1. Catastrophes Insurable vs. Non-Insurable Catastrophes
History of Insured Losses from Catastrophes
Reasons for Growth in Catastrophe Exposure
How Insurers Deal with Catastrophe Exposure
What Is Being Done to Help Industry Cope with Catastrophes
Securitization of Catastrophe Risk

2. Insurable vs. Non-Insurable Catastrophes
Ideal Criteria for an Insurable Exposure
1 Large Number of Similar Exposure Units
2 Fortuitous Losses
3 Catastrophe Unlikely
4 Definite Losses
5 Determinable Probability Distribution
6 Economic Feasibility

3. What Makes a Loss Uninsurable?
1 Large Number of Similar Exposure Units
If losses are concentrated in a particular area
Earthquakes, Floods
2 Fortuitous Losses
If location and timing of losses can be predicted
Flooding downstream after upstream area affected
Catastrophe Unlikely
If potential loss could hurt financial condition of industry
Tornadoes, riots can be covered
War, nuclear disaster cannot be covered

4. History of Insured Losses from Catastrophes - 1

5. History of Insured Losses from Catastrophes - 2

6. History of Insured Losses from Catastrophes - 3
Significant change in size of catastrophes occurred starting in 1989
The ten largest insured losses have all occurred since 1989
Taking inflation into account, eight of the ten largest losses have occurred since 1989
Current estimates of possible losses
New Madrid Fault Earthquake $116 billion
California Earthquake $77 billion
Florida Hurricane $76 billion
Northeast Hurricane $21 billion

7. Reasons for Growth in Catastrophe Exposure
Weather Pattern Change
Period of Unusually Good Weather (?)
Recent Return to the Long Term Norm
Population Growth in At Risk Areas for Hurricanes
Southeastern seacoast
Lowered Building Standards
Lulled by Reduced Storm Activity
Overwhelmed by Population Growth
Mandates to Cover Earthquakes
Impact of Catastrophe on Repair/Rebuilding Costs

8. How Insurers Deal with Catastrophe Exposure
Reinsurance
Managing Exposures
Sophisticated catastrophe modeling
Limiting concentration of exposures
Monitoring by zip code
Higher deductibles
Premium Increases
Withdrawals from Some Markets

9. What Is Being Done to Help Industry Cope with Catastrophes
California Earthquake Authority
Florida Hurricane Catastrophe Fund
Hazard Mitigation Grant Program (Floods)
Homeowners Insurance Availability Act (1999)
Not enacted yet
Would provide catastrophe reinsurance
Tax Deferred Catastrophe Reserves
Proposals under consideration in Congress

10. New Developments Securitization of Catastrophe Risk
Exchange-traded catastrophe options
Contingent capital
Risk capital

11. Insurance Securitization
Impetus
Insurance Markets
$ Billion in Capital
Financial Markets
$10-15 Trillion in Capital
Catastrophe Potential $ 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

12. 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

13. Contingent Capital Insurer Could Buy Put Options 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 12

14. 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 13

15. Benefits of Cat-E-Puts
Allows the buyer to protect its balance sheet
Rating agencies view this approach favorably
Cost compares favorably with reinsurance 14

16. Risk Capital Over $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 funds Hedge funds Reinsurers
Life insurers Money managers 19

17. 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 20

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 Re 6 times
BB rated debt 2.2 times
Emerging markets times
Problem: This approach ignores the loss distribution. Catastrophe coverage has greater chance of total loss of principal than other debt. 25

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. 26

20. Summary
Catastrophes can be so large that the insurance industry may be unable to handle them under traditional method
Securitization can be an effective way to handle catastrophe and other insurance risks
This field is just beginning to develop
Expertise needed in both insurance and finance 27