1. Financial Risk Management of Insurance Enterprises
Securitization of Catastrophe Risk 1 1

2. Securitization of Catastrophe Risk
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

3. Securitization of Catastrophe Risk
Three Basic Approaches
Exchange traded securities
CBOT Catastrophe Futures and Options
Contingent Capital
Cat-E-Puts
Risk Capital
Catastrophe Bonds 3

4. CBOT Catastrophe Insurance Futures and Options
CAT Insurance Futures
Introduced in December, 1992
Quarterly contracts
National, Eastern, Midwestern and Western regions
Based on ISO paid loss data for 22 insurers, adjusted to industry level
Perils included:
Wind Hail Earthquake Riot Flood
Settlement value
Loss Ratio x $25,000 ($50,000 cap) 4

5. 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

6. PCS Catastrophe Insurance Options
Introduced in 1996
Underlying is the PCS Index
Nine Geographic Areas
National Five Regions Three States
Two Sizes
Small Cap (up to $20 Billion)
Large Cap ($20 to $50 Billion)
Development Period to Value PCS Index
Six Months
Twelve Months 6

7. 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

8. PCS Option Pricing
PCS Option prices are quoted in points and tenths of a point. Each point equals a cash value of $200.
Example:
On 11/28/97, 50 Western Region 1998 Annual Calls with a Strike Price of 150 traded at The cost of each option was $500. If losses in 1998 exceed $15 billion (150x100 million), each option will be worth $200 for each $100 million of losses in excess of $15 billion. Since this is a small cap option, the maximum value of each option is $10,000 ($5 billion/100 million x $200). Thus, for a total cost of $25,000, the buyer of these 50 options purchased $500,000 of catastrophe coverage. 8

9. Status of PCS Options Open Interest 16,793 (as of 11/28/97)
Daily Trading Volume: Low
Week of 11/24: 310 Options
Week of 11/17: No trades
Week of 11/10: 40 Options
Typical Trade: Option Spreads
Buyer purchases the lower strike price option and simultaneously sells the higher strike price option. 9

10. Problems with the PCS Options
Large Bid/Ask Spreads
Example (11/28/97)
National 5/25 Call Spread for December 1997
Bid 1.7
Ask 6.0
Low Liquidity
Entire day’s trading equals $500,000 of coverage 10

11. PCS Options
No longer traded

12. 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 12

13. 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

14. 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

15. Components of Cat-E-Puts
Put Option Terms
Face amount of securities to be issued (with minimum)
Exposure period: 1-10 years
Annual option premium
Trigger and post event term option can be exercised
Establishes minimum net worth the company must have to exercise the option to assure option writer that the company is viable after the loss
Warranties regarding maintenance of reinsurance, aggregate ratios and change in management control 15

16. Components of Cat-E-Puts
Equity Security Terms
Type of security
Common stock
Convertible debt
Term
Conversion details
Yield
Voting interests and board representation
Conditions for buying back the issue to avoid long term dilution of interests 16

17. Hypothetical Cat-E-Put Example
Primary insurer contracts with investment bank to obtain contingent financing in the event of a single aggregate industry loss (measured by PCS) in excess of $5 billion over the next 3 years. For an annual payment of $4 million, the insurer can sell up to 1 million shares of restricted common stock to the investment bank at $50 per share within 90 days of the loss, with a minimum issue of 400,000 shares. Insurer has the right to buy back the stock over the following three years at a price representing a 15% annual return to the bank. This option cannot be exercised if the statutory surplus of the insurer is less than $60 million. The agreement is void if the insurer fails to maintain a set amount of reinsurance or incurs a change in management control. 17

18. Hypothetical Cat-E-Put Example
If the industry does not experience a $5 billion loss within the next 3 years, the bank gets a total of $12 million in premiums and does not buy the insurer’s stock. If there is a loss of that magnitude, the insurer may decide not to exercise the put option if its stock price exceeds the strike price or if it does not need the additional capital. If the loss is so large that it bankrupts (or severely impairs) the insurer, the option cannot be exercised. If the insurer does exercise the put option, it may buy the stock back from the bank when it regains its financial position. In the worst case, the bank ends up owning a significant portion of this insurer, which it can then sell when the buy-back option period expires. 18

19. Alternative Catastrophe Securitization
Risk Capital
$6 billion of risk capital raised since 1994
45 Cat risk transactions
Typical case - pre-funded, fully collateralized
Provides cedants 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

20. Issuers and Investors Sponsorship of transactions includes:
Allianz, AGF, CEA, Gerling, Kemper, Mitsui, USAA , State Farm, Tokio, Winterthur, XL Capital, Yasuda, Zurich
AXA Re, Hannover Re, Munich Re, Scor, St. Paul Re, Swiss Re
Investors include:
Reinsurers, Insurers, Banks, Investment Advisors/Mutual Funds, Hedge/ Proprietary Funds

21. Risks Covered Gulf Coast Hurricane California Earthquake Europe Wind
Japan Earthquake
Japan Typhoon
Midwest Earthquake
Northeast Hurricane
Monaco Earthquake
Puerto Rico Hurricane
Europe Hail
Hawaii Hurricane

22. Triggers
Indemnity
Parametric
PCS
Modeled Loss

23. Examples of Risk Capital
USAA raised $477 million in June, 1997
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

24. USAA Catastrophe Bonds
Residential Re raised $477 million in capital
Two tranches
A-1 Extendible Principal Protected Bonds
Pay LIBOR 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 basis points
$313.2 million bonds 21

25. 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 22

26. 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 23

27. 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 24

28. 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
Current 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

29. Additional Points Concerning Risk Capital
Offshore subsidiary 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

30. Summary
Insurers and reinsurers are developing new ways to transfer risk. Some of these techniques will be modeled after other financial securities, such as options, futures, and CMOs. Actuaries will need to play a role in this process, which will necessitate learning about non-traditional financial instruments. This represents an opportunity for actuaries of the third kind. 27