Cummins - CAT bonds Flashcards
Risk linked securities
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
CAT Bonds
- 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
SPR & benefits
- 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
if CAT event does occur, it only impacts
the interest & spread payments as well as timing principal repayment of this tranche
structure of a typical CAT bond:
insurer
spr
investors
trust accounts
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
3 types of triggers that would generate a payment
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
indices for index triggers
- 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
selecting a trigger will involve a tradeoff between
moral hazard & basis risk
moral hazard & basis risk
-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
CAT bonds are often issued to cover
high layers of exposure which may be uninsured
high layers of exposure which may be uninsured due to:
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)
investors are willing to accept lower spreads from CAT bonds because
they offer diversification benefits ie cat events usually have low correlations to investment returns
another advantage of CAT bonds over reinsurance
multiyear bonds are available unlike traditional reinsurance; CAT bonds therefore shelter sponsor from cyclical price fluctuations of reinsurance market
Sidecars
- 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
sidecars advantages
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
Catastrophic Equity Puts (Cat-E-Puts)
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
cat e puts advantages and disadvantages
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
CAT Risk Swaps
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
CAT risk swaps advantages and disadvantages
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
Industry Loss Warranties, ILW
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
ILW dual triggers
- retention trigger: based on incurred loss of insurer
- warranty trigger: based on industry wide loss index
ILW: 2 categories of payments
- binary trigger: full payment is made once both triggers are satisfied
- pro rata trigger: payoff depends on magnitude by which losses exceed warranty
Factors Impeding Growth of risk linked securities Market
regulatory issues
accounting issues
tax issues
-many factors that could potentially be impediments to growth of risk linked securities market
factors impeding growth do not seem
to currently pose a material impediment and this is confirmed by the fact that the market is still growing in size
Regulatory/Accounting Issues
- 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
advantages of issuing offshore
lower transaction costs and offshore jurisdictions have demonstrated that they can perform very well in issuing and settling securities
market has come up with number of different methods to circumvent concerns of basis risk and potential use as a speculative instrument
base payment on narrowly defined geographic indices & dual-trigger contracts where the insurer can not collect more than its net loss
Tax Issues
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
one problem is that securities regulations discourage
releasing info about private placements which would include CAT bonds
-lack of info about these bonds, impeding the market developments
prospectuses of privately placed bonds can only be issued to
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)
suggestions for regulators
- 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
