PCS Options

1
INSURITIZATION Presentation to CAS CARe
Seminar Nick Giuntini, FCAS August 15, 2000
2
AGENDA

• Insuritization
• What is the Opportunity
• Why Does it Exist
• General Underwriting Approach
• Possible Pricing Pitfalls / Issues

3
1) Definition

• Insuritizition
• Placing risks that originate in the capital
  markets into the (re)insurance markets.- e.g.
  wrapped bonds (credit enhancement) ltltvs.gtgt
• Securitization
• Placing risks that would otherwise reside with
  (re)insurance companies into the capital
  markets- e.g. cat bonds

4
1) Opportunities

• Types of Risks where Insuritization has been/can
  be used
• Municipal Bond Insurance
• CDOs
• Project Finance
• Royalty Streams
• film
• franchise
• drug
• musicNEW, ESOTERIC OR UNDERSERVED ASSET
  CLASSES ARE REAL OPPORTUNITIES FOR (RE)INSURERES.

5
Coupon - Decomposition
1) Capital Markets Pricing
Bonus for investing in a new asset class (novelty
premium) - decrease over time
Novelty Premium
Spread
Compensating the default risk of a non risk-free
investment
Risk premium
Coupon
Risk-free rate
6
1) Capital Markets Pricing
7
1) Pricing Comparison - Examples
Spread to LIBOR
8
1) Why is Capital Markets Pricing Higher for
Certain Risks?

• Illiquid
• Small Volumes of Risk Traded
• New Asset Class
• Lack of Coverage / Interest
• Uncertainty About Risk / Loss Estimates
• Accumulating vs. Diversifying Risks (1 Sided vs.
  2 Sided)

9
1) Accumulating vs. Diversifying Risks

• Diversifying Risks
• 2 Sided Risks
• Natural Longs Shorts
• Capital is not needed for risk if you can match
  up longs shorts
• Generally most efficiently handled through
  Capital Markets
• e.g. Foreign Exchange Risk, Interest Rate Risk.
• Accumulating Risks
• 1 Sided Risks
• Society is overall long in these risks
• Society net needs capital for these risks
• Generally most efficiently handled by entities
  that can diversify their capital exposure with
  other accumulating risks (i.e. Insurance Cos.)
• e.g. Property Cat risk

10
1) (Re)insurers Competitive Advantages

• Ability to underwrite price difficult
  underlying risks, while separating or mitigating
  the risks that cannot be underwritten effectively
• Ability to manage the risk within a diversified
  risk portfolio
• High quality Ratings (i.e. AAA)

11
1) SRNM Risk Screening Process

• Criteria for underwriting of Asset Backed Risks
• Strong deal economics - lack of an efficient
  alternative market for the risk
• Access to expertise, or ability to acquire needed
  expertise
• Accepted model for the risk
• Quality data that can be used to define the
  expected distribution
• Low management risk or moral hazard risk

12
1) Form of Risk Transfer

• Un-Funded Solution
• Derivative Transaction
• Liquidity Facility
• Surety
• Financial Guarantee Policy
• Insurance of Underlying Risks
• Monoline Company as a Front
• Funded Solutions
• On-Balance Sheet
• Off-Balance Sheet - Conduit, Repo, Total Return
  Swaps, Rented CP Facilities

13
2) POTENTIAL PRICING PITFALLS / ISSUES

• Alignment of Interests / Moral Hazard
• Trend or Cycle?
• Too Little Data
• Too Much Data
• Change in Underlying Process
• Inappropriate Data
• Over-Reliance on Linear Regression
• Trending, Developing On-levelling
• others...

14
2) Alignment of Interests - Moral Hazard
We wouldnt have done these deals had they not
been insured - John Miller, Managing Director -
Chase Securities In reference to insured film
loans where claim have been filed against the
insurers. The insurers, however, claim that
they were relying on Chases track record of
historically successful film lending. WSJ -
July 20, 2000
15
2) Trend or Cycle?
Are current oil prices part of a trend or just a
temporary peak?
16
2) Too Little Data
17
2) Too Much Data
We used 17,500 data points to predict the price
of electricity. This will show the price of
electricity as a function of gas prices,
temperature, generating capacity, time of day,
and day of week. However, these data points are
only 2 years worth of information (hourly
observations).
18
2) Change in Underlying Process
Start of Open Rating
19
2) Inappropriate Data
Correlation between daily price movements is
2. However, correlation when Ford is down at
least 3 is 24.
20
2) Over-Reliance on Linear Regression
Regression estimate would have dramatically
overestimated new stores.
21
2) Trending, Developing On-Leveling
Data not adjusted for economy or increasing size
of portfolio.
22
CONCLUSION

• Big Opportunities for (Re)Insurers
• Risk Understanding Quantitative Analysis
  Crucial
• Be Careful
• Make Informed Judgements
• Where Uncertainty Exists - Be Conservative
• Include both Insurance Finance Perspective