Cummins - CAT Bonds and Other Risk-Linked Securities Flashcards
CAT Bonds
- CAT bonds are event-linked bonds
- pay off on the occurrence of a specified event.
- Most have been linked to catastrophes such as hurricanes and earthquakes.
CAT bonds often are issued to cover the so-called higher layers of reinsurance protection, e.g. protection against events that have a prob. of occurrence of 0.01 or less. Why is the higher layers of protection often go unreinsured by ceding companies?
- For events of this magnitude, ceding insurers are more concerned about the credit risk of the reinsurer.
CAT bonds are fully collateralized, they eliminate concerns about credit risk,
2.high layers tend to have the highest reinsurance margins or pricing spreads.
Because catastrophic events have low correlation with investment returns, CAT bonds may provide lower spreads than high-layer reinsurance because they are attractive to investors for diversification.
- CAT bonds also can lock in multi-year protection, unlike traditional reinsurance, which usually is for a 1-year period, and shelter the sponsor from cyclical price fluctuations in the reinsurance market.
- The multi-year terms of most CAT bonds also allow sponsors to spread the fixed cost of issuing the bonds over a multi-year period, reducing costs on an annualized basis.
Explain how a typical CAT bond is structured.
The transaction begins with the formation of a single purpose reinsurer (SPR). The SPR issues the bonds to investors and invests the proceeds in safe, ST securities (gov’t bonds or AAA corp. bonds), held in a trust account. Embedded in the bonds is a call option that is triggered by a defined catastrophic event. On the occurrence of the event, proceeds are released from the SPR to help the insurer pay claims arising from the event. In most CAT bonds, the principal is fully at risk. The fixed return on the securities are usually swapped for floating returns based on LIBOR. => to immunized from interest rate risk, and default risk. Some CAT bond have principal protected tranches, where the return of the principal is guaranteed. In this tranche, the triggering event would affect the interest and spread payments and the timing of the repayment of principal. (rare) Add picture
Why are CAT bonds attractive to investors?
Catastrophic events have low correlation with returns from securities markets and hence valuable for diversification purposes.
What are the three types of triggering variables for CAT bonds pay off.
- Indemnity triggers: based on the size of the insurer’s actual losses
- index triggers: based on an index not directly tied to the insurer’s losses
- hybird triggers: blend more than one trigger in a single bond
What are the three broad types indices that can be used as CAT bond triggers
- Industry loss indices: payoff is triggered when estimated industry-wide losses exceeds threshold
- Modeled loss indices: apply aggreed upon catastrophe risk model, using the physical parameters of actual events, to the insured’s exposure data and pay according to the model’s estimated losses rather than actual losses.
- parametric indices: triggered by specified physical measures of the catastrophic event such as the wind speed and location of a hurricane or the magnitude and location of an earthquake.
What are the factors to consider in the choice of a trigger?
The choice of a trigger involves a trade-off between moral hazard and basis risk.
- Indemnity triggers:
- often favored by insurers and reinsurers because they minimize basis risk
- Disadvantage:
- they require disclosure of confidential information on the sponsor’s policy portfolio.
- It may require more time to reach final settlement because of the length of loss adj. process.
Index triggers:
- favored by investors: minimize the problem of moral hazard
- always contain copayment provisions to control moral hazard => remains a concern
- lowest exposure to moral hazard, highest exposure to basis risk
- advantage: measurable more quickly after the event
- disadvantage:
- expose the sponsor to a higher degree of basis risk (Industry loss indices based on narrowly defined geographical areas tend to have less basis risk)
- modeled-loss indices are subject to model risk
Sidecars
Special purpose vehicles formed by insurance and reinsurance companies to provide additional capacity to write reinsurance.
- typically off-balance sheet
- provides capacity
- enable reinsurer to move some of its risks off-balance sheet => improve leverage
- formed quickly, with minimal documentation and administrative costs.
Catastrophic Equity Puts (Cat-E-Puts)
In return for a premium paid to the writer of the option, the insurer obtains the option to issue preferred stock at a preagreed price on the occurrence of a contingent event. => Enables the insurer to raise equity at a favorable price after a catastrophe. Lower transaction costs than CAT bonds.
Why Cat-E-Puts have not become as important as CAT bonds?
Not collateralized => conterparty performance risk. Issuing the preferred Stock can dilute the value of the firm’s existing share
Catastrophe Risk Swaps
- Executed between two firms with exposure to different types of catastrophic risk.
- Triggers under the swap are carefully defined (e.g. a parametric trigger such as an earthquake of a specified magnitude in Tokyo and a comparable earthquake in San Francisco.)
- Designed so that the two sides of the risk achieve parity (i.e. expected loss are equivalent using models developed externally or internally)
- no exchange of money at inception of contract.
The swap also defines a specific amount of money to be paid if an event occurs. (some have sliding scale payoff function => full payout for severest events and partial payout for smaller events)
Can be annual or span several years, can fund multiple risks simultaneously
Why swaps may be attractive substitutes for reinsurance, CAT bonds, and other risk financing devices? What are the potential disadvantages?
Advantage:
- reinsurer simultaneously lays off some of its core risk
- obtains a new source of diversification => enable reinsurer to operate with less equity capital
- low transaction costs
- reduce current expense because no money exchange until occurrence of a triggering event
Potential disadvantages
- modeling the risks to achieve parity can be challenging and may not be completely accurate
- may create more exposure to basis risk
- create exposure to counter-party nonperformance risk
Industry Loss Warranties
Dual-trigger reinsurance
- Retention trigger: based on the incurred losses of the insurer buying the contract
- Warranty trigger: based on an industry-wide loss index.
Contracts pay off on the dual event that a specified industry-wide loss index exceeds a threshold at the same time the issuing insurer’s losses >= a specified amount.
It provides protection in the states of the world when its own losses are high and the reinsurance market is likely to enter a hard-market phase.
Payouts:
Binary triggers: - full amount pay off once the two triggers are satisfied
Pro rata triggers where the payoff depends upon how much the loss exceeds the warranty
Advantages of ILWs
- They are treated as reinsurance for regulatory purposes
- They can be used to plug gaps in the reinsurance program
- An efficient use of funds in the they pay off in states of the world where both the insurer’s losses and industry-wide losses are high
Why CAT bond market will continue to grow?
- Most catastrophes are small relative to the size of capital markets and could easily be absorbed
- Securities markets are more efficient than insurance markets in reducing information asymmetries and facilitating price discovery
