Z Issues Related to Insurance Securitization Dan Isaac Swiss Re Investors, Inc.

1. Z Issues Related to Insurance SecuritizationDan Isaac Swiss Re Investors, Inc. Presented: 2000 CAS Special Interest Seminar October 16, 2000

2. Basis risk: The risk that the derivative security does not move precisely with the underlying “hedged” security; the risk arising from the uncertainty regarding the future basis. For an insurer using a securitization as a hedge, it is the risk that the “coverage” does not change precisely with the catastrophe experience of the insurer.

3. Three Basic Dimensions • Basis of Coverage • Trigger Mechanism • Payment Type

4. Basis of Coverage • Company’s Exposure • Industry’s Exposure • Event Parameters

5. Basis of Coverage Company’s Exposure • Advantages: • Limited Basis Risk • Easiest to Model Benefits • Directly Comparable to Other Reinsurance Treaties • Disadvantages: • Highest Disclosure Standard • Less Marketable Example: USAA CAT Bond (96-98)

6. Basis of Coverage Industry’s Exposure • Advantages: • Manageable Basis Risk • More Marketable • Less Subject to Manipulation by Company • Disadvantages: • Harder to Model Benefits • Fewer Benchmark Prices Example: CBOT Options

7. Basis of Coverage Event Parameters • Advantages: • Little or No Disclosure • Most Marketable • No Reliance on “Black Boxes” • Fastest Settlement • Disadvantages: • Largest Basis Risk • No Benchmark Prices Example: Parametric Re (97)

8. Trigger Mechanism • Actual Results • Modeled Results

9. Trigger Mechanism Actual Results • Advantages: • Less Basis Risk • Fits Well With Traditional Coverage • Disadvantages: • Harder to Extend to Multi-Year • Can be “Gamed” • Requires Long Development Period Example: CEA Bond (96)

10. Trigger Mechanism Modeled Results • Advantages: • Faster Settlement • Eliminates Model Bias Concern • Easily Extended • Disadvantages: • Potentially Large Basis Risk • May Fail Reinsurance and/or Hedge Accounting Rules Example: Golden Eagle Capital (99)

11. “Payment” Type • Cash • Equity • Loan • Line of Credit • Surplus Notes • Bond

12. “Payment” Type Cash • Advantages: • Loss Payment Ends Contract • Most Accounting Flexibility • No Limitations on Recovery • Disadvantages: • Costly

13. “Payment” Type Equity • Advantages: • Cheaper • Can Include Options to Further Lower Cost • Usually Includes a Call Feature • Disadvantages • Only Protects Balance Sheet, not Income Statement • Loss of Control Example: LaSalle Re CatEPut (97)

14. “Payment” Type Loan • Advantages: • Cheapest, by Far • Disadvantages • Doesn’t Improve Either Balance Sheet or Income Statement • Coverage is Usually Limited/Eliminated for Largest Events Example: Nationwide Surplus Notes (95)

15. Other Considerations Desired Accounting Options • Reinsurance • Hedge • Mark to Market

16. Other Considerations Desired Accounting Impacts • Where benefits appear • Underwriting Insurance • Investment Income • Balance Sheet • When benefits appear

17. FAS 113 - Accounting for Reinsurance Conditions for Reinsurance Accounting (Paragraph 9) • Reasonably Possible that Reinsurer will Lose Money • Reinsurer Assumes Substantial Insurance Risk • Relates to Underlying Exposure

18. FAS 113 - Accounting for Reinsurance Conditions for Indemnity (Paragraph 62) • Payments Vary Directly with Cedants Results • Applies to Both Timing and Amount of Payments

19. ISTF - Insurance Securitization Task Force • Formed in Conjunction with Protected Cell Legislation • Focused on Defining Bounds of “Acceptable” Coverages • Specifically, non-indemnity covers

20. Statistics Originally Reviewed • Change in expected policyholder deficit (EPD) • Change in Value at Risk (VaR) • Change in standard deviation • Coverage ratio • Correlation

21. Statistics Proposed • Change in Tail Value at Risk (TVaR) • Melding of the EPD and VaR measures above.

22. Graphical Explanation G E H F C B A D 99%

23. Statistics Proposed • Change in Tail Value at Risk (TVaR) • Melding of the EPD and VaR measures above. • Change in standard deviation (StD) • Similar to the above measure except that it is modified to include the cost of the hedge and as a result measures the potential for investment gain.

24. Post-Hedge TailVaR = - Reduction in TailVaR1 Pre-Hedge TailVaR Post-Hedge StdDev = - Reduction in StdDev1 Pre-Hedge StdDev Reduction of Risk

25. Conclusions Based on the research completed we believe that if it can be shown that both, the change in TVaR and StD (Post-Hedge – Pre-Hedge), are less than 0 then the transaction is effective. If one or both record positive values then transaction has a high potential of producing returns that exceed the hedged exposure and should be considered an investment.

26. ISTF - Insurance Securitization Task Force • http://www.casact.org/research/istf/istfindex.htm • Easier way: • Go to CAS Website • Click on RESEARCH (in right column) • Under Committee/Task Force Projects and Web Sites, click on Work of the Index Securitization Task Force

27. Bifurcation: The act of notionally splitting one contract into two (or more) equivalent contracts for accounting purposes. For insurance, this usually results in splitting a contract into an indemnity contract (which gets reinsurance accounting) and a “basis risk” contract (which gets mark to market accounting).

28. Bifurcation Industry Exposure Based Coverage can be Split into: • An Approximate Company Based Coverage • e.g. Adjust Attachment Point and Limit by Company’s Market Share in Coverage Region • A “Basis Risk” Swap • Company Pays Based on Their Own Results • Company Receives Based on Industry’s Results

29. Other Considerations Transaction Format Options • Reinsurance • Swap • Catastrophe Bond

30. Other Considerations Transaction Format: Impacts • Cost and time of setting up transacations • Eligible investors • Securityof recoverables