Cummins CAT

Question 1

Define risk-linked securities

Answer 1

Financing devices that enable insurance risk to be sold in capital markets for primary purpose of raising funds to pay claims associated with catastrophes.

It is an alternative to reinsurance.

Question 2

Define event-linked bonds

Answer 2

Assets that pay off on occurrence of specific event.

These events are typically catastrophe events such as hurricanes and earthquakes.

Question 3

Provide 2 reasons why insurers often do not have reinsurance for extremely high loss layers and how CAT bonds address these issues.

Answer 3

1. For events of this magnitude, ceding insurers are concerned about credit risk of reinsurer.

CAT bonds are fully collateralized thus credit risk is not an issue.

2. High layers tend to have the highest reinsurance margins.

Since CAT events are not highly correlated with investment returns, spreads on CAT bonds may be lower than high-layer reinsurance.

Question 4

Define Spread

Answer 4

Premium - Expected Loss

Question 5

Contrast CAT bonds and traditional reinsurance in terms of length of coverage.

Answer 5

CAT bonds can provide multi-year protection while traditional reinsurance is usually for a one-year period.

This shelters the sponsor from cyclical price fluctuations in reinsurance market.

It also allows sponsors to spread fixed costs of issuing bonds over multiple years which decrease annualized cost.

Question 6

Describe a traditional CAT bond structure.

Answer 6

A single purpose reinsurer (SPR) is formed.

The SPR issues CAT bonds to investors and invests proceeds in fixed rate, short-term securities held in trust account.

Insurer pays premium to investors as payment for CAT protection.

The fixed returns from securities in trust account are swapped for floating returns based on LIBOR. The intent is to immunize the insurer and investors from interest rate risk and default risk.

The investors receive insurer premium + LIBOR

If the contingent event (CAT) occurs, the option is triggered resulting in payment to the insurer to cover claims. If event is extremely large, investors could lose entire principal.

If no contingent event occurs, principal is returned to investors.

Question 7

Describe a reason why INSURER might prefer to use SPR

Answer 7

Insurers receive tax and accounting benefits associated with traditional reinsurance since SPR is considered a licensed reinsurer.

Question 8

Describe 2 reasons why INVESTORS prefer SPRs.

Answer 8

1. Investors are able to isolate their investment risk to purely CAT risk (no general business risk and/or insolvency risk associated with traditional reinsurance)
2. Since proceeds from bonds issuance are held in trust account, bonds are fully collateralized and investors are protected from credit risk.

Question 9

Explain how CAT bonds provide a diversification benefit to INVESTORS.

Answer 9

CATs have low correlations with investment returns, thus CAT bonds provide diversification benefit to investors.

Question 10

Describe 3 types of triggering variables.

Answer 10

1. Indemnity triggers: payouts are based on size of insurer’s actual losses
2. Index triggers: payouts are based on an index not directly tied to insurer’s actual losses
3. Binary triggers: payouts are based on blending of more than 1 trigger

Question 11

Describe 3 types of index triggers and name an example of each.

Answer 11

1. Industry loss index: CAT bond is triggered when industry-wide losses for an event exceed specified threshold.
   Ex: payout based on estimated cat losses in specified geographic area.
2. Modelled loss index: CAT bond is triggered when modelled losses for an event exceed specified threshold.
   Ex: run a model on industry-wide exposures for specific geo area.
3. Parametric index: CAT bond is triggered by physical measures of the event.
   Ex: wind speed, location of hurricane or magnitude of earthquake.

Question 12

Name an advantage and a disadvantage of industry loss index trigger.

Answer 12

Advantage: tend to have less basis risk

Disadvantage: May not be correlated with insurer losses

Question 13

Name an advantage and a disadvantage of modelled loss index trigger.

Answer 13

Advantage: has benefits of index trigger without significant basis risk.

Disadvantage: subject to model risk.

Question 14

Name an advantage and a disadvantage of parametric index trigger.

Answer 14

Advantage: lowest exposure to moral hazard.

Disadvantage: highest exposure to basis risk.

Question 15

Provide 1 advantage and 1 disadvantage of indemnity trigger from INSURER POV.

Answer 15

Advantage: indemnity triggers minimize basis risk

Disadvantage: indemnity triggers require disclosure of confidential information on insurer’s policy portfolio.

Question 16

Name a disadvantage of indemnity triggers from INVESTOR POV

Answer 16

Require investors to obtain information on risk exposure of insurer’s UW portfolio which can be difficult for complex risks.

Question 17

Provide 1 advantage and 1 disadvantage of index trigger from INSURER POV

Answer 17

Advantage: indices are measurable more quickly resulting in quicker bond payout.

Disadvantage: exposure insurer to more basis risk. Basis risk can be reduced by using indices based on narrowly defined geo areas.

Question 18

Name an advantage of index trigger from INVESTOR POV.

Answer 18

Index triggers minimize moral hazard existing since insureds may be less apt to control loss amounts when settling losses (know they will receive a higher payout if losses are higher).

Thus, it maximizes transaction transparency.

Question 19

List 3 reasons first risk-linked securities gained little interest

Answer 19

1. Counterparty (default) risk
2. Basis risk
3. Potential of exposure to general business risk of insurer

Question 20

Describe sidecars

Answer 20

Sidecars provide an avenue for insurers to obtain CAT protection through funding provided by capital markets.

Reinsurer receive override commissions for premiums ceded to sidecar.

Question 21

Provide 2 advantages of sidecars from REINSURER POV.

Answer 21

1. They are designed to increase capacity for reinsurer to write specific types of reinsurance such as PROP CAT QS or XOL reinsurance.
2. They enable reinsurer to move some of its risk off-balance sheet. This improves reinsurer leverage.

Question 22

Provide 2 advantages of sidecars from INSURER POV.

Answer 22

1. They can be formed quickly
2. They require minimal documentation and admin costs

Question 23

Describe Catastrophic Equity Puts.

Answer 23

Cat-E-Puts are not asset-backed securities like CAT bonds.

Instead, insurer pays premium in return for an option to issue preferred stock at a pre-agreed price on occurrence of a contingent event.

When a CAT occurs, an insurer’s stock price is likely to fall. Using this put option, insurer can raise capital by selling stock at a higher price.

Question 24

Provide 1 advantage and 2 disadvantages of Cat-E-Puts

Answer 24

Advantage: lower transaction costs since no SPR involved.

Disadvantages:
1. Cat-E-Puts are not collaterized, which exposes insurer to counterparty risk.
2. Issuing stock may dilute value of insurer’s existing shares.

Question 25

Describe catastrophic risk swaps.

Answer 25

Agreements between 2 entities exposed to different types of catastrophic risk.

For ex:
Reins A with exposure to Cali earthquake risk might swap its risk with Reins B exposed to Japanese earthquake risk.
Thus, if an earthquake occurs in Japan that meets conditions necessary to trigger swap, Reins A would send a payment to Reins B.

Question 26

Provide 4 advantages of catastrophic risk swaps.

Answer 26

1. Reinsurer reduces its core risk by swapping it to another reinsurer.
2. Assuming risk obtained under swap is uncorrelated with reinsurer original risk, reinsurer gains diversification benefits resulting in smaller capital requirement.
3. Swaps have low transaction costs.
4. Swaps reduce current expenses since no money changes hands until occurrence of triggering event.

Question 27

Provide 3 disadvantages of catastrophic risk swaps.

Answer 27

1. Parity occurs when expected losses under both sides of swap are equal. Modelling required to design contract with parity is challenging.
2. Swaps increase exposure to risk.
3. Swaps are not collaterized which exposes insurer to counterparty risk.

Question 28

Describe Industry Loss Warranty (ILW)

Answer 28

Reinsurance contract with 2 triggers:
1. Retention trigger: based on incurred losses of insurer buying contract.
2. Warranty trigger: based on industry-wide loss index.

These contracts pay off when industry wide loss index exceeds specified threshold AND the insurer’s losses exceed specified threshold at the same time.

ILWs are typically 1y contract.

Insurer is covered in states of the world where own losses are high and reinsurance market is likely to enter hard phase.

Question 29

Provide 2 types of ILW payout

Answer 29

1. Binary trigger: full amount (policy Lim) of contract pays off when the 2 triggers are satisfied.
2. Pro Rata trigger: payoff depends on how much the loss exceeds warranty

Question 30

Provide 3 advantages to ILWs

Answer 30

1. More likely to be treated as reinsurance for regulatory purposes than a non-indemnity CAT bond
2. Used to plug gaps in reinsurance programs
3. Efficient use of funds in sense that they pay off when both insurer losses and industry losses are high

Question 31

Provide 5 takeaways from CAT bond market statistics

Answer 31

1. CAT bond market is growing every year steadily
2. Shorter term bonds are becoming the norm
   Maturities longer than 1y are favoured since provide steady source of risk capital that is insulated from YtoY swings in reinsurance prices.
   Bonds larger than 5y are not favoured by market since preferable to reprice risk periodically to reflect new information on freq/sev of cats and recognize changes in UW risk profile.
3. Below investment-grade bonds are more common than investment-grade bonds.
   Not necessarily bad since CAT bonds are fully collaterized so ratings tend to be determined by probability that bond principal will be hit by triggering event.
4. Market is becoming standardized. Leading index type is parametric.
5. Bonds are more attractive to investors.

Question 32

Describe how CAT bonds are priced.

Answer 32

CAT bonds are priced over LIBOR which means that investors receive floating interest (LIBOR) + premium over floating rate.

Question 33

Define Rate on Line (ROL)

Answer 33

ROL is the reinsurance premium divided by policy Limit.

ROL = P / Lim

Question 34

Define Loss on Line (LOL)

Answer 34

LOL is expected losses divided by policy limit.

LOL = E(L) / Lim

Question 35

What does the comparison of ROL/LOL on traditional reinsurance show versus ratio of yield to expected loss on CAT bonds.

Answer 35

That CAT bonds do not appear to be expensive in comparison to traditional reinsurance.

Question 36

Some have argued CAT bonds are primarily issued offshore for regulatory reasons.

Prove a counterpoint to this argument.

Answer 36

Research by Cummins showed that issuing bonds offshore provides low insurance costs and high levels of market expertise from those jurisdictions.

Question 37

Some have argued CAT bonds with non-indemnity triggers will face problems when trying to obtain favorable reinsurance accounting treatment.

Provide a counterpoint to this argument.

Answer 37

Research by Cummins showed that as long as triggers are highly correlated with insurer losses, regulatory hurdles should not be an issue.

ex: contract pays off on narrowly defined geographic index correlated with insurer losses.

Question 38

Describe the tax issue impeding growth on CAT bonds market

Answer 38

In general, CAT bonds do not create taxation issues for insurers.

Tax issue for CAT bonds relate to investors and treatment of bond premiums under US income tax law.

As of the time paper was written, CAT bond income was being included in taxable income as dividends rather than interest.

Question 39

Describe the dissemination of information on bonds issue.

Answer 39

CAT bonds are privately placed bonds.

Current securities regulations discourage information sharing about private placements.

For ex: bond prospectuses for privately placed bonds can only be distributed to a specific set of qualified investors.

If the SEC were to allow non-investors such as academics to receive these prospectuses, we might see quicker development of public market for these.

Question 40

Describe 3 recommendations to be explored on CAT bonds market

Answer 40

1. Insurance regulators could mandate cat loss reporting for events above given industry threshold such as $1B.
2. Explicitly incorporate reinsurance credit quality into regulatory capital calculations and related regulatory credit evaluations.
3. Deregulate prices at state level so primary insurers do not have to be caught in price-cost bid.