CAIA - 36 - Structured Products II: Insurance-Linked Products and Hybrid Securities

Question 1

___-___ ___ are tradable financial instruments whose values are driven by an insured loss event.

Answer 1

Insurance-linked securities (ILS) are tradable financial instruments whose values are driven by an insured loss event.

Question 2

___ ___are risk-linked debt instruments designed to transfer catastrophe risks from issuers to investors.

Answer 2

Catastrophe bonds are risk-linked debt instruments designed to transfer catastrophe risks from issuers to investors.

Question 3

___ ___ represent the largest portion of the ILS market.

Answer 3

Cat bonds represent the largest portion of the ILS market.

Question 4

Cat bonds are typically ___-rate with ___coupons and maturities of ___-___ years (most with ___ years)

Answer 4

Cat bonds are typically floating-rate with quarterly coupons and maturities of 1-5 years (most with 3 years)

Question 5

Spreads on cat bonds have typically been between ___-___% with events occurring 1 in ___ to ___ years. Expected losses have historically been ___-___ basis points when an event occurs.

Answer 5

Spreads on cat bonds have typically been between 4-10% with events occurring 1 in 50 to 100 years. Expected losses have historically been 50-500 basis points when an event occurs.

Question 6

With an ___ ___, payment to the issuer is based on actual excess claims paid by the issuer.

Answer 6

With an indemnity trigger, payment to the issuer is based on actual excess claims paid by the issuer.

Question 7

The ___ ___of the trigger is the point at which at least part of the principal must be used to cover claims.

Answer 7

The attachment point of the trigger is the point at which at least part of the principal must be used to cover claims.

Question 8

The ___ ___is the amount of claims loss at which the cat bond loses 100% of the principal and investors are not responsible for additional claims.

Answer 8

The exhaustion point is the amount of claims loss at which the cat bond loses 100% of the principal and investors are not responsible for additional claims.

Question 9

The ___ ___is the estimated probability that the cat bond’ attachment point will be reached.

Answer 9

The attachment probability is the estimated probability that the cat bond’ attachment point will be reached.

Question 10

An ___ ___ ___ is based on index estimates of total industry losses due to the insured event.

Answer 10

An industry loss trigger is based on index estimates of total industry losses due to the insured event.

Question 11

The indemnity trigger is advantageous for ___ and unfavorable for ___.

Answer 11

The indemnity trigger is advantageous for issuers and unfavorable for investors.

Question 12

Indemnity triggers can create ___ ___since issuers have an incentive to underwrite excessive risk.

Answer 12

Indemnity triggers can create moral hazard since issuers have an incentive to underwrite excessive risk.

Question 13

Industry loss triggers are settled ___ than indemnity triggers.

Answer 13

Industry loss triggers are settled faster than indemnity triggers.

Question 14

With a ___ ___, payment to the issuer is triggered when a certain threshold is surpassed based on prespecified parameters of a natural event in a specified location.

Answer 14

With a parametric trigger, payment to the issuer is triggered when a certain threshold is surpassed based on prespecified parameters of a natural event in a specified location.

Question 15

With a ___ ___, payment to the issuer is based on estimated claims generated by a computer model, which provides estimates of losses for an exposure portfolio given various extremes of a natural disaster.

Answer 15

With a modeled trigger, payment to the issuer is based on estimated claims generated by a computer model, which provides estimates of losses for an exposure portfolio given various extremes of a natural disaster.

Question 16

Cat bonds have (the same/less/more) liquidity than most equities and corporate bonds.

Answer 16

Cat bonds have less liquidity than most equities and corporate bonds.

Question 17

Cat bonds payoff distribution (is/is not) highly skewed with significant ___ tail risk.

Answer 17

Cat bonds payoff distribution is highly skewed with significant downside tail risk.

Question 18

___ ___aims to earn short-term, low risk profits from pricing discrepancies due to complicated investment traits.

Answer 18

Complex arbitrage aims to earn short-term, low risk profits from pricing discrepancies due to complicated investment traits.

Question 19

___ ___is the risk that policyholders and pensioners have higher than projected life expectencies.

Answer 19

Longevity risk is the risk that policyholders and pensioners have higher than projected life expectencies.

Question 20

Longevity risk can be hedged using index-based and indemnity-based ___ ___ ___.

Answer 20

Longevity risk can be hedged using index-based and indemnity-based longevity swap contracts.

Question 21

In ___-based longevity swap contracts, if a pension plan’s beneficiaries live longer than assumed, the pension plan will receive higher payments from the counterparty.

Answer 21

In indemnity-based longevity swap contracts, if a pension plan’s beneficiaries live longer than assumed, the pension plan will receive higher payments from the counterparty.

Question 22

In ___-based contracts, an increase in general longevity will result in higher payments from the counterparty to the plan.

Answer 22

In index-based contracts, an increase in general longevity will result in higher payments from the counterparty to the plan.

Question 23

Pension plans that hold longevity swap contracts are exposed to the following risks:

1. C___
2. R___
3. B___
4. L___

Answer 23

Pension plans that hold longevity swap contracts are exposed to the following risks:

1. Counterparty
2. Rollover
3. Basis
4. Legal

Question 24

___ risk refers to the risk that pension plans’ hedging contracts have shorter maturities than the liabilities they are trying to cover.

Answer 24

Rollover risk refers to the risk that pension plans’ hedging contracts have shorter maturities than the liabilities they are trying to cover.

Question 25

\_\_\_ risk refers to the risk that, when index-based longevity contracts are used, the pension plan's mortality experience differs from that of the index used in the contract.

Answer 25

**Basis** risk refers to the risk that, when index-based longevity contracts are used, the pension plan's mortality experience differs from that of the index used in the contract.

Question 26

\_\_\_ risk arises if longevity swaps are not exchange traded.

Answer 26

**Legal** risk arises if longevity swaps are not exchange traded.

Question 27

\_\_\_ risk is the risk that a person dies sooner than expected.

Answer 27

**Mortality** risk is the risk that a person dies sooner than expected.

Question 28

Who is mortality risk borne by?

Answer 28

Who is mortality risk borne by? Families of breadwinners and insurance companies

Question 29

\_\_\_ are the primary cause of increased mortality rates

Answer 29

**Pandemics** are the primary cause of increased mortality rates

Question 30

Life insurance policies (do/do not) typically include war as a covered cause of death.

Answer 30

Life insurance policies **do not** typically include war as a covered cause of death.

Question 31

Catastrophic mortality bonds may have (higher/lower) diversification benefits than non-life cat bonds.

Answer 31

Catastrophic mortality bonds may have **lower** diversification benefits than non-life cat bonds.

Question 32

A ___ \_\_\_ ___ refers to the sale of a life insurance policy to a third party, who becomes its beneficiary and assumes the payment of the premiums.

Answer 32

A **life insurance settlement** refers to the sale of a life insurance policy to a third party, who becomes its beneficiary and assumes the payment of the premiums.

Question 33

The ___ \_\_\_is the price at which the insurance company will buy back its commitments under a contract.

Answer 33

The **surrender value** is the price at which the insurance company will buy back its commitments under a contract.

Question 34

A policyholder and a purchaser of a policy as an investment both benefit if:

Answer 34

A policyholder and a purchaser of a policy as an investment both benefit if: surrender value \< purchase price \< NPV of cash flows

Question 35

A ___ \_\_\_ is a transaction in which a terminally ill policyholder sells his life insurance policy at a discount to its face value to a third party.

Answer 35

A **viatical settlement** is a transaction in which a terminally ill policyholder sells his life insurance policy at a discount to its face value to a third party.

Question 36

A transaction is considered a viatical settlement if the policyholder's life expectancy is less than ___ years. Otherwise it is considered a \_\_\_settlement.

Answer 36

A transaction is considered a viatical settlement if the policyholder's life expectancy is less than **2** years. Otherwise it is considered a **life** settlement.

Question 37

Viatical settlements are (tightly/loosely) regulated in many U.S. states.

Answer 37

Viatical settlements are **tightly** regulated in many U.S. states.

Question 38

Life settlements have (high/low) correlations with other asset classes.

Answer 38

Life settlements have **low** correlations with other asset classes.

Question 39

\_\_\_ ___ is a hybrid of debt and equity financing typically used by profitable companies to fund expansion projects, acquisitions, and management and leveraged buyouts.

Answer 39

**Mezzanine debt** is a hybrid of debt and equity financing typically used by profitable companies to fund expansion projects, acquisitions, and management and leveraged buyouts.

Question 40

\_\_\_ ___ \_\_\_ is Mezzanine Debt has the following characteristics: 1. Subordinated debt with detached equity warrants 2. Principal repaid after senior 3. Cash coupon 4. Equity warrants may have 0/low exercise price

Answer 40

**Debt with Warrants** is Mezzanine Debt has the following characteristics: 1. Subordinated debt with detached equity warrants 2. Principal repaid after senior 3. Cash coupon 4. Equity warrants may have 0/low exercise price

Question 41

\_\_\_ \_\_\_are mezzanine debt that are: typically subordinated principal paid at maturity More dilutive than debt with warrants Usually applied during an IPO

Answer 41

**Convertible loans** are mezzanine debt that are: typically subordinated principal paid at maturity More dilutive than debt with warrants Usually applied during an IPO

Question 42

\_\_\_ \_\_\_are mezzanine debt with the following characteristics: 1. Base interest rate + performance spread 2. Interest rate lined to net profit, EBITDA, or sales 3. No equity 4. Difficult to structure

Answer 42

**Participating loans** are mezzanine debt with the following characteristics: 1. Base interest rate + performance spread 2. Interest rate lined to net profit, EBITDA, or sales 3. No equity 4. Difficult to structure

Question 43

Debt with \_\_\_-\_\_\_or ___ \_\_\_ is mezzanine debt with the following characteristics: 1. Subordinated with deferred interest 2. No equity participation 3. Principal repayment back ended 4. Not appropriate for longer-term finance

Answer 43

Debt with **Step-up** or **deferred interest** is mezzanine debt with the following characteristics: 1. Subordinated with deferred interest 2. No equity participation 3. Principal repayment back ended 4. Not appropriate for longer-term finance

Question 44

\_\_\_ ___ \_\_\_ is mezzanine debt that: 1. Similar to conv debt except default doesn't accelerate other debt or bankruptcy 2. Essentially senior equity 3. Used in start up financing

Answer 44

**Convertible preferred equity** is mezzanine debt that: 1. Similar to conv debt except default doesn't accelerate other debt or bankruptcy 2. Essentially senior equity 3. Used in start up financing

Question 45

\_\_\_ covenants include limitations on asset sales, debt issuance, control changes, restricted payments, affiliate transactions, and liens.

Answer 45

**Negative** covenants include limitations on asset sales, debt issuance, control changes, restricted payments, affiliate transactions, and liens.

Question 46

\_\_\_ covenants may require maintenance of insurance, financial reporting, and compliance with certain regulations.

Answer 46

**Affirmative** covenants may require maintenance of insurance, financial reporting, and compliance with certain regulations.

Question 47

Mezzanine returns are earned from ____ and \_\_\_\_payments.

Answer 47

Mezzanine returns are earned from **current** and **deferred** payments.

Question 48

\_\_\_ ___ \_\_\_ interest is paid by increasing the principal via capitalization of interest payments.

Answer 48

**Payment in kind** interest is paid by increasing the principal via capitalization of interest payments.

Question 49

A ___ \_\_\_is an extra negotiated payment.

Answer 49

A **bonus payment** is an extra negotiated payment.

Question 50

\_\_\_ \_\_\_with \_\_\_-\_\_\_rates is used when a firm cannot assume more fixed-rate debt since its senior and subordinated debt are depleting its cash flows.

Answer 50

**Subordinated debt** with **step-up** rates is used when a firm cannot assume more fixed-rate debt since its senior and subordinated debt are depleting its cash flows.

Question 51

Step-up debt typically uses a ___ model where a fixed rate is paid plus a variable rate depending on performance.

Answer 51

Step-up debt typically uses a **hybrid** model where a fixed rate is paid plus a variable rate depending on performance.

Question 52

Subordinated debt with PIK interest have maturities of \_\_\_-\_\_\_ years.

Answer 52

Subordinated debt with PIK interest have maturities of **7-8** years.

Question 53

PIK interest (is/isn't) typically tax deductible.

Answer 53

PIK interest **is** typically tax deductible.

Question 54

A ___ \_\_\_ is sometimes paid by the borrower of a PIK loan to compensate the lender for the time lag between the commitment on the loan and the actual disbursement.

Answer 54

A **ticking fee** is sometimes paid by the borrower of a PIK loan to compensate the lender for the time lag between the commitment on the loan and the actual disbursement.

Question 55

Subordinated debt with ___ \_\_\_provides mezzanine lenders a risk balance between debt and equity, offering downside protection and participation in the upside potential.

Answer 55

Subordinated debt with **profit participation** provides mezzanine lenders a risk balance between debt and equity, offering downside protection and participation in the upside potential.

Question 56

Warrants are issued by unlisted firms and, thus, regarded as ___ securities.

Answer 56

Warrants are issued by unlisted firms and, thus, regarded as **OTC** securities.

Question 57

Debt with warrants (is/is not) dilutive.

Answer 57

Debt with warrants **is** dilutive.

Question 58

Debt with warrants (are/are not) standardized.

Answer 58

Debt with warrants **are not** standardized.

Question 59

Debt with warrants typically have (longer/shorter) maturity than options.

Answer 59

Debt with warrants typically have **longer** maturity than options.

Question 60

\_\_\_ \_\_\_are similar to bonds with a warrant attached, except the option component of ___ \_\_\_is embedded in the fixed-income instrument.

Answer 60

**Convertible bonds** are similar to bonds with a warrant attached, except the option component of **convertible bonds** is embedded in the fixed-income instrument.

Question 61

Most convertibles (are/are not) callable.

Answer 61

Most convertibles **are** callable.

Question 62

Compared to non-covertible bonds, convertibles provide issuers 2 advantages: 1. L 2. L

Answer 62

Compared to non-covertible bonds, convertibles provide issuers 2 advantages: 1. Lower interest rates 2. Less restrictive covenants