1 Economic Benefits of Integrated Risk Products Lawrence A. Berger Swiss Re New Markets CAS Financial Risk Management Seminar Denver, CO, April 12, 1999 Session: Innovative Approaches to Managing Financial Risk

2 Integrated contracts combine several risk lines over several years into a product with common retention and coverage Single Line vs. Integrated Program Design Years Traditional single line approach Yearly renewals Separate lines Many providers Cost intensive Coverage Integrated approach Multi-year Multi-line One provider Cost efficient Years Insurance Line 1 Insurance Line 2 Financial Line 1 Financial Line 2 Coverage Insurance Line 1 Insurance Line 2 Financial Line 1 Fin Line 2

3 Integrated coverage is a more efficient way to provide insurance capacity One block of capacity is available to meet all losses. Across lines of insurance Across financial exposures Across time Unused capacity from one risk is available to fund losses from other risks. Unused capacity from one year is available to fund losses from future years.

4 Integrated coverage is a more efficient way to provide insurance capacity Insurance and Financial Capacity Insurance Capacity Integrated Solution Single Lines Insurance Loss Financial Loss Financial Capacity Loss Experience Retention

5 Integrated coverage is a more efficient way to provide insurance capacity Insurance Loss Financial Loss Insurance Loss Financial Loss Unused Capacity Not Covered Unused Capacity Integrated Solution Single Lines

6 Integrated contracts provide a superior coverage structure compared to single line contracts Line 2 Line 1 Coverage with two single lines 50 Line Line 1 Coverage with limits

7 Integrated contracts provide a superior coverage structure compared to single line contracts Line 2 Line 1 Line 2 Line 1 Integrated coverage enables a superior risk management technology: New full coverage for large combined losses regardless of their composition (A) Elimination of coverage for low losses in one risk line if the loss in the other risk line is relatively small (B) Covers low frequency, high severity events. Insured retains high frequency, low severity risks. Integrated Coverage B B A A

8 Cost Savings Cost savings can range from 10-20% when the probability of losses in area A is considerably less than area B. Alternatively, retention can be lowered and/or capacity can be increased to be comparable in cost to single line coverage.

9 Quantifying the Benefits How to include the higher expected retention? Utility theory approach: Expected utility is higher for the purchaser of an integrated cover than for the purchaser of an unbundled cover with the same cost.

10 DFA Analysis Economic and Asset Simulation A Liability & Business Simulation L Optimization & Valuation M Measurable Financial Risk

11 A simulation model is used to project possible future economic and capital market conditions. Interest rates, inflation, P/E ratios, GDP, currency strength, alternative yield curve factors Asset class characteristics and parameters ,000 or more stochastic (random) economic and capital market scenarios Asset class total returns, broken down into income and capital appreciation Key Inputs Key Outputs Economic and Capital Market Simulation Model

12 Interest rates are simulated to capture year-to-year volatility and its impact on financial results % 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 12/31/9612/31/9712/31/9812/31/9912/31/0012/31/01 90-day T-bill Rate

13...to reflect the risk exposure of alternative investment strategies. Bonds Cash1-5 year5-10 yearEquities Mean Standard Dev. 6.0%6.7%7.1%11.0% 1.5%4.6%9.5%20.6% Percentile 95th 75th 50th 25th 5th Average Annual Returns Total Return (%)

14 Liabilities are simulated to create a picture of current and future premium, loss and expense cash flows. Existing reserve data & characteristics Business Plan assumptions (3-5 yrs) ,000 stochastic liability scenarios Distribution of existing reserve cash flows Distribution of new business cash flows Key Inputs Key Outputs Liability Simulation Model

15 The asset and liability scenarios are put together to assess risk and reward opportunities. Economic and asset scenarios Liability and business scenarios Financial data (statutory, GAAP, tax) Objectives and constraints Sensitivity testing ALM efficient investment strategies (surplus risk & reward) Stochastic financial statements Risk Management Analysis Strategic business applications Key Inputs Key Outputs/Uses Optimization & Valuation System

16 Statutory Surplus Risk Profile

17 GAAP Income Risk Profile

18 Equities Interest Rates Foreign Exchange Corporate Bond Defaults Commodities Capital Markets Coverages

19 Equity Market Risk Company 1 is a mutual company with a large position in equities due to the runup in equity values. Management is concerned about future declines in value. Solution: Combine reinsurance protection with protection against declines in the S&P 500. Provide aggregate excess of loss where retention is reduced with declines in S&P. Protects against impact of equity market declines on income and surplus.

20 Equity Market Risk Provides cost savings for a company that buys reinsurance and equity market protection separately. Provides expanded protection at additional cost for a company that does not currently hedge its equity position. Alternatively, an Integrated Collar approach can be used to provide equity market protection at no additional cost (see below).

21 Interest Rate Risk Company 2 is a stock company with a large position in corporate and government bonds. Management is concerned about the potential impact of increases in interest rates on net worth. Solution: Combine reinsurance protection with protection against increases in interest rates. Provide aggregate excess of loss where retention is reduced with increases in an interest rate index.

22 Combined Capital Markets Coverage If Company 2 is also concerned about equity market declines, retention can be reduced with an increase in interest rates and/or a decline in the S&P 500 in one combined cover.

23 Corporate Bond Defaults Company 3 has a large position in corporate bonds. Management is concerned about the potential impact of corporate bond defaults on surplus. Solution: Combine reinsurance protection with protection against corporate bond defaults. Aggregate excess of loss is extended to include losses on corporate bonds as insurable coverage.

24 Combined Capital Markets Coverage A company with exposures to equity markets, interest rates and corporate bond defaults can include all of these risks in an integrated cover together with traditional reinsurance.

25 Aggregate Excess of Loss where retention goes up or down depending on performance of capital markets exposures. Example: Retention moves up when S&P goes up by more than 15% in one year. Retention moves down when S&P goes down by more than 5% in one year. Integrated Collar

26 Can be designed to add no additional cost to the aggregate cover. Retention can also move with interest rates, or can move with the S&P and/or interest rates in a combined cover Integrated Collar