Managing Catastrophic Risk: Developments in Capital Market Alternatives to Reinsurance

1. Managing Catastrophic Risk: Developments in Capital Market Alternatives to Reinsurance Sylvie Bouriaux, Ph.D. Richard MacMinn, Ph.D. College of Business Illinois State University Presentation for the Third Annual Illinois State University Actuarial Research Event April 19th, 2007

2. Presentation Outline • Genesis of the Insurance-Linked Securities (ILS) and Insurance-Linked Derivatives markets • ILS Market Overview and Current Status • Market Drivers • Market Impediments • Latest Development in CAT-linked futures and options

3. Market Genesis • 1992: CBOT Homeowners Insurance futures • 1995: CBOT CAT Insurance (cash) options • 1997: First credit-rated CAT bonds and notes • 2001: First Sidecar • 2003: • First extreme mortality risk bonds • First terrorism risk related bonds • 2006: First XXX bonds • 2007: • NYMEX CAT Risk Index Futures and Options • CME Hurricane Futures and Options

4. Market Overview and StatusThe Catastrophe Bond Market

5. Market Overview and StatusThe Catastrophe Bond Market • Size and growth: • Annual issuance in the CAT bond market totaled $4.69 billion in 2006, more than twice the amount issued in 2005 • Since 1997, 89 bond transactions have been completed for a total of $15.35 billion issued

6. Market Overview and StatusThe Catastrophe Bond Market

7. Market Overview and StatusThe Catastrophe Bond Market • New cedents: • New insurance companies: • e.g. Liberty Mutual issued the Mystic Re. Ltd bond program raising $525 million in capacity for its U.S. wind exposure • New direct writers: • Government of Mexico issued $160 million in CAT-triggered debt • Dominion Resources issued $50 million in CAT-triggered debt as a protection for its oil-drilling assets located in Louisiana and Texas

8. Market Overview and StatusThe Catastrophe Bond Market • CAT bond payout triggers • Indemnity or company-based triggers: Payout to the issuer of the bond is based on the insurer’s actual losses • Index-based or industry-based triggers: Payout to the issuer of the bond is based on an “index” of: • Industry losses resulting from one CAT event or from multi-events • Physical characteristics of a catastrophe (called parametric trigger) • Hybrid triggers: use more than one trigger type in a single bond transaction. For instance: • A loss trigger for a US based catastrophe and a parametric trigger for a Japanese based disaster • A sequential event trigger: e.g. the bond payout is triggered by a second catastrophe occurring that year with losses exceeding X dollars

9. Market Overview and StatusThe Catastrophe Bond Market • Pros/cons of various triggers for bond issuers

10. Market Overview and StatusThe Catastrophe Bond Market • Pros/cons of various triggers for investors

11. Market Overview and StatusThe Catastrophe Bond Market • Bond Ratings: • The bulk of ILS ratings is in the range of BBB (investment grade) to B. • There is a trend towards lower ratings of ILS due to: • Higher demand from institutional investors who prefer taking additional risk for a higher yield. • Market reaction to the 2004-2005 hurricanes

12. Market Overview and StatusThe Catastrophe Bond Market • Pricing: • On average, yields on Cat bonds and other ILS have increased due to: • excess demand for coverage (i.e. increased bond issuance) compared to supply (i.e. pool of investors) • increased perception of risk due to • 2005 storm activity • Role of some modeling companies that revised their US wind exposure models to: • Key vulnerability • Post-event loss-amplification assumptions

13. Market Overview and StatusThe Catastrophe Bond Market

14. Market Overview and StatusOther types of ILS securities • Fitch Ratings estimate that, as of September 2006, property CAT bonds only represent 39% of insurance securitisation issues. • Other types of ILS securities that have emerged in the last few years are: • Sidecars • Extreme mortality bonds • Regulation XXX securities • Terrorism bonds • Others

15. Market Overview and StatusOther types of ILS securities

16. Market Overview and StatusSideCars

17. Market Overview and StatusSideCars • In 2006 there were 11 sidecar transactions totaling $2.91 billion in debt and equity capital. • Sidecars are designed to last two to three years and then liquidate or renew based on market conditions • The 2005 hurricane season did wipe out the $650 million sidecar, Olympus Re, arranged in 2001 by White Mountain Insurance Group

18. Market Overview and StatusSidecars

19. Market Overview and StatusExtreme Mortality bonds • Extreme mortality transactions allow insurers and reinsurers to transfer exposure to extreme mortality events, e.g. pandemic, war or terrorist event, to the capital market. • Investors may forfeit bond principal in these events. • These bonds have a structure very similar to parametrically triggered CAT bonds. The trigger is typically an average death rate for a country or countries • Because of the trigger there is basis risk. • To date there have been four transactions.

20. ILS Market: Current Market Drivers • Post Katrina: Reinsurance capacity dramatically tightening • Katrina cost $65 billion in insured losses. Insurance companies are looking for capital market alternatives to reinsurance. • Reinsurance companies either want to get out or retrocede their risks. • States are investigating alternatives to reinsurance or to state pools. See Florida’s ‘super cat” fund. • Fear factor: Katrina, bird flu, terrorism risk • Large interest from investors, especially hedge funds • Regulators are turning around especially in Europe but also in the US.

21. Impediments to growth in ILS market • Lack of dual coincidence of wants: • Investors prefer index-based securities: • They are wary of adverse selection ( an insurance company securitizing the most unattractive part of its risk portfolio) and moral hazard (an insurance company transferring its risk to the capital markets may no longer have an incentive to limit its losses) • Bond issuers traditionally have preferred indemnity-based securities • They are wary of basis risk, which may impair an insurer or a reinsurer's ability to fully recover its loss • In CAT insurance, basis risk is hard to assess and quantify. • However, in the last few years, index-based CAT bonds have started to flourish, indicating a willingness by insurers to deal with the basis risk issue. • Some research has also indicated that index-based CAT bonds may be a superior to indemnity-based bonds because the moral hazard issue outweighs the basis risk issue • Market is only institutional: ILS fall under SEC rule 144A • Low liquidity because of no transparency • Unfavorable regulatory treatment (for index-based securities), although regulators in the US (NAIC) may be willing to re-open the issue

22. Basis Risk in Insurance and Reinsurance Markets • In general, basis risk occurs when an insurance company may not fully recover its loss. Basis risk is well-known and well quantified in the financial markets. In insurance markets, basis risk is harder to quantify. • In a 1999 report, the American Academy of Actuaries (AAA) identifies various sources of basis risk in insurance securitized structures: • Nature, intensity and geographic location of an event • Operational or underwriting differences between an insurer’s portfolio of policies and the portfolio underlying the index-based instrument. • Construction of the capital market instruments’ underlying index

23. Latest Developments in CAT-linked futures and options • New York Mercantile Exchange (NYMEX) CAT Risk index futures and options • Chicago Mercantile Exchange (CME) Hurricane futures and options on futures

24. NYMEX CAT Risk Index Futures and Options • Standardized futures and options contracts co-developed by NYMEX and Gallagher Re. • Futures and options settle against an index of PCS industry loss estimates (Re-Ex index developed and maintained by Gallagher Re). • Futures contracts are offered in open outcry. Option contracts are offered on the Globex electronic venue. • Options contracts can also be executed off-exchange in an over-the-counter transaction and cleared by NYMEX clearing corporation

25. NYMEX CAT Risk Index Futures and Options • Futures Contract Specifications • The Futures contract price is based on market estimates of cumulative industry losses (as estimated by PCS) over a calendar year. • The Re-Ex index contains estimated losses from the following perils: hurricane, tropical storm, wind and thunderstorm, water damage, winter storm, riots, volcanic eruption, utility service disruption and wild land fire. Earthquake and terrorism losses are NOT included in the index • The index value is computed as the sum of cumulative industry loss estimates divided by $10 million. For instance, a market estimate of $25 billion cumulative industry losses translate into a 2,500 index. • In the futures market, 1 point is $10, therefore a 2,500 index translates into a $25,000 value • The futures and option contracts settle against cash, three months after the end of the calendar year. • Futures and option contracts are currently offered on three regions: Nationwide, Texas to Maine (except Florida) and Florida

26. CME Hurricane Futures and Options on Futures • The futures contract price is based on the Carvill Hurricane Index (CHI) which is based on the parametric features of a hurricane, such as maximum wind velocity and size (radius) of each official storm to calculate the potential for damage. • The futures and option contracts stop trading and expire as soon as an official hurricane makes landfall. The contracts settle in cash against the value of the Carvill index, which is immediately released after the hurricane landfall • The dollar size of the CME hurricane futures contract is $1,000 times the Carvill index. For instance, if the market predicts a Carvill index of 200, the futures contract’s value is $200,000. the futures contract is traded in increments of 0.10 CHI index points or $100 • Hurricane Futures trade on the Globex electronic platform. Options on hurricane futures trade on the CME floor • Futures and option contracts are currently offered on the following regions (for the 1st to 10th event) • Gulf Coast • Florida • Southern Atlantic • Northern Atlantic • Eastern

27. Additional sources of basis risk in NYMEX and CME derivatives • Basis risk, when identified and quantified, is well known in futures and options markets. If a company can assess and quantify its basis risk, it can over-hedge (i.e. buy more futures contracts) or under-hedge (i.e. buy less futures contracts). • NYMEX futures and options: • “Noise” in the Re-Ex index developed by Gallagher Re. Why include riots or utility service disruption? • Tail risk. Futures contracts expire 3 months after the end of the calendar year. Some losses may have not fully developed • CME futures and options • The futures and options contracts settle immediately after hurricane landfall • But how do insurers compare their risk exposure with a newly developed parametric index?

28. Concluding remarks • The CAT bond market has grown in response to • New CAT events • New triggers • A better understanding and control of basis risk • The CAT bond and futures instruments should be reconsidered by the NAIC • Sidecars are flexible, off-the-shelf and provide added capacity. • Extreme mortality bonds have the same costs and benefits as the CAT bonds • The futures and options contracts on the NYMEX and CME may provide far more liquidity and real time risk management capabilities if the trading volume appears and if the NAIC allows regulatory and accounting treatment comparable to that of traditional reinsurance