2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008

1. Canadian Institute of Actuaries L’Institut canadien des actuaires 2008 Seminar for the Appointed Actuary Colloque pour l’actuaire désigné 2008

2. Reinsurance: cat bond process and risk management Pierre G. Laurin, FCAS, FCIA, MAAASeptember 25, 2008Montréal (QC)

3. Contents • Risk management issues • Index linked securities • Cat bond • Side-car market • PCS index trigger • ILS over time • Trends

4. Risk management issues • Reinsurance is a source of contingent capital • Reduction of volatility of results on a excess of loss basis • Reduction of actual capital on a quota share basis • Same concepts for primary insurers as for reinsurers who use retro-cessions • Need to ensure quality of such capital

5. Canadian context Source: AM Best data

6. Risk management issues • Availability of reinsurance • Increase quality of capital • Diversification of capital sources • Cash flow issues • Multi year covers

7. Securitised cat cover Cat Bond Collaterised layers Traditional Reinsurance Layers Retention

8. Historical context • Index linked securities started in 1992 • Response to risk management issues • Alternative to hard reinsurance markets • Need to find alternative sources of capital

9. Development • Purpose: • Increase reinsurance capacity • Reduce earnings volatility • Reduce capital volatility • Diversification of source of capital • Overall: • Increasingly important strategic component for insurers & reinsurers • Alternative to traditional reinsurance entities for private investors • Can be customized to handle any type of insurance risk (e.g, workers comp.)

10. Index linked securities • Cat bonds • Indemnity • Parametric • Hybrids • Side cars • PCS index trigger

11. Overview of Nat Cat Trigger Types Source: Swiss Re

12. Cat bonds characteristics • One sponsor • Event based • Only modeled exposures are covered • Fully collaterised • Non-indemnity cover (trigger based) • Regular reset of attachment point • Strict disbursements of proceeds • High basis risk • High yield

13. Catastrophe bonds – basic structure (diagram) Interest = LIBOR + Premiums Sponsor/Originator Insurance Company Premiums Investors (Qualified Institutional Buyers) Issuer Bankruptcy Remote Special Purpose Vehicle Principal at maturity and liquidation Reinsurance Contract Note Proceeds/Funding Remaining funds at maturity Note Proceeds LIBOR Trust Account Highly Rated Short-Term Investments LIBOR Swap Counterparty Investment Income

14. Securitised cat cover Attachment pointreset based on pre-determined excedence probability Cat Bond Collaterised layers Traditional Reinsurance Layers Retention

15. Reset of attachment point • Timing is essential • Renewal dates should be coordinated with traditional program • Pre-event • Initial attachment point determined prior renewal • Final attachment point determined mid-year • Potential gap in coverage • Post-event • Attachment point revised depending on date of event

16. Compared to traditional reinsurance • Utilizes normal reinsurance agreements • Typically excess of loss • Fully collaterised • Different source of capital • Defined perils coverage • Consolidation issues

17. Stakeholder perspectives • Debt investor • Relatively higher yield than corporate bonds • Ability to customize terms & conditions • Clearly defined risk categories & parameters • Strong diversification of investments

18. Stakeholder perspectives • Sponsor perspective • Addresses risk management issues • Diversification of capital • Collaterisation of cover • Certainty of coverage • Multi year cover

19. Indemnity Based on company actual losses No basis risk Paid as losses get paid Parametric Trigger on modeled data Higher basis risk Can be paid immediately Cat bonds

20. Cat bonds requirements • High level of sophistication in reinsurance thought process • High investment of time • Typically cost more than traditional reinsurance • Good medium to address risk management issues

21. Historical context side cars • “Traditionally” new reinsurers in market post large event • Capital available • Current players wanting to increase writings • Strong pressures from rating agencies • Uncertainty with catastrophe models results

22. Lessons learned • From prior promotions • Many new entrants have short time horizon • Opportunistic perspective • Need to change capital structure if reinsurer intends to continue operations • Many IPOs on survivors

23. Side-car characteristics • One sponsor • Typically portfolio based • While strong model based, include coverage of unmodeled exposures • Indemnity cover • No real reset of attachment points but capacity resets • strict disbursements of proceeds • Low basis risk • High yield for bond holder but somewhat lower than cat bond • Short tail lines of business • Some commercial lines • Actuarial opinion required • Some pay-back mechanism

24. Structure (diagram) Proceeds Side-Car Holding Co. Debt Investors Notes: P&I Proceeds Equity Investors Shares $ Capital Dividends Quota Share Reinsurance Reinsurer Side-Car Reins. Co. Premium less Brokerage & Commission $ Contribution held for benefit of Cedant Distribution (Debt Interest, Profits) Payment for Losses Collateral Trust

25. Structure • How they operate: • Newly created holding company funded by private equity investors • Usually hedge funds and other institutional investors • Typically funded by debt & equity financing • Assumes risk & premiums; pay claims to ceding company

26. Analytic issues – legal structure • Review of legal & structural documents • Quota share reinsurance agreement • Collateral trust agreement • Debt prospectus & covenants • Structural soundness • Legal enforceability

27. Analytic issues – business profile • Review business profile • Ceding company’s operations • Underwriting management of insurance portfolio • Risk tolerance levels • Ability to avoid adverse selection • Insufficient premium • Excessive losses

28. Analytic issues – portfolio & modeling techniques • Analysis of portfolio • Develop default probability • Can be multiple tranches • Rating reflects ability to; • Pay claims (side-car Reinsurer) • Principal & interest (side-car holding company debt) • Catastrophe loss modeling techniques employed • Quality of assets in collateral trust • Analytics similar to evaluating catastrophe bonds & other structured financings

29. Compared to traditional reinsurance • Utilizes normal reinsurance agreements • Typically quota share • Depends on ceding company for reserving & claims practices • Performance of side-car a result of underwriting & claims-settling capabilities of ceding company • Typically private ownership • Limited lifetime (not a going concern) • Highly structured & limited purpose • Typically limited to single cedant and/or contract • Absence of active management team • Cash disbursement tightly controlled by collateral trust agreement

30. Stakeholder perspectives • Equity investor • Opportunistic investment during hard markets • Access to underwriting expertise • Limited exposure to operating and legacy risks • Relatively low cost to establish • Can be established relatively quickly • Allows for relatively easy exit • Typically automatic winding down

31. Stakeholder perspectives • Debt investor • Relatively high yield • Ability to customize terms & conditions • Clearly defined risk categories & parameters • Side-car is not a going concern • Not likely to be recapitalized after a loss

32. Stakeholder perspectives • Ceding company perspective • Cedant can customize terms & conditions to meet needs • Ability to capture market share during hard market • Potential to obtain management fee & profit commission • Allows for relatively easy exit of excess capital • Diversification of source of capital

33. PCS index securities • Bonds pay if the market loss is above a certain threshold • Threshold determined by market loss • Largest basis risk • Very liquid • Very popular alternative investment

34. P&C securization growth Source: Guy Carpenter, 2007

35. Risk capital by specific peril Source: Guy Carpenter, 2007

36. Risk Capital / Transactions by Trigger Type Source: Guy Carpenter, 2007

37. Trends - US • Increase use of shelf offering • Softening in the terms and conditions (multi perils and locations) • More investment grade ILS • Primary insurers are getting more in the game, where reinsurers were the principal driver of ILS • Consolidation issues IFRS:SIC 12 vs US GAAP:FIN 46R

38. Trends - Canada • Availability of quality reinsurance market • Limits generally lower in Canada vs US • Few cat bonds covering Canadian exposures (Merna Re) • Cat models not truly tested • Increased awareness of ILS