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June 2, 2008
Alternative Collateral Update
An Efficient Approach
Confidential
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SECURITIES OR INVESTMENTS ARE OFFERED THROUGH MMC SECURITIES CORP (“MMCSC”), A REGISTERED BROKER-DEALER,
AND MEMBER OF FINRA/SIPC. MAIN OFFICE: 1166 AVENUE OF THE AMERICAS, NEW YORK, NY 10036. PHONE: 212.345.5000.
MMCSC, OLIVER WYMAN, AND MARSH INC., ARE AFFILIATED ENTITIES THAT ARE OWNED AND OPERATED BY MARSH &
MCLENNAN COMPANIES, INC. MMCSC OR ANY OF ITS AFFILIATES MAY HAVE AN INDEPENDENT BUSINESS RELATIONSHIP WITH
ANY OF THE COMPANIES DESCRIBED HEREIN. TRADEMARKS AND SERVICE MARKS ARE THE PROPERTY OF THEIR
RESPECTIVE OWNERS.
THIS MATERIAL HAS BEEN PREPARED FOR INFORMATIONAL PURPOSES ONLY. IT IS NOT AN OFFER TO BUY OR SELL ANY
SECURITY OR COMMODITY OR OTHER FINANCIAL INSTRUMENT OR TO PARTICIPATE IN ANY TRADING STRATEGY. AN
INVESTMENT IN THE ALTERNATIVE COLLATERAL PROGRAM (“ACP”) IS SPECULATIVE, INVOLVES A HIGH DEGREE OF RISK AND
SHOULD BE CONSIDERED ONLY BY INSTITUTIONAL INVESTORS WHO CAN BEAR THE ECONOMIC RISKS OF THEIR
INVESTMENTS AND WHO CAN AFFORD TO SUSTAIN THE LOSS OF THEIR INVESTMENTS. INSTITUTIONAL INVESTORS SHOULD
THOROUGHLY CONSIDER THE INFORMATION CONTAINED HEREIN.
CERTAIN OF THE INFORMATION CONTAINED HEREIN CONCERNING CREDIT RATINGS AND DEFAULT RATES IS BASED UPON OR
DERIVED FROM INFORMATION PROVIDED BY THIRD-PARTIES AND OTHER INDUSTRY SOURCES AS INDICATED HEREIN. NO
REPRESENTATION OR WARRANTY, EXPRESS OR IMPLIED, IS MADE BY MMCSC AS TO THE ACCURACY OR COMPLETENESS OF
THE INFORMATION SET FORTH HEREIN, AND NOTHING CONTAINED IN THIS PRESENTATION IS, OR SHALL BE RELIED UPON AS,
A PROMISE OR REPRESENTATION, WHETHER AS TO THE PAST OR THE FUTURE. MMCSC HAS NOT INDEPENDENTLY VERIFIED
ANY SUCH INFORMATION AND ASSUMES NO RESPONSIBILITY FOR ITS ACCURACY OR COMPLETENESS. IN ADDITION, THIS
PRESENTATION INCLUDES CERTAIN ESTIMATES AND ASSUMPTIONS MADE BY MMCSC WHICH MAY OR MAY NOT PROVE
ACCURATE. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.
RESULTS FROM SIMULATIONS ARE FOR ILLUSTRATIVE PURPOSES ONLY AND CERTAIN ASSUMPTIONS HAVE BEEN MADE
REGARDING SIMULATIONS BECAUSE SOME MODELS ARE PROPRIETARY TO THEIR RESPECTIVE OWNERS AND CANNOT BE
REPLICATED. THEREFORE, RECIPIENTS SHOULD NOT PLACE UNDUE RELIANCE ON THESE RESULTS.
NO PERSON HAS BEEN AUTHORIZED TO MAKE ANY REPRESENTATION OR GIVE ANY INFORMATION WITH RESPECT TO THE
ACP, OTHER THAN THE INFORMATION CONTAINED HEREIN. PROSPECTIVE INSTITUTIONAL INVESTORS SHOULD NOT RELY ON
ANY INFORMATION OTHER THAN THAT CONTAINED IN THIS PRESENTATION OR ANY SUPPLEMENT TO THIS PRESENTATION.
NEITHER MMCSC NOR ANY OF ITS REGISTERED REPRESENTATIVES, IS MAKING ANY REPRESENTATION REGARDING THE
LEGALITY OF AN INVESTMENT HEREIN BY INSTITUTIONAL INVESTORS. PROSPECTIVE INSTITUTIONAL INVESTORS ARE NOT TO
CONSTRUE THE CONTENTS OF THIS PRESENTATION AS LEGAL, TAX OR BUSINESS ADVICE. EACH INSTITUTIONAL INVESTOR
SHOULD CONSULT WITH ITS OWN ADVISORS AS TO LEGAL, TAX BUSINESS, FINANCIAL, AND RELATED ASPECTS OF INVESTING
IN THE ACP.
THIS MATERIAL MAY NOT BE REDISTRIBUTED WITHOUT THE PRIOR WRITTEN CONSENT OF MMCSC.
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“However beautiful the strategy, you should occasionally look at the
results”
Sir Winston Churchill
(1874 – 1965)
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Contents
 Overview
 Credit Market Overview
 ACP Program Performance
 Conclusion
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Overview
Overview

Over $20 billion in collateral posted within state WC self-insured programs.

Posting Letters of Credit (“L/C”) and Surety uses valuable credit capacity

Alternative Collateral Programs access financial markets

Credit markets have gone through unprecedented turmoil over the last twelve months…
–
increased credit spreads (including individual companies)
–
marked by decreased liquidity
–
large writedowns at leading institutions to re-create business

However, financial institutions are seeking well structured transactions

Alternative Collateral Programs continue to perform well
Alternative Collateral Programs continue to provide a more efficient method to manage collateral.
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Overview
Self Insurance Programs
For most WC self-insurance programs, companies post collateral individually…
Claims
Claims
Company 1
Company 2
Collateral
Collateral
Claims
Company 3
Collateral
Claims
Company 4
Collateral

collateral (letter of credit, surety or escrow) posted
to regulator / security fund

companies manage and pay claims

annual collateral fees paid to market (banks,
sureties) and “lost” each year
Security Fund
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Overview
Self Insurance Programs
In the event of default, a Security Fund (“SF”) uses collateral and additional assessments to pay
claims…
Defaulted
Company
Claims
Claims
Collateral

collateral used to pay claims

additional assessments made for shortfalls
(remaining companies liable)
Company 2
Claims
Company 3
Claims
Company 4
Additional
Assessments
Security Fund
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Overview
Self Insurance Programs
Individual instruments (letters of credit, surety, cash) are not ideal…
–
inefficient use of resources

use credit capacity – scarce resource, especially in current market

premium / fees “lost” to market – in excess of $150 million annually1

“silo” effect

inflexible
–
credit exposure to sureties / bank
–
capacity constraints (surety)
A portfolio based risk management approach provides a more efficient means for companies
to post security.
1. MMCSC estimate, assumes L/C fees of 1.25%
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Overview
Self Insurance Programs
A portfolio based approach, where the Security Fund arranges collateral on behalf of companies…
Claims
Company 1
Premium
Claims
Company 2
Claims
Company 3
Claims
Company 4
Program
Fees
AA-/Aa3 or better
Counterparties1
Risk
Transfer
Credit
Protection
Credit
Protection
Retention
Security Fund
1. Minimum counterparty credit rating determined by the security fund
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Overview
Self Insurance Programs
ACP only impacts the method by which collateral is posted, not the underlying program…
Underlying program
unchanged
– companies must meet minimum requirements
– annually report outstanding WC liabilities
– security deposit requirements
– regulator retains full oversight and provides approval of the program
Members pay premium
to Security Fund
– premium based upon creditworthiness and outstanding WC liabilities
– SF arranges security on a portfolio basis on behalf of all eligible companies
– all eligible companies (based on minimum credit rating) must participate
Security Fund retains
risk loss
– cash and investment income net of program costs is retained
– designed to mitigate additional assessments
– cost to members may be reduced significantly as fund becomes self-sustaining
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Credit Market Overview
Credit Market Overview

Credit market problems emerged summer of 2007

Sub-prime mortgage crisis began with the bursting of the US housing bubble

Mortgages repackaged through securitizations (mortgage backed securities – MBS) using Collateralized Debt
Obligations (“CDOs”)

The underlying assets (mortgages, home equity) created the problems, not the CDOs

Credit markets have gone through unprecedented change…
–
extreme price (credit spread) volatility
–
disappearance of liquidity for certain segments – e.g. asset backed, Auction Rate
–
large writedowns – in excess of $300bn at May 30, 2008
–
re-evaluation of business, e.g. monolines (Ambac, MBIA, Assured Guaranty, FSA)
Market consensus is that the worst is behind us and conditions are becoming less volatile,
but liquidity remains tight.
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Credit Market Overview
Generalized Credit Spreads
Generalized credit spreads (CDX Indices) peaked in March ’08, but are settling…
500
450
400
350
300
250
200
150
100
50
Investment Grade
5/
15
/0
8
5/
1/
08
4/
17
/0
8
4/
3/
08
3/
20
/0
8
3/
6/
08
2/
21
/0
8
2/
7/
08
1/
24
/0
8
1/
10
/0
8
12
/2
7/
07
12
/1
3/
07
11
/2
9/
07
11
/1
5/
07
11
/1
/0
7
10
/1
8/
07
10
/4
/0
7
9/
20
/0
7
0
Crossover
Source: Bloomberg, 5 Year CDX.NA.IG.9 & 5 Year CDX.NA.XO.9, 9/20/07 – 5/19/08
Note: Indices are compiled as a basket of North American company CDS, selected by major industry participants.
Investment grade: 125 investment grade ; Crossover: 35 with at least one BB rating, but no single-B rating
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Credit Market Overview
Credit Spreads
The cost of credit for companies has lagged and continues to increase…
Industrial spreads to Treasuries (1 year)
600
500
Spread (bps)
400
300
200
100
0
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
5/18/07
Baa1
Baa2
11/20/07
Baa3
Ba1
Ba2
Ba3
B1
B2
B3
5/19/08
Source: Bloomberg 5/20/08
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Credit Market Overview
Credit Default Swap - Activity
Credit protection for individual companies continues to grow…
CDS Notional Outstanding
70,000
Notional ($MM)
60,000
50,000
40,000
30,000
20,000
10,000
0
Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07
Date
Source: International Swaps and Derivatives Association, 2007 Market Survey
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Credit Market Overview
Default Rates – Non-investment Grade
…and rating agencies continue to expect default rates to increase to historical levels…
8.0
Est. ‘09
Actual 07/08
Trailing 12-month default rate %
7.0
6.0
5.0
Historical
average
4.0
3.0
2.0
1.0
0.0
Sep
Oct
Nov
S&P (US)
Dec
Moody's (US)
Jan
Feb
Mar
Mar
Moody's (Global)
Source: Wall Street Journal 4/30/08, Moody’s 4/17/08, and Standard and Poor’s 4/29/08
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Credit Market Overview
Risk Appetite
However, credit markets have begun to stabilize and risk takers are looking at new transactions…
•
Appetite for well structured deals
•
Not asset backed and real estate related
•
Balance sheets remain constrained
•
Liquidity a primary factor
•
Investors have different risk appetites
-
Banks – well structured transactions
-
Financial Guarantors – focusing on core business
-
Hedge Funds – opportunistic, seeking well structured transactions
Well structured transactions are being favorably considered.
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Credit Market Overview
ACP – Key structural points
ACP is attractive due to several unique structural features...
Double trigger
Alignment of interest
Commercial motivation
Minimum credit rating
Rating
Short tenor
Single name limits
MMC Securities
Bankruptcy /Failure to pay (per ISDA)
AND
Non-payment of workers’ compensation
Security Fund retains equity
Not an arbitrage trade
B3/B- or equivalent
Tranches rated by Moody’s
1 year
[3]% < BBB+
[4]% ≥ BBB+
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ACP Program Performance
ACP Program Performance
Given the challenging credit market, how are existing programs performing?
–
two existing programs – California and North Carolina
–
performing well – cash accumulation ahead of projections
–
risk transfer completed – albeit at higher rates (in line with market)
–
cost to members remains competitive
–
even more attractive to companies in current market
ACP continues to provide a more efficient method of posting collateral.
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ACP Program Performance
California
The California Self Insurers’ Security Fund has continued its strong financial performance…
$200.00
$170.06
$142.74
$150.00
$100.50
$100.00
$51.10
$50.00
$0.00
($3.50)
($50.00)
($54.70)
($100.00)
June '03
June '04
June '05
June '06
June '07
April '08
Source: California Self Insurers' Security Fund.
Past performance does not guarantee future results.
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ACP Program Performance
California
…as cost to members continues to fall…
600
Assessment rate (bps)
500
400
300
200
100
2003-2004
2004-2005
2005-2006
2006-2007
B3
B2
B1
Ba
3
Ba
2
Ba
1
Ba
a1
Ba
a2
Ba
a3
A3
A2
A1
Aa
3
Aa
2
Aa
1
Aa
a
0
2007-2008
Source: California Self Insurers' Security Fund.
Past performance does not guarantee future results.
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ACP Program Performance
North Carolina
North Carolina has outperformed initial projections despite market conditions…
North Carolina Self
Insurers’ Security
Association
$ 478 million portfolio, 120 members, 2006 and ongoing
–
Successfully completed 2nd year in challenging credit environment
–
70% projected increase in cash to $10.2 million (Dec 2008) from $6.0 million in (Dec
2006)
–
Minimal assessment rate increase (6.5%) – average industrial spreads increased
100% year over year
–
Total program costs were largely unchanged year over year
Past performance does not guarantee future results.
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ACP Program Performance
Summary
More states are exploring ACP because it benefits all stakeholders in the business environment…
Workers
Ensures cash is available for any claims – not company specific
Seamless to employees
– current claims and benefit process is unchanged
Employers
Releases credit lines for operational purposes
Less administrative burden
No cross-subsidization
Regulators
Reduces regulatory burden
– one security system replaces many bilateral arrangements
Improves relationship with business
– more efficient self-insurance creates a competitive business environment
Highly rated counterparties
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Conclusion
Conclusion

Alternative Collateral programs remain attractive to risk takers

Corporate credit availability tightening

Attractive to companies

Several states are exploring alternative collateral programs to…
–
secure appropriate collateral levels
–
stabilize member assessment rates
–
provide members alternative credit sources in a difficult credit environment
–
capture a portion of the approximately $250 million in fees lost to the market annually
–
create a more efficient system that benefits the state and its membership
Alternative Collateral Programs continue to provide benefits during a difficult credit year.
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“If an idea’s worth having once, it’s worth having twice”
Tom Stoppard
British Dramatist & Screenwriter (1937 -
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Conclusion
Questions?
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Contact Information
Quentin Hills – Managing Director
Patrick W. Tully – Managing Director
MMC Securities Corp.
MMC Securities Corp.
1 California Street, 7th Floor
1166 Avenue of the Americas, 10th Floor
San Francisco, CA 94111
New York, NY 10036
Phone:
(415) 743-8569
Phone:
(212) 345-3556
Cell:
(917) 292-0937
Cell:
(973) 222-2064
Fax:
(415) 743-8029
Fax:
(212) 345-2727
Email:
[email protected]
Email:
[email protected]
Quentin Hills is a registered representative and supervisory principal
of MMC Securities Corp., a FINRA registered broker-dealer.
MMC Securities
Patrick Tully is a registered representative of MMC Securities Corp.,
a FINRA registered broker-dealer.
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