Catastrophes Insurable vs. Non-Insurable Catastrophes History of Insured Losses from Catastrophes Reasons for Growth in Catastrophe Exposure How Insurers Deal with Catastrophe Exposure What Is Being Done to Help Industry Cope with Catastrophes Securitization of Catastrophe Risk

Insurable vs. Non-Insurable Catastrophes Ideal Criteria for an Insurable Exposure 1 Large Number of Similar Exposure Units 2 Fortuitous Losses 3 Catastrophe Unlikely 4 Definite Losses 5 Determinable Probability Distribution 6 Economic Feasibility

What Makes a Loss Uninsurable? 1 Large Number of Similar Exposure Units If losses are concentrated in a particular area Earthquakes, Floods 2 Fortuitous Losses If location and timing of losses can be predicted Flooding downstream after upstream area affected Catastrophe Unlikely If potential loss could hurt financial condition of industry Tornadoes, riots can be covered War, nuclear disaster cannot be covered

History of Insured Losses from Catastrophes - 1

History of Insured Losses from Catastrophes - 2

History of Insured Losses from Catastrophes - 3 Significant change in size of catastrophes occurred starting in 1989 The ten largest insured losses have all occurred since 1989 Taking inflation into account, eight of the ten largest losses have occurred since 1989 Current estimates of possible losses New Madrid Fault Earthquake $116 billion California Earthquake $77 billion Florida Hurricane $76 billion Northeast Hurricane $21 billion

Reasons for Growth in Catastrophe Exposure Weather Pattern Change 1949-1989 Period of Unusually Good Weather (?) Recent Return to the Long Term Norm Population Growth in At Risk Areas for Hurricanes Southeastern seacoast Lowered Building Standards Lulled by Reduced Storm Activity Overwhelmed by Population Growth Mandates to Cover Earthquakes Impact of Catastrophe on Repair/Rebuilding Costs

How Insurers Deal with Catastrophe Exposure Reinsurance Managing Exposures Sophisticated catastrophe modeling Limiting concentration of exposures Monitoring by zip code Higher deductibles Premium Increases Withdrawals from Some Markets

What Is Being Done to Help Industry Cope with Catastrophes California Earthquake Authority Florida Hurricane Catastrophe Fund Hazard Mitigation Grant Program (Floods) Homeowners Insurance Availability Act (1999) Not enacted yet Would provide catastrophe reinsurance Tax Deferred Catastrophe Reserves Proposals under consideration in Congress

New Developments Securitization of Catastrophe Risk Exchange-traded catastrophe options Contingent capital Risk capital

Insurance Securitization Impetus Insurance Markets $200-250 Billion in Capital Financial Markets $10-15 Trillion in Capital Catastrophe Potential $70-120 Billion Too Large for Insurance Markets Less than a 1% Impact on Financial Markets Need to Develop Mechanisms to Spread Catastrophe Risk More Widely 2

Securitization of Catastrophe Risk Three Basic Approaches Exchange Traded Derivatives CBOT Cat Insurance Futures and Options Bermuda Commodities Exchange Cat Options Contingent Capital Line of Credit Contingent Surplus Notes Catastrophe Equity Puts Risk Capital Catastrophe Bonds 3

Contingent Capital Insurer Could Buy Put Options on Its Own Stock Moral Hazard Puts Not Traded for Most Insurers Cat-Equity-Puts At least 17 trades to date for $4.7 billion of contingent capital 12

Cat-E-Puts Written by AON Prenegotiated Option on a Firm’s Own Securities Triggered by a Catastrophic Event Buyer Pays Premium to Option Writer Option Writer Provides Post-event Equity Normally Written for 3 years 13

Benefits of Cat-E-Puts Allows the buyer to protect its balance sheet Rating agencies view this approach favorably Cost compares favorably with reinsurance 14

Risk Capital Over $1.5 billion of risk capital raised since 1995 Typical case - pre-funded, fully collateralized Provides insurance company with additional capital and multiyear coverage for catastrophes Provides investors with diversification and high yields Investors include: Mutual funds Hedge funds Reinsurers Life insurers Money managers 19

Examples of Risk Capital USAA raised $477 million in June, 1997 and $450 million in June, 1998 Created Residential Re, Ltd. Covers East Coast Hurricane Risk Swiss Re raised $137 million in July, 1997 Created SR Earthquake Fund, Ltd. Covers California Earthquake Risk 20

Pricing of Risk Capital Comparison of interest rate differential between risky capital and risk free rate with the expected losses USAA Initial offer 9 times Later trading 6 times Swiss Re 6 times BB rated debt 2.2 times Emerging markets 1.3-2.7 times Problem: This approach ignores the loss distribution. Catastrophe coverage has greater chance of total loss of principal than other debt. 25

Additional Points Concerning Risk Capital Offshore subsidiary (Special Purpose Vehicle) used to avoid taxation of interest Insurers using this approach should expect litigation after a loss. This is common practice after a default on high yield debt. 26

Summary Catastrophes can be so large that the insurance industry may be unable to handle them under traditional method Securitization can be an effective way to handle catastrophe and other insurance risks This field is just beginning to develop Expertise needed in both insurance and finance 27