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You call that ART?!!

Derek Newton2nd December 2002

The Actuarial Professionmaking financial sense of the future

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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

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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

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Meeting in the middle

ART

Capitalmarkets

Insurancecompanies

Traditional risk transfer Traditional financing

Insurance policy

Packagedinsurancepolicies

Multi-line multi-year

policies

Loss-sensitivepolicies

Finite-risk contract

SecuritisationContingent capitalReal options

Capital structure financial hedges

Source: The Economist

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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.

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Estimated size of insurance market worldwide $2,129bn (Sigma Vol. 2/1999)

Market size

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)

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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

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Common types of contracts

Discounting covers e.g. run-

off covers, funding covers

Other funding mechanisms, e.g. insurance derivatives,

swaps

Integrated risk covers, e.g. multi year - multi line,

blended covers

Securitisation, e.g.

catastrophe, other

Post loss funding, e.g. contingent

nature, capital injections

Captives, mutuals and

other forms of self insurance

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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

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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

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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

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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

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Typical securitisation process

InsurerReinsurer

“SPV”Investors

Reinsurance Treaty

Premium

Issue Notes

Note Proceeds

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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

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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

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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

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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”

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Catastrophes: costs and management

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Example: large UK manufacturer

Issue Solution

European competitionUse 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 salesUse weather derivatives to hedge sales issue

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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

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Actuarial pricing versus capital markets pricing

Actuarial Capital markets

Identify past data Identify appropriate market

Trend to current levels Identify size, liquidity and duration of contract

Adapt to contract terms Obtain prices for an appropriate combination of contracts

Load for exchanges Add internal exchanges

Add a risk load No risk loads in markets with short sales

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Common motivations for taking out an ART contract

Stabilisation

of results

Solvency margin

Taxation

Source of capital

Cheaper cover More effective

provision of risk managementGreater

security

of

payment

Provides cover that might otherwise be unavailable

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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

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11th September 2001

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Acceleration for ART?

Insurance rates soar? Reinsurance rates soar? Market capacity slashed? Risk awareness heightened - demand for cover higher?

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Market premiums

Cat XL rates for 13 major markets

0

20

40

60

80

100

120

1994

1995

1996

1997

1998

1999

2000

2001

2002

Source: Swiss Re Study, updated by Heath Lambert observations for 2002 renewal season

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Market premiums

Catastrophe Reinsurance

0

50

100

150

200

250

300

350

400

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Wo

rld

rat

e o

n l

ine

Source: Guy Carpenter & Co World Catastrophe Reinsurance Market 2002

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…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

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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

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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

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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

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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

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You call that ART?!!…..contact

Derek Newton, Director, Heath Lambert Hybrid SolutionsHeath Lambert GroupFriary CourtCrutched FriarsLondon EC3N 2NP

Tel: 020 7560 3330email: dnewton@heathlambert.com