WMO EXPERT ADVISORY GROUPON FINANCIAL RISK TRANSFEREAG-FRT-I

Session 2:

Traditional and Alternative Risk Transfer Markets (Physical assets and property) and Needs for Meteorological, Hydrological and Climate Services

Geneva, 13 December 2011

Rowan Douglas, CEO Willis Global Analytics and Chairman Willis Research Network

Global Property & Casualty Capital,and Reinsurance Capital & Premium

Reinsurance:Traditional Risk Transfer Capital = $300bnAlternative Risk Transfer Capital = $5bn…..

Governments

Risk/Capital Sharing

ReinsuranceInsurance

CapitalMarket

Fire/WS Ins

FL/EQ Ins

Developed Countries Developing Countries

1/200

Owner

Penetration

50 to>90%

5 to <1%

CollateralisedMarket

Major pools

Elemental CEA

Unlimited State

Guarantee

Limited State

Guarantee

No State

Guarantee

Compulsory Insurance(Consumers)

Compulsory Reinsurance(Insurers)

Voluntary Participation(Insurers & consumers)

SCR

TCIP

ACIP

TREIF

RCIS

“High Intervention”

Unlimited State

Guarantee

Limited State

Guarantee

GuaranteeMAIPARK

EQCCCS

JER FHCF

CCR

“Liberal”

NaturskadeICI

ACIP Algerian Catastrophe Insurance Pool (Algeria)

CCR Caisse Centrale de Réassurance (France)

CCS Consorcio de Compensación de Seguros (Spain)

CEA California Earthquake Authority (USA)

Elemental Elementarskadepool (Switzerland)

EQC Earthquake Commission (New Zealand)

FHCF Florida Hurricane Catastrophe Fund (USA)

ICI Iceland Catastrophe Insurance (Iceland)

JER Japan Earthquake Reinsurance Co (Japan)

MAIPARK PT. Asuransi MAIPARK (Indonesia)

Naturskade Norsk Naturskedepool (Norway)

RCIS Romanian Catastrophe Insurance Scheme (Romania)

SCR Société Centrale de Réassurance (Morocco)

TCIP Turkish Catastrophe Insurance Pool (Turkey)

TREIF Taiwan Residential Earthquake Fund (Taiwan)

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Spoiled for choice

Insured

Insured

Insured

Insured

Insured

Insured

Insured

Insured

Retrocessionaire

Retrocessionaire

Specialist Investment and Trading Capital

Capital Investors

Insurance

Insurance

Company

Company

Reinsurer

Reinsurer

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Functions of reinsurance

Loss limitation

Protection from:Single Risk Losses

Catastrophic Events

Higher Loss Frequency

Reinsurance = Claims!

Providing capacityUse “The Law of Large Numbers”

Capacity to write more risks

Capacity to write bigger risks

Creating stability

Yearly results may fluctuate greatly

Financial planning difficult

Reinsurance can limit or remove the effect

Levels fluctuations

Strengthening finances

How “safe” is the company?

Regulation requirements?

Reinsurance improves solvency margins

Reinsurance = Capital!

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Types of reinsurance

Proportional

E xcess o f L oss

S top L oss / A ggregate E xcess o f L oss

N on-P roportional

Facu ltative

Q uota S hare

S urp lus

F acultative / O bligato ry

P roportional

P er risk excess o f loss

C atastrophe excess o f lo ss

E xcess o f L oss

S top L oss / A gg regate E xcess o f L oss

N on-P roportional

T reaty

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Loss paid by ceding company

Loss recovered from excess of loss reinsurance

Loss paid by ceding company

$ 200,000

$ 1,000,000

$ 2,000,000

$ 3,000,000

Size

of l

oss

Excess of loss treaty

$1,800,000

excess of

$200,000

Excess of loss treaty - illustration

Recovered LossRetained Loss

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Overview of traditional reinsurance

Starting point for all buyers

– No company would purchase reinsurance without first considering traditional coverage

Ability to meet many needs

– Balance sheet de-leveraging, volatility control, “lights on” coverage, etc.

Benchmark for all alternative reinsurance considerations

– Is it more or less expensive than traditional reinsurance?

– Does it offer more or less coverage? Maturity of market

– Offers many positives and few negatives

Benefits of traditional reinsurance

Execution– Ease: transaction costs understood; standardized approach to

marketing and placement – Speed: faster than almost all forms of alternative coverage

Predictability of cost– Less volatile capital allows brokers to forecast pricing accurately

Market access: breadth of market offers global choice Supply of capacity

– More than all alternative sources combined Leading to soft market pricing advantages

– Other alternatives are sometimes opportunistic capacity Flexibility of coverage

– Contract language, Ultimate Net Loss coverage, minimal basis risk Scalability: can meet growth demands of all but most extreme clients

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Challenges and suitability of traditional reinsurance

Challenges– Intelligent capital: it can be difficult to discover and exploit new

opportunities– Susceptibility to market cycles– Quality of credit: ability to settle all claims after “mega cats”

Who is the product best suited for?– Suits all companies regardless of size or structure (stock / mutual)

Small niche companies not economical for non-traditional markets $500M+ coverage requires traditional market to some extent

Who should not buy the product?– Companies with portfolios which model punitively and find it more

difficult to get coverage at economic terms

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Other considerations for traditional reinsurance

Rating agency / regulatory view

– Transparency: easily analyzed

– Credit risk can be mitigated by syndication Market trends that affect price, capacity, availability

– Less affected by capital volatility, due to long term commitment of reinsurance specialists in the marketplace

– Natural catastrophes, primary industry results, regulation Data & key metrics used in evaluating the products

– Predominantly, experience and exposure

– Subjective arguments considered in pricing process

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Overview ofIndustry Loss Warranties

Industry loss warranties (ILWs)

– Cover triggered by an index of insured industry loss

– Cover payoff can be pro-rata or digital

– Cover can be tailored to specific region and peril e.g. Florida Wind, California EQ

– Index providers vary by region PCS in the US PERILS in Europe ABI in the UK Swiss Re / Munich Re worldwide 13

Benefits to a carrier of ILWs

ILWs are

– Easy to execute

– Easy to model

– Relatively anonymous Carrier does not have to share exposure data

– An access route to non-traditional capital i.e. hedge funds, banks, etc.

– Often cheaper than traditional reinsurance

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Common challenges of ILWs

Basis risk is always an issue for ILWs

– Unless the ILW trigger is chosen well, substantial risk exists that the cover will not respond as expected

– The index itself may not respond as expected e.g. initial estimates from PCS for Katrina were less than $10B

ILWs do not get full reinsurance credit from rating agencies

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Overview of Exchange Traded Derivatives

Exchange traded cat derivatives (ETDs)

– Cover triggered by an index of some sort Typically parametric

– Payoff can be pro-rata or digital

– Can be tailored to specific region

– ILWs can be traded on exchange using PCS index

– Most used parametric index is the CME Hurricane Index (CHI)

– Do not have to show an indemnified loss to collect claim

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Benefits to a carrier of ETDs

ETDs are

– Easy to model

– Completely anonymous

– An access route to non-traditional capital i.e. hedge funds, banks, etc.

– Often “cheaper” than traditional reinsurance

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Common challenges of ETDs

Basis risk is always an issue for ETDs

– Unless the trigger / index is chosen well, substantial risk exists that the cover will not respond as expected

ETDs do not get full reinsurance credit from rating agencies

Trading ETDs requires infrastructure not normally found in reinsurance

– Clearing bank relationships, inter-dealer brokers, etc.

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Overview of Catastrophe BondsA catastrophe bond (“cat bond”) is a security that transfers a specified set of risks from a

sponsor to investors

If no catastrophe occurs, the insurance company will pay a coupon to the investors, who make a healthy return

If a catastrophe does occur, the principal will be forgiven and this money will be used to pay their claimholders Often structured as floating rate bonds whose principal is lost if specified trigger conditions are met Triggers are linked to major natural catastrophes

The risk transfer is analogous to an excess of loss reinsurance treaty

A cat bond illustrative structure: Multi-year reinsurance contract

between Sponsor and Special Purpose Reinsurance Vehicle (SPRV)

Sponsors are typically insurers and reinsurers but may be corporate or government entities

Bonds, “cat bonds” are issued by the SPRV to the investors

Reinsurance contractSPRV

Sponsor InstitutionalInvestors

TRUST

Stable ValueInvestment

(Typically U.S. Treasury money market funds)

Premium

Cash proceeds

Cat bonds

Investmentearnings

InvestmentsWCMA

Advises sponsor on structure

Where applicable works with Willis Re on integrating structure with reinsurance program

WCMA

Sells bonds to investors

May act as initial purchaser in Rule 144A placement

Reinsurance contractSPRV

Sponsor InstitutionalInvestors

TRUST

Stable ValueInvestment

(Typically U.S. Treasury money market funds)

Premium

Cash proceeds

Cat bonds

Investmentearnings

InvestmentsWCMA

Advises sponsor on structure

Where applicable works with Willis Re on integrating structure with reinsurance program

WCMA

Sells bonds to investors

May act as initial purchaser in Rule 144A placement

Benefits and considerationsof Catastrophe Bonds

Cat bonds have unique features that make a direct comparison with traditional reinsurance rates-on-line inappropriate

Benefits Considerations

Multi-year cover Allows lock-in of capacity at fixed price

Reduces exposure to reinsurance price volatility

Facilitates longer-term planning

Collateralized cover Reduces counterparty credit risk exposure to

catastrophe losses Provides security where it matters; extreme cat

events

Additional source of risk transfer capacity Diversify sources of reinsurance capital and can

result in savings in traditional program Hedge against a future hard re/insurance market

large nat cat losses

No reinstatement results in savings, especially relative to a reinstate premium of 1 @ 100; avoids increased counterparty risk to weakened reinsurers from multiple events

Risk modeling Investors rely heavily on model output Perils need to be independently model-able

Coverage / Basis Risk Non-indemnity triggers introduce basis risk

The risk recoveries from the bond do not match actual losses incurred by the company

Basis risk may need to be managed in the context of the overall reinsurance program

Time and cost to execute Two to three month timetable to execute Legal, modeling and rating agency fees Increasingly standard but still complex documentation

No reinstatement could leave a gap in reinsurance program if not otherwise addressed

Combined Ratio:Property & Casualty Market

Source: A.M. Best’s Aggregates and Deutsche Bank

Underwriting Returns

Relying on Investment Returns

Incurred Loss + Expenses Earned PremiumCombined ratio =

Assets are no longer working for insurers: understanding risk is key

Insurance Product Risk

The uncertainty of the insurance business lies in the fact that the costs of goods sold is not known at the time of production/contract (Deutsche Bank, 2010)

Modelling must be an intrinsic part of the product

Calculable Loss:Platforms for Trading

Risk Models: Vendor and in-house tools

>90% of WW property exposure and 90% GDP related risk represented in models (EQ, WS, Terror, FL, Fire, Surge, Tsunami and more)

Thesis: The primary purpose of vendor catastrophe models is to provide a “currency” to trade with

Global vendor catastrophe models at end of 2011

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• Vendor cat models cover 90% of the world by GDP

• Vendor cat models cover >90% of property insurance premium

• Territory-Peril-Model (TPM) combination – USA-HU-RMS = 1

• There > 460 TPMs available from model vendors

• This year: 112 changes and 72 new TPMs

2011 – end of year report 2011 – the year of the “cat” (according to the Vietnamese calendar) Impact on traditional and capital markets

– Re/insurers profits exhausted after events in Japan, NZ, Australia, US

– Thai floods could be the tipping point – impact on capital

– 1 cat bond has a full loss to investors after tornado losses in the US

– Potential market hardening and rate increases Impact of model changes

– Better (or worse) understanding of cat models – implementation of latest science and state of the art methodology leading to significant changes in loss estimates

– Traditional reinsurance slight increase in rates

– Reduction in cat bonds purchased in 2011 Traditional vs ART

– Traditional much cheaper than ART

– New ART mechanisms being developed to reduce the price and make it more competitive with the traditional market

– ART are fully dependant on a modelled approach – whether the triggering metric or a probabilistic model for pricing

– ART coverage aimed primarily at protecting extreme / tail events

– Traditional cover broad and flexible

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