Cummins CAT Flashcards
Why were the first catastrophe futures and options unappealing to insurers?
Thinness of the market
possible counterparty risk on the occurrence of a major cat
potential for disrupting long-term relationships with reinsurers
for options:
excessive basis risk (payoffs not correlated with insurer loss)
What are CAT bonds?
modeled on asset-backed security transactions
“event-linked bonds”
have become standardized due to need for bonds to respond to sponsors, investors, rating agencies, and regulators
issued to cover extreme right-tail events (return period > 100)
reins often much more expensive option (worry about reinsurer credit risk)
CAT bonds are fully collateralized, low correlation with investments
can be multi-year (shelter from price fluctuation)
What is the role of a “single-purpose-reinsurer”?
formed to issue bonds to investors and then invest the proceeds in safe, short-term securities like government bonds or AAA corporate bonds
theres a call option embedded in the cat bonds triggered by a cat
when a cat happens, proceeds go from SPR to the insurer to pay claims
principal is fully at risk (for most CAT bonds)
fixed returns in securities swapped for LIBOR (floating) in order to immunize investors from interest rate risk and default risk
investors get LIBOR + risk premium
no event occurs = principal is returned upon expiration
What is a principal protected tranche?
some CAT bonds have this
return of principal is guaranteed
triggering event would impact the interest and spread payments and timing of principal repayment
e.g. 2 year CAT bond converts to 10 year zero coupon bond
have become rare
Why do insurers and investors prefer a SPR?
insurers b/c it captures tax/accounting benefits associated with traditional reinsurance
investors b/c it isolates the risk of their investment from the general business and insolvency risks of the insurer (pure cat risk)
also fully collateralized (held in trust)
for insurer, more transparent than a debt issue
investors love the diversification
What are three pay-off triggers for insurance-linked securities?
(1) Indemnity triggers => based on insurer’s actual losses
(2) Index triggers => based on an index not tied to losses
(3) Hybrid triggers => blend multiple triggers
What are three broad type indices that can be used for CAT bonds?
(1) Industry loss => estimated industry losses from an event exceed a specified threshold
(2) Modeled loss => calculated losses by a major cat modeling firm (RMS, EQECAT)
(3) Parametric => bond payoff is triggered by specified physical measures of the event such as wind speed and magnitude
What are some considerations in choosing a trigger?
trade-off between moral hazard (transparency to investors) and basis risk
insurers prefers indemnity triggers (but require investors to obtain info on insurers underwriting portfolio, disclosure of confidential info)
also requires more time to settle due to loss adjustment
index favored by investors because they minimize moral hazard (moral hazard can be if insurers fails to settle cat losses carefully (overpays) or excessively write in covered areas)
co-payment provisions to combat moral hazard
What is a sidecar?
similar to reinsurance and cat bonds
special purpose vehicles formed by ins/reins companies to provide addt capacity to write reinsurance (serve to accept retrocessions from a single reinsurer)
off balance-sheet, formed to write specific types of reinsurance, limited lifetime
reinsurers get override commissions for premiums ceded to sidecars, capitalized by private investors (hedge funds)
can improve leverage for reinsurer
can be formed quickly with minimal documentation and admin fees
What are cat risk swaps?
generally not pre-funded, but rely on agreement between two counterparties
can be executed between two firms with exposure to different cats
e.g. California EQ risk with Japan typhoon risk
sometimes done with a reinsurer intermediary, but not often
facilitated by cat risk exchange (CATEX)
events that trigger payment are clearly defined
can be designed to reach parity (E[Loss] are equal)
annual or span several years
some have sliding scale payoff functions
adv of diversification (possibly operate with less equity capital)
low transaction costs
but.. modeling of risks to achieve parity is hard and prone to error
some basis risk and counterparty non-performance risk
Industry loss warranties
dual-trigger contracts overcome regulatory objections to non-indemnity bonds
retention trigger based on incurred loss of insurer buying the contract
warranty trigger based on industry-wide loss index
both triggers hit for a payoff
cover events from specified cat perils in a certain region
typically one year
binary trigger: full amount pays off once triggers are met
pro-rata trigger: payoff depends on how much exceeds warranty
advs: treated as reinsurance, plug gaps in reins programs
efficient use of funds
What are some regulatory issues with CAT bonds?
onshore transaction costs typically higher
regulatory treatment of non-indemnity cat bonds supposedly doesnt present an obstacle to market development (found many alternative risk financing to blunt concerns)
would be helpful if regulators took a more flexible approach and let the market decide certain things
Whats the tax treatment on cat bonds?
generally no income, corporate, withholding, or other significant taxes in offshore jurisdictions that apply to CAT bonds
SPRs are not taxable for federal income
on the investor side, tax on bond premia is a concern
currently treated as PFIC
currently taxed as dividends
What is something that inhibits research on cat bonds?
SEC regulations discourage the dissemination of information about private cat bond placements
bond prospectuses can only be distributed to investors falling under the definition of an accredited investor (institutional investors and high net worth individuals)
What can be done to further the cat bond market?
insurance regulators in key jurisdictions can mandate cat loss reporting in sufficient detail
