Cummins: CAT Bonds

Question 1

CAT Bond

Answer 1

Fully collateralized instrument that pays off when a CAT happens

Question 2

Early history of CAT bonds

Answer 2

Thin market

Basis risk

“Act of God” notes – exposed to general business risk

Question 3

Basis risk

Answer 3

Risk that payoffs under contracts would be insufficiently correlated with insurer losses

Question 4

CAT bond overview

Answer 4

Covers high layers of reinsurance protection

Multi-year price protection

Valuable for diversification

Low systematic risk

Tax and accounting benefits of reinsurance

Isolates risk of investment from general risks

Question 5

CAT bond with SPR (flow)

Answer 5

Question 6

Three types of triggers

Answer 6

Indemnity

Index

Hybrid

Question 7

Indemnity trigger

Answer 7

Payouts based on size of insurer’s actual losses

Question 8

Index trigger

Answer 8

Payouts based on an index not tied directly to sponsoring firm’s losses

Question 9

Three broad types of indices

Answer 9

Industry loss indices

Modeled loss indices

Parametric indices

Question 10

Industry loss indices

Answer 10

Triggered when estimated industry-wide losses exceed a threshold

Question 11

Modeled-loss index

Answer 11

Calculated using model provided by a major firm

Question 12

Parametric trigger

Answer 12

Triggered by specified physical measures of event (ex: wind speed, location)

Question 13

Disadvantage to insurer using industry loss index

Answer 13

HIgher basis risk

Question 14

Disadvantages to insurer using indemnity trigger

Answer 14

1. May need to reveal confidential information
2. May require more time to reach settlement

Question 15

Disadvantages to investor of indemnity trigger

Answer 15

1. Moral hazard potential
2. Need to obtain information on sponsor portfolio

Question 16

Sidecar

Answer 16

SPV formed to increase capacity to write reinsurance

Question 17

CAT-E-Puts

Answer 17

In return for premium paid, insurer obtains option to issue preferred stock at preagreed price

Question 18

CAT Risk Swaps

Answer 18

Executed between two firms with different CAT exposures

Question 19

Advantages of CAT risk swaps

Answer 19

May enable reinsurers to operate with less equity capital

Low transaction costs

Reduce current expenses

Can be designed to achieve parity

Question 20

Disadvantages of CAT risk swaps

Answer 20

Modeling risks to achieve parity challenging/inaccurate

May create more exposure to basis risk

Creates exposure to counterparty nonperformance risk

Question 21

Impediments to growth of CAT market

Answer 21

Whether securities are treated as reinsurance

Regulatory issues

Tax issues

Dissemination of information

Question 22

Industry loss warranties

Answer 22

Dual-trigger contracts to overcome regulatory issues

Uses retention and warranty triggers

Could be binary or pro-rata

Question 23

Retention trigger

Answer 23

Based on incurred losses of insurer buying contract

Question 24

Warranty trigger

Answer 24

Based on industry-wide loss index

Question 25

3 reasons CAT bonds are superior to reinsurance

Answer 25

Fully collateralized

Investors willing to accept lower spreads from CAT bonds

Multi-year bonds available (price fluctuations neutralized)

Question 26

Advantages of sidecar

Answer 26

Enable sponsoring reinsurer to move risks off-balance sheet, improving leverage

Can be formed quickly with little cost

Question 27

Advantages to CAT e-put

Answer 27

Able to raise equity after CAT when stock price depressed

Lower transaction costs than CAT bonds (no SPR needed)

Question 28

Disadvantages to Cat e-put

Answer 28

Not collateralized (credit risk)

Value of existing shares diluted if issued

Question 29

Other than ILW, increasing chance CAT bond receives reinsurance treatment

Answer 29

1. Narrow geography
2. Dual-trigger contracts where insurer can not collect more than its net loss