Cummins - CAT bonds

Question 1

Risk linked securities

Answer 1

enable insurance risk to be transferred to capital market, providing the insurance market with additional capacity

-CATs that are large relative to resources of insurers will often still be small relative to size of capital markets

Question 2

CAT Bonds

Answer 2

• most common type of risk linked security
• bonds are included in class event-linked bonds which provide payment on occurrence of a specified event
• single purpose reinsurer, SPR is created by insurer (sponsor)
• CAT bonds contain a call option that is triggered by specified CAT event: if event occurs, proceeds are transferred from SPR to insurer

Question 3

SPR & benefits

Answer 3

• single purpose reinsurer, SPR is created by insurer (sponsor)
• benefits of SPR= shields the investors from general business risk of insurer, financing costs of insurer will be lower, transaction is more transparent than debt issue because the funds are held in a trust and released according to very specific criteria

Question 4

if CAT event does occur, it only impacts

Answer 4

the interest & spread payments as well as timing principal repayment of this tranche

Question 5

structure of a typical CAT bond:

insurer

spr

investors

trust accounts

Answer 5

Insurer: pays premiums to the SPR

-receives funds from the SPR if a catastrophe occurs

SPR: sells a bond to investors, and invests the funds in a highly rated investment.

• collects premiums from the insurer and will pay the insurer a sum of money if a catastrophe occurs
• returns money (plus additional return) to the investors if catastrophe doesn’t occur

Investors: provide the initial funds to the SPR (via purchase of the cat bonds)

-receive interest payments from the SPR, and will receive principal at maturity if no catastrophe occurs

Trust account: SPR maintains the funds from the investors in this trust account until they need to be paid out

-fixed returns from investments are usually swapped for floating returns in order to immunize the insurer and investor from interest rate risk

Question 6

3 types of triggers that would generate a payment

Answer 6

indemnity triggers: payouts are based on sponsoring insurer’s actual losses

Index triggers: payouts are based on index of industry losses

hybrid triggers: blend more than 1 trigger

Question 7

indices for index triggers

Answer 7

• industry loss indices: estimated losses to industry from event
• modeled loss indices: runs the parameters of even through model of cat-modeling firm to generate either industry losses or losses specific to sponsoring insurer
• parametric indices: triggered by specified physical measures of event

Question 8

selecting a trigger will involve a tradeoff between

Answer 8

moral hazard & basis risk

Question 9

moral hazard & basis risk

Answer 9

-Basis Risk=risk that the defined trigger is not very closely related to the insurance company’s exposure.

**think base

-Moral Hazard=risk that the insurer may artificially increase in losses in order to qualify for reimbursement

**think lying

Question 10

CAT bonds are often issued to cover

Answer 10

high layers of exposure which may be uninsured

Question 11

high layers of exposure which may be uninsured due to:

Answer 11

due to credit risk of reinsurer is a major concern in events of this magnitude (CAT bonds are much safer as they are fully collateralized)

highest layers usually have highest reinsurance profit margins (premium can be quite high compared to expected losses)

Question 12

investors are willing to accept lower spreads from CAT bonds because

Answer 12

they offer diversification benefits ie cat events usually have low correlations to investment returns

Question 13

another advantage of CAT bonds over reinsurance

Answer 13

multiyear bonds are available unlike traditional reinsurance; CAT bonds therefore shelter sponsor from cyclical price fluctuations of reinsurance market

Question 14

Sidecars

Answer 14

• special purpose vehicles formed by insurers or reinsurers to provide additional capacity to write reinsurance
• usually accept retrocessions exclusively from a single reinsurer, reinsurer will receive commissions for premium ceded to sidecar
• sidecars are mainly capitalized by private investors but can be funded by insurers and reinsurers as well

Question 15

sidecars advantages

Answer 15

transactions are usually off balance sheet (and therefore sidecars can be used to improve the reinsurer’s leverage) and can be formed quickly with minimal documentation/administration costs

Question 16

Catastrophic Equity Puts (Cat-E-Puts)

Answer 16

are options not asset backed securities

-insurer purchases the Put from the writer and in return receives the right to issue preferred stock to writer at a specified price on occurrence of specified event

Question 17

cat e puts advantages and disadvantages

Answer 17

Advantages: insurer will be able to raise equity after a CAT when its stock price is likely to be depressed and lower transaction costs than CAT bonds as no need to form a SPR

Disadvantages: not collateralized so exposes insurer to credit risk and if insurer issues preferred stock, value of existing shares will be diluted

Question 18

CAT Risk Swaps

Answer 18

swap between 2 (re)insurers which are exposed to different types of CAT risk

• swap defines specified amount of money that needs to be paid by each reinsurer in occurrence of specified event
• if swap is structured such that 2 parties achieve parity (have equal expected losses) no money is exchanged @ inception

Question 19

CAT risk swaps advantages and disadvantages

Answer 19

Advantages: (re)insurer reduces some of its core risk and achieves diversification and lower transaction costs than some of other securities

Disadvantages: it is difficult to create a swap that achieves parity, can create more exposure to basis risk than some other types of contracts, not prefunded

Question 20

Industry Loss Warranties, ILW

Answer 20

possibility that the risk linked securities may not be treated as reinsurance by regulators

• ILW is one type of security that does not suffer from this
• this security has dual-triggers that need to be satisfied for losses to be paid

Question 21

ILW dual triggers

Answer 21

1. retention trigger: based on incurred loss of insurer
2. warranty trigger: based on industry wide loss index

Question 22

ILW: 2 categories of payments

Answer 22

1. binary trigger: full payment is made once both triggers are satisfied
2. pro rata trigger: payoff depends on magnitude by which losses exceed warranty

Question 23

Factors Impeding Growth of risk linked securities Market

Answer 23

regulatory issues

accounting issues

tax issues

-many factors that could potentially be impediments to growth of risk linked securities market

Question 24

factors impeding growth do not seem

Answer 24

to currently pose a material impediment and this is confirmed by the fact that the market is still growing in size

Question 25

Regulatory/Accounting Issues

Answer 25

• some people believe that due to regulations, CAT bonds have mainly been issued offshore and this fact may threaten their attractiveness
• others are concerned about the uncertain regulatory/accounting treatment of nonindemnity CAT bonds due to basis risk and potential use as a speculative instrument

Question 26

advantages of issuing offshore

Answer 26

lower transaction costs and offshore jurisdictions have demonstrated that they can perform very well in issuing and settling securities

Question 27

market has come up with number of different methods to circumvent concerns of basis risk and potential use as a speculative instrument

Answer 27

base payment on narrowly defined geographic indices & dual-trigger contracts where the insurer can not collect more than its net loss

Question 28

Tax Issues

Answer 28

some are concerned about the tax treatment of these securities

• they do not pose tax problems on sponsors -> there are no income, corporate, or other significant taxes in offshore jurisdictions that impact CAT bonds
• sponsors have been deducting the premium payments on bonds for income tax purposes which is consistent with treatment of reinsurance premiums

Question 29

one problem is that securities regulations discourage

Answer 29

releasing info about private placements which would include CAT bonds

-lack of info about these bonds, impeding the market developments

Question 30

prospectuses of privately placed bonds can only be issued to

Answer 30

accredited investors which mainly consists of institutional investors and high net worth individuals -> discourages research on bonds

-rules should be changed to allow sponsors to distribute the prospectuses to researchers (disclosing that posting the prospectuses does not constitute an offer to sell)

Question 31

suggestions for regulators

Answer 31

• regulators in certain jurisdictions mandate CAT loss reporting of a certain level of detail of events with industry losses exceeding a certain threshold
• regulators account for reinsurance credit quality in regulatory capital calculations -> improve insurance solvency regulation and encourage the use of insurance linked securities market