René Cotting, PhDFinancial Institutions Solutions Group - Insurance

International Insurance SocietyBerlin, July 8-11, 2007

Growth Agenda for the Insurance Industry

A Capital Markets Perspective

2

Growth Agenda for the Insurance Industry

A Capital Markets’ Perspective:

1. Markets – size, growth and interaction

2. Innovations – recent & pending

3. Requirements – to facilitate growth

4. Conclusions

3

1. Insurance & Capital Markets – Areas of Interaction

Adapted from P. Shimpi, Integrating Corporate Risk Management

R/I:

XL / SL

QS /Sidecars

Credit Lines

Contingent Capital

Derivatives

Equity, Rates, FX, Commod., Inflation, Weather,…

Senior Debt

Subordinated Debt

Equity

Insurance Linked

Securities (Cat Bonds)

Risk Transferred Retained

Ca

pit

al

Off

-B/S

P

aid

-Up

risk

risk

CFO

RM

Risk-Capital MapHow can the Capital Markets supportYour Business?

Capital: Accelerate the B/SFlexible Capital Structures

RBC: Associates Risk with Capital and hence Cost

Applies to Economic, Regulatory and Signal Capital

Risk Transfer / Risk Management

4

1. Global Capital Markets – Size (matters…..)

Total Global Capital Markets Outstanding

Estimate2:

Equity $ 75’000 bn

Fixed Income $ 75’000 bn

Total $ 150’000 bn (100%)

MSCI Global Capital Markets Index1

$44’900 bn

Asset Segment Weight

Equity $25’800 bn

North America 28.5%

Europe 16.7%

Asia & Pacific 8.2%

Emerging Markets 4.1%

Total Equity 57.5%

Fixed Income $19’100 bn

Sovereign 22.1%

US 4.7%

Europe 8.6%

Japan 6.0%

Other 2.8%

Investment Grade Credit 18.7%

US 7.3%

US Mortgage Backed 6.1%

Europe 4.5%

Other 0.8%

High Yield 1.7%

Total Fixed Income 42,5%

Source: SIFMA

1: only liquid investable assets, as of March 20062: Extrapolation based on U.S. gross-up factors

Total FI27,700

U.S. Capital Markets Outstanding $ 49'500 bl as of March 31, 2007

21,800

4,4002,6002,400

6,600

2,400

4,000

5,300 Equity

Treasury

Federal Agency

Municipal

Mortgage Related

Asset-Backed

Money Market

Corporate

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1. Insurance Market Size

Global Insurance Premiums1

non-life $ 1’619 bn

Life $ 1’707 bn

Total $ 3’311 bn

Global Catastrophe Market2

Premium $12.9 bn

Limit $143 bn

(0.1%)

Capital Increase (following KRW)

Existing Companies $ 5.3 bn

Start-Ups $ 1.9 bn

Alternative Capacity2,3,4

ILS $ 28.0 bn

of which cat.

$ 10.3 bn

ILW $ 6.5 bn

Side Cars $ 5.1 bn

Private Placements ???

Total Alternative Insurance Capacity ≥$ 40 bn (0.027%)

1: OECD markets 2004, source: OECD2: 1/2007 figures, source: Guy Carpenter3: source: Swiss Re sigma4: source: LaneFinancial

Alternative Cat Capacity accounts for

>15% of Global Catastrophe Limits

6

ILS Outstanding

0

5

10

15

20

25

30

1996 1998 2000 2002 2004 2006

$ b

l

CreditMotorLiabilityCatastropheLife settlementExcess mortalityReg. XXXEV

1. Growth of Alternative Insurance Capacity

Life Risks securitized to date

XXX/AXXX regulatory reserves

Catastrophic Mortality

Embedded Value

P&C Risks securitized to date Natural Catastrophe

Big Four: US HU, US EQ, EU WS, JP EQ JP TY, Med EQ, TW EQ, Aus CY/EQ,

Mex EQ, UK river flood, …

Credit (Trade, R/I Recoverables) Liability Motor

Longevity conspicuously absent

Insurance Linked Securities (ILS)

20061 has been a banner year 60% of ILS is life related Still only 0.03% of Global FI Markets

Source: Swiss Re sigmaUpdated with company disclosures for full 2006

1: trend continued in 1H07

CAGR: 42%

7

1. Impact on Reinsurance Market - Cycle is flattening

21192314

945

13

10

AndrewNorthridge WTC

Rita Wilma

Katrina

CharleyIvan

Rate Impact per Dollar Loss1 decreased significantly:

Andrew 92: 2.4% / $bn

WTC 01: 1.2% / $bn

KRW 05: 0.7% / $bn

Speed of Capital is increasing

Cycle Amplitude is flattening

Post-Loss Recuperation is no longer a viable strategy

1: indexed, not trended

2: Source: Swiss Re Sigma 2/07(liability and NFIP flood losses excluded)

3: Source: Lane Financial LLC Trade Notes

April 2007 (with data from Paragon)

55% / 23bn = 2.4% / $bn 1.2% / $bn

1985 1990 1995 2000 2005 1Q07

YoY Index Change (detrended)

+25%

+45%+55%

The eight largest global catastrophe insured losses 1970-2006, indexed, not trended2

Reinsurance Rate Changes3

0.7% / $bn

YoY Index Change

SidecarsILSStart-UpsRecapitalization

Loss

8

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

2002 2004 2006 2008 Est.

$ b

l

Other

Insurance Companies

Investment Managers

Leveraged / hedge funds

Banks

CAGR: 81%

CAGR: 25%

CAGR: 9%

CAGR: 7%

1. Capital Market Comparables

Credit Default Swaps (CDS)

CDS = “credit insurance”

today the global CDS market exceeds the cash market

Mortgage Backed Securities (MBS)

Allowed banks to sell down risks previously held on B/S (de-risk & accelerate B/S)

Facilitated by Government Agencies

Acceptance criteria Standardization

Creation of secondary market

Guarantee timely payment to investors

Global CDS Market (Notional Amounts)

Source: Mellon / BBA

(U.S. only)

Source: SIFMA

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1. Private Equity Markets

Total PE capital raised: $ 800 bn

of which by top-50 PE firms: $ 551 bn

Cumulative buying power1: $ 4’000 bn

Global IPOs: $ 2’322 bn

Top-5 PE firms Capital Raised

1. The Carlyle Group $ 32.5 bn

2. Kohlberg Kravis Roberts $ 31.1 bn

3. Goldman Sachs Principal Investment Area$ 31.0 bn

4. The Blackstone Group2 $ 28.4 bn

5. TPG (Texas Pacific Group) $ 23.5 bn

Top-50 PE firms by Location

Insurance

Post KRW Sidecars raised $ 5.1 bn capital;

$ 3.6 bn of which equity

Corresponds to 0.45% of average annual

PE buying power

High Sidecar activity in 2006 abated in 2007

source: Dealogic / Private Equity International All data for the period 1.1.2002 – 18.4.2007

1: assumes 5-times leverage multiple

2: IPO on June 22, 2007

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11

5 1

U.S.

U.K.

WesternEuropeAustralia

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A: Elimination of Credit Cliff in Catastrophe Bonds

2. Examples of Recent Innovations

A standard catastrophe bond gives investors and rating agencies no early default warning (digital credit cliff)

Cat bond rating ceiling of A and strong pricing compared to CDO/ABS market

Applying CDO technology to a basket of natural catastrophe perils1

– Decouples security rating from individual layer risk profile– Results in gradual rating migration rather than digital default

As a result, the Senior Tranche of Fremantle achieved AAA/Aa1 rating

1: Bay Haven, Fremantle, Gamut Re

2: Fitch/Moody’s rating

Mezzanine (Class B)BBB+/A3

Senior (Class A)AAA/Aa12

$33.375m Each Event

Event 9

Event 3

Event 8

Event 7

Event 6

Event 5

Event 4

Event 2

Event 1

Junior (Class C)BB-/Ba2

Region Peril Trigger

UK Windstorm Param.Europe Windstorm Param.

Japan Quake Param.

Japan Typhoon Param.

California Quake PCS

New Madrid Quake PCS

East Coast Hurricane PCS

Gulf States Hurricane PCS

Florida Hurricane PCSBy-pass Hurricane PCS

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B: Dynamic Hedging of Secondary Guarantees

Guaranteed Minimum Benefits (GMB) are value added guarantees embedded into U.S. style savings products such as Variable Annuities

A Guaranteed Minimum Death Benefit (GMDB) for example represents a mortality investment hybrid risk with sensitivity to

– Equity (delta, gamma, vega)

– Interest rates (rho)

– Realised mortality

– Persistency / policyholder behaviour

Dynamic hedging of complex guarantees with liquid, traded instruments (i.e. swaps, futures, options)

Requires periodic / frequent hedge adjustment

Net Market Risk Minimized

Hedging Activity prompted by introduction of new regulation (C-3 Phase II Market Risk Requirement Nov. 2005)

2. Examples of (not so) recent Innovations

Investment risks

Maturity

Account Value

NAV

GMAB

GMDB (ratchet)

Death Pay-off

Maturity Pay-off

Surrender Pay-off

Insurance risks

GMDB: Guaranteed Minimum Death Benefit

GMAB: Guaranteed Minimum Accumulation Benefit

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2. Examples of recent & pending Innovations

C: Regulatory Reserve Financing

(i.e. XXX / AXXX reserves)

Move from pure credit support (i.e. standard

5-7y LoCs) to mortality linked credit structures

as alternative to securitizations

Resulting credit risk is conditional upon

underperformance of underlying block (double

trigger)

Allows to secure capital support for much

longer tenors (e.g. 30y) for a similar pricing as

7y LoCs

Requires insurance (mortality / persistency)

as well as credit expertise

D: Longevity

(pending)

Not much securitization activity to date

Attempt to create liquid swap market

Difference in expectation between buyer and seller – in particular on tenor

Negative accounting arbitrage for corporate sponsors

Current FTSE 100 pension deficit at Dec.06 is £38bn from £75bn at Dec.051

1850 1875 1900 1925 1950 1975 20000

10

20

30

40

50

60

70

80

year of death

age

Mortality Ratesqx (U.K. Males)

?

1: source: Deloitte, FTSE 100 went up +12% during 2006

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3. Requirements for Capital Markets Solutions Growth

1. Risk Standardization (I) – Documentation Insurance policy / reinsurance treaty vs. ISDA Master & Schedule Lack of standardization introduces basis risk

2. Risk Standardization (II) – Natural Catastrophe Indices Indices create liquidity & reduce transaction costs

– PCS-style market loss reporting for non-U.S. perils

– Longevity Indices (relevant and independent)

3. Market Consistent Valuation of Risks & Reserves Reduces arbitrage / creates level playing field Facilitates economically motivated hedging decisions

4. Insurance Rates remain at technical levels Capital is not locked into insurance sector Will be reallocated quickly, if return expectations no longer meet expectations

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3. Requirements Growth (cont.)

5. Further educate & develop investor base

Reach for investors beyond cat. / hedge fund world

CDO / ABS investors

Institutional investors

6. Continuous flow of new issues

Allowing investors to build portfolio

Economy of scales

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4. Conclusions

Capital Markets Solutions are well established by now But more work needs to be done Self-enforcing process (supply, liquidity, demand, granularity of hedging indices) We are only at the beginning

Basis Risk as an Opportunity for Risk Aggregators Wholesale risk transfer to capital markets based on parametric / industry triggers Basis risk fully priced in and retained where expertise is highest Likely to become a lesser issue as markets mature

Longevity market expected to explode Global Correlation of Mortality Improvement greatly reduces Diversification Benefits Size of Exposure: $ 19’000 bn of global pension assets1 (13%) Set-up of dedicated pension / closed block buy-out firms

1: OECD, FIAP, IFSL estimates, Dec. 2004

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4. Conclusions (cont.)

Paradigm Change

From Claims experience driven capital level and variable rates (recuperation)

To Pro- and retroactively managed capital level and stable rates

…And ultimately to

A Fee-based rather than Risk-based Insurance Business Model

Based on Sourcing, Characterizing, Packaging and Selling of Insurance Risks

With the majority of the Risks transferred to investors

Similar to how banks manage loans, mortgages and credit card debt