1 Z Swiss Re New Markets INSURITIZATION Presentation to CAS CARe Seminar Nick Giuntini, FCAS August 15, 2000

2 Z Swiss Re New Markets AGENDA Insuritization What is the Opportunity Why Does it Exist General Underwriting Approach Possible Pricing Pitfalls / Issues

3 Z Swiss Re New Markets 1) Definition Insuritizition Placing risks that originate in the capital markets into the (re)insurance markets. - e.g. wrapped bonds (credit enhancement) > Securitization Placing risks that would otherwise reside with (re)insurance companies into the capital markets - e.g. cat bonds

4 Z Swiss Re New Markets 1) Opportunities Types of Risks where Insuritization has been/can be used: Municipal Bond Insurance CDOs Project Finance Royalty Streams film franchise drug music NEW, ESOTERIC OR UNDERSERVED ASSET CLASSES ARE REAL OPPORTUNITIES FOR (RE)INSURERES.

5 Z Swiss Re New Markets Coupon - Decomposition Coupon Spread Risk-free rate Risk premium Novelty Premium Compensating the default risk of a non risk-free investment Bonus for investing in a new asset class (novelty premium) - decrease over time 1) Capital Markets Pricing

6 Z Swiss Re New Markets 1) Capital Markets Pricing

7 Z Swiss Re New Markets Spread to LIBOR 1) Pricing Comparison - Examples

8 Z Swiss Re New Markets 1) Why is Capital Markets Pricing Higher for Certain Risks? Illiquid Small Volumes of Risk Traded New Asset Class Lack of Coverage / Interest Uncertainty About Risk / Loss Estimates Accumulating vs. Diversifying Risks (1 Sided vs. 2 Sided)

9 Z Swiss Re New Markets 1) Accumulating vs. Diversifying Risks Diversifying Risks 2 Sided Risks Natural Longs & Shorts Capital is not needed for risk if you can match up longs & shorts Generally most efficiently handled through Capital Markets e.g. Foreign Exchange Risk, Interest Rate Risk. Accumulating Risks 1 Sided Risks Society is overall long in these risks Society net needs capital for these risks Generally most efficiently handled by entities that can diversify their capital exposure with other accumulating risks (i.e. Insurance Cos.) e.g. Property Cat risk

10 Z Swiss Re New Markets 1) (Re)insurer’s Competitive Advantages  Ability to underwrite & price difficult underlying risks, while separating or mitigating the risks that cannot be underwritten effectively  Ability to manage the risk within a diversified risk portfolio  High quality Ratings (i.e. AAA)

11 Z Swiss Re New Markets 1) SRNM Risk Screening Process Criteria for underwriting of Asset Backed Risks Strong deal economics - lack of an efficient alternative market for the risk Access to expertise, or ability to acquire needed expertise Accepted model for the risk Quality data that can be used to define the expected distribution Low management risk or moral hazard risk

12 Z Swiss Re New Markets Un-Funded Solution Derivative Transaction Liquidity Facility Surety Financial Guarantee Policy Insurance of Underlying Risks Monoline Company as a Front Funded Solutions On-Balance Sheet Off-Balance Sheet - Conduit, Repo, Total Return Swaps, Rented CP Facilities 1) Form of Risk Transfer

13 Z Swiss Re New Markets 2) POTENTIAL PRICING PITFALLS / ISSUES Alignment of Interests / Moral Hazard Trend or Cycle? Too Little Data “Too Much” Data Change in Underlying Process Inappropriate Data Over-Reliance on Linear Regression “Trending, Developing & On-levelling” others...

14 Z Swiss Re New Markets 2) Alignment of Interests - Moral Hazard “We wouldn’t have done these deals had they not been insured” - John Miller, Managing Director - Chase Securities In reference to insured film loans where claim have been filed against the insurers. The insurer’s, however, claim that they were relying on Chase’s track record of historically successful film lending. WSJ - July 20, 2000

15 Z Swiss Re New Markets 2) Trend or Cycle? Are current oil prices part of a trend or just a temporary peak?

16 Z Swiss Re New Markets 2) Too Little Data

17 Z Swiss Re New Markets 2) “Too Much” Data “We used 17,500 data points to predict the price of electricity.” This will show the price of electricity as a function of gas prices, temperature, generating capacity, time of day, and day of week. However, these data points are only 2 years worth of information (hourly observations).

18 Z Swiss Re New Markets 2) Change in Underlying Process Start of Open Rating

19 Z Swiss Re New Markets 2) Inappropriate Data Correlation between daily price movements is 2%. However, correlation when Ford is down at least 3% is 24%.

20 Z Swiss Re New Markets 2) Over-Reliance on Linear Regression Regression estimate would have dramatically overestimated new stores.

21 Z Swiss Re New Markets 2) “Trending, Developing & On-Leveling” Data not adjusted for economy or increasing size of portfolio.

22 Z Swiss Re New Markets CONCLUSION Big Opportunities for (Re)Insurers Risk Understanding & Quantitative Analysis Crucial Be Careful Make Informed Judgements Where Uncertainty Exists - Be “Conservative” Include both Insurance & Finance Perspective