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Essays and Commentaries
Rationale and Results with the LFC CAT Bond Pricing Model
December 31, 2003

Published in Insurance and the State of the ART in Cat Bond Pricing, Etudes et Dossiers No. 278, Working Paper Series of The Geneva Association, January 2004

By Morton N. Lane, Ph.D.

Cat bond pricing presents theorists with both an opportunity and a challenge.  The opportunity is that for the first time ever, investors have been presented with explicit probability statistics about the likelihood of full repayment at maturity.  They receive these probability estimates at the time of issue.  Other fixed income securities may allude to likely default statistics, via a letter rating, but none, prior to the advent of cat bonds, did this with precision. Indeed, the rating agencies themselves used different metrics to arrive at their letter ratings, therefore representing different things.  In spite of this, the traded market often uses the letter ratings interchangeably as surrogate ranges of default probability.  The opportunity then is to observe transaction prices and examine them relative to precise statistics provided at issue. 

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Arbitrage Algebra and the Price of Multi-Peril ILS
July 4, 2003.

By Morton N. Lane, Ph.D.

INTRODUCTION

At this year’s third annual  Bond Market Association Risk-Linked Securities Conference, John Seo gave an excellent address entitled “Risk Management Tools for Investors.”  The more colorful subtitle was along the lines of ‘evaluating multi-peril bonds and avoiding the Bermuda rectangle.’  Yes, rectangle.  We will leave the Bermuda angle (rect- or tri-) for John to explain and he can be found (together with his brother Nelson) at Fermat Capital Manage¬ment LLC managing a fund specializing in investing in cat bonds and other exotica.  However, this paper takes advantage of his basic plea (simplification) to further explore a favorite topic of ours – how should Cat bonds be priced. In particular, to explore the vexing question of multi-peril bonds compared to single peril bonds. Our approach is to explore “arbitrage-equivalent”  pricing in which covers can be either bought or sold. We do not yet know how to determine how the absolute level of cat bond prices should be set – although we expect it must be driven by two old friends (a.k.a. supply and demand) but the Seo simplification allows greater insights into relative prices of single vs. multi-peril bonds even in our arbitrage context. We begin with a reprise of John’s examples.

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Pricing Issues in Aviation Insurance and Reinsurance
April 16, 2003.

By Morton N. Lane, Ph.D.

INTRODUCTION

Airlines are in the business of transporting passengers or freight from origin to destination as efficiently as possible.  They do this with mixed financial success.  However, they do it with remarkable physical success.  The accident rate for airline travel is lower than for any other mode of transportation, and it continues to decline.  Nevertheless, when accidents do happen they can cause considerable financial, as well as emotional, distress.  Airlines choose to avoid the financial distress by purchasing insurance against loss-through-accident.  Aviation insurers accommodate the desire of airlines to get rid of loss-due-to-accident by assuming all such losses.  The remarkable thing is that the insurers have provided this cover on a ground-up basis for each and every loss, i.e., on an unlimited basis.  The question such large and unlimited cover provokes is, how should it be priced?

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Alternative Risk Strategies
Edited by Morton Lane, Risk Books, London 2002.

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Recognizing the Costs of Options and Disguising the Cost of Insurance
August 2, 2002

By Morton N. Lane, Ph.D.

In one of those delicious ironies that occur from time to time, the August 1st edition of The Wall Street Journal contained two  excellent articles−one about options, the other about insurance−which when juxtaposed, show the ever-present nature of contradictions between finance theory and current corporate practice.  The contradictions exist side by side even in the full glare of the current soul searching environment. 

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An Analyst's View of the Aviation Insurance Industry
September 1, 2002

By Morton N. Lane, Ph.D.
 
INTRODUCTION
The events of September 11, 2001 generated devastating monetary losses for the aviation insurance industry.  Figure 1 shows the true extent of that loss. Minor as these monetary losses are com¬pared the personal trauma suffered by individuals, families and America as a whole, they have produced their own trauma-induced monetary responses.  Future aviation insurance prices have risen dramatically, easily doubling and in some cases quintupling. Exclu¬sions have been added to policies and certain cover¬ages have been specifically withdrawn from the market.  More interestingly, having survived and put in place temporary solutions to enable the market to move forward, the industry through this conference and numerous internal reviews has begun to ask itself how it should charge for its services, whether it has sufficient capital and if past pricing practices should be perpetuated.

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Whither Securitization
April 30, 2002,

Excerpt from Alternative Risk Strategies, Morton Lane, ed., Risk Books, 2002

By Morton N. Lane

INTRODUCTION
[This paper is the closing editorial chapter of a book entitled Alternative Risk Strategies, edited by Morton Lane, published by Risk Books and due for publication in May 2002.  Details of the multi-contributor book can be found on www.riskbooks.com.  The substance of the chapter was also the subject of Morton Lane’s address to the Bond Market Association’s Second Annual Meeting at Turnberry Isle in March 2002.  While there are references to particular chapters in the book, this chapter stands as a separate piece.]

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Premium Increases for the January 1 Renewals
October 8, 2001, The Message of the Markets

By Morton N. Lane and Roger G. Beckwith

INTRODUCTION
Two questions have consumed the reinsurance industry now that the sadness and emotional shock from the awful events of September 11, 2001 have given way to consideration of future business.  The first is the size of the loss to the industry, said to be between $35billion and $70billion.  The second, obviously dependant on that first answer, is how much will premiums rise?  Anecdotal evidence says increases of 40% to 100% can be expected in the cat market.  (We confine ourselves to the cat market in this Note.)  But how satisfactory is the anecdotal evidence?  Are there other ways to gauge expected increases?  We suggested as much in March this year in our paper “Stirrings in the Secondary Markets.”  Now is the time to test the assertions we made there.  We do this not only to obtain a more precise estimate ourselves (recognizing that the picture is still unfolding), but also to test whether our instincts are consistent with “the market.”

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Alternative Capital Sources
December 15, 2002,

Excerpt from Rational Reinsurance Buying, Nick Golden, ed. Risk Books 2002

By Morton N. Lane, Ph.D.

INTRODUCTION
The above definition of “capital” captures two things; first, the essential meaning of capital as the resource necessary for production of wealth and, second, the fact that capital can mean many things to many people.  On the other hand, one thing that may be missing is any reference to the relation between risk and capital.  The definition was written before the modern capital market theories were expounded, yet it does capture the essentials —present value of income, etc.—before the significant contributions of Black, Scholes, Merton and other modern finance theorists formalized the concepts.  The theories contributed by these Nobel Laureates added to our general understanding of capital markets, and the insights allowed a proliferation of new, innovative instruments by which capital can be accessed and managed. Swaps, options, futures, collateralized debt obligations (CDOs), converts, caps, floors, collars, Remics, collateralized mortgage obligations (CMOs) and derivatives of all kinds are all aids in the use of capital to produce wealth.

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Stirrings in the Secondary Market
March 8, 2001.

By Morton N. Lane
 
INTRODUCTION
There is some evidence that the secondary market for insurance-linked securities (ILS) is beginning to stir.  It is faint, but we think it is important.  Viable secondary markets contain important intelligence about underlying trends.  In the ILS market, where underlying (reinsurance) price trends are hard for outsiders to discern, secondary market prices could provide valuable investor information.  This allows investors to better evaluate new transactions.  It also gives issuers a better insight into what new issue prices would be acceptable in the capital market.  So far, the still nascent ILS market has provided little price information outside of new issue prices.

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