Return period
Often, the data is presented in the form of return period instead of exceedance probability. These two terms are closely related. Return period is the average length of time between occurrences of events exceeding a specified threshold. If the annual exceedance probability is 1%, the return period is 100 years.As with the probability exceedance curve, we can draw a graph of return period as a function of loss level, and base decisions on the data presented in this format.
Stress testing and sensitivity analysis
Stress testing, by necessity, has to be performed using the same modelling
tools as those used to produce the probability distribution of catastrophe
losses. Since no other tool is available, stress testing often involves moving
along the probability curve and evaluating the results of a catastrophic event
that the model considers less likely.
Sensitivity analysis could be performed in the standard way of varying
the input parameters of the model and observing the effect on the probability
exceedance curve and losses affecting the cat bond. Ideally, more than
one type of catastrophe modelling software would be used to produce probabilistic
results that could then be compared. While it is sometimes done by
the sponsor of a cat bond, this data rarely finds its way to investors. The socalled
cat bond remodelling process introduced by the three major
catastrophe-modelling firms attempts to alleviate this informational deficiency.
INVESTMENT PERFORMANCE OF CAT BONDS
Ever since the first cat bonds, insurance-linked securities have been issuedat widely fluctuating yields. Such market inefficiency is normal for any new
type of security, in particular if the market is still developing and lacking
real liquidity. As a group, catastrophe bonds have outperformed many
other securities bearing the same degree of risk, when risk is defined only in
terms of probability of default and loss in the case of default.
(In the cat bond vernacular, these are called “attachment probability” and “conditional
expected loss”.)
More importantly, their volatility has been lower and correlation
with the markets weaker than for most other fixed-income securities.
This stellar performance, however, suffered in 2008, when there emerged
credit-risk issues in cat bonds (though these were corrected in the newer
structures described in Chapter 7, and when the forced selling by multistrategy
hedge funds temporarily depressed cat bond prices in the
secondary market.
Historical performance
Figure 3.8, overleaf, shows investment weekly performance of publicly dis -closed catastrophe bonds relative to the corporate debtwith the same ratings.
Excess spread
Spreads for catastrophe bonds have historically exceeded those for comparablyrated corporate securities. There are multiple reasons for the extra
spreads enjoyed by cat bond investors. The most important of these are the
following.
- NOVELTY PREMIUM.
unfamiliarity with insurance-linked securities. The novelty premium
will eventually disappear as investors educate themselves about catastrophe
bonds and as transaction structures become more standard. To
some degree, this has already happened.
- LIQUIDITY PREMIUM.
premiumplayed a very important rolewhen the very first cat bonds
were issued. At the time, there was virtually no liquidity in the marketplace,
and investorswere limited to the buy-and-hold strategy. Over time,
however, it has become easier to trade catastrophe bonds.
Even immediately before hurricane landfall, when evacuation warnings are issued, it is
usually possible to buy and sell securities potentially affected by the hurricane.
Initially some structurers of insurance-linked securities havemade a
special effort to provide liquidity in order to help develop the overall cat
bond market.
While liquidity is now improving, the bid–ask spreads are
still relativelywide and some bonds remain largely illiquid.As themarket
is growing quickly, both in terms of the number of securities issued and the
number of investors, liquidity should continue to improve, reducing the
liquidity premium now included in the excess spread.
- “SUDDEN-DEATH” PREMIUM.
debt, but there is a very important difference in the timing of default.
The default of a corporate bond is usually preceded by the deterioration
of the financial condition of the issuer and gradual downgrades by rating
agencies. Sudden defaults are rare. Cat bonds, on the other hand, could
default with no prior warning or rating agency downgrade.
For example, an earthquake could cause an immediate default, resulting in total loss to
investors. For some investors, the possibility of a sudden default is unsettling.
Certain investors prefer never to see a default in the portfolios, and
would sell a security if it is downgraded and chances of default increase.
This behaviour is often based on purely psychological factors, with portfolio
managers not wanting to be blamed for defaults in their portfolios.
- ASYMMETRIC INFORMATION PREMIUM.
This component of the excess spread is present in cat bonds with indemnity-based triggers. Investors in indem-nity-based cat bonds are at an information disadvantage relative to the
insurance company sponsoring the bond. The company has better knowledge
than investors of the riskiness of its portfolio of insurance policies.
- RE-RATING PREMIUM (DISCOUNT).
and effectively re-rate them by internally assigning their own ratings for
the purposes of pricing and risk analysis.
This situation is much more common with cat bonds than with other rated securities. Some rating agencies even have caps on ratings assigned to cat bonds. In general,
investors tend to believe that cat bonds deserve higher ratings than those
assigned by rating agencies. The explanation is that rating agencies, like
some investors, might be averse to the situation of sudden default without
prior downgrade, and consequently assign ratings to cat bonds based on
criteria stricter than those applied to other securities.
Another differentiator of cat bonds from other securities is the greater average loss given
default (LGD) than for most bonds. Many cat bonds, if defaulted, would
likely suffer full default with total loss to investors. Since some investors
tend to think that the “real” rating is higher than the one assigned by
rating agencies, the excess spread is reduced. In other words, this component
of the excess spread, if present, would usually be negative.
It is important to note that, for some catastrophe peril types, the risk during
the term of the bond is not uniform. For example, hurricane season in the
Caribbean lasts from June till November; the rest of the year, the probability
of a hurricane is low. The dependence of risk level on the time period allows
us to construct a type of term structure for a catastrophe bond. The non uniformity
of the risk distribution over time has a significant effect on
pricing levels in the secondary market.
Because cat bond sponsors usually have the option of reinsuring their risk
instead of securitisation, the price levels in the reinsurance market have
some effect on the cat bond spreads, in particular the original spreads at
issue.
Spreads on cat bonds have been subject to significant volatility. Initially
very high, they trended downward until the 2005 hurricane season, when
demand level increased. The yields increased in 2005 also because questions
were raised about the quality of modelling and analysis provided to
investors. The reliability and accuracy of the cat modelling software were
questioned, resulting in improvements to the models and reassessment of
encountered by the cat bond market in the second half of 2008 led to
the greatest period of volatility and depressed values. This changed in the
first half of 2009, when the new collateral structures and the hardening of
catastrophe reinsurance markets led to the renewed growth of the market
and more stability in pricing.
MARKET STABILITY AND GROWTH
The first loss in a publicly disclosed catastrophe bond was the Kamp Retransaction, in which the risk of a hurricane was transferred to the capital
markets investors. Hurricane Katrina in 2005 caused insurance losses of a
level that led to the full loss of interest and principal for Kamp Re investors.
The loss tested the cat bond market, which prior to Hurricane Katrina had
not been known to result in losses to investors. In fact, overall, investors
have profited handsomely from catastrophe bonds, with spreads usually
being significanty over comparably rated corporate bonds. The default of
the cat bonds affected by the bankruptcy of Lehman Brothers as the total
return swap counter-party was another difficult test for investors.
The market addressed the issues of credit risk by introducing new cat bond
structures The 2004 and 2005 hurricane seasons in the US generated a renewed focus
on catastrophe risk management in the insurance and reinsurance industry.
The analysis, along with recalibration of catastrophe models, led to the realisation
that the risk exposure is far greater than previously believed.
This created a strong demand for cat bonds and other capital markets solutions
on the part of insurers. The demand was boosted by the limited reinsurance
capacity for catastrophe risks.
Hurricane Katrina had an additional impact: the payout of the Kamp Re
bond to its insurance sponsor clearly demonstrated that cat bonds could
provide reliable protection to insurance companies.
Fixed-income investors are also increasingly interested in catastrophe
bonds and other insurance-linked securities. With investors searching for
new types of securities to provide diversification and yield, the growing
insurance-linked securities marketplace appears more and more attractive.
MORE ON THE SPONSOR AND INVESTOR PERSPECTIVES
The structure and pricing of a cat bond are an outcome of the process oftrying to find a balance between the interests of the sponsor and the
investors.
Diversification
A key reason for investors to buy cat bonds is to diversify their investmentportfolios. This is true even for the specialised hedge funds that invest only
in insurance-linked securities, since other investors obtain diversification by
investing in these funds either directly or through the fund-of-funds mechanism.
Cat bonds provide investors with a financial instrument weakly
correlated with the equity and fixed-income markets, which has led to cat
bonds being called zero-beta securities.
The view that there is no correlation between the performance of cat
bonds and that of other securities was initially questioned in the aftermath
of Hurricane Katrina. While a typical hurricane would not affect financial
markets, a very large catastrophic event such as an earthquake in California
could have a shock effect on the economy. In these extreme cases, many
types of risk suddenly become highly correlated, even if the degree of
dependence is very low under normal circumstances.
The “zero-beta” view was clearly shown to be invalid by the events of 2008, which uncovered
sources of correlation with the markets that had never been appreciated
before that period. While the zero-beta view is incorrect in its application to cat bonds, the
relatively weak correlation of cat bonds with traditional financial assets is a
major source of potential diversification and a strong reason for investors to
gain exposure to this asset class. Cat bonds undeniably provide a diversification
benefit in addition to affording exposure to a new type of investment.
Within a portfolio of catastrophe bonds and related securities, investors
can achieve diversification in a variety of ways. One of them involves
building the portfolio with an eye on geographic and peril diversification.
Managing portfolios of cat bonds is described in Chapter 16, in the broader
context of active management of portfolios comprising various types of catastrophe
insurance-linked securities.
Slicing and packaging of risk
A cat bond designed to securitise the risk to an insurance portfolio resultingfrom a specific natural catastrophe would generally consist of tranches with
various degrees of risk. In the example shown in Figure 3.9, if the total loss
level exceeds US$750 million, tranche A is activated. As long as the aggregate
loss level remains below US$850 million, investors in tranche B and
tranche C receive interest and principal in full. Since the loss level is above
US$750 million, investors in tranche A suffer the loss of part or entire
interest and principal.
To avoid moral hazard, there is usually participation by the sponsor in the
excess losses. In structuring terms, this means that not all of the excess risk
is reinsured to the SPV, and the sponsor retains a share of potential excess
losses.
assigned different ratings, with tranche C as the safest, receiving the highest
rating and the lowest spread. It is possible for some tranches to be unrated
and others to be rated, in the same transaction.
Another way to slice and package risk is to issue several tranches, with
each individual tranche associated with the risk of a specific natural catastrophe
in a certain geographic region. Each tranche would have its own
trigger; trigger type may even differ from tranche to tranche. A “combo”
tranche could also be issued, based on the combination of risks contained in
individual tranches. This combination tranche provides diversification to
investors unwilling or unable to achieve it on their own. Figure 3.10
provides an example of such a structure.
The Successor cat bond issued by Swiss Re in 2006 is a good example of
this structure. The Successor programme placed US$950 million of principal-
at-risk variable-rate notes, transferring to investors the risks of North
Atlantic hurricane, European windstorm, California earthquake and
Japanese earthquake in individual and multi-peril tranches.
Another pioneering transaction brought to the market by ABN Amro in
2006 was structured as a collateralised debt obligation (CDO) from the very
beginning. In fact, it was the first publicly rated CDO of natural catastrophe
risk. The CDO offered to investors was based on the cat bonds with industry
loss triggers sponsored by the Catlin Group.
The least risky tranche of the CDO was then rated AA by Standard & Poor’s. Higher ratings open up a new universe of investors who otherwise would have no interest in catastrophe
insurance-linked securities. The negative connotation of the term CDO has led to renaming this type of security collateralised risk obligation
(CRO). A managed CRO structure was introduced by Nephila Capital in the
Gamut transaction developed by Goldman Sachs in 2007. At this point, it is
unclear whether CRO structures will be actively used in the future.
Types of sponsor
Catastrophe bonds are generally sponsored by insurance or reinsurancecompanies. However, corporations can also get protection against natural
catastrophe losses by going directly to the capital markets. Tokyo
Disneyland’s securitisation of earthquake risk in Japan provides an example
of a non-insurance company bypassing the insurance marketplace and
going directly to the capital markets to obtain cat protection.
Many believed that in the future cat bonds would be issued only on behalf
of reinsurance companies. This view was based on its being seemingly more
efficient for primary insurance companies to reinsure their risk as opposed
to sponsoring cat bonds. Reinsurance companies would then accumulate all
the risk, and transfer a part of it to the capital markets. This has not
happened and we do see cat bonds issued directly by insurance companies.
One of the reasons is the credit risk involved in catastrophe reinsurance.
Reinsurance companies are particularly exposed to the risk of natural catastrophes,
and might default on their obligations should such an event
happen. Cat bonds, on the other hand, provide a fully collateralised protection
with little exposure to credit risk.
From the point of view of an investor, the identity of the sponsor of a nonindemnity
cat bond is largely irrelevant, with the analysis focused on
natural catastrophe modelling performed by the same cat modelling firms
as would be modelling insurance company books of business.
Investor types
While the first major investors in cat bonds were reinsurance companies,now they represent only a small percentage of the overall investor base. A
number of specialised hedge funds have been formed for the sole purpose
of investing in insurance-linked securities.
These funds often possess superior expertise and drive the pricing of cat bonds both at issue and in the secondary markets. In addition, many other investors such as pension funds
have invested in cat bonds. The number of investors in insurance-linked
securities and the total capital committed to this asset class continue to
grow.
MODELLING PROPERTY CATASTROPHE INSURANCE RISK
The reason for including risk analysis in cat bond offering documents is thatinvestors do not have the means to assess default probabilities on their own.
This is the case in part because most of them do not possess expertise in
determining the likelihood of natural catastrophes and resultant insurance
losses. The other reason, applicable to indemnity-type transactions, is that
detailed information on the exposure by geographic location is not
provided, making it impossible for investors to determine exact default
probabilities even if they had superior expertise in analysing insurance risk
of hurricanes and earthquakes.
Specialised catastrophe modelling firms play a critical role in the securitisation
of insurance catastrophe risk. The modelling software provides the
only objective way to analyse the probability of default. It is also the only
way for rating agencies to assess the risk and be able to assign a rating to
these securities.
The modelling generally includes two components. First, a probabilistic
analysis of specific types of natural catastrophes is performed for a certain
geographic area. For example, the model could simulate hurricanes in
Florida or typhoons affecting Japan. The second step involves assessing the
financial impact that these natural catastrophes would have on the portfolio
of insurance policies held by the sponsoring insurance company. This
assessment is also probabilistic.
The final output of the model is the probability distribution of the insured losses, which takes into account not only policy conditions and limits, but also the reinsurance structure in place.
The damage module is based on structuring engineering input. Its function
is to take a specific catastrophe scenario and superimpose it onto a portfolio of insurance policies being analysed.
The damage calculator takes individual exposures such as insured properties and probabilistically estimates the damage caused by the catastrophe under the scenario, taking into account such parameters as policy limits and deductibles. The output is the
insured loss that the company would have to pay out under the scenario.
The model runs a large number of scenarios and generates a set of catastrophic
losses and probabilities associated with them.
There are only three major recognised independent providers of modelling
services for insurance catastrophe exposure. The three companies, AIR
Worldwide, EQECAT and Risk Management Solutions (RMS), are primarily
software developers for the property-casualty insurance industry. While
the RMS model is the most widely used in the industry, AIR is currently
leading in providing consulting analytical services for structuring cat bond
transactions.
The output of catastrophe modelling software includes the data necessary
to construct an exceedance probability curve. The exceedance probability
curve could be used for structuring and pricing a cat bond. In structuring, it
would help determine the trigger level to provide the needed protection to
the insurance company. In pricing, the exceedance probability curve is used
to provide a probabilistic look at exceeding the trigger level (that is, bond
default) that determines the bond price.
TRENDS AND EXPECTATIONS
The catastrophe bond marketplace is growing and will continue to do so,along with other capital markets mechanisms for transferring catastrophe
insurance risk. We are witnessing both an increase in cat bond issuance and
growth in the total capital committed to this asset class. Some of the reasons
for the growth and its drivers are as follows.
- The insurance-linked securities market has finally reached the criticalmass needed to make cat bonds a solution always to be considered in evaluating available options in the transfer of insurance catastrophe risk.
- The 2004 and 2005 hurricane seasons have led to an increased emphasis on catastrophe risk management. This emphasis has been both internal and external, stimulated by increased scrutiny by the rating agencies and regulators. It has resulted in a demand for additional catastrophe-riskbearing capacity that is not met by traditional reinsurance mechanisms.
- The recalibration of catastrophe models post-Katrina has led to the realisation that the insurance industry is exposed to much greater risk of natural catastrophes than previously thought.
- The second half of 2008 was the greatest test of the viability and future
prospects of the market. The bankruptcy of Lehman Brothers led to the
default of cat bonds for which Lehman served as the total-return-swap
counterparty. Besides the counterparty risk, these events revealed structural
weaknesses in the way collateral arrangements had been made in
the standard cat bond structures. Ultimately, however, the market has
emerged from this debacle stronger, as the weaknesses were addressed in
new structures and all other potential weak points carefully examined. - The depressed values of cat bonds in 2008 caused by the forced selling of
cat bonds by multi-strategy hedge funds made the low-correlation (lowbeta)
argument slightly weaker, to some degree reducing the
diversification value of cat bonds. However, it also highlighted the advantages
of this asset class: the multi-strategy funds faced with redemptions
were selling cat bonds because they held value better than the great
majority of other asset classes. - The educational process in the insurance industry has led to better understanding
of cat bonds and other risk-linked securities, allowing insurance
and reinsurance companies to see the advantages of the securitisation
approach. - Investors, too, have become better educated about catastrophe bonds and
the benefits of diversification provided by these securities. The number of
investors in risk-linked securities is growing, including the hedge funds
focused exclusively on insurance risk. - Structuring of catastrophe bonds has become more standardised, making
the process easier for the sponsors and the analysis more straightforward
for investors. - The cost of issuance of catastrophe bonds has gone down, due to the
standardisation of cat bond structures, the use of multi-year bond terms
to spread the cost of issuance over a longer period of time, and shelf
registration. - With the growth in the number of cat bonds issued and in the total
investor capital, the secondary market for cat bonds and similar securities
is growing, too, resulting in greater liquidity. This, in turn, creates greater
opportunities for active management of investment portfolios including
cat bonds.
Other important developments that will affect the future of the market are
the following.PROPERTY CATASTROPHE BONDS
- Innovation is continuing, resulting in new products or modifications of
the old products to better suit the needs of both issuers (sponsors) and
investors. - There has been some movement away from indemnity-based towards
parametric index triggers, with bond default not depending on the actual
losses of a specific insurance company. Many investors are no longer
willing to be at an informational disadvantage and demand that default
triggers and payout be based on a more objective index. - With the movement away from indemnity-based triggers, basis risk is
becoming a growing concern for the sponsors of catastrophe bonds. The
risk that cat bonds would turn out to be an ineffective hedge and will not
provide protection when expected is necessitating better modelling and
trigger choices. - The development of new parametric triggers that have the ability to
further reduce basis risk of the sponsors is an ongoing process and will
likely lead to the greater use of these new triggers at the expense of the
indemnity and standard industry loss triggers. The ability to address the
issue of basis risk can expand the universe of sponsors and lead to market
growth. - Securitisation of new types of insurance risk, including liability insurance,
will probably grow and has a potential to become a viable alternative to
reinsurance for some extreme catastrophic events. It is also expected that
insurance securitisation will move beyond very low-frequency/extremeseverity
events and will involve higher-frequency insurance risk.
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