 University of Illinois Finance 431 April 20, 2006 CATS ARE DOGS

PricewaterhouseCoopers April 2006 Slide 2 Finance 431 Agenda What is a Catastrophe Managing Catastrophe Risk Property Catastrophe Reinsurance Hurricane Katrina Rating Agencies and Catastrophes Final Points 

PricewaterhouseCoopers April 2006 Slide 3 Finance 431 Catastrophe Exposure in the United States Types of Catastrophes – Traditional Hurricanes / Typhoons Earthquakes Floods Tornados Man-made (fires, explosions) Types of Catastrophes – Alternative Terrorist Acts Asteroids Tsunami Power Outages What is a Catastrophe 

PricewaterhouseCoopers April 2006 Slide 4 Finance 431 The Costs of Catastrophes Property Damage -Homes – Most losses except for flood are covered by a traditional homeowners policy. Storm Surge during a hurricane is considered flood and not covered. -Cars - Vehicles are covered for most events. -Commercial Structures – Commercial buildings and structures are generally covered for most events including flood. Human Casualties -These may not correlate with economic loss (Tsunami, Galveston TX 1900) -May have incidental impact on insured losses (Life insurance, casualty damages) Other Costs -Additional Living Expense – Temporary accommodations and expenses. -Loss adjustment expenses – Insurers usually spend a large amount of money to service policyholders following a catastrophe. -Coverage Extensions – Business Interruption, Contingent Business Interruptions, Civil Authority, Off Premises Power. What is a Catastrophe 

PricewaterhouseCoopers April 2006 Slide 5 Finance 431 The Rising Costs of Catastrophes The economic costs of covering catastrophes is outpacing inflation for the following reasons: Demographic Shifts – Populations are moving into more catastrophic exposed regions. New Perils – The emergence of new potential risks, such as terrorism increase the expected catastrophic loss. Global Economic Development – As countries develop economically the amount of exposed property increases. This property is generally covered by an insurance vehicle. Public Expectation – The public has rising expectations about their entitlement to “be made whole” after an event. What is a Catastrophe 

PricewaterhouseCoopers April 2006 Slide 6 Finance 431 Financing the Costs of Catastrophes What is a Catastrophe  Public – Individuals pay premiums for insurance to cover their personal property from damage due to catastrophes and other perils. Government – Uninsurable perils such as flood and war are generally covered by the government. The government may also subsidize private insurers (ie TRIA, FHCF, FEMA). Insurers – Investors put capital at risk in the form of insurance/reinsurance companies (or cat bonds) to make an adequate return.

PricewaterhouseCoopers April 2006 Slide 7 Finance 431 Managing Catastrophe Risk The insurance industry plays a significant role in assuming catastrophe risk and has developed several products to manage catastrophe risk. The initial risk is written in the form of insurance policies to either individuals, businesses or governments. Insurance companies have several ways of managing catastrophe risk. These include: Exposure Reduction Government Subsidies Reinsurance 

PricewaterhouseCoopers April 2006 Slide 8 Finance 431 Ways Insurance Companies Manage Catastrophe Risk Exposure Reductions – Insurers have reduced exposure to catastrophes two main ways. -Restriction of policy terms – Insurers have implemented wind and hurricane deductibles which are much higher than the standard policy deductibles. These are typically stated as a % of a building’s value. -Non renewal of high risk customers – Insurance companies are non-renewing coastal properties in an attempt to reduce exposure to wind events. This is happening in the gulf and northeastern states. Managing Catastrophe Risk 

PricewaterhouseCoopers April 2006 Slide 9 Finance 431 Ways Insurance Companies Manage Catastrophe Risk Government Subsidies – Federal and State governments have legislation that assumes exposure from the insurance industry. -California Earthquake Authority (CEA)– Insurers write policies and cede premium and losses to the CEA. -Florida Hurricane Catastrophe Fund (FHCF)– Subsidized reinsurance is provided to the industry. Shortfalls funded through statewide premium assessments. -Terrorism Risk Insurance Program – Covers defined acts of terrorism. -New initiatives are being forwarded by the industry subsequent to Hurricane Katrina Managing Catastrophe Risk 

PricewaterhouseCoopers April 2006 Slide 10 Finance 431 Ways Insurance Companies Manage Catastrophe Risk Reinsurance – Insurers look to the private sector to provide coverage in various forms. -Excess of Loss Property Catastrophe Reinsurance -Per-Risk Excess Reinsurance* -Facultative Reinsurance* -Cat Bonds *These Coverages cover large losses in addition to catastrophes Managing Catastrophe Risk 

PricewaterhouseCoopers April 2006 Slide 11 Finance 431 Introduction to Property Catastrophe Reinsurance Treaties Property catastrophe treaty reinsurance is the most popular way for insurance companies to mitigate catastrophe risk. Common Terms of a Property Catastrophe Treaty -Per Occurrence – They only cover losses from a distinct catastrophic event. -Excess of Loss – They have a fixed limit of coverage and have a fixed retention. -Two Loss Warranty – At least two insured structures must be damaged for the treaty to apply. Catastrophic damage to a single structure is covered by facultative contracts or risk excess treaties. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 12 Finance 431 …More Treaty Terms Covers losses for a distinct period (usually 12 months) regardless of when the underlying policy was written. Reinstatement Provisions –Should one event occur that causes losses to the policy, the reinsurer must offer an additional reinstatement of the limit at the premium rate. The reinsurer is usually forced to offer one reinstatement. After two events the primary insurer must renegotiate another treaty. Hours Clause – An hours clause defines the duration of the catastrophe. This is typically 72 hours. The retention and limit apply to all losses during the occurrence. Should the catastrophe last more than 72 hours, the limit may be reinstated. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 13 Finance 431 Property Catastrophe Reinsurance Programs Property Catastrophe Reinsurance Treaties are typically part of a program. This program would be stated as follows: Reinsurer A is taking an 80% share of the layer 80x20. This translates into Reinsurer A is reimbursing the primary carrier for losses in excess of $20 Million per occurrence up to a limit of $80 Million. Reinsurer B is taking an 80% share of the layer 40x100. The primary insurer is responsible for any losses in gray or above $140 Million. Property Catastrophe Reinsurance Reinsurer A Reinsurer B $0 $100M $20M $140M 

PricewaterhouseCoopers April 2006 Slide 14 Finance 431 Property Catastrophe Reinsurance Programs - Coinsurance Primary insurers are usually not able to cede 100% of the loss. The portion they retain in called coinsurance. Coinsurance is required to avoid the two following forms of adverse selection. Writing large amounts of catastrophe exposed risk because they have reinsured the risk away. Not controlling losses during the claim settlement process after the event has occurred. Property Catastrophe Reinsurance Reinsurer A Reinsurer B $0 $100M $20M $140M Coinsurance 

PricewaterhouseCoopers April 2006 Slide 15 Finance 431 Property Catastrophe Reinsurance – Models In the past insurers used to look at long term analysis of catastrophe data to assess the cat potential and price insurance. This technique may still be used to price freeze and or tornado risks. Today computer models dominate the risk management landscape of the property catastrophe insurance markets. There are a handful of models available although three companies dominate the market (AIR, RMS, EQECAT). The models are stochastic in nature and estimate damages for thousands of years at a time. This gives a picture of not only the average of expected value but the entire loss distribution. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 16 Finance 431 Property Catastrophe Reinsurance – Models These models have two main components. Peril scenario generators and damage functions. The peril scenario generators model hurricane path and wind- speed for storms and earth movement for earthquakes. Often historical records are scrutinized and thousands of years of geological data are considered. What is a Catastrophe 

PricewaterhouseCoopers April 2006 Slide 17 Finance 431 Property Catastrophe Reinsurance – Models The damage functions are engineering functions that estimate the percent of structure damage for a given wind-speed or earth movement. These are often a function of a structure’s Location Age Class Construction Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 18 Finance 431 Property Catastrophe Reinsurance – Model Output An insurer would input information on his book of business into the model. The output would include expected value estimates and an exceedance curve similar to the one of the left. Using management judgment and risk tolerances the insurer can begin to manage its risk. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 19 Finance 431 Property Catastrophe Reinsurance – Model Output Expected loss – The loss cost for various layer of reinsurance. PMLs (Probable maximum loss) – This is generally stated with an associated annual frequency. 250 Year PML = $500 Million 500 Year PML = $1,500 Million Property Catastrophe Reinsurance  These imply: 1.On average a loss of at least $500 Million will occur every 250 years. 2.On average a loss of at least $1.5 Billion will occur every 500 years.

PricewaterhouseCoopers April 2006 Slide 20 Finance 431 Property Catastrophe Reinsurance – Model Output Property Catastrophe Reinsurance RATE ON LINE = TREATY PREMIUM TREATY LIMIT Roughly equal to the probability of payment. Rates on a property catastrophe treaty are typically quoted using the term “Rate On Line”.

PricewaterhouseCoopers April 2006 Slide 21 Finance 431 Property Catastrophe Reinsurance – Reinsurers Property catastrophe reinsurers take advantage of geographic diversification. They write treaties all over the world with the idea that Japan is not correlated with Florida is not correlated with California. This is simple financial management. Adding uncorrelated risks decreases the overall volatility of the portfolio. This premise also raises the profit or risk load charged in areas with high cat risk. Property catastrophe reinsurers are not in a position to take large amounts of investment risk. Should a catastrophe occur they require a large amount of cash in a short period of time to pay claims. This is changing as more are engaging in credit facilities to assist with post-event cash flow. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 22 Finance 431 Property Catastrophe Reinsurance – Reinsurers Property catastrophe reinsurers manage their risk very much like their customers. One vehicle is retrocessional coverage: Retrocessional coverage is reinsurance for reinsurers. It is very expensive due to the risk and uncertainty of the underlying exposure. There is a lot of parameter uncertainty because the retrocessionaire is so far removed from the original risks. “Retro” writers generally cannot purchase traditional reinsurance because of market spiral. Property Catastrophe Reinsurance  Loss Ratios PrimaryProp CatRetro YearInsurerReinsurerWriter 169.1%0.0% 297.3%123.4%191.9% 371.5%0.0% %289.5%1022.7% 595.2%102.4%87.2% 666.0%0.0% 791.2%61.7%0.0% 835.8%0.0% 917.1%0.0% %0.0%

PricewaterhouseCoopers April 2006 Slide 23 Finance 431 Property Catastrophe Reinsurance – Reinsurers In addition to retrocessional coverage, reinsurers also manage risk using: -ILWs -Cat Bonds -Cat Swaps -“Side cars” Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 24 Finance 431 Property Catastrophe Reinsurance – ILWs Industry loss warranties pay a fixed amount based of the amount of industry loss. For example, a $20 Million ILW with a $5 Billion trigger, would pay the purchaser $20 Million in the event of a $5 Billion or greater industry loss. Industry loss amounts are published by PCS (Property Claim Services) for US losses and SIGMA (a division of Swiss Re) for other losses around the world. These expose the purchaser to basis risk, or the risk that the purchaser has a large loss but the industry does not. These are currently an easy way to enter the property catastrophe reinsurance market. Many hedge funds are getting into this arena. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 25 Finance 431 Property Catastrophe Reinsurance – Cat Bonds Bonds issued to cover catastrophe risk were developed subsequent to Hurricane Andrew. These bonds are structured so that the investor has a good return if there are no qualifying events and a poor return if a loss occurs. Losses can be triggered on an industry index or on an indemnity basis. The advantage of these vehicles is that you gain access to the large capital available in the financial markets and that the bonds diversify a standard investment portfolio. The disadvantages is that they expose the issuer to basis risk, they have large issuing costs. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 26 Finance 431 Property Catastrophe Reinsurance – Cat Swaps Generally between two sophisticated parties. Reinsurer A will have too much exposure in one area and Reinsurer B will have over-exposure in an uncorrelated zone. The two parties will agree on indexes which are typically general reinsurance programs in the market and design a treaty whereby losses are triggered by the experience of the index treaties in the particular zones. Both are exposed to significant basis risk. This is attractive since, theoretically, no profit changes hands and the cost of the protection is small from an allocated capital standpoint. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 27 Finance 431 Property Catastrophe Reinsurance – Side cars These vehicles came into existence in the past few years. A hedge fund that wishes to get into the reinsurance business will start a special purpose vehicle with a reinsurer. This is usually capitalized by both parties. The side car assumes a portion of the exposure from the reinsurer in the form of a reinsurance contract. The reinsurer is able to reduce its exposure. The hedge fund is able to get into reinsurance without: -Hiring underwriters -Buying models -Getting rated by the rating agencies. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 28 Finance 431 Property Catastrophe Reinsurance – Side cars These vehicles came into existence in the past few years. A hedge fund that wishes to get into the reinsurance business will start a special purpose vehicle with a reinsurer. This is usually capitalized by both parties. The side car assumes a portion of the exposure from the reinsurer in the form of a reinsurance contract. The reinsurer is able to reduce its exposure. The hedge fund is able to get into reinsurance without: -Hiring underwriters -Buying models -Getting rated by the rating agencies. Property Catastrophe Reinsurance 

PricewaterhouseCoopers April 2006 Slide 29 Finance 431 Hurricane Katrina Changed the Industry Largest insured loss ever as the insurance costs are approaching $50 Billion. This does not include the government’s tab of an estimated $200 Billion. Estimates of damages produced by the models for storms similar to Katrina were grossly understated. Several reinsurers were impaired by the losses incurred from Hurricane Katrina. Reinsurance demand and prices went up by significant percentages (Was it enough?) Models were/are being adjusted for the multi-decadal changes in hurricane activity, driving up loss costs. Rating agencies imposed stricter rules for capital adequacy. Hurricane Katrina 

PricewaterhouseCoopers April 2006 Slide 30 Finance 431 Rating Agencies Have a Significant Impact on Property Catastrophe Insurance and Reinsurance The major rating agencies, AM Best and S&P publish financial strength ratings for insurers and reinsurers. Ratings are indicative of financial strength and are used by buyers of (re)insurance to select counterparties. (Re)insurance is not useful if you cannot collect recoveries after an event. The key factors analyzed by the rating agencies are: -Financial performance -Exposure to catastrophes -Strength of management Rating Agencies 

PricewaterhouseCoopers April 2006 Slide 31 Finance 431 Rating Agencies Have a Significant Impact on Property Catastrophe Insurance and Reinsurance Reinsurers typically cannot write any business if their rating is below a certain level. (Typically “A”) Rating agencies have become much more focused on cat risk after the past few years of significant losses. Their quantitative models consider aggregate PMLs and the impact of such events on the financial statements. Previously only event PMLs were considered. Actual Katrina loss results were compared against peers and previously supplied estimates to determine the potential for downgrades. Rating Agencies 

PricewaterhouseCoopers April 2006 Slide 32 Finance 431 Conclusions If you work in insurance, catastrophes will affect you. Catastrophe risk is an increasing cost for society. The property catastrophe reinsurance business is very complex. New vehicles are being created to mitigate catastrophe risk. Conclusion

PricewaterhouseCoopers April 2006 Slide 33 Finance 431 Follow-Up Should you need any assistance please contact me at: James Matusiak PricewaterhouseCoopers One North Wacker Chicago, IL