1	Parametric Insurance: How it Compares with CAT Bond Alternatives (Comparing Apples with Oranges)
2	“Parametric Insurance”: How it compares with CAT Bond Alternatives Other than the largest companies in the world, most potential “corporate” issuers of cat bonds find that “minimum denominations” of $100 million + are too high to be economic. Many organizations are required to purchase “insurance” to comply with bond indenture agreements, lender requirements, and regulatory requirements. A new product, parametric insurance, addresses this problem.
3	Quick Review: Benefits of CAT Bonds as compared with Traditional Insurance Immediacy of loss payout, as compared with 3 years or more to settle a complex, multi-location conventionally-insured CAT loss with business interruption and indirect costs. Reduced credit exposure to insurer insolvency due to a major catastrophe. Ability to cover some exposures, such as earthquake deductibles, where conventional insurance capacity doesn’t exist, or where it may be severely over-priced. More-specific underwriting of risks that are highly-engineered, where the exposure of specific locations to CAT risks has been modeled through engineering analysis. Possibly a more-cost-efficient method of risk transfer, to the extent that the risks of loss to investors are within the range of loss from BBB-rated bonds and are not overly correlated with the risks of other CAT bonds.
4	What is “Parametric Insurance” Parametric insurance is an insurance policy that agrees to a “payout” to an insured entity if a prescribed type of event, within defined “parameters,” occurs during the policy period. The “payout” may be made, regardless of whether the degree to which the insured entity sustained loss or damage, as a result of an event that is within the prescribed parameters. Parametric insurance has many of the benefits of CAT bonds, including rapid claims settlement (within 45 days) and reduced exposure to insurer insolvency risk (having claims payment money in hand while the insurer’s loss estimates from an event escalate to the point of financial impairment). But parametric insurance also may be better-able than pure CAT bonds to satisfy requirements that “insurance” be purchased to meet bond indenture agreements, regulatory requirements, etc. And, parametric insurance may be available in “denominations” as low as $250,000 annual premium.
5	“Basis Risk” The difference between the amount of payout and the actual loss or damage sustained is referred to as “basis risk.” Such risk includes the possibility that insurance recoveries from a parametric program may exceed the amounts customarily received in connection with conventional insurance, or that there may be situations where actual loss has occurred but no recovery is available from a parametric program when one might have been available from a conventional program. Typically, the program is designed so that the “parametric payout formula” incorporated in the policy closely parallels the insured’s actual risk exposures, thereby minimizing basis risk. Some organizations prefer that insurance recoveries exceed the customarily-modeled amounts, so as to cover indirect costs of loss, which may be substantial. For them, some “basis risk” may be beneficial. When the delayed timing of recoveries from conventional insurance is considered, money in hand from a parametric program loss payout may be better than waiting for a potentially larger amount from a conventional program. Again, some basis risk may be beneficial, if it means receiving funds now, rather than waiting.
6	“Modeled Risk” Programs To “calibrate” the parametric payout formula to minimize basis risk, it may be helpful to perform CAT modeling of the insured’s CAT risk exposures, sometimes including “site-specific” models of its largest operations and locations. To compare the parametric insurance program’s modeled payouts against actual loss sustained, or conventional insurance loss recoveries, it is necessary to utilize the CAT model’s “event set” and the modeled loss for every insured location for every simulated event. Note: This information is not always available from [some of] the leading CAT modelers as part of their standard reporting of modeled results. In a “modeled risk” program, the Parametric Insurance policy loss payout formula is a simplification of the modeling algorithms used in the leading CAT models. For example: distance of each location from an earthquake’s rupture zone, magnitude of the earthquake, value insured at each location, and adjustments for soils conditions and building type/engineering.
7	Efficiencies in Reinsuring a Portfolio of Parametric Insurance Policies Insurers offering parametric insurance can benefit from aggregating a portfolio of such exposures and then “hedging” their portfolio exposure in the CAT bond market in a far more-efficient way that by purchasing traditional reinsurance. However, such a portfolio needs to mesh with investors’ “risk appetites” and preferably not be highly correlated to other available CAT bond offerings. The efficiencies which may be gained ought to flow back to providers of parametric insurance in the form of higher profits and to insureds in the form of reduced premiums.
8	Efficiency of CAT Bonds as Parametric Insurance Portfolio Hedges Expenses as a percentage of limits “insured” by a CAT Bond are as little as 5-7%, as compared with 30% for conventional insurance. The risk-taking premium (yield % over LIBOR) required by bond investors often is just 2%-5% over risk-free rates of return, for risks having a 1/50-1/100 chance of occurrence. This compares with risk-taking premiums charged by traditional reinsurers of as much as 20%-60%. Will the reinsurers in the audience please rise to defend themselves?
9	Selecting the type of program that fits your corporate risk preferences CAT bonds and private placements, as described by Mike Leybov of Willis, can be viable alternatives to conventional insurance and reinsurance for certain organizations. Whether they are your own “best” solution depends on such factors as your organization’s “risk profile” and “financial preferences.” Sometimes it makes financial sense for your organization to choose CAT bonds if the cost is higher than that of conventional insurance or reinsurance. I will focus on what are the most appropriate criteria which pertain to “YOUR organization,” and what decision framework and tools are commonly used to make such “apples-to-oranges” decisions.
10	CAT Risk? Where – How Frequent / Severe? (source: RMS.com)
11	Why pay more? Financial Instruments used to transfer risk, such as CAT Bonds, can cost MORE than “Traditional” insurance and reinsurance. Why, then, would you wish to consider these alternatives?
12	Because: Traditional insurance and reinsurance might not be available for the limits you need. At the higher limits, capacity might be available only from insurers whose chances of financial survival might be less than the event being insured. It might take years to settle a complex loss involving multiple locations, but your company or organization might need cash right away – and access to such cash might give you a competitive advantage.
13	and . . . Because Your Stock Price might slide due to the uncertainty of spending years to finalize a loss settlement for “indemnity”-triggered coverage. Your CAT risk exposures might be of a type that are “plain vanilla” for treatment with financial instruments. You might be investigating a full range of alternatives, including “going bare” and/or spending saved insurance dollars for risk reduction through better engineering.
14	Putting together the Pros and Cons So, how do you put all these considerations together, and make the best decision? To do so, you need to go back to a very basic frame of reference.
15	5-Step Process Organize your location and exposure data. Perform a preliminary evaluation and model of loss expectancy probabilities. Identify the areas of your risk where the most benefit can be achieved through an alternative approach. Identify, calibrate, and quantify the costs and payoffs of risk-finance alternatives that are feasible for the selected area of risk. Compare the alternatives, within an appropriate risk decision framework, using CAT modeling and stochastic models from the CAT model event set.
16	Decision Framework based on Shareholder Value: Earnings and Risk The value of shareholder investments typically are measured in ways that consider two factors: “Earnings” factor, consisting of the anticipated stream of future earnings, and The “R” factor, consisting of investors’ required rate of return, based on the perceived Risk Level attendant to the earnings projections. Seek Optimum tradeoff between risk and return, through active management of the “R” factor.
17	“Risk” from a Financial Perspective Financial theorists define risk as: Uncertainty as to achieving an Expected Outcome, observed through: Variability from an Expected Result.
18	Compare with Typical Insurance Definition of Risk “Risk” is not simply the “chance of loss.” All economic activities involve a certain amount of loss all the time. But if the losses are small and predictable, such “leakage” is not “risk.” “Risk” is the possibility that economic impacts will significantly deviate from “average.” Volatility, both on the upside and downside, creates uncertainty and lesser predictability of overall results. Such volatility is penalized by investors, who tend to be “risk-averse.”
19	Risk is Integral to all Economic Activity The VALUE of an investment, such as a company’s stock is: Based both on the Amount of the Estimated Future Earnings Stream, and the Degree of Uncertainty in realizing those estimated earnings.
20	Enterprise Valuation Formula The value of the firm equals the sum of future earnings, divided by the investors’ required rate of return (cost of capital), which depends on the degree of risk associated with the future earnings stream. i.e.: Value = S Earnings _year _1…..n Investors’ Required Rate of Return Investors’ required rate of return is a squared function of Risk (expressed as financial volatility. We call this R² - the “R Factor.”
21	Leveraged Effect of Risk In the V = E / R² formulation, it is clear that any small change in a firm’s risk level has a magnified effect on the firm’s overall valuation. This is because the effect of risk on share valuation is squared. In fact, the negative effect of perceived increases in risk may offset the positive effect of improved earnings. Conversely, the reduction in earnings resulting from lower-risk / lower return investments, or from costs of risk transfer, may improve overall valuation.
22	Effect of Risk Reduction on Share Value Cost of risk reduction through risk transfer reduces incremental earnings stream Benefit of risk reduction is reduction in the denominator of the equation – Investors’ required rate of return Net benefit is achieved if Earnings minus cost of risk reduction, divided by new (lower required rate of return) is higher than pre-risk reduction equation.
23	Example Before Risk Reduction: Present Value of $1 billion annual after tax income for 30-yr. horizon / .09 required rate of return = $10.27 billion. After Risk Reduction: Present Value of $.95 billion annual after tax income for 30-yr. horizon / .085 required rate of return = $10.61 billion, which is more than the value before incurring the cost of reducing risk. Decision: Yes, proceed with risk reduction.
24	Risk Management: Not about risk avoidance The difference between “risk aversion” and “risk avoidance” Enrique Sabater: The World Bank, Washington, DC “Sometimes we need to take more risk.” “Risk management is not about avoiding or getting rid of risk. It’s all about “managing” the risks we choose to assume, or which we have no choice but to undertake.” Good risk management decisions involve identifying risks, assessing their size and probability, and identifying alternative courses of action that have differing risk profiles.
25	Earnings consistency typically explains 25% of annual change in share price (Towers Perrin study)
26	Risk Decision-making Principal Risk Characteristics: Frequency of Loss Average Severity of Loss Degree of “Internal” Correlation with other risks Relative “External” (I.e. Insurance or Capital Markets) risk correlation. These factors affect the cost and benefit of risk transfer.
27	Measuring Tradeoffs
28	Risk Prioritization: Risk Maps
29	Which Alternatives to Evaluate CAT bonds: Minimum denominations of $100 million. More is better, to spread $5 million issuance cost over a broad base Difficult to structure a modeled trigger or a parametric trigger if assets at risk are diverse and widely spread. Requires faith in modeling (models are not good predictors if the epicenter of the event is “very close” to assets at risk) Private placements have lower minimum denomination and greater room for “negotiation,” so they may be viewed as a hybrid between conventional insurance and publicly traded CAT bonds. Credit enhancement and parametric loans address “some” of the deficiencies or conventional insurance, and may be less expensive than CAT bonds. Hybrid insurance programs with Parametric triggers Industry Loss Warranties, with one or more parametric triggers
30	Case Study: CAT Model Results for a Major Property Owner, with 300+ EQ-exposed locations
31	Case Study: Program Structure
32	Example of financial modeling, using CAT model event set and modeled loss for each location for each simulated event
33	Example of “Details” for a single simulated earthquake loss
34	Details of Parametric Payout Formula Calculation for a single simulated EQ event
35	Cost-exceedance Probability Analysis
36	Summarizing Relevant Financial Statistics
37	The Best Alternative is closest to the “Efficient Frontier”
38	Risk Measurement Statistical measurement of historical performance Stochastic Modeling / measurement of correlation effects through aggregation Sample tool: @Risk (Palisade Software – www.palisade.com) and Crystal Ball software CAT models, such as RMS, EQE, AIR, HAZUS GIS analysis of how individual locations would be affected by parametric triggers
39	Financial Modeling of alternatives
40	Modeling and Visualization of Site-Specific Risks
41	Using GIS to Analyze Risk Exposure
42	Map Views of locations and exposures
43	Objective Apply the best combination of risk management techniques, consistent with the optimum effect on the firm’s overall Value.
44	How to Contact Us
45	Speaker Biography: Allen Monroe Allen Monroe Founder and CEO, RiskINFO Allen Monroe is the founder of RiskINFO and RFactor, based in Larkspur, California. RFactor designs and implements unique risk-finance strategies and programs, supported by enterprise risk management technologies. Risk Technology Applications developed by RiskINFO include a recent Smithsonian Award nomination and the World Bank's Enterprise Risk Management Intranet. For 35 years, Allen specialized in risk finance consulting with major corporate clients. His responsibilities included: - Director of Insurance Managers Limited in Bermuda - President of Reed Risk Management in the U.S. - Senior Vice President of Reed Stenhouse - Vice President of Marsh & McLennan. During that time, he organized captive insurance companies and mutual insurers, with combined assets exceeding $1 billion. He developed many of the concepts currently employed in financial reinsurance, finite risk, and alternative risk finance. He coined the phrase "RMIS" (Risk Management Information System) and was the first to develop risk management systems that operate on “personal computers.” He was selected by RIMS to design its risk information system course curriculum. Allen received his degree in Economics from The Wharton School, majoring in Finance.