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Seismic Limited Case Study
John Kiernan
August 15, 2000
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Catastrophe Securitization Why?
Convergence of the Insurance and Capital Markets

• Traditional reinsurance markets today
• Cyclical pricing and fluctuating capacity
• Andrew/Northridge
• Large losses for reinsurers
• Significant increases in premium rates
• Reduction of catastrophe reinsurance coverage
  available to primary insurance companies
• Insurance companies turned to capital markets
• Efficiency and capacity

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Catastrophe Securitization Why?
Insurance Risk as an Asset Class

• Insurance risk has become next major asset class
  absorbed by Capital Markets
• Corporate bond market replaced traditional
  practice of long-term bank lending to
  corporations
• SLs used to originate and hold mortgage risk,
  now supplanted by mortgage bond market
• Following this pattern, the capital markets are
  transforming the traditional reinsurance market

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Why Do Insurance Companies Care?
Alternative and Supplement to Traditional
Reinsurance

• Limited number of highly-rated reinsurers
• Credit risk concern particularly for
  upper-layers
• Capital markets easily addresses this concern
• Capital markets capacity and pricing efficiency
  makes them attractive
• Desirable characteristics that dont exist in
  traditional market
• Flexibility in terms of maturity
• Keeps traditional market providers honest

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Why Do Investors Care?
CAT Bonds Offer Attractive Returns on a
Risk-Reward Basis

• Valuing a CAT bond
• Based on pure expectation hypothesis, investor
  should be compensated for expected loss
• Expected loss - average loss to a CAT bond as
  determined by independent third party through
  multi-year simulation
• CAT bonds usually trade at a multiple, usually
  61 to 71 of expected loss

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Why Do Investors Care?
Why Do CAT Bonds Trade As a Multiple to Expected
Loss?

• Concentration of risk in reinsurance hands leads
  to cheap pricing of risk
• Liquidity concerns
• Concern over accuracy of modeled expected
  losses
• Fat Tails
• Extreme aversion to lose everything scenario

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Why Do Investors Care?
1 Problem Faced by Portfolio Managers Is Lack of
Diversification When They Need It Most

• The correlation among existing asset classes
• High Grade/High Yield Corporate Bonds
• Mortgage-backed Securities
• Emerging Markets
• Equities
• can rise dramatically when just a small sector
  of the global economy, even regionally or market
  specific, takes a downturn

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Why Do Investors Care?
Excess Returns in Stressful Times Are Negative
and Highly Correlated
Excess returns over similar duration U.S.
Treasuries All long duration
mortgages Excess return over 30-year U.S.
Treasury Bond
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Why Do Investors Care?
CAT Bonds Are Uncorrelated to Other Capital
Markets Risks

• CAT bonds are securities whose trigger events are
  based upon uncorrelated phenomena
• Occurrence of earthquakes
• Extreme temperature variations
• This is an asset class whose trigger events are
  truly independent of economic factors such as
• Interest Rates
• Foreign Exchange Rates
• Risk Premia for Credit Spreads
• GDP
• Market Perception of Economy

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Seismic Limited Case Study
Problem

• Lehman Re has substantial California Earthquake
  exposure
• Looking for retro capacity

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Seismic Limited Case Study
Which Way Do I Go?
Capital Markets
Reinsurance Industry
Hungry for high yielding, low risk securities
that are easy to understand
Difficult to obtain California earthquake
reinsurance of significant size from highly rated
counterparties
Solution Create a California earthquake CAT bond
with losses tied to an index
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Seismic Limited Case Study
Seismic Limited-March 2000

• US 150,000,000 exposed to insured losses in
  California from earthquakes and fires following
• Payment of principal, interest, and dividends on
  Securities linked to Property Claim Services
  (PCS) reported Cumulative Estimated Insured
  Losses over 22 month Risk Period
• First securitization involving Lehman Re Ltd.,
  the reinsurance subsidiary of Lehman Brothers
  Holdings Inc.
• Risk assessment performed by Risk Management
  Solutions
• Only single risk California Earthquake
  Catastrophe Bond currently in market

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Seismic Limited Case Study
Overview
Lehman Re
Payout ifTrigger
Periodic Payments
CounterpartyContract
SwapCounterparty
Securityholders
Seismic Ltd.
LIBOR 4.501 LIBOR 6.502
LIBOR
150M
CollateralAccount
Investment Earnings
Net PrincipalAmount
(1) Notes (2) Preference Shares
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Seismic Limited Case Study
Structural MotivationsLehman Re/Lehman Brothers

• Create a product that is easy to understand
• Seismic closely resembles Industry Loss
  Warranties (ILWs)
• Capacity constraints lessened
• Arbitrage between traditional and capital markets
• Value of full collateralization

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Seismic Limited Case Study
Structural Motivations Investor

• Attractive risk/reward
• Value of purchasing non-correlated asset
• Only single risk, California only CAT Bond in
  market
• Like index based nature of loss measurement -
  addresses moral hazard
• ILW nature of security provides a pricing
  back-stop in case of capital markets disruption
• Transparency of structure promotes liquidity

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Seismic Limited Case Study
Basis Risk Issues

• A unique characteristic of Seismic is the role of
  Lehman Re
• Lehman Re is able to hold and manage risk, thus
  allowing it to tailor products that Capital
  Market participants want

Catastrophic California Earthquake Risk
Lehman Re
Basis Risk
Securitizable Risk
CAT Bonds
(Indemnity)
(Index)
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Seismic Limited Case Study
Sources of Basis Risk

• Residential vs. Residential/Commercial
• Fire Following
• General correlation between industry losses
  losses on specific reinsurance treaty
• Lehman opinion Market pays you handsomely for
  assumption of basis risk

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Seismic Limited Case Study
Basis Risk Retention The Future

• If catastrophic securitization is to grow
  dramatically, Seismic is a template for such
  growth
• Current issues holding back market growth
• Cedents speed to market, pricing
• Investors complexity, moral hazard, lack of
  transparency
• Solution Intermediary (broker, cedent,
  underwriter) takes basis risk
• Market gets simpler deals, faster execution,
  better liquidity more investors
• Investor willingness to pay for transparency -
  differential between structures apparent in
  secondary trading of outstanding deals

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Seismic Limited Case Study
Rating Agency Issues

• Have expressed dismay over structural complexity
  of recent insurance-linked transactions. Have
  asked for more transparency
• Strong preference for index or parametric deals
  over indemnity
• Relied on both internal models and quality of
  RMS model to assess the validity of expected loss
  calculations
• Developed comfort with PCSs ability to
  accurately reflect aggregate industry losses in
  California
• Moral hazard concerns largely eliminated by
  virtue of industry-wide loss measurement

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Seismic Limited - Case Study
Why PCS?

• Industry Gold Standard
• Long history of providing catastrophic loss
  measurements
• Usage of PCS loss estimates in ILW contracts
  underscores legitimacy of index in eyes of
  investors

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Seismic Limited Case Study
Why RMS?

• Investors require detailed analysis of risk
  associated with the bonds including attachment
  and exhaustion probabilities and expected losses
• Rating agencies and investors have developed a
  level of comfort with the analysis provided by
  these companies
• RMS was used for the Seismic deal because of its
  knowledge and background in the study and
  assessment of California earthquake risk
• RMS plays a critical role in marketing as
  supplier of independent analysis and is also
  available to address investor questions

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Seismic Limited Case Study
Summary of RMS Analysis Annualized Aggregate
Probabilities
As measured by RMS
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Seismic Limited Case Study
Term Sheet
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Seismic Limited Case Study
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Seismic Limited Case Study
Trigger Amount Schedule
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Seismic Limited Case Study
Investor Demand
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Seismic Limited Case Study
Investor Trends

• Increase in money managers participation - more
  stable capacity
• General increase in recognition of value of
  non-correlated nature of risk
• Shift toward lower yielding single peril deals
  and away from kitchen sink retro deals
• Recent issuance has led to ability to create
  portfolio of non-correlated CAT risks, bringing
  previously on-the-fence accounts into CAT bond
  markets
• Recognition that liquidity is much better than
  skeptics contend

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Seismic Limited Case Study
Conclusions

• Seismic oversubscribed and well traded in
  secondary market
• Transparency
• Simplicity
• Lack of moral hazard
• Liquidity
• Reinsurance market backstop
• At same time, Lehman Re (Cedent) achieves
  objectives
• Big capacity
• Fully collateralized
• Attractive pricing adjusted for basis risk

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