Alternative Capital in the Insurance and Reinsurance Industry April 15 th, Willis Towers Watson. All rights reserved.

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1 Alternative Capital in the Insurance and Reinsurance Industry April 15 th, 2016

2 Discussion Topics What is Alternative Capital How does Alternative Capital access the Reinsurance / Insurance Market 2

3 What is Alternative Capital Traditional capacity consists of rated carriers operating as long term insurance or reinsurance companies Balance sheets hold liabilities of company Alternative capital consists of unrated carriers providing access to third party capital Liabilities are collateralized through funds under management The insurance/reinsurance industry is compelling to alternative capital providers for two reasons: Low interest rate environment - an alternative to other short term low interest investment vehicles Diversification insurance/reinsurance risk, specifically catastrophe risk, has little correlation to financial market risk 3

4 Growth in Alternative Capital Total reinsurance market is roughly $500B+, with alternative capital accounting for 10%-15% Within the property catastrophe market, alternative capital makes up more than 20% of the total limit The alternative capital market has more than doubled in size since $30B in 2011 to close to $70B in 2015 Led by expansion of fully collateralized reinsurance capacity While a significant portion of reinsurance capacity, specifically within the property catastrophe market, it is a very small portion of most investor portfolios For comparison, the outstanding US corporate debt market is more than $8T Insurance risk is generally less than 1% of an investor portfolio 4

5 Alternative Capital Focus Property Catastrophe Alternative capital is most frequently associated with property catastrophe business Hurricane Earthquake Other natural perils Property catastrophe risk is attractive for several reasons Profit / loss is known in a relatively short time frame final losses are known within months It is more easily modeled through standard vendor models AIR and RMS Viewed as a non-correlating risk Other lines such as Workers Compensation are suspected to correlate with overall market conditions in down turns 5

6 Alternative Capital Suppliers Typical investors are hedge funds, pension funds, sovereign wealth funds and other mutual funds Significant funds under management 13 companies with $1B+ ($ in millions) ($ in millions) % ILS Est. Mkt. % ILS Est. Mkt. Rank Fund Manager Partner Owned AUM Share (a) Rank Fund Manager Partner Owned AUM Share (a) 1 KKR 25% $9,500 14% 13 Management --- $1,300 2% ,500 9% % 850 1% ,500 8% 15 Montpelier Re 33% 790 1% 4 Management --- 4,800 7% 16 Management % 5 Management --- 3,862 6% % 6 Northill Capital --- 3,530 5% 18 Atropos % 7 100% 3,200 5% 19 50% 369 1% 8 20% 2,500 4% 20 Lancashire % 9 Management --- 2,500 4% 10 75% 2,410 3% % 2,400 3% 12 30% 1,800 3% Estimated ILS Alternative Capital Outstanding by Investor Type 25.0% 2.5% 7.5% 65.0% Specialist Fund Money Manager Multi-Strategy Fund (Re)insurer Est. ILS Alternative Capital Outstanding: $70 billion 6

7 Discussion Topics What is Alternative Capital How does Alternative Capital access the Reinsurance / Insurance Market 7

8 Alternative Capital Vehicles There are three main types of alternative capital vehicles Catastrophe Bonds (Cat Bonds) / Industry Loss Warranties (ILWs) Sidecars Collateralized reinsurance As the market has evolved we have observed an increase in the availability off all types, but the growth in collateralized reinsurance has far outpaced the growth in the other categories 2000 ILS Market Breakdown 2008 ILS Market Breakdown 6% 2015 ILS Market Breakdown 29% 13% 43% 44% 71% 81% 13% Total: $3 billion Total: $16 billion Cat Bonds / ILWs Sidecars Collateralized Re Total: $70 billion 8

9 Catastrophe Bonds A Cat bond is an insurance linked security which transfers risk from the issuer (insurance/reinsurance company) to the group of investors (alternative capital) The investor assumes the risk associated with bond Qualifying events result in the loss of the principal of the bond Triggers for bonds are predetermined and can be a measure of either Indemnification actual losses to the company beyond a predetermined amount Industry loss based on an industry loss value Parametric based on a predetermined set of conditions A cat 5 hurricane making landfall in Miami-Dade County Cat bonds were first issued in the 1990 s in response to voids left within the catastrophe market after large events such as Hurricane Andrew (1992) and the Northridge earthquake (1994) 9

10 Explanation of Triggers Description Examples Indemnity Base recovery on the actual losses of the sponsor (ultimate net loss) subject to exclusions Citrus Re Indemnity / OCC -US Named Storms Ursa Re Indemnity / AGG -US Quake Hybrid Trigger Combine multiple approaches, e.g. modeled loss and industry index approaches Queen Street Re VII -US Hurricane: Industry Loss / Modeled Loss Hybrid (OCC) -Australia Cyclone: Modeled Loss (OCC) Modeled Loss Determine payout by inputting actual physical parameters into a predetermined cat model and running the model for an escrowed portfolio to produce an event loss Golden State Re Modeled Loss / OCC -US Quake Industry Index Use estimated industry losses (e.g., PCS in the U.S. and PERILS in Europe) to determine losses Galileo Re PCS & PERILS / AGG -US & CAN EQ, US Wind Kilimanjaro Re PCS / OCC -US & CAN Quake Parametric Use actual reported physical event parameters (e.g., wind speed or earthquake magnitude or location) to determine loss MultiCat Mexico Parametric Index / OCC -Mexico Quake PennUnion Re Parametric Index / OCC -US Named Storm & EQ 10

11 Triggers - Transparency vs Basis Risk Parametric Transparency For Investors Hybrid Trigger Modeled Loss Industry Index Indemnity Basis Risk to Issuer Increased Cost and Complexity to Structure 11

12 Catastrophe Bond Evolution Cat bonds have evolved significantly over time Initial cat bonds were limited to large scale purchases, precluding much of the insurance market from taking advantage of this capacity USAA, AIG, FL Citizens, Allstate, State Farm, etc High frictional costs and complexities of the transaction limited the demand for Cat bonds to all but the largest insurance companies Transaction costs, terms and size of cat bond transactions have all been improved over time allowing more companies to access the Cat bond market Introduction of Cat bond-lite Separate issuance platforms Sample 2016 Catatrophe Bonds Issuer Cedent Risks / Perils covered Size Date Merna Re Ltd. (Series ) State Farm U.S. earthquake (New Madrid region) $300m Mar-16 Operational Re Ltd. Zurich Insurance Co. Ltd. Operational risks CHF630m Mar/Apr 2016 Aozora Re Ltd. (Series ) Sompo Japan Japan typhoon $220m Mar-16 Espada Reinsurance Limited (Series ) USAA U.S. tropical cyclones, EQ/thunderstorm/winter storm/wildfire/volcanic eruption/meteorite impact/other perils $50m Mar-16 Caelus Re IV Ltd. (Series ) Nationwide Mutual Insurance Co. U.S. named storm, earthquake, severe thunderstorm, winter storm, wildfire, meteorite impact, volcanic eruption $300m Feb-16 Citrus Re Ltd. (Series ) Heritage P&C U.S. named storms (Florida & Hawaii only initially) $250m Feb-16 Galileo Re Ltd. (Series ) XL Insurance Ltd. U.S. named storms, U.S. earthquake, Canada earthquake, European windstorm $300m Jan-16 Atlas IX Capital DAC (Series ) SCOR Global P&C SE U.S. named storm, U.S. and Canada earthquake $300m Jan-16 12

13 Industry Loss Warranties (ILW) ILWs are a derivative contract whereby an insurer buys protection against a specific amount of industry damage Rather than a contract of indemnification an insurer purchases coverage that is triggered by a specified peril (hurricane/earthquake/etc) that exceeds a given damage threshold for the industry Company X will receive $20M in coverage if a hurricane in Texas results in more than $15B of industry loss ILWs are beneficial as limited information on a specific company is needed However, significant basis risk does exist with ILW contracts A loss may occur where an insurance company has a significantly larger or smaller share of the industry loss Ceding companies may set ILW factors to minimize basis risk 13

14 Sidecar Overview A sidecar is a limited life, special purpose vehicle that provides property cat quota share reinsurance Sidecar Overview Sidecar is a collateralized quota share reinsurance arrangement A Special Purpose Vehicle is set up exclusively for sponsors to transfer selected risk Cedant benefits from override and profit commissions Potential precursor to more permanent capital alternatives Sidecars are limited in the current marketplace Most prominent during 2004/2005 hurricane seasons as a lack of capacity was available within the traditional marketplace As other forms of alternative capacity have become available the use of sidecars has diminished relative to the size of the overall alternative market 14

15 Collateralized Reinsurance Collateralized reinsurers provide indemnification coverage that more closely matches traditional reinsurance These are unrated carriers providing capacity through fully collateralized limits of liability or through a rated fronting carrier This is the fastest growing segment of the Alternative Capital market This segment of the market allows investors to access a wider selection of insurance companies and is not limited to large transactions for peak perils Collateralized reinsurance can be placed through two main methods: Fully funded trust in ceding companies name Trust funds the full limit of liability less premium Fully funded trusts are generally used where only one limit of liability is provided Fronting arrangements In order to provide coverage more similar to traditional reinsurers collateralized companies may utilize a front 15

16 Reinsurance Vehicle Detail Collateralized markets are using multiple platforms to access insurance risk In cases where ceding companies have required terms that are more in line with traditional terms or require a rated carrier collateralized markets have utilized various mechanism Fronting Agreement A highly rated reinsurer (ex Tokio Millennium, Hannover Re, Allianz Risk Transfer) will, in exchange for a fee, provide paper for the transaction. As with traditional reinsurance, the security relies on the counterparty strength of the fronting reinsurer Used on a case by case basis however it is more common with collateralized markets new to the reinsurance market Third Party Reinsurer Some collateralized markets prefer to use a third party reinsurer to provide paper for the transaction. For a fee, these unrated reinsurers provide full limit funding for a transaction via a protected cell arrangement. Horseshoe Re obo Elementum or Coriolis 16

17 Where is Capital being Utilized Alternative Capital accounts for roughly 20% of total reinsurance market Capital gravitates to layers with mid single digit plus rate on line Rate on line = layer premium / layer limit Sample of 21 large national writers, placing $17B in total limit Alternative capital becomes one third of program layers with ROLs greater than 15% 120% Willis Re 2016 Large Line Study 100% 80% 60% 40% Traditional Market Alternative Capital 20% 0% 8% 24% 22% 0% - 3.9% 4% - 6.9% 7% % 33% 15%+ 17

18 Traditional Market Response Traditional reinsurers have responded in varying ways to the entrance and expansion of collateralized markets Partnerships traditional markets partnering with collateralized markets, writing on half of or providing them with a quota share portion of their book Fronting traditional reinsurers operate as fronting carriers for collateralized markets, providing insureds with expanded terms (reinstatements or rated paper) while collecting a fronting fee Avoidance some markets have attempted to differentiate themselves from collateralized markets by providing expanded terms or focusing on geographies and lines of business outside of collateralized appetite 18

19 Comparison of Cat Bonds and Collateralized Reinsurance Catastrophe Bonds Fully collateralized limit Large up front cost Complexity of deal process More rigid terms Term of contract multiple years Limited to cat perils with little to no attritional loss Collateralized Reinsurance Fully collateralized or fronted Minimal to no upfront fees Similar process as traditional placement Flexible language and coverage Most often single year contract Often include unmodelled perils and attritional loss 19

20 Impact on Reinsurance Pricing Overall market has experienced significant decreases in pricing Downward pricing pressure Limited catastrophe experience Increased supply of capital lack of correlation with portfolios, no existing aggregates 120 Willis Re Catastrophe Pricing Index Catastrophe Pricing Index cat pricing at 62% of 2007 levels - 20

21 Benefits to Insurance Companies Collateralized reinsurance offers several benefits to insurance companies It provides added capacity to the marketplace By adding collateralized markets to a placement ceding companies are able to further diversify their counterparty risk While multiyear deals are more readily accepted in today s traditional marketplace, alternative capital, specifically cat bonds have been a large source of multiyear support Increased supply can lead to reduced pricing The inclusion of collateralized markets within medium to large placements is becoming the norm The extent to which alternative capital is utilized is dependent on the Size and scope of a given reinsurance program The dominant perils impacting a company s catastrophe risk A company s need / openness to exploring this new source of capacity 21

22 Future of Alternative Capital Alternative Capital has continued to grow within the marketplace Collateralized capacity is more closely matching traditional reinsurance coverage Without significant changes to the current environment, interest rate or large loss, alternative capital is expected to remain a growing portion of the reinsurance market From 10 through 15, non-life alternative capital outstanding grew at a compounded annual rate of 29% $70 $65 $ $50 ($ in billions) $15 $20 $16 $18 $19 $24 $35 10 $3 $4 $5 $6 $7 $ Catastrophe Bonds & ILW Sidecars Collateralized Re 22

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