Catastrophes, Capital markets, and Risk Securitization Funding catastrophes: Reinsurance Bonds

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Catastrophes, Capital markets, and Risk
Securitization Funding catastrophes
Reinsurance? Bonds?

• NAIC and use of cat modeling in rate-making
• Risk Securitization courtesy of David Na, FCAS,
  MAAA, Deloitte Touche, Bermuda
• 3. Risk Securitization 101 courtesy of Kymn
  Astwood, CA, Arrow Reinsurance Company, Limited,
  (A Goldman Sachs Group Company)
• 4. Slides from CEA, FHCF, TWIA - Federal role?
  States?

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NAIC Catastrophe Computer Modeling Handbook
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Purpose of the Handbook
What on Earth do we need this for?

• The purpose of the Catastrophe Modeling Handbook
  is to explore in some detail catastrophe computer
  models and to discuss issues that have arisen or
  can be expected to arise from their use.
• Used by insurance regulators to review models
  primarily used in underwriting, rate-making and
  solvency procedures.

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User Perspectives of Models
Well heres what we think...

• Insurers Perspective
• Old rate making methods underestimate the cost of
  insuring catastrophe prone areas.
• Consumers Perspective
• Modelers must disclose input and output so
  independent tests can be run to assure that
  results are reasonable.

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User Perspectives of Models (continued)

• Regulators Perspective
• Must learn to replace traditional models with a
  methodology that is in its relative infancy in
  terms of producing consistently reliable results.
• Must work with modelers to provide enough
  disclosure to make informed decisions while
  preserving the confidentiality of proprietary
  details.

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Components of the Model
The whole is greater than the sum of its parts.

• Science Module
• Physical characteristics about the catastrophe
  (factors include wind speeds, landfall
  location, magnitude, location of fault,
  liquefaction potential).
• Engineering Module
• Estimates the effect of catastrophic events on
  different types of structures (factors include
  age of structure, construction type, attachment
  anchoring).
• Insurance Module
• Estimates the insured damage at a location
  (factors include guaranteed replacement cost
  multiplier, deductible, reinsurance limits).

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Risk Securitization 1012000 CAS Special
Interest Seminar

• David Na, FCAS, MAAA
• Deloitte Touche, Bermuda

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Background

• Effects of Natural Catastrophes in Late 80s
  Early 90s
• Decreased Insurance/Reinsurance Capacity
• Increased Demand for Reinsurance
• Realization of Inadequate Pricing
• Increased Awareness re Insurers Exposures

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Types of ILSs

• Catastrophe Bonds - Will Discuss in Detail...
• Catastrophe Risk Exchange (CATEX) Swaps
• Insurance Related Derivatives/Options
• Catastrophe Equity Puts (CAT-E-Puts)
• Contingent Surplus Notes
• Weather Derivatives

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Advantages - Investor

• Above average yield relative to other securities
  (e.g. corporate bonds) of similar risk
• Outstanding diversification effect - Unlike
  investments in insurance company stocks, CAT
  events are generally uncorrelated with an
  investors portfolio
• Allows non-insurance investors to participate in
  insurance related transactions
• Preparation for convergence of Insurance Banking

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Advantages - Issuer

• Capacity - Access the Capital of the Financial
  Markets
• Greater Flexibility in Terms of Coverage
• Reinsurance Protection Fully Collateralized, No
  Credit Risk
• More Stable Pricing - Insulated from U/W cycles
• High aggregate level risk transfer
• Innovation/Prestige - Cutting Edge

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Issues

• Requires understanding of both Capital and
  Insurance Markets (Investors as well as Issuers)
• Historical separation of Capital and Insurance
  Markets (e.g. Regulatory Issues)
• Uncertainty involved in pricing high layer or
  catastrophic events (Reliance on Modeling)
• Issuers Costs (Relative to Purchase of
  Reinsurance)
• Investors Return (Relative to Comparably Risky
  Securities)
• Accounting, Legal, Regulatory, Tax, etc.

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Casualty Actuarial Society Risk Securitisation
101

• Kymn Astwood, CA
• Arrow Reinsurance Company, Limited
• (A Goldman Sachs Group Company)
• 16th October, 2000

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Agenda

• Insurance and the Capital Markets are Converging

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Risk Transfer vs Risk Financing
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Overview of the Risk-linked Securities Sector
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Benefits of Risk-linked Securities
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Structure of Risk-linked Securities
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Weather Derivatives and Other Alternatives
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Insurance and Capital Markets are Converging
Corporations, Traditional Insurance
and Reinsurance Markets
Capital Markets
New Risk Instruments

• Pricing and volatility for insurance and
  reinsurance
• 1999 second worst catastrophe year for the PC
  industry
• Weather hedging driven by utility deregulation
• Portfolio credit hedging driven by BIS rules,
  cyclical considerations
• Availability of coverage for high capacity/new
  exposures

• Concern over correlation particularly in down
  markets
• Desire for more concrete risk assessment
• Alpha-driven investing

Legal and Regulatory Infrastructure
Risk Assessment Technology

• Securities rulings and opinions
• Standard documentation
• SVO rating guidelines

• Modeling firms
• Academic and government-sponsored research
• Internet-based data accessibility
• Rating agency expertise

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Overview of Coverage Types

• Types of Coverage

Risk Financing Options
Pre-Funded Coverage
Post-Funded Coverage
Risk Transfer Coverage

• Premiums paid at levels exceeding the market
  price of risk. Excess builds up in a fund which
  is returned if there is no loss

• Payout determined and paid post-event. It is
  repaid over time. There may be a small option
  premium paid in advance

• A premium is paidin advance equaling the market
  price of risk

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Impact of Market Forces
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• Securitization will become increasingly cost
  competitive with reinsurance because of the
  forces driving both the markets

• Securitization
• Stable spreads with respect to BB corporate bonds
• Lower transaction costs
• Increased investor comfort with the asset class

• Reinsurance
• Hardening of retrocessional markets
• Problems in Australian insurance market
• Earthquakes in Turkey, Taiwan, Greece, Mexico
• Hurricanes in U.S. and Central America
• Higher satellite and aviation losses
• Problems with workers compensation market due to
  Unicover-managed pool
• Pressure to increase premiums to restore investor
  confidence in insurance/reinsurance stocks
• Industry consolidation

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Benefits of Risk SecuritizationIssuer Perspective

• Diversification of sources of risk protection
• Additional capacity for certain risks /
  geographic areas
• No credit risk due to full-collateralization of
  securities
• Prompt claims payment following a loss event
• Clearly defined trigger reduces disputes
  regarding covered claims
• Multi-year coverage at a fixed cost may be locked
  in at inception
• Market perception as an innovator and industry
  leader

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Benefits of Risk SecuritizationInvestor
Perspective

• Uncorrelated Diversification can be achieved due
  to low correlation with equity and fixed income
  investments
• Attractive Risk/Return Profile compared with
  similarly rated corporate bonds
• Sophisticated Risk Analysis is performed by
  independent catastrophe-modeling firms
• Liquidity is provided by the growing secondary
  market trading of risk-linked securities

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Tim RichisonChief Financial Officer CAS
Catastrophe Seminar
The Challenges of Dealing with Natural
Catastrophes
October 7 - 8, 2002
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Excluding the 350 million Minimum Statutory
Capital, total claim-paying capacity at 12/31/01
is 7.172 billion proposed claims-paying
capacity at 1/1/03 is 7.003 billion.
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Florida Hurricane Catastrophe Fund
Texas Windstorm/Hail Conference November 17,
2004
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Florida Property Insurance Marketplace
Private Reinsurers (approximately 140)
FHCF
616.2 million FHCF Premium (about 11.6 of
residential premium)
FIGA Florida Insurance Guarantee Association
Insurers - 226 (includes Citizens)
5.3 billion residential premium (estimated)
Residential Policyholders (5.8 million policies)
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Initial Season Capacity For the 2004 Hurricane
Season (October 2004 Estimate)
Maximum Emergency Assessment -- 1.608 billion
53 year return time
15 Billion Capacity
(only 595.5 million needed)
21.4 B Overall Industry Loss
8.880 B Bonding Capacity (Includes Loss
Adjustment Expense)
1.9 B Industry Co-Payments
2.22
6.120 B Projected 2004 Year-end Cash Balance
4.5 B Industry Aggregate Retention
Not Drawn to scale.
Return time not adjusted for premium/exposure
growth.
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Current Financial Structure
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Current Structure and Bonds
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Protected CRTF