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INSURITIZATION Presentation to CAS CARe Seminar Nick Giuntini, FCAS August 15, 2000

INSURITIZATION Presentation to CAS CARe Seminar Nick Giuntini, FCAS August 15, 2000. AGENDA. Insuritization What is the Opportunity Why Does it Exist General Underwriting Approach Possible Pricing Pitfalls / Issues. 1) Definition . Insuritizition

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INSURITIZATION Presentation to CAS CARe Seminar Nick Giuntini, FCAS August 15, 2000

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  1. INSURITIZATION Presentation to CAS CARe Seminar Nick Giuntini, FCAS August 15, 2000

  2. AGENDA • Insuritization • What is the Opportunity • Why Does it Exist • General Underwriting Approach • Possible Pricing Pitfalls / Issues

  3. 1) Definition • Insuritizition • Placing risks that originate in the capital markets into the (re)insurance markets.- e.g. wrapped bonds (credit enhancement) <<vs.>> • Securitization • Placing risks that would otherwise reside with (re)insurance companies into the capital markets- e.g. cat bonds

  4. 1) Opportunities • Types of Risks where Insuritization has been/can be used: • Municipal Bond Insurance • CDOs • Project Finance • Royalty Streams • film • franchise • drug • musicNEW, ESOTERIC OR UNDERSERVED ASSET CLASSES ARE REAL OPPORTUNITIES FOR (RE)INSURERES.

  5. 1) Capital Markets Pricing Coupon - Decomposition Bonus for investing in a new asset class (novelty premium) - decrease over time Novelty Premium Spread Compensating the default risk of a non risk-free investment Risk premium Coupon Risk-free rate

  6. 1) Capital Markets Pricing

  7. 1) Pricing Comparison - Examples Spread to LIBOR

  8. 1) Why is Capital Markets Pricing Higher for Certain Risks? • Illiquid • Small Volumes of Risk Traded • New Asset Class • Lack of Coverage / Interest • Uncertainty About Risk / Loss Estimates • Accumulating vs. Diversifying Risks (1 Sided vs. 2 Sided)

  9. 1) Accumulating vs. Diversifying Risks • Diversifying Risks • 2 Sided Risks • Natural Longs & Shorts • Capital is not needed for risk if you can match up longs & shorts • Generally most efficiently handled through Capital Markets • e.g. Foreign Exchange Risk, Interest Rate Risk. • Accumulating Risks • 1 Sided Risks • Society is overall long in these risks • Society net needs capital for these risks • Generally most efficiently handled by entities that can diversify their capital exposure with other accumulating risks (i.e. Insurance Cos.) • e.g. Property Cat risk

  10. 1) (Re)insurer’s Competitive Advantages • Ability to underwrite & price difficult underlying risks, while separating or mitigating the risks that cannot be underwritten effectively • Ability to manage the risk within a diversified risk portfolio • High quality Ratings (i.e. AAA)

  11. 1) SRNM Risk Screening Process • Criteria for underwriting of Asset Backed Risks • Strong deal economics - lack of an efficient alternative market for the risk • Access to expertise, or ability to acquire needed expertise • Accepted model for the risk • Quality data that can be used to define the expected distribution • Low management risk or moral hazard risk

  12. 1) Form of Risk Transfer • Un-Funded Solution • Derivative Transaction • Liquidity Facility • Surety • Financial Guarantee Policy • Insurance of Underlying Risks • Monoline Company as a Front • Funded Solutions • On-Balance Sheet • Off-Balance Sheet - Conduit, Repo, Total Return Swaps, Rented CP Facilities

  13. 2) POTENTIAL PRICING PITFALLS / ISSUES • Alignment of Interests / Moral Hazard • Trend or Cycle? • Too Little Data • “Too Much” Data • Change in Underlying Process • Inappropriate Data • Over-Reliance on Linear Regression • “Trending, Developing & On-levelling” • others...

  14. 2) Alignment of Interests - Moral Hazard “We wouldn’t have done these deals had they not been insured” - John Miller, Managing Director - Chase Securities In reference to insured film loans where claim have been filed against the insurers. The insurer’s, however, claim that they were relying on Chase’s track record of historically successful film lending. WSJ - July 20, 2000

  15. 2) Trend or Cycle? Are current oil prices part of a trend or just a temporary peak?

  16. 2) Too Little Data

  17. 2) “Too Much” Data “We used 17,500 data points to predict the price of electricity.” This will show the price of electricity as a function of gas prices, temperature, generating capacity, time of day, and day of week. However, these data points are only 2 years worth of information (hourly observations).

  18. 2) Change in Underlying Process Startof Open Rating

  19. 2) Inappropriate Data Correlation between daily price movements is 2%. However, correlation when Ford is down at least 3% is 24%.

  20. 2) Over-Reliance on Linear Regression Regression estimate would have dramatically overestimated new stores.

  21. 2) “Trending, Developing & On-Leveling” Data not adjusted for economy or increasing size of portfolio.

  22. CONCLUSION • Big Opportunities for (Re)Insurers • Risk Understanding & Quantitative Analysis Crucial • Be Careful • Make Informed Judgements • Where Uncertainty Exists - Be “Conservative” • Include both Insurance & Finance Perspective

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