Chapter III: Catastrophe Bonds I

Question 1

Definition of Catastrophe bonds ?

Answer 1

Financial instruments whose values are mainly driven by catastrophe risk

Question 2

Aim of Catastrophe Bonds ?

Answer 2

They are designe to hedge sponsors against losses by natural disasters

Question 3

Explain the course of transaction of transaction bonds

Answer 3

SPV gains cat risk exposure via reinsurance contract with the sponsor.
It then issues the bonds and uses investors money to purchase highly-rated collateral.
Trigger event: sponsor is repaid from collateral, investors lose all/part of the principal

Question 4

Give the risks inherent in a cat bond and their range

Answer 4

• Property carastrophe risk: almost a “pure play”
• Liquidity risk: depends on the secondary market activity
• Interest rate risk: minimized due to floating rate coupons
• Minimized due to tight collateral provisions and highly-rated sponsors

Question 5

Explain the common trigger categories of cat bonds

Answer 5

• Indemnity: Cat bonds pays if the actual insurance losses suffered by the sponsor exceed a threshold
• Industry loss: Providers such as Property Claim Services (PCS) aggreagate indusry-wide losses into an index
• Parametric (pure and index): based on values of physical parameters such as wind speed
• Modeled loss: model insurance portfolio (matched to sponsor) and modeling software are held in escrow

Question 6

What are the 4 factors affecting the trigger choice ?

Answer 6

• Transparency for investor: Asymmetric info, sponsor have better info than investors
• Basis risk for sponsor: Possibility that the sponsor is not (perfectly) indemnified for its losses.
• Settlement time: Time needed to determine the cat bond payout after an event has occured
• Accounting and regulatory acceptance: Trigger determines if the cat bond receives a quasi-reinsurance status for the sponsor

Question 7

What are the reasons for the success of the cat bond market ?

Answer 7

• Rise of insured values in disaster-prone areas and stronger events in shorter intervals
• Size of global capital markets is well-suited to absorb extreme losses
• Investor-friendly characteristics:
• -attractive security format for institutional fixed income investors
• -minimal credit risk as cat bonds are fully collateralized transactions
• -limited model risk due to scientific knowledge about meteorolocial and seismic events
• -modern pricing approaches that are compatible with financial theory

Question 8

Definition of Shelf offering programs of cat bonds ?

Answer 8

Enable sponsors to repeatedly issue additional classes of cat bonds out of the same SPV. All “takedowns” are based on a single offering circular covering their general features. Shelf offering are restricted to a certain time span and a maximum volume.

Question 9

Advantage of Shelf offering programs for sponsors ?

Answer 9

• Allow to quickly draw down risk bearing capacity as required
• Signal experience and willingness to provide a steady future deal flow to investors
• Streamline structuring process and help to reduce transaction costs and spread

Question 10

Motivation for intra-bond diversification ?

Answer 10

Investors can diversify their ILS portfolio by buying different tranches of the same bond. Alternatively, a combo tranche can offer cross-peril diversification

Question 11

Current trends of Cat bonds ?

Answer 11

• Cat bonds have become an established risk transfer tool
• Many investors are familiar with the advantages of the asset class
• The structuring process is becoming increasingly streamlined and issuance costs decrease

Question 12

Outlook for Cat bonds ?

Answer 12

• Securitization of new peak risk s (e.g cyber risk) or high frequency risks
• New territories (e.g. China)
• Impact of Blockchain Technology on issuance and trading