CAIA L2 - 9.4 - Insurance-Linked and Hybrid Securities Flashcards
Define
Catastrophe bonds
9.4 - Insurance-Linked and Hybrid Securities
Insurance-linked securities (ILSs) with payoffs tied to insured loss events linked to natural disasters (e.g., hurricanes and earthquakes)
- Cat bonds are floating rate with quarterly-pay coupons
- Maturity ~3y (1-5y)
- cat bond investors earn high returns — spread vs short-term rate ~ 4% to 10%
- very low correlation with key market risks
- Expected losses (on an annualized basis) at issuance ~ 0.5%-5% ( 1.6% avg on a size-weighted basis)
- Can be reinsured (spread out (diversify) catastrophe risk from one entity to multiple entities)
- Diversification within cat bonds as an asset class is not important (investor allocate only a small portion of portfolio)
- Bonds usually private offered
- Should a catastrophe occur, then the SPV will compensate the insurer for the losses and the investor will likely lose some coupons and some or all of the principal.
9.4 - Insurance-Linked and Hybrid Securities
List and explain
4 trigger types
of catastrophe bonds
9.4 - Insurance-Linked and Hybrid Securities
Trigger event = loss event => payments have to be made
Indemnity trigger
* exhaustion point = attachment point of the trigger + bond original issue value
* explanation:
=> in case of an event - catastrophe -, the first value consumed is of the issuer.
=> If the value is above the attachment point, it consumes the bond’s (investor’s) principal, to pay the claims
=> If the value consumes all the principal, it has reached to the exhaustion point
Example: if the exhaustion point is $2.5 billion and the cat bond attachment point of the trigger is $2 billion, then it means that the bonds were originally issued for $0.5 billion.
=> attachment probability is the estimated probability (based on the history of natural disasters) that the attachment point will be attained
* Waiting period risk - Can be longer than maurity. The investor must wait for claims to be worked out before the final impact on the bond principal will be known
* Moral hazard => Insurer may insure bad risks (that earn higher premium) that they normally would not insure if they retained the risk themselves, because they can issue cat bonds
* NO BASIS RISK (issuer pays claimants the same as the cat bond pays the issuer)
The next 3 => reduced moral hazard because insurer retain basis risk
Industry loss trigger
* results in a lowering of the bond principal using index estimates of total industry losses arising from the loss event.
* Example: insurer represents 5% of the catastrophic coverage for hurricanes. A hurricane causes damage ($5 billion). An industry loss trigger would allocate $250 million (5% × $5 billion) of that loss to the investor
* subject to basis risk (unlike indemnity triggers) because the dollar amount of the insurer’s liability for claims (cash outflow) might not match the dollar amount based its percentage of the industry’s market share (cash inflow)
* process is quicker (e.g., compared to indemnity triggers)
Parametric trigger
* yields a loss for investors if catastrophic events occur beyond stated intensity thresholds (wind speed, hurricane category level, or Richter scale)
* Losses from parametric triggers can be resolved quickly and clearly, which is a benefit for investors.
Modeled trigger
* The bond principal payable to investors will be reduced if the modeled losses exceed stated thresholds.
* Actual claims are not involved, which means that that the losses are resolved quicker and that is a benefit to investors.
9.4 - Insurance-Linked and Hybrid Securities
Formula
coupon rate
(of cat bonds)
9.4 - Insurance-Linked and Hybrid Securities
coupon = market reference rate + spread
spread = constant + [loss multiplier × expected loss (%)]
expected loss (%) = (P’event’ x loss’annual’) / principal
constant = alpha (intercept)
loss multiplers = beta (slope)
9.4 - Insurance-Linked and Hybrid Securities
List
2 Potential advantages
and
3 Primary disadvantages
of cat bonds
9.4 - Insurance-Linked and Hybrid Securities
2 Potential advantages
1. Alternative beta risk premium
Cat bonds may be subject to alternative beta, which is incremental return for taking on event-specific risk.
2. Alpha opportunity
In addition to alpha from security selection and sector allocation, alpha from complexity arbitrage may exist for cat bonds. Complexity arbitrage involves trying to earn almost risk-free excess returns due to short-term and temporary mispricings due to very complex investment characteristics. Unfortunately, the relatively small cat bond market does not always make it feasible to capitalize on alpha strategies.
3 Primary disadvantages
1. Low liquidity
Generally less liquid than equities or investment-grade corporate bonds.
2. Left-side skew
Returns have negative skew with significant downside tail risk.
3. Credit risk
Although the risk is thought to be low, some potential credit enhancements include letters of credit, guarantee from a parent company, additional collateral, or credit insurance.
9.4 - Insurance-Linked and Hybrid Securities
Define
Longevity risk
9.4 - Insurance-Linked and Hybrid Securities
Longevity risk is a general term for any risk related to people living longer than projected due to improved living conditions or better health care, for example.
- Life insurance companies,
- pension funds, and
- governments
are most impacted by increased longevity.
9.4 - Insurance-Linked and Hybrid Securities
List
4 Risks
of Longevity Hedging
(e.g. buying longevity swap contract)
9.4 - Insurance-Linked and Hybrid Securities
4 Risks of Longevity Hedging:
-
Counterparty risk
The counterparty may not be able to make payments when required. -
Rollover risk
Pension plans may enter a contract for a duration that is shorter than that of the liabilities that need to be hedged. -
Basis risk
Applies to index-based contracts. It is possible that the true mortality rate within the beneficiaries of a pension fund could be different than that of the index on which the contract is based. -
Legal risk
Hedging contracts are nonpublic, which may result in nonstandard terms requiring legal expertise to properly interpret.
9.4 - Insurance-Linked and Hybrid Securities
Define
Wrapped bonds
and
credit wrap
(in bonds issued by SPV /
Mortality Risk and Structured Products)
9.4 - Insurance-Linked and Hybrid Securities
Wrapped bonds
= bonds with lowered risks (and lower returns)
because of credit wrap
‘–
Credit wrap =
is an enhancement added to a structured product
whereby the insurance company adds a
guarantee of interest and
mortality-adjusted principal repayment
to SPV bond investors
9.4 - Insurance-Linked and Hybrid Securities
Define
Life insurance settlements
and
Explain Values of
* surrender value
* purchase/sale price
* NPV of non-surrender cash flows
(in life insurance settlements)
9.4 - Insurance-Linked and Hybrid Securities
Life insurance settlements (life settlements) involves a policyholder selling or assigning a life insurance contract to a third party (investor) (life settlement investor).
The third party becomes the new beneficiary of the contract and must pay all the remaining premiums
surrender value < purchase/sale price < NPV of non-surrender cash flows
- surrender value (cash surrender value of a life insurance policy)
=> value the insurer (policyholder) would pay to buy back its insured commitment - purchase/sale price
=> price a investor (third party) offer to - NPV of non-surrender cash flows
=> intrinsec value
=> Example: Consider someone with an estimated life expectancy of 20 years, a policy with a $1 million face value, and an annual premium of 1%. If the appropriate discount rate is 10%, then the policy will have a NPV of $63,508 as shown:
NPV = ∑ [−$10,000 / (1+0.10)^t ] + [ $1,000,000 / (1+0.10)^20 ] =$63,508
9.4 - Insurance-Linked and Hybrid Securities
Explain
Main
Life insurance characteristics
9.4 - Insurance-Linked and Hybrid Securities
- Life insurance policies usually have constant premiums over the life of the policy.
- Early years PMT => above PMT of pure insurance. In the earlier years, the premiums are above what is needed to purchase the pure insurance that is being offered given the (lower) mortality rate. => policies often have a positive monetary value to the policyholder in the early years
- At some point, the premiums will switch to being less than is needed to cover the mortality risk and the present value of expected claims.
- The excess in the early years is conserved and used to buffer underpayments in later years and buffer the potential for earlier than expected mortalities.
9.4 - Insurance-Linked and Hybrid Securities
Define
Viatical settlement
and its
Benefits and Risks
9.4 - Insurance-Linked and Hybrid Securities
life settlement sold to a investor (viatical investor)
by a terminally ill policyholder (<2y life expectancy)
- value received by policyholder < face value (death benefit) => study showed policyholders earned 4x more vs if surrended to insurance company
- viatical investor will receive the death benefit when policyholder dies => study showed investors earned 12.5% IRR vs if surrended to insurance company
- market extremely regulated
Benefit
* Diversification (Low correlation with traditional assets)
Risks - main
* Interest rate risk (it is essentially a fixed-income investment)
* Legal risk (because of the highly sensitive nature of the investment)
Risks - other
* Longevity risk
* Credit risk
* Operational risk
* Tax policy risk
* Regulatory risk.
* Low availability of data
* illiquidity
9.4 - Insurance-Linked and Hybrid Securities
Define
Subordinated debt
with step-up rates
(Mezzanine debt)
9.4 - Insurance-Linked and Hybrid Securities
Loans with rates that start out low and then rise:
* time-based approach: rates increase each amount of time
1-2 year with no interest (preferred by lenders - income potential)
* criteria-based approach: rates will not increase unless a specific event (e.g., an interest coverage ratio above a set amount) occurs. (preferred by borrowers - reduced risk)
* hybrid: most frequently used
9.4 - Insurance-Linked and Hybrid Securities
Define
payment-in-kind (PIK)
interest
(Mezzanine debt)
9.4 - Insurance-Linked and Hybrid Securities
Subordinated Debt With Payment-In-Kind Interest:
debt that accrues interest and is all paid in maturity (principal + interest)
‘–
PIK interest can be deconstructed into three components:
(1) commitment fee
(2) accrued interest
(3) ticking fee - compensation to the lender for the delay between the loan commitment and the funds disbursement.
‘–
PIK toggle notes or bonds
allow borrower pay part or all interest at set intervals + rest at maturity (rest like PIK bond)
9.4 - Insurance-Linked and Hybrid Securities
Define
Subordinated debt
with profit participation scheme
(Mezzanine debt)
9.4 - Insurance-Linked and Hybrid Securities
- hybrid debt and equity exposure
- some upside and limited downside for the lender
Example:
A loan offers a profit participation scheme (PPS) of 3% of EBIT, with an annual floor of $165,000 and an
annual cap of $200,000
9.4 - Insurance-Linked and Hybrid Securities
Define
Subordinated debt
with warrants
(Mezzanine debt)
9.4 - Insurance-Linked and Hybrid Securities
Loans that offer equity exposure (or a sweetener) in the form of a warrant
- enhancement to a mezzanine debt
- lower interest rate to borrower
- possible additional return in addition to the bond coupons
Differences vs options:
1. usually issued by private companies
2. dilute earnings (because of new common shares issued)
3. greater maturities vs options (e.g., years vs. months)
4. not standardized
9.4 - Insurance-Linked and Hybrid Securities
Basis Risk
The risk that the payout from an ILS does not perfectly match the actual losses experienced by the insurance company.
This mismatch can occur due to the differences between the index or trigger used to determine the payout of the ILS and the actual losses incurred.
LO 9.4.2
