Aon Group Limited
From Reinsurance to ART
Dr. Alan Punter
Aon Capital Markets, London
21st September, 2000
Alternative Risk and Alternative Transfer
Aon Group Limited
Insurance and reinsurance have a long history
circa 2000 BC: Predecessor of marine insurance practised in
Babylon - “bottomry” involved a loan on the security of a
ship, but if the ship was lost the loan was not repaid.
1370: The first reinsurance transaction, as documented by Gustav
Cruciger, who described how an insurer obtained
reinsurance on a voyage it was insuring from Genoa, Italy, to
Sluys, Netherlands.
1654
Bodlean library contains entries from insurance broker’s
account book listing deals.
1688: Lloyd’s coffee house advertised in London Gazette.
1863: The formation of Swiss Re and Munich Re (in 1880) are
widely considered to be the start of the modern “professional
reinsurance” industry in continental Europe.
2
Aon Group Limited
World Insurance Market
1998 premiums (US$ billions)
Life
Non-life
Total
North America
368
411
779
Latin America
11
28
39
Americas
Western Europe
Central / Eastern Europe
379
South and East Asia
Middle East
818
399
286
685
4
11
15
Europe
Japan
439
402
297
699
361
92
453
74
33
107
4
7
11
Asia
439
132
571
Africa
22
7
29
Oceania
22
15
37
World
1,264
891
2,155
3
Aon Group Limited
US Insurance Results 1999
 Net income after taxes fell from $30.8 bn in 1998 to
$22.2 bn in 1999
 Combined ratio up from 105.6% in 1998 to 107.9% in
1999
 Rate of return on average net worth fell from 8.5% in
1998 to 6.4% in 1999
 Problems:
 poor premium growth
 weak profitability due to rising incurred losses and loss-adjustment
expenses
 falling investment income
4
Aon Group Limited
European reinsurers results 1999
 “Very sorry picture” (Standard & Poor’s)
 Estimated average combined ratio of 131% for 1999
(109% in 1998)
 Record number of catastrophes in 1999 (including
eight of over $1 billion)
 Weak premium rates, to continue in 2000
 late occurrence of December 1999 European storms
 many multi-year contracts signed at 1/1/99 to cover Y2K issues
 High Aviation claims
 Retrocession recovery problems
5
Aon Group Limited
Why do insurers buy reinsurance?
 Ancient
 Widen book of business - quota share
 Smooth earnings - excess of loss
 Off balance sheet “fund”
 Modern
 Liquidity
 Protect ratings & franchise
 Balance sheet management
 Enhance return on capital
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Aon Group Limited
The landscape of risk is changing ...
Increasing exposures
 Natural perils
 40 of the fastest 50 growing cities are in earthquake zones
 half off the world’s population lives in coastal regions, many of
them exposed to the dangers of rising sea levels, repeated
flooding and cyclones (World Disasters Report 1999)
 Man-made perils
 business interdependency
 critical reliance on integrated IT (communications and processing)
systems
 brand values and reputation risk
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Aon Group Limited
The landscape of risk is changing ...
Broadening view of risk
 “Risk is Risk”
 traditional insurance risks
 growth of capital markets and derivatives or financial and market
risks (interest rates, exchange rates, commodity prices, credit,
weather)
 operational risks (everything else - strategy, business, technology,
legal, political, people, etc.)
8
Aon Group Limited
The landscape of risk is changing ...
Change in the financing of risk
 (Re)Insurance does not appear to deliver:
 clarity of cover
 certainty of payment, timing and amount
 … and has a high frictional cost
 Increasing use of non-traditional forms of risk financing
 growth of captives, blended solutions
 Convergence with capital markets
 catastrophe bonds
 CatEPuts®
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Aon Group Limited
Intellectual convergence
Financial hedges
Cat Bonds
Capital
markets
Securitisation
Contingent capital - CatEPuts
ART solutions
Multi-line
Insurance Guaranteed Cost
markets
Insurance policy
Traditional Risk Transfer
ART / ARF
Traditional Risk Financing
10
Aon Group Limited
What does “Alternative” mean?
 Any mechanism used to substitute for traditional risk
transfer products offered by re/insurers
 A planned approach to financing risk involving:
 Alternative risks not traditionally reinsurable
 eg. interest rate or commodity exposure, brand image
 Alternative structures, not reinsurance contracts
 eg. weather derivatives, catastrophe bonds
 Alternative markets, not Insurers or Reinsurers
 eg. capital market entities such as pension funds, banks and fund managers
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Aon Group Limited
Common Objectives of ART Buyers
 Risk retention
 Efficient use of capital
 Long term continuity and pricing stability
 Specified historic / future loss problem smoothing
 P&L insulation
 Managing volatility and adding liquidity
 Unlock potential profit in long tail exposures
 Insurance of traditionally ‘uninsurable’ risks
12
Aon Group Limited
Common Solution Characteristics & Features
 Solution not product driven, with alignment of interests
(tailored to match client needs & market appetite)
 Multi-risk or aggregate nature of coverage (blending)
 Finite, aggregate limits of liability (per occ, annual, term)
 Multi-year contractual commitment
 Profit sharing, often with investment income
 Transparency
 Converged Banking / Insurance / Capital techniques

Generally, reinsured’s upside (i.e. reinsurer’s
downside) is limited in some way
13
Aon Group Limited
Trends & Future Development of ART
 Continued growth of many forms of self insurance
(i.e. larger retentions, insurance co. captive formation, ‘finite’ risk
programmes)
 Increasingly buyers require flexible, bespoke, broader
applications
 Accountancy treatment, taxation treatment and legal
contracts need to be analysed carefully
 Techniques and instruments need to be fully tested in
real circumstances
 New deals are moving away from insurance principles
of insurable interest and indemnity
 Whilst market remains soft, low financial incentive for
buyers to be too adventurous (current appear expensive)
14
Aon Group Limited
ART Markets: Characteristics
 The major financial organisations including
 Professional (re)insurers
(ACE, AIG, Allianz, Axa Global Risks / Paribas, Bankers Trust, Chubb,
Citicorp / Travellers, Custom Risk Solutions (RSA, Ace, Aon), ERC
Frankona, General Re, Gerling, Liberty Re, Munich American Risk
Partners, QBE, Scandinavian Re, Stockton Re, Swiss Re New Markets,
Transatlantic Re, Winterthur / Credit Suisse, XL / Pareto, Zurich Centre
Solutions)
 Global carriers
 Finance houses / merchant banks / capital markets
 Strong balance sheets
 Proven commitment to long term partnerships
 Proven commitment to tailor-made (customised)
solutions
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Aon Group Limited
Most Efficient use of Risk Capital ?
Identify risks and trading objectives
Perform risk analysis and evaluation of data
Quantitatively identify optimal solution
Placement and Negotiation
Retain
Traditional
ART
Capital
Markets
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Aon Group Limited
Alternative Risk Transfer & Financing
Structures in Context - Annual Placings
Capital Markets
Financing
Cashflow
SM
Contingent Equity Programmes (CatEPut )
Catastrophe Bonds
Integrated Risk (FX / Gradual Pollution)
Tens
Weather Derivatives / Commodities
Blended / Multiple Trigger /
Residual Value
Loss Portfolio Transfer
Multi-line / Multi-year
Captives
Thousands
Insurance
Risk Transfer
Millions
Motor / Property /
Liability - QS,
surplus, risk
& cat XL etc
Contracts Placed Annually Worldwide
Traditional (Re)Insurance
17
Aon Group Limited
Developments in Insurance ART
 Self-insurance
 Retrospectively rated plans (retros)
 Captive insurance company, rent-a-captive and
protected cell company
 Finite or financial insurance
 Multi-line, multi-year, aggregate or blended and
integrated programmes
 Enterprise-wide risk management
18
Aon Group Limited
Developments in Reinsurance ART
 Financial reinsurance
 Insurance derivatives
 Contingent capital (debt and equity)
 Double triggers
 Catastrophe Bonds
19
Aon Group Limited
Functions of financial reinsurance
 Smoothing of fluctuations in cedent’s loss experience
over a period of years
 Optimisation of balance sheet structure and reported
ratios, such as solvency or reserve adequacy
 Expansion of underwriting capacity, by ceding
premiums and/or technical reserves
 Increase in retentions
 Facilitation of acquisitions, mergers and corporate
restructuring
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Aon Group Limited
Summary of financial reinsurance contracts
Type of contract
Time dimension
Type of risk
Benefits
Loss Portfolio Transfer
Retrospective
Timing risk
Accelerate income
Underwriting risk
Discount reserves
Improve solvency
Adverse Development Cover
(or retrospective aggregate
excess of loss)
Retrospective
Underwriting risk
Transfer of aggregate risk
Timing risk
Credit risk
Finite (or Financial) Quota
Share
Prospective
Spread Loss Treaty
(or prospective aggregate
excess of loss)
Prospective
‘Blended’ cover
Prospective
Surplus relief
Increase capacity
Improve solvency
Timing risk
Underwriting risk
Underwriting risk
Non-traditional
risks
Smooth and protect reported
annual results
Transfer risk of portfolio
aggregation
Smooth and protect annual
reported results
21
Aon Group Limited
Insurance-linked securitisation
 Risk liquidity
 Contingent Surplus Notes (CSN)
 Catastrophe Equity Puts (CatEPuts)
 Risk transfer
 Chicago Board of Trade options
 Double trigger
 Catastrophe Bonds
22
Aon Group Limited
Contingent Surplus Notes - CSN
 Nationwide Mutual Insurance Company of Ohio,
Surplus Notes deal in 1995
 $400 million raised and deposited in trust fund
 Noteholders receive returns equal to yield on government bonds
plus 23/8%, but run risk of Nationwide drawing down cash from
trust fund and converting into surplus notes (like preference
shares)
 Nationwide can draw funds down under wide conditions
 Arkwright Mutual did similar $100 m deal in 1996
23
Aon Group Limited
Contingent capital - CatEPutSM
RLI Catastrophe Equity PutSM
 3-year agreement brokered by Aon Re Services
 RLI pays annual option premium to Centre Re
 Trigger is major California quake, then:
 Centre Re buys up to $50 million convertible
non-voting preference shares in RLI
 RLI pays annual dividends on preference shares
 RLI converts preference shares into full-voting common equity
after 3 to 4 years (but has option to repurchase at original issue
price)
24
Aon Group Limited
The CatEPutSM Structure
Option premium
Before option
exercised
INVESTOR
RLI
Option rights
Preferred shares
When option
exercised
INVESTOR
RLI
Cash
Common shares
At conversion
date
INVESTOR
RLI
Preferred shares
25
Aon Group Limited
CatEPuts - features
 Post-event capital negotiated at pre-event terms
 Pre-event
 option premium lower cost than traditional reinsurance
 protects shareholder value
 mitigates dilutive effects of upper layer reinsurance
 Post-event
 balance sheet recovery
 favourable treatment by ratings agencies
 no reinstatement
 no profit & loss protection
26
Aon Group Limited
Extract from RLI Corp. 1996 R&A
What are the benefits (of the CatEPut) to shareholders?
A: First, this is an extremely cost-effective level of security ...
a fraction of the price for a similar layer of reinsurance.
But by improving our ability to withstand a momentous
catastrophic event, we have also fortified shareholder
value. Even if such a disaster occurs, our earning power
would remain intact at its current level. Likewise the
ability of RLI to pay dividends and rise in value has also
been shielded.
27
Aon Group Limited
Double Trigger - Examples
 European multi-line insurance company
 suffered combined effect of not only poor returns from its stock
and bonds investment portfolio, but also large underwriting loss
 bought reinsurance programme that links retained losses to
underlying financial criteria
 CSAA reinsurance contract triggered by two elements
 occurrence of a major catastrophe
 fall in level of equity index
 CLM reinsurance contract responds if CLM suffers
from both a significant fall in the price of equities and
adverse underwriting results
28
Aon Group Limited
Catastrophe or “Act of God” Bonds
 Issued by insurer (or corporate)
 In the event of a pre-defined catastrophe bondholders
may be forced to:
 forfeit some or all of their interest repayments; or
 forfeit some or all of their principal; or
 delay/defer receipt of interest or principal
29
Aon Group Limited
USAA / Residential Re I (1997)
 Raised $400 million in cover through private
placement of $477 million in bonds by Residential Re,
Cayman Islands
 Oversubscribed by factor 2plus
 Trigger was single US East Coast hurricane intensity
3, 4 or 5
 Indemnity of 80% of USAA’s losses $500 m excess of
$1 bn
 Two tranches:
 A-1 $164 million principal protected, LIBOR + 273 bps
 A-2 $313 million principal-at-risk, LIBOR + 576 bps
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Aon Group Limited
Investor base for USAA bond issue
18%
8%
3%
Money managers
Mutual funds
Hedge funds
Life insurers
Reinsurers
Others
15%
44%
12%
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Aon Group Limited
Done Deals
Deal Date Completed Insured or Cedent
Investors
Advisors
Deal Description
Issue Size
($ 000's) Type
85,000 Risk Transfer
Perils Covered
1
1994
Hannover Re
Institutions
Citibank
Cat XL Retrocession
2
June 1994
HHRF
C Manhattan
Aon
Cat Line of Credit
3
September 1994 FWUA (Florida Fund)
Chemical Bank None
Cat Line of Credit
1,000,000 Contingent Capital Florida Wind
4
September 1994 Florida RPC JUA
J.P. Morgan
None
Cat Line of Credit
1,500,000 Contingent Capital Florida Wind
5
February 1995
Nationwide
Institutions
J.P. M, SB
6
Late 1995
AIG
Institutions
AIG
Contingent Surplus Notes 400,000 Contingent Capital Surplus
Protection
10,000 Risk Transfer
Cat XL
7
April 1996
Arkwright
Institutions
ML, MS
Contingent Surplus Notes 100,000 Contingent Capital PML Protection
8
July 1996
State Auto
C Manhattan
None
Catastrophe Line of Credit 100,000 Contingent Capital PML Protection
9
October 1996
RLI
Centre Re
Aon
CatEPut
Institutions
Citibank
Proportional Reinsurance 100,000 Risk Transfer
GS
Property Surplus Share
10 December 1996 Hannover Re
11 December 1996 St. Paul (George Town Re) Institutions
PML Protection
500,000 Contingent Capital Hawaii Wind
50,000 Contingent Capital PML Protection
50,000 Risk Transfer
US Windstorm
130,000 Risk Transfer
European Hail
12 January 1997
Winterthur
Institutions
CSFB
Cat XL
13 March 1997
Reliance
Institutions
Sedgwick
Cat XL - Multi-line
14 March 1997
Horace Mann
Centre Re
Aon
CatEPut
15 June 1997
USAA (Res'l Re)
Institutions
ML,GS,Lehman Cat XL
400,000 Risk Transfer
Florida Windstorm
16 July 1997
Swiss Re
Institutions
CSFB
Cat XL
122,000 Risk Transfer
California E’quake
17 July 1997
LaSalle Re
Swiss Re
Aon
CatEPut
100,000 Contingent Capital PML Protection
Institutions
GS, Swiss Re Cat XL
18 December 1997 Tokio Marine
(Parametric)
40,000 Risk Transfer
100,000 Contingent Capital PML Protection
90,000 Risk Transfer
Japanese E’quake
32
Aon Group Limited
Done Deals
Deal
Issue Size ($
000's)
Type
Date Completed
Insured or Cedent
Investors
Advisors
Deal Description
19
February 1998
RAM Re
PMI Group, Inc.
None
LOC Credit Enhancement
40,000 Contingent Capital
20
March 1998
Centre Re (Trinity Re)
Institutions
GS, Chase
Cat XL
75,000 Risk Transfer
21
April 1998
Mitsui
Institutions
Swiss Re
Cat XL - Swap
30,000 Risk Transfer
22
May 1998
Reliance
Institutions
Sedgwick
Option on Cat Notes
50,000 Risk Transfer
23
June 1998
CNA (HF Re)
Institutions
Hedge FinancialCat XL
24
June 1998
Arrow Re
Goldman Sachs
Direct
25
June 1998
USAA (Res'l Re II)
Institutions
ML, GS, LehmanCat XL
26
June 1998
Yasuda(Pacific Re)
Institutions
Aon
Cat XL
80,000 Risk Transfer
27
June 1998
AXA Re
Institutions
Axa / Paribas
Cat XL
25,000 Risk Transfer
28
July 1998
USF&G (Mosaic Re)
Institutions
GS, EWB
Cat XL
54,000 Risk Transfer
29
July 1998
XL Re
Institutions
GS, Aon
Cat XL
100,000 Risk Transfer
US Wind and EQ
30
September 1998
Toyota Motor Credit
Institutions
GS
Residual Value Excess
566,300 Risk Transfer
Res Value of Car Leases
31
December 1998
Centre Re
Institutions
GS, Chase
Cat XL
32
December 1998
Allianz (Gemini Re)
Institutions
GS
Option on Second Cat XL
33
December 1998
CNA
Institutions
Soc. Gen.
Cat XL
34
January 1999
Horace Mann
Centre Re
Aon
CatEPut
35
January 1999
Constitution Re
Re/Institutions
GS, EWB
Cat XL
10,000 Risk Transfer
36
February 1999
St. Paul Re (Mosaic Re II)Institutions
GS, EWB
Cat XL
45,000 Risk Transfer
US Wind and Earthquake
37
March 1999
Kemper (Domestic Inc.) Reinsurers
Aon
Cat XL - Equity
20,000 Risk Transfer
Mid-Western EQ
March 1999
Kemper (Domestic Inc.) Institutions
Aon
Cat XL
80,000 Risk Transfer
Mid-Western EQ
38
March 1999
Gerling (SECTRS 1999-1)Institutions
GS
Credit Reinsurance
39
April 1999
Sorema (Halyard Re)
ML, Aon
Cat XL
40
May 1999
Oriental Land (Concentric Re/Institutions
Ltd)
GS
Cat XL
100,000 Risk Transfer
Japanese Earthquake
41
May 1999
Oriental Land (Circle Maihama)
Re/Institutions
GS
Extendible Debt
100,000 Contingent Capital
Japanese Earthquake
42
May 1999
Intrepid Re
Aon
CatEPut
100,000 Contingent Capital
PML Protection
43
May 1999
USAA (Residential Re III) Inst. Investors
GS, ML, LehmanCat XL
200,000 Risk Transfer
Florida Windstorm
44
June 1999
Gerling
Institutions
Aon, GS
Cat XL
45
October 1999
Koch Energy
Inst. Investors
GS
Weather Contracts
46
November 1999
American Re
Inst. Investors
AM Re, ML, SSBCat XL
194,000 Risk Transfer
US Wind and Earthquake
47
November 1999
Gerling
Institutions
Aon, GS
100,000 Risk Transfer
Japanese Earthquake
Institutions
Insurers
Contingent Capital
Cat XL
Total capacity added
Perils Covered
PML Protection
Japanese Earthquake
85,000 Risk Transfer
300,000 Contingent Capital
PML Protection
450,000 Risk Transfer
Florida Windstorm
Japanese Wind
US Wind and Earthquake
54,000 Risk Transfer
150,000 Risk Transfer
European Wind
25,000 Risk Transfer
100,000 Contingent Capital
463,000 Risk Transfer
17,000 Risk Transfer
PML Protection
European Credit Risk
Japan/US Wind and EQ
80,000 Risk Transfer
US Wind and EQ
50,000 Risk Transfer
Weather Risk
5,535,300
33
Aon Group Limited
What investors want
 Clarity of trigger mechanism
 No moral hazard
 Quality exposure data
 Objective risk assessment
 Rated investments
 Liquidity
 Diversification (low beta plus)
… and excess returns!
34
Aon Group Limited
What sellers want
 Access to new source(s) of secure risk capital
 Certainty of cover
 Minimum basis risk
 Contract structure - probably (re)insurance
 Fair price, cost effective transaction
 Confidentiality
 Longer-term capacity and price
 Strategic capital and balance sheet management
35
Aon Group Limited
Rethinking (re)insurance
 Product showing lack of growth
 global non-life insurance premiums only grew by 0.2% in real
terms in 1997 (Swiss Re)
 Service not highly rated
 insurers, brokers and other service providers all given ‘D’ grades
in 1999 Quality Scorecard published at US RIMS in 1999
 Risk is becoming a Boardroom issue (Cadbury,
Greenbury, Hampel, Turnbull)
 but insurance is not mentioned in corporate Report & Accounts
“Traditional insurance does not provide protection against 80% of
risks faced by companies”
(Bob Cooney, XL)
36
Aon Group Limited
What risks are clients concerned about?
Per cent
34
Loss of reputation
30
System failure through Y2K
25
Brand/trademarks
21
Intellectual property erosion
Fraud
14
Terrorism
9
Climatic
7
Credit risk
7
Class action
5
Currency risk
5
Claims against directs & officers
2
Genetically modified organisms
2
Stress claims against employees
0
0
Source: Airmic/Lloyd’s
5
10
15
20
25
30
35
40
37
Aon Group Limited
Rethinking (re)insurance
Why do we limit ourselves to traditional property /
casualty exposures ?
 Microsoft
 Market capitalisation US$ 400 billion
 Plant, property & equipment US$ 1.5 billion
 Cash US$ 14 billion
 Reputation risk

Total value of FTSE 100 companies was £1.37 trillion in 1998
 “Goodwill” accounted for 71% of total value in 1998 (44% in
1988)
Research by Interbrand and Citibank
38
Aon Group Limited
Rethinking (re)insurance
Why do we need insurable interest ?
 Example
 On 4th July 1993 the Sumitomo Chemical Company plant in
Niihama, Japan exploded
 Spot prices for computer memory chips rose by 50% because
Sumitomo plant made 65% of the world’s supply of epoxy cresol
novolac resin used to seal most computer chips into their plastic
packages
 Sumitomo can buy property and business interruption cover on
their plant
 Question
 Why can’t any other economically interested parties, e.g.
computer manufacturers, buy the same insurance policy on the
same terms and conditions?
39
Aon Group Limited
Rethinking (re)insurance
Why does cover have to indemnity-based ?
 Example
 Oriental Land, operators of Disney themepark in Japan, have
borrowed to finance further development of the site
 Any disruption to revenues from existing site will impair their
ability to service this debt
 Answer
 Oriental Land have issued a catastrophe bond to the capital
markets that pays up to $100 million in the event of an earthquake
in the region around the themepark
 Trigger is occurrence of earthquake
 Payment amount determined by epicentre and size of earthquake
40
Aon Group Limited
Concentric Re - Parametric trigger
 If the event happens then
client is paid, regardless
of whether he has actually
sustained a loss or not
Inner Circle
Inner Ring
Chiba
Tokyo
 The pay out is linked to
the epicentre and
magnitude of quake in
three concentric rings
(JMA scale)
Malhama
Boso
Yokohama
Peninsula
 6.5 inner circle,
Outer Ring
Izu
 7.1 inner ring,
 7.6 outer ring
Peninsula
41
Aon Group Limited
Illustrative Terms and Conditions
100%
75%
50%
Inner Circle
Inner Ring
25%
Outer Ring
0%
6.5
6.6
6.7
6.8
6.9
7.0
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
JMA Magnitude
Trigger: Physical, based on earthquake magnitude, location and depth
• Magnitude - Sliding scale based on magnitudes > 6.5
• Location - Three circles (Inner Circle, Middle Ring, Outer Ring) in the
Southern Kanto region of Japan defined by latitude and longitude
• Depth - Shallow earthquakes only, 60km or less
• Reporting Agency - Japan Meteorological Agency (JMA)
• Development period - [30] days
42
Aon Group Limited
Traditional Risk Transfer, ART & Capital Market
Solutions should be considered in combination
Capital Markets
Facultative
Reinsurance
3rd Cat
2nd Cat
Surplus Share
Retention
ART
Debt
Excess
Reinsurance
Equity
4th Cat
1st Cat
Cat Retention
43
Aon Group Limited
Any
questions?
8 Devonshire Square
London EC2M 4PL
Direct tel: 020 7216 3400
Direct fax: 020 7375 1760
Email: alan.punter@aon.co.uk
44