Covered Agreements, Credit for Reinsurance and Counterparty Credit Risk. History of U.S. reinsurance collateral debate

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1 Covered Agreements, Credit for Reinsurance and Counterparty Credit Risk Learning Objectives History of U.S. reinsurance collateral debate What is a covered agreement? Potential preemption of state laws? EU and Solvency II Why does equivalence matter? Counterparty Credit Risk Differing methodologies.

2 Reinsurance Collateral Historically, state insurance regulators have required foreign reinsurers to hold 100% collateral within the U.S. for the risks they assume from U.S. insurers. As reinsurers are ultimately providing insurance to other insurance companies that are directly protecting American policyholders, requiring consumer protection collateral in the U.S. is intended to ensure claimspaying capital is available and reachable by U.S. firms and regulators should it be needed, particularly in the wake of a natural disaster. Foreign reinsurers regulators and politicians have objected to their companies having to post consumer protection collateral in the U.S. as such capital is unavailable for other purposes, including investment opportunities. Change is Happening Recently, the NAIC passed amendments to its Credit for Reinsurance Models that once implemented by a state, will allow certified reinsurers to post significantly less than 100% consumer protection collateral for U.S. claims. To date, 36 states have passed legislation to implement the revised NAIC Credit for Reinsurance Models, representing more than 66% of direct insurance premium written in the U.S. across all lines of business. An additional five states have indicated plans to take up the model law in the near future, which would raise the total market coverage to 93%.

3 Covered Agreement The notion of a covered agreement was included in Title V of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) as a unique stand-by authority for the Treasury and the United States Trade Representative (USTR) to address, if necessary, those areas where U.S. state insurance laws or regulations treat non-u.s. insurers differently than U.S. insurers. A covered agreement can serve as a basis for preemption of state law under certain circumstances, but only if the agreement relates to measures substantially equivalent to the protections afforded consumers under state law. What is a Covered Agreement? A covered agreement is a bilateral or multilateral agreement among the United States and foreign jurisdiction(s) regarding the recognition of regulatory measures with respect to the business of insurance or reinsurance. A regulatory measure subject to a covered agreement must achieve a level of protection for consumers that is substantially equivalent to the level of protection achieved under state law. A covered agreement can serve as a basis for preemption of state law under certain circumstances.

4 How can one enter into a Covered Agreement? A covered agreement is negotiated jointly by the U.S. Treasury s Federal Insurance Office (FIO) and the USTR with foreign authorities. Before initiating negotiations, during the negotiations, and before entering into a covered agreement, the Treasury Secretary and USTR must jointly consult with the House Financial Services Committee, House Ways and Means Committee, Senate Banking Committee, and Senate Finance Committee. At a minimum, such consultation must cover: 1) the nature of the agreement, 2) how and to what extent such agreement will achieve the purposes of Title V of the Dodd-Frank Act, and 3) the implementation of the agreement and its effect on state laws. How can state law be preempted? A state insurance measure can only be preempted if the FIO Director determines that: 1. The measure results in less favorable treatment of a non-u.s. insurer domiciled in a foreign jurisdiction that is subject to a covered agreement, than a U.S. insurer domiciled, licensed, or admitted to do business in that state. 2. The measure is inconsistent with a covered agreement.

5 How can state law be preempted? The scope of the review for such determination is limited to: 1. The subject matter contained within the covered agreement involved. 2. Whether the subject matter of the agreement achieves a level of protection for insurance consumers that is substantially equivalent to the level of protection achieved under state law. Before a state law can be preempted, the FIO Director is required to: 1. Notify and consult with the appropriate state regarding any potential preemption. 2. Notify and consult with the USTR regarding any preemption. 3. Publish in the federal register for public comment a notice of the potential preemption including a description of each state insurance measure at issue and any applicable covered agreement. How can state law be preempted? Upon making a determination of a preemption, the FIO Director is required to: 1. Notify the appropriate state of the determination, 2. Establish a reasonable period of time for the preemption to become effective, and 3. Notify the relevant Congressional committees of such preemption. Once the preemption has become effective, the FIO Director is required to: 1. Publish another notice in the Federal Register. 2. Notify the appropriate state.

6 How can state law be preempted? A state has a right to appeal this determination in court pursuant to the provisions of the Administrative Procedures Act and such appeal shall be considered under a de novo standard of review (i.e. without judicial deference to the FIO Director s determination). Not all insurance regulatory measures can be preempted. The following state laws and regulations cannot be preempted: 1. Those governing rates, premiums, underwriting, or sales practices; 2. State insurance coverage requirements; 3. State antitrust laws relating to the business of insurance; and 4. Those relating to capital and solvency except to the extent that such measure results in less favorable treatment for non-u.s. insurers than U.S. insurers. What about the EU and Solvency II? The Solvency II Directive provides for the EU to make an equivalence determination for non-eu countries in the areas of group supervision, group solvency, and reinsurance. The Directive also requires that an appropriate confidentiality regime be in place. Non-EU based companies from countries that have been deemed equivalent may be subject to less stringent regulatory standards to operate in the European Union than those jurisdictions that have not been deemed equivalent. Importantly, EU companies do significantly more business in the U.S. than U.S. companies do in the EU and many, if not all, EU subsidiaries of U.S. companies are already structured in a way to meet the new European requirements even in the absence of equivalence.

7 What about the EU and Solvency II? While the U.S. and EU systems are different, they strive for similar outcomes of protecting policyholders and ensuring a competitive and fair marketplace for consumers. The ongoing US/EU Dialogue process has been instrumental in enhancing our mutual understanding of our respective regulatory systems including the areas of group supervision and reinsurance collateral among other matters. While a Covered Agreement may be one mechanism for achieving recognition of the United States under Solvency II, it is clear that it can also be achieved through other mechanisms such as recognition of existing structures and processes. In fact, the European Commission issued a decision deeming the U.S. system of group solvency and confidentiality provisionally equivalent without the need for a covered agreement. What about the EU and Solvency II? According to the NAIC, the federal government has not demonstrated benefits to U.S. insurers or consumers that would warrant a covered agreement preempting state law. There are alternatives to such drastic action, including state action already underway. However, if Treasury and USTR move forward, state insurance regulators expect to be a direct part of the negotiations to ensure that mutual recognition is not paid for with unnecessary preemption of state law.

8 What about the EU and Solvency II? To the extent Treasury and the USTR maintain that a covered agreement is in the best interests of the United States, we have a number of questions, including: 1. What is the scope of the agreement? How narrow is it? Is it limited to reinsurance consumer protection collateral or does it extend to other topics? 2. What is the cost-benefit for the United States? Requiring all states to eliminate collateral requirements for foreign reinsurers would clearly help non-u.s. companies, but is there a corresponding benefit to U.S. policyholders and companies? What about the EU and Solvency II? (cont d.) 3. How will the agreement be substantially equivalent to the protections afforded U.S. consumers under state insurance laws? Reinsurance collateral protects insurance consumers by ensuring that reinsurers pay on their claims to ceding insurers, who in turn, rely on such coverage to pay consumer claims. Reducing collateral beyond a prudent risk-based regulatory assessment, as the NAIC approach provides, may increase the likelihood that reinsurance claims may not be paid, in full or on time, thereby potentially increasing risks to U.S insurers and policyholders.

9 SCR and RBC Similarities and Differences Frankenstein Approach Capital requirements in the U.S. have been risk-based for nearly 20 years, with the initial life insurance risk-based capital ( RBC ) formula implemented in Numerous improvements have been implemented in the RBC formulas over time and currently are targeted for various types of insurers. Solvency II is finally in place effective January 1, 2016 after 10+ years of deliberations, impact studies and billions spent by the insurance industry. RBC: Reinsurance Implications RBC will continue to be a component in the legal framework of U.S. solvency regulation in order to maintain a floor for triggering regulatory intervention. The NAIC and U.S. insurance regulators knowingly excluded some risks in the RBC calculation over the years as well as creating certain risk factors utilizing purely subjective criteria.

10 Capital is only one piece of the puzzle Is Solvency II Revolutionary?

11 Reinsurance Implications RBC - Transparency The RBC factors as well as the formula for calculating RBC in the U.S. are publicly available and are thus transparent to all interested stakeholders in a (re)insurer. The advantage of this is that it has been more difficult for insurers to delay regulatory action by challenging regulatory authority in court. The disadvantage of this transparency is that it also provides moral hazard in that troubled (re)insurers may be able to manipulate the RBC ratio in order to avoid certain triggering events. This has sometimes resulted in the (re)insurer being in a financially hazardous condition at a later date where damage to stakeholders might have been minimized if corrective action plans were required earlier.

12 Reinsurance - Counterparty Credit Risk Reinsurance recoverables are amounts due from the company s reinsurers. Amounts due from reinsurance companies are categorized according to whether they are overdue and, if so, by how many days. Those recoverables deemed uncollectible are reported as a surplus penalty on the liability side of the balance sheet, thus reducing surplus. The current U.S. property-casualty credit component of the formula applies a 10 percent charge to reinsurance recoverables from non-affiliates and affiliated alien insurers (minus the penalty for unauthorized or overdue reinsurance), a 1 percent charge to interest, dividend, and real estate income due and accrued, and a 5 percent charge to other miscellaneous receivables. Reinsurance - Counterparty Credit Risk A significant degree of judgment was utilized in designing the current NAIC P/C RBC formula, choosing parameters used to calculate capital charges for individual risks, and specifying risk dependency. Nationally Recognized Statistical Rating Organizations ( NRSROs or Rating Agencies ) have also been attempting to better quantify reinsurance counterparty credit risk. Rating agency credit charges have typically been lower than the NAIC threshold for highly-rated reinsurers (i.e. those with ratings in the A range and above).

13 Shortfalls in the Current Treatment The factor is based on judgments applied to a number of interrelated issues and is not based on statistical analysis. The current factor is not calibrated to a particular risk level. The factor does not reflect variation in credit risk by reinsurer. The R3 reinsurance credit risk factor does not consider the potential reinsurance credit risk for future significant events like catastrophes. Reinsurance - Counterparty Credit Risk Regulators have indicated that there is some justification for these discrepancies as the regulatory 10 percent charge is intended to reflect four elements: pure reinsurer credit risk, the extent to which the ceded reinsurance liability may be underestimated, the extent to which risk transfer to the reinsurer may be limited, and the possibility of disputes regarding coverage.

14 Reinsurance - Counterparty Credit Risk Since the NAIC s RBC framework was introduced, a number of new controls on reinsurance risk have been implemented, each of which has a potential impact on the size of the reinsurance credit risk. 1. In the Statement of Actuarial Opinion, the opining actuary now attests to both the gross and net reserves of the company. 2. Consistent with the increasing emphasis on corporate governance, companies are expected to have greater internal controls over their operations, including the nature and use of reinsurance. 3.More testing and documentation is required in the realm of risk transfer. As such, there is more formal assurance that reinsurance arrangements include a sufficient degree of risk transfer, and there is more actuarial modeling of the effects of reinsurance transactions Reinsurance - Counterparty Credit Risk Reinsurance Recovery Risk - The reinsurance recovery risk is the risk that the ceding insurer will be unable to collect the full amount of reinsurance recoverables. This risk arises primarily from three scenarios: (1) Counterparty default risk the ceding company s inability to collect the full amount of reinsurance recoverables anticipated under the contract terms due to reinsurer default(s). (2) Commutation risk the ceding insurer mitigating its credit risk by accepting a reinsurance commutation for an amount less than that anticipated to be recoverable under the contract due to deterioration in the financial condition (but not actual default) of the reinsurer. (3) Coverage dispute risk a reinsurer is able to pay the full amount expected by the ceding insurer, but the reinsurer successfully disputes the applicability of reinsurance coverage and/or the actual amount to be paid.

15 Reinsurance - Counterparty Credit Risk Relative risk of company impairment increased as the group percentage of ceded premium increased from 25 percent to 50 percent and thereafter a. The 2,620 companies of total 3,269 in the data set had a ceded reinsurance percentage of 25 percent or less. b. The 630 companies with group ceded reinsurance of 25 percent to 50 percent had twice the probability of impairment risk of companies with 0 percent to 25 percent group ceded reinsurance. c. The 338 companies with group ceded reinsurance of over 50 percent had nearly three times the probability of impairment risk of companies with 0 percent to 25 percent group ceded reinsurance. Reinsurance - Counterparty Credit Risk NRSRO ratings tend to be credit-only quality opinions and may not comment on other factors such as the adequacy of market price or market liquidity. Rating opinions are relative rankings and not based on any specific probability of default. Rating opinions tend to have a longer forecast horizon attempting to look through any temporary cyclicality. Typically, implied ratings are only available for publicly-traded firms and would not necessarily be available for mutual organizations or smaller entities.

16 Counterparty Credit Risk One methodology Reinsurance - Counterparty Credit Risk At the time of development, there was significant concern about the quality of reinsurance. The uniform 10 percent factor, regardless of whether the reinsurer was large or small, U.S. or non-u.s., or subject to collateral or not, resulted in part from an effort to avoid creating unnecessary bias for or against the purchase of reinsurance generally or purchases from different types of insurers. U.S. insurance regulators are not alone in attempting to address these risk factors. The European Union s Solvency II initiative, Swiss Solvency Test and the Bermuda Monetary Authority have all experienced difficulties in addressing this risk factor. Both standard formulas and internal models appear to utilize significant judgment in arriving at a calculation as well as how potential defaults are dependent upon one another.

17 Reinsurance - Counterparty Credit Risk At the time of development, there was significant concern about the quality of reinsurance. The uniform 10 percent factor, regardless of whether the reinsurer was large or small, U.S. or non-u.s., or subject to collateral or not, resulted in part from an effort to avoid creating unnecessary bias for or against the purchase of reinsurance generally or purchases from different types of insurers. U.S. insurance regulators are not alone in attempting to address these risk factors. The European Union s Solvency II initiative, Swiss Solvency Test and the Bermuda Monetary Authority have all experienced difficulties in addressing this risk factor. Both standard formulas and internal models appear to utilize significant judgment in arriving at a calculation as well as how potential defaults are dependent upon one another. Musings on Models Objective: Make a model of the Airbus 380 airplane.

18 Musings on Models Models built for which purpose? Reinsurance - Counterparty Credit Risk The U.S. RBC factor does not take into account the amount of risk being transferred from the cedent to the reinsurer, nor does it differentiate between proportional and non-proportional reinsurance protection, long-tail versus short-tail risks or treaty versus facultative protection. One possibility for addressing catastrophe risk would be to have the (re)insurers calculate a separate contingent credit risk charge for the 1- in-100 years expected hurricane loss and 1-in-250 years expected earthquake loss. The charge could be a factor of the difference between the losses gross and net of reinsurance. The RBC factor could then apply factors based upon the financial strength ratings of the reinsurers.

19 Reinsurance - Counterparty Credit Risk In the Life RBC ratio computation instructions, the risk associated with the recoverability of money from reinsurers is comparable to highlyrated NAIC bond classes 1 and 2 and is consequently assigned a 0.8% pre-tax factor. A 0.8% credit is given to avoid overstatement of RBC for reinsurance with non-authorized companies, affiliated companies, funds withheld, collateral other than funds withheld supporting non-affiliate reinsurance and for reinsurance involving policy loans. U.S. insurance regulators are also discussing the role of reinsurance collateral held in trusts and the utilization of special captive insurance vehicles relating to reinsurance collateral requirements. The NAIC and U.S. insurance regulators are also addressing whether this factor is too high or needs to be revised under the SMI process. Reinsurance - Counterparty Credit Risk Solvency II Solvency II, has now established new capital requirements for European companies and their American subsidiaries. Under Solvency II, a market value balance sheet is created, with assets held at market value and liabilities held at fair value. The fair value of liabilities is calculated using a stochastic approach with both the projection and discount rate equal to the swap curve plus an illiquidity premium. The liabilities are based on best estimate assumptions and reflect cashflows for the lifetime of the liability. The liability best estimate assumption includes a risk margin for the current cost of funding. Liabilities are typically discounted at a lower rate than in the U.S. statutory system.

20 Reinsurance - Counterparty Credit Risk Solvency II The Solvency Capital Requirement ( SCR ) is the level of capital needed to withstand the wide variety of risks that an insurer faces with a 99.5% certainty over a one-year period (i.e., 99.5% Value at Risk ( VaR ) confidence level). If the SCR level is breached, increased regulatory scrutiny results, but the shortfall will not force a company to cease operations. This scrutiny is comparable to the RBC s Company Action Level or 200%. The SCR applies to an insurance group as a whole (which differs from RBC), so some members of the group with higher capital can offset members with lower capital, if the entire group is above the SCR. The Minimum Capital Requirement ( MCR ) is calibrated to an 85% VaR over a one-year period. The MCR defines the minimum solvency level for each legal entity within a group. Breach of the MCR would result in the company cessation of operations. Reinsurance - Counterparty Credit Risk Solvency II U.S. insurance regulators should encourage (re)insurers to establish and maintain global credit exposure monitoring platforms to be used in conjunction with their underwriting and other risk monitoring and management. Systems should enable immediate grasp of the current organization-wide risk exposure against a specific counterparty which would tie directly into a (re)insurer s RBC calculation in times of stress. Data management is critical in managing credit, insurance and investment risks as it allows the measurement of the aggregation and correlation of risks. Data systems should also allow stress-testing by allowing parameters and counterparty credit positions to vary, and by incorporating contractual relationships (capital and credit ratingtriggered provisions, etc.). Stress tests should include systemic crises such as major catastrophe losses, asset market turmoil and the evaporation of retrocession capacity.

21 VaR vs. TVaR - Problems with Methodology The portfolio represented by the distribution in blue has the highest average expected loss, but is actually the least risky, with its short tail, while the portfolio represented by the distribution in yellow has the lowest average expected loss, but is the riskiest because it has potential for much higher losses in its long tail. While tail value at risk (TVaR) shares many of the same limitations as VaR and may also contribute to volatility when relied upon as the sole measure of risk, it can be a better measure of underwriting risk. In this example, the VaR at 99.5 percent probability is USD10 million for all three distributions. However, the TVaR at the same level of probability is USD10.7 million for the blue distribution, USD11.4 million for the green and USD13.4 million for the yellow. VaR vs. TVaR - Methodology This illustration vividly shows that the simplistic use of VaR to manage risk may result in increased concentrations and gross underestimation of exposure to tail events. It can also give a false sense of security that can contribute to the overcorrection in risk appetite following unanticipated events.

22 Reinsurance - Counterparty Credit Risk Solvency II Risk models based on past data can lead regulators to underestimate the probability of extreme outcomes, and we cannot assume that (re)insurers have adequately managed reinsurance counterparty credit risk simply by arriving at a quantitative representation. Company management and U.S. insurance regulators also need strong qualitative skills. As part of a (re)insurer s risk management framework, no counterparty should be accepted without a comprehensive review of its financials, resources and people. Rating Opinions? Ratings provided by NRSROs»Rating Opinions: Rating opinions issued by Nationally Recognized Statistical Rating Organizations tend to be credit-only quality opinions and may not comment on other factors such as the adequacy of market price or market liquidity. Rating opinions are relative rankings and not based on any specific probability of default. Rating opinions tend to have a longer forecast horizon attempting to look through any temporary cyclicality.

23 Rating Opinions? Ratings provided by NRSROs» Implied ratings based on Credit Default Swaps/Bond Spreads: These market-implied ratings are generally software-based algorithms using credit and equity market valuations. Implied ratings enable relative value analyses both within and across different market instruments globally. Typically, implied ratings are only available for publicly-traded firms and would not necessarily be available for mutual organizations. Implied ratings can be quite volatile experiencing shocks unrelated to the issue. Rating Opinions? Ratings provided by NRSROs Default Studies: Each rating agency does a "look-back" of credit performance. These studies tend to show that higher rated securities (i.e., AAA, AA, etc) tend to have lower defaults than lower rated securities. In essence, the default studies attempt to validate the relative ranking of the Rating Opinions. While many have equated the results of these studies to be "calibration", these empirical studies may be affected by» 1) low frequency events where a smooth default transition may not be evident between two rating categories or maturities,» 2) how asset sectors are grouped such as public finance, corporates, structured finance, and» 3) the length of the exposure period. For example, a default study would yield significant differences if the period were versus

24 Solvency II Proposed Reinsurance Treatment The probability of default in this case for simplicity by rating group must also be established for the calculation of the capital requirement. The grouping of a number of reinsurers in a group is basically conservative, in particular as diversification effects within a group are disregarded. Solvency II Proposed Reinsurance Treatment If two reinsurer groups are compiled, EIOPA suggests using the following risk factors to determine the capital requirement for the counterparty default risk: LGD= max[50% (RI recoverable + SCR gross SCR net Collateral

25 Solvency II Proposed Reinsurance Treatment The capital requirement for the counterparty default risk is then aggregated across all rating groups taking diversification into account. EU Reinsurance Treatment Apart from financial strength, the number of reinsurance partners is an important factor in the measurement of the capital requirement. Risk management can help make a company less vulnerable to losses resulting from reinsurer default by diversifying its risk on reinsurers. However, it cannot be assumed that concentrating reinsurance on a single Reinsurer with a good rating will result in a higher risk than spreading it across a number of reinsurers with worse ratings.

26 EU Reinsurance Treatment Even if companies do not group reinsurers together and the diversification effect resulting from the use of reinsurers is taken into account, the counterparty default risk on financially less robust companies is fundamentally higher and not necessarily fully compensated by the risk relief provided by diversification. Thus, spreading the risk across several reinsurers is not always beneficial, especially if the reinsurers concerned have a variety of ratings. EU Reinsurance Treatment As the chart on the next slide illustrates, the percentage of the LGD that must be held in risk capital almost doubles with each drop in rating class. For example, diversifying risk by changing from a single AA-rated business partner to six separate A- rated counterparties would increase the capital requirement by almost 2%. From a quantitative perspective, concentrating the risk on a financially strong company therefore appears to produce a better result.

27 EU Reinsurance Treatment Solvency II Proposed Reinsurance Treatment Thus, for a program covered by one A-rated reinsurer, the default probability for reinsurance credit risk evaluation is 6.7%, even though the longterm average default probability is.05%. For ten A-rated counterparties, each with an expected default rate of 0.05%, the required capital would be 4.5% of LGD, rather than 6.7% of LGD, reflecting credit for diversification but recognizing that there is a systemic component to the risk.

28 Rating Agency Historical Approaches The A.M. Best BCAR model includes a surcharge for insurers that are considered to be excessively dependent on unaffiliated reinsurance, given their lines of business and financial resources. This additional charge reflects the increased exposure to reinsurance disputes and cash-flow problems the insurer might face as a result of the higher dependence on reinsurance. A.M. Best uses two dependence tests to recognize this risk. The first test compares the company s recoverable-to-surplus ratio to an industry benchmark. The second test examines the company s total ceded leverage to thresholds of five, seven and 10 times surplus, resulting in charges of 15%, 20% and 25% of nonaffiliated recoverables. Rating Agency Historical Approaches S&P uses their own ratings on domestic and international reinsurance companies to assess credit risk on reinsurance recoverables. The reinsurance recoverable charge is applied to the recoverables from reinsurers that fall into the specific rating category to derive a total charge. Reinsurers under some form of regulatory control are deemed to be similar to a 'CCC reinsurer; reinsurers that are not rated are deemed to be similar to 'B' reinsurers.

29 Historical Rating Agency Issues Credit risk - reinsurance recoverables AAA AA A BBB Reinsurers rated 'AAA' 1.167% 1.096% 0.992% 0.820% Reinsurers rated 'AA' 1.600% 1.509% 1.378% 1.159% Reinsurers rated 'A' 2.159% 2.065% 1.927% 1.699% Reinsurers rated 'BBB' 5.958% 5.742% 5.430% 4.908% Reinsurers rated 'BB' % % % % Reinsurers rated 'B' % % % % Reinsurers rated 'CCC' % % % % Reinsurers rated 'R' % % % % Unrated reinsurers % % % % Historical Rating Agency Issues AAA AA A BBB Nonproportional reinsurance (treaty and facultative) Homeowners' multi-peril 43% 38% 35% 27% Farm owners' multi-peril 43% 38% 35% 27% Private passenger auto liability 18% 16% 15% 11% Fire 18% 16% 15% 11% Allied lines 18% 16% 15% 11% Mortgage guaranty 67% 60% 55% 41% Inland marine 18% 16% 15% 11% Financial guaranty 67% 60% 55% 41% Earthquake 18% 16% 15% 11% Group accident and health 67% 60% 55% 41% Credit accident and health 67% 60% 55% 41% Burglary and theft 18% 16% 15% 11% Credit 67% 60% 55% 41% Auto physical damage 22% 19% 18% 13% Fidelity 18% 16% 15% 11% Surety 18% 16% 15% 11% Warranty 67% 60% 55% 41% International 56% 50% 45% 34% Commercial auto liability 38% 34% 31% 24% Medical malpractice occurrence 109% 97% 89% 67% Medical malpractice claims made 80% 71% 65% 49% Special liability 31% 27% 25% 19% Aircraft 31% 27% 25% 19% Boiler and machinery 31% 27% 25% 19% Other liability occurrence 62% 55% 50% 38% Other liability claims made 47% 42% 38% 29% Products liability occurrence 66% 59% 54% 41% Products liability claims made 51% 45% 41% 31% Commerical multiple peril 27% 24% 22% 16% Workers' compensation 37% 32% 30% 22%

30 Rating Agency Historical Approaches Moody s defines credit risk solely as Reinsurance Exposure. As they do with most of the asset risk category, Moody s uses a stochastic approach to determining credit risk. To do so, their model simulates reinsurance risk from four categories: 1) Paid Loss Recoverables and Ceded Reserves; 2) Ceded Reserve Development; 3) Ceded Underwriting; and 4) Ceded Catastrophes. Historical Rating Agency Issues

31 Rating Agency Historical Approaches Each recoverable is identified with the Moody s Insurance Financial Strength Rating (IFSR) of the responsible reinsurer. All Lloyd s syndicates are assigned to the Baa category while involuntary reinsurance facilities are assigned to the Aa rating category. The simulation approach assumes a normal distribution. The model provides an offset collateral equal to 95% or 100% of the Schedule F Part 5 detail for a letter of credit or funds withheld, respectively. Additionally, Moody s Reinsurance Exposure considers contingent liabilities associated with reinsurance recoverables. These consist of contingent exposure to ceded reserve development (adverse net reserve development implies a corresponding adverse ceded reserve development) and contingent reinsurance assets (ceded underwriting and ceded catastrophes). Counterparty Default Risk

32 Counterparty Default Risk Counterparty Default Risk

33 Counterparty Default Risk Counterparty Default Risk

34 Counterparty Default Risk Questions?

35 Thank you! Bryan Fuller, CPCU, ARe / Director Examination Resources, LLC 116 West 47 th Street, Suite 203 Kansas City, MO Tel. (678) Fax: (816) Cell: (816) bryanfuller@examresources.net