Financial Risk Management of Insurance Enterprises Securitization of Catastrophe Risk 1 1

Securitization of Catastrophe Risk Impetus Insurance Markets $150-200 Billion in Capital Financial Markets $10-15 Trillion in Capital Catastrophe Potential $60-100 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 securities CBOT Catastrophe Futures and Options Contingent Capital Cat-E-Puts Risk Capital Catastrophe Bonds 3

CBOT Catastrophe Insurance Futures and Options CAT Insurance Futures Introduced in December, 1992 Quarterly contracts National, Eastern, Midwestern and Western regions Based on ISO paid loss data for 22 insurers, adjusted to industry level Perils included: Wind Hail Earthquake Riot Flood Settlement value Loss Ratio x $25,000 ($50,000 cap) 4

Initial CBOT CAT Insurance Futures Minimal trading volume developed Reasons: High risk for sellers Buyers not used to futures Marking-to-market Buyer loses money on the future if catastrophes are low Insurance regulatory resistance Newly created index, which may not correspond to catastrophe risk for a particular insurer Reinsurance is available as an alternative 5

PCS Catastrophe Insurance Options Introduced in 1996 Underlying is the PCS Index Nine Geographic Areas National Five Regions Three States Two Sizes Small Cap (up to $20 Billion) Large Cap ($20 to $50 Billion) Development Period to Value PCS Index Six Months Twelve Months 6

PCS Catastrophe Index Valuation PCS Loss Index = PCS Estimate/100 Million Value is rounded to one decimal point Example: PCS Loss Estimate = $7,328,340,000 PCS Index = 73.3 7

PCS Option Pricing PCS Option prices are quoted in points and tenths of a point. Each point equals a cash value of $200. Example: On 11/28/97, 50 Western Region 1998 Annual Calls with a Strike Price of 150 traded at 2.5. The cost of each option was $500. If losses in 1998 exceed $15 billion (150x100 million), each option will be worth $200 for each $100 million of losses in excess of $15 billion. Since this is a small cap option, the maximum value of each option is $10,000 ($5 billion/100 million x $200). Thus, for a total cost of $25,000, the buyer of these 50 options purchased $500,000 of catastrophe coverage. 8

Status of PCS Options Open Interest 16,793 (as of 11/28/97) Daily Trading Volume: Low Week of 11/24: 310 Options Week of 11/17: No trades Week of 11/10: 40 Options Typical Trade: Option Spreads Buyer purchases the lower strike price option and simultaneously sells the higher strike price option. 9

Problems with the PCS Options Large Bid/Ask Spreads Example (11/28/97) National 5/25 Call Spread for December 1997 Bid 1.7 Ask 6.0 Low Liquidity Entire day’s trading equals $500,000 of coverage 10

PCS Options No longer traded

Alternative Catastrophe Securitization Contingent Capital Insurer Could Buy Puts 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

Components of Cat-E-Puts Put Option Terms Face amount of securities to be issued (with minimum) Exposure period: 1-10 years Annual option premium Trigger and post event term option can be exercised Establishes minimum net worth the company must have to exercise the option to assure option writer that the company is viable after the loss Warranties regarding maintenance of reinsurance, aggregate ratios and change in management control 15

Components of Cat-E-Puts Equity Security Terms Type of security Common stock Convertible debt Term Conversion details Yield Voting interests and board representation Conditions for buying back the issue to avoid long term dilution of interests 16

Hypothetical Cat-E-Put Example Primary insurer contracts with investment bank to obtain contingent financing in the event of a single aggregate industry loss (measured by PCS) in excess of $5 billion over the next 3 years. For an annual payment of $4 million, the insurer can sell up to 1 million shares of restricted common stock to the investment bank at $50 per share within 90 days of the loss, with a minimum issue of 400,000 shares. Insurer has the right to buy back the stock over the following three years at a price representing a 15% annual return to the bank. This option cannot be exercised if the statutory surplus of the insurer is less than $60 million. The agreement is void if the insurer fails to maintain a set amount of reinsurance or incurs a change in management control. 17

Hypothetical Cat-E-Put Example If the industry does not experience a $5 billion loss within the next 3 years, the bank gets a total of $12 million in premiums and does not buy the insurer’s stock. If there is a loss of that magnitude, the insurer may decide not to exercise the put option if its stock price exceeds the strike price or if it does not need the additional capital. If the loss is so large that it bankrupts (or severely impairs) the insurer, the option cannot be exercised. If the insurer does exercise the put option, it may buy the stock back from the bank when it regains its financial position. In the worst case, the bank ends up owning a significant portion of this insurer, which it can then sell when the buy-back option period expires. 18

Alternative Catastrophe Securitization Risk Capital $6 billion of risk capital raised since 1994 45 Cat risk transactions Typical case - pre-funded, fully collateralized Provides cedants 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

Issuers and Investors Sponsorship of transactions includes: Allianz, AGF, CEA, Gerling, Kemper, Mitsui, USAA , State Farm, Tokio, Winterthur, XL Capital, Yasuda, Zurich AXA Re, Hannover Re, Munich Re, Scor, St. Paul Re, Swiss Re Investors include: Reinsurers, Insurers, Banks, Investment Advisors/Mutual Funds, Hedge/ Proprietary Funds

Risks Covered Gulf Coast Hurricane California Earthquake Europe Wind Japan Earthquake Japan Typhoon Midwest Earthquake Northeast Hurricane Monaco Earthquake Puerto Rico Hurricane Europe Hail Hawaii Hurricane

Triggers Indemnity Parametric PCS Modeled Loss

Examples of Risk Capital USAA raised $477 million in June, 1997 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

USAA Catastrophe Bonds Residential Re raised $477 million in capital Two tranches A-1 Extendible Principal Protected Bonds Pay LIBOR + 273 basis points $163.8 million bonds plus option on $77 million invested in 10 year zero coupon bond Option protects principal, but not economic value A-2 Principal Variable Bonds Pay LIBOR + 576 basis points $313.2 million bonds 21

USAA Catastrophe Bonds Residential Re reinsures USAA Single East Coast hurricane causing in excess of $1 billion in insured losses to USAA Reinsurance is 80% of losses between $1 and $1.5 billion Stated maturity of bonds is 1 year If there is a loss, maturity can be extended 6 months Interest is payable during extension If a loss occurs on tranch A-1, maturity is extended to 10 years, but no interest will be paid 22

Swiss Re Catastrophe Bonds SR Earthquake Fund raised $137 million in 2 year notes Three tranches 1 - $42 million floating rate $20 million fixed rate 60% of principal at risk Ratings: Baa2 Moody’s, BBB- Fitch 2 - $60.3 million fixed rate all of principal is at risk Ratings: Ba1 Moody’s, BB Fitch 3 - $14.7 million Not rated 23

Swiss Re Catastrophe Bonds Triggers PCS index of industrywide losses Investors in first two tranches lose 1/3 of principal at each level $18.5 billion $21 billion $24 billion Lower triggers apply to the third tranch SR Earthquake Fund provides Swiss Re with $112.2 million reinsurance for a single California earthquake 24

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 Current 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 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 Insurers and reinsurers are developing new ways to transfer risk. Some of these techniques will be modeled after other financial securities, such as options, futures, and CMOs. Actuaries will need to play a role in this process, which will necessitate learning about non-traditional financial instruments. This represents an opportunity for actuaries of the third kind. 27