Adapting to an Evolving Market

Transcription

1 Adapting to an Evolving Market redefining Capital Access Advocacy Innovation

2 Aon Benfield Securities, Inc. and Aon Benfield Securities Limited (collectively, Aon Benfield Securities ) provide insurance and reinsurance clients with a full suite of insurance-linked securities products, including catastrophe bonds, contingent capital, collateralized reinsurance, industry loss warranties, sidecars and derivative products. As the most experienced investment banking firm in this market, Aon Benfield Securities offers expert underwriting and placement of new issues, financial advisory services, as well as securities trading in the secondary market. Aon Benfield Securities integration with Aon Benfield s reinsurance operation expands its capability to provide analytics, modeling, rating agency, and other consultative services. Securities advice, products and services described within this report are offered solely through Aon Benfield Securities, Inc. and/or Aon Benfield Securities Limited.

3 Aon Benfield Securities Foreword I am pleased to present the second annual Aon Benfield Securities review of the insurance-linked securities market. Insurance-Linked Securities 2009 offers a distinctive analysis of this dynamic sector and should prove an indispensible resource for anyone with an interest in the market. Like most financial markets, insurance-linked securities (ILS) have been affected in many ways by the recent global economic disruption. This publication addresses the impact of that disruption and reviews the ILS market in that context. Over time, the ILS market has provided much-needed capital to the insurance industry. Our analysis illuminates the resilience of the ILS market and our expectation of its continued importance to the insurance and reinsurance industry. Our 2009 edition offers the following: Comprehensive review of the catastrophe bond market Review of Aon Benfield Cat Bond Indices performance, providing insight into ILS returns compared to both previous periods and other investment benchmarks Analysis of the ILS investor base Analysis of related ILS instruments, including industry loss warranties, sidecars and collateralized reinsurance structures Analysis of diversification opportunities in the non-u.s. ILS market Thorough explanation of credit risk management and its application to the insurance industry Aon Benfield s annual review of the Insurance-Linked Securities market was launched in 2008, and rapidly emerged as the industry s premier analytical work. We are pleased by your response, and look forward to continuing to offer this service for the advancement of our industry. For convenient reference, you can find this and future editions at I welcome your thoughts and suggestions, which you can share with an to paul.schultz@aonbenfield.com. Paul Schultz President, Aon Benfield Securities 3

4 Insurance-Linked Securities 2009 Contents 5 Aon Benfield Securities Annual Review of the Catastrophe Bond Market Market-driven adaptation positions industry for a bright future 15 Aon Benfield Cat Bond Indices Unparalleled insight into ILS market returns 18 The Buy Side A review of ILS investor activity 22 Related Markets Industry Loss Warranties, Sidecars and Collateralized Reinsurance 28 Diversification Opportunities Outside the United States Moderating portfolio concentration in U.S.-based perils 32 The Developing Frontier of Credit Risk Management Credit Default Swaps explained 39 Appendix I Catastrophe bond issuance statistics 44 Appendix II ILS market transaction summary 4

5 Aon Benfield Securities Aon Benfield Securities Annual Review of the Catastrophe Bond Market Market-driven adaptation positions industry for a bright future Unprecedented economic events have affected all financial markets, and the ILS market has been no exception. In addition to the general dislocation of financial markets, structural concerns and rising prices of ILS securities adversely affected volumes. And yet, in an extraordinarily challenging environment, the ILS market demonstrated a remarkable ability to adapt something that will certainly continue as the market continues to grow and evolve. Issuance Review The importance and resilience of the catastrophe bond market can be demonstrated by the $25 billion of capital provided since its beginning. New issuance declined over the last 12 months from $5.8 billion to $1.7 billion despite the maturity of more than $4 billion in bonds. The combination of these effects resulted in a decline in the total amount of bonds on risk to $11.4 billion. During the annual period to June 30, 2009, some sponsors either delayed plans to issue bonds or cancelled them altogether. Considering the economic environment and the resulting activity, the ILS market continued to provide an important source of capital to the insurance industry. CATASTROPHE BOND Volume, (Years ending June 30) 30,000 25,000 $ Millions 20,000 15,000 10,000 5, Bonds On Risk Cumulative Issuance Source: Aon Benfield Securities 5

6 Insurance-Linked Securities 2009 Capital constraints among investors, resulting primarily from impaired investment portfolios, created a hurdle in the form of the higher risk premiums demanded. In addition, since catastrophe bond market values did not decline as much as other sectors, some funds adhering to a fixed percentage diversification strategy found themselves overweight (particularly in the U.S. hurricane category) and were unable to add more cat risk. Due to price sensitivities of sponsors, the majority of new issuance in the first half of 2009 experienced attachment probabilities above 1.25%. Still, looking back over the recent two-year decline, 12-month volumes remained higher than in CATASTROPHE BOND ISSUANCE BY YEAR (Years ending June 30) $ Millions 8,000 7,000 6,000 5,000 4,000 3,000 3,124 7,003 5,815 2,000 1,000 1, ,558 1,137 1, Source: Aon Benfield Securities In the second half of 2008, the bankruptcy of Lehman Brothers and Lehman Brothers Special Financing left four notes (Carillon Ltd. Series 1 Class A, Ajax Re Limited Series 1 Class A, Willow Re Series Class B, and Newton Re Series Class A) without a viable total return swap counterparty. While each transaction had been thoroughly documented, none of them anticipated the sudden demise of a swap counterparty coinciding with a market dislocation that impaired the underlying collateral. Further, the prevailing documentation did not prescribe appropriate remedies for investors or sponsors in the absence of a replacement swap counterparty. Consequently, only two transactions were completed in the second half of 2008, comprising a total issuance of just $320 million: Allianz sponsored another iteration of the Blue Coast Ltd. transaction for $120 million in July (Allianz s first transaction in 2007 was named Blue Wings Ltd.), and Platinum Underwriters Bermuda Ltd. sponsored $200 million under the Topiary Capital Limited transaction in August. 6

7 Aon Benfield Securities After a six-month impasse, the market began a resurgence in February 2009, with nine transactions successfully completed through June 30, The first deal entering the market during this period was the $200 million Atlas V Capital Limited. This represented the fifth offering sponsored by SCOR and contained three tranches with U.S. hurricane and earthquake exposures. In response to collateral management concerns following the Lehman bankruptcy, this transaction used a total return swap with permitted investments limited to cash, government securities, money market funds and FDIC-guaranteed bank debt. In stark contrast to previous transactions that allowed investments with maturities of up to 45 years, new transactions required far shorter maturities. The Atlas V Capital Limited transaction, for example, capped collateral maturities at just five years. CATASTROPHE BOND ISSUANCE BY HALF-YEAR 8,000 7,000 $ Millions 6,000 5,000 4,000 4,455 2,410 3,000 2,000 1, , /6 2, /7 3, /8 1, /9 Jan - Jun Jul - Dec Source: Aon Benfield Securities In the second quarter of 2009, the Allianz-sponsored Blue Fin Ltd. Series 2 Class A Notes saw the emergence of a new form of collateral without the need for a swap counterparty. The issue s proceeds were invested in medium-term notes structured specifically to match the transaction s tenor. These notes were issued by KfW (Kreditanstalt für Wiederaufbau), supported by the Federal Republic of Germany. Investors welcomed the new form of collateral, and the deal was upsized from $150 million to $180 million. 7

8 Insurance-Linked Securities 2009 CATASTROPHE ISSUANCE BY TRANCHE / DEAL / SPONSOR (Years ending June 30) Tranches Issued Deals Issued First time Sponsors Source: Aon Benfield Securities Two new sponsors entered the catastrophe bond market in the 12 months though June 30, 2009: Platinum Underwriters Ltd. with Topiary Capital Limited, and Assurant with the two-tranche $150 million Ibis Re Ltd. transaction. U.S. hurricane and earthquake perils dominated the issuances completed during this period. Of the eleven transactions issued in the 12-month period, three were exposed solely to U.S. hurricane risk, while seven others covered both U.S. hurricane and earthquake risk. Ianus Capital Ltd., sponsored by Munich Re, was the only Euro-denominated catastrophe bond issued. This 50 million transaction covered exposure to European windstorm and Turkish earthquake risk. CATASTROPHE BOND ISSUANCE BY YEAR AND PERIL (Years ending June 30) 8,000 Notional Limit Issued by Peril ($ Millions) 7,000 6,000 5,000 4,000 3,000 2,000 1,000 1, ,558 1,137 3,124 7,003 5,815 1,705 U.S. Hurricane U.S. Quake Euro Wind Japan Quake Asia Pacific Other Source: Aon Benfield Securities 8

9 Aon Benfield Securities Transaction Structure Resolution As noted, credit-related concerns of investors, sponsors and rating agencies led to the scrutiny and eventual resolution of three categories of structural issues. Collateral Management and Investment Structures To ensure the integrity of collateral supporting the obligations of the issuer, market participants recognized the need to narrow the definition of permitted investments. Investors called for restrictions on the types of permitted investments, frequency of their valuation and concentration to single exposures. The primary market began implementing innovative solutions to these issues during the first half of In cases where a total return swap continued to be used, counterparties were expected to meet minimum ratings criteria and to replace collateral that failed to meet enhanced guidelines. The improved structures sought to minimize counterparty credit risk, which resulted in a shift away from leveraged financial institutions managing loosely defined collateral pools. Although total return swaps had been standard for cat bond transactions, sponsors and investors were encouraged to consider alternative structures, including money market funds and notes backed by a government entity. The following table details the collateral management solutions employed this year: CATASTROPHE BOND COLLATERAL MANAGEMENT (Year ending June 30, 2009) Collateral Issue Structure Assets Atlas V - 1 Atlas V - 2 Atlas V - 3 Total Return Swap TLGP, UST Mystic Re II 2009 Total Return Swap TLGP, UST East Lane Re III Total Return Swap TLGP, UST Ibis Re A Ibis Re B Total Return Swap TLGP, UST Blue Fin 2 Medium-Term Notes KfW Ianus Capital Medium-Term Notes KfW Calabash Re III A Calabash Re III B Medium-Term Notes IBRD Successor II F-IV Money Market UST, Cash Residential Re Residential Re Residential Re Money Market UST, Cash Legend: TLGP: Temporary Liquidity Guaranty Program UST: U.S. Treasury KfW: Kreditanstalt für Wiederaufbau IBRD: International Bank for Reconstruction and Development Source: Aon Benfield Securities 9

10 Insurance-Linked Securities 2009 Transparency, Documentation and Oversight Regardless of the investment structure chosen, investors also demanded greater transparency through more extensive reporting on collateral trust investments. To reduce uncertainty and improve transparency, recent transactions have disclosed both primary and subsequent transaction documents. A new standard now exists for the indenture, reinsurance/ counterparty contract and collateral documents to be made available via secure online portals, ensuring all investors have immediate access to pertinent information as it becomes available. Investors also demanded that documents clearly specify, in the event service providers ceased to be available, how their replacements would be engaged. Although some scenarios had not been contemplated in the past, the replacement mechanics had always been clearly defined. As a result, the documentation of this process has improved substantially. Finally, outside agents must now validate collateral management, reporting, compliance, performance, and reporting. Credit Risk Management Recent market events have given insurers and reinsurers a heightened awareness of their credit exposures. While catastrophe bonds bear credit risk through the investment portfolio, investors (and potentially sponsors) also face the credit risk associated with service providers such as the swap counterparty or collateral manager. These risks are generally managed through structure and documentation. Other credit risk management techniques such as credit default swaps are also available, but are not widely used at present. 10

11 Aon Benfield Securities Recovery Trigger Trend The recovery trigger for catastrophe bonds is often categorized into four distinct groups: parametric, industry loss, modeled loss, and indemnity. Of the four triggers, indemnity often requires the greatest amount of risk premium (although price variations exist among recovery triggers based on the line of business composition and the geographic exposure concentration). While indemnity bonds offer sponsors the purest mitigation of their risk portfolios and the least amount of basis risk, investors in indemnity bonds face a higher degree of uncertainty. This includes uncertainty from the ongoing management, underwriting and claims policies of the sponsor. From , the ILS market witnessed a surge in the proportion of indemnitytriggered catastrophe bonds issued. The height of this trend was reached in 2008, when a record 47 percent of all catastrophe bonds issued during the year used an indemnity trigger ($2.75 billion of the total $5.82 billion issued). The financial market disruption reversed that trend. In fact, the percentage of indemnity transactions issued in 2009 fell to 23 percent of the total ($400 million of $1.71 million in total annual issuance). The dramatic change reflected investors unease with the complexity of indemnity transactions compared to more quantifiable structures. Also at issue was a lack of knowledge of less-creditworthy or less-recognized sponsors. In a new era marked by a demand for greater transparency, the indemnity trigger proved less popular with investors. Catastrophe Bond Issuance versus Percent Indemnity (Years ending June 30) Risk Transfer ($ Millions) 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, , , Cat Bonds 7,003 5,815 3,124 1, % Indemnity Issued 1, % 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Percent of New Issuance with Indemnity Loss Trigger Source: Aon Benfield Securities 11

12 Insurance-Linked Securities 2009 Catastrophe bond Issuance By Loss Trigger (Years ending June 30) Indemnity Multiple 25% 4% 14% 16% 41% Modeled Loss 19% 4% 5% 47% 23% Source: Aon Benfield Securities In contrast, the 12-month period ending June 30, 2009 has seen heightened interest in industry loss index-triggered transactions. In this period, 41 percent of transactions were on an industry loss-based index, compared to only 14 percent in the same period in At the same time, there were no transactions with exclusive parametric or parametric index structures, as the market experienced an increase in the percentage of multiple trigger bonds issued (a number of which included components of the parametric or parametric-index structures). 12

13 Aon Benfield Securities Securitized Life Risk While catastrophe bonds have grown substantially since the mid-1990s, the market for securitized life risks continues to develop. Representative life-based security transactions over the past decade have included XXX regulation, extreme mortality and embedded value. More recently, we have seen a number of longevity risk transactions come to the market. Improvements in life expectancy have had a negative impact on entities bearing longevity risk. Longevity risk reflects the uncertainty in future life expectancy and, specifically, the risk that an individual or group of individuals lives longer than expected. Entities with economic exposure to longevity risk include pension funds, annuity writers and life settlement investors, as well as the U.S. Social Security Trust Fund and comparable institutions worldwide. All of these entities increasingly face larger liabilities than previously anticipated, as pensioners and annuitants outlive and outlast the assets previously set aside for them. The recent market change has further underscored pension woes. Before 2007, high equity investment returns helped mask the challenge presented by increasing life expectancy. Recently, however, poor equity returns and low interest rates have left pension plans significantly underfunded as liabilities soar while pension assets erode. In recent years, pension funds have increasingly sought mechanisms to hedge their longevity risk. One new development in this area is the emergence of capital markets solutions using longevity swap structures. Since January 2008, there have been four capital markets transactions involving longevity swaps or derivatives: RECENT LONGEVITY SWAP DEALS Sponsor Issuance Year Value ($ MM)* Canada Life Lucida Norwich Union Babcock Total 2,629 * Transactions in non-us Dollar currencies were converted to US Dollars based on prevailing rates at time of issuance. Source: Aon Benfield Securities Longevity swaps involve the exchange of agreed-upon cash streams between the sponsor (the entity with the existing pension liability) and a counterparty. The sponsor pays the counterparty a fixed rate ( fixed leg ) with monetary payment tied to estimated projections of future payments. These payments are based on agreedupon mortality risks in the underlying portfolio. To make the transaction worthwhile to the counterparty, the sponsor pays an additional risk premium in excess of the fixed rate. In return, the counterparty makes periodic payments on a floating basis ( floating leg ) dependent on actual mortality rates experienced by the underlying portfolio. In essence, the sponsor transfers the longevity risk to the counterparty who effectively assumes responsibility for the actual payment stream associated with the sponsor s pension liabilities. 13

14 Insurance-Linked Securities 2009 Structural premise of Longevity swap Pensioners in Reference Portfolio Actual Annuity Payments Cedent (Sponsor) Actual Annuity Payments* Est. Annuity Payments + Risk Premium + Costs/Fees Counterparty * Subject to a cap and floor Source: Aon Benfield Securities All four transactions to date have focused on the U.K. pension market, where legislative changes have amplified the need to seek longevity risk transfer solutions and where the legal and regulatory landscapes made transactions more feasible. In an effort to drive greater transparency, the United Kingdom has implemented new accounting rules over the past several years that require sponsors to disclose pension plan deficits. In addition, regulators have begun forcing pension fund managers to take a more active stance regarding longevity risk. While the market for longevity swaps is still emerging, many observers and participants agree it is poised to grow, with anticipated U.K. market growth in the range of 5 10 billion over the next several years. These projections are supported by studies suggesting that pension liabilities for private companies within the United Kingdom exceed 1 trillion. Companies are more actively seeking ways to transfer longevity risk and reduce the volatility of their balance sheets caused by the financial market disruption and increased regulatory scrutiny. Following the completion of the first-ever longevity swap involving a U.K. pension fund (by Babcock in the spring of 2009), interest in this market continues to grow, and for now pricing is aggressive given the current level of capacity. 14

15 Aon Benfield Securities Aon Benfield Cat Bond Indices Unparalleled insight into ILS market returns In an extraordinarily challenging investment environment, the ILS sector outperformed most asset-backed securities and provided positive returns over the past year, inclusive of the mark-to-market losses resulting from the effects of Lehman swaps. Performance lagged the previous year, however, due to the effects of the global economic crisis. The Aon Benfield Cat Bond Indices offer investors the best means of tracking ILS market performance. These indices represent the return an investor would have achieved by allocating a weighted amount of capital to each cat bond available in the market on a sector-by-sector basis. To define the market and form the basis for our total return calculations, we use the monthly indicative bids tabulated by Aon Benfield Securities. Indicative bids are derived from Aon Benfield Securities trading experience, combined with the results of a proprietary model that analyzes market dynamics and seasonality on a category-by-category basis. Aon Benfield Cat Bond Indices sectors follow conventional market segments: Asia/Pacific, Europe, Multiperil, North American Earthquake, and North American Wind. We also segment the market between investment-grade and non-investment-grade, given the disparity of returns for each of these markets. Aon Benfield Securities calculates each group of indices by considering the following components: Mark-to-market change for each ILS Coupon returns for each ILS LIBOR returns for the period Individual securities contribute to the total return for the sector on a weighted basis by issue size and days on risk. For example, an ILS that has been on risk only half the quarter will not contribute as much as an identical issue that was on risk for the entire quarter. Aon Benfield Cat Bond Indices As a market, insurance-linked securities provided a total return of 3.89 percent for the year ending June 30, 2009, down from percent the previous year. Individual sector returns for the 2009 period were lower in all cases than those observed in the 2008 period. These lower returns can be primarily attributed to mark-to-market losses across all perils. The mark-to-market principal losses were more than offset by interest income. 15

16 Insurance-Linked Securities 2009 Aon Benfield Cat Bond Indices (June 30, 2009) Twelve Months Ended Six Months Ended ILS SECTOR 6/30/2009 6/30/2008 6/30/2009 6/30/2008 Asia/Pacific 4.13% 8.96% 5.68% 3.87% Europe 6.12% 6.99% 6.24% 3.92% Multi-peril 4.47% 9.96% 2.91% 3.56% N.A. Earthquake 1.95% 10.28% 6.71% 4.73% N.A. Wind 2.29% 12.53% 2.64% 3.76% Investment Grade ILS 2.66% 4.69% 0.55% 0.60% Non-investment Grade ILS 4.15% 11.38% 4.23% 4.59% ALL ILS SECTORS 3.89% 10.12% 3.59% 3.84% BENCHMARKS 3-5 Year US Treasury Notes 7.14% 10.67% (2.34%) 2.28% 3 Year US Corporate BB+ 6.85% 6.46% 10.04% 3.96% S&P 500 (26.21%) (14.04%) 3.16% (11.91%) ABS 3-5 Yrs, Fixed Rate (2.54%) (5.91%) 11.52% (6.34%) CMBS Fixed Rate 3-5 Yrs (0.59%) 5.56% 11.87% 0.28% Source: Aon Benfield Securities Aon benfield cat bond indices by sector (Years ending June 30) 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% 6/30/2005 6/30/2006 6/30/2007 6/30/2008 6/30/2009 Asia Pacific Europe Multi-peril North American Quake North American Wind Source: Aon Benfield Securities 16

17 Aon Benfield Securities In the recent period, European bonds posted the strongest performance, followed by Multi-peril, Asia/Pacific bonds, North American Wind and North American Earthquake. These returns generally followed the relationship between expected losses and reinsurance rates as a whole, in which the Multi-peril sector offered the highest returns. Performance was also influenced by mark-to-market losses in each sector. For instance, bonds in the European Wind and Asia/Pacific sectors performed relatively well because none of the bonds in these sectors were impacted by the Lehman bankruptcy. In contrast, the North American Earthquake sector posted the lowest returns due to mark-to-market losses experienced by investors in the Ajax bond which represented a substantial six percent of the total U.S. earthquake market. In an investment climate where many asset classes provided little if any diversification benefit, ILS performance clearly demonstrated the uncorrelated nature of ILS risks, as insurance-linked securities provided solid growth in contrast to the severe credit-driven correction experienced by the equity markets. What will the next year offer? As in the past, investors can anticipate a combination of variables to affect the Aon Benfield Cat Bond Indices. Prevailing reinsurance rates will play a key role as sponsors consider the economics of reinsurance compared to ILS issuance. We expect strong returns as the cat bond market softens and existing issues benefit from mark-to-market gains a trend that seems to have already begun as the first half of 2009 ended. 17

18 Insurance-Linked Securities 2009 The Buy Side A review of ILS investor activity In the third quarter of 2008, investor appetite for catastrophe bonds remained strong, facilitating the successful placement of both the $120 million Blue Coast Ltd. transaction and the $200 million Topiary Capital Ltd. transaction. Investors expected a very active primary market in the fourth quarter, with up to $1 billion of European windstorm bonds combined with the annual Redwood renewal, replacing approximately $500 million of the expiring Redwood X bonds. Due to the financial dislocation in the broader markets, however, none of the expected issues materialized. Instead, both sponsors and investors withdrew from the market. As credit markets dried up, leverage that was once available for the purchase of cat bonds was withdrawn, in part due to the collapse of storied Wall Street investment banks like Bear Stearns and Lehman Brothers. The reduction in leverage required investors to fund the entire notional value of their positions. Many investors did not have capital to support their positions and were forced to reduce exposure. This deleveraging, coupled with fund redemptions, sparked widespread secondary selling across the cat bond market. Aon Benfield Securities secondary trading desk experienced record trading volume throughout the financial crisis and worked with investors to find available liquidity. Cat bond prices declined to sustained levels of the mid 90s, but maintained better pricing levels than nearly all other sectors. Most heavy selling came from multi-strategy hedge funds, although several market participants were well-positioned to capitalize on the distressed prices and purchased cat bonds at substantial discounts. Despite the disruption, the secondary market for cat bonds remained relatively liquid throughout this period. Lehman s bankruptcy also left investors directly exposed to the market value of the principal, a prospect that further dampened investor interest through year-end. Primary market effects were further compounded by fund redemptions across the investor spectrum. In the first quarter of 2009, buyers remained hesitant to purchase secondary bonds and required thorough due diligence on collateral accounts and transaction documents. In addition, investors demanded compensation for the credit risk of the swap counterparty. Secondary trading, driven primarily by selling, remained at historically elevated levels until the middle of the first quarter when the final overhang of excess bonds finally cleared the market. Coincidently around this time, the primary market began to open up and investors shifted their focus to new issues. All eyes were on the SCOR-sponsored Atlas V Capital Limited issuance in February, the first bond to market after a six-month hiatus. Investors focused on the bond s structure and, in the end, the transaction enjoyed broad market support as investors came together to make the transaction a success. 18

19 Aon Benfield Securities Atlas V Capital Limited was followed by seven straight transactions covering U.S. hurricane exposure. The drawback of multiple U.S. hurricane-exposed cat bonds was that some investors exceeded their targeted allocation to this specific risk. While investors welcomed the Ianus Capital Ltd. transaction, which offered exposure to European Windstorm and Turkey Earthquake, tight pricing tamed interest in the bond and the proposed 100 million transaction stalled and was subsequently downsized to 50 million. Overall, eight of the nine recent issues were sponsored by seasoned issuers who regularly tap the capital markets as an important source of reinsurance capacity. Segmenting the Cat Bond Investor Market Investor by type (% of new transactions) PRE CREDIT CRISIS POST CREDIT CRISIS Cat Funds Hedge Funds Institutional 20% 4% 36% 18% 13% 40% Reinsurers Mutual Funds 33% 7% 29% 2007 & Source: Aon Benfield Securities A review of investors in transactions managed by Aon Benfield Securities reveals that much has changed. The most drastic and startling change for the annual period ending June 30, 2009 is that hedge fund participation has quadrupled, taking market share from both reinsurers and institutional investors. In this period, hedge funds comprised 29 percent of the investor base, compared to just 7 percent one year earlier. Although one might assume hedge fund selling in the secondary market would translate into decreased participation in the primary market, quite the opposite has occurred. Despite the exit of some hedge funds from the catastrophe bond market, rising risk premiums have caused other hedge funds to enter the market in a manner not seen since the months following Hurricane Katrina. Although reinsurer participation fell from 20 percent to 13 percent for Aon Benfield Securities transactions, the average number of reinsurers investing in cat bonds remained relatively unchanged. Reinsurers will continue to find opportunities to invest in the ILS space, which is evidenced by the number of reinsurers that have established or plan to establish dedicated cat bond funds. 19

20 Insurance-Linked Securities 2009 Institutional investor participation in Aon Benfield Securities transactions declined from 33 percent to 18 percent, while mutual fund participation vanished altogether after representing four percent of the investor base last year. Investors in both categories have deployed substantial capital across all sectors of the fixed income and broader markets, and systematically analyze and monitor their portfolio concentrations. This process has led both groups of investors to two conclusions. First, distressed debt opportunities were perceived to be so attractive during the past year that, on a relative value basis, investors view catastrophe bonds as less desirable than other opportunities even after considering the diversification benefits of insurance-linked securities. Second, since catastrophe bond market values did not decline as much as other sectors, funds adhering to a fixed percentage diversification strategy found themselves overweight and unable to add more cat risk. Despite these temporary setbacks, catastrophe bonds continue to be an important asset class for institutional investors. Aon Benfield Securities expects their participation to return to pre-disruption levels as the broader market recovers. Dedicated funds continue to be a force in the market, rising to 40 percent of the investor base for Aon Benfield Securities transactions in the period. By definition, these investors have all of their capital dedicated to the ILS space; being overweight in this asset class is not a concern. Nor would they pare back ILS investments to pursue distressed debt or other opportunities. Instead, dedicated funds increased their participation in primary and secondary offerings, expecting the market to soften and, consequently, benefit from mark-to-market gains. Considering the number of start-up funds currently attempting to raise capital, Aon Benfield Securities expects participation from dedicated investors to grow. An increase in the number of new funds will present a good barometer of the continued importance of this asset class in the broader market. A Geographic Overview Investor By Country (Years ending June 30) U.S. PRE CREDIT CRISIS 9% POST CREDIT CRISIS 6% 5% Bermuda Switzerland UK Other* 12% 13% 21% 45% 14% 19% 56% 2007 & * Other includes Germany, Canada, Norway, Italy, France and Australia. Source: Aon Benfield Securities 20

21 Aon Benfield Securities The geographic distribution of investors in Aon Benfield Securities transactions has not experienced drastic change since last year. Over the year ended June 30, 2009, U.S. investors still held the greatest share of new cat bonds issues at 56 percent, versus 45 percent the prior year. Bermuda, Switzerland and the United Kingdom follow next with 19, 14 and 6 percent, respectively. As we observed in last year s ILS review, few Asia Pacific investors have yet to enter the cat bond market in a meaningful way. Nonetheless, this market continues to interest investors and sponsors, and Aon Benfield Securities is in the process of establishing an office in the region to develop this market s potential. Outlook: Capital Inflow Aon Benfield Securities sees many positive signs in the market. Although redemptions became a regular occurrence in the fourth quarter of 2008 and the first quarter of 2009, these requests were largely satisfied. In the second quarter of 2009, investors began to find success in raising capital, and indicated they were experiencing net inflows. In May, the Aon Benfield Securities trading desk experienced more buyers than sellers a welcome reprieve from the heavy selling activity of the prior six months. Demand is high for 2009 vintage bonds containing improved collateral structures and increased transparency; investors began to bid over par for certain bonds during June Leverage has started to return to the market as some banks are now extending credit for cat bonds, albeit at a comparatively high price. Several new investors have entered the space, including traditional fund of fund players and family offices investing directly in bonds. Taken together, these signs seem to indicate the tide has turned. Assuming a loss-free year, Aon Benfield Securities expects catastrophe bond risk premium will decrease 10 to 15 percent by the 2010 renewals. 21

22 Insurance-Linked Securities 2009 Related Markets Industry Loss Warranties, Sidecars and Collateralized Reinsurance In times of crisis, it is often said that one should go back to basics that is, to concentrate efforts on those elements of business which are best understood. Largely, that maxim has been reflected in investor appetites and behaviors since October The liquidity provided by the secondary market in catastrophe bonds allowed investors the opportunity to exit positions or, alternately, to take advantage of attractive prices to acquire catastrophe bonds. Also during this time, new issuance favored non-indemnity triggers. Similar trends were evident in the related insurance and reinsurance markets of index-based trading, sidecars and collateralized reinsurance, with capital favoring simpler structures, well-defined underlying risks and higher returns. ILW & Industry Loss -Based Trading Of all the ways investors can access direct exposure to catastrophe risk, contracts based on industry loss estimates offer low barriers to entry in terms of transparency, required expertise, market knowledge and structural complexity. Buyers value the speed of execution and lack of required portfolio disclosure, while heightened basis risk presents the primary hurdle. The majority of these transactions are structured as Industry Loss Warranty contracts (ILWs) in the traditional reinsurance space. They are often structured between two reinsurers, but can use a transformation or collateralization approach when capital is provided by a hedge fund or other investor. In May 2009, the International Swaps and Derivatives Association (ISDA), which maintains standard language for institutional derivatives contracts, released a standard form for a U.S. hurricane catastrophe swap. This ISDA initiative aims to standardize catastrophe swaps to facilitate increased volume and liquidity. Where insurers and reinsurers have historically preferred to effect index-linked transactions in reinsurance form, several have executed swap transactions directly with counterparties from outside the insurance arena. This structure holds some appeal for those who wish to acquire significant limits discretely. Catastrophe swaps are accounted for as derivatives. Because today s catastrophe swap markets are relatively illiquid, parties apply U.S. GAAP for insurance liabilities when booking these transactions. However, if swap markets deepen and become more liquid in the future, reference prices may become more readily available and reliable, bringing mark-to-market variation to cat swap transactions. 22

23 Aon Benfield Securities Time Evolution of IFEX B and 20B Event-Linked Future Contract Pricing IFEX ELF Quoted Closing Price $ price per $100 closing price EQE Sep 19, updated estimate onshore loss 8-12bn 5 PCS Preliminary Estimate Sept 30 USD 8.1bn 6 RMS Sep 17, updated estimated onshore and offshore loss USD, 7-12bn 4 20 Hurricane Ike Landfall Sept 13; EQE Sep 13, estimated onshore loss USD 8-18bn 1 0 June-08 July-08 Aug-08 Sep-08 Oct-08 RMS Sep 14, estimated onshore and offshore loss USD 6-16bn 3 AIR Sep 13, estimated onshore loss 8-12bn 2 Nov-08 Dec-08 Jan-09 PCS 3rd estimate Feb 3 USD 11.5bn 9 PCS 2nd estimate Dec 5 USD bn 8 RMS Oct 24, updated estimated onshore and offshore loss USD 13-21bn 7 Feb-09 Dec08 1E10B Dec08 1E20B Estimate Dates Source: Prices (Chicago Climate Futures Exchange Estimates (Various)) 1 EQECAT Initial Post-Landfall Estimates of Insured Onshore Losses from Hurricane Ike, EQECAT press release, Sept. 13, AIR Worldwide Estimates Insured Losses to Onshore U.S. Properties from Hurricane IKE at between USD 8 Billion and USD 12 Billion, AIR Worldwide press release, Sept. 13, Hurricane Ike Could Cause $6 Billion to $16 Billion of Insured Damage According to Initial RMS Estimates, RMS press release, Sept. 14, Hurricane Ike Insured Losses Estimated at $7 Billion to $12 Billion, RMS press release, Sept. 17, EQECAT Narrows Range of Estimated Onshore Insured Losses from Hurricane Ike Based Upon Reconnaissance- Team Reports, Review of Storm s Characteristics, EQECAT press release, Sept. 19, news/2008/ike_9-19_08_refinedloss.htm 6 Property Claims Services Inc Catastrophe Insured Property Damage Estimates, 7 RMS Revised Hurricane Ike Industry Loss Estimate to $13 to 21 Billion, RMS press release, Oct. 24, Property Claims Services Inc Catastrophe Insured Property Damage Estimates, 9 Ibid. 23

24 Insurance-Linked Securities 2009 The potential for such variation may be illustrated using data from exchange-traded catastrophe futures contracts. The chart on the previous page shows how the prices of the IFEX $10 and $20 billion 2008 U.S. Tropical Wind event-linked futures contracts varied from before Hurricane Ike s landfall in September 2008 through February During this time, PCS and catastrophe modeling companies produced various estimates of the actual losses that would eventually be calculated by PCS. These actual losses are the values upon which these contracts settle, and the estimates play an important role in shaping market expectations. As the magnitude of the loss from Ike became clear, pricing on the $10 billion contract rose quickly from the high 30s to the mid 80s. The pricing on the $20 billion contract fell from the high 20s to the high teens, until traders realized the loss was unlikely to reach the $20 billion level at that point, the contract s pricing began a decline to zero. Pricing on the $10 billion contract experienced some volatility in the initial phase of loss estimation and then tracked upwards, trading at a slight discount by the end of the period shown. Exchange-traded cat futures and options platforms have seen limited growth since our last update, while the platforms themselves and their supporters have seen several changes. The CME and NYMEX platforms merged in August 2008, bringing together their respective Gallagher Re-Ex and Carvill Hurricane (CHI) products. Subsequently, Aon Corporation acquired Gallagher Re, and the CME Group bought the CHI index from Carvill, renaming it the CME hurricane index and selecting EQECAT as the calculation agent. All platforms have experienced limited market depth and volume, with the vast majority of industry index-based transactions continuing to be placed on an over the counter (OTC) or brokered basis. It remains to be seen whether the role of event-linked futures and options in the reinsurance space will progress beyond its current niche position. Several potential applications provide some potential, including the ability to hedge or speculate on pricing. Although the ILW product arguably enjoys the greatest degree of standardization among all catastrophe reinsurance products, investors and reinsurers without financial strength ratings still generally need to agree upon collateral release conditions and execute trust agreements (or other suitable mechanisms such as letters of credit) with their cedents. This leads to great variation in the precise mechanics of each individual market transaction. This variation worked to the detriment of unrated providers in early June 2009, as rated reinsurers who had excess capacity after the June 1 renewal season entered the market as sellers of ILW capacity on a reinsurance basis providing a product with greater ease of execution to the marginal buyer of ILW capacity. The additional capacity provided by rated entities contributed to a recent reduction in the pricing of U.S. ILW products relative to the capital-constrained start of

25 Aon Benfield Securities Sidecars Historically speaking, the sidecar market has provided almost $11 billion of capital to the market. The effects of Hurricanes Gustav and Ike last year, combined with asset write-downs resulting from the financial markets dislocation, led to an overall drain on reinsurers balance sheets estimated at the equivalent of 18 percent of pre-crisis shareholders funds 10. This erosion of capital sparked a contemporary increase in sponsors demand for sidecars and sidecar-like structures. Typical Sidecar Structure Sponsor Reinsurance Contract Ceded Premiums Sidecar Reinsurance Trust Accounts Interest Bank Loan Proceeds Debt Investors Equity Investors Equity Proceeds Dividends Equity Proceeds Sidecar Holdings Dividends Security Interest in Shares Source: Aon Benfield Securities Typical Sidecar Structure with Leverage A typical sidecar structure is shown in the figure above. The attractiveness of the structure for the three principal participants equity investors, debt investors and the sponsor depends on the returns available to each. Many investors concluded volatility in the financial markets had created the potential for returns greater than the mid 20s level typical of sidecars created in 2007 and Equity investors increased their required returns on sidecar-like structures to more than 30 percent on an internal rate of return basis. With the increased cost of debt leverage in the bank loan markets, and lower expectations for growth in reinsurance rates-on-line, 10 The Aon Benfield Aggregate, June

26 Insurance-Linked Securities 2009 sidecar capacity became scarce and sometimes non-existent during the recent twelve months. This generally reduces the attractiveness of a transaction to the sponsor. Together, these factors made it more difficult than in the recent past to create a structure that satisfied the parties required returns, and severely limited the classes of business that would be amenable to supporting such a structure moving into 2009 hurricane season. During the year ending June 30, 2009, several sidecar renewals were rumored to have been pursued before ultimately being withdrawn. Renaissance Re s $60 million Timicuan Reinsurance II Ltd, a sidecar primarily covering Florida hurricane risks for the Bermuda company s customers, was one of a small number of successful issuances for the 2009 hurricane season. Hannover Re and Swiss Re placed the latest iterations of their K (K6 at 129 million) and Sector (Sector Re III) transactions, respectively, and the MAP, Hiscox, Ark and Amlin Lloyds syndicates raised a total of 160 million external capital to fund Special Purposes Syndicates (effectively sidecars within Lloyds) to support their ongoing business. Potential sidecar sponsors also turned to the traditional reinsurance markets looking for quota share retrocession, but generally found a similar lack of available capacity. As a result, many reinsurers planned to reduce net lines as we entered the peak hazard season on June 1, Collateralized Reinsurance The convergence of the reinsurance and capital markets continues to be reflected by greater emphasis on collateralized reinsurance in cedents traditional reinsurance programs. The collateralized reinsurance market gained new capacity from Juniperus Capital, Alphacat Re, Cartesian Iris Re, additional funds raised by Pentelia Capital Management and Steamboat Re. It also benefited from the continued support of Aeolus Re, DE Shaw Re and Nephila, among others. As buyers of collateralized protection have become more familiar with this mechanism, events in the broader financial markets have driven greater appreciation for the benefits of collateralized coverage and a preference for safer assets in the trusts used to secure the reinsurance obligations. New York Regulation 114 Permitted assets in a Reg. 114 compliant trust are specifically limited to the following asset classes: Cash (USD) CDs issued by U.S. bank U.S. Federal or State obligations U.S. corporate debt obligations which are either i) secured by collateral, ii) rated A or better, iii) insured by an Aaa-rated insurer, or iv) carry highest possible rating by the NAIC SVO Preferred shares of U.S. firms if all of their debt obligations are rated A or better Common stock of U.S. firms, if all of its obligations are eligible as investments under Section 1404 of the New York Insurance Law and it is registered under the Securities Exchange Act of 1934 Investment companies which invest 90% or more of their assets in the asset classes described above 26

27 Aon Benfield Securities In the past, New York Regulation 114 was the industry standard for permitted trust assets. However, the general approach today is to accept only cash, Treasuries and other government guaranteed assets. Restrictions on the degree of portfolio concentration in a single asset class or single issuer are also frequently imposed. In addition, letters of credit may still be used, although cedents are closely monitoring the aggregation of financial institution counterparty credit risk in the wake of the Lehman bankruptcy. Hurricane Ike also provided a valuable test of collateralization agreements for several cedents. While incurred losses alone may not have been enough to pierce layers of protection, the collateral release language typically provided for the assets to be maintained in the trust beyond the expiration of the risk period in the event of a loss large enough to impact the layer after further development. Generally, these clauses appear to have provided acceptable security to cedents, although the market still supports a wide variety of different forms and mechanisms for this process. Notable among the departures from the collateralized reinsurance market was CIG Re, sponsored by Citadel Investment Group, the well-known Chicago-based hedge fund. In November 2008, Citadel announced the intention to close CIG Re, citing a high cost of capital and difficulty in competing with rated entities. (New Castle Re, CIG Re s A.M. Best-rated sister entity, remained open, but renewal rights were sold to Torus Insurance Holdings in December 2008.) The highly visible difficulties of Citadel s main investment funds related to the financial market dislocation following October 2008 were partially responsible for reducing the firm s appetite for the asset class. In an April 2009 presentation at the Federal Reserve Bank of Chicago, Citadel COO Gerald Beeson made specific reference to the effectively closed securitization market, naming it as a contributing cause of this high cost of capital. 11 Summary Despite the disruption of the capital markets in October, the catastrophe risk securitization and related markets have taken several positive steps that paved the way for the return of capital to the cat bond space. This capital has been used to provide collateralized reinsurance coverage, support sector-specific hedge funds and fund index trades as well as less complex securitization structures. As the broader financial world returns to equilibrium, we expect these markets will continue to expand their robust contribution to the reinsurance industry. 11 Future of Financial Innovation, Citadel presentation to Financial Institutions Risk Management Conference, April 14,