Property catastrophe bonds are the largest part of the insurance linked securities market. Insurers and reinsurers sponsor cat bonds to hedge the risk of very large losses from events such as hurricanes and earthquakes.
Investors can buy bonds either on the primary or secondary market. The principal is at risk in the event of a catastrophe that affects the sponsoring company. Following a trigger event, the principal will be released to the sponsor to enable it to pay for financial losses (the claims they receive from their policyholders).
For sponsors, cat bonds offer an attractive alternative to standard catastrophe reinsurance for low frequency, high severity catastrophes. The benefits of cat bonds include the tenor (cat bonds are usually multi year deals compared to annual reinsurance contracts), the security (there is no reliance on the credit of the seller of reinsurance) and pricing (in recent years many cat bonds have been competitively priced compared to traditional reinsurance contracts).
Cat bonds are structured to protect the sponsor from low probability, high severity events (analogous to an out-of-the-money option). Insurers pay normal (or attritional) losses from the premium that they receive from their policyholders. Catastrophe losses can be larger than an insurer’s premium and can threaten its capital. Cat bonds can be used to reduce the capital that an insurer is required to hold by regulators and rating agencies.
Occurrence cat bonds respond to a single large event. Following a large event, either the sponsor calculates the total losses from pre-agreed lines of business or an index is calculated by a third party. If this number is greater than the attachment point of the bond it will default. A complete default will occur if this number is greater than the exhaustion point.
Aggregate cat bonds work in a similar way except that losses from all events in a period are aggregated. If this amount is greater than the attachment point it will default.
Less common structures include bonds that pay out following two or more large events.
Indemnity cat bonds are triggered by the sponsor’s actual losses. For instance a bond could cover losses of $100m in excess of $200m, meaning that the bond will be triggered if the sponsor's losses add up to more than $200m and will default in full if the sponsor's losses are greater than $300m.
In recent years, indemnity triggers have been used in increasing numbers of bonds. They are popular with sponsors due the limited amount of basis risk. Unlike other trigger types, there is limited miss factor between the pay-out of the bond and the sponsor’s actual losses.
Modelled loss index
In the case of a modelled loss trigger, the losses are calculated using catastrophe models provided by companies such as AIR Worldwide, RMS and EQECAT. When there is a large event, the event parameters are run against a model of the sponsor’s exposure. The cat bonds is triggered if modelled losses go beyond a certain threshold.
Cat bonds that are indexed to industry losses are triggered when the insurance industry loss from a particular event reaches a certain threshold, such as $30 billion. The cat bond will specify which agency it will use to determine the industry loss figure, the most popular being ISO’s Property Claim Services in the US and Swiss Re Sigma and PERILS AG in Europe.
Parametric cat bonds are triggered by a formula that uses parameters that are measurements taken from actual catastrophe events. Examples include: the strength of the ground motion at particular measuring stations during an earthquake; windspeeds during a hurricane; or water depth during a flood. Parametric triggers are popular with investors due to their transparency. Another benefit is the potential for rapid payouts.