09_Cummis_CAT_bond Flashcards
Define “risk-linked securities” and “event-linked bonds.”
Risk-linked securities are financing devices that enable insurance risk to be sold in capital markets for the primary purpose of raising funds to pay claims associated with catastrophes.
Event-linked bonds are assets that pay off on the occurrence of a specific event.
Provide two reasons why insurers often do NOT have reinsurance for extremely high loss layers.
Explains how CAT bonds address these two issues.
The two reasons are as follows:
1. For events of this magnitude, ceding insurers are concerned about the credit risk of the reinsurer
2. High layers tend to have the highest reinsurance margins
CAT bonds solve these two issues in the following ways:
1. CAT bonds are fully collateralized. Thus, credit risk is not an issue
2. Since catastrophic events are not highly correlated with investment returns, spreads on CAT bonds may be lower than high-layer reinsurance
Fully describe a traditional CAT bond structure. Assume that the floating rate is based on LIBOR.
- A single purpose reinsurer (SPR) is formed. The SPR issues CAT bonds to investors and invests bond proceeds in fixed-rate, short-term securities held in a trust account
- The insurer pays a premium to the investors as payment for catastrophe protection
- The fixed returns from the securities in the trust account are swapped for floating returns based on LIBOR
- The investors receive the insurer premium plus LIBOR
- If the contingent event (i.e. the catastrophe) occurs, the option is triggered resulting in payment to the insurer to cover claims. If the event is extremely large, investors could lose their entire principal
- If no contingent event occurs, the principal is returned to investors
Briefly describe one reason why an insurer might prefer to use a single purpose reinsurer.
Briefly describe two reasons why an investor might prefer to use a single purpose reinsurer.
Insurer
Insurers receive the tax and accounting benefits associated with traditional reinsurance since the SPR is considered a licensed reinsurer
Investor
1. Investors isolate their investment risk to purely catastrophe risk (i.e. no general business risk and/or insolvency risks associated with traditional reinsurers)
2. Since the proceeds from bond issuance are held in a trust account, the bonds are fully collateralized. Thus, the investor is protected from credit risk
Explain how CAT bonds provide a diversification benefit to investors.
Catastrophes have low correlations with investment returns. Thus, CAT bonds provide a diversification benefit to investors.
Briefly describe three types of triggering variables for CAT bonds.
- Indemnity triggers – Payouts are based on the size of the insurer’s actual losses
- Index triggers – Payouts are based on an index not directly tied to the insurer’s actual losses
- Hybrid triggers – Payouts are based on a blending of more than one trigger
Briefly describe three types of indices that can be used for an index trigger.
- Industry loss index – CAT bond is triggered when industry-wide losses for an event exceed a specified threshold
- Modeled loss index – CAT bond is triggered when modeled losses for an event exceed a specified threshold
- Parametric index – CAT bond is triggered by physical measures of the event（eg. wind speed)
Provide one advantage and one disadvantage for insurers from using indemnity triggers.
Provide one disadvantage for an investor from using indemnity triggers.
Insurer
Advantage – indemnity triggers minimize basis risk
Disadvantage – indemnity triggers require disclosure of confidential information on the insurer’s policy portfolio
Investor
Disadvantage – indemnity triggers require investors to obtain information on the risk exposure of the insurer’s underwriting portfolio, which can be difficult for complex risks
Provide one advantage and one disadvantage for insurers from using index triggers.
Provide one advantage for an investor from using index triggers.
Insurer
Advantage – indices are measurable more quickly resulting in a quicker bond payout
Disadvantage – index triggers expose the insurer to more basis risk
Investor
Advantage – index triggers minimize moral hazard originating from the insurer
Fully describe a “sidecar.”
Sidecars provide an avenue for insurers to obtain catastrophe protection through funding provided by the capital markets. They are designed to increase capacity for reinsurers to write specific types of reinsurance such as property catastrophe
quota share or excess of loss reinsurance. They also enable the reinsurer to move some of its risk off-balance sheet. This improves the reinsurer’s leverage.
Describe a “Cat-E-Put.”
Provide one advantage and two disadvantages for an insurer from using a Cat-E-Put.
Cat-E-Puts are not asset-backed securities. Instead, the insurer pays a premium in return for an option to issue preferred stock at a pre-agreed price on the occurrence of a contingent event.
When a catastrophe occurs, an insurer’s stock price is likely to fall. Using this put option, the insurer can raise capital by selling stock at a higher price.
Advantage – lower transaction costs since there is no SPR involved
Disadvantages
1. Cat-E-Puts are not collateralized, which exposes the insurer to counterparty risk
2. Issuing stock may dilute the value of the insurer’s existing shares
Briefly describe a “catastrophic risk swap” and provide an example.
Provide two advantages and two disadvantages of catastrophic risk swaps.
Catastrophic risk swaps are agreements between two entities exposed to different types of catastrophic risk.
For example, Reinsurer A with exposure to California earthquake risk might swap its risk with Reinsurer B exposed to Japanese earthquake risk. Thus, if an earthquake occurs in Japan that meets the conditions necessary to trigger the swap, Reinsurer A would send a payment to Reinsurer B.
Advantages
1. The reinsurer reduces its core risk by swapping it to another reinsurer
2. Assuming the risk obtained under the swap is uncorrelated with the reinsurer’s original risk, the reinsurer gains diversification benefits resulting in a smaller capital requirement
3. low transaction costs
4. reduction in current expenses - no exchanged money until triggering event
Disadvantages
1. Swaps increase exposure to basis risk - losses may not be correlated with exposure
2. Swaps are not collateralized, which exposes the insurer to counterparty risk
3. model risk - if model is wrong, corresponding premium will be
4. credit risk - CAT swaps are not prefunded
Describe an industry loss warranty (ILW).
An ILW is a reinsurance contract with two triggers:
1. Retention trigger – based on the incurred losses of the insurer buying the contract
2. Warranty trigger – based on an industry-wide loss index
Provide three advantages of an ILW.
- More likely to be treated as reinsurance for regulatory purposes than a non-indemnity CAT bond
[cummis discusses the possibility that the risk linked securities may not be treated as reinsurance by regulators] - Used to plug gaps in reinsurance programs
- Efficient use of funds in the sense that they pay off when both the insurer’s losses and industry losses are high
Briefly describe how CAT bonds are priced.
Define “rate on line (ROL)” and “loss on line (LOL).” Explain how they can be used to compare CAT bond prices to traditional catastrophe reinsurance prices.
CAT bonds are priced at spreads over LIBOR, which means that investors receive floating interest (i.e. LIBOR) plus a premium over the floating rate.
ROL is reinsurance premium divided by the policy limit. LOL is expected loss divided by the policy limit. The ratio of ROL to LOL on traditional reinsurance can be compared to the ratio of yield to expected loss on CAT bonds. This comparison shows that CAT bonds do not appear to be expensive relative to traditional reinsurance.
Some have argued that CAT bonds are primarily issued offshore for regulatory reasons. Provide a counterpoint to this argument.
Some have argued that CAT bonds with non-indemnity triggers will face problems when trying to obtain favorable reinsurance accounting treatment.
Provide a counterpoint to this argument.
Research by Cummins showed that issuing bonds offshore provides low issuance costs and high levels of market expertise from those jurisdictions.
Research by Cummins showed that as long as the triggers are highly correlated with the insurer’s losses, regulatory hurdles should not be an issue.
CAT bond vs CAT risk swap on exposure to basis risk
Both depend on the trigger selected.
Most CAT bonds are issued on an index trigger basis which exposes insurers to substantial risk of actual loss not perfectly correlated with actual payoff.
The swap, on the other hand, has a trigger predefined by the contract. If it is an index trigger it has no benefit over CAT bond. If it is an indemnity trigger, it would be beneficial. However most contracts are on index trigger basis to prevent moral hazard.
Therefore there is likely to be no real difference between the two.
Identify and briefly describe 2 risks that may exist depending upon the type of trigger utilized
Basis risk: the risk that the defined trigger is not very closely related to the insurance company’s exposure
Moral Hazard: the risk that the insurer may artificially increase in losses in order to qualify for reimbursement
Insurer looking to cede its exposure.
Why reinsurance profit/risk margin is higher than market rate of the CAT bond?
Investors are willing to accept lower spreads from CAT bonds because they offer diversification benefits.
