Evolution of Insurance Securitization

1. Evolution of Insurance Securitization Stephen P. D’Arcy Fellow of the Casualty Actuarial Society Professor of Finance University of Illinois UNSW Actuarial Studies Alumni Event 2 July 2007 Sydney, Australia

2. Impetus for Securitization of Insurance Risk • One major catastrophe could eliminate most of the world’s insurance capital • The largest potential loss is less than the daily fluctuation of total financial markets • If insurance losses could be shifted to financial markets, the risk would be manageable

3. Steps in Insurance Securitization • Catastrophes • Chicago Board of Trade Catastrophe Futures – 1992 • PCS Catastrophe Options – 1996 • Contingent Capital – 1996 • Risk Capital – 1997 • Longevity • Mortality Index Bonds – 2003 • Motor Insurance • French Motor Insurance Portfolio – 2005 • Multinational Motor Insurance Portfolio - 2007

4. Catastrophe Insurance Securitization • CBOT Catastrophe Futures • Underlying index: Paid claims for 22 insurers • Perils: Wind, Hail, Earthquake, Riot and Flood • Settlement Value: Loss Ratio x $25,000 • PCS Catastrophe Option • Underlying index: PCS Estimate/100 million • All catastrophe claims (over $25 million) • Small (up to $20 billion) and large ($20 to 50 billion) caps

5. Cat-E-PutsWritten by AON Pre-negotiated 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 Minimum net worth required to exercise put

6. Risk Capital Typical case Issue bonds with repayment and/or coupons dependent on catastrophe losses Provides cedents 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

7. Risks Covered • U. S. Gulf Coast Hurricane • California Earthquake • Europe Wind • Japan Earthquake • Japan Typhoon • U. S. Midwest Earthquake • U. S. Northeast Hurricane • Monaco Earthquake • Puerto Rico Hurricane • Europe Hail • Hawaii Hurricane

8. Triggers • Indemnity • Parametric • PCS • Modeled Loss

9. 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 Online reference for many deals http://www.artemis.bm/html/dealdir/index.htm

10. Longevity Risk • Longevity risk is the risk of mortality rates deviating from expected levels • Over last century, mortality rates have steadily declined, leading to longer life expectancies • Significant improvement for most recent period has been noted • Primary concern for insurers and pension funds is improvement for those age 60 and older

11. Exposure to Longevity Risk • Life insurance • Risk is if mortality rates increase • Coverage concentrated on particular ages (30-70) • Recent concerns • Catastrophic losses • Pandemics • Annuities and pension funds • Risk is if mortality rates decline more than expected • Annuities are concentrated on particular ages (60+)

12. Managing Longevity Risk • Life insurers • Could balance life insurance and annuity exposure • Difficult to accomplish • Reinsurance for sudden increased mortality • Concentration of reinsurers • Cost of coverage • Pension funds • Spreading losses forward under pension accounting • Use of asset returns as discount rate • Lower investment returns can no longer cover increasing longevity

13. Longevity Derivatives • First life insurance securitizations involved offsetting premium loadings or reducing reserve requirements • Current securitizations involve securitizing mortality risk • Swiss Re (2003) • Life insurance catastrophe bond • EIB/BNP (2004) • Long term longevity bond

14. Swiss Re Mortality Index Bond • Issued December, 2003 • $400 million in 3 year notes, quarterly coupons • Bond paid LIBOR + 135 basis points • Mortality rate was based on the weighted average mortality of US, UK, France, Italy and Switzerland • Option to reduce repayment on bond if mortality exceeds 130% of 2002 mortality rate • Principal is reduced 5% for every 0.01 increase in mortality over threshold • Vita Capital was the Special Purpose Vehicle

15. Swiss Re Bond • Ratings: A3/A+ • Fully subscribed • Investors included pension funds • High coupon • Natural hedge

16. Motor Insurance Securitization • AXA securitized French motor insurance – 2005 • Securitized European motor insurance – 2007 • Bonds pay variable rate based on underlying loss experience

17. What’s Next? • Catastrophes • Exchange traded derivative • Mortality • Zero-coupon or deferred mortality bonds • Mortality swaps • Mortality futures and options • Other coverages • Securitizing runoff business • Other lines besides motor insurance

18. Conclusions about Securitization • Allows insurers to focus on writing policies without having to retain all the risk • Alternative to reinsurance and useful for reinsurers • Provides an attractive investment alternative for institutional investors • Allows market to solve risk aggregation issues without relying on government • Growth is very likely • Will change the face of the insurance industry