lecture 7 - ILS Flashcards
what are insurance linked securities?
important but relatively small/specialised part of reinsurance market
convergence of banking and insurance
protects insurance markets against catastrophic events
what are cat bonds?
cat bond = catastrophe bond. intermediary between banking and insurance markets
what is a supply cycle?
tend to happen in highly commoditised markets, which are typically easier to get into than get out of (like insurance or animals). e.g. pig market - when price of pigs is high, buy a small pig to feed it and once grown sell the meat. price of pork falls. produces long price curve caused by delay in understanding of price movements
how does the supply cycle work for reinsurance?
people get in because profitable, but insurance has a tail (caused by the fact that it takes a while to work out you’re losing money), reinsurer won’t understand what’s been made or lost until deciding whether to renew. delay while people appreciate whether they’ve made or lost money. more complex insurance = longer tail.
means you see prices rise, long period where they go down, then usually there is an event (first dip is the 9/11 attacks) where people realise they’ve lost money, price goes up and capital floods in, then another event (Katrina, 2005), further increase in pricing and capital floods in, and prices fall again. can see the cycle running
who invented cat bonds?
goldman sachs - looked at supply cycle graphs and saw volatility of prices. wanted to find more intelligent way to structure market. underlying idea of cat bond = using bond capital to support insurers.
how do cat bonds work?
cedant gives risk to special purpose vehicle that pays claim in event that it arises. SPV issues a bond to bond investors, they put up capital, SPV pays a coupon which is typically the normal bond coupon + risk of event happening. event usually some sort of catastrophe like an earthquake or floods
if triggered, SPV pays claim to cedant and is fully collateralised (all amount needed for claim is in SPV, unlike insurance company where typically all amount is not held). no return of principal - bond investors dont get money back.
SPV set up usually by trust that can’t go bankrupt. in practice, by an advisory business (to the cendant, not to the bank).
what are the advantages and disadvantages of cat bonds for the cedant?
advantages - more capacity, very low credit risk
disadvantages - basis risk, frictional costs, traditional reinsurance easier to understand
what are the pros and cons of cat bonds for the bond holder?
pros - high yield securities, very low correlation
cons - the credit cliff
why are cat bond correlations interesting?
if you hold a bond portfolio of mainly corp/sovereign, odds that they all get marked down at same time fairly high (therefore high correlation). cat bonds respond to different things, so have low correlation and are good for diversifying.
why is basis risk a problem for cat bond cedants?
in original form, SPV held fixed amount of money and in cat event it was paid out, largely irrespective of whether you’d lost any money at all. e.g. if you insured your buildings against earthquake and it happens but your buildings are fine, you end up in the money. if you have lost lots and there wasn’t enough, you end up out of the money.
what is the credit cliff (for cat bond holders)?
may not get any money back, unusual in bond environment. argument made by buffett, as cat bonds are major competitor to reinsurers. turned out to be wrong, when structures started to experience losses it became obvious that bond holders understood and actually put money back into the market (’reload’)
what are the three types of cat bond trigger?
parametric - payouts based on objective measurable variables. don’t need to tell investors much apart from risk of event being triggered. does leave disjuncture between what you’re paid and what you need (basis risk).
modelled loss - payouts based on modelled impact of parameters on representative portfolio. some substantive disclosure about sponsor to investors, reduced basis risk.
indemnity - payouts are based on actual losses incurred. much closer to how reinsurance works. removes basis risk, adds need for lots of information to sponsors (bond holders) so they understand.
have squeezed out parametric triggers almost completely.
what did sidecars provide a solution for?
thinking was that reinsurance fine, cat bonds fine but not successful because thought to be too inflexible (parametric measures). needed to get capital from bond market to insurance markets. sidecars seen to be answer to this
what is a sidecar (ILS)?
usually a bermudian (class 3 insurer) insurance company with 1 client, the insurer. would payout insurer on basis that it accepts losses in proportion with insurer’s losses.
don’t participate in any other risks that insurer does; insurer is a large fund with own assets, makes and loses money on insurance. lots of risks involved with this. only exposing yourself to underwriting side, bond investors still get lack of correlation with rest of investment book.
why didn’t sidecars work?
went bust fundamentally because investment banks underestimated correlation of default events through structure/between buckets. typically, shouldn’t be much correlation between one risk and another (e.g. if you insure 10k cars they’re fairly independent in terms of risk of accident). aggregation of risk therefore unlikely, but is big part of bankers’ world view (companies go bust together). insurers therefore exposed themselves to higher correlation and didn’t realise, would’ve gone bust but dug out by govs.
