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CAS Exam 9 > Cummins - CAT > Flashcards

Cummins - CAT Flashcards

1
Q

Risk-linked securities

Cummins - CAT

A

securities that allow insurance risk to be sold in the capital markets (ex: CAT bonds)

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2
Q

Reasons original risk-linked securities gained little interest (3)

(Cummins - CAT)

A

exposure to:

  1. counterparty (default) risk
  2. basis risk
  3. insurer’s general business risk
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3
Q

Basis risk

Cummins - CAT

A

risk that contract payoffs would be insufficiently correlated with insurer losses (payoff < or > actual losses)

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4
Q

CAT bonds

Cummins - CAT

A

type of risk-linked security where payoff is based on event occurrence (typically EQ or hurricane events)

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5
Q

Layer of reinsurance protection from CAT bonds

Cummins - CAT

A

high layers with probability of occurrence < 1% (e.g. 1-in-100 yr events)

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6
Q

Reasons that high layers of insurance (< 1% probability) often go uninsured (2)

(Cummins - CAT)

A
  1. ceding insurers are concerned about credit risk for reinsurers for events of this magnitude
  2. high layers tend to have the highest reinsurance margins
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7
Q

Advantages of CAT bonds (3)

Cummins - CAT

A
  1. fully collateralized (no credit risk)
  2. lower spreads compared to high-layer reinsurance b/c CAT events are uncorrelated with investment returns
  3. can provide multi-year protection
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8
Q

Typical CAT bond structure

Cummins - CAT

A

single purpose reinsurer (SPR) issues CAT bonds to investors and invests bond proceeds in fixed-rate short-term securities held in a trust account

fixed returns from securities in the trust account are swapped for floating returns to immunize insurer and investor from interest rate & default risk

insurer pays a premium to investors as payment for CAT protection

if a CAT event occurs, the call option is triggered and insurer receives payment to cover claims, otherwise principal is returned to investors

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9
Q

Reason insurers prefer to use SPRs for CAT bonds

Cummins - CAT

A

SPRs receive the same tax and accounting benefits associated with traditional reinsurance

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10
Q

Reasons investors prefer to use SPRs for CAT bonds (2)

Cummins - CAT

A
  1. able to isolate investment risk to purely CAT risk (no general business or insolvency risk associated w/traditional reinsurers)
  2. protected from credit risk because the bonds are fully collateralized in a trust account
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11
Q

Reason CAT bonds are attractive to investors

Cummins - CAT

A

CAT bonds offer a diversification benefit b/c CAT events have low correlation with market returns

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12
Q

Types of triggers for CAT bond payouts (3)

Cummins - CAT

A
  1. indemnity trigger
  2. index trigger
  3. hybrid triggers
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13
Q

Indemnity triggers for CAT bond payouts

Cummins - CAT

A

payout triggers based on the size of actual insurer losses

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14
Q

Index triggers for CAT bond payouts & types (3)

Cummins - CAT

A

payout triggers based on an index not directly tied to actual insurer losses

types:
1. industry loss index
2. modeled loss index
3. parametric index

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15
Q

Hybrid triggers for CAT bond payouts

Cummins - CAT

A

payout triggers based on multiple types of triggers

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16
Q

Industry loss index for CAT bond payouts (type of index trigger)

(Cummins - CAT)

A

payout triggered when industry losses exceed a specified threshold

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17
Q

Modeled loss index for CAT bond payouts (type of index trigger)

(Cummins - CAT)

A

payout triggered when modeled losses for an event exceed a specified threshold

18
Q

Parametric index for CAT bond payouts (type of index trigger)

(Cummins - CAT)

A

payout triggered by physical measures of the event such as wind speed or EQ magnitude

19
Q

Tradeoff b/w basis risk and moral hazard with CAT bond triggers

(Cummins - CAT)

A

indemnity triggers minimize basis risk, but have more moral hazard

index triggers minimize moral hazard, but have higher basis risk

20
Q

Disadvantage of indemnity triggers for CAT bond payouts

Cummins - CAT

A

require information on an insurer’s UW portfolio, so it takes additional time to determine loss payouts

21
Q

Advantages of index triggers for CAT bond payouts (2)

Cummins - CAT

A
  1. maximized transparency

2. measurable & processed more quickly

22
Q

Method to reduce basis risk when using index triggers for CAT bond payouts

(Cummins - CAT)

A

use indices based on more narrowly defined geographic areas

23
Q

Sidecars and unique feature

Cummins - CAT

A

special purpose vehicles that provide additional reinsurance capacity through funding provided by capital markets

allows reinsurer to have off-balance sheet risk, which improves leverage

24
Q

CAT equity puts (CAT-E-Puts)

Cummins - CAT

A

put option to issue preferred stock at a pre-agreed price on occurrence of a contingent event (allows insurer to raise capital by selling stock at a higher price)

25
Q

Advantage of CAT-E-Puts for insurers

Cummins - CAT

A

lower transaction costs (b/c no SPR involved)

26
Q

Disadvantages of CAT-E-Puts for insurers (2)

Cummins - CAT

A
  1. exposed to counterparty risk because they are not collateralized
  2. value of existing shares may be diluted by stock issuance
27
Q

CAT risk swaps

Cummins - CAT

A

swap agreements allowing insurers/reinsurers to swap specific CAT exposures to diversify their portfolios (e.g. exchange types of CAT risk)

28
Q

Advantages of CAT risk swaps (3)

Cummins - CAT

A
  1. reduced core risk through swap
  2. diversification benefits as long as risk obtained in swap has low correlation with remainder of portfolio
  3. low transaction costs
29
Q

Disadvantages of CAT risk swaps (3)

Cummins - CAT

A
  1. modeling of parity contracts can be difficult
  2. increased exposure to basis risk
  3. exposed to counterparty risk b/c they are not collateralized
30
Q

Industry loss warranties (ILWs)

Cummins - CAT

A

reinsurance contracts with 2 triggers:

  1. retention trigger based on insurer’s incurred losses
  2. warranty trigger based on industry-wide loss index

both are required for payout

31
Q

Types of triggers for industry loss warranties (ILWs, 2)

Cummins - CAT

A
  1. binary trigger

2. pro-rata trigger

32
Q

Binary trigger for industry loss warranties (ILWs)

Cummins - CAT

A

full amount of contract is paid once both the retention & warranty triggers are satisfied

33
Q

Pro-rata trigger for industry loss warranties (ILWs)

Cummins - CAT

A

payoff depends on the amount losses exceed warranty trigger

34
Q

Advantages of industry loss warranties (ILWs, 3)

Cummins - CAT

A
  1. more likely to be treated as reinsurance for regulatory purposes compared to non-indemnity CAT bonds
  2. can be used to plug gaps in reinsurance programs
  3. efficient use of funds b/c payouts are high when both insurer and industry losses are high
35
Q

Trends in the CAT bond market (4)

Cummins - CAT

A
  1. CAT bond market has been growing
  2. increasing market standardization
  3. shift towards shorter-term bonds
  4. below-investment grade bonds are more common compared to investment grade bonds
36
Q

Rate on line (ROL)

Cummins - CAT

A

traditional CAT reinsurance pricing metric

ROL = reinsurance premiums / policy limit

37
Q

Loss on line (LOL)

Cummins - CAT

A

traditional CAT reinsurance pricing metric

LOL = expected losses / policy limit

38
Q

Comparisons of CAT bond yields to traditional cost of CAT reinsurance

(Cummins - CAT)

A

compare ratio of ROL / LOL as a measure of traditional reinsurance to yields / expected losses for CAT bonds

39
Q

Conclusion about CAT bond pricing and traditional CAT reinsurance

(Cummins - CAT)

A

comparison shows CAT bond pricing can be competitive with more traditional CAT reinsurance

40
Q

Factors impeding growth of the CAT bond market (3)

Cummins - CAT

A
  1. strict regulatory/accounting requirements
  2. taxation of CAT bond premium
  3. dissemination of information on bonds (SEC discourages sharing of information)

CAS Exam 9 (26 decks)

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