Cummins Cat Bonds

Question 1

What is a CAT bond?

Answer 1

CAT bonds are fully collateralized instruments that pays off on the occurrence of a defined CAT.

Question 2

Why do high layers often go unreinsured?

Answer 2

• For events this size, ceding insurer more concerned about credit risk of reinsurer.
• High layers tend to have the highest reinsurance margins above the expected loss.

Question 3

How do CAT bonds address the issue of high layers going unreinsured?

Answer 3

1) Fully collateralized.
2) No correlation with investment so may provide lower margin.
3) CAT bonds can lock in multi-year period reducing cost.
4) Can be used for high reinsurance layers.

Question 4

3 types of triggers for CAT bonds

Answer 4

1) Indemnity trigger
2) Index trigger
3) Hybrid trigger

Question 5

Indemnity trigger

Answer 5

• Payout based on size of sponsor insurer’s actual losses.
• Favored by reinsurers because minimize basis risk, or that payout >= actual losses.
• Require time to settle, and for investors to obtain significant information for pricing.
• Conducive to moral hazard.

Question 6

Index trigger

Answer 6

• Payout based on an index not directly tied to the sponsoring firm’s losses.
• Minimize problem of insurer overpaying, moral hazard.
• Measurable more quickly.
• Exposure to high degree of basis risk.

Question 7

Hybrid trigger

Answer 7

• Blend more than one trigger into a single bond.

Question 8

3 Broad Types of Indices

Answer 8

1) Industry loss
2) Modelled loss
3) Parametric loss

Question 9

Industry Loss Indices

Answer 9

• When estimated industrywide loss from an even exceeds a threshold.

Question 10

Modelled Loss Indices

Answer 10

• Based on specified CAT model output based on a specified geo area or insurer’s own exposure.
• Subject to model risk.

Question 11

Parametric Loss Indices

Answer 11

• Based on components of the event; e.g. wind speed.
• Lowest exposure to moral hazard.
• Highest exposure to basis risk.

Question 12

Other CAT Risk Securities

Answer 12

• Sidecars (fully collateralized, formed quickly)
• CAT Equity Puts (Easy setup, not fully collateralized)
• CAT Risk Swap (core risk, diversification, low costs, however modelling and credit risk)

Question 13

Industry Loss Warranties (ILW)

Answer 13

Dual triggers

1) retention, insurer loss
2) warranty, industry loss

Receives favorable treatment by regulators for reinsurance accounting.

Question 14

CAT Swap Procedures

Answer 14

Given table with pr(loss) and loss amt by reinsurer and by event.

Calculate potential loss ceded to reinsurer.

Calculate expected loss by event and reinsurer.

Each reinsurer should provide reinsurance a certain event.

Fore each reinsurer subtract the expected loss for the event they reinsurer from the event they don’t reinsure.

Premium will go from negative expected loss to positive reinsurer and will be between the expected losses.

Question 15

CAT Swap Advantages/Disadvantages:

Answer 15

Advantages
- Diversification of CAT exposure.

Disadvantages

• Basis Risk (losses may not be correlated with exposure)
• Model Risk (if model is wrong, premium will be)
• Credit Risk (CAT swaps are not prefunded)

Question 16

Additional Issues

Answer 16

1) Regulatory - typically setup offshore since US is too rigid and way to bypass reinsurance accounting concerns.
2) Taxes - Onshore bonds given unfavorable tax treatment but not a problem offshore.
3) Information - Prospecti only available for qualified investors which inhibits research on bonds.
4) Additional - Better reporting to PCS would promote market growth, Revise solvency regulation to recognize credit quality and full collateralization, and Deregulate DOIs.