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Purpose of risk-linked securities
Change the industry's reliance on the reins mkt as the sole vehicle for managing property caT risk
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Define catastrophe bonds
- Investors provide capital (to purchase a bond) to a trust or single purpose reinsr, which simultaneously offers a traditional reins contract to the insr.
- If they have to pay a covered claim under the reinsurance agreement, it causes the bond to default.
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Characteristics of caT bonds
- Collateral: no credit risk from reinsr
- Multi-year coverage: usually 3 years
- Risk-remote layers: usually 1%-5%
- Pricing: arguably possible for pricing to reflect lower risk margin since investors don't have any natural exposure to ins risks
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CaT bond loss triggers
- Determines the circumstances and amount of the covered claims under the reins treaty
- Indemnity trigger: covers actual loss, subject to retention and limits
- Index Trigger: intended to pay claims based upon an index that is not tied directly to the insd's actual losses. Examples include (1) industry index loss triggers that rely on aggregate industry loss from specified event, (2) modeled loss triggers that apply an agreed upon model to exposures, and (3) parametric triggers that pay fixed $ amt based upon physical characteristics of caT event (wind speed, earthquake magnitude)
- Hybrid triggers
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CaT bonds: choice of loss trigger
- Consider moral hazard, transparency and basic risk
- Indemnity triggers have no basis risk but require more disclosure
- Index triggers are not subject to claim handling practices, but it comes w/ increased basis risk
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Other risk-linked securities (aside caT bonds)
- Sidecars: provide quota share reins capacity. Financing typically includes equity and debt tranches
- CaT risk swaps: similar to regular swap contract (Xchg exposures)
- Cat-E-Puts: if event occurs, insr can raise add'l capital on pre-agreed terms
- Industry Loss Warranties (ILW): index-based reinsurance agreement, where payoff is based on industry-wide claims. Often subject to dual trigger (industry and company)
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2 reasons why caT bonds are not cheaper than reins
- Expenses: issuing a bond costs more than reins
- Value Pricing: charge a spread that reflects risk transfer value to insr
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Factors that could facilitate further growth in the risk-linked securities mkt
- Improved reporting of insd loss
- Regulatory capital requirements should acknowledge the counterparty credit risk associated w/ reins recoveries
- Personal lines ins rates should be deregulated
- ERISA rules impacting caT bonds should be explored
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Describe the role of the total return swap (TRS)
- Provides a fixed-for-floating interest rate swap to the Special Pupose Reinsr for investors
- Guarantee agains mark-to-mkt losses
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