Cummins CAT Flashcards
(13 cards)
Risk Linked Securities
What is it? + Advantages
Alternate method to insurance to transfer risk
* Enables insurance risk to be transferred to the capital market
* The capital market has a much higher capacity to absorb the impact of catastrophes vs the insurance market
Cat Bonds
Single Purpose Reinsurer
What is it? Purposes
Shields the investors from the general business risk of the insurer (i.e. insurer goes bankrupt due to issues unrelated to cats, they are unable to access the money from the SPR)
- Financing costs for the issuer will be lower (since the bonds are fully collateralized)
- Transaction is more transparent than debt issues because the funds are held in a trust and only released acccording to very specific criteria
Cat Bonds
Cat Bond Triggers
Indemnity triggers - payouts are based on the sponsoring insurer’s actual losses
Payouts are based on an index of industry losses
* Industry loss indices: estimated loss to the industry from an event (can be slow)
* Modeled loss indices (faster): modeled industry losses or losses specific to the sponsoring insurer
* Parametric indices: triggered by specified physical measures of an event (e.g. EQ magnitude)
Hybrid trigger - blend more than 1 triggers
Moral Hazard vs. Basis Risk vs. Modeled Risk
What type of triggers to use?
Moral hazard - risk to investors that insureds are not incentived to minimize losses
* Appropriate trigger: industry loss index, but then insurer are prone to basis risk
Basis Risk - risk to insurers that they aren’t indemnified enough to cover their losses due to cats
* Appropriate trigger: indemnity
* Insurers may need to reveal confidential info and require more time to reach settlement
* Investors are prone to moral hazard risk
Modeled loss indices also have low moral hazard and low basis risk, but subject to model risk
Why are high layers of exposures (XS) often not reinsured? And why cat bonds are better?
- The credit risk of the reinsurer is a major concern
- The highest layers usually have the highest reinsurance profit margins
Why cat bonds are better:
* Cat bonds are fully collateralized - no credit risk
* Cat bonds accepts less of a profit margin
* Cat bonds have a multi-year options –> primary insurer can be less prone to cyclical price fluctuations
Rate on Line / Loss on Line
ROL = reinsurance premium / policy limit
Loss on Line = expected loss / policy limit
Ratio of ROL to LOL = premium / expected loss
is comparable to the ratio of yield to expected losses on cat bonds
RIsk Linked Security
Sidecars
What is it + advantages
Special purpose vehicles formed by insurers or reinsurers to provide additional capacity to write reinsurance
Advantages:
* sidecars allow the reinsurer to move some of its risk off-balance sheet, improving leverage
* can be formed quickly with minimal documentation / administration costs
* reinsurer receivescommossions for business ceded to sidecar
Risk Linked Security
Catastrophic Equity Puts
What is it? + Advantages/Disadvantages
Insurer purchases the put - option to sell preferred stock at specified price on the occurrence of a specified event
When theres a big cat, insurer stock price likely to drop / hard to sell, so the put comes in handy
Advantages:
* Insurer will be able to raise equity after a cat when its stock price is likely depressed
* Lower transaction costs than cat bonds, no need for SPR
Disadvantages:
* Not collateralized, so exposes the insurer to credit risk of whoever is selling the put
* If insurer issues preferred stock, the value of existing shares (shareholders) will be diluted
Risk Linked Securities
Catastrophe Risk Swap
What is it? Advantage/Disadvantage
Given CA Quake and Japan Quake
Reinsurer A has more CA Quake Exposure and vise versa
if CA Quake occurs, Reinsurer B pays (Pb) to Reinsurer A
if Japan Quake occurs, Reinsurer A pays (Pa) to Reinsurer B
Advantages
* Reduces risks and achieves diversification
* Lower transaction costs than other alternatives
Disadvanages - It is difficult to create a swap that achieves parity
* Model Risk - if model is wrong, corresponding premium is wrong
* Basis risk - even if you get payment from other reinsurer, may not be enough to cover all the cat loss
* Not prefunded - so there is credit risk
Industry Loss Warranties (ILW)
What problem is it addressing? What triggers it? What will it pay out?
Problem: risk linked securities may not be treated as reinsurance by regulators, especially if the payout is not dependent on the losses of the issuing insurer
Solution: ILW
Dual-triggers basis
* Retention trigger: based on the incurred loss of the insurer
* Warranty trigger: based on an industry wide loss index (addresses moral hazard, insurer still needs to minimize losses, or else industry index will not trigger)
ILWs have two categories of payments:
* Binary trigger: full payment is made once both triggers are satisfied
* Pro rata trigger: payoff depends on the magnitude by which the loss exceeds the warranty trigger
Factors Impeding Growth of Risk Linked Securities Market
Regulatory Issues - Issuing Cat Bonds Offshore
And also advantages
CAT bonds have mainly been issued offshore - which may be unattractive as it is not US domiciled
Uncertain regulatory / accounting treatment of nonindemnity CAT bonds due to the basis risk and potential use as a speculative instrument
* Base the payment on narrowly defined geographic indices which are highly correlated with insurer losses
* Incorporate dual-trigger contracts (where insurer cannot collect more than its net loss)
Advantages
* Lower transaction costs
* Off-shore jurisdictions have demonstrated that they can perform very well in issuing and settling the securities
Factors Impeding Growth of Risk Linked Securities Market
Tax Issues
- There are no income or corporate taxes in offshore jurisdictions that impact CAT bonds
- Sponsors have been deducting the premium payment son the bonds for tax purposes, consistent with how reinsurance premiums are treated
Factors Impeding Growth of Risk Linked Securities Market
Dissemination of Information on Bonds
What is the problem, what are the solutions/suggestions?
Problem
* Lack of information about these cat bonds - securities regulations discourage releasing information about private placements
* Prospectuses (document that provides info useful to potential investors) - of privately place bonds can only be issued to accredited investors (institutional investors and high net worth individuals) - discourages research on these bonds
Suggetions:
* Allow prospectuses to be distributed to researchers to encourage research
* Regulators in certain jurisdiction sshould mandate catastriphe loss reporting of events with industry losses exceeding a certain threshold
* Regulators should account for reinsurance credit quality in regulatory capital calculations - cat bonds have lower credit risk so the use of insurance linked securities could be higher
