Alternative Reinsurance

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Alternative Reinsurance and Shareholder Value
October 1998
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Return and Capital

• Uncertainty creates need for capital
• Cost of Capital is reflection of risk
• Returns generated are measured over time
• Three variables under constraint of available
  profits capital, risk, time

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Optimal Capital Structure
Other Derivatives Insurance Common
Stock Preferred Stock Surplus
Notes Subordinated Debt Senior Debt
Quantity of Risk
Capital Structure
Time
Period 1 Period 2 Period 3
Risk Class
FX Cat GL Fire
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Alternative Forms of Capital

• Forms of Capital depend on return form, risk
  form, and duration
• P/C Reinsurance and financial options generally
  non-recourse contingent capital no return is
  required for capital, but receive fee in advance.
• Fees paid should be less than cost of raising and
  maintaining other forms of capital (i.e.. equity,
  surplus notes, debt)
• Measurement of these costs is critical to
  decision making about form of capital

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Class Diversification

• May actually reduce value to stakeholders
  (shareholders, etc.) by transferring individual
  risk classes separately from shareholders and
  other stakeholders to derivative and reinsurance
  providers, de-linking risk groups within
  corporate portfolio
• When de-linked, risk charge (volatility)
  determined individually, and sum of individual
  risk charges may be greater than cost of
  stakeholders capital exposed to risk portfolio
• Stakeholders may be willing to take combined
  volatility on the portfolio of risk and keep risk
  charge

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Combined and Joint Risk Options

• If retained combined volatility not desirable to
  stakeholders for available or any risk charge,
  can transfer with correlation benefit or raise
  prices
• Transfer can add value to stakeholders by
  reducing volatility at lower cost than passing
  risks individually and at lower cost than what
  stakeholders would want to keep risk, if at all
• Use Combined and Joint Risk Options

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Combined Risk Option

• Combined Retention Sum of Individual Retentions

200
Catastrophe Loss
100
Financial Loss
Financial Loss
Catastrophe Loss
0
Before
After
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Joint Risk Options
Intersection of Risks
Asset Price Decline (Financial Event)
Catastrophe Loss (Insurance Event)
Forced Realization
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Joint Risk Options

• Losses Frequency x Severity
• Example Combining Insurance and Financial Risks
• Frequency Insurance Risk
• Severity Financial Risk

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Diversification of Risk over Time

• Different stakeholders/capital providers have
  different duration tolerances
• Purchase of single period options/reinsurance
  done at single year volatilities (risk charges)
• Can add value to stakeholders by purchasing
  coverage at multiple period aggregate volatility
• Less than sum of individual year volatilities

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Diversification of Risk over Time
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Diversification of Risk Structures

• Different stakeholders/capital providers have
  different payback commitments/priorities
• Can add value to stakeholders by matching
  uncertainty level of business flows with capital
  tranches
• Risk financing matches more certain profit
  streams with reinsurers/capital providers
  (multi-year finite risk transactions) than
  traditional risk transfer (single year high
  volatility)
• Reduce cost by layering return to capital
  providers, whereby average cost of capital
  reduced from equity alone
• Package and secure future profits in risk
  financing to access cheaper capital

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Risk Financing Solutions
Full Risk Transfer
Magnitude of Event
Risk Financing
Structural Change
Time Event Frequency
Earnings Bump
Budgeted Events
5 Yrs.
1 Yr.
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Spread Loss Transaction