From Reinsurance to ART Dr. Alan Punter Aon Capital Markets, London 21st September, 2000 Alternative Risk and Alternativ

1. From Reinsurance to ART Dr. Alan Punter Aon Capital Markets, London 21st September, 2000 Alternative Risk and Alternative Transfer

2. Insurance and reinsurance have a long history circa 2000 BC: Predecessor of marine insurance practised in Babylon - “bottomry” involved a loan on the security of a ship, but if the ship was lost the loan was not repaid. 1370: The first reinsurance transaction, as documented by Gustav Cruciger, who described how an insurer obtained reinsurance on a voyage it was insuring from Genoa, Italy, to Sluys, Netherlands. 1654 Bodlean library contains entries from insurance broker’s account book listing deals. 1688: Lloyd’s coffee house advertised in London Gazette. 1863: The formation of Swiss Re and Munich Re (in 1880) are widely considered to be the start of the modern “professional reinsurance” industry in continental Europe.

3. World Insurance Market 1998 premiums (US$ billions) Life Non-life Total North America 368 411 779 Latin America 11 28 39 Americas 379 439 818 Western Europe 399 286 685 Central / Eastern Europe 4 11 15 Europe 402 297 699 Japan 361 92 453 South and East Asia 74 33 107 Middle East 4 7 11 Asia 439 132 571 Africa 22 7 29 Oceania 22 15 37 World 1,264 891 2,155

4. US Insurance Results 1999 • Net income after taxes fell from $30.8 bn in 1998 to $22.2 bn in 1999 • Combined ratio up from 105.6% in 1998 to 107.9% in 1999 • Rate of return on average net worth fell from 8.5% in 1998 to 6.4% in 1999 • Problems: • poor premium growth • weak profitability due to rising incurred losses and loss-adjustment expenses • falling investment income

5. European reinsurers results 1999 • “Very sorry picture” (Standard & Poor’s) • Estimated average combined ratio of 131% for 1999 (109% in 1998) • Record number of catastrophes in 1999 (including eight of over $1 billion) • Weak premium rates, to continue in 2000 • late occurrence of December 1999 European storms • many multi-year contracts signed at 1/1/99 to cover Y2K issues • High Aviation claims • Retrocession recovery problems

6. Why do insurers buy reinsurance? • Ancient • Widen book of business - quota share • Smooth earnings - excess of loss • Off balance sheet “fund” • Modern • Liquidity • Protect ratings & franchise • Balance sheet management • Enhance return on capital

7. The landscape of risk is changing ... Increasing exposures • Natural perils • 40 of the fastest 50 growing cities are in earthquake zones • half off the world’s population lives in coastal regions, many of them exposed to the dangers of rising sea levels, repeated flooding and cyclones (World Disasters Report 1999) • Man-made perils • business interdependency • critical reliance on integrated IT (communications and processing) systems • brand values and reputation risk

8. The landscape of risk is changing ... Broadening view of risk • “Risk is Risk” • traditional insurance risks • growth of capital markets and derivatives or financial and market risks (interest rates, exchange rates, commodity prices, credit, weather) • operational risks (everything else - strategy, business, technology, legal, political, people, etc.)

9. The landscape of risk is changing ... Change in the financing of risk • (Re)Insurance does not appear to deliver: • clarity of cover • certainty of payment, timing and amount • … and has a high frictional cost • Increasing use of non-traditional forms of risk financing • growth of captives, blended solutions • Convergence with capital markets • catastrophe bonds • CatEPuts®

10. Intellectual convergence Financial hedges Cat Bonds Capital markets Securitisation Contingent capital - CatEPuts ART solutions Multi-line Insurance markets Guaranteed Cost Insurance policy Traditional Risk Transfer ART / ARF Traditional Risk Financing

11. What does “Alternative” mean? • Any mechanism used to substitute for traditional risk transfer products offered by re/insurers • A planned approach to financing risk involving: • Alternative risks not traditionally reinsurable • eg. interest rate or commodity exposure, brand image • Alternative structures, not reinsurance contracts • eg. weather derivatives, catastrophe bonds • Alternative markets, not Insurers or Reinsurers • eg. capital market entities such as pension funds, banks and fund managers

12. Common Objectives of ART Buyers • Risk retention • Efficient use of capital • Long term continuity and pricing stability • Specified historic / future loss problem smoothing • P&L insulation • Managing volatility and adding liquidity • Unlock potential profit in long tail exposures • Insurance of traditionally ‘uninsurable’ risks

13. Common Solution Characteristics & Features • Solution not product driven, with alignment of interests (tailored to match client needs & market appetite) • Multi-risk or aggregate nature of coverage (blending) • Finite, aggregate limits of liability (per occ, annual, term) • Multi-year contractual commitment • Profit sharing, often with investment income • Transparency • Converged Banking / Insurance / Capital techniques • Generally, reinsured’s upside (i.e. reinsurer’s downside) is limited in some way

14. Trends & Future Development of ART • Continued growth of many forms of self insurance (i.e. larger retentions, insurance co. captive formation, ‘finite’ risk programmes) • Increasingly buyers require flexible, bespoke, broader applications • Accountancy treatment, taxation treatment and legal contracts need to be analysed carefully • Techniques and instruments need to be fully tested in real circumstances • New deals are moving away from insurance principles of insurable interest and indemnity • Whilst market remains soft, low financial incentive for buyers to be too adventurous (current appear expensive)

15. ART Markets: Characteristics • The major financial organisations including • Professional (re)insurers(ACE, AIG, Allianz, Axa Global Risks / Paribas, Bankers Trust, Chubb, Citicorp / Travellers, Custom Risk Solutions (RSA, Ace, Aon), ERC Frankona, General Re, Gerling, Liberty Re, Munich American Risk Partners, QBE, Scandinavian Re, Stockton Re, Swiss Re New Markets, Transatlantic Re, Winterthur / Credit Suisse, XL / Pareto, Zurich Centre Solutions) • Global carriers • Finance houses / merchant banks / capital markets • Strong balance sheets • Proven commitment to long term partnerships • Proven commitment to tailor-made (customised) solutions

16. Most Efficient use of Risk Capital ? Identify risks and trading objectives Perform risk analysis and evaluation of data Quantitatively identify optimal solution Placement and Negotiation Retain Traditional ART Capital Markets Captive Blended Surplus Risk XL Cat. XL Stop Loss Quota Share Aggregate XL Finite Risk ML/MY Sub Insurance Notes Weather derivatives Hybrid Equity Double Trigger Cat bonds Portfolio Transfer CatEPuts Whole Account Stop Loss

17. Financing Cashflow Insurance Risk Transfer Alternative Risk Transfer & Financing Structures in Context - Annual Placings Capital Markets Contingent Equity Programmes (CatEPutSM) Catastrophe Bonds Integrated Risk(FX / Gradual Pollution) Weather Derivatives / Commodities Blended / Multiple Trigger / Residual Value Loss Portfolio Transfer Multi-line / Multi-year Captives Motor / Property / Liability - QS,surplus, risk & cat XL etc Traditional (Re)Insurance Tens Thousands Millions Contracts Placed Annually Worldwide

18. Developments in Insurance ART • Self-insurance • Retrospectively rated plans (retros) • Captive insurance company, rent-a-captive and protected cell company • Finite or financial insurance • Multi-line, multi-year, aggregate or blended and integrated programmes • Enterprise-wide risk management

19. Developments in Reinsurance ART • Financial reinsurance • Insurance derivatives • Contingent capital (debt and equity) • Double triggers • Catastrophe Bonds

20. Functions of financial reinsurance • Smoothing of fluctuations in cedent’s loss experience over a period of years • Optimisation of balance sheet structure and reported ratios, such as solvency or reserve adequacy • Expansion of underwriting capacity, by ceding premiums and/or technical reserves • Increase in retentions • Facilitation of acquisitions, mergers and corporate restructuring

21. Summary of financial reinsurance contracts

22. Insurance-linked securitisation • Risk liquidity • Contingent Surplus Notes (CSN) • Catastrophe Equity Puts (CatEPuts) • Risk transfer • Chicago Board of Trade options • Double trigger • Catastrophe Bonds

23. Contingent Surplus Notes - CSN • Nationwide Mutual Insurance Company of Ohio, Surplus Notes deal in 1995 • $400 million raised and deposited in trust fund • Noteholders receive returns equal to yield on government bonds plus 23/8%, but run risk of Nationwide drawing down cash from trust fund and converting into surplus notes (like preference shares) • Nationwide can draw funds down under wide conditions • Arkwright Mutual did similar $100 m deal in 1996

24. Contingent capital - CatEPutSM RLI Catastrophe Equity PutSM • 3-year agreement brokered by Aon Re Services • RLI pays annual option premium to Centre Re • Trigger is major California quake, then: • Centre Re buys up to $50 million convertiblenon-voting preference shares in RLI • RLI pays annual dividends on preference shares • RLI converts preference shares into full-voting common equity after 3 to 4 years (but has option to repurchase at original issue price)

25. Option premium Before option exercised RLI INVESTOR Option rights Preferred shares When option exercised RLI INVESTOR Cash Common shares At conversion date RLI INVESTOR Preferred shares The CatEPutSM Structure

26. CatEPuts - features • Post-event capital negotiated at pre-event terms • Pre-event • option premium lower cost than traditional reinsurance • protects shareholder value • mitigates dilutive effects of upper layer reinsurance • Post-event • balance sheet recovery • favourable treatment by ratings agencies • no reinstatement • no profit & loss protection

27. Extract from RLI Corp. 1996 R&A What are the benefits (of the CatEPut) to shareholders? A: First, this is an extremely cost-effective level of security ... a fraction of the price for a similar layer of reinsurance. But by improving our ability to withstand a momentous catastrophic event, we have also fortified shareholder value. Even if such a disaster occurs, our earning power would remain intact at its current level. Likewise the ability of RLI to pay dividends and rise in value has also been shielded.

28. Double Trigger - Examples • European multi-line insurance company • suffered combined effect of not only poor returns from its stock and bonds investment portfolio, but also large underwriting loss • bought reinsurance programme that links retained losses to underlying financial criteria • CSAA reinsurance contract triggered by two elements • occurrence of a major catastrophe • fall in level of equity index • CLM reinsurance contract responds if CLM suffers from both a significant fall in the price of equities and adverse underwriting results

29. Catastrophe or “Act of God” Bonds • Issued by insurer (or corporate) • In the event of a pre-defined catastrophe bondholders may be forced to: • forfeit some or all of their interest repayments; or • forfeit some or all of their principal; or • delay/defer receipt of interest or principal

30. USAA / Residential Re I (1997) • Raised $400 million in cover through private placement of $477 million in bonds by Residential Re, Cayman Islands • Oversubscribed by factor 2plus • Trigger was single US East Coast hurricane intensity 3, 4 or 5 • Indemnity of 80% of USAA’s losses $500 m excess of $1 bn • Two tranches: • A-1 $164 million principal protected, LIBOR + 273 bps • A-2 $313 million principal-at-risk, LIBOR + 576 bps

31. Investor base for USAA bond issue

32. Issue Size Insured or Cedent Investors Advisors Deal Description ($ 000's) Type Perils Covered Deal Date Completed Hannover Re Institutions Citibank Cat XL Retrocession 85,000 Risk Transfer PML Protection 1 1994 C Manhattan Aon Cat Line of Credit 500,000 Contingent Capital Hawaii Wind 2 June 1994 HHRF FWUA (Florida Fund) Chemical Bank None Cat Line of Credit 1,000,000 Contingent Capital Florida Wind 3 September 1994 Florida RPC JUA J.P. Morgan None Cat Line of Credit 1,500,000 Contingent Capital Florida Wind 4 September 1994 Nationwide Institutions J.P. M, SB Contingent Surplus Notes 400,000 Contingent Capital Surplus Protection 5 February 1995 Institutions AIG Cat XL 10,000 Risk Transfer 6 Late 1995 AIG Arkwright Institutions ML, MS Contingent Surplus Notes 100,000 Contingent Capital PML Protection 7 April 1996 State Auto C Manhattan None Catastrophe Line of Credit 100,000 Contingent Capital PML Protection 8 July 1996 Centre Re Aon CatEPut 50,000 Contingent Capital PML Protection 9 October 1996 RLI Hannover Re Institutions Citibank Proportional Reinsurance 100,000 Risk Transfer 10 December 1996 St. Paul (George Town Re) Institutions GS Property Surplus Share 50,000 Risk Transfer US Windstorm 11 December 1996 Winterthur Institutions CSFB Cat XL 130,000 Risk Transfer European Hail 12 January 1997 Reliance Institutions Sedgwick Cat XL - Multi-line 40,000 Risk Transfer 13 March 1997 Horace Mann Centre Re Aon CatEPut 100,000 Contingent Capital PML Protection 14 March 1997 USAA (Res'l Re) Institutions ML,GS,Lehman Cat XL 400,000 Risk Transfer Florida Windstorm 15 June 1997 Swiss Re Institutions CSFB Cat XL 122,000 Risk Transfer California E’quake 16 July 1997 LaSalle Re Swiss Re Aon CatEPut 100,000 Contingent Capital PML Protection 17 July 1997 Tokio Marine (Parametric) Institutions GS, Swiss Re Cat XL 90,000 Risk Transfer Japanese E’quake 18 December 1997 Done Deals

33. Done Deals

34. What investors want • Clarity of trigger mechanism • No moral hazard • Quality exposure data • Objective risk assessment • Rated investments • Liquidity • Diversification (low beta plus) … and excess returns!

35. What sellers want • Access to new source(s) of secure risk capital • Certainty of cover • Minimum basis risk • Contract structure - probably (re)insurance • Fair price, cost effective transaction • Confidentiality • Longer-term capacity and price • Strategic capital and balance sheet management

36. Rethinking (re)insurance • Product showing lack of growth • global non-life insurance premiums only grew by 0.2% in real terms in 1997 (Swiss Re) • Service not highly rated • insurers, brokers and other service providers all given ‘D’ grades in 1999 Quality Scorecard published at US RIMS in 1999 • Risk is becoming a Boardroom issue (Cadbury, Greenbury, Hampel, Turnbull) • but insurance is not mentioned in corporate Report & Accounts “Traditional insurance does not provide protection against 80% of risks faced by companies” (Bob Cooney, XL)

37. Per cent What risks are clients concerned about? Source: Airmic/Lloyd’s

38. Rethinking (re)insurance Why do we limit ourselves to traditional property / casualty exposures ? • Microsoft • Market capitalisation US$ 400 billion • Plant, property & equipment US$ 1.5 billion • Cash US$ 14 billion • Reputation risk • Total value of FTSE 100 companies was £1.37 trillion in 1998 • “Goodwill” accounted for 71% of total value in 1998 (44% in 1988) Research by Interbrand and Citibank

39. Rethinking (re)insurance Why do we need insurable interest ? • Example • On 4th July 1993 the Sumitomo Chemical Company plant in Niihama, Japan exploded • Spot prices for computer memory chips rose by 50% because Sumitomo plant made 65% of the world’s supply of epoxy cresol novolac resin used to seal most computer chips into their plastic packages • Sumitomo can buy property and business interruption cover on their plant • Question • Why can’t any other economically interested parties, e.g. computer manufacturers, buy the same insurance policy on the same terms and conditions?

40. Rethinking (re)insurance Why does cover have to indemnity-based ? • Example • Oriental Land, operators of Disney themepark in Japan, have borrowed to finance further development of the site • Any disruption to revenues from existing site will impair their ability to service this debt • Answer • Oriental Land have issued a catastrophe bond to the capital markets that pays up to $100 million in the event of an earthquake in the region around the themepark • Trigger is occurrence of earthquake • Payment amount determined by epicentre and size of earthquake

41. If the event happens then client is paid, regardless of whether he has actually sustained a loss or not The pay out is linked to the epicentre and magnitude of quake in three concentric rings (JMA scale) 6.5 inner circle, 7.1 inner ring, 7.6 outer ring Concentric Re - Parametric trigger Inner Circle Inner Ring Chiba Tokyo Malhama Boso Yokohama Peninsula Outer Ring Izu Peninsula

42. Illustrative Terms and Conditions 100% 75% 50% Inner Circle Inner Ring Outer Ring 25% 0% 6.5 6.6 6.7 6.8 6.9 7.0 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 JMA Magnitude • Trigger: Physical, based on earthquake magnitude, location and depth • Magnitude - Sliding scale based on magnitudes > 6.5 • Location - Three circles (Inner Circle, Middle Ring, Outer Ring) in the Southern Kanto region of Japan defined by latitude and longitude • Depth - Shallow earthquakes only, 60km or less • Reporting Agency - Japan Meteorological Agency (JMA) • Development period - [30] days

43. Equity Debt Retention Traditional Risk Transfer, ART & Capital Market Solutions should be considered in combination Capital Markets Facultative Reinsurance 4th Cat Excess Reinsurance 3rd Cat ART 2nd Cat Surplus Share 1st Cat Cat Retention

44. Any questions? 8 Devonshire Square London EC2M 4PL Direct tel: 020 7216 3400 Direct fax: 020 7375 1760 Email: alan.punter@aon.co.uk