Presentation to NY actuarial meeting giving my insurance underwriting perspective on the financial crisis, the CDS market, and solutions we should consider.

1. Actuarial Society of Greater New York
“Black Swans”, the “Sub-prime
Crisis” and Systemic Risk:
One underwriter’s Perspective
James W. Macdonald, ARM
JW Macdonald Associates, LLC
November 10, 2008
Page 1

2. Presentation Overview
• How did we get here?
• Who is to blame?
• What have we learned?
Page 2

3. How did we get here?
Financial Risk Policies: Not new to insurance…
• Surety Bonds (predate industrial revolution)
• Municipal Bond Insurance (1971 – Present)
• Credit Insurance
• Title Insurance
• Warranty Insurance
• Other expense related covers (e.g., products recall
insurance)
Page 3

4. Financial Risk Insurance:
Underwriting Challenges
• “Business Risk” – “Insurable Interest”?
• Moral Hazard / Adverse Selection
• “Transaction Value” – Is a Zero Loss Ratio assumption
Valid?
• Collateral - Liquid, fungible?
• Recourse - Unlimited?
• Pricing – Credible, equitable?
• Coverage: Non-standardized, complicated - understood?
Page 4

5. Financial risk Insurance Products
Accelerated growth in soft markets
Domestic P&C Market Cycle -Growth in Net Written Premium: 1970 - 1984
1980-90: S&L Crisis
1973: MBIA
1983: WPPS!
1980-1984: New
generation of financial
1971 AMBAC insurance products
1975: NYC Financial
Crisis
Source: Insurance Information Institute

6. WPPS and S&L Crisis
Resulted in full limits losses to D&O and E&O Insurers
• WPPS Bond Default (1983)
• $2.25 billion municipal (revenue) bond default
• Largest municipal default in USA history
• In litigation almost ten years
• Losses included D&O of 30 municipalities with “take-or-pay”
obligations, A&E, Accountants, Lawyers
• S&L Crisis (1980-1990)
• Over 2,400 savings and loan association failures
• Estimated losses of $560 billion - $320 B paid by US Government
• Major D&O losses sustained by F&D, MGIC and others
Page 6

7. Early Eighties Soft Market (1980-1984):
New Financial Insurance Products “to the rescue”?
• MGM Grand Fire Retroactive Liability Insurance
• Residual Value Insurance
• Limited Partnership Surety Bonds
• Homeowner’s Warranty Insurance Company (first RRG)
• Systems Performance insurance
• “Career Guard” Insurance
• NYIE: Baseball Strike Insurance
• Excess SIPC Insurance
Page 7

8. MGM Grand Fire Retroactive Liability Insurance
• In early 1981, thirty insurers agreed to multi-layered placement of
$120 M limits insured for
• Approximate $40 M premium
• Arguably the first, high profile “finite” deal
• Resulted in detailed industry debate over risk elements to permit
“insurability” (including payout timing, and investment income)
• Fronting insurer went into liquidation in March 1995
• Several years later, MGM settled out-of-court for $87.5 million,
shortly after jury selection.
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9. Residual Value Insurance
• Typically characterized, like municipal bond insurance, as low-risk
credit enhancements to otherwise solid transactions,
• Normally related to asset-based financing, with sale / leasebacks;
• Recourse to insurer / guarantors was normally limited to taking
ownership of underlying assets;
• Assets varied widely – included trains, planes, buildings, and even
movies.
• Extremely complicated multi-party contracts with numerous possible
events of default.
Page 9

10. Financial Insurance 1986 -2007:
Key developments…
Domestic P&C Market Cycle -Growth in Net Written Premium: 1986 -2007
25%
1986: Federal Tax Reform Act
20% 1989: New York Article 69 – requires FGIs
to be “mono-line”
15%
10% 1992: FASB 113
1995-2000: Extensive use of finite
reinsurance
5%
0%
19995-1998: PLSRA enacted, D&O insurers
-5% 1988: Centre Re give full allocation, entity coverage
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Current $ Real $ 2000: Reliance offers
Earnings Insurance
Source: A.M. Best, Insurance Information Institute

11. Limited Partnership Surety Bonds:
Another “Black Swan” event?
• Guaranteed General Partners full payment of scheduled 5 year
investments by high net worth individuals. No collateral but full recourse
was required;
• Partnerships highly leveraged with gross deductions permitted by early
eighties tax code;
• Tax reforms were expected but almost everyone thought the risk to
existing deals was zero
• 1986 Tax Reform Act eliminated gross deductibility; no “grandfathering”;
• Wealthy investors defied expectations: refused to make future payments;
• Huge initial losses paid by Surety insurers were eventually recouped.
Page 11

12. 2000-2008
“Black Swans” (Extreme Events), Market Softening, and the
“Panic of 2007”
Domestic P&C Market Cycle -Growth in Net Written Premium: 2000 -2007
2003: Hurricane Spitzer –
Mutual Fund Timing Scandal 2004: Hurricane Eliot – Bid-
15% 9/11/01 Attacks Rigging, Finite Reinsurance
10% Katrina, Wilma,
Rita: New Capital
5% Flows to P&C
0% 2001-2005: Fed Funds Rate 1%,
negative real cost of capital to banks
-5%
2000
2001
2002
2003
2004
2005
2006
01-02: Corporate Scandals,
SOX
“Panic of 2007”
Current $ Real $
Sources: Insurance Information Institute, Fortune Magazine (10/08)

13. Presentation Overview
• How did we get here?
• Who is to blame?
Page 13

14. Who is to blame?
“It is hard for us, without being flippant, to even see
a scenario within any kind of realm of reason that
would see us losing one dollar in any of those
transactions.”
Joseph J. Cassano, a former A.I.G. executive, August
2007
Page 14

15. Who is to blame?
• “Perfect Storm” (Everyone, ergo: No One?)
• Greed (i.e., human nature?)
• Late nineties legislative pressure on GSEs?
• “NINJA” and “Alt A”loans – What possible
justification?
• Ideological faith in deregulation?
• “Market Conduct” Regulatory Failures (e.g., Is any
cost to consumers - be it premiums or mortgages -
too cheap?)
Page 15

16. Who is to blame?
• Unprecedented Gross Leverage
• No Originator Risk-Taking (“Fronting”/ “Pass the Trash”)
• Synthetic Financial Instruments?
• Financial rating agencies?
• Flawed mathematical models (i.e., empirical data
suggested “all Swans are White”)?
• CPA auditor failures
• Fed Funds Rate, 2001-2005, too low, too long.
• Post-Enron, Mark-to-Market Accounting
• GLB, Sarbox: Bring back Glass Steagle?
Page 16

17. Presentation Overview
• How did we get here?
• Who is to blame?
• What have we learned?
Page 17

18. What have we learned?
• Financial insurance product growth is pervasive in
soft market cycles.
• Regulatory response has been consistently slow,
generally ineffective.
• Paradigm shift is occurring: Need alternatives to
reliance on private sector self-regulation, e.g.,
NAIC is currently discussing forming new
financial rating agency.
Page 18

19. Financial & Insurance Underwriting:
Back to the Future?…Many lessons learned
• “Business Risk” – “Insurable Interest”?
• Moral Hazard / Adverse Selection
• “Transaction Value” – Is a “Zero Loss Ratio” assumption
Valid?
• Collateral- Liquid, fungible?
• Recourse - Limited?
• Pricing – Credible, equitable?
• Coverage: Non-standardized, complicated - understood?
Page 19

20. Financial & Insurance Underwriting:
Some positive examples under discussion…
• Real Estate / Recourse: Require the lender to have
full recourse in the event of default, not just rights to
given real property (similar to surety bonds – limits
moral hazard).
• Originator: Require some financial risk retention –
“skin in the game” – recalls “fronting” and “MGA”
legislation in response to insurer insolvencies, e.g.
Failed Promises – 1990 Dingell report.
Page 20

21. Financial & Insurance Underwriting:
Some positive examples under discussion…
• Require some underlying “insurable interest” in
short selling or CDS transactions – classic difference
between “insurance” and “gambling”.
• Introduce new modeling approaches such as
terrorism risk “deterministic” scenarios to better
anticipate tomorrows “Black Swan” events, e.g.
Nassim Taleb’s “counterfactual reasoning”.
Page 21

22. Bibliography
• Charles R. Morris, The Trillion Dollar Meltdown: Easy Money, High
Rollers and the Great Crash, Public Affairs, March 2008
• Bruner & Carr, The Panic of 1907: Lesson’s Learned from the Market’s
Perfect Storm, Wiley & Sons, 2007
• Gary Gorton, The Subprime Panic, NBER Working Paper 14398,
Available at: http://www.nber.org/tmp/1063-w14398.pdf
• Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly
Improbable, Random House 2007
• Subcommittee on Oversight & Investigations, Failed Promises:
Insurance Company Insolvencies, February 1990, US Government
printing Office
Page 22

23. Q&A
Contact Information
Jim Macdonald is an independent consultant based in Philadelphia.
Macdonald has 35 years of experience as an insurer, reinsurer, and
consultant with market-leading companies such as AIG, ACE-INA,
C.N.A., Munich Re, Conning & Company, Navigant Consulting, and
General Re . His consulting services include expert witness services in
arbitrations and litigations, as well as strategic assessment services for
investment bankers and the public sector. Macdonald is also a Senior
Fellow with the RAND Corporation.
This presentation does not express or imply any opinion on the subject
by RAND and offers solely the personal opinions of the author.
Phone: 215-925-2188
Email: jwmacdonald@msn.com
Web: http://www.jwmacdonald.net
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