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Presentation to: Presentation to: The CAS Seminar on The CAS Seminar on

Financial Risk ManagementFinancial Risk ManagementApril 12, 1999April 12, 1999

Securitization of Securitization of Catastrophe Risk:Catastrophe Risk:

A USAA ExampleA USAA Example

Presented by: Rhonda K. AikensExecutive Director, Financial Actuary

USAA

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Objective of BriefingObjective of Briefing

To summarize the Residential ReTo summarize the Residential Re

transaction and its implicationstransaction and its implications

for USAA, the P&C Insurance Industryfor USAA, the P&C Insurance Industry

and investors.and investors.

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How will USAA insulate itselfHow will USAA insulate itselffrom the next mega-hurricane?from the next mega-hurricane?

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Hurricane Andrew made landfall in South Dade County Florida devastating Hurricane Andrew made landfall in South Dade County Florida devastating Homestead Air Force Base.Homestead Air Force Base.

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1992 Hurricane Andrew1992 Hurricane Andrew

USAAUSAA$600,000,000$600,000,000

IndustryIndustry$16,500,000,000$16,500,000,000

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A stormA stormthe sizethe sizeof Andrewof Andrew

just just 40 mi.40 mi.northnorth would wouldhave resultedhave resultedin insuredin insuredlosses oflosses ofoverover

$50 billion$50 billion

HAFBHAFB

Miami40 miles

north

Miami40 miles

north

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Exposure to Mega-HurricaneEstimated U.S. Insured Losses (1/500 Yr.)Exposure to Mega-Hurricane

Estimated U.S. Insured Losses (1/500 Yr.)

$22 Billion$22 BillionHurricaneHurricane

Houston-GalvestonHouston-Galveston

$21 Billion$21 BillionHurricaneHurricane

Northeast RegionNortheast Region

$17 Billion$17 BillionHurricaneHurricane

Southeast RegionSoutheast Region

$76 Billion$76 BillionHurricaneHurricane

Florida RegionFlorida Region

Source: Risk Management Solutions, Inc.; Insurance Services Office, Inc.Source: Risk Management Solutions, Inc.; Insurance Services Office, Inc.

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Strategic Challenge:Industry PerspectiveStrategic Challenge:Industry Perspective

Since 1989, a series of natural disasters has resulted in variability in Since 1989, a series of natural disasters has resulted in variability in insurance losses.insurance losses.

Prior to Hurricane Hugo, the insurance industry had never suffered Prior to Hurricane Hugo, the insurance industry had never suffered losses from a single disaster over $1 Billion.losses from a single disaster over $1 Billion.

Since then, 11 natural disasters have exceeded this amount.Since then, 11 natural disasters have exceeded this amount.

Traditional reinsurance mechanisms are limited in capacity.Traditional reinsurance mechanisms are limited in capacity.

Recent events have caused the insurance industry to reconsider its Recent events have caused the insurance industry to reconsider its approach in handling low frequency, high severity occurrences.approach in handling low frequency, high severity occurrences.

The questions have centered around the following:The questions have centered around the following:

— What steps can we take toWhat steps can we take to reduce lossesreduce losses from future disasters? from future disasters?— What steps can we take to What steps can we take to reduce variabilityreduce variability in insurer results in insurer results

from future disasters?from future disasters?

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Serving members who live in catastrophe-prone Serving members who live in catastrophe-prone areas requires maintenance of a high level of areas requires maintenance of a high level of capitalization and liquidity.capitalization and liquidity.

If such exposures could be mitigated, then If such exposures could be mitigated, then transferred or separately securitized, USAA could transferred or separately securitized, USAA could more efficiently deploy its capital resources.more efficiently deploy its capital resources.

Strategic Challenge:USAA Perspective

Strategic Challenge:USAA Perspective

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Options Considered By USAAOptions Considered By USAATo AddressTo Address

The Strategic ChallengeThe Strategic Challenge

Options Considered By USAAOptions Considered By USAATo AddressTo Address

The Strategic ChallengeThe Strategic Challenge

Expanded Traditional ReinsuranceExpanded Traditional Reinsurance

Catastrophe BondsCatastrophe Bonds

Catastrophe OptionsCatastrophe Options

Surplus Notes and Contingent Surplus NotesSurplus Notes and Contingent Surplus Notes

Contingent EquityContingent Equity

Catastrophe SwapsCatastrophe Swaps

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Options’ Issue: Options’ Issue: Financing vs. HedgingFinancing vs. Hedging

FinancingFinancing HedgingHedging

Impact on:Impact on:

PMLPML NoNo YesYes SurplusSurplus YesYes YesYes LiquidityLiquidity YesYes YesYes Balance SheetBalance Sheet Yes *Yes * YesYes

* Contingent type can be kept off balance sheet until exercised.* Contingent type can be kept off balance sheet until exercised.

Risk TransferRisk Transfer NoNo YesYes

InstrumentInstrumentSurplus NotesSurplus Notes ReinsuranceReinsurance

Cat BondsCat BondsCBOTCBOT

Contingent Surplus NotesContingent Surplus NotesContingent EquityContingent Equity

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- Competitive.- Competitive.- Financially Strong.- Financially Strong.- Highly Rated.- Highly Rated.- No regulatory concerns.- No regulatory concerns.

RR

USAAUSAA

CapacityCapacity CostCost

SecuritySecurity PermanencePermanence

Risk TransferRisk Transfer

CapitalCapitalMarketsMarkets

ReinsuranceReinsuranceMarketsMarkets

USAA Preferred HedgingUSAA Preferred Hedging StrategyStrategy

USAA Preferred HedgingUSAA Preferred Hedging StrategyStrategy

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Hedging Design FieldHedging Design Field

Re-Re-insuranceinsurance

C. B. O. T.C. B. O. T.

Cat BondCat BondIndemnityIndemnity

Cat BondCat BondIndexIndex

Source: “Financial Risk Management For Catastrophes”- Neil DohertySource: “Financial Risk Management For Catastrophes”- Neil Doherty

CCrre e d d i i tt

RRiisskk

Moral HazardMoral Hazard

Basis RiskBasis Risk

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Index ApproachIndex Approach

1. Index based payment1. Index based payment

2. Speculative2. Speculative

3. May/may not transfer risk3. May/may not transfer risk

4. Basis risk4. Basis risk

5. Accounted as investment5. Accounted as investment

6. Low transaction cost6. Low transaction cost

7. Very small capacity7. Very small capacity

Capital Market Contracts:Capital Market Contracts: Index vs. Indemnity ApproachesIndex vs. Indemnity Approaches

Indemnity ApproachIndemnity Approach

1. Actual loss based payment1. Actual loss based payment

2. Non-speculative2. Non-speculative

3. Risk transfer3. Risk transfer

4. No basis risk4. No basis risk

5. Accounted as reinsurance5. Accounted as reinsurance

6. Transaction cost material6. Transaction cost material

7. Medium capacity for now7. Medium capacity for now

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Selected Hedging Selected Hedging InstrumentsInstruments

Selected Hedging Selected Hedging InstrumentsInstruments

Expanded Traditional ReinsuranceExpanded Traditional Reinsurance

Catastrophe BondsCatastrophe Bonds

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Characteristics OfCharacteristics OfCatastrophe BondsCatastrophe BondsCharacteristics OfCharacteristics OfCatastrophe BondsCatastrophe Bonds

Rated security Rated security

Renewable process Renewable process

Supplement to traditional reinsuranceSupplement to traditional reinsurance

Objective risk assessmentObjective risk assessment

Potentially attractive to investorsPotentially attractive to investors

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Special Purpose ReinsurerSpecial Purpose Reinsurer How it Works How it Works

CompanyCompany SPR SPR ReinsuranceReinsurance

PremiumPremium

InvestorInvestor

To secure obligations To secure obligations under the Reinsurance under the Reinsurance

AgreementAgreement

Reg 114 TrustReg 114 TrustAccountAccount

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The Reinsurance AgreementThe Reinsurance AgreementThe Reinsurance AgreementThe Reinsurance Agreement

Obligates Residential Reinsurance to pay USAA Obligates Residential Reinsurance to pay USAA for the claims in the layer between $1.0 billion for the claims in the layer between $1.0 billion and $1.5 billion resulting from a single Class 3, and $1.5 billion resulting from a single Class 3, 4 or 5 hurricane in the Covered States during a 4 or 5 hurricane in the Covered States during a 12 month claims period.12 month claims period.

USAA will retain not less than 10% of the risk.USAA will retain not less than 10% of the risk.

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Catastrophe Bond Catastrophe Bond Transaction TimelineTransaction Timeline

Catastrophe Bond Catastrophe Bond Transaction TimelineTransaction Timeline

June 15, 1998 - May 31, 1999June 15, 1998 - May 31, 1999 June 1, 1999 -June 1, 1999 -

Dec 1, 1999Dec 1, 1999

Risk PeriodRisk PeriodExtended Extended

ClaimsClaimsPeriodPeriod

June 1June 1 Dec 1Dec 1 June 1June 1 Dec 1Dec 1

Typical Hurricane SeasonTypical Hurricane Season

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Key Issues EncounteredKey Issues Encountered Federal TaxFederal Tax

– SPR off-shoreSPR off-shore– Debt vs. equity interestDebt vs. equity interest

RegulatoryRegulatory– Recognition that investors are not in the business Recognition that investors are not in the business

of insuranceof insurance

SecuritiesSecurities– Public vs. private offeringPublic vs. private offering

Bond StructureBond Structure– Principal at risk vs. principal protectedPrincipal at risk vs. principal protected– Single year vs. multi-year transactionSingle year vs. multi-year transaction

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The Investor’s The Investor’s PerspectivePerspective

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Why Do I Buy?Why Do I Buy?Why Do I Buy?Why Do I Buy?

Increase YieldIncrease Yield

Reduce Portfolio Reduce Portfolio VariabilityVariability

Porfolio Risk

Por

tfol

io R

etu

rn

Before

After

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What Do I Need To Know? What Do I Need To Know? Questions that need to be answered from Investor’s PerspectiveQuestions that need to be answered from Investor’s Perspective

What Do I Need To Know? What Do I Need To Know? Questions that need to be answered from Investor’s PerspectiveQuestions that need to be answered from Investor’s Perspective

How do I assess the risk ?How do I assess the risk ?

How credible is the risk assessment ?How credible is the risk assessment ?

When do I feel that I have become educated enough to buy ?When do I feel that I have become educated enough to buy ?

Is this the first transaction of this kind?Is this the first transaction of this kind?

Is there a pipeline of future deals to further increase Is there a pipeline of future deals to further increase diversification ?diversification ?

Why have they bypassed the reinsurance market ?Why have they bypassed the reinsurance market ?

Can I afford to lose all my principal ?Can I afford to lose all my principal ?

What are the regulatory impacts (especially for life insurers and What are the regulatory impacts (especially for life insurers and pensions funds) ?pensions funds) ?

Isn’t one year too short; wouldn’t a multi-year commitment Isn’t one year too short; wouldn’t a multi-year commitment improve the utility of this instrument ?improve the utility of this instrument ?

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Who Are The Investors?Who Are The Investors?Who Are The Investors?Who Are The Investors?

Bottom line: 90 - 95% of the money is new to the P&C Insurance Bottom line: 90 - 95% of the money is new to the P&C Insurance Industry. This is “found money”; capital that would never have Industry. This is “found money”; capital that would never have been applied to the problem of catastrophe protection through been applied to the problem of catastrophe protection through either investment in primary insurers or reinsurers.either investment in primary insurers or reinsurers.

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Categories Of Investors:Categories Of Investors:This is a Global MarketThis is a Global MarketCategories Of Investors:Categories Of Investors:This is a Global MarketThis is a Global Market

Life InsurersLife Insurers

Pension FundsPension Funds

Reinsurers Reinsurers

Hedge FundsHedge Funds

BanksBanks

Investment AdvisorsInvestment Advisors

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Wall Street JournalWall Street JournalJune 18, 1997June 18, 1997Wall Street JournalWall Street JournalJune 18, 1997June 18, 1997

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Even Nature Even Nature Can Be TurnedCan Be Turned Into a SecurityInto a Security

High Yield and Big Risk High Yield and Big Risk With Catastrophe BondsWith Catastrophe Bonds

Even Nature Even Nature Can Be TurnedCan Be Turned Into a SecurityInto a Security

High Yield and Big Risk High Yield and Big Risk With Catastrophe BondsWith Catastrophe Bonds

THE NEW YORK TIMESAUGUST 6, 1997THE NEW YORK TIMESAUGUST 6, 1997

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ObservationsObservationsObservationsObservations Traditional reinsurance capacity is plentiful, but limited.Traditional reinsurance capacity is plentiful, but limited.

Capital markets offer the potential to supply additional capacity.Capital markets offer the potential to supply additional capacity.

USAA’s success in renewing its transaction at reduced cost is evidence USAA’s success in renewing its transaction at reduced cost is evidence that:that:

1. Securitization of catastrophe risk on a large scale is 1. Securitization of catastrophe risk on a large scale is possible and sustainable.possible and sustainable.

2. Improving efficiency and cost is also possible; multi-year 2. Improving efficiency and cost is also possible; multi-year transaction could help in this regard.transaction could help in this regard.

Note: There have been about 21 capital market risk Note: There have been about 21 capital market risk transfer securitizations to date.transfer securitizations to date.

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ObservationsObservationsContinuedContinued

ObservationsObservationsContinuedContinued

Growth of capital markets reinsurance will be slow due to:Growth of capital markets reinsurance will be slow due to:

1. Lack of expertise, basis risk/low risk transfer/speculative 1. Lack of expertise, basis risk/low risk transfer/speculative nature of investment, accounting and regulatory restrictions nature of investment, accounting and regulatory restrictions

(index options) (index options)

2. High transactions costs, tax issues/offshore nature, need 2. High transactions costs, tax issues/offshore nature, need for for more investor education (indemnity catastrophe bonds) more investor education (indemnity catastrophe bonds)

3. Soft traditional reinsurance market with large capacity 3. Soft traditional reinsurance market with large capacity and declining reinsurance prices. and declining reinsurance prices.

Significant growth in capital market reinsurance will requireSignificant growth in capital market reinsurance will require::

1. Addressing the issues mentioned above.1. Addressing the issues mentioned above.

2. NAIC adopting changes to support securitization of insurance.2. NAIC adopting changes to support securitization of insurance.

3. Changes at the Federal level and removal of tax disincentives so these 3. Changes at the Federal level and removal of tax disincentives so these SPR transactions can take place on-shore SPR transactions can take place on-shore..

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ConclusionConclusionConclusionConclusion

This pioneering (and now renewed), mutually This pioneering (and now renewed), mutually beneficial transaction fulfills the strategic purposes of:beneficial transaction fulfills the strategic purposes of:

– Tapping into the vast pool of capital for capacity.Tapping into the vast pool of capital for capacity.

– Introducing a new asset class which supplements Introducing a new asset class which supplements reinsurance.reinsurance.

– Providing a vehicle for investors to increase yield,Providing a vehicle for investors to increase yield,while reducing portfolio risk through while reducing portfolio risk through diversification.diversification.

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Insulating Insulating USAAUSAAfrom thefrom theFinancial Financial ImpactImpactof aof aMega-Mega-CatastropheCatastrophe

Insulating Insulating USAAUSAAfrom thefrom theFinancial Financial ImpactImpactof aof aMega-Mega-CatastropheCatastrophe