State of the Market - Linked Securities, Poised for Growth?

Larry McClure, FCAS – Senior Actuary, Travelers

1 What are Insurance-Linked Securities?

• Insurance-Linked Securities (ILS) are an asset class comprised of a number of financial instruments whose values are derived from insurance risk. •A Catastropp(he (“Cat” ) is a s pecific t ype of ILS that provides the s ponsor with collateralized, and often multi-year, reinsurance protection. – Sponsors are generally a primary insurer or reinsurer, but can also include governmental entities and corporations. – Cat Bonds allow sponsors to obtain reinsurance protection from a new pool of capital separate from traditional reinsurers. • Money managers, hedge funds, and pension funds represent a new pool of capital for insurers and reinsurers. – capital provides collateralized cover. • Investor capital sits in a segregated collateral trust account. If a covered event occurs, dedicated funds are available, virtually eliminating the credit risk inherent in traditional reinsurance. – Cat Bonds are “principal at risk” notes. If the triggering event occurs, the ’ principal amount is imperiled.

2 How ILS Emerged – A Brief History

• In 1992, Hurricane Andrew made landfall in Florida causing $15.5b in insured losses.

• The resulting shortage of reinsurance capacity prompted reinsurers, banks, and academics to investigate new ways of transferring catastrophe risk outside the traditional reinsurance capital pool.

• In 1997, Residential Re, the first catastrophe bond, was sold to capital market s i nvest ors, prot ecti ng USAA aga ins t the r is k o f a ma jor hurr icane.

• Since then, approximately $45 billion of cat bonds have been issued, providing protection to over 70 insurers, reinsurers, governments, and corporations for a multitude of risks.

3 Typical Cat Bond Structure

1 The sponsor (insurer or reinsurer) enters into a Investments financial contract with the Special Purpose Reinsurer 3 (SPR). Investment Principal 2 Investors purchase Earnings & Interest securities from the SPR 1 2 which simultaneously enters into a reinsurance Risk Premium Notes (or ) contract SPONSOR SPR INVESTORS with the sponsor. Contingent Cash Claim Pmt Proceeds 3 Proceeds from the securiiities o ffer ing are Investment Scheduled Not currently invested in high quality Earnings Interest “en vogue” as securities (typically US TED spreads Treasuries) and held in a (3 mo T-Bills to 4 LIBOR) are collateral trust. relatively small. Swap Could make a comeback if TED Counterparty spreads widen. (Optional) Investment 4 returns can be swapped fixed-for-variable to a LIBOR-based rate by a • Sponsors get collateralized reinsurance protection. swap counterparty • Investors get risk premium & investment income from collateral account

4 Cat Bond Triggers & Basis Risk • A variety of triggers can be used with Cat Bonds. The most common are: – Indemnity: Recovery based on the sponsor’s actual losses. – Industry Index: Recovery based on an industry loss amount, such as PCS. – Parametric: Recovery based on actual reported physical event (maximum sustained wind speed / central pressure). – Modeled Loss: Recovery based on modeling an acutal event using a pre- determined Cat model.

– The trend has been toward an increased use of indemnity triggers for Cat Bonds, largely due to an increased awareness of model risk (RMS v11) and growing, albeit not universal, investor acceptance of this trigger.

• Basis Risk: When a trigger other than indemnity is employed, there is a risk that the loss determined by the trigger will not align with the actual losses incurred by the Sponsor.

5 Historical and YTD Cat Bond Issuance

• Issuance peaked in 2007. 18, 000 17, 263 • Issuance dropped off in 15,677 2008-09 due to the 16,000 15,401 financial crisis, but market 14,866 14,044 was open and available, 14,000 13,691 albeit at wide spreads 8,801 • EtiEstimat es f or f fllull year 12,000 2012 are $5b to $7b 10,115 • 2012 includes the 10,000 11,138 9,019 largest single tranche 12,697 11,386 9,111 $mm issuance to date 8,000 4,419 (Everglades Re on behalf 6,441 of Citizens of FL) 6,000 4,644 • Prospects for renewed 4,595 3,941 period of expansion 4,000 8,462 2,801 2,206 based on high investor 2,379 3,502 5,696 1,884 5,025 4,580 demand for diversifying, 2,000 1,812 4,263 896 1,005 759 1,412 2,980 3,480 relatively high-yield asset 714 2,388 2,500 0 153 180 class. 714 742 825 1,125 967 990 1,143 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Issued Outstanding from previous years

As of Aug 31, 2012 SSiRCitlMktSource: Capital Markets Current year reflects year-to-date totals

6 Historical and YTD Cat Bond Issuance

Outstanding Cat Bonds by Peril

US Wind represents 70% 66% the largest peril in the ILS space, consistent 60% 58% with its position as the 54% 53% 50% most capital intensive 50% peril in the global re- /insurance markets 40% 40% 38% Diversifying perils Percent 29% achieve tighter Exposed 30% spreads and appeal to to Peril investors whose 20% 17% 18% investment guidelines 13% 11% require them to be 10% 8% 4% diversified within their 2% 3% 2% 1% 0% ILS portfolio 0%

Source: Swiss Re Capital Markets. As of Aug 31, 2012 with percentages calculated based on notional amount. Percentages will not add due to multiple perils included in most bonds

7 Cat Bond Triggers Outstanding

Catastrophe Bond Trigger Breakdown Sponsors have increasingly looked at (Natural Catastrophe Bonds Only) idindemn ittiity triggers in the pas t year, as they

look to minimize their basis risk. Hybrid 4% MITT 2% ($550mm) ($240mm)  Industry index is still the largest trigger Modeled Loss outstanding, but is waning 6% ($885mm) Industry Index Parametric 40%  Traditionally, index-based transactions Index 12% ($6,323mm) have typically priced tighter than indemnity ($1,822mm) transactions

 However, an indemnity trigger will offer a sponsor the lowest basis risk in a cat bond

Indemnity 37% ($5,793mm)

Source: Swiss Re Capital Markets. As of Aug 31, 2012 with percentages calculated based on notional amount

8 Cat Bond Investor Segmentation

Investors by Type Investors by Region

Insurer Reinsur er 3% Canada Australia 6% 1% 1% Japan Dedicated 3% US 47% 59% 14% Bermuda 11%

Bank 8%

Eur ope Money 25% Manager 22%

As of Aug 31, 2012 Source: Swiss Re Capital Markets

9 Why Consider Cat Bonds? • Sponsor’s Perspective – Cat Bonds… – are collateralized, thus no concern about counterparty credit risk – offer an alternate source of capacity – can provide structural features that traditional reinsurers may find challenging, such as aggregate covers, 2nd event covers, drop down covers, etc. – provide multi-year pricing / capacity stability

• Investor’s Perspective – Cat Bonds… – pp(gy)rovide investors with an assets class that is (largely) uncorrelated with more traditional assets classes (equities, corporate/government bonds), thus cat bonds are generally regarded as a diversifying assets class – provide attractive risk-adjusted yields, especially in the current low interest rate environment – have experienced relatively low volatility (to date)

10 State of the Cat Bond Market

• Cat Bonds represent a small, but growing, component of the risk transfer space. • Most large primary insurers and reinsurers have utilized ILS capacity in some form, with many coming back for additional capacity. – ILS in the form of Collateralized Reinsurance comprises a large portion of the retrocessional market. • Investor demand is high, especially for non-peak exposures, attributable, at least in part, to the persistent low-interest-rate environment. – Investors are searching for yield and are willing to look at new asset classes. – The diversifying nature of Cat Bonds within many investors’ portfolios also increases demand. – Investors are becoming more comfortable with indemnity triggers , which are favored by many sponsors. • Sponsor supply is growing steadily, but likely will not be sufficient to meet investor demand without siggpggnificant price tightening. • Market-makers continue to investigate new perils & geographies, but these seem unlikely to close the supply/demand gap in the short run.

11 Case Study: Long Point Re III Ltd.

• In June 2012, Travelers successfully sponsored Long Point Re III Ltd. Series 2012-1, its first indemnity cat bond – Travelers had previously sponsored two PCS-based transactions

• Long Point Re III covers certain Travelers business units for Hurricanes in certain Northeast states

• The Subject Business for the transaction includes the Personal Insurance segment as well as the Select Accounts and Commercial Accounts business units of the Business Insurance segment – Business units which cover large and/or unique exposures are excluded from the Subject Business – Feedback from investors was that they liked the "main street" nature of subject business

12 Long Point Re III Ltd. Series 2012-1 Notes Class A Summary Terms

Ceding Company: The Travelers Indemnity Company (and several of its affiliates)

Original Principal Amount: $250,000,000

Initial Modeled Trigger Probability(a): 097%0.97%

Initial Modeled Exhaustion Probability(a): 0.77%

Initial Modeled Expected Loss(a): 0.88%

MdliModeling Fi rm: AIR

Risk Period: June 7, 2012 to June 7, 2015

Trigger: Indemnity, per occurrence

Covered Event: Hurricane

Covered Area: Connecticut, Delaware, District of Columbia, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont, Virginia

Rating (S&P): BB+ sf

Collateral: Treasury Money Market Funds

Investor Spread: 6.00%

(a) As estimated by AIR, sensitivity case (Warm Sea Surface Temperature Conditioned Catalogue)

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