1. Aon Limited is authorised and regulated by the Financial Services Authority in respect of insurance mediation activities only Financing Catastrophic Risks The Effect of Capacity Cycles on Developing Countries Jonathan Barnes Aon Capital Markets December 2005

2. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Disclaimer This document has been prepared for information purposes only, and is not intended, nor shall it be considered, as an offer to sell or the solicitation of an offer to enter into any contract for purchase of any security, loan or financial product. Aon Capital Markets makes no representation that any transaction can be effected at the prices provided, and all material contained herein, including proposed terms and conditions, are for preliminary discussion purposes only. This information is intended to aid the recipient, and is not a confirmation or statement of Aon Capital Markets. We accept no responsibility for any costs, losses or damages resulting from the use of, or reliance upon, this document. 2

3. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Risk Matrix 3

4. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Risk Matrix Loss Prevention Loss Reduction Cash Flow ReservesDebt / LOCInsure Reinsure Equity CaptivesContingent Capital Finite ( prospective) Cat Bond & ILS Finite (retrospective) Pre-lossPost-lossPre-lossPost-lossPre-lossPost-loss UnfundedFunded Risk ControlRisk FinanceRisk Transfer RetainTransfer Risk Traditional Alternative 4

5. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Focus on Risk Financing and Transfer Loss Prevention Loss Reduction Cash Flow ReservesDebt / LOCInsure Reinsure Equity CaptivesContingent Capital Finite ( prospective) Cat Bond & ILS Finite (retrospective) Pre-lossPost-lossPre-lossPost-lossPre-lossPost-loss UnfundedFunded Risk ControlRisk FinanceRisk Transfer RetainTransfer Risk Traditional Alternative 5

6. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. First Priority is Risk Control Loss Prevention Loss Reduction Cash Flow ReservesDebt / LOCInsure Reinsure Equity CaptivesContingent Capital Finite ( prospective) Cat Bond & ILS Finite (retrospective) Pre-lossPost-lossPre-lossPost-lossPre-lossPost-loss UnfundedFunded Risk ControlRisk FinanceRisk Transfer RetainTransfer Risk Traditional Alternative 6

7. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. First Priority is Risk Control Financing and Transfer is secondary to Risk Control –Awareness, education, preparation (warnings, disaster planning evacuation procedures and recovery planning) –Building codes, retrofitting –Planning and land use –Flood defences –Natural defences - planting to reduce landslide, coastal erosion and flooding Financing programme needs to reinforce risk control –Scheme incentives: eligibility, deductible and premium incentives –Other financial incentives: tax, mortgage and improvement loans 7

8. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Catastrophe Risk Financing 8

9. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Catastrophe Risk Financing Low penetration of private insurance in developing countries –Life and savings policies a higher priority than property Requirement for State participation in a national or regional scheme –Insurability depends on portfolio diversification –Catastrophe exposure is a systematic risk for domestic insurers Government involvement can –Help to spread loss over time –Integrate scheme with Risk Control measures –Introduce and enforce an element of compulsion 9

10. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Catastrophe Risk Financing The case for compulsion Low take-up of optional insurance cover in developed countries –NFIP: flood cover is available –California: earthquake must be offered –Florida: wind coverage must be included Makes economics more efficient by removing the anti-selection prevalent in optional schemes For developing countries, infrastructure financing may be the primary economic consideration –Highways, bridges, tunnels, ports, power & water networks, hospitals, schools 10

11. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Catastrophe Risk Financing First task is to understand the nature of the threat –Frequency and severity of potential occurrences –Areas most at risk Implications for land use –Construction vulnerabilities Cost of repair / replacement - including post loss demand surge Implications for loss mitigation and construction code Develop models for risk financing / transfer planning –Quantify the financial exposures –Determine how risk is to be financed –Determine appetite / budget for risk retention / transfer –Models used by protection buyers and protection sellers to assess risk 11

12. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Influence of the Insurance Cycle 12

13. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Influence of the Insurance Cycle Insurance industry is notoriously cyclical Recent incidence of catastrophe losses is exerting upward pressure on catastrophe reinsurance prices “Seven of the ten most expensive hurricanes in US history occurred in the fourteen months from August 2004 to October 2005: Katrina, Rita, Wilma, Charley, Ivan, Frances and Jeanne” Robert P Hartwig Ph D, CPCU, Senior Vice President & Chief Economist Insurance Information Institute 2004/5 insured hurricane damage estimated at circa USD 75 billion Standard & Poor’s revised its global reinsurance outlook from stable to negative on September 28, 2005 13

14. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Influence of the insurance cycle Price increases most pronounced in loss impacted areas (US hurricane) –Upward pressure on pricing elsewhere –Particularly for peak concentration perils Cyclical price fluctuations are generally most pronounced for contracts covering remote events (1-in-50 to 1-in-250 year losses) –Covers generally purchased by national pools / schemes –Movements in absolute minimum prices relative to the limit provided –Particularly for non-peak ‘diversifying’ risks such as those provided by developing countries ‘Minimum rates on line’ can fluctuate from 0.5% to 1.5% of limit 14

15. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Influence of the insurance cycle ? US Catastrophe Risk Price Index - per Insurance Information Institute 15

16. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Structuring Efficient Risk Transfer 16

17. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Structuring Efficient Risk Transfer Advantages for developing countries seeking catastrophe risk cover –Market is dominated by exposures in developed countries –Protection sellers seek to develop diversified portfolios of catastrophe risk –Developing countries with exposures that don’t correlate with protection sellers’ existing risks provide diversification –Diversification benefit is reflected in lower margin charge Disadvantages –Coverage typically required for low probability events, subject to higher margin charges and cyclical pricing volatility –Some protection sellers are deterred by the availability and quality of catastrophe models 17

18. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Structuring Efficient Risk Transfer Understanding how the markets price risk Premium as a multiple of the expected loss to the contract Margin expressed as a percentage of the standard deviation of expected losses (cat bond Sharpe Ratio) –Sharpe ratio 18

19. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Structuring Efficient Risk Transfer Illustrative 2005 retro contract pricing Study based on 5 clients / 25 contracts N.B. Expected losses and premiums calculated for contracts providing one paid reinstatement 19 (EL)

20. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Retro Pricing Discussion 2005 Sharpe ratios vs. expected loss Study based on 5 clients / 25 contracts N.B. Expected losses and Sharpe ratios calculated for contracts providing one paid reinstatement 20

21. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Structuring Efficient Risk Transfer Example for contracts covering low probability windstorm risks (peril outside US & Europe peak territories) 21

22. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Structuring Efficient Risk Transfer Developing countries with non-correlating catastrophe exposures should consider purchasing protection collectively Achieves pricing efficiency - particularly for remote events –Events with return periods of 1-in-50 to 1-in-250 years Illustrative example – separate purchasing –Two countries each seeking to purchase reinsurance of USD 50 million per event (standard policy also provides one reinstatement at 100% additional premium) –Expected losses to each policy = 1.5% –Premium expressed as a multiple of expected loss = (say) 2.75x –Premium rate expressed as a percentage of cover (1.5% x 2.75) = 4.125% –Cost to each country USD 50m x 4.125% = USD 2,062,500 –Combined cost of the two separate policies USD 2,062,500 x 2 = USD 4,125,000 22

23. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Structuring Efficient Risk Transfer Illustrative example – collective purchasing –Two countries collectively purchase reinsurance of USD 50 million per event (standard policy also provides one reinstatement at 100% additional premium) –Expected losses to combined peril policy = 1.5% 2.956% –Premium expressed as a multiple of expected loss = (say) 2.75x 1.75x –Premium rate expressed as a percentage of cover (2.956% x 1.75) = 5.17% –Cost of combined peril policy USD 50m x 5.17% = USD 2,585,000 –Saving over purchase of separate policies = USD 1,540,000 = 37% Reinsurance provides one automatic reinstatement at 100% additional premium (covers two events in any one year) –Slightly less cover, but –Probability of combined policy being exhausted circa 0.044% 23

24. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Structuring Efficient Risk Transfer Global reinsurance brokers are best placed to assist –Independent advice on structuring and distribution Experience in developing national pools for developed countries Extensive risk modelling expertise –Vendor models (AIR, EQECAT, RMS) –Proprietary models Routinely negotiate with protection sellers to obtain most efficient pricing for clients –Reinsurance markets –Capital markets 24

25. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Closing Comments 25

26. Aon Capital Markets is a division of Aon Capital Services Limited authorised and regulated by the Financial Services Authority. Closing Comments Role for the World Bank Initiate and co-ordinate catastrophe risk model development Co-ordinate and structure collective risk transfer arrangements World Bank Re ? Assume individual country risk Structure collective risk transfer products Distribute to reinsurance / capital markets 26

27. Aon Limited is authorised and regulated by the Financial Services Authority in respect of insurance mediation activities only Financing Catastrophic Risks The Effect of Capacity Cycles on Developing Countries Jonathan Barnes Aon Capital Markets December 2005