Seismic Limited Case Study LEHMNABROTHER S John Kiernan August 15, 2000

Seismic Limited Case StudySeismic Limited Case Study

LLEHEHMM NNAA BBRROOTTHHEERRSS

John KiernanJohn Kiernan

August 15, 2000August 15, 2000

LLEHEHMM NNAA BBRROOTTHHEERRSS22

Convergence of the Insurance and Capital MarketsConvergence of the Insurance and Capital Markets

Catastrophe Securitization – Why?Catastrophe Securitization – Why?

Traditional reinsurance markets today Traditional reinsurance markets today Cyclical pricing and fluctuating capacityCyclical pricing and fluctuating capacity

Andrew/NorthridgeAndrew/NorthridgeLarge losses for reinsurers Large losses for reinsurers Significant increases in premium ratesSignificant increases in premium ratesReduction of catastrophe reinsurance coverage Reduction of catastrophe reinsurance coverage

available to primary insurance companiesavailable to primary insurance companies Insurance companies turned to capital marketsInsurance companies turned to capital markets

EfficiencyEfficiency and and capacitycapacity


Insurance Risk as an Asset ClassInsurance Risk as an Asset Class

Catastrophe Securitization – Why?Catastrophe Securitization – Why?

Insurance risk has become next major asset class Insurance risk has become next major asset class absorbed by Capital Marketsabsorbed by Capital Markets

Corporate bond market replaced traditional practice of Corporate bond market replaced traditional practice of long-term bank lending to corporationslong-term bank lending to corporations

S&Ls used to originate and hold mortgage risk, now S&Ls used to originate and hold mortgage risk, now supplanted by mortgage bond marketsupplanted by mortgage bond market

Following this pattern, the capital markets are Following this pattern, the capital markets are transforming the traditional reinsurance markettransforming the traditional reinsurance market


Alternative and Supplement to Traditional Reinsurance

Why Do Insurance Companies Care?Why Do Insurance Companies Care?

Limited number of highly-rated reinsurers Limited number of highly-rated reinsurers Credit risk : concern particularly for upper-layersCredit risk : concern particularly for upper-layers Capital markets easily addresses this concernCapital markets easily addresses this concern

Capital markets capacity and pricing efficiency makes them Capital markets capacity and pricing efficiency makes them attractiveattractive

Desirable characteristics that don’t exist in traditional marketDesirable characteristics that don’t exist in traditional market Flexibility in terms of maturityFlexibility in terms of maturity

Keeps traditional market providers honestKeeps traditional market providers honest


CAT Bonds Offer Attractive Returns on a Risk-CAT Bonds Offer Attractive Returns on a Risk-Reward BasisReward Basis

Why Do Investors Care?Why Do Investors Care?

Valuing a CAT bondValuing a CAT bondBased on pure expectation hypothesis, investor should Based on pure expectation hypothesis, investor should

be compensated for expected lossbe compensated for expected lossExpected loss - average loss to a CAT bond as Expected loss - average loss to a CAT bond as

determined by independent third party through multi-determined by independent third party through multi-year simulationyear simulation

CAT bonds usually trade at a multiple, usually 6:1 to CAT bonds usually trade at a multiple, usually 6:1 to 7:1 of expected loss7:1 of expected loss


Why Do CAT Bonds Trade As a Multiple to Why Do CAT Bonds Trade As a Multiple to Expected Loss?Expected Loss?


Concentration of risk in reinsurance hands leads to Concentration of risk in reinsurance hands leads to “cheap” pricing of risk“cheap” pricing of risk

Liquidity concernsLiquidity concerns Concern over “accuracy” of modeled expected lossesConcern over “accuracy” of modeled expected losses ““Fat Tails”Fat Tails” Extreme aversion to “lose everything” scenarioExtreme aversion to “lose everything” scenario


#1 Problem Faced by Portfolio Managers Is Lack of #1 Problem Faced by Portfolio Managers Is Lack of Diversification When They Need It MostDiversification When They Need It Most


The correlation among existing asset classesThe correlation among existing asset classesHigh Grade/High Yield Corporate BondsHigh Grade/High Yield Corporate BondsMortgage-backed SecuritiesMortgage-backed SecuritiesEmerging MarketsEmerging MarketsEquitiesEquities

can rise dramatically when just a small sector of the can rise dramatically when just a small sector of the global economy, even regionally or market specific, global economy, even regionally or market specific, takes a downturntakes a downturn


Excess Returns in Stressful Times Are Negative and Excess Returns in Stressful Times Are Negative and Highly CorrelatedHighly Correlated

Excess Returns*Aug 1990 – Nov 1990

Excess Returns*July 1998 – Sept 1998

High Grade Corporate Index -2.21% -2.97%

High Yield Corporate Index -10.89% -10.90%

Mortgages** -0.98% -2.95%

Emerging Markets Index n/a -23.72%

S&P 500*** -12.62% -17.26%


** Excess returns over similar duration U.S. TreasuriesExcess returns over similar duration U.S. Treasuries**** All long duration mortgagesAll long duration mortgages****** Excess return over 30-year U.S. Treasury BondExcess return over 30-year U.S. Treasury Bond


CAT Bonds Are Uncorrelated to Other Capital CAT Bonds Are Uncorrelated to Other Capital Markets RisksMarkets Risks


CAT bonds are securities whose CAT bonds are securities whose trigger eventstrigger events are based upon are based upon uncorrelateduncorrelated phenomena phenomena Occurrence of earthquakesOccurrence of earthquakes Extreme temperature variationsExtreme temperature variations

This is an asset class whose This is an asset class whose trigger eventstrigger events are are truly independenttruly independent of economic factors such as:of economic factors such as: Interest RatesInterest Rates Foreign Exchange RatesForeign Exchange Rates Risk Premia for Credit SpreadsRisk Premia for Credit Spreads GDPGDP Market Perception of EconomyMarket Perception of Economy


Seismic Limited – Case Study Seismic Limited – Case Study

ProblemProblem Lehman Re has substantial California Earthquake Lehman Re has substantial California Earthquake

exposureexposure Looking for retro capacityLooking for retro capacity



Which Way Do I Go?Which Way Do I Go?

Difficult to obtain Difficult to obtain California earthquake California earthquake

reinsurance of significant reinsurance of significant size from highly rated size from highly rated

counterpartiescounterparties

Capital MarketsCapital Markets Reinsurance IndustryReinsurance Industry

Hungry for high yielding, Hungry for high yielding, low risk securities that are low risk securities that are

easy to understandeasy to understand

Solution: Create a California earthquake CAT bond with lossesSolution: Create a California earthquake CAT bond with lossestied to an index tied to an index



Seismic Limited-March 2000Seismic Limited-March 2000 US $150,000,000 exposed to insured losses in California from US $150,000,000 exposed to insured losses in California from

earthquakes and fires following earthquakes and fires following Payment of principal, interest, and dividends on Securities Payment of principal, interest, and dividends on Securities

linked to Property Claim Services’ (PCS) reported Cumulative linked to Property Claim Services’ (PCS) reported Cumulative Estimated Insured Losses over 22 month Risk Period Estimated Insured Losses over 22 month Risk Period

First securitization involving Lehman Re Ltd., the reinsurance First securitization involving Lehman Re Ltd., the reinsurance subsidiary of Lehman Brothers Holdings Inc.subsidiary of Lehman Brothers Holdings Inc.

Risk assessment performed by Risk Management SolutionsRisk assessment performed by Risk Management Solutions Only single risk California Earthquake Catastrophe Bond Only single risk California Earthquake Catastrophe Bond

currently in marketcurrently in market


Seismic Limited– Case StudySeismic Limited– Case Study

SwapSwapCounterpartyCounterparty

SecurityholdersSecurityholders

Seismic Ltd.Seismic Ltd.

CollateralCollateralAccountAccount

Lehman ReLehman Re

PeriodicPeriodicPaymentsPayments

CounterpartyCounterpartyContractContract

LIBOR LIBOR

InvestmentInvestmentEarningsEarnings

LIBOR + 4.50LIBOR + 4.5011

LIBOR + 6.50LIBOR + 6.5022

$150M$150M

Net PrincipalNet PrincipalAmountAmount

Payout Payout ifif

TriggerTrigger

OverviewOverview

(1) Notes(1) Notes(2) Preference Shares(2) Preference Shares



Structural Motivations:Lehman Re/Lehman BrothersStructural Motivations:Lehman Re/Lehman Brothers Create a product that is easy to understandCreate a product that is easy to understand Seismic closely resembles Industry Loss Warranties (ILWs) Seismic closely resembles Industry Loss Warranties (ILWs) Capacity constraints lessenedCapacity constraints lessened Arbitrage between traditional and capital marketsArbitrage between traditional and capital markets Value of full collateralizationValue of full collateralization



Structural Motivations: InvestorStructural Motivations: Investor Attractive risk/rewardAttractive risk/reward Value of purchasing non-correlated assetValue of purchasing non-correlated asset Only single risk, California only CAT Bond in marketOnly single risk, California only CAT Bond in market Like index based nature of loss measurement - addresses moral Like index based nature of loss measurement - addresses moral

hazardhazard ILW nature of security provides a pricing back-stop in case of ILW nature of security provides a pricing back-stop in case of

capital markets disruptioncapital markets disruption Transparency of structure promotes liquidityTransparency of structure promotes liquidity



Basis Risk IssuesBasis Risk Issues A unique characteristic of Seismic is the role of Lehman Re A unique characteristic of Seismic is the role of Lehman Re

Lehman Re is able to hold and manage risk, thus allowing it to Lehman Re is able to hold and manage risk, thus allowing it to tailor products that Capital Market participants wanttailor products that Capital Market participants want

CatastrophicCatastrophicCaliforniaCaliforniaEarthquakeEarthquake

RiskRisk

Basis RiskBasis Risk

SecuritizableSecuritizableRiskRisk

Lehman ReLehman Re

CAT BondsCAT Bonds

(Indemnity)(Indemnity) (Index)(Index)



Sources of Basis RiskSources of Basis Risk Residential vs. Residential/CommercialResidential vs. Residential/Commercial Fire FollowingFire Following General correlation between industry losses & losses General correlation between industry losses & losses

on specific reinsurance treatyon specific reinsurance treaty

Lehman opinion: Market pays you Lehman opinion: Market pays you handsomely for assumption of basis riskhandsomely for assumption of basis risk


Seismic Limited – Case Study Seismic Limited – Case Study Basis Risk Retention : The FutureBasis Risk Retention : The Future If catastrophic securitization is to grow dramatically, Seismic is a If catastrophic securitization is to grow dramatically, Seismic is a

template for such growthtemplate for such growth Current issues holding back market growthCurrent issues holding back market growth

Cedents: speed to market, pricingCedents: speed to market, pricing Investors: complexity, moral hazard, lack of transparencyInvestors: complexity, moral hazard, lack of transparency

Solution: Intermediary (broker, cedent, underwriter) takes basis Solution: Intermediary (broker, cedent, underwriter) takes basis riskrisk

Market gets simpler deals, faster execution, better liquidity = more Market gets simpler deals, faster execution, better liquidity = more investorsinvestors

Investor willingness to “pay” for transparency - differential Investor willingness to “pay” for transparency - differential between structures apparent in secondary trading of outstanding between structures apparent in secondary trading of outstanding dealsdeals



Rating Agency IssuesRating Agency Issues Have expressed dismay over structural complexity of recent Have expressed dismay over structural complexity of recent insurance-linked transactions. Have asked for more transparencyinsurance-linked transactions. Have asked for more transparency Strong preference for index or parametric deals over indemnityStrong preference for index or parametric deals over indemnity Relied on both internal models and quality of RMS model to Relied on both internal models and quality of RMS model to assess the validity of expected loss calculationsassess the validity of expected loss calculations Developed “comfort” with PCS’s ability to accurately reflect Developed “comfort” with PCS’s ability to accurately reflect aggregate industry losses in Californiaaggregate industry losses in California Moral hazard concerns largely eliminated by virtue of industry-Moral hazard concerns largely eliminated by virtue of industry-wide loss measurementwide loss measurement


Why PCS?Why PCS?

Seismic Limited - Case StudySeismic Limited - Case Study

Industry Gold StandardIndustry Gold Standard Long history of providing catastrophic loss measurementsLong history of providing catastrophic loss measurements Usage of PCS loss estimates in ILW contracts underscores Usage of PCS loss estimates in ILW contracts underscores

legitimacy of index in eyes of investorslegitimacy of index in eyes of investors



Why RMS?Why RMS? Investors require detailed analysis of risk associated with the Investors require detailed analysis of risk associated with the

bonds including attachment and exhaustion probabilities and bonds including attachment and exhaustion probabilities and expected losses expected losses

Rating agencies and investors have developed a level of Rating agencies and investors have developed a level of “comfort” with the analysis provided by these companies“comfort” with the analysis provided by these companies

RMS was used for the Seismic deal because of its knowledge RMS was used for the Seismic deal because of its knowledge and background in the study and assessment of California and background in the study and assessment of California earthquake riskearthquake risk

RMS plays a critical role in marketing as supplier of RMS plays a critical role in marketing as supplier of independent analysis and is also available to address investor independent analysis and is also available to address investor questionsquestions


Summary of RMS AnalysisSummary of RMS AnalysisAnnualized Aggregate Probabilities*Annualized Aggregate Probabilities*


ExpectedLoss

AttachmentProbability

ExhaustionProbability Spread

Notes 0.73% 1.13% 0.47% 4.50%

PreferenceShares

1.13% 1.13%1.13% 6.50%

* As measured by RMS* As measured by RMS



Issuer Seismic Limited. (“Seismic”), a Cayman Islands specialpurpose company

Securities $145,500,000 Notes

$4,500,000 Preference Shares

Redemption Date January 1, 2002

Extended Maturity Securities may be extended for up to eighteen months afterthe Redemption Date if certain Extension Events occur

Offering Type Rule 144A private placement

Interest/Dividends Notes: LIBOR + 4.50%, reset quarterly

Preference Shares: LIBOR + 6.50%, reset quarterly

Expected Loss *(Annualized)

Notes: 0.73%

Preference Shares: 1.13%

Term SheetTerm Sheet


Seismic Limited – Case Study Seismic Limited – Case Study Earthquake Any catastrophic event that is identified and assigned a

number by PCS as a “catastrophe”, where the perilsidentified by PCS with respect to such catastrophe includethe peril of earthquake

Covered Event All Earthquakes (including all fires following suchEarthquakes) occurring during the Risk Period that havebeen identified by PCS as having caused insured propertylosses in the State of California

Cumulative InsuredLosses

The sum of estimated insured property losses in the Stateof California arising from Covered Events as stated byPCS and verified by RMS

Rating BB+ (S&P) / Ba2 (Moody’s)Attachment Point Cumulative Insured Losses equal to or in excess of $22.5

billion, according to scheduleExhaustion Point Cumulative Insured Losses equal to or in excess of $31.5

billion, according to schedule


Seismic Limited– Case Study Seismic Limited– Case Study Trigger Amount ScheduleTrigger Amount Schedule

Cumulative Insured Losses

% of Original PrinicpalAmount of Securities

Written Down$22,500,000,000 10%$23,500,000,000 20%$24,500,000,000 30%$25,500,000,000 40%$26,500,000,000 50%$27,500,000,000 60%$28,500,000,000 70%$29,500,000,000 80%$30,500,000,000 90%$31,500,000,000 100%


Seismic Limited– Case Study Seismic Limited– Case Study Investor DemandInvestor Demand

60%

5%

15%

9%

6%5% Money Managers

Hedge Funds

InsuranceCompaniesReinsurers

Banks

Other



Increase in money managers participation - more stable Increase in money managers participation - more stable capacitycapacity

General increase in recognition of value of non-correlated General increase in recognition of value of non-correlated nature of risknature of risk

Shift toward lower yielding single peril deals and away from Shift toward lower yielding single peril deals and away from “kitchen sink” retro deals“kitchen sink” retro deals

Recent issuance has led to ability to create portfolio of non-Recent issuance has led to ability to create portfolio of non-correlated CAT risks, bringing previously “on-the-fence” correlated CAT risks, bringing previously “on-the-fence” accounts into CAT bond marketsaccounts into CAT bond markets

Recognition that liquidity is much better than skeptics contendRecognition that liquidity is much better than skeptics contend

Investor TrendsInvestor Trends



Seismic oversubscribed and well traded in secondary market Seismic oversubscribed and well traded in secondary market TransparencyTransparency SimplicitySimplicity Lack of moral hazardLack of moral hazard LiquidityLiquidity Reinsurance market backstopReinsurance market backstop

At same time, Lehman Re (Cedent) achieves objectivesAt same time, Lehman Re (Cedent) achieves objectives Big capacityBig capacity Fully collateralizedFully collateralized Attractive pricing adjusted for basis riskAttractive pricing adjusted for basis risk

ConclusionsConclusions

LL BBEHEHMM NNAA RROOTTHHEERRSS

Documents

Seismic Limited Case Study LEHMNABROTHER S John Kiernan August 15, 2000