1. 1 Presentation to: The CAS Seminar on Financial Risk Management April 12, 1999 Securitization of Catastrophe Risk: A USAA Example Presented by: Rhonda K. Aikens Executive Director, Financial Actuary USAA

2. 2 Objective of Briefing To summarize the Residential Re transaction and its implications for USAA, the P&C Insurance Industry and investors. and investors.

3. 3 How will USAA insulate itself from the next mega-hurricane?

4. 4 Hurricane Andrew made landfall in South Dade County Florida devastating Homestead Air Force Base.

5. 5 1992 Hurricane Andrew USAA$600,000,000 Industry$16,500,000,000

6. 6 A storm the size of Andrew just 40 mi. north would have resulted in insured losses of over $50 billion HAFB Miami 40 miles north Miami 40 miles north

7. 7 Exposure to Mega-Hurricane Estimated U.S. Insured Losses (1/500 Yr.) $22 Billion HurricaneHouston-Galveston $21 Billion Hurricane Northeast Region $17 Billion Hurricane Southeast Region $76 Billion Hurricane Florida Region Source: Risk Management Solutions, Inc.; Insurance Services Office, Inc.

8. 8 Strategic Challenge: Industry Perspective l Since 1989, a series of natural disasters has resulted in variability in insurance losses. l Prior to Hurricane Hugo, the insurance industry had never suffered losses from a single disaster over $1 Billion. l Since then, 11 natural disasters have exceeded this amount. l Traditional reinsurance mechanisms are limited in capacity. l Recent events have caused the insurance industry to reconsider its approach in handling low frequency, high severity occurrences. l The questions have centered around the following: — What steps can we take to reduce losses from future disasters? — What steps can we take to reduce variability in insurer results from future disasters?

9. 9 l Serving members who live in catastrophe- prone areas requires maintenance of a high level of capitalization and liquidity. l If such exposures could be mitigated, then transferred or separately securitized, USAA could more efficiently deploy its capital resources. Strategic Challenge: USAA Perspective

10. 10 Options Considered By USAA To Address The Strategic Challenge Options Considered By USAA To Address The Strategic Challenge l Expanded Traditional Reinsurance l Catastrophe Bonds l Catastrophe Options l Surplus Notes and Contingent Surplus Notes l Contingent Equity l Catastrophe Swaps

11. 11 Options’ Issue: Financing vs. Hedging FinancingHedging Impact on: PML PMLNoYes Surplus SurplusYesYes Liquidity LiquidityYesYes Balance Sheet Balance Sheet Yes * Yes * Contingent type can be kept off balance sheet until exercised. * Contingent type can be kept off balance sheet until exercised. Risk Transfer NoYes Instrument Surplus Notes Reinsurance Cat Bonds CBOT Contingent Surplus Notes Contingent Equity

12. 12 - Competitive. - Financially Strong. - Highly Rated. - No regulatory concerns. R USAA Capacity Cost Security Permanence Risk Transfer CapitalMarkets ReinsuranceMarkets USAA Preferred Hedging Strategy Strategy USAA Preferred Hedging Strategy Strategy

13. 13 Hedging Design Field Re-insurance C. B. O. T. Cat Bond Indemnity Index Source: “Financial Risk Management For Catastrophes”- Neil Doherty Credit Risk Moral Hazard Basis Risk

14. 14 Index Approach 1. Index based payment 2. Speculative 3. May/may not transfer risk 4. Basis risk 5. Accounted as investment 6. Low transaction cost 7. Very small capacity Capital Market Contracts: Index vs. Indemnity Approaches Indemnity Approach 1. Actual loss based payment 2. Non-speculative 3. Risk transfer 4. No basis risk 5. Accounted as reinsurance 6. Transaction cost material 7. Medium capacity for now

15. 15 Selected Hedging Instruments l Expanded Traditional Reinsurance l Catastrophe Bonds

16. 16 Characteristics Of Catastrophe Bonds l Rated security l Renewable process l Supplement to traditional reinsurance l Objective risk assessment l Potentially attractive to investors

17. 17 Special Purpose Reinsurer How it Works Company SPR SPRReinsurancePremium Investor To secure obligations under the Reinsurance Agreement Reg 114 Trust Account

18. 18 The Reinsurance Agreement l Obligates Residential Reinsurance to pay USAA for the claims in the layer between $1.0 billion and $1.5 billion resulting from a single Class 3, 4 or 5 hurricane in the Covered States during a 12 month claims period. l USAA will retain not less than 10% of the risk.

19. 19 Catastrophe Bond Transaction Timeline Catastrophe Bond Transaction Timeline June 15, 1998 - May 31, 1999 June 15, 1998 - May 31, 1999 June 1, 1999 - June 1, 1999 - Dec 1, 1999 Dec 1, 1999 Risk Period ExtendedClaimsPeriod June 1 Dec 1 June 1 Dec 1 Typical Hurricane Season

20. 20 Key Issues Encountered l Federal Tax – SPR off-shore – Debt vs. equity interest l Regulatory – Recognition that investors are not in the business of insurance l Securities – Public vs. private offering l Bond Structure – Principal at risk vs. principal protected – Single year vs. multi-year transaction

21. 21 The Investor’s Perspective

22. 22 Why Do I Buy? l Increase Yield l Reduce Portfolio Variability

23. 23 What Do I Need To Know? Questions that need to be answered from Investor’s Perspective l How do I assess the risk ? l How credible is the risk assessment ? l When do I feel that I have become educated enough to buy ? l Is this the first transaction of this kind? l Is there a pipeline of future deals to further increase diversification ? l Why have they bypassed the reinsurance market ? l Can I afford to lose all my principal ? l What are the regulatory impacts (especially for life insurers and pensions funds) ? l Isn’t one year too short; wouldn’t a multi-year commitment improve the utility of this instrument ?

24. 24 Who Are The Investors? Bottom line: 90 - 95% of the money is new to the P&C Insurance Industry. This is “found money”; capital that would never have been applied to the problem of catastrophe protection through either investment in primary insurers or reinsurers.

25. 25 Categories Of Investors: This is a Global Market l Life Insurers l Pension Funds l Reinsurers l Hedge Funds l Banks l Investment Advisors

26. 26 Wall Street Journal June 18, 1997 Wall Street Journal June 18, 1997

27. 27 Even Nature Can Be Turned Into a Security Into a Security High Yield and Big Risk With Catastrophe Bonds Even Nature Can Be Turned Into a Security Into a Security High Yield and Big Risk With Catastrophe Bonds THE NEW YORK TIMES AUGUST 6, 1997 THE NEW YORK TIMES AUGUST 6, 1997

28. 28 ObservationsObservations l Traditional reinsurance capacity is plentiful, but limited. l Capital markets offer the potential to supply additional capacity. l USAA’s success in renewing its transaction at reduced cost is evidence that: 1. Securitization of catastrophe risk on a large scale is possible and sustainable. 2. Improving efficiency and cost is also possible; multi-year transaction could help in this regard. Note: There have been about 21 capital market risk transfer securitizations to date.

29. 29 Observations Continued l Growth of capital markets reinsurance will be slow due to: 1. Lack of expertise, basis risk/low risk transfer/speculative nature of investment, accounting and regulatory restrictions (index options) 2. High transactions costs, tax issues/offshore nature, need for more investor education (indemnity catastrophe bonds) 3. Soft traditional reinsurance market with large capacity and declining reinsurance prices. l Significant growth in capital market reinsurance will require : 1. Addressing the issues mentioned above. 1. Addressing the issues mentioned above. 2. NAIC adopting changes to support securitization of insurance. 2. NAIC adopting changes to support securitization of insurance. 3. Changes at the Federal level and removal of tax disincentives so these SPR transactions can take place on-shore. 3. Changes at the Federal level and removal of tax disincentives so these SPR transactions can take place on-shore.

30. 30 ConclusionConclusion l This pioneering (and now renewed), mutually beneficial transaction fulfills the strategic purposes of: –Tapping into the vast pool of capital for capacity. –Introducing a new asset class which supplements reinsurance. –Providing a vehicle for investors to increase yield, while reducing portfolio risk through diversification.

31. 31 Insulating USAA from the Financial Impact of a Mega-Catastrophe

32. 32 The low volume of transactions for insurance index options stem from: l Unfamiliarity with these markets l Lack of expertise l Low correlation with underlying exposure and lack of appropriate risk reduction mechanism l Speculative nature of investment l Accounting restrictions l Unresolved tax issues l Regulators and rating agencies reluctant to embrace these innovations Capital Market Contracts: Index vs. Indemnity Approaches

33. 33 Existing Indices l PCS (Property Claim Service Index) l GCCI (Guy Carpenter Catastrophe Index l Sigma Index l RMS Index l Custom constructed index (between buyer and counterparty)

34. 34 Additional Issue: Offshore Nature of Transaction Offshore Tax Advantage (Cayman Islands) Offshore Tax Advantage (Cayman Islands) l SPR pays no income or corporate tax, no withholding tax, no capital gains or capital transfer tax. l No withholding or other taxes on interest, principal or other amounts paid by the SPR under the notes. l If on-shore, SPR will be subject to U.S. tax, making transaction less attractive. l If offshore but deemed to be engaged in U.S. trade (substantive negotiations about transaction done on U.S. soil), SPR subject to U.S. taxes. Note: SPR reinsurance premium subject to 1% U.S. excise tax. Note: SPR reinsurance premium subject to 1% U.S. excise tax.

35. 35 NAIC Securitization Task Force l Regulators willing to reconsider accounting treatment of index options if high correlation with underlying exposure. l Task Force’s aim is to evaluate rules and regulatory changes that will help support capital market securitization solutions (both loss and index based transactions). l The Task Force has requested that the AAA provide the technical support needed to effect these changes: 1. The AAA technical to conduct research needed to understand and evaluate the effectiveness of index based transaction: Use of models and historical experience to study basis risk and correlation. 2. Publication of research results and recommendation by 12/1999.

36. 36 NAIC Securitization Task Force l Task Force to use results of technical study to set the following: Accounting 1. Set correlation threshold 2. Appropriate accounting treatment (3/2000). Implementation Issues 1. Actuarial opinion on level of hedge effectiveness 2. Footnote or disclosure requirements in current actuarial opinion 3. Development of standard of practice (12/2000) 3. Development of standard of practice (12/2000)Training

37. 37 #DateInsuredInvestorsSize ($ million) 1.1994Hannover ReLife Insurers 85 1.1994Hannover ReLife Insurers 85 2.Late 95AIGMercury Asset Mgmt 10 2.Late 95AIGMercury Asset Mgmt 10 3.12/96Hannover ReLife Insurers 100 3.12/96Hannover ReLife Insurers 100 4.12/96St. Paul ReLife insurers/Money Mngt 69 4.12/96St. Paul ReLife insurers/Money Mngt 69 5.01/97WinterhurEuropean Market 130 5.01/97WinterhurEuropean Market 130 6.03/97RelianceLife Insurers & Individuals 40 6.03/97RelianceLife Insurers & Individuals 40 7.06/97USAA144A Market 400 7.06/97USAA144A Market 400 8. 07/97Swiss Re144A Market 100 8. 07/97Swiss Re144A Market 100 9.09/97Tokio Marine144A Market 90 9.09/97Tokio Marine144A Market 90 10.02/98Center Re144A Market 80 Risk Transfer Securitizations To-Date

38. 38 #DateInsuredInvestorsSize ($ million) 11.04/98Mitsui MarineSwap Transaction 30 12.05/98RelianceLife insurers & Individuals 50 13.06/98UnamedMoney Managers 60 14.06/98CAN144A Market 9 15.06/98Toyota Motor144A Market 566 16.06/98USAA144A Market 450 17.06/98Yasuda Fire144A Market 80 18. 07/98St Paul Re144A Market 50 19.07/98X.L. Global ReSwap Transaction 100 20.08/98Undisclosed (NY)Swiss Re 10 21.09/98European InsurersSwap Transaction 25 Risk Transfer Securitizations To-Date