Chapter V: Catastrophe derivatives Flashcards
Definition of Catastrophe derivatives?
Derivative contracts whose underlying is an index of insurance losses or disaster severity. It can be used to hedge property-catastrophe exposure or for speculation. The underlying is not traded and hence physical delivery is impossible.
What are the catastrophe derivative markets ?
1) Over-the -Counter (OTC): trading takes place directly between the counterparties.
2) Exchanged-traded: derivative contracts intermediated by an organized exchange.
What are the general and format problems for the failed exchanged-traded ?
-General Problems:
It needs insurable interest.
Low liquidity
Uncertainty about regulatory and accounting
treatment
-Format problems:
Lack of historical data
Long settlement time for EU options and certain
industry loss index solutions
What are the 4 quality dimensions of indices for ILS and derivatives ?
- Accuracy: index values should be reliable and subject to as little revision as possible
- Granularity: high geographic and business line resolution allow to minimize basis risk
- Timeliness/frequency: index should be responsive and published without great delays
- Index history: the more data available, the better the risk can be assessed
Industry loss indices ?
Property Claim Services (PCS)
Provides industry loss estimates for the United Statesby polling insurers and other parties
Pan-European Risk Insurance-Linked Services (PERILS)
Insurance loss estimates for catastrophic events in Europe(similar to PCS in the US)
Paradex
Designed by RMS to proxy industry losses in the US, Europe, and Japanon a parametric basis
Sigma (Swiss Re) and NatCatSERVICE(Munich Re)
The two largest reinsurers have been compiling worldwide industry loss estimates for decades
Anatomy of Paradex index ?
- Event definitions
- Hazard footprint
- Index Lookup Table
- High-Level Indices
Key features and Thresholds types for ILWs and natural catastrophe swaps ?
Key characteristics
•Covered territory and reference peril are defined as for catastrophe bonds
•One-year risk term (multi-year contracts are still rare) and single-event coverage
•Usually upfront premium and binary payoff (but: linear payoffs up to a cap possible)
Thresholds
• Event threshold (ET):triggers payoff if reached/exceeded by a final industry loss estimate
• Acceleration threshold (AT):slightly higher threshold for interim loss estimates
• Extension thresholds (ExT):exceedance leads to prolongation of the contract term
Why derive implied intensities?
- Reference point for consistent pricing of less standardized instruments such as cat bonds
- Full term structure may be derived as soon as longer term cat swaps become available
- Time series pattern (stochastic process) can be employed for forecasting purposes
What are the Opportunistic trading strategies for cat derivatives ?
Market timing
Prices shift on news concerning disasters, changes in reinsurance capacity, major losses etc.
Opportunistic investors may speculate on these price movements (without a reinsurance license)
Live and dead cat trading
Live cat: buy/sell derivative contracts as hurricanes develop and approach the covered territory
Dead cat: buy/sell derivative contracts after landfall (speculation on loss development)
Negative basis trading with cat bonds
By no-arbitrage reasoning, cat swaps and comparable cat bonds should offer similar spreads
If the basis (cat swap spread -cat bond spread) is negative, buy the bond and buy protection
Exploitation of reinsurance mispricings
The reinsurance market is inefficient and regularly throws up pricing anomalies
Catastrophe derivatives offer a cheap, quick, and convenient way to take advantage of them
4 Examples of failed exchange-traded catastrophe derivative markets ?
- Chicago Board of Trade (CBOT)
- Bermuda Commodity Exchange (BCE)
- New York Mercantile Exchange (NYMEX)
- Insurance Futures Exchange (IFEX)
5 features of catastrophe derivatives ?
- Standardizaton: limits complexity, reduces transaction costs, accelerates execution, enhances liquidity
- Rapid Settlement: Index transaction settle much more quickly than indemnity transaction
- Simplicity: An index as underlying is easier to understand for investors than insurance portfolios
- Transparency: The magnitude that determines the trigger event needs to be easily observable
- Objectivity: Computation by independent third party based on rules (moral hazard)
Illustration of the PERILS methodology
- PERILS collect data directly from insurers with business in the covered territories
- Categories: exposure data (sums insured), premium data, and event loss data
- The company data is made anonymous and tested for quality and completeness
- Finally, company losses are aggregated and extrapolated to the industry level based on exposure and premium information per country
Credit risk and collateralization of cat derivatives
- For exchange-traded products, credit risk is minimized by the clearing house
- ILW and cat swap protection sold by highly-rated reinsurers is usually uncollateralized
- Partial or full collateralization can be demanded in case of unrated counterparties
Basis risk of cat derivatives
- Being index-linked, cat derivatives are an imperfect hedge for insurance portfolios
- Problem: parametric triggers or differences between portfolio of hedger and industry
- Careful modeling and choice of strike prices/attachment points can reduce basis risk
Why draw on catastrophe derivatives?
- Beyond buy-and-hold: derivatives are an effective tool to actively manage ILS portfolios
- Yet, these instruments require the investor to have more expertise than cat bonds
