Cummins CAT Bond Flashcards
Describe risk-linked securities
Financing devices that enable insurance risk to be sold in capital markets for the primary purpose of raising funds to pay claims associated with catastrophes
Describe event-linked bonds
These types of assets pay off on the occurrence of a specified events.
These events are typically catastrophe events such as hurricanes and earthquakes
2 reasons that ceding insurers often do not have reinsurance for higher layers
- For the events of this magnitude, ceding insurers are concerned about the credit risk of the reinsurer
- High layers tend to have highest reinsurance margins
How CAT bonds solves the two issues with reinsurance for high layers
- CAT bonds are fully collateralized, thus credit risk is not an issue.
- Since cat events are not highly correlated with investment returns, spreads on CAT bonds may be lower than high-layer reinsurance.
- Another advantage of CAT bonds is that they provide multi-year protection, whereas traditional reinsurance is usually for a one-year period.
Describe the CAT bond structure
- A single Purpose Reinsurer (SPR) is formed. The SPR issues CAT bonds to investors and invests bond proceeds in fixed-rate, short-term securities held in a trust account.
- The insurer pays a premium to the investors as payment for catastrophe protection.
- The fixed returns from the securities in the trust account are swapped for floating returns based on LIBOR. the intent of the swap is immunize the insurer and the investors from interest rate risk and default risk.
- The investors receive the insurer premium plus LIBOR.
- If the cat event occurs, the option is triggered resulting in payment to the insurer to cover claims . If the event is extremely large, investors could lose their entire principle.
- If no contingent event occurs, the principal is returned to investors
Why insurers prefer SPRs (Single purpose reinsurer)
Since they still receive tax and accounting benefits associated with traditional reinsurance (since SPR is considered a licensed reinsurer)
Why investors prefer SPRs?
- Investors are able to isolate their investment risk to purely catastrophe risk (no general business risk or insolvency risks associated with traditional reinsurers)
- Since the proceeds from bond issuance are held in a trust account, the bonds are fully collateralized. Thus the investor is protected from credit risk.
Why cat bonds are attractive to investors
Catastrophes have low correlations with investment returns. Thus they provide a diversification benefit to investors.
3 types of triggering variable
- Indemnity triggers (payouts are based on the size of the insurer’s actual losses)
- Index triggers (payouts are based on an index not directly tied to the insurer’s actual losses)
- Hybrid triggers (payouts are based on a blending of more than one trigger)
3 types of indices for index triggers
- Industry loss indices (CAT bond is triggered when industry-wide losses for an event exceed a specified threshold)
- Modeled loss indices (CAT bond is triggered when modeled losses for an event exceed s specified threshold)
- Parametric Indices (CAT bond is triggered by physical measures of the event, such as wind speed)
Advantage of indemnity triggers
Advantageous for the insurer, since these triggers minimize basis risk (the risk that the loss payout of the bond will be greater or less than the sponsoring insurer’s actual losses)
Disadvantage of indemnity triggers
- Disadvantageous for the insurer: since it requires disclosure of confidential information on the insurer’s policy portfolio.
- Disadvantageous for the investors: it requires investors to obtain information on the risk exposure of insurer’s underwriting portfolio, which can be difficult for complex risks
Advantage of index triggers
- Advantageous for investors, since it minimize moral hazard. (moral hazard exists with indemnity triggers since insureds may be loss apt to control loss amounts when settling losses)
- Advantageous for the insurer since indices are measurable more quickly resulting in a quicker bond payout
Disadvantage of index trigger
Disadvantageous for the insurer since they expose the insurer to more basis risk. Basis risk can be reduced by using indices based on more narrowly defined geographical areas.
(Industry losses may not correlate with insurer’s losses. Modeled losses subject to model risk. Parametric may not result in large losses)
Describe sidecars
Similar to CAT bonds, it provides an avenue for insurers to obtain catastrophes protection through funding provided by the capital markets.
Sidecars are designed to increase capacity for reinsurers to write specific types of reinsurance.
Sidecars enable the reinsurer to move some of its risk off-balance sheet. This improves the reinsurer’s leverage.
Describe Catastrophic Equity Puts (Cat-E-puts)
Unlike CAT bonds, Cat-E-puts are not asset-backed securities. The insurer pays a premium in return for an option to issue preferred stock at a pre-agreed price on the occurrence of a contingent event.
When a catastrophe occurs, an insurer’s stock price is likely to fail. Using this put option, the insurer can raise capital by selling stock at a higher price.
Advantage of Cat-E-Puts
Since there is no SPR involved, the transaction cost is lower
Disadvantage of Cat-E-Puts
- Cat-E-Puts are not collateralized, which exposes the insurer to counterparty risk
- Issuing stock may dilute the value of the insurer’s existing shares
Describe catastrophic risk swaps
They are agreements between two entities exposed to different types of catastrophic risks.
Allow firms to swap exposures, diversifying risk portfolio
Advantage of catastrophic risk swaps
- The reinsurer reduces its core risk by swapping it to another reinsurer
- Assuming the risk obtained under the swap is uncorrelated with the reinsurer’s original risk, the reinsurer gains diversification benefits resulting in a smaller capital requirement.
- Swaps have low transaction costs
Disadvantage of catastrophic risk swaps
- Parity occurs when the expected losses under both side of swap are equal. The modeling required to design a contract with parity is challenging.
- Swaps increase exposure to basis risk
- Swaps are not collateralized, which exposes the insurer to counterparty risk
Describe Industry Loss Warranties (ILWs)
they are reinsurance contracts with two triggers
1. Retention trigger (based on the incurred losses of the insurer buying the contract)
2. Warranty trigger (based on an industry-wide loss index)
These contracts pay off when the industry-wide loss index exceeds a specified threshold AND the insurer’s losses exceed a specified threshold at the same time.
ILWs are typically one-year contracts.
Industry Loss Warranties (ILWs)’s payout is based on one of the following:
- Binary trigger (the full amount of the contract pays off once the two triggers are satisfied)
- Pro Rata Triggers (the payoff depends on how much the loss exceeds the warranty)
Advantages of ILWs
- More likely to be treated as reinsurance for regulatory purposes than a non-indemnity CAT bond.
- Used to plug gaps in reinsurance programs
- Efficient use of funds in the sense that they pay off when both the insurer’s losses and industry losses are high.
