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PCS Third-Quarter 2012 Catastrophe Bond Report:

The Calm before the Fourth-Quarter Storm
By Gary Kerney Assistant Vice President Property Claim Services

Catastrophe bond issuance tends to slow down in the third quarter, and this year is no exception. While third-quarter use of the PCS® Catastrophe Loss Index as a trigger is up when compared with the same period last year, overall issuance has slowed, largely because less capacity for European natural catastrophe perils has come to market. Despite what is likely a brief pause in transactions exposed to European natural catastrophes, the global insurance-linked securities (ILS) community seems to expect catastrophe bond issuance to approach or surpass the record-setting $7 billion level we saw five years ago. Capital exposed to U.S. natural catastrophe risks — which account for the vast majority of outstanding catastrophe bond exposure — has grown significantly year over year. And sponsors and investors continue to apply the lessons they’ve learned over the past 15 years to managing risk and capital more effectively.

PCS ACTIVITY IN THE CATASTROPHE BOND MARKET
According to data from the Artemis.bm Deal Directory, insurers and reinsurers issued approximately $4.1 billion in catastrophe bonds during the first nine months of 2012, up from $2.9 billion in the first nine months of 2011. Nineteen catastrophe bond transactions have closed so far this year, up from the 16 completed in the same period in 2011. Issuance of bonds exposed to U.S. hurricane risk is rare in the third quarter. The quarter coincides with hurricane season, and by then most insurers and reinsurers have completed their capital management planning and execution for U.S. hurricane exposure. Artemis reports that more than 70 percent of all outstanding catastrophe bond capital has exposure to U.S. hurricane risk. Consequently, overall issuance tends to be light, with only a few thirdquarter deals, usually for U.S. earthquake and European exposure. Early in the third quarter of 2012, Queen Street VI Re used the PCS Catastrophe Loss Index for the U.S. hurricane risks in its portfolio. (It also covers European windstorm.) In total, the transaction amounted to $100 million. The company’s remaining catastrophe bonds had indemnity triggers and covered European windstorm and California earthquake. The European catastrophes are outside the scope of PCS activity, and the risk profile of the California earthquake exposure is not the right fit for the PCS Catastrophe Loss Index. So far this year, insurers and reinsurers have used the PCS Catastrophe Loss Index in 10 transactions, up 43 percent from the first nine months of 2011. Raised capital is up 42 percent from 2011. Insurers and reinsurers used the Index in 53 percent of all transactions so far this year — and in 67 percent of catastrophe bonds exposed to U.S. natural catastrophes — by number of transactions.*

*Some of the transactions included in this estimate cover a number of perils or geographies in addition to U.S. natural catastrophe.

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9 Months 2012 PCS trigger use ($ billions) PCS trigger use (number of transactions) Total issuance ($ billions) Total issuance (number of transactions)
Sources: PCS, Artemis Deal Directory

9 Months 2011 1.2 7.0 2.9 16.0

1.7 10.0 4.1 19.0

PUBLICLY MANAGED ENTITY CATASTROPHE BONDS
In the third quarter of 2012, insurers and reinsurers used the PCS Catastrophe Loss Index in 25 percent of catastrophe bond transactions exposed to U.S. natural catastrophes. The Embarcadero Re 2012-2 transaction, sponsored by the California Earthquake Authority (CEA), was a $300 million indemnity-triggered catastrophe bond, accounting for the remaining 75 percent. Embarcadero Re transactions use an indemnity trigger because of CEA’s unique risk profile — based on market factors and policyholder concentrations — for which the PCS Catastrophe Loss Index probably would not be appropriate. Since the beginning of 2012, insurers and reinsurers have used the PCS Catastrophe Loss Index in transactions valued at $1.7 billion — or 50 percent of the $3.4 billion in transactions exposed to U.S. natural catastrophes.** Of that $3.4 billion, $1.3 billion came from indemnity-triggered bonds. Thus, insurers and reinsurers used the Index in 81 percent of the transactions where industry-loss triggers were an appropriate alternative.

**Again, some of the transactions cover a number of perils or geographies in addition to U.S. natural catastrophe.

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CATASTROPHE BOND MODELING TRENDS
Throughout 2012, catastrophe bond sponsors have increased their use of Verisk’s AIR Worldwide to model the risk profile of their transactions. The AIR models estimate: • the probability of attachment — that is, the probability that a bond will trigger • the probability of exhaustion — the probability that a bond will suffer a complete loss • the expected loss As of September 2012, sponsors around the world have used AIR Worldwide in 100 percent of public transactions exposed to property risk. That’s up from 76 percent of the deals completed during the same period in 2011. So far this year, AIR Worldwide has provided modeling services for transactions valued at $3.8 billion, compared with $3.1 billion for all of 2011 and $1.6 billion for 2010. Already, the use of AIR Worldwide has grown 238 percent in two years, and that does not include transactions in the anticipated busy fourth quarter this year. Percent of Risk Capital Raised Using AIR Worldwide Modeling Services

100 80 60 40 20 0

2010
*Through August 2012

2011

2012*

CATASTROPHE-TRIGGERED CONTINGENT EQUITY CAPITAL
When a catastrophe strikes, the ability to absorb losses is only one side of the challenge insurers and reinsurers face. In the wake of significant losses, carriers often need to raise equity capital, and that can become an expensive proposition in certain economic climates. The absence of a plan for post-loss recapitalization is itself a risk — but one that insurers and reinsurers can mitigate. By using contingent equity capital transactions — supported by trusted, reliable triggers — carriers can plan for the worst and return promptly to business as usual.

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Contingent equity capital allows insurers and reinsurers to generate common equity capital when a particular event occurs. The “triggering” event can range from the declaration of a macroeconomic event by a regulator to aggregate annual catastrophe losses of a predetermined amount. Carriers can also use a combination of triggers to customize their protection. A recent contingent equity capital transaction completed by Scor, for example, includes an indemnity trigger for catastrophe losses as well as a trigger based on a decline in share price of a given amount (based on a daily-volume-weighted average). Contingent equity capital deals can provide an important source of post-loss liquidity, allowing insurers and reinsurers to return quickly to writing business. Yet the industry has not widely adopted such deals. The reasons for not doing so may vary, but a potential factor does stand out: the triggers themselves. The indemnity triggers in contingent equity capital transactions are certainly attractive to issuers, but they may not resonate with investors. When left to their own devices, issuers can over-allocate losses to catastrophes, ultimately hitting trigger levels sooner. In some cases, that could mean sticking investors with the bill for suboptimal underwriting. To remedy the situation, issuers could structure contingent equity capital facilities to include only losses from PCS-declared catastrophes. Several catastrophe bonds already do that. While some room for moral hazard remains, using PCS-declared catastrophes provides increased protection for investors. To mitigate moral hazard still further, issuers may want to use the PCS Catastrophe Loss Index instead of an indemnity trigger. The Index, which has been an important part of the catastrophe bond market for more than 15 years, uses PCS catastrophe loss estimates to determine when to issue common equity, eliminating the need to rely on issuer data. The determination to trigger the bond comes from an independent and trusted third party, resulting in another layer of investor protection. As the contingent equity capital market evolves and achieves wider adoption among insurers and reinsurers, it will have to demonstrate flexibility to meet a broad range of issuer needs. The catastrophe bond market has succeeded because it has demonstrated such flexibility, along with the ability to cover a number of perils with several triggers for varying amounts of time. The contingent capital market shows the same potential, particularly when you look at the covered risks in Scor’s transaction, which include seaquake (or underwater earthquake), winter weather, and asteroid impact, among others. Added flexibility could come from using the PCS Catastrophe Loss Index to provide perevent protection, rather than just aggregate annual loss, and from customizing triggers to reflect industry loss estimates by peril and region in the United States and Canada. Carriers would be able to customize their post-loss recapitalization plans to align specifically with certain types of catastrophes — a significant step forward for strategic capital management.

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EXPECTATIONS FOR THE FOURTH QUARTER
The fourth quarter tends to be busy, and December is usually a very active month for catastrophe bond issuance. Transactions are already in the pipeline, and speculation continues about whether 2012 will match or exceed the $7 billion in 2007. Hurricane season has almost two months left, and strong winds can swiftly invalidate today’s assumptions. Other catastrophes could strike as well, drastically changing sponsor attitudes, investor appetite, and overall capital availability. Nonetheless, the reinsurance industry has clearly committed itself to the use of catastrophe bonds for risk transfer, suggesting strong issuance levels this quarter and next year — absent a market-changing event. In the end, risk bearers vote with their capital, and so far, their support of the catastrophe bond market has been significant — and growing. The market has seen the convergence of traditional reinsurance and insurance-linked securities. Rather than make that distinction in the future, carriers are likely to perceive capital as capital, evaluating the different forms to construct targeted and effective strategies for capital optimization.

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© Insurance Services Office, Inc. 2012. ISO, the ISO logo, Verisk Analytics, and the Verisk Analytics logo are registered trademarks and Verisk, Verisk Insurance Solutions, and the Verisk Insurance Solutions logo are trademarks of Insurance Services Office, Inc. Property Claim Services and PCS are registered trademarks of ISO Services, Inc. AIR Worldwide and the AIR Worldwide logo are registered trademarks of AIR Worldwide Corporation. Xactware is a registered trademark of Xactware Solutions, Inc. All other product or corporate names are trademarks or registered trademarks of their respective companies.

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