Cummins CAT Flashcards
CAT Bonds vs High Layer Reinsurance
Cover high layers of reinsurance protection
-Credit risk of reinsurers
-High reinsurance margins
Solve by:
Fully collateralized (no credit risk)
Events not highly correlated with investment returns=Spreads lower on CAT bonds than reinsurance
Single Purpose Reinsurer Benefits
Good for Insurers:
Considered licensed reinsurer so still get tax/accounting benefits
Good for Investors:
-Isolate investment risk to pure CAT risk (no business risk)
-Bonds fully collateralized (no credit risk)
Types of CAT Bond Triggers
- Indemnity (Size of insurer loss)
- Index
-Industry Loss (industry loss exceeds threshold)
-Modeled Loss (modeled loss exceeds threshold)
-Parametric (e.g. wind speed) - Hybrid
Pros and Cons of Indemnity Triggers
Pro (insurer): Minimizes basis risk
Con (insurer): Require disclosure of confidential info on policy portfolio
Con (investor): Must obtain info on insurer’s UW portfolio, difficult for complex risks
Pros and Cons of Index Triggers
Pro (investor): Minimize moral hazard
Pro (insurer): Indices more quickly measurable
Con (insurer): Basis risk, can be reduced with more narrowly defined geo indices
Sidecar
Designed to increase capacity for reinsurers
Enable reinsurer to move some risk off balance sheet (improves leverage)
Catastrophic Equity Puts
Not asset-backed
When CAT occurs, stock price falls, raise capital with put option
Pros: Lower transaction costs since no SPR
Cons:
-Not collateralized
-Issuing stock may dilute existing shares
Catastrophic Risk Swap
e.g reinsurers swap CA EQ and Japan flood risks
Pros:
-Diversification (smaller capital requirement)
-Low transaction costs
Cons:
-Parity when both expected losses equal
-Basis risk
-Not collateralized
Industry Loss Warranties
Insurer losses AND industry losses trigger
Payout binary or pro-rata
Pros:
-More likely treated as reinsurance for regulatory purposes than CAT bond
-Plug gaps in reinsurance programs
-Efficient use of funds
LIBOR
Floating interest paid to investors
Swapped with fixed return on trust to immunize both parties from interest rate risk and default risk
Rate on Line and Loss on Line
ROL = Reins Prem / Policy Limit
LOL = Expected Loss / Policy Limit
Ratio of ROL to LOL on trad reinsurance compared to ratio of yields on CAT bonds show bonds not expensive
Other issues around CAT bonds
Regulatory:
-Often issued offshore, but low cost and high expertise
-No hurdles as long as triggers highly correlated with insurer losses
Tax:
-For investors, income falls under dividends instead of interest
Dissemination of Info:
-Privately placed (no public market) info not openly shared
