Catastrophe Bonds: Using the Capital

Markets to Create Risk Protection

Wednesday, April 30, 2008

8:00 am – 9:15 am

Milken Institute

Global Conference 2008

Wednesday

8:00 AM - 9:15 AMCatastrophe Bonds: Using the Capital Markets to Create Risk Protection

Speakers:John Brynjolfsson, Managing Director and Portfolio Manager, PIMCO

Jeffrey Cooper, Assistant Vice President, Protection Finance, Allstate Insurance CompanyBeat Holliger, Managing Director, Munich American Capital Markets

Dan Ozizmir, Managing Director and Head of Insurance-Linked Capital Markets andEnvironmental and Commodity Management, Swiss Re Financial Products

Jose Siberon, Director, Merrill Lynch & Co.Moderator:

Glenn Yago, Director of Capital Studies, Milken Institute

Catastrophe bonds first appeared on the radar screens in the early 1990s, after Hurricane Andrewleft insurers footing a bill for more than $23 billion in damages. A number of insurers went

bankrupt, and alarms sounded across the industry worldwide. The accelerating pace of climatechange may trigger weather systems that strike more frequently and with greater intensity, andexplosive population growth in coastal areas spells greater exposure to natural disaster. The

current market volume of catastrophe bonds exceeds $15 billion, but more issuance is neededto protect individuals, communities and companies from disaster. How can existing capital-market solutions for catastrophic risk be improved to provide greater global risk protection?

What products would attract a more diversified investor base and increase the availablecapital? How can we develop strong public-private partnerships to address catastrophic risk

management?

“Financial Innovationsfor Catastrophic Risk:

Cat Bonds and Beyond”

Milken Institute

Financial Innovations LabReport prepared by:

Glenn Yago and PatriciaReiter

The funding challenge for catastrophic riskmanagement

Twenty most costly insurancelosses 1970-2006

Source: Wharton Risk Center.

Impact of catastrophes onemerging markets

Source: Allstate Insurance Company.

Financial Innovations Lab forCatastrophic Risk: Cat Bonds and Beyond

October 25, 2007, New York

Financial Innovations Lab forCatastrophic Risk: Cat Bonds and Beyond

The challenge:

How can catastrophic risk be financed anddistributed utilizing the capital markets?

The Lab participantsidentified the following barriers…

Barrier I: There is insufficient supply ofinsurance-based securities issuances.

Barrier II: There is insufficient demand frommainstream investors.

Barrier III: Transaction fees are too high.

Barrier IV: Regulation hinders growth.

Barrier V: Large markets remain untapped.

….and came up with thefollowing solutions

Solution 1: Address the needs ofthe issuers

• Address basisrisk

• Reducetransaction costs

• Improve legalframework

Source: Swiss Re.

Solution 2: Securitize low-riskevents

Source: Merrill Lynch.

• 85% of all cat bond issuances received a below-investment-grade rating from 1997 through 2006.

• Investment-grade ratings are essential for tapping thelarge institutional investor base.

Solution 3: Diversify risksecuritizations

• The vast majority of cat bonds are issued on U.S. risk:

• In 2007:

– California earthquakes (22%)

– U.S. wind (32%)

– Others included: U.S. river flood risk, earthquake riskcovering Greece, Turkey, Israel, Cyprus and Portugal.

• An important driver of market growth will be thesecuritization of new risk – both a greater range of perilsand geographic distribution.

• Investors request new transactions to diversify theirportfolios.

Solution 4: Legitimize cat bondsas an asset class

Sources: Swiss Re, Lehman Brothers.

• Increased number and volume of issuances are key tothe recognition of an asset class.

• Educate investors about cat bonds and other ILSproducts.

Solution 5: Develop tools forinvestors

• Improve risk management tools for fixed-incomeinvestors and pension funds.

• Develop appropriate benchmarks for Europe andemerging markets (similar to most popular U.S. indices -Property Claim Service [PCS]).

• Issue more collateralized debt obligations (CDOs) basedon catastrophic risk (cat bonds, derivatives, reinsurancecontracts, etc.).

Solution 6: Increase liquidity andtransparency in the secondary market

The future of the cat risk market

Sources: Swiss Re.

Solution 7: Promote increasedparticipation from rating agencies

Source: Merrill Lynch. Note: AUM = Assets under management

Rating decisions and investors

Solution 8: Standardizetransactions, and lower legal fees

• Increase the use of shelf programs.

• Establish International Swaps and DerivativesAssociation industry loss warranty (ILW) documents forOTC transactions.

• Standardize issuance structuring and documentation.

• Establish the special purpose vehicle (SPV) onshore(costly under current tax code).

Solution 9: Address regulationthat promotes growth

• A strong public-private partnership is essential forprotecting individuals, enterprises and communitiesfrom large-scale disasters.

Recommendations for future legislation:

• Granting tax benefits to insurers and reinsurers forholding catastrophe reserves.

• Establishment of a federal charter for insurancecompanies.

Solution 10: Expand to emergingmarkets and attract new issuers

Source: Víctor Cárdenas, Ministry of Finance, Mexico.

The Cat-Mex transaction

Market overview and developments

Capital market solutions forcatastrophic risk management

Source: Allstate Insurance Company.

Basic cat bond structure

Source: Swiss Re.

Total ILS and cat bondsoutstanding 1997-2007

Source: Swiss Re, Guy Carpenter & Co.

Milestones in the market forcatastrophe bonds

Source: Milken Institute. *as of September 2007

Panelists’ Slides

John Brynjolfsson

Managing Director and Portfolio Manager

PIMCO

Different Perspectives,Different Skills

• Capital-market investors and reinsurance companies are drawnto concentrations of wealth and abundance. Historically,premiums and insured losses are confined to these areas.Sadly, financial players have been oblivious to pain andsuffering caused by catastrophes in less affluent regions.

• Private and governmental relief agencies try to deal withcatastrophic losses on an occurrence basis. They find thevariability and unpredictability of events make it difficult torespond as quickly and forcefully as they’d like.

• To benefit the underprivileged, the catastrophe-bond markethas successfully extracted the synergies of companies lookingto do good, and charities charged with responding to disasters– and can do so even more in the future.

Global warming Climate fluctuates, but recent temperature

increases may continue

Source: American Geophysical Union.

• Global warming is detectable and operates on ascale of centuries and millennia.

• Global warming theoretically leads to hurricanes;this may lead to increased insurance demand.

• Increasing storm intensity may lead to “tail events”that traditional reinsurance market finds hard tobear.

Global warming Some facts

Global markets are huge Capital and Property & Casualty Markets, 2005

Sources: Bank for International Settlements, Insurance Information Institute, World Federation of Stock Markets.

Conclusions

People in underdeveloped parts of the world areexposed most harshly to nature’s fury.

The catastrophe-bond market and disaster-reliefcharities are natural long-term partners.

They complement one another to diversify the risks.

Working together, we can develop charitable event-linked bonds and use them to their full potential.

We can all look forward to developing innovativesolutions that may make insurance more affordable foreveryone and more available to the people who need itmost.

Jeffrey Cooper

Assistant Vice President

Protection Finance

Allstate Insurance Company

Insured assets exposed tocatastrophe losses are huge

Insurance investors dislike earnings volatility tied to

catastrophe losses.

Typhoon exposures nationwide

Earthquake exposures nationwide

Japan

North Atlantic winter storms

Floods in Central Europe

Earthquake in Southern Europe

Europe

Hurricane landfalls along Gulf and Atlantic coastlines

Earthquake epicenters on West Coast, in Central U.S.

USA

Asia: Rapidly expanding middle class creating new exposure

concentration. India, China, other developing countries.

Expanding urban areas are in exposed zones.

London, Dublin, Amsterdam, Paris all growing steadily.

Europe:

Population migration to hurricane - exposed coastal states.

Population growth 1980-2003:

Florida 75%

Texas 52%

Insured values in coastal properties is exploding.

Florida coastal property values $1.94 trillion.

NY coastal property values $1.9 trillion.

LA+MS coastal property values $66 billion.

LA, SF, Seattle highly exposed to earthquakes.

U.S.:

Exposure growing rapidly incatastrophe - exposed areas

Insurance exposure isconcentrated in few balance sheets

11.7%

6.1%

6.1%

4.9%

3.4%

32.2% Top 10 46%

AIG

Travelers

Zurich

Liberty Mutual

CNA

Top 5

U.S. commercial property insurance market share:

21.8%

11.1%

6.7%

4.5%

4.4%

48.5% Top 10 63%

State Farm

Allstate

Zurich

Nationwide

Travelers

Top 5

U.S. homeowners insurance market share:

Insurers seek risk transferpartners pre-event

Lloyds of London

Berkshire Hathaway

Bermuda market: 25+ reinsurance companies

Swiss Re / Munich Re

Other U.S., Euro-based companies

Reinsurance sources concentrated:

$150 billion contract limit purchased

in U.S.

Reinsurance:

Historical source of insurers’ risk transfer

Pay annual premiums in negotiated contracts with third parties.

Net risk exposure is key determinate in their credit rating.

Uninsured exposure tocatastrophe also huge and growing

Financing needs for infrastructure repair and humanitarian

relief

Central, South America: Earthquakes

Caribbean, Central America: Hurricanes

Asia: Typhoons, tsunamis, earthquakes

Governments unable to fund by themselves

Large events typically trigger post-event relief efforts

Tsunami relief commitments: $2B post-event

Beat Holliger

Managing Director

Munich American Capital Markets

Risk management concepts

Capital Markets

Reinsurer

Participation in

placements

Secondary market

trading

Book building

Private

placement

Placement Agent

Insurer Insurer Insurer Insurer

Source: Munich Re Capital Markets.

Cat bond structure

Insurer

Reinsurer

Principal

At-Risk

Var. Rate

NoteholdersCollateral

Account

Total Return

Swap

Provider

SPV

Reinsurance

Agreement

Premiums

Premiums

Retrocession

Agreement

LIBOR –

Eligible Bank

Fee

Bank Deposit

LIBOR + xx bps

Note Proceeds

Outstanding Principal

Amount at Redemption

LIBOR generated by collateral investments

and are not to be paid by client (xx bps only)

Insurer

Reinsurer

Principal

At-Risk

Var. Rate

NoteholdersCollateral

Account

Total Return

Swap

Provider

SPV

Reinsurance

Agreement

Premiums

Premiums

Retrocession

Agreement

LIBOR –

Eligible Bank

Fee

Bank Deposit

LIBOR + xx bps

Note Proceeds

Outstanding Principal

Amount at Redemption

LIBOR generated by collateral investments

and are not to be paid by client (xx bps only)

Source: Munich Re Capital Markets.

• Softening traditional markets with tighter spreadsand looser terms and conditions also spilled overto the cat bond market.

• The crisis in the financial markets impacted theselection of the permitted assets as well as theselection of the total return swap provider.

• Both effects will be discussed in detail.

Impact of softer re/insurancemarkets and credit crisis

• Investors can accept tighter spreads becauseof growing market maturity, but demandproducts that are well structured.

• Intransparent cat bonds are difficult to sell toinvestors.

• On the other hand, well structured andtransparent deals are very well received and aregenerally oversubscribed.

Terms and conditions

• While the quality of the permitted assets in thetrust account was previously not of particularconcern, both cat bond investors and sponsorsdevote more attention to the selection of suchpermitted assets.

• Quality of total return swap provider has gainedimportance due to the heavily impaired balancesheets of financial institutions and total returnswap providers.

Collateral quality and total returnswap (TRS) provider

Market development 2002-2008

Source: Munich Re Capital Markets.* Up to Q1

Dan Ozizmir

Managing Director and Head of Insurance-Linked Capital Markets and Environmental

and Commodity Management

Swiss Re Financial Products

Insured value concentrationgrowing in areas of peak catastrophes

Projected population change1994-2015

Count of observed hurricanesin the US in the last 110 years

3020100

Sources: Swiss Re’s Nat Cat team, National Oceanic and Atmospheric Administration (NOAA).

The P&Creinsurance worldknows about 5 socalled “peakrisks”

Peak risk =Geographicalzone with:

- High risk ofnatural hazards(e.g. earthquakes)- High density ofinsured values(e.g. houses)

Transfer to capital markets isexpected to increase

•Securitisation

• ILW

• Collateralisedquota shares

• Sidecars addto the

flexibility ofcapital in the

industry

0

100

200

300

400

500

600

'97 '99 '01 '03 '05 '07 '09F '11F '13F '15F '17F

US$ billions

Cash format is only thetop of a larger potential;derivative format is key

Potential future growth of ILS outstanding Projections using 75% of actual historical CAGR

Source: Swiss Re Capital Markets.

Risk securitized from 1997-2008

Source: Swiss Re Capital Markets. *As of 5 March2008

Embedded Value (USD 9.3bn)

Extreme Mortality (USD 2.1bn)

Life XXX (USD 8.9bn)

Multi-peril (USD 7.8bn)

US Wind (USD 5.9bn)

Other – Life (USD 2.6bn)

California EQ (USD 3.2bn)

Others (USD 6.8bn)

Total 100% (USD 46.7 bn)

19%

20%

6%4%

17%

7%

13%

14%

US$ billions

Source: Swiss Re Capital Markets.

Who participates in the ILS market? A diverse range of institutional investors

Market size USD 15.4 bn

Insurer

3%Reinsurer

4%

Money Manager

22%

Bank

13%

Hedge Fund

14%

DedicatedFund

44%

Market Size = US$ 15.4 bn

Source: Swiss Re Capital Markets. *As of 5 March2008

Who participates in the ILS market? Primary insurance companies make up the largest percentage of sponsors

0

5

10

15

20

25

30

35

40

45

50

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Gov't Entity

Corporate

Reinsurer

Insurer

Hedge Fund

Previous

Example: GlobeCat Ltd.

Donors

Charity GlobeCat Ltd.SPV

Donations

No CatastropheEventTrust

Disaster Relief inDevelopingCountries

Investors

Notes

Proceeds

Interest

CatastropheEvent

Proceeds PrincipalRepayment At Maturity

BondPrincipal

BondPrincipal

Source: Swiss Re Capital Markets.

Example: GlobeCat Ltd.

IssuanceStructure

Size: $25,000,000

Maturity Date: Dec30, 2008

Term: 1 year

Risk: Latin AmericaEarthquake

Call Feature: NoCall

Nat CatExposure

Latin AmericaEarthquake Event

Covered Area:Guatemala and ElSalvador

Populations:

El Salvador – 6.5million (31%)

Guatemala – 14.2million (69%)

TriggerDescription

Index: PopulationExposed to severeshaking

Trigger Level:750,000 peopleexposed

Exhaustion Level:1,000,000 peopleexposed

Source: Swiss Re Capital Markets.

Satellite Based Vegetation Indices

Source: Swiss Re Capital Markets.

Satellite Based Vegetation Indices

• Problem: Remote areas lack historical field data andmany emerging markets have no suitable insurancemechanism or government subsidy.

• Solution: Satellite imagery provides objective means andsolves issue of lack of local measurement data atnumerous locations.

• Index: Vegetation Index (VI) computed from NormalizedDifference Vegetation Index (NDVI) from satellite data,ideally suited for pasture and range land.

• Coverage: Lack of green matter, approximately 300 LatinAmerican locations during growing season.

Satellite Based Vegetation Indices

• Concept extendible to emerging markets such as Africa andBRIC

• Swiss Re worked with Millennium Promise, a 501(c)(3) entityled by Jeffrey Sachs, Director of Columbia University's EarthInstitute‘s, operating in 78 villages across 10 countries insub-Saharan Africa to mobilize the private sector to findsolutions to key problems that contribute to extreme povertyin Africa

• Swiss Re combined NDVI coverage with a local waterrequirements satisfaction index (WRSI) to create a combinedNDVI/WRSI Climate Impact Index to cover grains and othercrops not suited for a pure satellite coverage

• Payout-digital if trigger is met with flexibility for scaledpayments such that moderate drought can trigger onepayment, catastrophic drought a higher payout

Jose Siberon

Director

Merrill Lynch & Co.

Insurance-linked securities Why issuers engage in securitization

Risk management (alternative risk transfer tools)Alternatives to reinsurance

Multi-yearReduce counterparty credit riskQuicker payment of claims

Capital managementImprove the risk based capitalRegulatory relief

Enhance ROEImprove claims recovery mechanismUnlock value of a run-off block

Catastrophe bonds and swaps (natural, mortality)Embedded value monetizationLeveraged acquisitionFund new business strainFund redundant reserves (Reg. XXX,AXXX)Capital relief transactionsSidecarsLife settlement and premium finance trusts

Insurance-linked securities Types of insurance-linked transactions

Insurance-linked securities Examples of risks being securitized

1. Mortality/longevity2. Morbidity3. Auto insurance4. Hurricane/typhoons5. Quake6. Flood7. Fire8. Variable annuity M&E fees9. Tornados10. Terrorism

and…many others!

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rom

Rein

su

ran

ce

Tru

st

Investors

Cash/ Collateral

InvestorSecurities/CDS

FinanceVehicle

(SPV)

Originator/ Retailer

OwnershipInterest

Cash/ Risk Protection

Customer

Cash/Collateral

Notes/CDS

Financial Guarantee

FinancialGuarantor

Traditional asset-backedsecurities structure • Security holders

• SPV pass-through• Counterparty on a CDS• Leveraged hedge fund• Risk Buyer

• SPV• SPV Reinsurer• Counterparty on a CDS• Trust

• Insurance Company• Reinsurance Company• Counterparty on a CDS• Life Settlement Provider•Intermediary

• Insurance Company• Reinsurance Company• Policyholder• Risk Seller

How does a cat bond work?

Insurer Special Purpose Vehicle Investors

Trust Account

Premium

Principal and

Coupon

Property Cat

Cover

Principal

PrincipalPrincipal and

Investment

Returns

Return on

Liquidity Swap

Yield on

Underlying

Assets

Asset Manager or Swap Counterparty

Insurer Special Purpose Vehicle Investors

Trust Account

Premium

Principal and

Coupon

Property Cat

Cover

Principal

PrincipalPrincipal and

Investment

Returns

Return on

Liquidity Swap

Yield on

Underlying

Assets

Insurer Special Purpose Vehicle Investors

Trust Account

Premium

Principal and

Coupon

Property Cat

Cover

Principal

PrincipalPrincipal and

Investment

Returns

Return on

Liquidity Swap

Yield on

Underlying

Assets

Asset Manager or Swap Counterparty

Reg. XXX/AXXX overview What is Reg. XXX/AXXXX?

Regulation 30 (i.e. XXX) was passed to controlinsurance companies misreserving formortality risk, particularly for term insurance

Statutory reserves, which are calculated basedon rule-based methods and assumptions,resulted in substantial increases in reserves

New Statutory reserves are now 2-5x theeconomic/GAAP reserves creating asubstantial strain in statutory capital

Insurance Companies funded the excessreserves by reinsuring the business to off-shoreaffiliates and LOC collateral (1-5 yr terms)

Actuarial Guideline 38 (AXXX) wasadapted to adjust Reg. 30 to addressuniversal life policies with no lapseguarantees

Prudential funded the excessreserves by issuing public debt(recourse transactions)

Genworth established a non-recourse securitization to fund theexcess reserves

Rating Agencies require that the fundingsolutions have a longer tenor (min 8 yrs for reg.30 & 15 for AXXX)

LOCs Capacity for long tenor is limited

Banks began to offer more creative solutions[LOC, Private Funding, Principal Investments,Public Funding, Securitization (term &Auction-market)]

Estimated future funding need estimated to bebetween $100-$150 B over the next 5 yrs by therating agencies

Market estimate of fundingsolution estimated to be $35-$45 B(mostly private)

Auction-Market fundedSecuritization failed causinginsurance companies to look forterm-out alternatives

2001 2003 2005 2007

Insurance-linked securitization Full securitization solution

Investors

CashInvestorSecurities

FinanceVehicle

CaptiveReinsurer

OwnershipInterest

Cash

ReinsuranceTrust

Eligible Assets

Right of Draw

Ceding Insurer

Reinsurance Agreement

Cash Notes

Financial Guarantee

FinancialGuarantor

Insurer Parent

Cash

Equity*

InvestorsInvestors

CashInvestorSecurities

FinanceVehicle

CaptiveReinsurer

OwnershipInterest

Cash

ReinsuranceTrust

Eligible Assets

Eligible Assets

Right of Draw

Ceding Insurer

Reinsurance Agreement

Cash Notes

Financial Guarantee

FinancialGuarantor

Insurer Parent

Cash

Equity*

Event-linked futures

CCFE (Chicago Climate Futures Exchange) IFEX

Source: Chicago Climate Futures Exchange.