Catastrophe bonds emerged from a need by (re)insurance companies to alleviate some of the risks they would face if a major catastrophe occurred, which would incur damages that they could not cover with the invested premiums. An insurance company issues bonds through an investment bank, which are then sold to investors. Catastrophe bonds are non-investment gradecorporate bonds (roughly equivalent to B or BB) with floating interest rates,[1][2] and have an average maturity of 3 years with some up to 5 years but are uncommon.[3][4] If no catastrophe occurred, the insurance company would pay a coupon to the investors. But if a catastrophe did occur, then the principal would be forgiven and the insurance company would use this money to pay their claim-holders. Investors include hedge funds, ILS-dedicated funds, pension plans, (re)insurance companies, and asset managers. They are often structured as floating-rate bonds whose principal is lost if specified trigger conditions are met. If triggered, the principal is paid by the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds are typically used by insurers as an alternative to traditional catastrophe reinsurance.
For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of SOFR plus a spread. If no hurricane hits Florida, then the investors will make a positive return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially contributed by the investors would be transferred to the sponsor to pay its claims to policyholders. The bond would technically be in default and be a loss to investors.[5]
Michael Moriarty, Deputy Superintendent of the New York State Insurance Department, has been at the forefront of state regulatory efforts to have U.S. regulators encourage the development of insurance securitizations through cat bonds in the United States instead of off-shore, through encouraging two different methods—protected cells and special purpose reinsurance vehicles.[6] In August 2007 Michael Lewis, the author of Liar's Poker and Moneyball, wrote an article about catastrophe bonds that appeared in The New York Times Magazine, titled "In Nature's Casino."[7]
History
The notion of securitizing catastrophe risks became prominent in the aftermath of Hurricane Andrew, notably in work published by Richard Sandor, Kenneth Froot, and a group of professors at the Wharton School who were seeking vehicles to bring more risk-bearing capacity to the catastrophe reinsurance market. The first experimental transactions were completed in the mid-1990s by AIG, Hannover Re, St. Paul Re, and USAA.
The market grew to $1–2 billion of issuance per year for the 1998–2001 period, and over $2 billion per year following 9/11. Issuance doubled again to a run rate of approximately $4 billion on an annual basis in 2006 following Hurricane Katrina, and was accompanied by the development of reinsurance sidecars. Issuance continued to increase through 2007, despite the passing of the post-Katrina "hard market", as a number of insurers sought diversification of coverage through the market, including State Farm, Allstate, Liberty Mutual, Chubb, and Travelers, along with long-time issuer USAA. Following the Tohoku Earthquake and April 27, 2011 Super Outbreak, issuance hovered around $6-8 billion per year from 2012 - 2016.[8] In 2017, Hurricanes Harvey, Irma, and Maria all impacted the market. This spurred yet another increase in issuance, now to the $10 billion per year mark.[8] At year end 2023, Swiss Re Capital Markets estimates the market size is $43.1 billion with a record $15.4 billion issued in 2023 alone.[9]
The cat bond market has withstood a multitude of catastrophes, both natural and manmade. These include 9/11, Hurricane Katrina, the 2008 Financial Crisis, Tohoku Earthquake, Hurricanes Harvey, Irma, and Maria, COVID-19, Hurricane Ida, and Hurricane Ian. Following each of these events, the market has increased the volume of primary issuance. Moreover, it is estimated that the market suffers from a historical loss rate between 2.69% and 3.00%.[9] This loss rate is generally quite close to the estimated loss rate given by the catastrophe models broadly used in the market (2.00% - 3.00%).[10]
Investors
Investors choose to invest in catastrophe bonds because their return is largely uncorrelated with the return on other investments in fixed income or in equities, so cat bonds help investors achieve diversification. Investors also buy these securities because they generally pay higher interest rates (in terms of spreads over funding rates) than comparably rated corporate instruments, as long as they are not triggered.
Key categories of investors who participate in this market include hedge funds, ILS-dedicated funds, and asset managers. Life insurers, reinsurers, banks, pension funds, and other investors have also participated in offerings.
A number of specialized fund managers play a significant role in the sector, including Fermat Capital Management, K2 Advisors, Leadenhall Capital Partners, Nephila Capital, Aeolus Capital Management, Elementum Advisors, Schroder Investment Management, Neuberger Berman ILS, Twelve Capital,[11]AXA Investment Managers, Plenum Investments, and Tangency Capital. Several mutual fund and hedge fund managers also invest in catastrophe bonds, among them Stone Ridge Asset Management, Amundi US, and PIMCO.[12]
Ratings
Cat bonds are sometimes rated by an agency such as Standard & Poor's, Moody's, or Fitch Ratings. A typical corporate bond is rated based on its probability of default due to the issuer going into bankruptcy. A catastrophe bond is rated based on its probability of default due to a qualifying catastrophe triggering loss of principal (attachment probability). This probability is determined with the use of catastrophe models. Most catastrophe bonds are rated below investment grade (B and BB category ratings), and the various rating agencies have adopted moved the view that securities generally must require multiple events before an occurrence of a loss in order to be rated investment grade.
For all cat bonds regardless of rating, a third-party modeling agent is hired as part of the transaction. This agent will generate a risk analysis of the bond taking into account the underlying structure of the notes using a catastrophe model. This risk analysis will generate an attachment probability (probability of first-dollar loss to the notes), an expected loss probability, and an exhaustion probability (probability of complete loss of principal). The two most commonly utilized modeling firms are Verisk AIR, and Moody's RMS.
Structure
Most catastrophe bonds are issued by special purpose reinsurance companies domiciled in the Cayman Islands, Bermuda, or Ireland. These companies typically participate in one or more reinsurance treaties to protect buyers, most commonly insurers (called "cedants") or reinsurers (called "retrocedents"). This contract may be structured as a derivative in cases in which it is "triggered" by one or more indices or event parameters (see below), rather than losses of the cedant or retrocedent. Cat bonds are generally issued under rule 144A and are commonly listed on the Bermuda Stock Exchange (though they trade OTC).
Cover Types
The sponsor and investment bank that structures the cat bond must choose how the principal impairment is triggered. Cat bonds can be categorized into four basic cover types.[13] The cover types listed first are more correlated to the actual losses of the insurer sponsoring the cat bond. The cover types listed farther down the list are not as highly correlated to the insurer's actual losses, so the cat bond has to be structured carefully and properly calibrated, but investors would not have to worry about the insurer's claims adjustment practices.
Indemnity: triggered by the issuer's actual losses, so the sponsor is indemnified, as if they had purchased traditional catastrophe reinsurance.
Modeled loss: instead of dealing with the company's actual claims, an exposure portfolio is constructed for use with catastrophe modeling software, and then when there is a large event, the event parameters are run against the exposure database in the cat model.
Industry Loss: instead of adding up the insurer's claims, the cat bond is triggered when the insurance industry loss from a certain peril reaches a specified threshold, say $30 billion. The cat bond will specify who determines the industry loss; typically it is a recognized agency like PCS or PERILS. "Modified index" linked securities customize the index to a company's own book of business by weighting the index results for various territories and lines of business. Common "modified index" structures are the State-Weighted Industry Loss (SWIL - pronounced swill) and the County-Weighted Industry Loss (CWIL - pronounced quill).
Parametric: instead of being based on any claims (the insurer's actual claims, the modeled claims, or the industry's claims), the trigger is indexed to the natural hazard caused by nature. So the parameter would be the windspeed (for a hurricane bond), the ground acceleration (for an earthquake bond), or whatever is appropriate for the peril. Data for this parameter is collected at multiple reporting stations and then entered into specified formulae. For example, if a typhoon generates windspeeds greater than X meters per second at 50 of the 150 weather observation stations of the Japanese Meteorological Agency, the cat bond is triggered.
Parametric Index: Many firms are uncomfortable with pure parametric bonds due to the lack of correlation with actual loss. For instance, a bond may pay out based on the wind speed at 50 of the 150 stations mentioned above, but the insurer loses very little money because a majority of their exposure is concentrated in other locations. Models can give an approximation of loss as a function of the speed at differing locations, which are then used to give a payout function for the bond. These function as hybrid Parametric / Modeled loss bonds, and have lowered basis risk as well as more transparency.[14]
Trigger Types
Once a cover type has been chosen by the sponsor and investment bank, a trigger type must be selected. These can broadly be broken down into two categories.
Aggregate: the sum of losses over a time period (commonly one year, a so-called Annual Aggregate) breach a threshold (the attachment level) to trigger the bond payout.
Per Occurrence: the loss from a single event must breach a threshold (the attachment level) to trigger the bond payout.
Common Examples
While it is possible to structure a cat bond in a multitude of ways, below are three of the most commonly found structures in the cat bond market.
Industry Loss Aggregate: the sum of losses to the insurance industry (as reported by PCS or PERILS) over a given time frame must breach the attachment level. Say for example, 3 hurricanes and 1 earthquake all affect the covered area for a catastrophe bond. Each hurricane does $20 billion in damages and the earthquake does $40 billion. In this case, if the attachment of the note was set to $90 billion, the bond would pay out as the sum of the insured losses are $100 billion = 20 + 20 + 20 + 40.
Indemnity Per Occurrence: the loss from a single event to a specific insurer must breach the attachment level. For example, an insurance company suffers a $500 million loss from an earthquake and a $400 million loss from a hurricane. If the attachment level was set to $550 million, then the bond would not pay out as neither the earthquake or hurricane caused enough damage to the insurer for the attachment level to be exceeded.
Parametric Per Occurrence: the parameter for a single event exceeds the preset threshold. For example, the wind speed in a certain location exceeded 150mph.
Notable Securitizations
Second and Subsequent Events: Some bonds cover the risk that multiple losses will occur (i.e. 2 or more qualifying events must occur before the cat bond suffers a loss). The first-second event bond (Atlas Re) was issued in March of 2000. This note covered European Windstorm and California or Japanese Earthquake. This was an indemnity cover for SCOR.[15] Following this issuance, the first third event bond (Atlas II) was issued in December of 2001.[16] Since the early 2000's many different second and subsequent event notes have been issued with a variety of coverages for a multitude of sponsors.
Life & Health Risk: Issued in April of 1998, the L1 Securitization for Hannover Re covered life reinsurance risk. This was a pseudo-quota share coverage. [17] More comparable to the cat bonds of today, the Vita Re transaction of 2003 on behalf of Swiss Re is claimed to be the "pioneer of life ILS globally".[18]
Lottery Winnings: In September of 2011, the Hoplon Re transaction provided $101 million of coverage to the MyLotto24 lottery. The covered risk was "the risk of exceptional jackpot wins" which could potentially cause the lottery to fail.[21]
Stock Market Crashes & Hedge Fund Collapses: Citigroup developed the Stability Note in 2003, which protects the issuer against catastrophic stock market crashes; it was later adapted to protect against hedge fund collapses.[22] Professor Lawrence A. Cunningham of George Washington University suggests adapting cat bonds to the risks that large auditing firms face in cases asserting massive securities law damages.[23]
Cyberattack: Beazley successfully sponsored the first Cyber cat bond in January 2023, dubbed "Cairney". This was a $45 million Section 4(2) private cat bond that triggers on an Indemnity Per Occurrence basis.[24] The first public rule 144A cat bond was the Long Walk Re transaction in November of 2023, providing AXIS Capital with $75 million of Indemnity Per Occurrence coverage. These notes cover so-called "systemic cyber events".[25]
Terrorism: Pool Reinsurance Company (Pool Re), the UK government-backed mutual terrorism reinsurance facility, sponsored the issuance of Baltic PCC Limited (Series 2019) notes. This was an Indemnity Annual Aggregate transaction issued in February of 2019. It raised $97 million of support.[26]
Event Cancellation: Ahead of the 2006 FIFA World Cup, FIFA sponsored the Golden Goal Re transaction. The transaction was issued in September of 2003 and raised $262 million. If the 2006 FIFA tournament was canceled because of terrorism risk, the bond would pay out, resulting in a loss of 75% of the money invested in the bonds. As a result of the attacks in the USA on 11 September 2001 and the subsequent withdrawal by insurers from the 2002 FIFA World Cup cancellation insurance policy, FIFA requires any future protection to be immune from such risk, thus resulting in the issuance of Golden Goal Re.[27]
Other: The first actively managed pool of bonds and other contracts ("Catastrophe CDO") called Gamut was issued in 2007, with Nephila as the asset manager.
Market participants
Examples of cat bond sponsors include insurers, reinsurers, corporations, and government agencies. Over time, frequent issuers have included USAA, Scor SE, Swiss Re, Munich Re, Liberty Mutual, Hannover Re, Allianz, and Tokio Marine Nichido. Mexico is the only national sovereign to have issued cat bonds (in 2006, for hedging earthquake risk and in 2009 and 2012, a multi structure instrument that covered earthquake and hurricane risk).[28] In June 2014, the World Bank issued its first catastrophe bond linked to natural hazard (tropical cyclone and earthquake) risks in sixteen Caribbean countries,[29] and in 2017 it launched the Pandemic Emergency Financing Facility to provide funding in case of pandemic disease.
To date, all direct catastrophe bond investors have been institutional investors, since all broadly distributed transactions have been distributed in that form.[30] These have included specialized catastrophe bond funds, hedge funds, investment advisors (money managers), life insurers, reinsurers, pension funds, and others. Individual investors have generally purchased such securities through specialized funds.
There are 5 main investment banks that are active in the issuance of cat bonds. These include Aon Securities Inc., Swiss Re Capital Markets, GC Securities (a division of MMC Securities Corp. and an affiliate of Guy Carpenter), Howden Capital Markets and Advisory, and Gallagher Securities. There are also 5 main secondary market makers in the space. These are RBC, Beech Hill Securities, Gallagher Securities, Swiss Re Capital Markets, and Tullet Prebon.
Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to protect against the risk of a contingent or uncertain loss.
Reinsurance is insurance that an insurance company purchases from another insurance company to insulate itself from the risk of a major claims event. With reinsurance, the company passes on ("cedes") some part of its own insurance liabilities to the other insurance company. The company that purchases the reinsurance policy is referred to as the "ceding company" or "cedent". The company issuing the reinsurance policy is referred to as the "reinsurer". In the classic case, reinsurance allows insurance companies to remain solvent after major claims events, such as major disasters like hurricanes or wildfires. In addition to its basic role in risk management, reinsurance is sometimes used to reduce the ceding company's capital requirements, or for tax mitigation or other purposes.
Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liability arising from such guarantee. An underwriting arrangement may be created in a number of situations including insurance, issues of security in a public offering, and bank lending, among others. The person or institution that agrees to sell a minimum number of securities of the company for commission is called the underwriter.
Structured finance is a sector of finance — specifically financial law — that manages leverage and risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of financial instruments.
Catastrophe modeling is the process of using computer-assisted calculations to estimate the losses that could be sustained due to a catastrophic event such as a hurricane or earthquake. Cat modeling is especially applicable to analyzing risks in the insurance industry and is at the confluence of actuarial science, engineering, meteorology, and seismology.
Markel Group Inc. is a group of companies headquartered in Richmond, Virginia, and originally founded in 1930 as an insurance company..
Reinsurance sidecars, conventionally referred to as "sidecars", are financial structures that are created to allow investors to take on the risk and return of a group of insurance policies written by an insurer or reinsurer and earn the risk and return that arises from that business. A re/insurer will only pay ("cede") the premiums associated with a book of business to such an entity if the investors place sufficient funds in the vehicle to ensure that it can meet claims if they arise. Typically, the liability of investors is limited to these funds. These structures have become quite prominent in the aftermath of Hurricane Katrina as a vehicle for re/insurers to add risk-bearing capacity, and for investors to participate in the potential profits resulting from sharp price increases in re/insurance over the four quarters following Katrina. An earlier and smaller generation of sidecars were created after 9/11 for the same purpose.
Alternative risk transfer is the use of techniques other than traditional insurance and reinsurance to provide risk-bearing entities with coverage or protection. The field of alternative risk transfer grew out of a series of insurance capacity crises in the 1970s through 1990s that drove purchasers of traditional coverage to seek more robust ways to buy protection.
Industry loss warranties (ILWs), are a type of reinsurance contract used in the insurance industry through which one party will purchase protection based on the total loss arising from an event to the entire insurance industry above a certain trigger level rather than their own losses.
Bond insurance, also known as "financial guaranty insurance", is a type of insurance whereby an insurance company guarantees scheduled payments of interest and principal on a bond or other security in the event of a payment default by the issuer of the bond or security. It is a form of "credit enhancement" that generally results in the rating of the insured security being the higher of (i) the claims-paying rating of the insurer or (ii) the rating the bond would have without insurance.
Sir Clive Cowdery is an English businessman and philanthropist who made a personal fortune in the insurance industry, founding two FTSE100 insurers and a third insurer which has deployed circa $5bn in capital with $90bn in assets, and has since donated large amounts to charity, including the Resolution Foundation which he founded in 2005.
An insurance-linked security (ILS) is a financial instrument whose value is driven by insurance loss events. Those such instruments that are linked to property losses due to natural catastrophes represent a unique asset class, the return from which is uncorrelated with that of the general financial market.
Insurability can mean either whether a particular type of loss (risk) can be insured in theory, or whether a particular client is insurable for by a particular company because of particular circumstance and the quality assigned by an insurance provider pertaining to the risk that a given client would have.
Juniperus Capital Limited is a Bermuda-based hedge fund. It was incorporated in Bermuda on April 11, 2008. The investment management company became operational in May 2008.
Caribbean Catastrophe Risk Insurance Facility Segregated Portfolio Company is an insurance company headquartered in the Cayman Islands. The sixteen original member-countries of CCRIF included participants in CARICOM, and the membership of the Board of Directors is selected by CARICOM and by the Caribbean Development Bank.
Cyclone Herwart was a European windstorm that affected Southern Denmark, Germany, Poland, Austria, Hungary and the Czech Republic on 28–29 October 2017. Named by the Free University of Berlin Meteorology Department, the storm was an extratropical cyclone formed as a secondary low to a more northerly centre of low pressure named Grischa coming southward from the Svalbard Islands region, the latter splitting in two low-pressure areas late on 28 October. The center of Herwart started rotating counterclockwise around the main low pressure area, passing over Norway, Sweden, Latvia and then losing power while moving over western Russia.
Russian National Reinsurance Company (RNRC) is the largest Russian reinsurance company. The Central Bank of Russia is a full shareholder of RNRC. The state-owned reinsurance company was established in 2016. RNRC is the largest in terms of the authorized share capital and second-largest in terms of paid-in capital on the domestic insurance market.
Build America Mutual Assurance Company is a mutual, monoline bond insurer of essential public-purpose U.S. municipal bonds. Since its inception in July 2012, the company has insured more than $65 billion in par amount for more than 3,300 member-issuers. In 2018, it insured $8.36 billion par across 653 new-issue insured transactions. BAM also publishes a credit profile for every transaction it insures and updates them. More than 6,000 are now available. The company is the preferred provider of financial guaranty insurance on debt for member municipalities of the National League of Cities. NLC endorsed BAM upon its launch.
AIR Worldwide was an American risk modeling and data analytics company based in Boston, Massachusetts that was acquired by Verisk Analytics in 2022.
The effects of climate change on extreme weather events is requiring the insurance industry in the United States to recalculate risk assessments for various types of insurance. From 1980 to 2005, private and federal government insurers in the United States paid $320 billion in constant 2005 dollars in claims due to weather-related losses while the total amount paid in claims annually generally increased, and 88% of all property insurance losses in the United States from 1980 to 2005 were weather-related. Annual insured natural catastrophe losses in the United States grew 10-fold in inflation-adjusted terms from $49 billion in total from 1959 to 1988 to $98 billion in total from 1989 to 1998, while the ratio of premium revenue to natural catastrophe losses fell six-fold from 1971 to 1999 and natural catastrophe losses were the primary factor in 10% of the approximately 700 U.S. insurance company insolvencies from 1969 to 1999 and possibly a contributing factor in 53%.
↑ "Atlas Reinsurance plc". Artemis.bm - The Catastrophe Bond, Insurance Linked Securities & Investment, Reinsurance Capital, Alternative Risk Transfer and Weather Risk Management site.
↑ "Atlas Reinsurance II plc". Artemis.bm - The Catastrophe Bond, Insurance Linked Securities & Investment, Reinsurance Capital, Alternative Risk Transfer and Weather Risk Management site.
↑ "L1 - Securitization". Artemis.bm - The Catastrophe Bond, Insurance Linked Securities & Investment, Reinsurance Capital, Alternative Risk Transfer and Weather Risk Management site.
This page is based on this Wikipedia article Text is available under the CC BY-SA 4.0 license; additional terms may apply. Images, videos and audio are available under their respective licenses.
