You call that ART?!!

1. The Actuarial Profession making financial sense of the future You call that ART?!! Derek Newton2nd December 2002

2. Agenda • ART market overview • what is it? how did we get here? size, players, etc. • Product review • what do they look like & how do they work? • applications • Market trends • impact of 9.11, regulatory/economic convergence, supply and demand • Can actuaries be ARTists? • what skills and techniques are required? • Outstanding market issues

3. Definition of ART • No wholly accepted definition • “Alternative Risk Transfer” • Anything that is not traditional insurance • Often uses both banking and insurance techniques • Tailor-made solutions • Multi-year policies • Risks that the conventional market would regard as uninsurable • Transfer of non-insurance risk • Hybrid products • Some definitions also include some traditional insurance • Maybe also some self-insurance

4. Capitalmarkets Insurancecompanies Traditional risk transfer Traditional financing Meeting in the middle Capital structure financial hedges Securitisation Contingent capital Real options Finite-risk contract Multi-line multi-yearpolicies Packagedinsurancepolicies Loss-sensitivepolicies Insurance policy ART Source: The Economist

5. History • The real driver of the growth was the desire to discount claims reserves to offset significant deterioration in the early 1980s • This was highly attractive business for the reinsurer; therefore many joined in • Closing the accounting loop holes stimulated reinsurers’ desire for alternative lucrative sources of business • Growth of the use of captives also stimulated demand for new approaches to risk funding • Developments in the property catastrophe reinsurance market also affected the market.

6. Market size • Estimated size of insurance market worldwide • $2,129bn (Sigma Vol. 2/1999) ART market still very fragmented - mostly a few large deals Estimated size of reinsurance market worldwide = $124bn (Sigma Vol. 2/1999) Estimated size of ART market worldwide = $13bn (Tillinghast)

7. Market centres and players • London, New York, Bermuda, Zurich, Dublin, Luxembourg and the German centres • Most large brokers have specialist ART units • e.g. Aon, Marsh, Heath Lambert, Benfield Grieg, etc. • Most large reinsurance entities have specialist ART units • e.g. Swiss Re, Munich Re, Zurich (Centre Solutions), etc. • Many insurance groups have specialist ART operations • e.g. ACE, XL, AIG, etc. • Many banks have specialist ART operations (as writers or intermediaries) • e.g. Citibank, Goldman Sachs, Lehmans, RBC • Many risks eventually placed (at least in part) in Lloyd’s

8. Common types of contracts Captives, mutuals and other forms of self insurance Discounting covers e.g. run-off covers, funding covers Post loss funding, e.g. contingent nature, capital injections Securitisation, e.g. catastrophe, other Other funding mechanisms, e.g. insurance derivatives, swaps Integrated risk covers, e.g. multi year - multi line, blended covers

9. Discounted covers • Provide full cover without immediate need to finance full undiscounted liability • Uses: solvency, risk transfer, capping losses • Can be prospective or retrospective • Run-off covers are a typical example

10. Integrated risk covers • Typically between insurance/reinsurance entities • Therefore not an example of convergence in the markets but can be used as a substitute for debt or equity in books of cedant • Uses: one-stop shop, avoidance of buying excessive cover, smoothing of results, locking into attractive terms • Multi-year, multi-line covers • premium savings due to cost savings and to greater stability of results over longer period/across more (uncorrelated) lines • Blended/hybrid solutions, e.g. for pension funds

11. Securitisation • Transfer of insurance risk to the banking and capital markets, e.g. • Catastrophe • Life embedded values • Banking and capital markets used because of capacity and/or because risks are ones with which the banking and capital markets are more comfortable

12. Example: Catastrophe securitisation • Essentially a low grade bond (BB or similar) • Default is subject to the insured peril - e.g. earthquake, storm, flood - and can be coupon, principal or both • May respond to actual losses or parameter derived losses • Rationale has been that insurance catastrophe risk is not correlated with market (systematic) risk so of benefit to investors • Financial markets large and capable of absorbing catastrophe risk • Pricing to date similar to traditional cat reinsurance and much more expensive than similarly rated Corporate Bonds

13. Typical securitisation process Insurer Reinsurer “SPV” Investors Reinsurance Treaty Issue Notes Premium Note Proceeds

14. Post loss funding • Major losses deplete capital and increase its cost • Post-loss funding guarantees that funding will be provided in the event of a specified loss in exchange for a commitment fee • Funding usually a loan, on pre-agreed terms, or equity (contingent puts) • Commitment fee is less than insurance costs (as the cost of the funding will be borne largely post the event) - hence this appears (pre-loss) to be cheaper than conventional insurance • No benefit to underwriting results

15. Other funding mechanisms: insurance derivatives • Chicago Board of Trade ("CBOT") Cat Insurance Options launched in 1995 • nine catastrophe loss indices covering US exposures established by Property Claims Services (PCS) • failed to generate sufficient trades to establish a viable market • Bermuda Commodities Exchange (BCE) inaugurated 1997, suspended due to lack of trading volume 1999 • Catastrophic Risk Exchange (CATEX) founded 1996 in New York continues to operate, volume of actual cat transactions unknown • Weather-based derivatives look more promising • generally at the lower end of catastrophe exposures

16. Other funding mechanisms: swaps • Swapping of risks between insurers to provide greater diversification but without some of the costs of reinsurance • e.g. Swiss Re & Tokio Marine and Fire Insurance Co. • The swap is structured in three risk exchanges of $150m each • 1. Japan earthquake for California earthquake • 2. Japan typhoon for Florida hurricane • 3. Japan typhoon for France storm • Note the need to find good, matching, non-correlated exposures • Could also swap risks between parties with opposite risks, e.g. energy supplier and household insurer

17. Example: Cat risk transfer mechanisms • Reinsurance - catastrophe excess of loss (Cat XoL) • Securitisation: Cat Bonds • Multi-year spread loss contracts / blended covers • Contingent capital - Surplus Notes, Cat Equity Puts • Derivatives • Swaps “There’s more than one way to skin a CAT”

18. Catastrophes: costs and management

19. Example: large UK manufacturer Issue Solution European competition Use currency markets to minimise competitive risk Large closed defined benefit pension plan Use equity markets with a spread loss contract to reduce the pension fund exposures Weather has a material impact on sales Use weather derivatives to hedge sales issue

20. Can actuaries be ARTists? • There are obvious opportunities for actuaries within ART • Identifying/understanding risks • commercial awareness? • risks are not just insurance risks • Quantifying risks through modelling • are our modelling skills strong enough? • Deal structuring/placing • Underwriting • Need to be receptive and adaptable to rapid changes in markets and techniques

21. Identify past data Identify appropriate market Identify size, liquidity and duration of contract Trend to current levels Obtain prices for an appropriate combination of contracts Adapt to contract terms Add internal exchanges Load for exchanges No risk loads in markets with short sales Add a risk load Actuarial pricing versus capital markets pricing Actuarial Capital markets

22. Common motivations for taking out an ART contract Taxation Stabilisation of results Provides cover that might otherwise be unavailable Cheaper cover More effective provision of risk management Greater security of payment Solvency margin Source of capital

23. What should be drivers for ART market growth • Volatility of conventional markets • Rapidly rising cost of conventional reinsurance • Lack of capacity for natural catastrophes • Greater requirements for risk transfer from buyers • Need for multi-year smoothing • Convergence of financial markets • Concentration of talent in ART providers • Historic profitability of ART market

24. 11th September 2001

25. Acceleration for ART? • Insurance rates soar? • Reinsurance rates soar? • Market capacity slashed? • Risk awareness heightened - demand for cover higher?

26. Market premiums

27. Market premiums Source: Guy Carpenter & Co World Catastrophe Reinsurance Market 2002

28. …but... • Rising rates have attracted capital - so there is still capacity • Opportunity to make good returns on conventional covers have focused insurers/reinsurers back onto key activities • ART market hardening too • ART deals remain expensive to organise, with questionable triggers • Enron • financial reinsurance, balance sheet manipulation • growing puritanism in accounting • Regulation

29. Some regulatory issues with ART • ART increases market capacity and protection • good for consumers and market confidence • Complexity poses danger for unsophisticated purchasers • Rarely transparent and can frustrate intentions of regulators • solvency • accounting • consumer information • Definitions • Multi-regulatory environment • Global regulatory environment • differences in exposure to ART • fair value accounting

30. So what has happened? • Not altogether clear • little publicly available data increase in finite deals at lower ends • more non-cat securitisations • continuing activity in contingent funding, weather derivatives, cat bonds, cat swaps, etc., but not the anticipated big surge • need for transparency, and delivery of real benefit • most products remain insurance or capital markets - not a great deal of truly hybrid solutions • continuing regulatory and accounting activity (CP144, Solvency II, Basel, IFRS, etc.) • Market issues continue to emerge that lend themselves to ART-type solutions

31. Emerging issues • Some opportunities • pension funds • life funding • financing • capacity issues (e.g. PI) • Some issues • need for transparency • has to deliver real benefit • most products remain insurance or capital markets - not a great deal of hybrid solutions

32. What does the future hold? • Reinsurance • has worked well over many years, is relatively simple and is well understood • has limited and variable capacity (or supporting capital) • prone to violent swings in premiums for the same exposure • Capital Markets • relatively recent interest in insurance linked products, cautious and mistrustful of industry, which it does not yet understand well • many insurance risks not (closely) correlated with financial risks • almost unlimited capacity to handle insurance cat risks • Therefore there must be a role for both to provide increasing levels of risk management/mitigation capacity and stability • The future is yours

33. You call that ART?!!…..contact Derek Newton, Director, Heath Lambert Hybrid Solutions Heath Lambert Group Friary Court Crutched Friars London EC3N 2NP Tel: 020 7560 3330 email: dnewton@heathlambert.com