Cummins - CAT Flashcards
Risk-linked securities
Cummins - CAT
securities that allow insurance risk to be sold in the capital markets (ex: CAT bonds)
Reasons original risk-linked securities gained little interest (3)
(Cummins - CAT)
exposure to:
- counterparty (default) risk
- basis risk
- insurer’s general business risk
Basis risk
Cummins - CAT
risk that contract payoffs would be insufficiently correlated with insurer losses (payoff < or > actual losses)
CAT bonds
Cummins - CAT
type of risk-linked security where payoff is based on event occurrence (typically EQ or hurricane events)
Layer of reinsurance protection from CAT bonds
Cummins - CAT
high layers with probability of occurrence < 1% (e.g. 1-in-100 yr events)
Reasons that high layers of insurance (< 1% probability) often go uninsured (2)
(Cummins - CAT)
- ceding insurers are concerned about credit risk for reinsurers for events of this magnitude
- high layers tend to have the highest reinsurance margins
Advantages of CAT bonds (3)
Cummins - CAT
- fully collateralized (no credit risk)
- lower spreads compared to high-layer reinsurance b/c CAT events are uncorrelated with investment returns
- can provide multi-year protection
Typical CAT bond structure
Cummins - CAT
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
Reason insurers prefer to use SPRs for CAT bonds
Cummins - CAT
SPRs receive the same tax and accounting benefits associated with traditional reinsurance
Reasons investors prefer to use SPRs for CAT bonds (2)
Cummins - CAT
- able to isolate investment risk to purely CAT risk (no general business or insolvency risk associated w/traditional reinsurers)
- protected from credit risk because the bonds are fully collateralized in a trust account
Reason CAT bonds are attractive to investors
Cummins - CAT
CAT bonds offer a diversification benefit b/c CAT events have low correlation with market returns
Types of triggers for CAT bond payouts (3)
Cummins - CAT
- indemnity trigger
- index trigger
- hybrid triggers
Indemnity triggers for CAT bond payouts
Cummins - CAT
payout triggers based on the size of actual insurer losses
Index triggers for CAT bond payouts & types (3)
Cummins - CAT
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
Hybrid triggers for CAT bond payouts
Cummins - CAT
payout triggers based on multiple types of triggers
Industry loss index for CAT bond payouts (type of index trigger)
(Cummins - CAT)
payout triggered when industry losses exceed a specified threshold
Modeled loss index for CAT bond payouts (type of index trigger)
(Cummins - CAT)
payout triggered when modeled losses for an event exceed a specified threshold
Parametric index for CAT bond payouts (type of index trigger)
(Cummins - CAT)
payout triggered by physical measures of the event such as wind speed or EQ magnitude
Tradeoff b/w basis risk and moral hazard with CAT bond triggers
(Cummins - CAT)
indemnity triggers minimize basis risk, but have more moral hazard
index triggers minimize moral hazard, but have higher basis risk
Disadvantage of indemnity triggers for CAT bond payouts
Cummins - CAT
require information on an insurer’s UW portfolio, so it takes additional time to determine loss payouts
Advantages of index triggers for CAT bond payouts (2)
Cummins - CAT
- maximized transparency
2. measurable & processed more quickly
Method to reduce basis risk when using index triggers for CAT bond payouts
(Cummins - CAT)
use indices based on more narrowly defined geographic areas
Sidecars and unique feature
Cummins - CAT
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
CAT equity puts (CAT-E-Puts)
Cummins - CAT
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)
Advantage of CAT-E-Puts for insurers
Cummins - CAT
lower transaction costs (b/c no SPR involved)
Disadvantages of CAT-E-Puts for insurers (2)
Cummins - CAT
- exposed to counterparty risk because they are not collateralized
- value of existing shares may be diluted by stock issuance
CAT risk swaps
Cummins - CAT
swap agreements allowing insurers/reinsurers to swap specific CAT exposures to diversify their portfolios (e.g. exchange types of CAT risk)
Advantages of CAT risk swaps (3)
Cummins - CAT
- reduced core risk through swap
- diversification benefits as long as risk obtained in swap has low correlation with remainder of portfolio
- low transaction costs
Disadvantages of CAT risk swaps (3)
Cummins - CAT
- modeling of parity contracts can be difficult
- increased exposure to basis risk
- exposed to counterparty risk b/c they are not collateralized
Industry loss warranties (ILWs)
Cummins - CAT
reinsurance contracts with 2 triggers:
- retention trigger based on insurer’s incurred losses
- warranty trigger based on industry-wide loss index
both are required for payout
Types of triggers for industry loss warranties (ILWs, 2)
Cummins - CAT
- binary trigger
2. pro-rata trigger
Binary trigger for industry loss warranties (ILWs)
Cummins - CAT
full amount of contract is paid once both the retention & warranty triggers are satisfied
Pro-rata trigger for industry loss warranties (ILWs)
Cummins - CAT
payoff depends on the amount losses exceed warranty trigger
Advantages of industry loss warranties (ILWs, 3)
Cummins - CAT
- more likely to be treated as reinsurance for regulatory purposes compared to non-indemnity CAT bonds
- can be used to plug gaps in reinsurance programs
- efficient use of funds b/c payouts are high when both insurer and industry losses are high
Trends in the CAT bond market (4)
Cummins - CAT
- CAT bond market has been growing
- increasing market standardization
- shift towards shorter-term bonds
- below-investment grade bonds are more common compared to investment grade bonds
Rate on line (ROL)
Cummins - CAT
traditional CAT reinsurance pricing metric
ROL = reinsurance premiums / policy limit
Loss on line (LOL)
Cummins - CAT
traditional CAT reinsurance pricing metric
LOL = expected losses / policy limit
Comparisons of CAT bond yields to traditional cost of CAT reinsurance
(Cummins - CAT)
compare ratio of ROL / LOL as a measure of traditional reinsurance to yields / expected losses for CAT bonds
Conclusion about CAT bond pricing and traditional CAT reinsurance
(Cummins - CAT)
comparison shows CAT bond pricing can be competitive with more traditional CAT reinsurance
Factors impeding growth of the CAT bond market (3)
Cummins - CAT
- strict regulatory/accounting requirements
- taxation of CAT bond premium
- dissemination of information on bonds (SEC discourages sharing of information)
