1. Insurance Securitization Impetus Insurance Markets $200-250 Billion in Capital Financial Markets $10-15 Trillion in Capital Catastrophe Potential $70-120 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 Derivatives CBOT Cat Insurance Futures and Options Bermuda Commodities Exchange Cat Options Contingent Capital Line of Credit Contingent Surplus Notes Catastrophe Equity Puts Risk Capital Catastrophe Bonds

3. CBOT Catastrophe Insurance Futures and Options CAT Insurance Futures Introduced in December, 1992 National and Regional Contracts Based on ISO paid loss data 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 Estimates of Insured Losses from Catastrophes National and Regional Contracts Two Sizes Small Cap (up to $20 Billion) Large Cap ($20 to $50 Billion)

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. Current Status of PCS Options No trading has taken place since December, 1999. Typical Trade: Option Spreads Buyer purchases the lower strike price option and simultaneously sells the higher strike price option.

8. Problems with the PCS Options Large Bid/Ask Spreads Example (11/28/97) National 5/25 Call Spread for December 1997 Bid1.7 Ask6.0 Low Liquidity Entire day’s trading equals $500,000 of coverage

9. 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

10. 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

11. Benefits of Cat-E-Puts Allows the buyer to protect its balance sheet Rating agencies view this approach favorably Cost compares favorably with reinsurance

12. Alternative Catastrophe Securitization Risk Capital $1.5 billion of risk capital raised since 1995 Typical case - pre-funded, fully collateralized Provides insurance company with additional capital and multiyear coverage for catastrophes Provides investors with diversification and high yields Investors include: Mutual fundsHedge funds Reinsurers Life insurersMoney managers

13. Examples of Risk Capital USAA raised $477 million in June, 1997 and $450 million in June, 1998 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

14. USAA Catastrophe Bonds Residential Re raised $477 million in capital in 1997 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

15. 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

16. 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

17. 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

18. 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 Later trading 6 times Swiss Re6 times BB rated debt2.2 times Emerging markets1.3-2.7 times Problem: This approach ignores the loss distribution. Catastrophe coverage has greater chance of total loss of principal than other debt.

19. Additional Points Concerning Risk Capital Offshore subsidiary (Special Purpose Vehicle) 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.

20. Securitization of Other Insurance Risks Potential for Satellite insurance Marine insurance (large vessels) Product liability Insurance related bonds issued by countries where insurance cannot be obtained

21. Summary Securitization can be an effective way to handle catastrophe and other insurance risks Field is just beginning to develop Expertise needed in both insurance and finance