Cummins - CAT

Question 1

Risk-linked securities

Cummins - CAT

Answer 1

securities that allow insurance risk to be sold in the capital markets (ex: CAT bonds)

Question 2

Reasons original risk-linked securities gained little interest (3)

(Cummins - CAT)

Answer 2

exposure to:

1. counterparty (default) risk
2. basis risk
3. insurer’s general business risk

Question 3

Basis risk

Cummins - CAT

Answer 3

risk that contract payoffs would be insufficiently correlated with insurer losses (payoff < or > actual losses)

Question 4

CAT bonds

Cummins - CAT

Answer 4

type of risk-linked security where payoff is based on event occurrence (typically EQ or hurricane events)

Question 5

Layer of reinsurance protection from CAT bonds

Cummins - CAT

Answer 5

high layers with probability of occurrence < 1% (e.g. 1-in-100 yr events)

Question 6

Reasons that high layers of insurance (< 1% probability) often go uninsured (2)

(Cummins - CAT)

Answer 6

1. ceding insurers are concerned about credit risk for reinsurers for events of this magnitude
2. high layers tend to have the highest reinsurance margins

Question 7

Advantages of CAT bonds (3)

Cummins - CAT

Answer 7

1. fully collateralized (no credit risk)
2. lower spreads compared to high-layer reinsurance b/c CAT events are uncorrelated with investment returns
3. can provide multi-year protection

Question 8

Typical CAT bond structure

Cummins - CAT

Answer 8

single purpose reinsurer (SPR) issues CAT bonds to investors and invests bond proceeds in fixed-rate short-term securities held in a trust account

fixed returns from securities in the trust account are swapped for floating returns to immunize insurer and investor from interest rate & default risk

insurer pays a premium to investors as payment for CAT protection

if a CAT event occurs, the call option is triggered and insurer receives payment to cover claims, otherwise principal is returned to investors

Question 9

Reason insurers prefer to use SPRs for CAT bonds

Cummins - CAT

Answer 9

SPRs receive the same tax and accounting benefits associated with traditional reinsurance

Question 10

Reasons investors prefer to use SPRs for CAT bonds (2)

Cummins - CAT

Answer 10

1. able to isolate investment risk to purely CAT risk (no general business or insolvency risk associated w/traditional reinsurers)
2. protected from credit risk because the bonds are fully collateralized in a trust account

Question 11

Reason CAT bonds are attractive to investors

Cummins - CAT

Answer 11

CAT bonds offer a diversification benefit b/c CAT events have low correlation with market returns

Question 12

Types of triggers for CAT bond payouts (3)

Cummins - CAT

Answer 12

1. indemnity trigger
2. index trigger
3. hybrid triggers

Question 13

Indemnity triggers for CAT bond payouts

Cummins - CAT

Answer 13

payout triggers based on the size of actual insurer losses

Question 14

Index triggers for CAT bond payouts & types (3)

Cummins - CAT

Answer 14

payout triggers based on an index not directly tied to actual insurer losses

types:
1. industry loss index
2. modeled loss index
3. parametric index

Question 15

Hybrid triggers for CAT bond payouts

Cummins - CAT

Answer 15

payout triggers based on multiple types of triggers

Question 16

Industry loss index for CAT bond payouts (type of index trigger)

(Cummins - CAT)

Answer 16

payout triggered when industry losses exceed a specified threshold

Question 17

Modeled loss index for CAT bond payouts (type of index trigger)

(Cummins - CAT)

Answer 17

payout triggered when modeled losses for an event exceed a specified threshold

Question 18

Parametric index for CAT bond payouts (type of index trigger)

(Cummins - CAT)

Answer 18

payout triggered by physical measures of the event such as wind speed or EQ magnitude

Question 19

Tradeoff b/w basis risk and moral hazard with CAT bond triggers

(Cummins - CAT)

Answer 19

indemnity triggers minimize basis risk, but have more moral hazard

index triggers minimize moral hazard, but have higher basis risk

Question 20

Disadvantage of indemnity triggers for CAT bond payouts

Cummins - CAT

Answer 20

require information on an insurer’s UW portfolio, so it takes additional time to determine loss payouts

Question 21

Advantages of index triggers for CAT bond payouts (2)

Cummins - CAT

Answer 21

1. maximized transparency

2. measurable & processed more quickly

Question 22

Method to reduce basis risk when using index triggers for CAT bond payouts

(Cummins - CAT)

Answer 22

use indices based on more narrowly defined geographic areas

Question 23

Sidecars and unique feature

Cummins - CAT

Answer 23

special purpose vehicles that provide additional reinsurance capacity through funding provided by capital markets

allows reinsurer to have off-balance sheet risk, which improves leverage

Question 24

CAT equity puts (CAT-E-Puts)

Cummins - CAT

Answer 24

put option to issue preferred stock at a pre-agreed price on occurrence of a contingent event (allows insurer to raise capital by selling stock at a higher price)

Question 25

Advantage of CAT-E-Puts for insurers | Cummins - CAT

Answer 25

lower transaction costs (b/c no SPR involved)

Question 26

Disadvantages of CAT-E-Puts for insurers (2) | Cummins - CAT

Answer 26

1. exposed to counterparty risk because they are not collateralized 2. value of existing shares may be diluted by stock issuance

Question 27

CAT risk swaps | Cummins - CAT

Answer 27

swap agreements allowing insurers/reinsurers to swap specific CAT exposures to diversify their portfolios (e.g. exchange types of CAT risk)

Question 28

Advantages of CAT risk swaps (3) | Cummins - CAT

Answer 28

1. reduced core risk through swap 2. diversification benefits as long as risk obtained in swap has low correlation with remainder of portfolio 3. low transaction costs

Question 29

Disadvantages of CAT risk swaps (3) | Cummins - CAT

Answer 29

1. modeling of parity contracts can be difficult 2. increased exposure to basis risk 3. exposed to counterparty risk b/c they are not collateralized

Question 30

Industry loss warranties (ILWs) | Cummins - CAT

Answer 30

reinsurance contracts with 2 triggers: 1. retention trigger based on insurer's incurred losses 2. warranty trigger based on industry-wide loss index both are required for payout

Question 31

Types of triggers for industry loss warranties (ILWs, 2) | Cummins - CAT

Answer 31

1. binary trigger | 2. pro-rata trigger

Question 32

Binary trigger for industry loss warranties (ILWs) | Cummins - CAT

Answer 32

full amount of contract is paid once both the retention & warranty triggers are satisfied

Question 33

Pro-rata trigger for industry loss warranties (ILWs) | Cummins - CAT

Answer 33

payoff depends on the amount losses exceed warranty trigger

Question 34

Advantages of industry loss warranties (ILWs, 3) | Cummins - CAT

Answer 34

1. more likely to be treated as reinsurance for regulatory purposes compared to non-indemnity CAT bonds 2. can be used to plug gaps in reinsurance programs 3. efficient use of funds b/c payouts are high when both insurer and industry losses are high

Question 35

Trends in the CAT bond market (4) | Cummins - CAT

Answer 35

1. CAT bond market has been growing 2. increasing market standardization 3. shift towards shorter-term bonds 4. below-investment grade bonds are more common compared to investment grade bonds

Question 36

Rate on line (ROL) | Cummins - CAT

Answer 36

traditional CAT reinsurance pricing metric ROL = reinsurance premiums / policy limit

Question 37

Loss on line (LOL) | Cummins - CAT

Answer 37

traditional CAT reinsurance pricing metric LOL = expected losses / policy limit

Question 38

Comparisons of CAT bond yields to traditional cost of CAT reinsurance (Cummins - CAT)

Answer 38

compare ratio of ROL / LOL as a measure of traditional reinsurance to yields / expected losses for CAT bonds

Question 39

Conclusion about CAT bond pricing and traditional CAT reinsurance (Cummins - CAT)

Answer 39

comparison shows CAT bond pricing can be competitive with more traditional CAT reinsurance

Question 40

Factors impeding growth of the CAT bond market (3) | Cummins - CAT

Answer 40

1. strict regulatory/accounting requirements 2. taxation of CAT bond premium 3. dissemination of information on bonds (SEC discourages sharing of information)