Aon Group Limited

From Reinsurance

to ART

Dr. Alan Punter

Aon Capital Markets,

London

21st September, 2000

Alternative Risk and

Alternative Transfer

Aon Group Limited

2

Insurance and reinsurance have a long historyInsurance and reinsurance have a long history

circa 2000 BC: Predecessor of marine insurance practised in Babylon - “bottomry” involved a loan on the security of a ship, but if the ship was lost the loan was not repaid.

1370: The first reinsurance transaction, as documented by Gustav Cruciger, who described how an insurer obtained reinsurance on a voyage it was insuring from Genoa, Italy, to Sluys, Netherlands.

1654 Bodlean library contains entries from insurance broker’s account book listing deals.

1688: Lloyd’s coffee house advertised in London Gazette.

1863: The formation of Swiss Re and Munich Re (in 1880) are widely considered to be the start of the modern “professional reinsurance” industry in continental Europe.

Aon Group Limited

3

World Insurance MarketWorld Insurance Market

1998 premiums (US$ billions)

Life Non-life Total

North America 368 411 779

Latin America 11 28 39

Americas 379 439 818

Western Europe 399 286 685

Central / Eastern Europe 4 11 15

Europe 402 297 699

Japan 361 92 453

South and East Asia 74 33 107

Middle East 4 7 11

Asia 439 132 571

Africa 22 7 29

Oceania 22 15 37

World 1,264 891 2,155

Aon Group Limited

4

US Insurance Results 1999US Insurance Results 1999

Net income after taxes fell from $30.8 bn in 1998 to $22.2 bn in 1999

Combined ratio up from 105.6% in 1998 to 107.9% in 1999

Rate of return on average net worth fell from 8.5% in 1998 to 6.4% in 1999

Problems: poor premium growth weak profitability due to rising incurred losses and loss-adjustment

expenses falling investment income

Aon Group Limited

5

European reinsurers results 1999European reinsurers results 1999

“Very sorry picture” (Standard & Poor’s)

Estimated average combined ratio of 131% for 1999 (109% in 1998)

Record number of catastrophes in 1999 (including eight of over $1 billion)

Weak premium rates, to continue in 2000 late occurrence of December 1999 European storms

many multi-year contracts signed at 1/1/99 to cover Y2K issues

High Aviation claims

Retrocession recovery problems

Aon Group Limited

6

Why do insurers buy reinsurance?Why do insurers buy reinsurance?

Ancient

Widen book of business - quota share

Smooth earnings - excess of loss

Off balance sheet “fund”

Modern

Liquidity

Protect ratings & franchise

Balance sheet management

Enhance return on capital

Aon Group Limited

7

The landscape of risk is changing ...The landscape of risk is changing ...

Increasing exposures

Natural perils

40 of the fastest 50 growing cities are in earthquake zones

half off the world’s population lives in coastal regions, many of them exposed to the dangers of rising sea levels, repeated flooding and cyclones (World Disasters Report 1999)

Man-made perils

business interdependency

critical reliance on integrated IT (communications and processing) systems

brand values and reputation risk

Aon Group Limited

8

The landscape of risk is changing ...The landscape of risk is changing ...

Broadening view of risk

“Risk is Risk”

traditional insurance risks

growth of capital markets and derivatives or financial and market risks (interest rates, exchange rates, commodity prices, credit, weather)

operational risks (everything else - strategy, business, technology, legal, political, people, etc.)

Aon Group Limited

9

The landscape of risk is changing ...The landscape of risk is changing ...

Change in the financing of risk

(Re)Insurance does not appear to deliver:

clarity of cover

certainty of payment, timing and amount

… and has a high frictional cost

Increasing use of non-traditional forms of risk financing

growth of captives, blended solutions

Convergence with capital markets

catastrophe bonds

CatEPuts®

Aon Group Limited

10

Intellectual convergenceIntellectual convergence

Traditional Risk Transfer ART / ARF Traditional Risk Financing

Capitalmarkets

Insurancemarkets

Financial hedgesCat Bonds

SecuritisationContingent capital - CatEPuts

Guaranteed CostInsurance policy

Multi-line

ART solutions

Aon Group Limited

11

What does “Alternative” mean?What does “Alternative” mean?

Any mechanism used to substitute for traditional risk transfer products offered by re/insurers

A planned approach to financing risk involving:

Alternative risks not traditionally reinsurable

eg. interest rate or commodity exposure, brand image

Alternative structures, not reinsurance contracts

eg. weather derivatives, catastrophe bonds

Alternative markets, not Insurers or Reinsurers

eg. capital market entities such as pension funds, banks and fund managers

Aon Group Limited

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Common Objectives of ART BuyersCommon Objectives of ART Buyers

Risk retention

Efficient use of capital

Long term continuity and pricing stability

Specified historic / future loss problem smoothing

P&L insulation

Managing volatility and adding liquidity

Unlock potential profit in long tail exposures

Insurance of traditionally ‘uninsurable’ risks

Aon Group Limited

13

Common Solution Characteristics & FeaturesCommon Solution Characteristics & Features

Solution not product driven, with alignment of interests (tailored to match client needs & market appetite)

Multi-risk or aggregate nature of coverage (blending)

Finite, aggregate limits of liability (per occ, annual, term)

Multi-year contractual commitment

Profit sharing, often with investment income

Transparency

Converged Banking / Insurance / Capital techniques

Generally, reinsured’s upside (i.e. reinsurer’s downside) is limited in some way

Aon Group Limited

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Trends & Future Development of ARTTrends & Future Development of ART

Continued growth of many forms of self insurance (i.e. larger retentions, insurance co. captive formation, ‘finite’ risk programmes)

Increasingly buyers require flexible, bespoke, broader applications

Accountancy treatment, taxation treatment and legal contracts need to be analysed carefully

Techniques and instruments need to be fully tested in real circumstances

New deals are moving away from insurance principles of insurable interest and indemnity

Whilst market remains soft, low financial incentive for buyers to be too adventurous (current appear expensive)

Aon Group Limited

15

ART Markets: CharacteristicsART Markets: Characteristics The major financial organisations including

Professional (re)insurers

(ACE, AIG, Allianz, Axa Global Risks / Paribas, Bankers Trust, Chubb, Citicorp / Travellers, Custom Risk Solutions (RSA, Ace, Aon), ERC Frankona, General Re, Gerling, Liberty Re, Munich American Risk Partners, QBE, Scandinavian Re, Stockton Re, Swiss Re New Markets, Transatlantic Re, Winterthur / Credit Suisse, XL / Pareto, Zurich Centre Solutions)

Global carriers

Finance houses / merchant banks / capital markets

Strong balance sheets

Proven commitment to long term partnerships

Proven commitment to tailor-made (customised) solutions

Aon Group Limited

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Most Efficient use of Risk Capital ?Most Efficient use of Risk Capital ?

ML/

MY

Portfo

lio T

rans

fer

Fini

te R

isk

Identify risks and trading objectives

Perform risk analysis and evaluation of data

Quantitatively identify optimal solution

Who

le A

ccou

nt

Stop

Loss

Doubl

e Tr

igge

r

CatEPut

s

Placement and Negotiation

Traditional ARTCapital Markets

Retain

Surpl

usRis

k XL

Aggre

gate

XL

Quo

ta S

hare

Cat. X

L

Stop

Loss

Hybrid

Equ

ity

Sub In

sura

nce

Notes

Wea

ther

der

ivat

ives

Captiv

eBle

nded

Cat b

onds

Aon Group Limited

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Alternative Risk Transfer & Financing Alternative Risk Transfer & Financing Structures in Context - Annual PlacingsStructures in Context - Annual Placings

Capital Markets

Contingent Equity Programmes (CatEPutSM

) Catastrophe Bonds Integrated Risk (FX / Gradual Pollution)

Weather Derivatives / Commodities Blended / Multiple Trigger / Residual Value

Loss Portfolio Transfer

Multi-line / Multi-year

Captives

Motor / Property / Liability - QS,

surplus, risk & cat XL etc

Traditional (Re)Insurance

Millions

Thousands

Tens

Contracts Placed Annually Worldwide

Financing Cashflow

Insurance Risk Transfer

Aon Group Limited

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Developments in Insurance ARTDevelopments in Insurance ART

Self-insurance

Retrospectively rated plans (retros)

Captive insurance company, rent-a-captive and protected cell company

Finite or financial insurance

Multi-line, multi-year, aggregate or blended and integrated programmes

Enterprise-wide risk management

Aon Group Limited

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Developments in Reinsurance ARTDevelopments in Reinsurance ART

Financial reinsurance

Insurance derivatives

Contingent capital (debt and equity)

Double triggers

Catastrophe Bonds

Aon Group Limited

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Functions of financial reinsuranceFunctions of financial reinsurance

Smoothing of fluctuations in cedent’s loss experience over a period of years

Optimisation of balance sheet structure and reported ratios, such as solvency or reserve adequacy

Expansion of underwriting capacity, by ceding premiums and/or technical reserves

Increase in retentions

Facilitation of acquisitions, mergers and corporate restructuring

Aon Group Limited

21

Summary of financial reinsurance contractsSummary of financial reinsurance contracts

Type of contract Time dimension Type of risk Benefits

Loss Portfolio Transfer Retrospective Timing risk

Underwriting risk

Accelerate income

Discount reserves

Improve solvency

Adverse Development Cover(or retrospective aggregateexcess of loss)

Retrospective Underwriting risk

Timing risk

Credit risk

Transfer of aggregate risk

Finite (or Financial) QuotaShare

Prospective Surplus relief Increase capacity

Improve solvency

Spread Loss Treaty(or prospective aggregateexcess of loss)

Prospective Timing risk

Underwriting risk

Smooth and protect reportedannual results

‘Blended’ cover Prospective Underwriting risk

Non-traditionalrisks

Transfer risk of portfolioaggregation

Smooth and protect annualreported results

Aon Group Limited

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Insurance-linked securitisationInsurance-linked securitisation

Risk liquidity

Contingent Surplus Notes (CSN)

Catastrophe Equity Puts (CatEPuts)

Risk transfer

Chicago Board of Trade options

Double trigger

Catastrophe Bonds

Aon Group Limited

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Contingent Surplus Notes - CSNContingent Surplus Notes - CSN

Nationwide Mutual Insurance Company of Ohio, Surplus Notes deal in 1995

$400 million raised and deposited in trust fund

Noteholders receive returns equal to yield on government bonds plus 23/8%, but run risk of Nationwide drawing down cash from trust fund and converting into surplus notes (like preference shares)

Nationwide can draw funds down under wide conditions

Arkwright Mutual did similar $100 m deal in 1996

Aon Group Limited

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Contingent capital - CatEPutContingent capital - CatEPutSMSM

RLI Catastrophe Equity PutSM

3-year agreement brokered by Aon Re Services

RLI pays annual option premium to Centre Re

Trigger is major California quake, then:

Centre Re buys up to $50 million convertiblenon-voting preference shares in RLI

RLI pays annual dividends on preference shares

RLI converts preference shares into full-voting common equity after 3 to 4 years (but has option to repurchase at original issue price)

Aon Group Limited

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The CatEPutThe CatEPutSMSM Structure Structure

Cash

Option premium

Option rights

Common shares

Preferred shares

Before option exercised

When option exercised

At conversion date

RLI

RLI

RLI

INVESTOR

INVESTOR

INVESTOR

Preferred shares

Aon Group Limited

26

CatEPuts - featuresCatEPuts - features

Post-event capital negotiated at pre-event terms

Pre-event

option premium lower cost than traditional reinsurance

protects shareholder value

mitigates dilutive effects of upper layer reinsurance

Post-event

balance sheet recovery

favourable treatment by ratings agencies

no reinstatement

no profit & loss protection

Aon Group Limited

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Extract from RLI Corp. 1996 R&AExtract from RLI Corp. 1996 R&A

What are the benefits (of the CatEPut) to shareholders?

A: First, this is an extremely cost-effective level of security ... a

fraction of the price for a similar layer of reinsurance.

But by improving our ability to withstand a momentous

catastrophic event, we have also fortified shareholder value.

Even if such a disaster occurs, our earning power would

remain intact at its current level. Likewise the ability of RLI

to pay dividends and rise in value has also been shielded.

Aon Group Limited

28

Double Trigger - ExamplesDouble Trigger - Examples

European multi-line insurance company

suffered combined effect of not only poor returns from its stock and bonds investment portfolio, but also large underwriting loss

bought reinsurance programme that links retained losses to underlying financial criteria

CSAA reinsurance contract triggered by two elements

occurrence of a major catastrophe

fall in level of equity index

CLM reinsurance contract responds if CLM suffers from both a significant fall in the price of equities and adverse underwriting results

Aon Group Limited

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Catastrophe or “Act of God” BondsCatastrophe or “Act of God” Bonds

Issued by insurer (or corporate)

In the event of a pre-defined catastrophe bondholders may be forced to:

forfeit some or all of their interest repayments; or

forfeit some or all of their principal; or

delay/defer receipt of interest or principal

Aon Group Limited

30

USAA / Residential Re I (1997)USAA / Residential Re I (1997)

Raised $400 million in cover through private placement of $477 million in bonds by Residential Re, Cayman Islands

Oversubscribed by factor 2plus

Trigger was single US East Coast hurricane intensity 3, 4 or 5

Indemnity of 80% of USAA’s losses $500 m excess of $1 bn

Two tranches: A-1 $164 million principal protected, LIBOR + 273 bps

A-2 $313 million principal-at-risk, LIBOR + 576 bps

Aon Group Limited

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Investor base for USAA bond issueInvestor base for USAA bond issue

44%

12%

15%

18%3%

8%

Money managers

Mutual funds

Hedge funds

Life insurers

Reinsurers

Others

Aon Group Limited

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Done DealsDone DealsDeal

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

Date Completed

1994

June 1994

September 1994

September 1994

February 1995

Late 1995

April 1996

July 1996

October 1996

December 1996

December 1996

January 1997

March 1997

March 1997

June 1997

July 1997

July 1997

December 1997

Insured or Cedent

Hannover Re

FWUA (Florida Fund)

Florida RPC JUA

Nationwide

Arkwright

State Auto

Hannover Re

St. Paul (George Town Re)

Winterthur

Reliance

Horace Mann

USAA (Res'l Re)

Swiss Re

LaSalle Re

HHRF

AIG

RLI

Tokio Marine (Parametric)

Investors

Institutions

C Manhattan

Chemical Bank

J.P. Morgan

Institutions

Institutions

Institutions

C Manhattan

Centre Re

Institutions

Institutions

Institutions

Institutions

Centre Re

Institutions

Institutions

Swiss Re

Institutions

ML,GS,Lehman

Advisors

Citibank

Aon

None

None

J.P. M, SB

AIG

ML, MS

None

Aon

Citibank

GS

CSFB

Sedgwick

Aon

CSFB

Aon

GS, Swiss Re

Deal Description

Cat XL Retrocession

Cat Line of Credit

Cat Line of Credit

Cat Line of Credit

Contingent Surplus Notes

Cat XL

Contingent Surplus Notes

Catastrophe Line of Credit

CatEPut

Proportional Reinsurance

Property Surplus Share

Cat XL

Cat XL - Multi-line

CatEPut

Cat XL

Cat XL

CatEPut

Cat XL

Issue Size($ 000's)

85,000

500,000

1,000,000

1,500,000

400,000

10,000

100,000

100,000

50,000

100,000

50,000

130,000

40,000

100,000

400,000

122,000

100,000

90,000

Type

Risk Transfer

Contingent Capital

Contingent Capital

Contingent Capital

Contingent Capital

Risk Transfer

Contingent Capital

Contingent Capital

Contingent Capital

Risk Transfer

Risk Transfer

Risk Transfer

Risk Transfer

Contingent Capital

Risk Transfer

Risk Transfer

Contingent Capital

Risk Transfer

Perils Covered

PML Protection

Hawaii Wind

Florida Wind

Florida Wind

Surplus Protection

PML Protection

PML Protection

PML Protection

US Windstorm

European Hail

PML Protection

Florida Windstorm

California E’quake

PML Protection

Japanese E’quake

Aon Group Limited

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Done DealsDone Deals

Deal Date Completed Insured or Cedent Investors Advisors Deal DescriptionIssue Size ($

000's) Type Perils Covered

19 February 1998 RAM Re PMI Group, Inc. None LOC Credit Enhancement 40,000 Contingent Capital PML Protection

20 March 1998 Centre Re (Trinity Re) Institutions GS, Chase Cat XL 75,000 Risk Transfer

21 April 1998 Mitsui Institutions Swiss Re Cat XL - Swap 30,000 Risk Transfer Japanese Earthquake

22 May 1998 Reliance Institutions Sedgwick Option on Cat Notes 50,000 Risk Transfer

23 June 1998 CNA (HF Re) Institutions Hedge FinancialCat XL 85,000 Risk Transfer

24 June 1998 Arrow Re Goldman Sachs Direct Contingent Capital 300,000 Contingent Capital PML Protection

25 June 1998 USAA (Res'l Re II) Institutions ML, GS, LehmanCat XL 450,000 Risk Transfer Florida Windstorm

26 June 1998 Yasuda(Pacific Re) Institutions Aon Cat XL 80,000 Risk Transfer Japanese Wind

27 June 1998 AXA Re Institutions Axa / Paribas Cat XL 25,000 Risk Transfer

28 July 1998 USF&G (Mosaic Re) Institutions GS, EWB Cat XL 54,000 Risk Transfer US Wind and Earthquake

29 July 1998 XL Re Institutions GS, Aon Cat XL 100,000 Risk Transfer US Wind and EQ

30 September 1998 Toyota Motor Credit Institutions GS Residual Value Excess 566,300 Risk Transfer Res Value of Car Leases

31 December 1998 Centre Re Institutions GS, Chase Cat XL 54,000 Risk Transfer

32 December 1998 Allianz (Gemini Re) Institutions GS Option on Second Cat XL 150,000 Risk Transfer European Wind

33 December 1998 CNA Institutions Soc. Gen. Cat XL 25,000 Risk Transfer

34 January 1999 Horace Mann Centre Re Aon CatEPut 100,000 Contingent Capital PML Protection

35 January 1999 Constitution Re Re/Institutions GS, EWB Cat XL 10,000 Risk Transfer

36 February 1999 St. Paul Re (Mosaic Re II)Institutions GS, EWB Cat XL 45,000 Risk Transfer US Wind and Earthquake

37 March 1999 Kemper (Domestic Inc.) Reinsurers Aon Cat XL - Equity 20,000 Risk Transfer Mid-Western EQ

March 1999 Kemper (Domestic Inc.) Institutions Aon Cat XL 80,000 Risk Transfer Mid-Western EQ

38 March 1999 Gerling (SECTRS 1999-1)Institutions GS Credit Reinsurance 463,000 Risk Transfer European Credit Risk

39 April 1999 Sorema (Halyard Re) Institutions ML, Aon Cat XL 17,000 Risk Transfer Japan/US Wind and EQ

40 May 1999 Oriental Land (Concentric Ltd)Re/Institutions GS Cat XL 100,000 Risk Transfer Japanese Earthquake

41 May 1999 Oriental Land (Circle Maihama) Re/Institutions GS Extendible Debt 100,000 Contingent Capital Japanese Earthquake

42 May 1999 Intrepid Re Insurers Aon CatEPut 100,000 Contingent Capital PML Protection

43 May 1999 USAA (Residential Re III) Inst. Investors GS, ML, LehmanCat XL 200,000 Risk Transfer Florida Windstorm

44 June 1999 Gerling Institutions Aon, GS Cat XL 80,000 Risk Transfer US Wind and EQ

45 October 1999 Koch Energy Inst. Investors GS Weather Contracts 50,000 Risk Transfer Weather Risk

46 November 1999 American Re Inst. Investors AM Re, ML, SSBCat XL 194,000 Risk Transfer US Wind and Earthquake

47 November 1999 Gerling Institutions Aon, GS Cat XL 100,000 Risk Transfer Japanese Earthquake

Total capacity added 5,535,300

Aon Group Limited

34

What investors wantWhat investors want

Clarity of trigger mechanism

No moral hazard

Quality exposure data

Objective risk assessment

Rated investments

Liquidity

Diversification (low beta plus)

… and excess returns!

Aon Group Limited

35

What sellers wantWhat sellers want

Access to new source(s) of secure risk capital

Certainty of cover

Minimum basis risk

Contract structure - probably (re)insurance

Fair price, cost effective transaction

Confidentiality

Longer-term capacity and price

Strategic capital and balance sheet management

Aon Group Limited

36

Rethinking (re)insuranceRethinking (re)insurance

Product showing lack of growth

global non-life insurance premiums only grew by 0.2% in real terms in 1997 (Swiss Re)

Service not highly rated

insurers, brokers and other service providers all given ‘D’ grades in 1999 Quality Scorecard published at US RIMS in 1999

Risk is becoming a Boardroom issue (Cadbury, Greenbury, Hampel, Turnbull)

but insurance is not mentioned in corporate Report & Accounts

“Traditional insurance does not provide protection against 80% of risks faced by companies”

(Bob Cooney, XL)

Aon Group Limited

37

What risks are clients concerned about?What risks are clients concerned about?

2

2

5

5

7

7

9

14

21

25

30

34

0

0 5 10 15 20 25 30 35 40

Stress claims against employees

Genetically modified organisms

Claims against directs & officers

Currency risk

Class action

Credit risk

Climatic

Terrorism

Fraud

Intellectual property erosion

Brand/trademarks

System failure through Y2K

Loss of reputation

Per cent

Source: Airmic/Lloyd’s

Aon Group Limited

38

Rethinking (re)insuranceRethinking (re)insurance

Why do we limit ourselves to traditional property / casualty exposures ?

Microsoft

Market capitalisation US$ 400 billion

Plant, property & equipment US$ 1.5 billion

Cash US$ 14 billion

Reputation risk

Total value of FTSE 100 companies was £1.37 trillion in 1998

“Goodwill” accounted for 71% of total value in 1998 (44% in 1988)Research by Interbrand and Citibank

Aon Group Limited

39

Rethinking (re)insuranceRethinking (re)insurance

Why do we need insurable interest ?

Example

On 4th July 1993 the Sumitomo Chemical Company plant in Niihama, Japan exploded

Spot prices for computer memory chips rose by 50% because Sumitomo plant made 65% of the world’s supply of epoxy cresol novolac resin used to seal most computer chips into their plastic packages

Sumitomo can buy property and business interruption cover on their plant

Question

Why can’t any other economically interested parties, e.g. computer manufacturers, buy the same insurance policy on the same terms and conditions?

Aon Group Limited

40

Rethinking (re)insuranceRethinking (re)insurance

Why does cover have to indemnity-based ?

Example

Oriental Land, operators of Disney themepark in Japan, have borrowed to finance further development of the site

Any disruption to revenues from existing site will impair their ability to service this debt

Answer

Oriental Land have issued a catastrophe bond to the capital markets that pays up to $100 million in the event of an earthquake in the region around the themepark

Trigger is occurrence of earthquake

Payment amount determined by epicentre and size of earthquake

Aon Group Limited

41

Concentric Re - Parametric triggerConcentric Re - Parametric trigger

If the event happens then client is paid, regardless of whether he has actually sustained a loss or not

The pay out is linked to the epicentre and magnitude of quake in three concentric rings (JMA scale)

6.5 inner circle,

7.1 inner ring,

7.6 outer ring

TokyoChiba

Boso

Peninsula

Izu

Peninsula

Yokohama

Inner Circle

Inner Ring

Outer Ring

Malhama

Aon Group Limited

42

Illustrative Terms and ConditionsIllustrative Terms and Conditions

6.5 6.6 6.7 6.8 6.9 7.0 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9

0%

25%

50%

75%

100%

JMA Magnitude

Inner CircleInner Ring Outer Ring

Trigger: Physical, based on earthquake magnitude, location and depth• Magnitude - Sliding scale based on magnitudes > 6.5• Location - Three circles (Inner Circle, Middle Ring, Outer Ring) in the Southern Kanto region of Japan defined by latitude and longitude• Depth - Shallow earthquakes only, 60km or less• Reporting Agency - Japan Meteorological Agency (JMA)• Development period - [30] days

Aon Group Limited

43

Traditional Risk Transfer, ART & Capital Market Traditional Risk Transfer, ART & Capital Market Solutions should be considered in combinationSolutions should be considered in combination

FacultativeReinsurance

ExcessReinsurance

Surplus Share

Retention Cat Retention

4th Cat

3rd Cat

2nd Cat

1st Cat

ART Equ

ity

Deb

t

Capital Markets

Aon Group Limited

44

8 Devonshire SquareLondon EC2M 4PL

Direct tel: 020 7216 3400

Direct fax: 020 7375 1760

Email: alan.punter@aon.co.uk

Any questions?