Risk tolerance levels
Ability to avoid adverse selection
Insufficient premium
Excessive losses

28. Analytic issues – portfolio & modeling techniques
Analysis of portfolio
Develop default probability
Can be multiple tranches
Rating reflects ability to;
Pay claims (side-car Reinsurer)
Principal & interest (side-car holding company debt)
Catastrophe loss modeling techniques employed
Quality of assets in collateral trust
Analytics similar to evaluating catastrophe bonds & other structured financings

29. Compared to traditional reinsurance
Utilizes normal reinsurance agreements
Typically quota share
Depends on ceding company for reserving & claims practices
Performance of side-car a result of underwriting & claims-settling capabilities of ceding company
Typically private ownership
Limited lifetime (not a going concern)
Highly structured & limited purpose
Typically limited to single cedant and/or contract
Absence of active management team
Cash disbursement tightly controlled by collateral trust agreement

30. Stakeholder perspectives
Equity investor
Opportunistic investment during hard markets
Access to underwriting expertise
Limited exposure to operating and legacy risks
Relatively low cost to establish
Can be established relatively quickly
Allows for relatively easy exit
Typically automatic winding down

31. Stakeholder perspectives
Debt investor
Relatively high yield
Ability to customize terms & conditions
Clearly defined risk categories & parameters
Side-car is not a going concern
Not likely to be recapitalized after a loss

32. Stakeholder perspectives
Ceding company perspective
Cedant can customize terms & conditions to meet needs
Ability to capture market share during hard market
Potential to obtain management fee & profit commission
Allows for relatively easy exit of excess capital
Diversification of source of capital

33. PCS index securities
Bonds pay if the market loss is above a certain threshold
Threshold determined by market loss
Largest basis risk
Very liquid
Very popular alternative investment

34. P&C securization growth
Source: Guy Carpenter, 2007

35. Risk capital by specific peril
Source: Guy Carpenter, 2007

36. Risk Capital / Transactions by Trigger Type
Source: Guy Carpenter, 2007

37. Trends - US Increase use of shelf offering
Softening in the terms and conditions (multi perils and locations)
More investment grade ILS
Primary insurers are getting more in the game, where reinsurers were the principal driver of ILS
Consolidation issues IFRS:SIC 12 vs US GAAP:FIN 46R

38. Trends - Canada Availability of quality reinsurance market
Limits generally lower in Canada vs US
Few cat bonds covering Canadian exposures (Merna Re)
Cat models not truly tested
Increased awareness of ILS