A D V A N C I N G C O R P O R A T E S T R A T E G Y T H R O U G H A L T E R N A T I V E S O L U T I...

A D V A N C I N G

C O R P O R A T E

S T R A T E G Y

T H R O U G H

A L T E R N A T I V E

S O L U T I O N S

Finite Insurance: Limiting Transactional Risk

World Services GroupMay 7, 2004

presented by:Todd Cunningham

Assistant Vice President, AIG Risk Finance

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Agenda

• Introduction• Alternative Risk Financing

Techniques– Loss Portfolio Transfers– Structured Insurance Solutions

• Scenarios

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Current Situation

• Insurance Market– Higher retention levels– Loss of certain key coverages– Layers with rates on line of 20% or more– Single-year basis only

• Industries Impacted – Healthcare– Construction– Financial Services – Manufacturing

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Alternative Risk Financing Techniques• Retrospective Exposures

– Loss Portfolio Transfers • Primary casualty liabilities• Exotic liabilities (asbestos, product liability)• Captive run-off

• Prospective Exposures– Finite Products - structured insurance

solutions– Structured Hedging

• Structured derivative and insurance transactions

• Financial risks

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Loss Portfolio Transfers

• The assumption of liabilities, typically developed over a substantial period of time (retrospective exposures)

• May cap potentially devastating balance sheet exposures related to prior events

• May create a more stable financial environment for the companies involved

• Also known as a “liability buyout”

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• Eliminate operational obstacles, advance growth

• Address volatility of accrued liabilities by transferring risks to an insurer

• Diminish negative impact to future profits• Release security behind existing

insurance• May accelerate tax deduction of the

liabilities• Manage cash flow with premium finance• Facilitate merger, acquisition, or

divestiture

Loss Portfolio Transfers - Benefits -

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• Medical malpractice & hospital professional liabilities

• Warranty liabilities• Merger & Acquisition-related risks • Asbestos and occupational disease

liabilities• Primary retentions of WC, GL, AL• Captive insurance companies• Public entity-related liabilities• Intellectual property (patent, copyright

infringement)

Loss Portfolio Transfers - Typical Risks -

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• Assumes future liability to an aggregate limit– Reserve estimate (to ultimate losses)– Payout pattern– Discount @ Treasury strip rates– Insurer profit margin– Claims handling costs– Intermediary compensation

Loss Portfolio Transfers - Pricing -

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Loss Portfolio Transfer

ABC Inc.

Self Insured W.C. Reserves

$55MM

Insurance Co.

Premium $50MM

Policy Limit $75MM

Assumes futureliab. to agg. limit Pricing Developed:

•Reserve Est.•Payout Profile•Discount•Claims Handling

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• Facts– Client - Self insured years 1996 - 2002– Accrued Liability - $55 million– Deferred Tax Asset - $18.7 million– Net Loss - $36.3 million

• Solution– Policy Limit - $75 million– Premium- $50 million – Tax benefit- $17 million

• Benefit– $3.3 million in net cash– $20 million in additional insurance protection

• (to cover under-valuation of accrued liability)

Loss Portfolio Transfers

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Structured Insurance Solutions

• Insurance solutions which often combine insurance and capital market techniques

• May contain: – a component of funding by client, – structured policy limits, and – a provision for insured to benefit from favorable

loss experience

• Highly customized programs to protect insureds from financial, strategic or operational risks

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• Multi year policy term• Customized limits of liability • Potential for sharing of favorable loss

experience (experience accounts)• Coverage for uninsurable or difficult to

insure risks• Customized structures


- Characteristics -

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• Difficult to insure risks– Construction defects - Medical/hospital

professional– Product liability - Casualty and

property– Financial lines - Residual Value

• Capacity constrained risks– Product recall, patent infringement, trade

credit

• Perceived ‘mispriced” risks• Capital Market-based exposures• Unique risks


- Risks -

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• Quantify maximum losses for a period of time • Lock in multi-year pricing (insulate market

fluctuations)• Address volatility of potential liabilities that affect

balance sheet• Stabilize cash flows• Maximize tax efficiencies• Benefit financially from favorable loss experience• Provide evidence of insurance coverage• Facilitate an underlying transaction


- Benefits -

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Accumulated Experience Balance

Yr 1 Yr 2 Yr 3

Accumulated Premium

Accumulated Interest

S.I.R.

5 M

20 M

15 M

Structured Insurance Solutions - Components -

Risk Transfer

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• Identify client objectives/motivation• Conduct preliminary risk assessment• Develop underwriting data• Preliminary cash analysis• Establish timing objective


- Underwriting Criteria -

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• Analysis of risk• Loss payout profile• PV costs at current market interest

rates• Risk Premium• Profit and administration• Applicable premium taxes• Term• Administration costs


- Pricing Considerations -

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Client Profile Difficult-to-insure, long-tail exposures

Medical Malpractice Financial Lines (E&O, D&O) Casualty Warranty

Liquidity Sufficient liquidity to address the issue Minimum target premium of $5M

Structured solution desired Wants a solution reflective of a specific risk profile Leveraged risk transfer is not the primary motivation

Loss data available Has a risk that can be sufficiently analyzed and priced

Evidence of insurance required

Senior decision maker involved Senior decision maker seeking to resolve a material problem in a

defined time-frame

Patent Infringement Trade Credit & Political

Risk Property Product Liability

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Scenarios

• Construction– Construction Defect

• Healthcare– Managed Care E&O

• Manufacturing– Product Recall

• Technology– Shock Loss Protection

• Other– Captive Purchase– Asbestos Liability

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Construction Defect Risk

Situation Solution

Benefits

A publicly traded U.S. homebuilder selling over 2,500 homes annually, averaging $300,000 each, had received a number of GL quotes which were expensive given its good loss history. The market was demonstrating concern for the construction defect exposure in many of the states in which the client builds.

A five-year GL insurance program with limits of $5,000,000 per occurrence excess a $500,000 per occurrence retention. Aggregate policy limits are $10,000,000. Policy Premium is $7,500,000.

•Policy form modeled after standard ISO General Liability Policy as required by insured.

•Client is able to insulate itself form vagaries of current insurance market cycle.

•Tax efficient solution.

1

Construction

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Situation Solution

Benefits

A regional HMO was seeking alternatives to the traditional insurance market, citing an increase in renewal rates. The client was interested in an insurance program in which they could benefit from their positive loss performance while cutting back on current insurance costs. Client also has to show evidence of insurance.

The three-year policy limits are $40,000,000 per claim with a $55,000,000 policy period aggregate.

•Provided multiple-year coverage. •Transaction provides client with a tax-efficient structured insurance solution.

•Program enables client to satisfy its certificate of insurance requirement.

Managed Care E&O

Healthcare

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Product Recall

Situation Solution

Benefits

An auto parts manufacturer faced large volatility in earnings per share due to its product recall exposure.

An insurance program covering product recall, product extortion and warranty exposures over a multi-year term.

•Allowed insured to fund the cost of recalls over several years.

•Transferred volatility risk.

•Tax efficient solution.

•Provided coverage that was otherwise unavailable in the market.

Manufacturing

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Benefits

Situation

A software company may have substantial exposures to future litigation for copyright infringement.

Solution

An insurance policy that provided protection against multiple perils that had the potential to adversely affect earnings. The policy provided this protection for 10 years.

•Potential to minimize exposure to copyright infringement lawsuits over the long term.

•Client initially retains claims control, which enables it to defend claims in the manner it deems appropriate.

•A tax efficient structure.•Substantial policy limits that were otherwise unavailable.

Technology

Shock Loss Protection

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Benefits

A UK entity inherited a redundant reinsurance captive through a recent M&A transaction.

Management wished to shut it down in the most tax effective manner.

•By arranging the purchase of the outstanding shares of the captive, it was completely removed from the client’s balance sheet.

•Client was able to record its gain on its investment in the captive.

•Client fully transferred all potential future liabilities from the captive (through the 3rd party) to the insurer.

Three Steps:

• A sale of the captive to an unrelated 3rd party.

• A buyout of the insurable risks in the captive.

• A closeout of the captive by the unrelated 3rd party.

Situation Solution

Captive Purchase

Other

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Situation Solution

Benefits

Client faced claims resulting from the past use of asbestos in its products. Uncertainty about this liability increased on the bankruptcy filing of another asbestos defendant.

Client was forced to make a reasonable estimate of the portion of its ultimate liability not covered by their existing insurance.

Solution enabled client to fund periodic uninsured or underinsured portions of their existing insurance, as well as a significant limit to cover liability that might exceed the existing coverage.

If cumulative paid claims exceeded a fixed sum, insurer provided a significant amount of risk transfer.

•Covered claims paid for the next 50 years, or until the limit of liability is exhausted, or policy is commuted.

•Provided annual policy limits that reimbursed client for paid claims not covered by existing insurance.

•Ring-fenced the material liability and potential source of future earnings volatility.

•Share in favorable loss experience.

Other

Asbestos Liability

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08/2003

Disclaimer

This presentation is for illustrative purposes only and should not be construed as an attempt to define any of the terms and conditions regarding a possible issuance of coverage. Clients are advised to make an independent review and reach their own conclusions regarding the economic benefits and risks of any proposed transaction, as well as the legal, regulatory, credit, tax and accounting aspects of a transaction as it relates to their particular circumstances. This presentation does not constitute an offer to sell coverage of the type generally described herein. Insurance provided by member companies of American International Group, Inc.

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