Alex Vartan MS&E 345 9/14/03 Catastrophic Risk and the Capital Markets Assets that are uncorrelated

to stock and bond returns are attractive to investors seeking to diversify their portfolios. However, such truly uncorrelated traded assets are few and far between. For an asset to be uncorrelated to the rest of the market, the factors (in an APT sense) defining its payoff must also be uncorrelated with other factors in the economy. Secondly, the factors must have an intrinsic economic meaning a bank could create a security whose payoff each period was the result of a coin flip. While uncorrelated, the security doesnt represent a fundamental asset. If the coin-flip security is the ideal in terms of correlation, can we find factors in the economy whose behavior approximates the randomness of a coin-flip? Its almost a contradiction to claim that an economic factor has no correlation to the economy to which it belongs. But a class of these factors does exist. Catastrophes are notoriously unpredictable and unrelated to market factors. Hedging against them is the role of insurance, an industry whose importance is clear from its history as being one of the worlds oldest economic professions. But to understand insurance, we must distinguish between the two types of risk at work. Fire insurance on a home can be diversified away through the writing of millions of policies the uncorrelated risk of a single fire is mitigated when millions of potential fires are bundled together. What then remains is a diversified portfolio one whose payoffs are more related to marketcorrelated factors such as the rise in home values, overhead costs, and demographic changes than they are to an individual fire. But the property and casualty insurance discussed above just cant cut it in our search for an ideal security. While the unpredictability of a single house fire is good, its too diversifiable. What we require is another type of event: a risk that is undiversifiable. For example: events that are common to large numbers of people, but rare enough to prevent adequate diversifying. The set of risks that most fit the bill are large-scale natural catastrophes, including floods, earthquakes, hurricanes, and terrorism. These events involve many more insured entities, and have the potential for very large aggregate claims. Unlike the typical high-frequency, lowseverity risks that are easily managed, such low-frequency, high-severity risks present particular difficulties [Litzenberger, et al., 1996] However, its in the resolution of these difficulties where our ideal security lies. The Role of Catastrophic Reinsurance Insurers face a bit of a paradox when writing property and casualty insurance. They can increase revenues and realize economies of scale by increasing market share in a particular region. Indeed, there is probably some optimal level of share that minimizes overhead and provides the cheapest insurance to customers. However, as market share increases, the risk to the insurer also increases, as a natural disaster that hits the region results in larger, more concentrated

losses. The solution to this problem lies in a secondary level of insurance known as catastrophe reinsurance. Reinsurance is the process by which first line insurers can offload some of their major-event risk to specialized companies so they can maintain economies of scale and competitiveness in the marketplace. In this paper, we will try to understand how the catastrophe (CAT) reinsurance market operates, and what, if anything, makes it a special asset for reinsures or investors to hold. The idea that there is something unique about reinsurance is motivated by the success of the worlds most famous investor, Warren Buffett. While his legendary status as a stockpicker is widely reported by the media to be the source of Berkshire Hathaways stunning compounded annual growth rate, what is woefully underreported is the significance of his reinsurance operations to his success. Its hypothesized that the uncorrelated nature of natural disasters and the pricing particularities of the industry can lead to a so called volatility pumping effect [Luenberger, 1998]. Through a simplified model, we will simulate the evolution of the industry and hopefully try to explain why Berkshire Hathaway, the largest reinsurer in the nation and second largest in the world, has a market value of over ten times its nearest competitor; and, why it has become more well known for its investment portfolio than its original reinsurance business! Lastly, well take a look at the possibility of reinsurance-linked securities as a new asset class, and what it means for the industry and investors at large. CAT Reinsurance In Action Reinsurers are specialized financial intermediaries whose role is to protect a primary insurance carrier against the losses that result from a momentous event. Typically, a primary insurer will cede risk through what is known as excess of loss coverage. For example, an insurer who writes policies covering an aggregate of $200 million in damages might only be willing to accept $50 million in losses in the event of a disaster. The insurer could then purchase a 150/50 excess loss layer from a reinsurer (typically with a 1 year duration), which would provide indemnification for $150 million (the limit) in losses over $50 million (the attachment point) associated with a single event. The purchase price for this coverage is normally quoted as a percentage of the limit, a number known as the rate on line (ROL) [Litzenberger, 1996]. The reinsurance model provides coverage for catastrophic liabilities. These are lowfrequency, high-magnitude events, so most years, a reinsurer will collect the premium on a single contract but pay out nothing. However, capital must be available in the event of a major disaster, so the reinsurer must have available a large and liquid surplus. This surplus is typically invested in a diversified, low risk portfolio of stocks and bonds. Thus, the reinsurer has two (uncorrelated) revenue streams the return on its investments, and the premiums collected from reinsurance. Corresponding profit streams are the underwriting profit premiums minus claims and the investment income. In the case of a major disaster, there will be severe underwriting losses arising from large claims, which will deplete the surplus. But in years with below average claims, the resulting underwriting profit is added to the surplus. Since the surplus is what funds potential CAT losses, it limits the amount of policies a reinsurer can write. In this way, the surplus represents the risk capacity of the reinsurer, and the aggregate surplus of the industry is a proxy for the total supply of reinsurance available. 2

As an example, the cumulative losses from major domestic catastrophic events in the first half of the 1990s were $35 billion, which was about 18% of the total surplus of the industry in 1996. Hurricane Andrew caused $15 billion of insured losses in 1992 when it swept through Florida and Louisiana. Floridas 1992 total insured losses for catastrophe related lines were nearly seven times the corresponding total premiums earned in that year. Additionally, the states insurance costs from Hurricane Andrew exceeded the $14.6 billion in total gross premiums earned in the seven years from 1986 through 1992 for the corresponding lines of coverage [Litzenberger, 1996]. Clearly, individual disasters have a major impact on capital surpluses and resulting reinsurance capacity. Pricing A reinsurer can be thought of as both an operating business providing CAT risk management and as an investment company, seeking to maximize total return on equity. Of course, these two goals are connected strongly, but to understand how they are, we must first examine how the reinsurance is priced. The two characterizations of a reinsurer leads to two pricing methodologies whose results are not always consistent with each other. The most obvious way of pricing reinsurance is actuarially. The underlying probability of an event is measured, both the attachment point of the contract and limit are taken into account, and an expected-loss figure results. But that is not enough to generate a price that will clear the market. What is also needed is a measurement of the risk aversion of the cedant and reinsurer. The very nature of reinsurance means that for a particular risk, the insurer will be more risk averse than the reinsurer. The difference in these utility functions helps specify the marketclearing price. An additional pricing factor is the variance of the expected loss volatility must be compensated for. In practice, segmenting the total reinsurance requirement into multiple layers controls variance. If a total of $500M is needed, five layers of $100M each could be priced separately. From an analytical standpoint, making the reinsurance payouts approximate all-ornothing simplifies pricing by reducing loss variance in each individual tranche. The market clearing price will be generated by the probability of the catastrophe affecting each tranche (declining for increasing layers), and the parties differing risk aversion. This price will be unquestionably higher than the expected loss, due to both compensating the reinsurer for the variance of the loss (reduced but not eliminated by layering), and the risk aversion differential. But this assumes there is accuracy in determining the probability of catastrophe. In this simplified model, the final but most fundamental pricing factor is the difficulty in estimating the chance of a natural disaster. The probability of an event can be estimated from historical records or forecast through simulation, but when it comes down to it, these are at best shots in the dark. For rare events, it is simply impossible to get an accurate measurement of the mean probability. Can we really say that incidence of hurricanes worldwide over the last 100 years has any predictive power for the next? And what about more targeted risks, like hurricanes off the Florida coast? Another paradox of reinsurance is that the most accurate worldwide statistics arent even much help, since reinsurance is specific to tightly defined regions. Even rarer but more catastrophic events (the more rare, arguably, the more catastrophic the event, and 3

hence more important to be able to price and insure) are impossible to predict with the required precision for pricing. If the best guess of the chance of a tsunami hitting Hong Kong is .25%, am I really sure that .75% is not as reasonable? Probably not and yet, this would result in (at least) a 3x price difference! As a sidenote, this pricing model is an abstraction. In practice, a reinsurer will sometimes take consistent underwriting losses in an accounting sense. The reason being that potential claims are paid out years after the event (due to exogenous factors), which can be as much as a year after the premium payment. In a sense, the reinsurer is taking out a loan from the cedant, which will be paid out in an expected-value sense years from now. This liability has a cost, and as long as it is lower than the prevailing cost of funds of similar duration, the reinsurer comes out ahead. Realistically, however, true underwriting losses are a function of the same underlying, high variance, event probabilities; they can be massaged almost at will because a range of catstrophe probabilities are acceptable. A loan of $1B in premiums with an expected term of 5 years could very likely be paid back with only $500M in claims not exactly an underwriting loss on the year. We propose that these three actuarial pricing factors event probability and risk aversion, loss variance, and probability imprecision make impossible a single market-clearing price. Indeed, a reinsurer, in searching for the correct event probability, could certainly underestimate that figure, and be underwriting unprofitably in an expected-value sense. At best, reinsurance prices can be characterized by a distribution of market-clearing prices, a range where all prices are rational. Indeed, Warren Buffett, in his 1996 Letter to Shareholders, had the following to say about pricing:
Even if perfection in assessing risks is unattainable, insurers can underwrite sensibly. After all, you need not know a man's precise age to know that he is old enough to vote nor know his exact weight to recognize his need to diet. In insurance, it is essential to remember that virtually all surprises are unpleasant, and with that in mind we try to price our super-cat exposures so that about 90% of total premiums end up being eventually paid out in losses and expenses. Over time, we will find out how smart our pricing has been, but that will not be quickly. The super-cat business is just like the investment business in that it often takes a long time to find out whether you knew what you were doing. [Berkshire Hathaway Letter to Shareholders, 1996]

The actuarial side of pricing then, at best, results in a range of acceptable prices. Pretending that there are hard upper and lower limits for a band of prices, any price in the range can be thought of as a reasonable combination of the three pricing factors above. Empirically, there is substantial evidence for large volatility in correct CAT prices. The following chart from the Guy Carpenter Co., the worlds largest reinsurance broker, demonstrates price volatility across all catastrophe classes. What is notable is the response of pricing to actual catastrophe realizations. The hurricane and earthquake losses of the early 90s correspond to an increase in pricing, as does the WTC disaster. Assuming that the industry is rational enough to understand that the realization of an event doesnt necessarily mean the probabilities of such an event change, something else must be causing the strongly correlated price movements. The assumption that the industry doesnt use actual events in updating probabilities and expectedlosses is admittedly a bit tenuous the actual losses might provide important information about nature and value of damage, etc. which would be helpful for future pricing. But investigations 4

into this effect conclude that there is limited evidence for probability updating, and what evidence there is suggests that the effect is of small magnitude. [Froot & OConnell, 1997]. What results is a (easy to solve) mystery about what causes price movements within the actuarially defined range.

While actuarial pricing is related to the underwriting side of reinsurance, it is the investment management side that is responsible for much of the price volatility. Remember that a reinsurers surplus serves two distinct purposes: to act as a payout reserve in the event of truly catastrophic losses, and to generate investment income. Since the surplus limits the amount of insurance that can be written, it represents the available supply of risk transfer. Thus, a simple supply/demand model is appropriate for modeling price swings within the actuarially defined range. If supply was completely elastic, then the price of reinsurance would be fixed in the sense as only being dependent on actuarial factors, not capacity constraints. Capital would flow in and out of the industry as needed to meet the demands of cedants and to replenish surpluses after catastrophic losses. However, if supply was inelastic, decreases in capacity would result in higher prices. Since protection against catastrophic losses is so vitally important, its not likely that quantity demanded by first line insurers would decline significantly. When Froot & OConnell concluded that probability updating isnt significantly responsible for price changes, the only reasonable explanation for price volatility was that supply of capital was constrained. In making this conclusion, they relied on analyzing the behavior of cross-sectional changes in reinsurance prices. If probability updating was responsible for price changes, it should only affect a single line of business. For example, a winter freeze in New England might change the future expected losses for similar perils in the region. Such an event shouldnt affect pricing on other reinsurance lines if probability updating was the only factor. Their analysis showed that 5

capital market imperfections appear to be the dominant explanationthe magnitudes of the supply effects are large: after controlling for relative contract exposure, a $10 billion catastrophic loss raises average prices by between 19% and 40%, and reduces quantity of insurance purchased by between 5% and 16%. There are many proposed explanations for why capital market imperfections exist. The most interesting is that the industry can maximize its shareholder return by taking advantage of the price volatility. If that is the case, then managers have an incentive to limit capital infusions, and the industry as a whole would be significantly undercapitalized. There is much anecdotal commentary confirming this hypothesis. By limiting capital flows, the industrys market power is strong relative to its customers, and they can act as price setters in certain cases. We would like to understand how this works, and what are the long-term effects of such price volatility. The following example illustrates the simplest effect of capacity constraints. Assume the industry takes a large loss as the result of a catastrophe, and each reinsurer is hit equally. Shareholders capital has been reduced, and a decision has to be made. Management can go to the capital markets to replenish surplus, and the reinsurer can write coverage at the same price as before. However, current shareholders will see their holdings diluted by the additional capital significantly, if the loss is large. On the other hand, the insurer decides not to replenish capital, and instead, raises prices. Now, although less business can be written, it is done higher prices and on a lower level of shareholders capital. Shareholders dont see their holdings diluted, and they get the benefit of a larger return on equity. Instead of management going to the capital markets to replenish surplus, which is much more efficient in terms of fair pricing, they seek to replenish their capital internally through price increases. Since the industry is relatively small, the actions of a few dominating firms is likely to make other firms follow suit. A Multiperiod Perspecitve In the capital markets, volatility has two somewhat paradoxical effects on valuation. From utility theory, the higher the variance of a payoff, the lower the certainty equivalent for a risk averse individual. CAPM provides a different interpretation of pricing volatility through the concept of beta. Identifying covariance to the market portfolio as the important statistic, CAPM concludes that investors are compensated not for raw volatility, but for the correlation of returns to the market. Thus, a security with high volatility but zero covariance to the market should return the risk free rate. In practice, most volatile securities have high beta due to exogenous factors, so high-volatility = high required compensation is a typical market rule of thumb. However, both utility and CAPM approaches are single-period models. A multiperiod perspective better approximates reality and in certain cases can lead to an opposite treatment of volatility. While not a theoretically precise notion, the idea that "volatility is bad" is turned on its head in the multiperiod setting. With a logarithmic utility function, the problem of maximizing the long-term growth rate is equivalent to maximizing expected single-period utility, and using the same strategy in every period. By using the logarithm as a utility function, we can treat the problem as if it were a single-period problem [Luenberger, 1998]. In this framework, positive growth can be generated from securities with positive volatilities - even if the expected (multiperiod) growth of each 6

individual security is zero! (e.g. Example 15.2 of Luenberger, 1998]. In a sense, the volatility "pumps" the growth rate through rebalancing - the log-optimal conclusion is to use the same allocation strategy every period. If a portfolio of these assets can generate positive growth, then it follows that the volatile asset has "value" in excess of its' expected long run payoff. In a singleperiod model, investors would have to be compensated for the undesirable volatility. In a multiperiod setting, this volatility is "valuable". A necessary condition for the volatility pumping effect to occur is the low covariance of portfolio securities. Luenberger shows through a continuous-time model how positive covariance in portfolio assets reduces optimal growth. The best we can do is to pump a portfolio of uncorrelated assets. Reinsurance Revisited We can examine reinsurance in this multi-period framework. It has already been established that reinsurance pricing is notoriously volatile. Since managers are stingy with capital infusions, pricing is largely a function of capacity, which is a function of catastrophic events. We've seen how sensitive pricing is to the occurrences of catastrophes, and how prices escalate to the top of the actuarial range. The following model attempts to show how the structure of the industry might induce a volatility pumping effect for reinsurers. It's widely held and confirmed assumption that the occurrences of catastrophes have a priori no correlation to security returns. Thus, reinsurance prices, while volatile, aren't correlated to market returns. The occurrence of a catastrophe will deplete a reinsurers capital. Managers will raise prices because they can. Since this induced price volatility is not related to market returns, this seems to satisfy the first volatility pumping requirement. Certainly it's evident that prices are "volatile enough" for a meaningful effect. Secondly, there must be some sort of rebalancing action. This is more hand-wavey. First, since we say prices increase as a result of a catastrophe, pre-event, they must be "lower". This low price means reinsurers have competed and made the contract asset "expensive" in the sense of a lower payoff for accepting the same amount of CAT risk. After the event, industry structure dictates that prices will rise. Now, for the reinsurer, accepting the risk is "cheaper" because they are being compensated more. It's similar to a bond - for a given coupon, a lower yield implies the bond is priced above par, and more "expensive" for the owner. In our model, the coupon can be thought of the reinsurance price in absence of any capital constraints, and somewhere in between the pre and post-catastrophe prices. Since the essence of rebalancing is cashing-out of the appreciated asset and investing in the cheap asset, we can consider that the "loss" of (market-invested) surplus in the event of catastrophe is "reinvested" in a now-cheaper asset. A less forced argument in support of volatility pumping effects will appear when looking at catastrophe-linked securities. Simulation Model We propose a simplified dynamic model of reinsurance to investigate multiperiod effects, and also try to understand Warren Buffetts success in managing Berkshire Hathaway as a combination reinsurer and investment company. 7

The simplest model we will use is that of a single reinsurer who starts with $1 of capital. X(t) denotes capital at time t, and r is the investment return on capital. P(t) is the yearly premium from reinsurance operations, expressed in terms of total capital. C(t) is the catastrophe losses on the year. We have X(t+1) = [1+r + p(t) - (c(t)-1)]X(t) p(t) = avgprem + [max((c(t-1)-avgprem), 0) + max((c(t-2)-avgprem),0) + max((c(t-3)-avgprem),0)]/3 X(1) = 1 The parameters for this model are as follows: r is normal, mean=6%, stdev=3%. c(t) is a lognormal random variable with parameter mu=0.15, sigma=0.07. The premium equation requires explanation. The average premium (avgprem) is the price, expressed in terms of total capital, if surplus supply was completely elastic. This price would be in the middle of the actuarial range, and in our model, is set to equal the long run expected claims (c(t)-1). The second term generates price volatility as a function of actual catastrophe losses. A three year rolling average of the underwriting losses is used. The selection of a lognormal random variable is important because of its asymmetric fattail distribution. This allows for the (rare) occurrences of large catastrophes, and limits the number of years where catastrophe losses are "negative" (we ignore this possibility, as the parameters make that occurrence unlikely. In MATLAB, 30,000 realizations of a 30-year time horizon were performed. The results for the above parameters show an effect - a compounded annual growth rate of capital of 8.8%. This is 2.8% higher than the simulation results when p(t) = avgprem alone. After 30 years, $1 of capital grows to $12.63 when reinsurance prices are volatile and $5.73 when they aren't. However, it still isn't completely clear whether this is a true VP effect. To be sure, we would need to vary correlations between the lognormal loss variable and the normal return. If the surplus return increased as the correlation declined, confidence in a VP effect would increase. As a sidenote, in the development and debugging of the model, a different rolling average was used. Instead of just underwriting losses, underwriting profits were used too. That is, the max() operator was removed, and prices were allowed to decline if there were underwriting profits the previous years. What happened was an opposite VP effect - the intuitive action of raising prices in response to a lossey rolling average led to a decrease in CAGR. Lowering prices in response to a catastrophe is what generated a slight (0.5%) increase in CAGR over the mean return. It is unclear if/why this is significant, but it's somewhat counterintuitive in light of the previous pricing discussion. Back to Buffett The above simulation shows a possible volatility pumping effect that, while meaningful, isn't of large enough magnitude to make a huge difference. And a huge difference is what we're looking for when trying to explain the dominating returns of Berkshire Hathaway as a reinsurer and investment company. The problem is that above, we only simulated a single reinsurer. In 8

reality, the reinsurance market has many players, each with their own asset allocations and reinsurance programs. The competitiveness of a reinsurer is based both on actuarial prowess, but also and this is the important point available capital. A larger reinsurer will be able to accept larger risks. Competition for these risks is far less ruthless, and pricing is more advantageous for the reinsurer. There is ample evidence for this phenomenon, especially in Berkshire Hathaway's operations. Buffett, a master of understatement, discloses this in his 1996 Letter to Shareholders:

In the super-cat business, we have three major competitive advantages. First, the parties buying reinsurance from us know that we both can and will pay under the most adverse of circumstances. Were a truly cataclysmic disaster to occur, it is not impossible that a financial panic would quickly follow...When it's Berkshire promising, insureds know with certainty that they can collect promptly. Our second advantage - somewhat related - is subtle but important. After a megacatastrophe, insurers might well find it difficult to obtain reinsurance even though their need for coverage would then be particularly great. At such a time, Berkshire would without question have very substantial capacity available - but it will naturally be our long-standing clients that have first call on it. That business reality has made major insurers and reinsurers throughout the world realize the desirability of doing business with us. Indeed, we are currently getting sizable "standby" fees from reinsurers that are simply nailing down their ability to get coverage from us should the market tighten. Our final competitive advantage is that we can provide dollar coverages of a size neither matched nor approached elsewhere in the industry. Insurers looking for huge covers know that a single call to Berkshire will produce a firm and immediate offering." [Buffett, 1996]

Berkshire's three competitive advantages are all a result of its' capacity advantages over other reinsurers. Indeed, there is an inkling of an important positive feedback loop. If capacity leads to the ability to do business when other reinsurers can't, or to collect sizable Mafia-esque "protection" fees, then a large reinsurer is likely to have an expected underwriting profit larger than the competition. This additional profit is reinvested back into the surplus, increasing the domination of the large reinsurer. We will expand the model to include this feedback effect. First, we populate ten reinsurers with initial capital of $1. The model is as above, and all reinsurers have normal returns of r=6%, stdev=3%. Reinsurers must have a low-risk portfolio (as the statistics confirm), but as a result, they are likely to be invested in similar assets. Returns for each reinsurer are assumed to be correlated at a coefficient of 0.75 to each other. As a percentage of their capital, the catastrophe losses each year are the same for each reinsurer, and c(t) has mu=.15, sigma=.07. The new model is as follows: X_n(t+1) = [1+r_n + p_n(t) - (c(t)-1)]X_n(t) n=1...10 p_n(t) = avgprem + (X_n(t-1) - average(X_n(t-1))*extra X_n(1) = 1 n=110 A reinsurer's extra premium earned via largesse is a function of the difference between its' capital and the average capital of the industry. The "extra" constant is set to .04, which roughly says that a reinsurer can raise prices around 25% on the low-competition lines. The simulation results are as expected - the standard deviation of final period capital is meaningfully higher for 9

the case when extra=.04 compared to when extra=0. An example graph shows the "breakaway" phenomenon - high initial investment returns lead to much higher end capital. This graph uses a stdev of 6% and return correlations of .5 just to make clear the breakaway effect.

Now, we could say that Berkshire Hathaway just happened to be the reinsurer who broke-away from the pack, and that would be the end of it. However, giving Buffett the benefit of the doubt, let's see what variables could affect the breakaway probability of a single reinsurer. Motivated by Warren Buffett's investment strategy, we will first look at correlation. Buffett has always made very diverse investments (almost shockingly diverse), purchasing entire companies when he can. Once a company becomes private, it isn't subject to market-based valuation, and hence covariance to the market is decreased in a practical sense. Also, Berkshire Hathaway is substantially the only reinsurer who holds such diverse operating businesses. In the above simulation, we assumed all reinsurers were correlated to each other at a coefficient of 0.75. Now, we will vary the correlation of a single reinsurer (Berkshire) and see if that affects the probability that Berkshire comes out on top. Note that we do not change Berkshire's mean return or standard deviation. The following graph relates Berkshire's return correlation coefficient to the probability that it has the largest capital after 30 years (5000 trials for each datapoint). Thus, within the positive feedback model, low-correlation alone can increase the probability of breakaway performance. This would certainly back up the case that Buffett's strategy has paid off.

10

0.3000

0.2250 % of outcomes with B-H on top

0.1500

0.0750

0 0 0.2 0.4 Correlation 0.6 0.8

Next, we will perform the most obvious analysis assuming Buffett is a better investment manager and can generate returns higher than the competition, how will that affect end-period results? The answer is clear Berkshire is likely to dominate irregardless with an increased return on capital, but the positive feedback effect basically guarantees this. Setting all parameters as above (and all return correlations back to 0.75), we set Berkshire's mean return on capital at 7%, 1% higher than the competition. Unsurprisingly, at the end of 30 years Berkshire's capital is the largest 60% of the time. More interesting is that the average compounded annual growth rate of the other reinsurers over 30 years equals the 6% expected return on their capital. But Berkshire's CAGR is 7.7% feedback effects multiply the 1% advantage into 1.7%! The following graph shows Buffett's mean return on capital advantage over his competition in relationship to Berkshire's 30 year CAGR advantage over the competition. This multiplying effect is very important not only does Berkshire do well because of increased returns, but returns are pumped further through feedback effects.

11

7.00

Surplus 30-year CAGR

5.25

3.50

1.75

0.00 0.00 1.00 2.00 3.00 4.00 Surplus mean return

Concluding Remarks
The above three simplied models of reinsurance showcase how the industry dynamics can create an uncorrelated, good form of volatility. While the VP effect alone is somewhat unclear, the effects of a single reinsurer with low-covariance to the rest and a single reinsurer with a highly skilled investment manager are clear. Warren Buffetts strategy has guaranteed Berkshire Hathaways breakaway performance over the last 30 years, and in practice, his returns have often been much higher than 4% over the competitors mean return. In light of this, one can argue that the industry dynamics were more responsible for Berkshires amazing growth than outsized investment management. The investment community and media treat Buffett as an investment genius, operating in the 99% percentile of managers. The real answer is that hes a reinsurance genius and understood how taking a small chance early on to increase returns has a substantial feed-forward effect. Even if Buffett was only in the 75% percentile of managers (not deserving of God-like admiration), Berkshire Hathaways performance would still eclipse any other reinsurer. Indeed, Berkshire Hathaway has grown capital so much that its known primarily a conglomerate these days, but one cannot discount how reinsurance dynamics have led to this outcome. The Future
Its a widely held belief that the industry is undercapitalized, and as weve seen, for a reason in an optimal-growth sense. However, to meet the future challenges facing the reinsurance industry, capital markets must have a role. Even if traditional reinsurers are hesitant to accept new capital, new innovations in CAT-linked securities means their monopoly on catastrophic risk management might very well end.
If a insurer needs to ofoad a large catastrophe risk, instead of going to a reinsurer, a so called CAT bond could be oated. Investors put up the full limit amount in a trust, and receive a coupon payment as payment for the risk. Such bonds have been in the works for a decade, but their issuance has been disappointingly low. They are, however, the best answer for our original 12

question of where to nd zero-covariance securities. They isolate individual events, are liquid, and can be bought by any investor who so desires. If pricing remains as volatile in the CAT bond market as it does in the reinsurance market (considering that traditional reinsurance is still market dominating, there is reason to believe this is so), then CAT bonds will likely have prices that uctuate widely and uncorrelated to market returns. Indeed, in the limited securitizations thus far, prices have been volatile when there is even mere forecast of a Hurricane. What a great asset, volatile in response to the weather, and liquid enough to be volatility pumped!
Why hasnt the CAT-bond market if it is so desirable to investors and necessary to bring new forms of capital into the risk management business? The following chart shows how dismal, and not continuously increasing, the deals have been (Guy Carpenter Co.)

An explanation for the stagnancy of the CAT-bond market returns us to Buffett. He writes in his 1997 Letter to Shareholders:
The influx of "investor" money into catastrophe bonds -- which may well live up to their name -has caused super-cat prices to deteriorate materially. Therefore, we will write less business in 1998. We have some large multi-year contracts in force, however, that will mitigate the drop. The largest of these are two policies that we described in last year's report -- one covering hurricanes in Florida and the other, signed with the California Earthquake Authority, covering earthquakes in that state. Our "worst-case" loss remains about $600 million after-tax, the maximum we could lose under the CEA policy. Though this loss potential may sound large, it is only about 1% of Berkshire's market value. Indeed, if we could get appropriate prices, we would be willing to significantly increase our "worst-case" exposure. [Buffett, 1997]

This is not exactly a glowing commentary in support of CAT securitizations. But Buffett clearly acknowledges the effect the presence of these bonds has had on his business. His next comment on the large CEA policy is worth mentioning. The CEA was to be one of 13

the largest reinsurance transactions in history, covering California earthquake losses and sponsored by the State. It was also to be a precedent-setting securitization in the form of a CAT bond. The investment banks were lined up, terms had been agreed upon, and it was days until the contracts were to be signed and the deal to be sealed. At the last minute, none other than Berkshires super-cat group, National Indemnity, lowballed the expected coupon on the bond and stymies its issuance. In fact, instead of questioning the logic of CAT bonds, Buffett basically bought the entire offering. Industry watchers dubbed this no less than a hijacking, and the action was huge in terms of squashing prospects for other bonds. If the bond was designed to undercut available traditional reinsurance, and it was all set to be oated at a price that no other reinsurer would (or could) accept, and then Buffett steps in and undercuts that price then pricing must be volatile and the actuarial range concept seems to be valid. As a sidenote, the CEA contract was for a limit of $1B. The mean actuarially expected loss was 1.7%. In return for bearing that risk, Berkshire was compensated an annual premium of $113 million. At the end of it all, the gamble amounted to Berkshire accepting a potential downside risk of $600M in exchange for the upside of a 93.7% chance to make $400M over the life of the contract. Make your own conclusions!

References Buffett, Warren. Berkshire Hathaway 1996 Letter to Shareholders. http:// 14

www.berkshirehathaway.com/letters/1996.html Froot, Kenneth and Paul G. J. OConnell. The Pricing of US Catastrophe Reinsurance. National Bureau of Economic Research. Working Paper 6043, May 1997. The World Catastrophe Reinsurance Market: 2003. Guy Carpenter Co. September 2003. Litzenberger, Robert and David Beaglehole & Craig Reynolds. Assesing Catastrophe Reinsurance-Linked Securities as a New Asset Class. The Journal of Portfolio Management. Special Issue 1996. Luenberger, David G. Investment Science. Oxford University Press, 1998.

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