americas insurance digest 0808

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Americas edition August 2008

Insurance

Sharing insights on ey industry issues*

Insurancedigest

19503_US_Digest_v14_SB0808.indd 1 8/8/2008


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The Americas Insurance digest is published twice ayear to address the ey issues driing the insuranceindustry. If you would lie to discuss any of theissues raised in more detail, please contact the

indiidual authors, or the Editor-in-chief, whosedetails are listed at the end of each article.

We also welcome your feedbac and comments onthe Insurance digest, and as such, we enclose aFeedbac Fax Reply form. Your feedbac will help

us to ensure our publications are addressing theissues that concern you.



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Insurance digest PricewaterhouseCoopers 1

Editors comment 2John Scheid

Bermuda reinsurance maret deelopments 4Arthur Wightman

Islamic insurance: A competitiely priced, ethical product with potentially

widespread appeal 10Bryan Joseph and Mohammad Khan

Contingent capital: Stepping into strategic capital planning 14Larry Rubin and Xiaokai Victor Shi

Recent deelopments in ris mitigation through reinsurance and capital marets 22Caroline Foulger

Life settlements: Inestment opportunity or irrational exuberance? 28Mary Bahna-Nolan, Larry Rubin, Steven Siow and Selina Wang

Corporate restructuring: The silent reolution 34Mark Batten and Jim Bichard

Improing budgeting and forecasting: Lining nancial planningwith strategic direction 38Randy Brown and Greg Galeaz

Global insurance and reinsurance tax deelopments 42Rick Irvine

Fair alue measurement: The fallout and the future 48Donald Doran, David Scheinerman, Mary Helen Taylor, Amie Thuener, Anne-Lise Vivier and Sergey Volkov

Is your ERM deliering? 56Paul Horgan and Nick Ranson

Americas edition August 2008

Contents



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Editors Comment

With few major catastrophes

and strong prices, recent

years hae been relatiely

good ones for most insurers.

In contrast, the current inestment maret is

ery challenging; although yield cures hae

shown some improement recently, economic

growth is slowing, marets are olatile, asset

alues are eroding, and interest rates remain

ery low by historical standards. Most notably

as is the case with many nancial institutions

life insurers are feeling the impact of maret

olatility, rising inestment losses and a credit

maret squeee, and pricing has becomea major concern for commercial insurers

and reinsurers.

Howeer, the insurance industry by and large

has sufcient capital and liquidity to withstand

these challenges. Moreoer, it is strengthening

underwriting practices and exhibiting an

increased appreciation for robust enterprise

ris management.

In this issue of the Americas Insurance Digest,

we focus on three topics of primary and

immediate importance to our readers:

marets and growth, product innoation,

and measurement/nancial reporting.

Our industry practice has identied recent

maret deelopments, assessed ey changes

in the maret, and presents seeral resulting

insights and ideas for your consideration.

Insurance digest PricewaterhouseCoopers2

JOHN S. SCHEID: CHAIRMAN, AMERICAS INSURANCE GROUP

Editors comment



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I hope you nd the following articles of interest.

As in the past, please continue to proide us

with your ideas for future articles. You also

may be interested in the Asia-Pacic and

European editions of the Insurance Digest,

which are aailable at www.pwc.com/insurance.

Sincerely,

John S. Scheid

Editor-in-Chief

PricewaterhouseCoopers (US)

Tel: 1 646 772 [email protected]



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Bermuda reinsurancemaret deelopments

AutHOr: ARTHUR WIGHTMAN



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As Bermuda reinsurers tae stoc following the 2008 insurance renewals and

rst-quarter earnings reports, Arthur Wightman explores some of the challengesin Bermudas deeloping maretplace and proides insight into the ey issues

facing the CEOs of Bermudas reinsurance companies.

Nobody wins the

Tour de France

on the at or

going downhill.

BErmuDA REINSURANCE MARkET DEvELOPMENTS

Oveview

With a second consecutie year

of faorable rates, benign losses,

and resere deelopment, the

Bermuda reinsurance maret is

booming. Share repurchase

programs hae recently realied

more than $4 billion in capital,

and strong net earnings continue

to boost boo alue and delier

high returns on aerage equity.

As Bermuda reinsurers tae stoc

following the 2008 insurance

renewals and rst-quarter earnings

reports, this article explores some

of the challenges in Bermudas

deeloping maretplace and

proides insight into the ey issuesfacing the CEOs of Bermudas

reinsurance companies.

Onoin soenin

With the exception of European

windstorm kyrill, 2006 and 2007

were notable for an absence of

major natural disasters. While

Bermuda reinsurers enjoyed

bumper returns, reports of a

softening maret grew in number

beginning in mid-2007, with some

sources reporting rate declines

een earlier. While the headlinenews is that rates are falling from

historically high pricing leels, the

2008 renewal season has also

thus far been characteried by

the following underlying factors:

Renewals placed relatiely late

in many marets;

Cedants electing to retain more

ris despite more attractie

rates and attritional losses;

Benign past-quarter losses and

seeral resere releases; and

Capacity changes, particularly

in the Gulf of Mexico region,

leading to increased

competition.

These factors hae sered as

catalysts for more attractie

pricing for reinsurance buyers.

In PricewaterhouseCoopers1

(PwC) biennial 2006 Bermuda

Maret Surey, Capitaliing on

Opportunity: A Time of Change,

Bermudas reinsurance CEOs

raned underwriting performance

and cycle management among

their top concerns. Early results

from the 2008 Bermuda Maret

Surey suggest that today een

more CEOs are raning these

issues among their biggest areasof focus.

Nobody wins the Tour de France

on the at or going downhill.

Everyone who has ever won the

race has done so climbing the

Alps. A sot market is the true testor an underwriter. Those are the

years when you separate the

winners rom the losers.

(Constantine Iordanou, President

and Chie Executive Ofcer, Arch

Capital Group)

As reinsurance marets soften,

the phrase underwriting

discipline is being referenced in

many inestor calls and in many

publications and press releases

as a defense against writing bad

business. A softening maret

calls for tough decisions, eenif it means waling away from

signicant renewal business.

On April 10, 2008, the Colorado

State Uniersity forecast team

upgraded its early-season

hurricane forecast, and predicted

that the US Atlantic basin will

liely experience a signicantly

aboe-aerage hurricane season.

Clearly, major natural disasters

will noticeably change the cycle

outloo, resulting in declining

rates. How well will Bermuda

reinsurers stand up to the

possibility of major lossesfollowing two unproblematic

1 PricewaterhouseCoopers refers to the global networ of member rms of PricewaterhouseCoopers International Limited,

each of which is a separate and independent legal entity.



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years? Hae underwriters been

disciplined enough to wal away

from technically inadequate riss

and leae business on the table?

How robust are the capital,

aggregation, management sills,

and underwriting talents of

Bermudas Class of 2005? How

will in-house stochastic models

hold up? Are the adjustments

made following Hurricanes

katrina, Wilma, and Rita robust?

Which companies are really

holding the underwriting line?

In tandem with a soft reinsurance

enironment, constrained growth,

inestment maret turbulence,

the wea dollar, and a string of

oil price records all indicate a

continuing decline in interest

rates in 2008. This decline will

hae a corresponding impact on

inestment returns principally

based on bond portfolios and,

ultimately, underwriting.

manain caia

Capital management is another

ey issue at the top of Bermudas

reinsurance CEOs agendas. By

the time second-quarter earnings

were reported in 2007, Bermuda

reinsurers had undertaen arious

initiaties to return underemployed

capital to their shareholders.

More than 15 major Bermuda

reinsurance companies

completed share repurchase

initiaties by the end of 2007,

with the notable exceptions of

ACE and validus (the latter onlyafter its IPO in July 2007). Both of

these companies elected to hold

capital to pursue acquisitions.

XL repurchased in excess of

$1 billion (approximately 10%

of opening shareholders funds),

and AWAC, only eighteen months

following its IPO, repurchased

in excess of 25% of opening

shareholders funds. Despite

these repurchases, most

Bermuda reinsurance companies

saw their capital swell by the

end of 2007, reecting the

considerable economic

successes of 2006 and 2007.

Of course, capital management

goes hand-in-hand with managing

an underwriting cycle, and

Bermuda reinsurance CEOs face

a ariety of pressures when

formulating their annual capital

management strategies. On one

hand, rating agency and

regulatory constraints proide

considerable impetus to retain

capital. As attention turns toward

a potentially destructie wind

season following 2007s

considerable capital returns, many

companies may decide to hold

surplus capital, at least for themedium term. But on the other

hand, shareholders objecties for

returns must be met, and after

two abundant years, shareholders

are understandably anticipating a

capital response. If Bermuda

reinsurance companies are

genuinely maintaining underwriting

discipline, further capital returns

or diidends are liely.

the sbie cisis

While few companies escaped

without a scratch from thesubprime lending crisis, the

relatiely conseratie inestment

policy of the Bermuda maret

(which tends to focus on boo

alue growth through high-quality,

xed-income inestments) sered

to minimie asset-side losses.

The exceptions hae generally

responded to declining interest

rates by widening their

inestment ris appetites.

Howeer, inestments in asset-

baced securities (including

mortgage-baced securities) hae

largely been sheltered from

signicant exposure due to the

propensity of the Bermuda

maret to inest in super-senior

inestment tranches. By holding

approximately 5% of its xed

income inestment portfolio in

securities exposed to subprime

and related riss, XL was

something of an outlier.

Directors and Ofcers and

Errors and Omissions liability

claims resulting from the

subprime mortgage crisis (e.g.,

claims against inestment

adisors, managers, and other

organiations) are causing

heightened concern amongBermuda reinsurers writing those

lines. Historically, claims from

these exposures are ery difcult

to predict or quantify. Maret

estimates ary wildly, with current

aluations rising in light of recent

maret deelopments (e.g., the

collapse of Bear, Stearns & Co.

Inc.; rst-quarter earnings

statements etc.).

Another issue that is reasonably

compartmentalied, but with

which the industry must still

contend, is losses stemming frominestments in nancial guaranty

companies. By guarantying

asset-baced securities (including

collateralied debt obligations

and mortgage-baced securities)

these companies hae incurred

steep losses lined to subprime

mortgages. XL reported

signicant losses relating to its

46% inestment in and other

reinsurance/indemnication

relationships with Security Capita

Assurance. Renaissance Re and

Partner Re also incurred losses

(albeit much less seere) from

their inestments in Channel Re.

taxaion sas

Bermudas tax status regarding

on-shore underwriting and

inestment income clearly

underpins the business models of

most reinsurance companies

attracted to the island, leading

Bermudas reinsurance CEOs to

focus on any circumstances that

could affect those models. In a

recent article,2 the rating agency

Fitch estimates that reinsurance

in the Bermuda marets median

20032007 effectie income tax

rate was roughly 15 percentagepoints lower than that of the US

maret. In late September 2007,

the Coalition for a Domestic

Insurance Industry (CDII), a group

of 14 large US-based insurance

groups led by W. R. Berley

Corporation, reported to the US

Senate Finance Committee that a

major tax adantage exists in

places such as Bermuda and the

Cayman Islands. This adantage,

said the coalition, allows foreign

insurance groups to legally aoid

paying billions of dollars in taxes

by moing sieable portions oftheir taxable underwriting and

inestment income from their

US-based businesses out of the

country by reinsuring the

business to another group

BErmuDA REINSURANCE MARkET DEvELOPMENTS continued

2 Fitch Ratings Insurance Property/Casualty Insurers Bermuda, US and Canada Special Report Bermuda Maret Oeriew.



9/68

7Insurance digest PricewaterhouseCoopers

company. The impact of the

CDIIs actiities is liely to

crystallie oer the coming

months. In anticipation of this,

its worth noting that the Internal

Reenue Serice (IRS) already

possesses signicant tools to

address questions of unfairincome shifting (e.g., Section 482).

A further tax consideration that

Bermuda companies are

ealuating is the IRSs recent

guidance on the application of

federal excise taxes on foreign

insurers and reinsurers. The IRS

has interpreted certain releant

tax codes to mean that excise

taxes should not only be imposed

on each policy of insurance or

reinsurance coering US rississued by any foreign insurer or

reinsurer, but also on subsequent

reinsurance policies. This

application of the excise tax is

commonly referred to as the

cascading theory. This could

hae a potentially signicant

prospectie, as well as retroactie,

effect on Bermuda reinsurers.

As the race for the White House

unfolds, tax reform can be

expected to become a hot topic

on the agenda of the next

President and the next Congress.

For corporations, tax reform

could proide for the most

signicant reisions to the tax

code since 1986. Fitch notes,

howeer, that Despite the

heightened criticism, Bermudas

tax adantage is unliely to

disappear in the foreseeable

future () Washingtons

reluctance to gie up tax reenue

maes legislation that would

reduce taxes on US reinsurers,

to leel the playing eld between

them and their Bermuda-

domiciled competitors, een

more unliely.

Divesifcaion and acqisiions

PricewaterhouseCoopers 2006

Bermuda Maret Surey also

identied diersication (both

product-line and geographical) as

another item high on the agenda

of Bermuda reinsurance CEOs.

Indications from the 2008 surey

also highlight this trend as

remaining of ital importance,

particularly as the maret enters a

softer phase. The last 12 months

hae been extremely actie, with

some companies seeing out and

securing signicant operations tobolster their global franchises,

and there is eery indication that

this actiity will continue.

Product-line diersications

mostly aoided the property

casualty business, and

geographic diersication

focused both on traditional

marets such as those in London

continental Europe, and the US,

and newer marets in Dubai and

Latin America.

Other industry actiity included

ACEs acquisition of Combined

Insurance and Atlantic, AXISs

acquisition of Media Pro, Ariels

acquisition of Atrium, and

validuss acquisition of Talbot.

Arch, Flagstone, and others

established presences in Dubai,

with Aspen setting up in Dublin.

AWAC added to its presence in

the US through its Conerium

purchase. Montpelier established

syndicate 5151 at Lloyds of

London, and Partner Re opened

an ofce in Beijing. Bermuda

reinsurers hae traditionally

preferred to compete directly

in other marets by establishing

their own representatie ofces

or companies. But as Bermudareinsurance companies loo to

pursue opportunities in traditional

marets such as Lloyds of London

or in the US, they are beginning

to perceie the acquisition of

existing and successful groups as

offering more sustainable and

secure growth.

Ohe chaenes

Bermudas reinsurance success

story, with roots going bac to

the liability insurance capacity

shortages of the mid-1980s, hasgien rise to distinct challenges.

These challenges relate to

continued growth opportunities

in Bermuda, which is placing

a premium on ofce space,




10/68



housing, and wor permits.

The need for local expertise is

ongoing, and the fact that a

degree of specialist expertise will

ineitably require continued

support outside Bermuda, these

local issues hae a direct impacton the simple expense ratios of

the islands reinsurance

companies. There is little doubt

that Bermuda, lie the rest of the

worlds high-cost reinsurance

locales including London and

New Yor will see an increased

focus on outsourcing or relocating

bac-ofce and other functions to

alternate lower-cost locations.

Oook

The future continues to be bright

for the Bermuda reinsurance

maret despite the global

softening phase and other

challenges. The next phase for

Bermuda is liely to include:

Increased consolidation and

acquisition actiity;

Further geographic distribution

and deelopment, as well as

product line diersication

including the growth in the use

of insurance-lined securities;

Capital returns and diidends;

Outsourcing, co-sourcing and

increased focus on expense

management; and

Further rate deterioration and reduced/negatie top

line growth.

Although Bermuda reinsurance

companies thrie on taing

big-ticet riss, those that hae

the resole to wal away when

technical pricing and disciplined

judgment do not support such

ris-taing will be rewarded.

AUTHOR

Ah WihanSenior Manager, Audit and Business Adisory SericesPricewaterhouseCoopers (Bermuda)

Tel: 1 441 299 7127

[email protected]

Beda: Ke acs

Bermuda is the largest reinsurance and general insurance domicile after London and New Yor.

Bermuda is also the largest domicile for capties, containing 65% of all capties globally.

In excess of 18,000 exempt or international companies are registered in Bermuda, taing adantage

of Bermudas faorable corporate tax structure and its highly professional business enironment.

Bermuda, a British oerseas territory, has a respected legal and regulatory system, the latter of which

is under the Bermuda Monetary Authority and a designated territory under the Uks Financial

Serices Act.

With a natie population of approximately 70,000 and an expatriate population of roughly 10,000,Bermuda is the third-most densely populated place on earth. It has one of the highest gross domestic

products in the world.

Bermuda is located in the North Atlantic Ocean, roughly 700 miles east-southeast of North Carolina

and roughly 3,000 miles west-southwest of London.



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12/68

Islamic insurance: A competitiely

priced, ethical product withpotentially widespread appeal

AutHOrS: BRYAN JOSEPH AND MOHAMMAD kHAN



13/68


Taaful (Islamic insurance) is one of the fastest growing types of insurance

worldwide and has potentially signicant appeal beyond just Muslim populations.Bryan Joseph and Mohammad khan describe taafuls attributes and attractions,

and offer suggestions on how insurers can maret it.

Although insurers

can market takaul

products to the

adult US Muslim

population, there

is a potentially ar

larger market thatconsists o every

insurance-buying

adult in the US who

wants competitively

priced, ethical

insurance products.

ISlAmIC INSurANCE: A COMPETITIvELY PRICED, ETHICAL PRODUCT WITH POTENTIALLY WIDESPREAD APPEAL

Taaful (Islamic insurance) is one

of the fastest growing types of

insurance worldwide. In the

Middle and Far East, it has

experienced growth rates of1020% per year, compared to an

oerall 9% annual rate of growth

in emerging insurance marets

oerall and a 5% growth rate in

the OECD insurance marets.1

In addition, the return on capital

for taaful products has aeraged

between 15% and 25%, and

based on growth forecasts,

remains promising. Moodys has

predicted that total taaful

premiums will rise to $7bn by

2015, and some of the worlds

largest taaful companies enision

that approximately one-third oftheir premiums will come from

Western countries by 2020.

For North American insurers,

taaful has as-yet untapped

potential for future growth. In

commercial lines alone, there is

an opportunity for US and

Canadian insurers to proide

taaful insurance and reinsurance

for an estimated $1.5 trillion of

infrastructure that Arabian Gulf

countries are planning to

construct in the next decade.2

Moreoer, although insurers canmaret taaful products to the

adult US Muslim population of

1.5 million people,3 there is a

potentially far larger maret that

consists of eery insurance-

buying adult in the US who wantscompetitiely priced, ethical

insurance products.

Wha is aka?

Taaful means guaranteeing

each other and is a form of

mutual insurance that is similar in

concept to the mutual and

co-operatie schemes in Europe

and North America. Taaful

insurance pools resources to pay

for eents/losses that none of the

indiidual members of a group

could afford.

Taafuls main principles include:

The customers (policyholders)1.

of the taaful business agree to

pool their contributions and

share the liability of each

policyholder. Therefore, if one

policyholder has to be paid a

claim, then it is paid out of the

combined pool of the

policyholder contributions.

Because each policyholder

agrees to allow his or her

contributions to fulll his/herobligations of mutual help to a

fellow policyholder should

he/she suffer a dened loss,

uncertainty (Gharrar)

something Islam does not

allow is eliminated.

Similar to mutual insurance, the2.

policyholders share in the prot

and loss of the taaful business.

The policyholders all share the

insurance ris howeer, they

do not cede the ris to the

taaful company (as occurs in

a conentional shareholder or

mutual insurance company).

Consequently, if the taaful

business maes a surplus at

the end of a nancial year, then

it is shared among the taaful

policyholders.

If the policyholders fund3.

maes a loss at the end of

the nancial year, then a Qard

Al-Hassan (interest-free loan)

from the shareholders funds

the decit; any future surpluses

of the policyholders fund are

used to repay the shareholders

loan. The shareholders cannot

access the surplus from the

policyholders fund except

when the Qard Al-Hassan is

being repaid.

1 http://www.salaam.co.u/themeofthemonth/noember02_index.php?l=8 and

http://www.unicorninestmentban.com/default.asp?action=article&ID=38.

2 http://www.ameinfo.com/145251.html.

3 http://news.bbc.co.u/2/hi/americas/6680939.stm.



14/68


The assets of the taaful4.

business hae to be inested

in Shariah (Islamic law)

compliant assets. For example,

inestments cannot be made

in gambling institutions,

businesses that mae alcohol,

businesses that sell weapons, or

assets that pay interest (Riba).

The operators of the business5.

are paid explicit fees for setting

up and running the company on

behalf of policyholders. These

fees coer all set-up costs,

operating costs, and prot

loading of the shareholders

(which is the only way they are

remunerated). These explicit

fees are in the taaful contract

that each policyholder signs

with the taaful company

and are fully transparent.

After the fees are deducted,

policyholders share any surplus

from the taaful business.

Taafuls appeal includes:

Taaful products are

competitiely priced against

conentional insurance

products. For this ery reason,

a signicant proportion of

taaful customers are non-

Muslim in deeloped taaful

marets (e.g., Malaysia);

By denition, taaful insurance

cannot inest in un-Islamic

products (such as arms

manufacturers, alcohol, and

gambling institutions). Anindependent committee, the

Shariah Board, annually

opines that the product meets

all releant ethical guidelines

and that the company is

operating in an ethical (Islamic)

manner. In the Uk, continental

Europe and North America,

where consumers are

increasingly spending a greater

proportion of their disposable

income on ethical products

(e.g., organic food),competitiely priced ethical

insurance has the potential to

be just as popular with non-

Muslims as it is with Muslims;

All charges and expenses are

explicit in insurance contracts,

thereby maing taaful products

transparent to purchasers;

If the taaful business

generates a surplus, then

shareholders are able to

distribute it amongst

themseles; and

A taaful company is lie a

mutual company within a

shareholder wrapper. It has the

benets of both mutuality and

shareholders capital, and

shareholders manage the

company on behalf of the

policyholders. Under the most

common taaful structure,

shareholders mae their return

on each taaful contract as

soon as the business is written.Shareholders are paid an

explicit proportion of each

taaful premium that coers

the expenses of running the

company and the shareholders

prot margin. Consequently,

the shareholders protability

is not wholly dependent on the

underwriting performance of

the insurance entity. Rather, it is

pre-allocated and only affected

by the cost of proiding an

interest-free loan to policyholders,

if the policyholders fund falls

into decit.

How is akas sce

dieen o conveniona

insance?

A taaful company is a mutual

company within a shareholder

wrapper. As Figure 1 shows,

the policyholder fund can be

thought of as the mutual

company as it receies the

policyholders contributions,

pays claims, sets up reseresto pay future claims and pays

broerage and Islamic

reinsurance premiums (Re-taaful

contributions). The shareholder

fund operates the taaful

business on behalf of the

policyholders and is paid explicit

fees for doing so. The two main

mechanisms that the shareholder

fund uses for charging fees to the

policyholder fund are a waala

fee (xed agency fee applied to

either contributions

or inestment income) or

mudharaba fee (percentageof contributions or inestment

income). Should the policyholder

fund fall into decit, then the

shareholders fund maes an

interest-free loan (qard al-hassan)

to the policyholders. As this is a

loan and not an equity loss, it is

repaid out of future surpluses in

the policyholders fund.

ISlAmIC INSurANCE: A COMPETITIvELY PRICED, ETHICAL PRODUCT WITH POTENTIALLY WIDESPREAD APPEAL continued

Policyholder

contributions

Surplus

Claims Retakaful Brokerage

Investment

income

Investment

income

Qard Al-Hassan

Explicit fees

Expenses

Shareholder

fund

Policyholder

fund

Figure 1 Policyholder und

Source: PricewaterhouseCoopers.



15/68


Chaenes acin aka

Awaeness

Research has found that many

Muslims in the EU do not now

what the word taaful4 means.

Therefore, many Muslims

do not now taafuls ey

attributes and benets.

Accordingly, insurers rst tas

will be to increase awareness of

exactly what taaful is and

educate Muslims about how

it is Shariah compliant.

Similarly, when mareting to

non-Muslims, insurers will need

to maret taaful products in

such a way that potential

customers understand that they

are getting both an ethical and

competitiely priced mutual

product that returns any surplus

to them.

Shaiah coiance and

skied esoces

The Shariah Board is independent

of the taaful business andensures that both the operation

and the products of the taaful

business are compliant with

Islamic law. The Shariah Board

normally consists of a minimum of

three Shariah scholars educated

in economics. The taaful industry

as a whole is struggling to nd

scholars and silled resources

who understand both the

intricacies of Shariah law and the

complexities of modern nance.

reao coexi

The Shariah Board is an

additional regulator of the taaful

business. Taaful products are

subject to not only the national

and/or local regulators who ensure

that policyholders are adequately

protected, but also the Shariah

Board that eries if the taaful

business is operating in an

Islamically appropriate manner.

reaka

Being Shariah compliant also

requires that taaful businesses

place their retaaful (Islamic

reinsurance) programme with a

retaaful company. There is

currently a dearth of adequately

rated retaaful companies. As of

June 2008, there were fewer than

20 retaaful entities in the world,and only three retaaful

companies and retaaful windows

had a rating of A- or aboe.

Taaful companies may

be forced to use conentional

reinsurance until more retaaful

capacity becomes aailable.

Invesen coiance

To be Shariah compliant, taaful

businesses are required to inest

their assets in Shariah-compliant

inestments. Howeer, because it

is often difcult to nd a wide

range of such inestment

products, there can be regulatory

compliance challenges

associated with a lac of

diersied inestment ris. In

response to this dilemma, many

companies are establishing

ethical inestment funds that are

in compliance or can easily be

made compliant with Shariah law.

Concsion

Taaful has the potential to be

a protable, ethical business

for insurers who adequately

price and maret taaful

products, as well as mareting

them compellingly to both

Muslims and non-Muslims.

Companies considering setting up

taaful businesses will need toensure that their processes and

products comply with Shariah law,

as well as all national accounting

and solency regulations.

ISlAmIC INSurANCE: A COMPETITIvELY PRICED, ETHICAL PRODUCT WITH POTENTIALLY WIDESPREAD APPEAL continued

AUTHORS

mohaad KhanDirector, Uk Retaaful and Actuarial PracticePricewaterhouseCoopers (Uk)

Tel: 44 20 7213 1945

[email protected]

Ban JosehPartner, Actuarial & Insurance ManagementSolutions (AIMS)PricewaterhouseCoopers (Uk)

Tel: 44 20 7213 2008

[email protected]

4 Taaful Opportunities in Uk & Europe. Presentation by Bradley Brandon Cross, CEO, British Islamic Insurance Holdings, at the

International Taaful Summit 2007.

Insurers frst task

will be to increase

awareness o

exactly what

takaul is and

educate Muslims

about how it is

Shariah compliant.



16/68

Contingent capital: Stepping intostrategic capital planning

AutHOrS: LARRY RUBIN AND XIAOkAI vICTOR SHI



17/68


Would the insurance industry be able to withstand losses arising from a crisis

equialent to the subprime crisis that is facing bans? Is now the time for critical

capital planning as a component of core enterprise ris management (ERM)strategies? Larry Rubin and Xiaoai victor Shi reiew contingent capital as a

ey element in an insurers ERM strategy.

Would the

insurance

industry be able

to withstand

losses arising

rom a crisis

equivalent tothe subprime

crisis that is

acing banks?

CONtINgENt CApItAl: STEPPING INTO STRATEGIC CAPITAL PLANNING

In recent decades, a reolution

in ris and capital management

swept through the insurance

industry. Today, the global

insurance industry is actielydiscussing and implementing

economic capital as part of its

strategic nancial planning.

Also, alternatie capital funding

approaches such as insurance-

lined securities and arious

securitiations became more

popular recently when traditional

reinsurance marets failed to

proide sufcient capacities.

Howeer, insurers face threats

from unexpected eents such

as natural disasters, unusual

economic uctuations and capitalmaret crashes. These eents are

called paradigm shifts or blac

swans by many practitioners.

For example, the recent subprime

crisis led to earthquaes in the

entire nancial serice industry,

and some insurers also suffered.

Would the insurance industry be

able to withstand losses arising

from a crisis equialent to the

subprime crisis that is facing

bans? Is now the time for critical

capital planning as a component

of core enterprise rismanagement (ERM) strategies?

This article reiews contingent

capital as a ey element in an

insurers ERM strategy.

Wha Is coninen caia?

For readers unfamiliar with

contingent capital, the concept

can be made more transparent

by comparing it to some

traditional capital funding

methods such as lines of credit

and reinsurance.

Although similar to a line of

credit, contingent capital

arrangements are far more

complex. Contingent capital is

a trigger-based nancing option:

Agreements are entered into by

two or more entities that gie

the holders the right to raise

capital or sell securities (at

gien prices) when predenedtriggering eents occur. The

trigger eents could be a

natural catastrophe, signicant

economic eents, an act of

terrorism, buyer nancial

conditions, a liability eent or

another predened condition.

Contingent capital can be

iewed as a put option on a

companys balance sheet,

by which the buyer pays a

premium (capital commitment

fee) in exchange for the right

to issue or sell securities at

gien conditions.

Although contingent capital

differs from a line of credit due

to its post-eent nature, it will

moe to the balance sheet

once the put is exercised and,

thus, is similar to line-of-credit

agreements.

Contingent capital similarities

can also be drawn to traditional

reinsurance (or catastrophe

bond transaction) in the sensethat they both proide off-

balance-sheet capital for riss.

Howeer, contingent capital

differs from reinsurance

because it gies the option of

access to capital rather than

proiding indemnication. In

addition, unlie reinsurance,

funds raised ia contingent

capital must be repaid to the

capital proider. Finally,

contingent capital does not

really transfer riss or losses to

sellers, but it proides a capital

injection after specied eents.

Contingent capital can be

proided in arious forms of

securities: equity, debt or some

hybrids. Typical arrangements

include standby credit facility,

contingent surplus notes or

catastrophe equity put options:1

Sandb cedi acii

a line of credit with the right

to receie a loan upon eent

of a loss;

Coninen ss noes

the option to borrow or

the right to issue surplus

notes contingent upon

triggering eents;

Caasohe eqi

the right to issue shares

of stoc contingent upon

triggering eents.

1 Michael W. Elliott, Contingent capital arrangements,Risk Management Quarterly, vol. 18, No. 2, September 2001.



18/68


CONtINgENt CApItAl: STEPPING INTO STRATEGIC CAPITAL PLANNING continued

Econoic caia odein

ais o cae exee

ai evens

Many will cite the standard

denition of economic capital

from Solency II, where economic

capital is dened as the amount

that an insurance company needs

so that it can absorb all losses

within a one-year time horion

with 99.5 percent probability. This

concept is shown in Figure 1.

Howeer, no matter how

sophisticated a companys

internal economic capital models

are, they still are often built based

on historical experiences (with

perhaps some additional stress

tests.) These models may fail to

capture some unnown

unnowns, the so-called

paradigm shifts and blac swans.

This is because:

By denition, these tail eents

cannot be modeled based on a

historical cure of losses;

The historical data set

represents one of many

possible outcomes; and

More importantly, recogniing

extremely unliely eents in

economic capital will require

insurers to hold excessie

amounts of equity capital, thus

lowering their return on equity.

Still, these unnown unnowns

are often the major driers behind

business failures. For decades,

Bear Stearns had been

recognied as one of the most

sophisticated ris modelers on

Wall Street. But Bear Stearns

recent failure was a direct result

of the subprime meltdown that,

according to its ris models, was

a 9 standard deiation eent.

When a paradigm shifts or a

blac-swan eent occurs,

disastrous consequences can

result (see Figure 2).

Paradigm shifts are either long-

or short-term changes in the state

of the world, which gies rise to

signicant losses to nancial

institutions. Examples include

the low leels of interest rates

experienced since 2000 (in the

early 1990s, most insurance

companies belieed we would notsee 3% interest rates in the

United States again) and

long-term-care policyholder

behaior. Paradigm shifts hae

higher impacts on insurance,

compared with many other

industries, due to the business

nature of the long-term

promises. Insurance products

are priced as the world existedrather than as it exists.

Paradigm shift

Paradigm

shift

Capital

needs

Loss Black swan event

Black swans

Figure 2 A paradigm shit or a black-swan event


Balance sheet

Minimum

asset

Liability

Economic

capital 99.5% of solvent

over one year

Figure 1 Concept chart




19/68



Blac swans are large-impact

eents that are statistically

remote and beyond the realm of

normal expectations. The 1987

stoc-maret crash, the 9/11

attacs, the burst of the Internet

bubble and the recent subprime

meltdown are examples of blac

swans. Those eents pose great

challenges to insurers because

of their unpredictability, which

is difcult for ris specialists

to model.

The maret appears to hae

included these unexpected

eents when it assessed the

riss of inesting in insurance

business. This could be obsered

from the capital adequacy rating

criteria from rating agencies,

(the three to e multiples of

ris-based capital insurers must

hold for competitie reasons).

This could also be obsered

from some insurance-related

securitiations, where capital

required to execute the deal isgreater than the capital that is

determined by a companys

economic capital model. In

addition to the information

disparity and frictional costs of

insurance business, unnown

unnowns would be one

important contributor to

redundant capital holdings.2

Can existing techniques or

future innoations help sole

or mitigate this problem? If so,

what strategic decisions should

companies mae to buildhealthier balance sheets?

Coninen caia as a

o Erm

In addition to unexpected losses,

the consequences of extreme tail

eents are more liely to pose

liquidity problems than solency

troubles for insurers. Under the

NAICs ris-based capital

requirement in the United States,

leading insurers are less liely to

hae solency problems because

most hold far more capital than

the required minimum. Howeer,short-term liquidity troubles (as

well as subsequent ratings

downgrades) are major triggers

to many banruptcies and

opportunistic acquisitions.

In the 1990s, the failures of two

prominent insurers, General

American in the United States

and Confederation Life in

Canada, were good examples of

the consequences of liquidity

problems. In addition, liquidity

was a contributor in the recent

failure of Bear Stearns.

Contingent capital3 is a solution

that should be utilied to

supplement a companys

economic capital. In our iew,

contingent capital, in conjunction

with traditional ris management

programs such as reinsurance,

economic capital modeling and

hedging, should be considered by

CEOs/CFOs /CROs as part of

their ERM programs. Contingent

capital creates a bridge to access

nancing sources in cases where

capital marets fail to do so.

Contingent capital arrangements

hae grown more common this

decade. In 2000, Swiss Re

mareted a contingent capital

arrangement with Royal Ban of

Canada. The arrangement stated

the ban could use its C$200

million preferred shares in

exchange for C$200 million cash

from Swiss Re if the bans

general resere leel for loans

fell below a certain threshold.

The C$200 million preferred

shares represented about 1% of

Royal Bans equity. The major

incentie to enter into this

transaction was that it was less

expensie than general insurance.

An article published in 2001 at

CFO.com labeled the potential

capital deried from this type of

transaction as just-in-case capital.

In 2006, XL Capital and its

subsidiaries entered a

$350 million contingent capital

arrangement with Stoneheath Re,

a Cayman Islands exempted

company issuing perpetual

preferred securities. The structure

of this transaction gies XLs

subsidiaries access to capitalbased on coered triggering

eents including US wind,

California earthquaes, European

wind and global terrorism.

Stoneheath Re solely inests in

AAA assets, which will be

conerted into preferred shares of

XL Capital if specic eents occur.

This structuring deal, adised by

Goldman Sachs, is an innoatie

and successful transaction that

enables XL to gain access to

signicant capital upon the

occurrence of a tail eent.

Howeer, we hae not seen many

examples lie XL Capital in the

insurance industry that actiely

use contingent capital as a core

ERM strategy. The use of the

contingent capital approach, as

a tool to hedge balance sheet

riss and loc in an insurers cost

of capital, could be expanded in

the capital planning and ris

management decision process.

Some industry leaders hae

pointed out that insurers should

bac their economic capital

(results from internal models) with

their companys equity and fund

other capital portions with

cheaper sources such as debt or

securitiations. Howeer, funding

blac-swan eents by accessing

debt capital would be an incident

of default. Most securitiations

proide for holding company

recourse, which would also be

considered an incident of default

should it be accessed. As a result

creditors would tae ownership of

the company and shareholders

would lose all alue. In contrast,

accessing contingent capital as

represented in the Royal Banand XL Capital examples is the

exercise of a contractual

agreement between a company

and an entity that proides the

funds. Consequently, shareholders

do not lose ownership (although

in some structures ownership

may be diluted).

Insurers should be able to

leerage contingent capital as an

enhancement to their claims-

paying ability, which may improe

a companys competitie

position. Done correctly, it shouldlower the companys cost of

capital. As these contingent riss

are deemed to occur infrequently,

the loss distribution should more

2 See Locerman, Polsgroe, Rubin, Shi, Tillis, Economic Measurement of Insurance Liabilities: The Ris and Capital Perspectie, 2008.

3 See bacground information at side box of contingent capital introduction to understand the basic concepts of this product.



20/68



closely resemble the loss

distribution of inestment-grade

debt instruments and be priced

accordingly (we see this with

holding company debt, which is

the simplest form of contingent

capital, but has the downside ris

of loss of control of the

company). Through strategic

contingent capital transactions

without signicant, expensie

equity buffering ones

companies can build maret

condences by mitigating the fear

of tail eents often disastrous

impacts to the company.

Admittedly, contingent capital

cannot remoe all unnown

unnowns from the balance sheet

due to its nature of dealing with

predened eents. Howeer,

gien certain shareholders ris

appetites, contingent capital, in

exchange for a reasonable cost,

is able to help companies build

both policyholder and inestor

condences and to surie large

tail eent losses. Capital marets,

on the other hand, see

diersication opportunities and

are expected to welcome some

orthogonal riss that are not

closely correlated with maret

riss. The popularity of

catastrophe bonds and other

arious insurance-lined

securities is eidence of this.

Our approach to capital structure

(also shown in Figure 3) is

two-fold:

Companies should use

shareholders equity to fund

economic capital, where

economic capital should be

sufcient to mae insurers

nance themseles at maret-

consistent cost of equity.4

Companies should utilie

contingent capital to hedge

out-of-the-money riss or riss

that are not captured in the

economic capital model.

This structure requires the

company to be able to explain to

the maret the sufciency of its

economic capital model in order to

receie contingent capital funding.5

Benefs o coninen caia

Contingent capital also proides

seeral economic benets as

alternatie capital funding. First, it

proides great exibilities in

capital funding and ris

management. It could include

triggering eents that may appear

in arious forms. It could be

one-year or multi-year period

coerage based on buyers ris

appetites and their iews on

potential riss. It could include

actual funds raised in the capital

marets, deep out-of-the-money

deriaties or traditional

reinsurance. There can be a

ariety of forms of exercising

triggers that are based on a

companys unique business

problems and that are able to

preent insurers from suffering

from different threats. For example

companies could enter some

transactions with the trigger as

the worse scenario for their

Guaranteed Minimum Withdrawal

Benet (GMWB) obligations in

the balance sheet. Insurance

companies or bans, as another

example, could dene their trigger

eent as a credit crash similar to

what is currently happening.

Second, contingent capital

proides a cheaper cost of capita

funding relatie to using equity

capital for out-of-the-money

riss. At certain points, insurance

companies are able to loc in

their cost of capital by paying

reasonable premiums (the cost

of the put). If the reduction in

cost of capital is lower than the

price of this put option, then

insurers are creating alue ia this

transaction.

Another signicant adantage ofcontingent capital is effectie

balance sheet protection for

some specied eents.

Uncertainties in companies

balance sheets incur additional

cost of capital and will put

shareholders and policyholders in

unfaorable positions if

something unexpected happens.

Leeraging contingent capital

enables insurers to hedge those

possible losses from their

corporate balance sheets without

losing capital ownership under

distressed situations. In addition,contingent capital proides

capital with stress-free spreads

under nancial distress.

Two-tier capital

structure

Contingent capital to

hedge xx o events

Economic capital

Components

Contingent capital

arrangements

Equity

Funding

LIBOR + ? bps

LIBOR + 500 bps

Cost (illustrative)

Figure 3 Two-tier capital structure


4 One of our separate articles, Economic Measurement of Insurance Liabilities: The Ris and Capital Perspectie, argued that the economic leel of capital should be sufcien

to help insurers fund losses without paying additional equity ris premiums. The implication of this iew is that insurers should hold sufcient economic capital so that the

capital maret would be willing to fund the contingent capital.

5 See Locerman, Polsgroe, Rubin, Shi, Tillis, Economic Measurement of Insurance Liabilities: The Ris and Capital Perspectie, 2008.



21/68



Finally, contingent capital could

also proide timely mid- to

long-term liquidity support. As

mentioned earlier, liquidity trouble

often contributes signicantly to

insurance business failures. If a

run on the ban happens, some

companies might hae difculties

accessing external liquidity

sources, or additional liquidity

may be ery expensie to obtain.

Entering contingent capital

transactions could effectiely

sole this problem if prespecied

eents transpire.

reao iicaions

Surplus notes are one type of

capital source that is similar to

contingent capital. Surplus notes,

where regulatory approal is

required, hae been popular in

the insurance industry to raise

capital, especially for mutual

companies. Surplus notes are

treated faorably from a

regulatory perspectie, and theyare iewed as equity for solency

purposes. If regulators preent a

company from maing coupon or

principal payments on the surplus

notes, the company would not be

considered in default.

It might be too early to assume

that regulatory pressure would

come into play to hold contingent

capital. But it should be a fair

presumption that regulators

would, at least, faor contingent

capital as another ehicle to

secure policyholders benets.If we accept that paradigm shifts

and blac swans will occur in the

future, and that by their nature

they cannot be captured in an



22/68



economic capital model, then we

should expect that Solency II,

which moes in the direction of

regulating companies based on

internal capital models, may

result in increased insolencies in

the industry.

In the short term, absent

regulatory pressures, company

management teams may lac

enough incenties to see

contingent capital arrangements.

Unlie the European iew that

management is maximiing

staeholders alues, US rms

tend to beliee that management

is responsible for maximiing

shareholders benets.

Contingent capital primarily

protects policyholders. From the

shareholders perspectie, paying

additional costs to protect

policyholders may not be in their

best interests, gien that the

result of accessing contingent

capital could lead to dilution of

capital or een a loss of control.Considering that extreme eents

are unliely to occur during a

particular term of a management

team, management might aoid

haing to explain the additional

underperformance that resulted

from purchasing contingent

capital during their limited years

in executie positions. This is

because companies that hedged

their oerall balance sheets with

contingent capital would hae

relatie lower capital performance

(assuming other factors equal)

than peers that were notimpacted by the cost of

contingent capital. We expect the

result of regulatory pressures to

help nancial institutions surie

potential nancial crises,

especially in a Solency II world.

rain aenc views

Contingent capital has been

faorably receied by rating

agencies due to its nancial

exibility and demonstration of

efcient capital management.

In one of its recently published

special reports, AM Best

commented: Recently, seeral

companies hae issued

contingent capital securities as

part of a capital managementplan Companies that can issue

these types of securities tend to

hae stronger leels of nancial

exibility and maret

acceptability. Howeer, AM Best

also stated that it does not gie

credit in AM Bests capital

adequacy model (BCAR),

although they do receie a

certain leel of qualitatie credit

at rating committee meetings.

In one 2006 published

commentary letter in Standard &

Poors Global Bond Insurance,S&P stated, a bond insurer can

receie 100 percent credit in the

capital adequacy model for a

contingent capital structure in

which the inested assets meet

Standard & Poors qualifying

assets guidelines.

liiaions and e

innovaions

While contingent capital appears

to be a good solution to many

capital management problems,

it also has some limitations:

In the near term, companies

might lac enough incenties

to hold contingent capital.

Although contingent capital

would essentially mae

companies immune from

certain extreme eents,

companies would hae relatie

lower performance than those

not impacted. Before

contingent capital gains

popularity or regulatory

pressures come into play, a

CEO might hae to explain to

his or her shareholders why

entering a contingent capital

transaction is necessary;

The existing structuring of

contingent capital appears

oerly complex, thus increasing

the transaction costs and

reducing the transparency of

this facility; and

Cost-efcient pricing of certain

triggering eents requires more

sophisticated ris measurement

and technology support.

Going forward, both the

insurance industry and the capital

maret should continuously focuson innoation. Three ey aspects

players need to concentrate on

include increased transparency,

extended coerage and more

sophisticated pricing.

Transparency is the ey to

success for this innoatie

product. The major benets for

insurance companies with

contingent capital arrangements

stem from their enhanced ability

to surie a nancial crisis. The

major benets to inestors are the

ability to purchase inestment-grade assets whose default ris is

uncorrelated with the rest of the

portfolio. Howeer, unnecessary

complexities or other

nontransparencies could diminish

this adantage as inestors will

automatically add ris margins on

each nontransparency. In other

words, inestors are willing to pay

for extra transparency. Increased

transparency on transactions,

faourable accounting treatments

and regulatory and rating agency

endorsement, may well boost the

future deelopment of contingent

capital as a core component of

strategic capital planning.

Extended coerage of trigger

eents and improed pricing

abilities would also add alue.

The capital maret should be able

to digest riss from issuing

contingent capital options. How

to correctly measure and quantify

the riss is the ey. Gien the

coered eents hae ery low

probabilities of happening, we

expect that, with enhanced pricing

abilities in the capital maret,

contingent capital will become a

ery cost-efcient ehicle to fund

capital and to hedge the balance

sheet with the adancements in

product deelopment from thecapital maret.

Concsion

More and more institutions hae

started to feel the pain from the

subprime credit crunch.

Sacrices must be made for

nancial institutions to return to

their former secure states. But US

nancial serice industries also

need to thin hard about how to

enhance their ris management

abilities.

Contingent capital, as an

innoatie ehicle in capital

planning, could become a

aluable component to insurers

ERM strategies. Howeer, with a

lac of regulatory pressure, it

might tae extra effort for US



23/68



rms to tae action regarding

purchasing contingent capital.

Management, which is primarily

responsible to shareholders,

might lac incentie to maximie

policyholders benets if

shareholders were paying the bill.

Looing bac in history, the

industry always climbed toward

higher destinations as it faced

more complex and risier realities.

Innoations from strategy, tools

and, most importantly, peoples

mindsets are the driers. We feel

contingent capital is one more

tool to help manage the insurance

industrys inherent complexities

and riss.

AUTHORS

la rbinPartner, Actuarial and Insurance Management Solutions (AIMS)PricewaterhouseCoopers (US)

Tel: 1 646 471 4017

[email protected]

Xiaokai Vico ShiSenior Associate, Actuarial and Insurance Management Solutions (AIMS)PricewaterhouseCoopers (US)

Tel: 1 646 471 8978

[email protected]



24/68

Recent deelopments in ris

mitigation through reinsuranceand capital marets

AutHOr: CAROLINE FOULGER



25/68


Caroline Foulger focusses on ey deelopments in the relationship between the

capital and reinsurance marets, proides insight into the broader reactions ofreinsurers to this new wae of capital maret participation, and explores different

perspecties on other changes in the reinsurance space in a softening maret.

Sot market

is always a

relative term.

rECENt DEVElOpmENtS IN RISk MITIGATION THROUGH REINSURANCE AND CAPITAL MARkETS

Oveview

Casualty reinsurance maret

rates declined throughout 2007,

and, absent of a major catastrophe,

the property maret is now

following suit. While underwriting

and ris management actiity on a

global scale centers on

appropriate and sustainable

responses to maret softening,

the catastrophic corner of the

global reinsurance maret (worth

upwards of $400 billion) has seen

signicant actiity from a less

traditional reinsurance source:

capital marets. Recent actiity,

although compartmentalied,

highlights the continuing

appetites of both the inestingcommunity and reinsurance

consumers for polished and

economically rewarding

substitutes to conentional

reinsurance.

This article focuses on some ey

deelopments in the relationship

between the capital and

reinsurance marets, proides

insight into the broader reactions

of reinsurers to this new wae of

capital maret participation, and

explores different perspecties on

other changes in the reinsurancespace in a softening maret.

Sa-s, sidecas,

seciizaions, and so caia

Most ey indicators showed an

ongoing softening of property

catastrophe reinsurance pricing

in the rst four months of 2008.

But soft maret is always a

relatie term. Rather than curtail

capital marets interest in

reinsurance, recent credit maret

eents hae yet again focussed

the attention of hedge funds

and priate equity rms to

uncorrelated riss through

reinsurance-baced inestments.

Until the 2004 and 2005 maret

dislocation eents, inestment in

the reinsurance maret wastraditionally long term (e.g.,

through the proision of capital

by direct shareholdings in

reinsurance companies).

Howeer, global capital marets

hae long played a broader role

in the property catastrophe

reinsurance maret. Recently,

insurance-lined securities

(including catastrophe bonds and

industry loss warranties) hae

gained momentum, and hae

proided the capital marets with

uncorrelated short- to medium-

term inestment opportunities.Inestment actiity in late 2005

through 2008 has cemented what

now seems to be the ongoing role

of hedge funds and priate equity

rms in the property catastrophe

reinsurance maret. Below is a

summary of the major aenues

behind the stream (well in excess

of $10 billion) of capital maretinestment in the reinsurance

maret oer the past few years.

New sa-s

Probably the most traditional

form of the capital marets

inolement in reinsurance

companies is by direct inestment

in new start-up companies. This

was most eident in late 2005

(following Hurricane katrina) with

the establishment of four new

Bermuda companies, each with

start-up capital in excess of$1 billion directly funded by the

capital marets.1 Actiity has

since continued, albeit at a

reduced leel, with carriers

formed in both Bermuda and the

Cayman Islands in 2007. Since

the billion-dollar Bermuda babes

of 2005, there has been limited

start-up actiity in the property

catastrophe space, with the

exception of Aeolus Re.

Sidecas

Although initial ersions ofsidecars were created as early as

the 1990s (e.g., Renaissance Res

Top Layer Re and Olympus), the

Hurricanes katrina, Rita, and

1 Amlin Bermuda also had start-up capital of $1 billion, though funded principally through the Amlin Plc group.



26/68


rECENt DEVElOpmENtS IN RISk MITIGATION THROUGH REINSURANCE AND CAPITAL MARkETS continued

Wilma (kRW) eents and the

formation of the Bermuda Class of

2005 companies proided the

impetus for a signicant inow of

hedge fund and priate equity into

sidecar structures, as shown in

Figure 1. From 2005 through 2007,

approximately $5.5 billion of

sidecar capital entered the

maretplace. More interesting is

that while a considerable portion of

that capital is now leaing the

maret, other sidecars (more

closely resembling catastrophe

bond structures) are being formed

with different objecties. Puma Re,

for example, has issued a three-

year catastrophe bond for the sole

purpose of nancing its sponsor

ehicle, Bridge Re (a new property

catastrophe retrocessionaire:

(reinsurer of a reinsurer).

Seciizaions

(caasohe bonds and

inds oss waanies)

The catastrophe bond maret is

probably the single largest growth

area in the property catastrophe

reinsurance maret, attracting

approximately $12 billion of

capital in 2006 and 2007. Unlie

sidecars, rating agencies hae

demonstrated a greater inclination

to rate certain bonds, which has

signicantly boosted this maretsgrowth. The subprime crisis has

proided a coincidental

compensator for price declines,

and the uncorrelated riss these

products proide inestors,

gien current maret conditions,

is fuelling the continued growth

of catastrophe bonds.

Original Industry Loss Warranties

(ILWs), traded in the 1980s,

resurged in 2006, proiding

similar inestor access to the

property catastrophe maret as

catastrophe bonds. Many maretobserers see ILWs as a huge

growth area, comparing them to

interest rate and credit deriatie

marets. But the absence of

recognied trading indices,

structure, pricing, liquidity, and

transparency (particularly in

secondary trading) is somewhat

stalling this growth.

Coninen caia

Contingent (or soft) capital has

long been a common feature of

the nancial guaranty maret. The

signicant benet that it brings,

(i.e., it is a protectie option

following a major catastrophic

eent without punitie post-

catastrophe costs and capital

dilution) has raised both the prole

and use of these products in other

sectors in the maret in recent

years. Signicant recent deals

totaled in excess of $1.3 billion

on a combined basis. Howeer,

while condence in these

products is growing, there are stil

reserations both on the issuer

side and by the rating agencies

related to essentially unrated,

off-balance sheet facilities.

lon-e vess sho-e?

Benefcia o advese?

As noted aboe, approximately

$6 billion of sidecar capital owed

into the reinsurance maret in

2005 through 2007, although that

ow has slowed oer the past 12

months. Seeral of the sidecars

established in late 2005 and early

2006 are now either cut off (i.e.,

their potential exposures hae

been settled by commutation as

they are expected to be minimal

or nil), or in run-off. In the past,

the inestment of such short-term

capital would hae been iewedas a lac of commitment to the

industry, but the maret has

changed in 2008. While surplus

capacity and declining rates

mae such entures less

attractie to some capital maret

inestors, the appeal of additiona

non-shareholder capital is less

important to reinsurance

company sponsors of sidecars,

thus aligning the interests of

both parties. This inow and

outow of hedge fund and priate

equity rm capital in response to

shifts between dislocated andstabilied reinsurance maret

conditions has been called the

bellows effect.

Among the reinsurance marets

leaders, there are mixed emotions

regarding the relatie benets of

this large inux of inestor capitalSource: PricewaterhouseCoopers.

Figure 1 Sidecar ormations (2005 to 2006)*

Sidecar Capital ($ millions) Cedant Setup

Olympus II $155 White Mountains 2005

Blue Ocean $355 Montpelier 2005

Cyrus Re $550 XL Capital 2005

Flatiron $840 Arch Capital 2005

Monte Fort Re $60 Flagstone 2006

Timicuan/RPP $70 Renaissance 2006

Sirocco $95 Lancashire 2006

BayPoint $150 Harbor Point 2006

Petrel $200 validus 2006Sector Re $220 Swiss Re 2006

Helicon $330 White Mountains 2006

Concord $730 AIG 2006

Syndicate 6105 $20 Syndicate 4020 2007

Syndicate 6104 $35 Syndicate33 2007

Monte Gele Re $60 Flagstone 2007

Cyrus Re II $105 XL Capital 2007

Norton Re I $120 Brit 2006

Norton Re II $120 Brit 2007

Puma Re $180 Bridge Re 2007

Starbound $315 Renaissance 2007

kaith/k5 $370 Hannoer Re 2007MaRI $400 Marsh / ACE 2007

$5,480

*This table is for informational purposes only. Aailable data relating to sidecars

is restricted, as much of it is not made public. The data in the table aboe is

based on information from press releases and other public sources, and

therefore there is no guarantee of its completeness or accuracy.



27/68


Obiously, one of the major

maretplaces affected by this

trend is the Bermuda property

catastrophe reinsurance maret.

In PricewaterhouseCoopers

(PwC) 2006 Bermuda Maret

Surey, we ased a cross sectionof reinsurance CEOs how they

iewed the inolement of the

capital marets. Figure 2

illustrates the results.

At the 2007 Bermuda Insurance

Conference, sponsored by

PricewaterhouseCoopers and

Standard & Poors and titled

Global Challenge: Optimiing

Capital in a Softening Maret,

speaer Michael A. Butt,

chairman of AXIS Capital

Holdings, noted, Sidecar and

other short-term capital are nottrying to create franchise alue.

That is one factor that gies us

hope that we may this time

experience a smoother cycle.

There will be many occasions in

the future when we will need

surplus capital for specic,

identied needs, because some

elements of the maret will lose

their nere.

As some sidecars wind down and

their inestors depart for now, the

stability they hae deliered byproiding capital and capacity in

a dislocated maret is hard to

dispute, and their obious desire

not to hang around when the

specic short-term opportunity

they targeted starts to fade is

widely considered to be a positie

thing. But in a soft cycle

questions are being ased about

the impact this short-term capital

has had on reinsurance

purchasers. While some sidecar

capital has been returned, of the

considerable capital maret

inestment proided since kRW(conseratie estimates range

between $8 billion and

$14 billion), a considerable

portion remains. The length and

impact of this trend on traditional

reinsurance proiders are widely

debated questions.

Choice and coexi

Reinsurance purchasers hae had

an array of choices aailable to

them through the addition of

seeral capital maret

mechanisms. In the recent, harder

maret, all coerage has been

relatiely expensie, and the rapid

addition of capital through sidecar

structures has quicly proided

capacity in response to a ery

complex and difcult situation.

As the maret softens, it essentially

becomes a buyers maret

for reinsurance purchasers.

The stability of capital maret

structures has helped the more

traditional reinsurance proiders

continue to meet the coerage

needs of their customers.

Following the stellar returns oftwo benign years, those

traditional proiders now hae

less need for the capital marets

sidecar contributions. If that

capacity remains, it will worsen

the impact of the soft cycle for

established reinsurance

franchises; by departing, it assists

in smoothing the cycle.

The Bermuda Maret Surey also

ased a cross section of CEOs

whether they iewed the

inolement of the capital

marets as short- or long-term.

Opinions split, with those iewing

the inolement negatiely alsoiewing it as long-term (see

Figure 2).

While sidecar formation has

slowed, the growth of insurance-

lined security issuances (i.e.,

catastrophe bonds and industry-

loss warranties) and contingent

capital facilities has not. As the

nowledge and aailability of

these products becomes more

widespread among reinsurance

buyers and the inestment

community, these longer-term

products are gathering pace.This has obiously been assisted

by the outperformance of

traditional bond marets by

catastrophe bonds following a

tumultuous period in the credit

marets and a benign period in

the catastrophe maret.


Negative

Positive

22%

78%

Figure 2 How do you view the signifcant capital provision into the market rom the capital markets (e.g. hedge unds)?


Short-termLong-term

55%45%

Negatie s Positie Short term s Long term



28/68


With all this additional and

potentially competitie capacity

aailable from the capital

marets, it is often reported that

traditional reinsurers are

becoming ictims to a predatory

attac on their core maret.

Reality is far different: thereinsurance maret is agile,

innoatie, and at the front edge

of the deelopment of this new

breed of ris mitigation techniques.

Conveence and

sohisicaion

Although designated for

inestment by the capital

marets, gien the complexity

of the riss these products

coer, it is essential that they

be in some way structured or at

least alidated by reinsurancespecialists. Swiss Re is widely

recognied as the pioneer of

the insurance-lined securities

maret, initiating catastrophe

bond trading since the hard

marets of the early 1990s

following Hurricane Andrew.

Since then, its specialities and

offerings hae eoled, and it

now includes signicant life

securitiations as well. Lloyds

insurer and Bermuda reinsurer

Amlin recently announced that

they will form an inestment

management partnership that will

manage funds focussed on traded

insurance ris. Other companiesare widely expected to follow this

trend. Although the partnership

is still subject to regulatory

authoriation in the Uk, Amlin

CEO Charles Phillipps has said,

Amlin intends to be an actie

participant in the insurance-lined

securities (ILS) maret, both to

enhance our capital and ris

management capabilities and to

generate returns from the growth

and high margins aailable in

the business. Amlin has

supplemented its team with a

preious head of ILS at Swiss Re.

Aeolus Re is a start-up Bermuda

reinsurer founded in 2006, and it

operates as an unrated

reinsurance platform that targets

the property catastrophe segment

of the worldwide reinsurance

maret. Specically, Aeolus

focusses on the industry loss

warranty (ILW) segment of the

maret. It has been so successful

that in early 2007 its capital base

was increased to oer $1 billion

by a group of inestors led by

Warburg Pincus and Merrill Lynch

Global Priate Equity.

In the meantime, so-called

traditional reinsurance

companies, including XL

and Renaissance Re, were

frontrunners in the formation

of sidecars, and both longer-

established and relatiely new

companies are maing extensie

use of contingent capital facilities.

Hedge fund and priate equity

rms are sophisticated and agile

inestors, and they will pursue

maret opportunities to secure

uncorrelated returns. Indeed, the

structured relationship between

inestment marets and

reinsurance companies through

sidecars and other shorter-term

products simplistically reects amutual recognition of where

expertise lies; hedge fund and

priate equity rms lac the

expertise of reinsurance

underwriters, just as reinsurance

underwriters lac the expertise of

hedge fund and priate equity

rms. The most signicant threat

to the stability of the reinsurance

maret usually occurs when those

lines are blurred.

Ohe deveoens

in einsance

Acqisiions

SCORs acquisitions of

Conerium and, on a smaller

scale, Toio Marines of kiln,

represent two of the major

reinsurance maret acquisitions

in 2007. There has also been

considerable actiity in the

Lloyds maret, particularly at

Bermuda companies (e.g. validus

acquisition of Talbot and Ariels

acquisition of Atrium). This

represents a reitalied appetite

for Lloyds following the ow of

capital in the opposite direction in

2005 and 2006.

Divesifcaion

Increased emphasis on the

diersication credit that rating

agencies can award has led

companies to broaden their

strategies respecting the breadth

of their business focus rather

than narrowly concentrating on

one business model. In a softening

maret, companies that put most

of their energies into deeloping

one narrow business model can

shrin disproportionately,

adersely affecting both their

bottom line and their maret

credibility. In 2007, Standard &

Poors downgraded IPC Re for

narrow underwriting that

concentrated principally on the

property catastrophe space. Thisdiersication credit, lie many

factors incorporated into rating

agency models, is a relatiely new

trend, perhaps causing some

chagrin at IPC Re gien their

consistent practice for oer a

decade of underwriting. It is

eident that Montpelier Re has

responded to the pressure to

diersify its business by

expanding into the US, Lloyds,

and Europe last year, earning a

positie rating agency response

in May 2008.

There is no doubt that

diersication can yield signicant

benets, ACE and AXIS being

notable examples. Howeer, the

penalty for diersication

perceied as beyond the core

resources or experience of a

company can also be damaging.

In the past, companies hae been




29/68


heaily penalied for this, the

writers of North American

casualty reinsurance being a

noteworthy example in the 1990s.

It will be interesting to reect a

few years in the future on the

results of the wide ariety of

diersication strategies now

being deployed by global

reinsurers, particularly in

emerging reinsurance

maretplaces.

Aenaive isk anse and

sced einsance

In the wae of a ariety of

industry inestigations a few

years ago, heightened sensitiity

to structured reinsurance has led

to a contraction in the aailability

of products in this space.

Howeer, interest in these

products has increased, and a

broader range of solutions are

being offered to the maret.

Consistent with heightened

sensitiity, howeer, the buyers of

structured products see obiousand higher leels of ris transfer.

Aggregate stop-loss coers are

among a wide range of products

proing to be popular.

Oook

The reinsurance maret is

eer-eoling as business cycles

continue to reole. In a hard

maret, the focus is always on

capacity, capital, and pricing. In

the current soft maret, the focus

is on deeloping creatie product

offerings and optimiing capitalreturns while also managing

pricing challenges. The challenge

for all parties reinsurance

companies, reinsurance

purchasers, and the capital

marets is to continue

recogniing where their expertise

and alue resides and where it

does not.


gossa o es

Insurance-lined securities

Securitiation is a nancial

technique that pools assets

together and, in effect, turns

them into tradable securities.

Most insurance-lined securities

(in the property and casualty

insurance marets) sere as

collateralied protection for

extreme eent ris (i.e., most

protection is proided in thecatastrophe space). Catastrophe

bonds and industry loss

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