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Guide to the Alternative Market September 2015


Guide to the Alternative Market – September 2015

Table of Contents Disclaimer 1

Purpose 2

Introduction to the Alternative Reinsurance Market 2

Traditional reinsurers vs collateralized reinsurers 3

Insurance-linked securities (ILS) 4

Catastrophe bonds 4

Industry loss warranties (ILWs) 6

Sidecars 7

Other ILS (swaps, derivatives) 7

Insights of the Collateralized Reinsurance Market 8

Parties involved in collateralized reinsurance transactions 8

Collateral requirements to protect ceding insurers 10

Collateral funding 12

Collateral release 13

Coverage differences between collateralized and traditional reinsurance 14

Reinsurance contract clauses unique to collateralized reinsurance transactions 15

Aon Benfield Assistance with Alternative Market Transactions 16

Additional Information & Contacts 17

Appendix I: The Collateralized Reinsurance Transaction 19

Appendix II: Collateralized Reinsurance Risk-Bearing Entities in Bermuda 21

Appendix III: Alternative Market Definitions 23


1 Guide to the Alternative Market – September 2015

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Purpose

Aon Benfield believes that collateralized reinsurers and / or Insurance-Linked Securities (ILS) may be a viable part of a well-structured reinsurance program. Despite a track record of paying claims, the risk of alternative market transactions is still somewhat untested and unknown. Additionally, there may be significant differences in the coverages and practices of alternative markets.

The purpose of this guide is to:

Provide an introduction to the alternative market

Identify the key issues and potential sources of risk of collateralized reinsurance transactions

Suggest ways ceding insurers may potentially mitigate the risks of collateralized reinsurance transactions

Introduction to the Alternative Reinsurance Market For years the reinsurance market has been dominated by traditional reinsurers. In traditional reinsurance transactions, ceding insurers rely on the reinsurer’s promise to pay claims. Traditional reinsurers publicly release financial statements so potential ceding insurers can assess their operating performance and balance sheet strength. They also secure interactive financial strength ratings from one or more of the most prominent rating agencies (e.g. A.M. Best (Best), Fitch, Moody’s and Standard & Poor’s (S&P)).

The non-traditional or alternative market is relatively new so there is some inconsistency in the naming of the market and its participants. We generally use the terms “markets” and “reinsurers” interchangeably. “Markets” are individual reinsurers, while the “market” refers to the reinsurance market as a whole.

Aon Benfield would define the alternative markets as all the non-traditional reinsurers. This includes reinsurers who provide collateral to support their participation on a reinsurance agreement. These “collateralized reinsurers” are typically unrated and do not publicly release financial statements. The alternative market also includes entities that issue catastrophe bonds and other ILS. Alternative markets may specialize in collateralized reinsurance, ILS or both.

The alternative markets represent the fastest growing segment of the reinsurance market. A growing number of capital market investors are interested in the reinsurance market primarily because these investments are largely uncorrelated to the broader capital markets. Investments in the reinsurance market provide diversification to their overall portfolio and may also offer higher rates of return than other investments. Third party investors are willing to invest without any representation (i.e. seats on the Board) in the company. Most of the investments are via open funds, to allow investors to withdraw funds periodically (subject to negotiated redemption policies). These investors typically enter the reinsurance market through investments in entities that offer ILS or collateralized reinsurance. To further explain the alternative market, it may be easier to divide it into two categories based on the type of product offered:

1. Catastrophe bonds (cat bonds), Industry Loss Warranties (ILWs), sidecars and other ILS transactions (e.g. derivatives, swaps)

2. Collateralized reinsurance



Below is a high level depiction of the traditional and alternative markets.

Traditional reinsurers vs collateralized reinsurers Traditional reinsurance arrangements rely on a “promise to pay” and therefore expose clients to counterparty credit risk. The intention of many collateralized placements is to reduce this risk by placing the full limit (potentially less the premium) in a single beneficiary trust or securing the limit via a Letter of Credit (LOC), for the benefit of the ceding insurer. The collateral should be secured before the inception of the corresponding reinsurance agreement. Certain practicalities can make this difficult to achieve and a number of additional considerations are highlighted throughout this document.

Another key difference is that the counterparty to the collateralized reinsurance transaction is likely to be an unrated, lightly regulated company with minimum capitalization. Typically, financial results for collateralized reinsurance counterparties are not available publicly. These differences contrast with traditional reinsurance counterparties, who are typically rated, release public financial statements and are subject to higher levels of regulatory scrutiny.

Also, the coverages offered by collateralized reinsurance counterparties may not be the same as those provided by traditional reinsurance counterparties. Unlike traditional reinsurance, many collateralized reinsurance contracts have a limited claims development period. As always, ceding insurers must read and understand the terms of the agreements they intend to sign in order to understand how these issues are addressed.

Lastly, there are a handful of reinsurers backed by hedge funds that may share characteristics of traditional and non-traditional markets. Some of these reinsurers are rated and release financial statements. Therefore, ceding insurers may classify them as traditional reinsurers, regardless of the fact that they employ an alternative investment strategy and their investments are managed by hedge funds. If the hedge fund-backed reinsurers do not pursue a rating and instead collateralize the limits of any reinsurance contracts they enter, they may be classified as a collateralized reinsurer.



Insurance-linked securities (ILS) As the name implies, ILS are financial instruments which are sold to investors, where the value of the security is linked to an insurable loss event. The insurable loss event may emanate from a life or a non-life peril. Historically, most of the non-life insurance loss events have been property catastrophe related events (e.g. hurricanes, windstorms, earthquakes). On the life side, the events may be related to mortality, longevity and monetizing the embedded value of a particular block of business or reserve financing.

Catastrophe bonds Catastrophe bonds are typically complementary purchases to a larger traditional reinsurance program. Ceding insurers may consider sponsoring a cat bond for a number of reasons, including:

Ability to secure capacity for a known cost over a multi-year period, which helps manage the volatility of pricing cycles

Opportunity to access an additional and diverse source of capital

Mitigating the credit risk exposure of traditional reinsurers, especially after one or more significant catastrophes

Ceding insurers may also look to the catastrophe bond market to securitize more structured alternatives than the typical annually renewable per occurrence covers. Aggregate and subsequent event covers, as well as top-and-drop structures, are regularly issued in the catastrophe bond market and may be more competitive in pricing and terms than traditional reinsurance.

Typical catastrophe bond features Single limit (no reinstatement)

Fully collateralized

Multi-year capacity at a known price

Excess of loss coverage includes:

- Per occurrence or aggregate loss basis

- Subsequent event coverage

- Top and drop structures

Property & Casualty ILS Catastrophe Bonds Industry Loss Warranties Sidecars Other ILS, including Derivatives,

Swaps

Life ILS Extreme Mortality and Longevity

Risk Securitizations Embedded Value and Life

Settlement Securitizations Reserve Financing (Regulations

XXX)



Commonly covered perils include:

- US hurricane, earthquake, severe convective storm, winter storm, wildfire

- Europe windstorm

- Japan typhoon, earthquake

Sample catastrophe bond transaction

1. The sponsor (usually a ceding insurer) employs a regulated investment bank such as Aon Benfield Securities to provide analysis, guidance and assist in the execution of the catastrophe bond

2. A Special Purpose Entity (SPE) is established to write the cat bond. The purpose of the SPE is to hold the assets being securitized in a trust and issue the catastrophe bonds

3. Using analysis provided by the investment banker, the sponsor determines the amount of coverage desired and the recovery trigger, and pays a reinsurance premium into the trust of the SPE

4. Investors purchase bonds issued by the SPE and the proceeds are used to collateralize the reinsurance agreement

5. Investors receive interest income on the invested funds, plus a premium (interest spread) for the risk assumed

6. If there are no loss events under the reinsurance agreement, the bond principal is repaid to investors, with interest

7. If there is a loss event under the reinsurance agreement, the sponsor will be indemnified from the assets in the SPE trust - Investors are paid their proportionate share of any remaining assets after the Sponsor has been reimbursed in full in accordance with the reinsurance agreement



Common catastrophe bond triggers There are several ways that catastrophe bonds can be structured to accomplish different objectives or address data and disclosure constraints. One of the key features of catastrophe bonds is the trigger for the sponsor to collect losses under the bond.

Both indemnity and non-indemnity triggers (industry index, parametric and modeled loss) have been used for a variety of reasons, including the quality of underlying data, quality and availability of catastrophe models and disclosure concerns. There are a number of important aspects that need to be properly assessed by both sponsors and investors alike before the optimal trigger and structure are selected. When structuring non-indemnity triggers, one of the primary goals of the ceding insurers is to minimize basis risk – the difference between the catastrophe bond payout and the ceding insurer’s ultimate net loss. (Aon Benfield Securities is uniquely positioned to assist ceding insurers in developing structures that seek to minimize this basis risk.)

The four primary triggers for cat bonds are outlined below.

Industry loss warranties (ILWs) ILWs are a type of reinsurance or derivative contract through which a ceding insurer can purchase reinsurance protection. These contracts have a specified amount of protection (referred to as the “limit”) which denotes the amount of compensation the buyer (or ceding insurer) receives if the industry loss exceeds a predetermined threshold (referred to as the “trigger”). It is this trigger that differentiates ILWs from traditional reinsurance. Recovery is based on total insured loss experienced by the entire industry from a specified event rather than the ceding insurer’s own losses.



For example, the buyer of a "$50mn limit US hurricane ILW attaching at $10bn" pays a premium to the ILW writer (typically an alternative market) and receives $50mn in protection if total losses to the insurance industry from a single US hurricane exceed $10bn.

ILWs can sometimes have additional conditions which must be met for a payout to be made. For example, in addition to the industry loss the buyer must also have incurred losses exceeding a predetermined threshold.

Sidecars A sidecar is legal risk-bearing entity that allows investors to participate in reinsurance (or insurance) transactions or transact in Insurance-Linked Securities. Sidecars are most often established by traditional reinsurers (or insurers) and provide an alternative underwriting platform. In many cases, most of the funding for the sidecar is obtained from third patrty investors. Many sidecars offer reinsurance on a fully collateralized basis. Through the risk bearing entity, the traditional reinsurer binds the sidecar to one or more reinsurance contracts. The traditional reinsurer typically provides all the underwriting, claims and accounting service to the sidecar for predetermined fees. The sidecar may take a portion of the traditional reinsurer’s business (through a proportional reinsurance agreement) or may be “client facing” and underwrite reinsurance transactions directly with ceding insurers. Sidecars may be of limited duration or may be more permanent in nature.

Other ILS (swaps, derivatives) Other common ILS include (but are not limited to) contingent reinsurance swaps, catastrophe swaps, and weather/temperature derivatives. Contingent reinsurance swaps are financial transactions whereby a fee is paid by the ceding insurer for a contingent payment by the reinsurer in the case of a catastrophic event. In response to a triggered loss event, the reinsurer compensates the ceding insurer and assumes the claim rights through subrogation. Catastrophe swaps allow the exchange of non-correlated catastrophe exposures. For example, assume a U.S. insurer had a large exposure to Florida wind and no exposure to Japanese earthquake. Also, assume a Japanese insurer had a large exposure to Japanese earthquakes, but no exposure to Florida wind. These two insurers could diversify their exposures by essentially trading the Florida wind exposure for the Japanese exposure. The primary reason a cat swap is used is to diversify insurance and reinsurance company portfolios (in terms of both types of cat risks and regional exposures).

Weather derivatives have been used within the insurance and reinsurance industry for the past 15 years. Unlike catastrophe bonds and ILWs, which provide protection for low frequency - high severity events, weather derivatives can be used to provide coverage for a series of high frequency - low severity events, such as snow, rain or adverse temperatures. Weather derivatives are most common in sectors (e.g. energy, agriculture, construction, transportation and hospitality) significantly impacted by weather. For example, energy companies may desire protection against lost revenue due to adverse temperatures. Weather derivatives allow for insurance protection to be triggered on measurable weather events, such as number of days where the temperature is below a threshold, accumulated snow, etc.



Insights of the Collateralized Reinsurance Market Collateralized reinsurers offer reinsurance on an indemnity basis, similar to traditional reinsurers. However, there may be several distinct differences between the reinsurance offered by a traditional reinsurer and the reinsurance offered by a collateralized reinsurer. These differences relate to:

The parties involved in collateralized reinsurance transactions and the fact that more than one entity fulfils the role of a traditional reinsurer

The primary form of protection provided (most often collateral in the form of a trust for the full limits of exposure) and the terms and conditions related to this protection (collateral funding and release)

The coverage provided (some collateralized reinsurers offer limited claims development)

Other unique terms and conditions (limited recourse etc.)

While credit risk is essentially eliminated with collateralized reinsurers, each of the above differences may create additional risk for ceding insurers. The following sections summarize these differences, identify some potential sources of risk and outline how ceding insurers may reduce or mitigate these risks.

Parties involved in collateralized reinsurance transactions The first step in understanding collateralized reinsurance transactions is to understand the parties involved in the transaction and how they may differ from the parties involved in a traditional reinsurance transaction.

In traditional reinsurance transactions, ceding insurers negotiate directly with the traditional reinsurer. The traditional reinsurer is the counterparty and bears certain risks of the transaction. Ceding insurers have comprehensive information on the traditional reinsurer (ratings, capital, financial performance, etc.) in order to evaluate the reinsurer’s credit risk.

One significant difference between traditional reinsurance transactions and collateralized reinsurance transactions is that there are typically two or more entities that fulfill the role of the reinsurer. Collateralized reinsurance transactions typically include:

1. An insurance or investment manager – the entity that underwrites the reinsurance and negotiates the transaction with the ceding insurer

2. One or more risk-bearing entities

This distinction is important as it will impact the potential recourse available to ceding insurers.

Those new to collateralized reinsurance transactions usually refer to the entity negotiating the reinsurance transaction as the collateralized reinsurer. However, this entity typically does not bear the risk of the transaction.



Below is a diagram that identifies the key parties involved in collateralized reinsurance transactions in Bermuda.

Third party investors: Most often, they provide the assets to support the collateralized reinsurance transaction.

Licensed insurance manager / investment manager: This is the entity that employs underwriters and negotiates the reinsurance transaction with the ceding insurer. They may also be responsible for soliciting funds from the third party investors. They are most often thought of as the alternative market or collateralized reinsurer. The collateralized reinsurer is a bit of a misnomer as this entity bears no risk in the reinsurance transaction. Instead, they should be thought of as a portfolio manager as their role is to group the assets from investors with similar risk and return expectations into one or more reinsurance transactions. In essence, they manage a portfolio of reinsurance transactions on behalf of their investors. In Bermuda, they are most often a “Licensed Insurance Manager” or an “Investment Manager”.

Risk-bearing entities: These are the counterparties to the reinsurance transaction. They bear the underwriting risk. The legal form of the counterparty varies by jurisdiction. In Bermuda, counterparties are typically, Special Purpose Insurers (SPIs), Class 3, Class 3A or 3B insurance / reinsurance companies or a Segregated Account Company in respects of its segregated accounts. The collateralized reinsurer may use one or more of these risk-bearing entities (representing groups of investors with different risk and return expectations) for the reinsurance placement. These entities typically have no employees. It is important for ceding insurers to understand that these risk-bearing entities may be “lightly” regulated and may have limited capital or assets beyond what has been committed to the various trusts to support reinsurance transactions. In some cases, ceding insurers may elect to use a traditional reinsurer as a front to a collateralized reinsurance transaction.



The use of fronting carriers on collateralized reinsurance placements From the ceding insurer’s perspective, the use of a fronting carrier essentially transforms the collateralized reinsurance placement into a traditional reinsurance cover. In other words, the ceding insurer is relying on the claims paying ability of the fronting carrier and there is no need to negotiate the trust agreement and other terms and conditions that are unique to collateralized reinsurance transactions.

The advantages and disadvantages of using a fronting carrier are outlined below.

Advantages of fronting carriers

- Fronting carriers are typically highly rated companies, tracked by regulators, investors and other stakeholders

- Reinstateable limits may be accommodated

- Claims development period is not limited (the fronting carrier assumes the tail risk)

- Eliminates the need to negotiate the collateral release provisions, the trust agreement and other clauses unique to collateralized reinsurance transactions

Disadvantages of fronting carriers

- Exposes ceding insurers to the credit risk of the fronting carrier

- May increase the cost of the collateralized reinsurance transaction

Collateral requirements to protect ceding insurers Both Single Beneficiary Trusts and Letters of Credit (LOCs) may be used to support collateralized reinsurance transactions.

Single Beneficiary Trusts are the most frequently used form of collateral to support collateralized reinsurance transactions. From a ceding insurer perspective, some important issues with respects to trusts used to support collateralized reinsurance transactions are:

The trust only permits high quality, liquid assets whose value is unlikely to change significantly for the duration of the collateral holding period

Access to the assets in the trust are not restricted in any way for valid claims

The cancellation provisions of the trust are appropriate

The trust is in place at the inception of the reinsurance agreement

The ceding insurer is the sole beneficiary of the trust

For U.S. ceding insurers it is also important that the trust meets the requirements for U.S. ceding insurers to take credit for the reinsurance on their statutory financial statement. This is rarely an issue as most trusts used to support collateralized reinsurance agreements have similar features to the New York Regulation 114 Trusts that are used by traditional reinsurers.

The most frequently reported issue is that trusts may not be funded at the inception of the reinsurance agreement. However, recently there have been very few reports of problems with the other issues.



Below is a diagram that depicts the parties to a trust agreement and the flow of funds.

There are three parties to the trust agreement.

The Beneficiary of the trust (in this example a U.S ceding insurer)

The Grantor of the trust (the counterparty to the reinsurance agreement)

The Trustee (a U.S. bank or financial institution approved by the NAIC)

Once the trust agreement is finalized and executed, the trust can be established by the Trustee. Aon Benfield recommends that the trust agreement be executed and the trust funded prior to the inception of the reinsurance contract. In most cases, the premium for the reinsurance agreement is paid directly into the trust. The counterparty should provide the remaining assets so the ceding insurer has assets equal to the full amount of the limits in the reinsurance contract. There may be a few exceptions to this.

Periodically, the interest or investment income from the trust may be paid to the counterparty. If there is a loss under the reinsurance contract, the ceding insurer submits a withdrawal notice directly to the Trustee. Reimbursement for the losses are paid to the ceding insurer out of the trust. Ultimately, the remaining assets (if any) are released back to the counterparty according to the collateral release provisions in the reinsurance contract. The collateral release provisions are addressed in a subsequent section of this Guide.

For U.S. ceding insurers, the trusts are most often governed by U.S. law (often the state of New York). Permitted assets in the trust for U.S. ceding insurers typically include:

Cash

U.S. treasury obligations

U.S. government agency obligations

Money market accounts that only invest in U.S. treasuries and/or U.S. government agency obligations



Non-U.S. ceding insurers should ensure that the assets permitted within the trust meet their requirements. Typically, the trust should be funded with highly liquid cash and marketable securities whose value is not expected to fluctuate.

LOCs are used primarily by some European domiciled collateralized reinsurers. There is typically no difference in the terms and conditions of these LOCs as compared to the LOCs used by traditional reinsurers. LOCs can be provided at the inception of the reinsurance contract period. While it is rarely an issue, U.S. ceding insurers should ensure that the LOCs meet the requirements for them to take credit for the reinsurance on their statutory financial statements. Specifically, the LOC must be:

Issued by a NAIC approved bank

Irrevocable – can only be cancelled by agreement of the parties

Clean and unconditional – no contingencies on draw-downs

LOCs are released by the ceding insurer after the ceding insurer confirms there are no losses under the contract. If there are losses under the contract, the ceding insurer may draw-down on the LOC. The LOC is released by the ceding insurer once the losses are paid in full.

Collateral funding Unless the collateralized reinsurance transaction is fronted by a traditional, rated reinsurer, the ceding insurer’s protection is primarily afforded by the LOC or the assets maintained in the trust.

LOCs are typically standardized. As long as the LOC is delivered to the ceding insurer in the proper form for the full amount of the limit (potentially less the ceded premium) by the inception of the reinsurance agreement, there typically are no funding concerns.

While we have seen many reinsurance contracts agreed in principle and formally executed after the inception of the coverage period, the same approach with the trust agreement may leave the ceding insurer with inadequate protection in a collateralized reinsurance transaction.

One of the reasons trusts are not funded on a timely basis is due to the delay in negotiating and executing the trust agreement. This occurs more frequently the first time a ceding insurer is placing reinsurance with a particular collateralized reinsurer. Aon Benfield suggests that all parties begin negotiating the trust agreement early in the placement process. The goal should be to get the trust agreement executed at least 5 days prior to the inception of the reinsurance contract period. This allows a few days for the trustee to set up the trust and for the trust to be funded by the counterparty / counterparties.

A second reason for trusts not being funded on a timely basis is that the counterparty may not have available funds at the time of the contract inception. Some collateralized reinsurers are not able to fund a trust for an incepting contract until their assets have been released from an expiring reinsurance contract. Therefore, there may be a delay of a few days or weeks before the trust of the incepting contract can be funded. Ceding insurers must determine whether they are comfortable with this risk.

Ceding insurers may also be exposed to collateral funding risk when an existing trust is amended or rolled-over from an expiring reinsurance contract to an incepting reinsurance contract.



When a ceding insurer renews an expiring reinsurance line with a collateralized reinsurer, it may be necessary to consider a roll-over of the trust. The collateralized reinsurers may suggest that an existing trust agreement be amended (i.e. “rolled-over”) to the new term as opposed to executing a new trust agreement and establishing a new trust. There are advantages and disadvantages to this approach.

From the ceding insurer’s perspective, the roll-over of the trust eliminates the need to negotiate a new trust agreement. The main disadvantage of the trust roll-over is that it may limit the ceding insurer’s ability to obtain payment under the expiring or the incepting reinsurance contract.

For some perils and covers, the ceding insurer may not know the extent of any losses until a few days or weeks after the contract has expired. Therefore, the trust should remain intact until the ceding insurers can confirm whether there are any losses under the contract. However, to ensure adequate protection for an incepting reinsurance agreement, a second trust should be in place at contract inception. The potential problem with the trust roll-over is that for a short period of time, two limits of coverage may be needed (one for the expiring contract and one for the renewing contract), when only one is available.

For some perils (e.g. Florida wind) and types of reinsurance contracts, the trust roll-over may not be a problem as the losses may be known in advance of the reinsurance contract inception. If a trust roll-over is pursued, ceding insurers should work with collateralized reinsurers to ensure there is no detriment to the ceding insurers (e.g. assets can be reported to the trust if there are losses in either the expiring or the incepting contract). Ceding insurers must assess the risks they are willing to assume with respect to all collateral arrangements.

Collateral release Some of the most important parts of a collateralized reinsurance agreement are the terms and conditions related to collateral release. Generally, the higher the percentage of collateral held and the longer the collateral is held, the better the protection for the ceding insurer. However, collateral represents a significant cost to collateralized reinsurers. If collateral is not needed, reinsurers will want the collateral released.

There are two aspects to collateral release that need to be negotiated:

1. Collateral release when there are no loss events under the reinsurance contract

2. Collateral release when there are loss events under the reinsurance contract

If the ceding insurer is sure that there is no possibility of loss under the reinsurance contract, the collateral can be released upon contract expiration. However, often the ceding insurer will need a few days after the contract expires to determine if there are any potential losses under the reinsurance contract. We have observed contracts where the ceding insurer has 15 days after the contract expires to determine if there are any losses under the contract. Ceding insurers may require a longer period of time for some perils (earthquake) or some types of reinsurance agreements (aggregate covers) to determine if there are any potential losses under the reinsurance contract. The amount of time the ceding insurer has to determine whether there are any losses under the contract is negotiable. Therefore, ceding insurers should negotiate a timeframe that is appropriate for the perils and type of reinsurance agreement.



In the event there are loss events under the reinsurance contract, the release of collateral is typically governed by a Buffer Loss Factor Table (or equivalent). The Buffer Loss Factor Table outlines when collateral may be released. It also provides a buffer (additional amount) above the loss amount for potential claims development. This buffer is gradually reduced over time. Below is an example of a Buffer Loss Factor Table.

Calendar Months Since Date of Occurrence Windstorm Earthquake All

Other 0 to 3 200% 300% 250%

> 3 to 6 150% 200% 175% > 6 to 9 125% 175% 150%

> 9 to 12 110% 150% 130% >12 to 15 105% 125% 115% > 15 to 18 100% 120% 110% Thereafter 100% 100% 100%

The Buffer Loss Factor Table is a negotiable term in the collateralized reinsurance contract. The release of collateral has a direct impact on the protections afforded the ceding insurer. Therefore, ceding insurers should negotiate for the terms that are appropriate for the specific perils reinsured. Also, ceding insurers may want the loss amount used in the Buffer Loss Factor Table calculation to be based on the undiscounted amount of the loss (including IBNR) rather than on a discounted (present value) amount.

The importance of the Buffer Loss Factor Table is increased for placements where once collateral is released, the corresponding limits of liability are reduced / extinguished. This issue is addressed in the next section.

Coverage differences between collateralized and traditional reinsurance The coverages offered by collateralized reinsurers may differ significantly from those offered by traditional reinsurers, even on single limit reinsurance contracts. A significant difference relates to the development of claims. Many collateralized reinsurers offer a limited claims development period. Other collateralized reinsurers offer coverage similar to a traditional reinsurer, where the claims development period is essentially unlimited (until the reinsurance limits are exhausted or the contract is commuted). The two different approaches to coverage are outlined below.

1. Limited claims development - Once assets are released from the trust, the counterparty’s corresponding liabilities are reduced / extinguished: Some of the collateralized reinsurers view the release of assets from the trust as a corresponding release of the limits of liability. For example, if 5M of assets are released from a trust under the terms of collateral release, some reinsurers support the position that the limits of liability are reduced by 5M. (This is consistent with Bermuda regulatory mandates that SPI transactions must be fully funded.) In some cases, the collateralized reinsurer may add wording to the reinsurance agreement that specifically states that the release of collateral results in a reduction of potential liabilities. When the release of collateral is believed to result in a corresponding reduction of liabilities, the contract may be classified as having a “limited claims development” period. In this case, the ceding insurer is assuming the tail risk of the reinsurance transaction.



2. Unlimited claims development - Releasing the assets from the trust does not reduce / extinguish the counterparty’s liabilities: Some collateralized reinsurers do not view the release of collateral as reducing or extinguishing their liability. These reinsurers support the view that the reinsurer’s obligations are not extinguished until the limits have been paid in full or the contract has been commuted. In this case, the ceding insurer is not assuming the tail risk of the reinsurance transaction. This view may be reinforced through the reinsurance contract. Specifically, Aon Benfield has observed contracts that state assets will be reposted to the trust if the reinsurer’s liabilities exceed the amount of assets in the trust (subject to the reinsurer’s limits of liability).

While some reinsurance contracts address the treatment of liabilities once collateral has been released from the trust, many contracts do not specifically address this issue. Some collateralized reinsurers have stated that even if they are not contractually required to pay losses after the release of the collateral, they may reimburse the ceding insurer for commercial reasons.

Ceding insurers should assess the issue of claims development (and /or the release of collateral and its impact on liabilities) and make sure the contract language is consistent with their assessment. From a ceding insurer perspective, it is most advantageous if the reinsurer assumes the tail risk of claims and reposts assets to the trust (if necessary).

However, ceding insurers should be aware that even if reinsurers agree to repost assets to the trust, there is the possibility that the risk-bearing entity may not have sufficient assets to repost assets to the trust. Once funds are released from a trust, the funds may be returned to investors or committed to other reinsurance transactions. Therefore, ceding insurers may be unable to collect payment for valid claims or the payment may be delayed.

Reinsurance contract clauses unique to collateralized reinsurance transactions There are other contract clauses beyond those related to the funding and release of collateral that may be included in a collateralized reinsurance contract. For example, collateralized reinsurers in Bermuda often include a “Limited Recourse and Bermuda Regulation” clause. This clause may serve the following four purposes:

1. Imposes Bermuda law with respect to the segregated accounts and other Bermuda domiciled risk-bearing entities (e.g. Special Purpose Insurers)

2. Limits recourse - More specifically, the clause states that any recourse is limited solely to the assets of the segregated account(s) (or SPI) specifically listed on the contract and there is no recourse to other segregated accounts, SPIs or the assets of the collateralized reinsurer. If the assets of the segregated account(s) (or SPI) specifically listed on the contract are insufficient to meet all the ceding company’s obligations, the obligations are extinguished

3. States that the ceding insurer had all necessary information to evaluate the risks of the Bermuda domiciled risk-bearing entity

4. Clarifies that the clause shall survive termination of the corresponding reinsurance agreement.



From the collateralized reinsurer’s perspective, this clause is contractually reinforcing the limited recourse available under Bermuda regulation and recognizing the regulatory structure of segregated accounts and SPIs in Bermuda. Other domiciles (besides Bermuda) may have contract clauses with similar or different contract language.

Lastly, while not unique, some collateralized reinsurance contracts may contain commutation clauses. Collateralized reinsurers prefer to commute contracts to finalize any liabilities under the collateralized reinsurance agreement. Ceding insurers should consider negotiating the commutation clause to allow for sufficient time for the losses to fully develop or the ceding insurer may assume the tail risk. Commutations by mutual agreement may best achieve this objective.

Aon Benfield Assistance with Alternative Market Transactions Aon Benfield has a number of experts to assist with all aspects of alternative market transactions, including:

Aon Benfield Securities specializes in the development and placement of ILS transactions, including cat bonds, sidecars and ILWs

Brokers with expertise in the placement of collateralized reinsurance transactions

Contract Wording staff who specialize in the unique terms and conditions of collateralized reinsurance agreement and the associated trust agreements (Although ceding insurers must obtain legal advice from their legal counsel as Aon Benfield is unable to provide such advice.)

Market Analysis staff who can provide information on the various alternative markets as well as identifying ways to mitigate the potential risks of collateralized reinsurance transactions

Other Analytics staff (cat modelers, actuaries, etc.) who provide the technical support needed to analyze and structure these transactions.



Additional Information & Contacts Additional information on the most prominent alternative markets can be found on MarketReView®. MarketReView is Aon Benfield’s proprietary market security portal that contains relevant information on traditional reinsurers and the industry as a whole. MarketReView also contains profiles of the most prominent alternative markets. Some of the information that may be included in the alternative market profile report includes:

Assets under Management

Underwriting appetite – products, lines of business and territories

Potential fronting carriers

Recent developments

Types of collateral provided

For additional information on collateralized reinsurance, please contact your Aon Benfield Broker or any member of Market Analysis team, including: Mike McClane Bryan Farkus Market Analysis, Americas Market Analysis, Americas Aon Benfield Analytics Aon Benfield Analytics +1.215.751.1596 +1.215.751.1267 [email protected] [email protected] Mike Van Slooten Market Analysis, International Aon Benfield Analytics +44.207.522.8106 [email protected] For additional information on catastrophe bonds or other insurance-linked securities, please contact a member of the Aon Benfield Securities team, including:

Sean McCarty Managing Director Aon Benfield, Aon Benfield Securities +1.312.381.5368 [email protected]

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About Aon Aon plc (NYSE:AON) is the leading global provider of risk management, insurance and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 66,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative and effective risk and people solutions and through industry-leading global resources and technical expertise. Aon has been named repeatedly as the world’s best broker, best insurance intermediary, best reinsurance intermediary, best captives manager, and best employee benefits consulting firm by multiple industry sources. Visit aon.com for more information on Aon and aon.com/manchesterunited to learn about Aon’s global partnership with Manchester United.

About Aon Benfield Securities 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, sidecars, collateralized reinsurance, industry loss warranties, and derivative products.

As one of the most experienced investment banking firms in this market, Aon Benfield Securities offers expert underwriting and placement of new debt and equity issues, financial and strategic advisory services, as well as a leading secondary trading desk. Aon Benfield Securities’ integration with Aon Benfield’s reinsurance operation expands its capability to provide distinctive analytics, modeling, rating agency, and other consultative services. Aon Benfield Inc., Aon Benfield Securities, Inc. and Aon Benfield Securities Limited are all wholly-owned subsidiaries of Aon plc. Securities advice, products and services described within this report are offered solely through Aon Benfield Securities, Inc. and/or Aon Benfield Securities Limited.

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Appendix I: The Collateralized Reinsurance Transaction The relationship between the parties involved in a collateralized reinsurance transaction may be best explained through the diagram below.

Flowchart of collateralized reinsurance transaction (with a Bermuda special purpose insurer)

The alternative market or collateralized reinsurer typically establishes a risk-bearing entity. In the example above, the risk-bearing entity is a Special Purpose Insurer (SPI). Through an underwriting services agreement (or similar agreement), the collateralized reinsurer is able to bind the risk-bearing entity to one or more reinsurance contracts. The collateralized reinsurer is paid fees for their underwriting, claims, accounting and other operational services. In some cases, they may also share in the profits of the risk-bearing entity.

Funds from third party investors are typically placed directly into the risk-bearing entity through equity, debt or other financing mechanisms. Preference shares (similar to equity without voting rights) are currently a popular financing mechanism. After the funds are placed in the risk-bearing entity, they are committed to one or more reinsurance transactions through the funding of a trust. A separate trust will be established for each reinsurance transaction. The investment income from the assets invested in the trusts is credited to the risk-bearing entity. Periodically, investors may receive dividends or interest payments (depending upon the financing mechanism) from the risk-bearing entity as profits from reinsurance contracts and investment income are received.



Third party investors may also withdraw all or part of their investment periodically, subject to some constraints. Many of the risk-bearing entities, particularly segregated accounts and SPIs, are designed to be shorter term vehicles often lasting only 18 – 36 months. Therefore, the net proceeds of the investments are returned to investors when the risk-bearing entity’s activities are concluded.

The risk-bearing entity will be the counterparty to both the reinsurance agreement and the trust agreement.

The trustee is a bank or financial institution that establishes and manages the trust according to the terms of the trust agreement.

Ideally, the reinsurance and trust agreement are finalized and executed prior to the inception of the reinsurance contract. At inception of the reinsurance contract, the trust should be funded by the risk-bearing entity. In most cases, the ceded reinsurance premium due to the risk-bearing entity is paid directly into the trust.

If there are loses due to the ceding insurer, the ceding insurer submits a withdrawal notice to the trustee according to the terms of the trust agreement. Ultimately, the remaining assets (if any) in the trust will be released back to the risk-bearing entity according to the terms of collateral release provisions made part of the reinsurance contract.



Appendix II: Collateralized Reinsurance Risk-Bearing Entities in Bermuda Below are additional details about each of the risk-bearing entities that may be used in a collateralized reinsurance transaction in Bermuda.

Class 3, 3A and 3B insurers and reinsurers: Bermuda has a multi-license system of regulation which categorizes general insurance companies into six classes. The most commonly used classes for collateralized reinsurance are:

Class 3: Applies to companies not included in other classes (Minimum capital of $1M)

Class 3A: Small commercial insurers (Minimum capital of $1M)

Class 3B: Large commercial insurers (Minimum capital of $1M)

Class 4 insurers and reinsurers: Used in some instances to front for collateralized reinsurance transactions. This group underwrites direct excess liability insurance and/or property catastrophe reinsurance risks (Minimum capital of $100M).

The other Bermuda classes not used for collateralized reinsurance are:

Class 1: A single-parent captive insurance company

Class 2: Multi-owner captives

Special purpose insurers (SPIs): SPIs are Bermuda domiciled companies designed to assume reinsurance risks. Most SPIs are designed to be shorter-term reinsurance vehicles, lasting 2-3 years. There are two requirements that must be met to be licensed as an SPI:

The business written by the SPI must be “fully-funded”, which is accomplished through a trust, Letter of Credit (LOC) or other financing mechanism

The parties to the transactions must be “sufficiently sophisticated”

Due to the fact that the transactions are fully funded and between sophisticated parties, SPIs are subject to lighter regulatory requirements and oversight:

There is a streamlined application process

Minimum capital is $1

There are no investment restrictions

There are no requirements for loss reserve opinions

It is possible to waive the requirement to prepare audited financial statements and instead file unaudited management accounts

The BMA expects that insurers that cede reinsurance to SPIs should be:

Adequately capitalized

Technically equipped to understand and manage all risk characteristics associated with the SPI cession



Segregated accounts company and segregated accounts: A Segregated Account Company (SAC) is a Bermuda domiciled (SPI or Class 3, 3A or 3B) entity that is permitted to create separate segregated accounts and to write insurance / reinsurance.

The easiest way to explain a SAC and its segregated accounts may be to compare them to a Protected Cell Company (PCC).

A PCC is a single legal entity comprised of a core and a number of segregated cells. In most domiciles where PCCS are established each cell is legally separated from the core and the other cells.

A SAC and its segregated accounts are a single legal entity. While an individual segregated account is not a legal entity by itself, the assets and liabilities of each segregated account are statutorily segregated from the assets and liabilities of other segregated accounts and the general account of the SAC.

Segregated accounts are essentially a collection of records detailing transactions related to each other. Segregated accounts are defined in the Bermuda Segregated Accounts Act of 2000, as follows:

““segregated account” means a separate and distinct account (comprising or including entries recording data, assets, rights, contributions, liabilities and obligations linked to such account) of a segregated accounts company pertaining to an identified or identifiable pool of assets and liabilities of such segregated accounts company which are segregated or distinguished from other assets and liabilities of the segregated accounts company for the purposes of this Act;”

When a segregated account is used in a collateralized reinsurance transaction, the counterparty to the ceding insurer is the SAC on behalf of (o.b.o.) the segregated account. In other words, it is not simply the segregated account or the SAC, but a combination of the two.



Appendix III: Alternative Market Definitions The non-traditional or alternative market is relatively new so there is some inconsistency in the naming of the market and its participants. The following descriptions may provide clarity around the terminology used in relation to placements involving alternative markets, especially in the Bermuda market. It should be noted that these descriptions are not from an authoritative source and may be subject to change given the developing nature of this market. Also, these same terms may have a different meaning when used outside the context of collateralized reinsurance placements.

Alternative market: Alternative Market may have two meanings. It could refer to 1) the entire market or all non-traditional insurance and reinsurance entities or 2) it may be used to refer to a single non-traditional market. By traditional market, we mean the collection of rated reinsurers who act as counterparties to the majority of reinsurance transactions. Traditional reinsurers release financial statements and the ceding insurers rely on the rating and financial strength of the traditional reinsurer and their promise to pay. In the non-traditional market, the reinsurers are typically unrated and do not release financial statements publicly. Instead, the ceding insurers are provided with collateral for the full limit (less the premium) of the reinsurance transaction. The non-traditional or alternative market is typically associated with collateralized reinsurance transactions and insurance-linked securities.

In most cases, the entity that underwrites and negotiates the reinsurance transaction with the ceding insurer and reinsurance intermediary is referred to as the “alternative market”. However, this entity does not assume any risk of the reinsurance transaction. The actual risk-bearing entities are often thinly capitalized, licensed entities that are under the management of the alternative market. Therefore, the alternative market can be thought of as a portfolio or underwriting manager who does not bear any risk.

In Bermuda, these portfolio managers are “Licensed Insurance Managers” or Investment Managers where they are licensed to underwrite and negotiate the reinsurance transaction, but not bear any risk. It is these Licensed Insurance Managers or Investment Managers who are referred to as the alternative market. For the avoidance of doubt, the alternative market is not the counterparty to the ceding insurer in the reinsurance agreement (as that would be the risk-bearing entity).

Beneficiary: With respect to the trust agreement used to support a collateralized placement, the beneficiary of the trust is the ceding insurer.

Bermuda class 3 insurance / reinsurance company: Bermuda has a multi-license system of regulation which categorizes general insurance companies into six classes, long-term insurance companies into five classes, a class for Special Purpose Insurers and provides for composite companies. Bermuda Class 3, 3A and 3B insurance / reinsurance companies are often used as the risk-bearing counterparties to ceding insurers in collateralized reinsurance placements. These entities typically have minimum capital of $1 million. For additional information on the classes of Bermuda domiciled licensed insurance companies, please access the Bermuda Monetary Authority website link (http://www.bma.bm/insurance/licensing/SitePages/Home.aspx).

Collateralized placement: The type of reinsurance placement where collateral (typically in the form of a trust or Letter of Credit) is provided for the full limits (less ceded premium) of exposure. The ceding insurer is relying on the collateral in the trust or Letter of Credit as opposed to the counterparty’s promise to pay. In the event of a loss under the collateralized placement, the ceding insurer will request payment from the bank or financial institution that is acting as trustee (when a trust has been used) or from the bank or financial institution that supplied the Letter of Credit.

http://www.bma.bm/insurance/licensing/SitePages/Home.aspx



Collateralized reinsurer: Most often used to reference the entity that underwrites and negotiates a collateralized reinsurance transaction, even though this entity does not assume any risk. In Bermuda, the entity that underwrites and negotiates a collateralized reinsurance transaction is a Licensed Insurance Manager. Please see the definition of “Alternative Market” for additional information.

Fronting carrier or fronting company: In some cases, ceding insurers prefer to use a rated traditional reinsurer as the counterparty in a collateralized reinsurance transaction, in lieu of the thinly capitalized risk-bearing entity. From the ceding insurer’s perspective, when using a traditional reinsurer as a fronting carrier, the reinsurance agreement becomes a traditional reinsurance placement. The ceding insurers is relying on the rating and financial strength of the traditional fronting carrier and the fronting carrier’s promise to pay. When a fronting carrier is used in a collateralized reinsurance placement, typically, the alternative market and the fronting carrier both review the potential transaction from an underwriting perspective. Once the reinsurance agreement between the ceding insurer and fronting carrier is executed, the risk is then retroceded to the alternative market. For its part in the transaction, the fronting carrier is paid a fee. In addition to the fronting fee, the fronting carrier receives collateral for their full limit of exposure (less the net premium) from one or more of the risk-bearing entities of the alternative market.

Grantors: With respect to the trust agreement used to support a collateralized placement, the grantors of the trust are the risk-bearing counterparties to the ceding insurer.

Investor: See definition of “Third Party Investor”

Risk-bearing entity: The entity that is the counterparty to the ceding insurer in a collateralized reinsurance placement. For example, it could be an Special Purpose Insurer, a Class 3 Insurer / Reinsurer or a Fronting Carrier or a Segregated Accounts Company in respect of one or more of its segregated accounts. For avoidance of doubt it is this entity, rather than the Alternative Market, which is the party providing the reinsurance indemnity pursuant to the reinsurance agreement.

Segregated account: A segregated account is a separate and distinct account (comprising or including entries recording data, assets, rights, contributions, liabilities and obligations linked to such account) of a Segregated Accounts Company (SAC) pertaining to an identified or identifiable pool of assets and liabilities. A segregated account is not a separate legal entity. However, the assets and liabilities of each segregated account are intended to be “walled off” or statutorily segregated from the assets and liabilities of other segregated accounts and the general account of the SAC.

Segregated accounts company (SAC): A SAC is a Bermuda domiciled company that is permitted to create segregated accounts. It can be thought of as being a standard limited company which maintains within it separate statutorily segregated accounts. In Bermuda, SACs are often a Class 3, 3A or 3B Bermuda Insurer / Reinsurer or a Special Purpose Insurer. Therefore, SACs are licensed to write insurance / reinsurance on behalf of one of more of its segregated accounts.



Special purpose insurer (SPI): Bermuda domiciled companies designed to assume insurance or reinsurance risks. To be licensed as a SPI, the business written must be “fully-funded” and the parties to the transaction must be “sufficiently sophisticated.” The “fully funded” requirement is typically met by the SPI providing collateral to the ceding insurer through a trust, Letter of Credit or other financing mechanism for the full limit (less the premium) of the reinsurance transaction. By “sufficiently sophisticated”, the Bermuda Monetary Authority (BMA) must be satisfied that the participants in the transaction are able to appreciate the nature of the risks involved. The BMA has broad discretion to determine whether or not the above two characteristics are met. Due to the intended lower regulatory risk, SPIs are subject to lighter regulatory requirements.

Third party investor: The third party capital provider that provides the risk-bearing entity with the funds to enter into collateralized reinsurance transactions. Please note that the Third Party Investor is not a party to the reinsurance contract, nor the trust agreement. Examples of Third Party Investors supporting the risk-bearing entities on collateralized reinsurance transactions include: pension funds, hedge funds, endowments, family trusts and high net worth individuals.

Trust: An account set up by the trust agreement and controlled by the trustee which holds assets that supports the reinsurer’s (or the risk-bearing entity’s) potential liability in a collateralized reinsurance transaction.