1 Financial Risk Products: Case Study Perspective

Swiss Re Capital Markets 2 Discussion Topics Insurance Linked Securities Case Study I - Hypothetical ILS Transaction Case Study II - Basis Risk Transaction

Swiss Re Capital Markets 3 Securitization - Overview SPVRe-insurer Investors Investments Swiss Re Financial Products Principal & Interest Cash Proceeds Reinsurance Premium Contingent Claim Payment Cash Proceeds Investment Earnings Scheduled Interest Investment Earnings 123 4

Swiss Re Capital Markets 4 Swiss Re Financial Products Investors Swap Transaction based on notional amount Floating Rate Amounts Re-insurer Contingent Claim Payment Reinsurance Premium Fixed Amounts Floating Rate Amounts Fixed Amounts Swap - Overview 123

Swiss Re Capital Markets 5 Case Study I - Overview Understanding of situation Risk mapping Exposure Structuring issues Delivery mechanism Elements of a Capital Market solution

Swiss Re Capital Markets 6 Case Study I: Risk Source Earthquake (EQ) risks in California Source: United States Geological Survey, National Earthquake Information Center,

Swiss Re Capital Markets 7 Case Study I - Situation Analysis ABC is global leader in the microchip industry Its factory is based in Palo Alto, California California is highly exposed to EQ risks Therefore, ABC seeks for protection against a potential profit drop resulting from a devastating EQ harming its microchip production Because of the current market conditions there is no cover available on the traditional insurance market; ABC approaches you to propose a Capital Market solution

Swiss Re Capital Markets 8 Magnitude (M) Measurement of energy release Richter Scale (and others) M max: ~8.5 Damage: M>=5.0 Intensity (MMI) Observation of effects Modified Mercalli Scale - MMI (and others) MMI 12 degrees: I to XII Damage: MMI >=VI Case Study I - Risk mapping, definition of EQ MMI = Modified Mercalli Shaking Intensity, average soil conditions Source: Swiss Re Reinsurance & Risk, RN/CP, SNAP EQ focus (hypocenter) epicenter Fault plane Intensity map

Swiss Re Capital Markets 9 Case Study I - Exposure Turnover Net profit In USD m Source: Annual Reports

Swiss Re Capital Markets 10 Case Study I - Risk mapping, return periods p.a.

Swiss Re Capital Markets 11 Case Study I - Structuring issues Issuer’s Needs vs. Investor’s Demand Loss Basis Risk Profile Triggering Event Coverage Period Other Structuring Considerations

Swiss Re Capital Markets 12 Case Study I - Delivery mechanism Structured Note –Onshore vs. Offshore Issuer –Defeased vs. Non-defeased –Fixed vs. Floating Rate –Public vs. Private –Single vs. Multiple Traches Derivative Instrument –Swap vs. Option –ISDA regs –Targeted Buyers

13 Case Study II Basis Risk Swap Transactions

Swiss Re Capital Markets 14 Basis Risk Transaction Exchange of cash flows based on two variable indices –Amount you pay and receive will change according to the movements in two separate indices Basis Swaps –Common capital markets instrument Capital Markets Indices –London Interbank Offer Rate (LIBOR) –Commercial Paper (CP) –F/X rates –S&P 500 –Etc.

Swiss Re Capital Markets 15 Example: LIBOR versus CP 5.40% 5.60% 5.80% 6.00% 6.20% 6.40% 6.60% 6.80% Year 1Year 2Year 3Year 4Year 5 LIBOR CP Domestic interest rates tend to move in the same direction However, the difference between different interest rates will vary over time

Swiss Re Capital Markets 16 Example: LIBOR versus CP Company A issues commercial paper and invests in floating rate notes at L + 50bps Company A does not wish to take the risk that CP rates will increase faster than LIBOR or decrease slower than LIBOR Company A approaches Swiss Re Financial Products (SRFP) and enters into a basis swap Company A pays LIBOR to SRFP SRFP pays CP + 10 to Company A Company A locks in 60 bps spread

Swiss Re Capital Markets 17 Example: LIBOR versus CP Company A Receives from FRN: LIBOR + 50 Pays to SRFP:LIBOR Net:+ 50 Receives from SRFP: CP + 10 Pays to investors:CP Net+ 10 Total+ 60 SRFP Company A Floating Rate Notes LIBOR + 50 Commercial Paper LIBOR CP + 10

Swiss Re Capital Markets 18 Basis Risk Transactions in Insurance Potential Loss Tiggers in Re/Insurance Markets –Actual losses –Industry Losses –Loss ratios –Losses on different perils Value of Basis Swap Transactions –To hedge a position already taken (reduce risk profile) –To arbitrage a market inefficiency (get cheaper overall pricing) –To be an innovator –To speculate

Swiss Re Capital Markets 19 Basis Transaction #1 SRNM Corporate/ Insurer/ Reinsurer Basis Transaction Indexed Protection Outside Source Client gets indexed cover from outside source Client enters into basis transaction with SRNM –Client pays to SRNM any recoveries made on indexed cover –SRNM pays client for actual losses incurred

Swiss Re Capital Markets 20 Basis Transaction #2 Corporate/ Insurer/ Reinsurer Indexed Reinsurance or Security or Swap or Option Investors Indemnity Agreement SRNM Basis Risk Client gets indemnity cover from SRNM SRNM issues indexed paper to the market –SRNM keeps the basis risk

Swiss Re Capital Markets 21 Basis Transaction #3 Client receives return on a portion of SRNM’s California earthquake book of business SRNM receives return on a portion of Client’s Japan earthquake book of business –SRNM may or may not enter into a transaction to hedge itself Client’s overall book of business is better diversified Corporate/ Insurer/ Reinsurer Indexed Reinsurance or Security or Swap or Option Outside Source SRNM Basis Risk Portfolio Swap Japan quake Cal. quake

Swiss Re Capital Markets 22 Basis Swap Example A XYZ Reinsurer is attempting to get windstorm coverage for Florida, Texas, and the East Coast –XYZ Re wants to pay 7% –No offers XYZ Re approaches SRNM for alternative solutions SRNM analyses XYZ Re’s book of business and determines the level of industry losses equivalent to the layer XYZ Re wants reinsured XYZ Re purchases ILW for 6% from an insurer / CM investor(s) and enters into basis transaction with Swiss Re for 1%

Swiss Re Capital Markets 23 Basis Swap Example (cont.) Basis risk transaction –XYZ Re pays claims to Swiss Re based on industry losses Any claims XYZ Re must pay to Swiss Re it will receive from Insurer as part of ILW –Swiss Re pays claims to XYZ Re based on losses on XYZ Re’s reinsurance book –If Windstorm occurs and industry losses are large relative to XYZ Re’s book, Swiss Re receives payment –If XYZ Re’s losses are large relative to the industry, Swiss Re makes a payment

Swiss Re Capital Markets 24 Basis Swap Structure XYZ Re Receives from Ins. / Investor: Industry Losses Pays industry losses to SR: Industry Losses Receives payment from SR: Actual Losses Net:Actual Losses XYZ Re Insurer / Investor Basis Risk - Sell Reinsurance Buy ILW Texas to Maine ILW Swiss Re Basis Risk XYZ ReSwiss Re 10 mm ILW Reinsurance 20 million - 50% QS