Cummins: CAT Bonds Flashcards
CAT Bond
Fully collateralized instrument that pays off when a CAT happens
Early history of CAT bonds
Thin market
Basis risk
“Act of God” notes – exposed to general business risk
Basis risk
Risk that payoffs under contracts would be insufficiently correlated with insurer losses
CAT bond overview
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
CAT bond with SPR (flow)
Three types of triggers
Indemnity
Index
Hybrid
Indemnity trigger
Payouts based on size of insurer’s actual losses
Index trigger
Payouts based on an index not tied directly to sponsoring firm’s losses
Three broad types of indices
Industry loss indices
Modeled loss indices
Parametric indices
Industry loss indices
Triggered when estimated industry-wide losses exceed a threshold
Modeled-loss index
Calculated using model provided by a major firm
Parametric trigger
Triggered by specified physical measures of event (ex: wind speed, location)
Disadvantage to insurer using industry loss index
HIgher basis risk
Disadvantages to insurer using indemnity trigger
- May need to reveal confidential information
- May require more time to reach settlement
Disadvantages to investor of indemnity trigger
- Moral hazard potential
- Need to obtain information on sponsor portfolio
Sidecar
SPV formed to increase capacity to write reinsurance
CAT-E-Puts
In return for premium paid, insurer obtains option to issue preferred stock at preagreed price
CAT Risk Swaps
Executed between two firms with different CAT exposures
Advantages of CAT risk swaps
May enable reinsurers to operate with less equity capital
Low transaction costs
Reduce current expenses
Can be designed to achieve parity
Disadvantages of CAT risk swaps
Modeling risks to achieve parity challenging/inaccurate
May create more exposure to basis risk
Creates exposure to counterparty nonperformance risk
Impediments to growth of CAT market
Whether securities are treated as reinsurance
Regulatory issues
Tax issues
Dissemination of information
Industry loss warranties
Dual-trigger contracts to overcome regulatory issues
Uses retention and warranty triggers
Could be binary or pro-rata
Retention trigger
Based on incurred losses of insurer buying contract
Warranty trigger
Based on industry-wide loss index
3 reasons CAT bonds are superior to reinsurance
Fully collateralized
Investors willing to accept lower spreads from CAT bonds
Multi-year bonds available (price fluctuations neutralized)
Advantages of sidecar
Enable sponsoring reinsurer to move risks off-balance sheet, improving leverage
Can be formed quickly with little cost
Advantages to CAT e-put
Able to raise equity after CAT when stock price depressed
Lower transaction costs than CAT bonds (no SPR needed)
Disadvantages to Cat e-put
Not collateralized (credit risk)
Value of existing shares diluted if issued
Other than ILW, increasing chance CAT bond receives reinsurance treatment
- Narrow geography
- Dual-trigger contracts where insurer can not collect more than its net loss
