Catastrophe-linked bonds (cat bonds) represent the transfer of insured catastrophe risk to capital market investors via a structured bond issuance. Fitch's cat bond rating methodology focuses on the loss probability of a transaction's underlying reinsurance arrangement. The starting point for this approach centres on the base results from sophisticated models developed by independent modelling firms. Fitch then stresses these modelled outputs to account for the uncertainties and risks associated with relying on the models to determine financial loss. These stressed loss outputs, which include both the probability of attachment and the expected loss, are then compared to Fitch's cat bond rating benchmarks to determine the appropriate rating. Such benchmarks are developed from corporate default studies.

**Model review**

Modelling plays an integral role in the rating of cat bonds. The sophistication of the modelling used in this asset class far exceeds that of many other asset classes. Because of this, cat bond ratings rely extensively on third party expert modelling firms to provide the lion's share of the quantitative risk analysis. As such, cat bond ratings acknowledge the expertise of the modelling firms, as well as the assumption that cat events and their related financial losses can be appropriately modelled.

Fitch performs an in-depth review of the cat models. This includes a step-by-step analysis of the methodology, an evaluation of the underlying data inputs and assumptions, and stress testing.

**Risk adjustment factors**

Fitch recognises that cat bond modelling is an imperfect process. In an attempt to capture these imperfections, risk adjustment factors are applied to the models' base outputs. The five primary areas that Fitch considers when applying the risk adjustment factors are:

Using a cat bond's payout method as a means of categorization, the asset class can be broadly segmented by the following four deal types:

**Loss probability statistics**

The primary output from a cat bond model is the loss exceedance curve (see graph below left). This curve is a representation of potential financial losses to a risk portfolio related to a cat peril, along with the probabilities of those losses.

By applying the specifics of a cat bond's underlying risk transfer agreement to the loss exceedance curve, a transaction's probability of attachment and probability of depletion can be determined. For example, given the loss exceedance curve as indicated, if it is assumed that the reinsurance cover attaches at $400m of losses (below that level the bondholders are not at risk) and exhausts at $800m, the probability of attachment (frequency) would be 1.0% and the probability of depletion (exhaustion) would be 0.5%. Note that in this case, the reinsurance layer (or protection layer) would be $400m (the $800m exhaustion minus the $400m attachment).

By considering the severity of loss for each of the events in the stochastic dataset, a transaction's expected loss can be determined. This number is an estimate of the average annual loss as it relates to the protection layer.

The two statistics that drive Fitch's rating decision are the probability of attachment and the expected loss. Whereas a cat bond's probability of attachment is a long-term estimation of the likelihood that investors will lose at least $1 of investment, its expected loss is a long-term estimation of what investors will lose in total. In determining a cat bond rating, Fitch will apply its risk adjustment factors to these two base model statistics.

It is important to recognise that of the five risk adjustment factors, not all need to be applied to all deal types. For example, under a parametric deal, only an event modelling uncertainty factor would be applied, whereas under an indemnity deal all five might be applied. The following table highlights Fitch's risk adjustment factor application by deal type.

**Rating benchmarks**

Once all of the risk adjustment factors are applied, Fitch arrives at a transaction's annualised risk-adjusted loss probability assessments.

These stressed assessments are then compared to Fitch's cat bond rating curves, which categorises certain probabilities of attachment (frequency) and expected loss with certain rating levels.

Both frequency and expected loss results are considered in assigning ratings. Fitch's primary focus is on expected loss in the non-investment-grade portion of the rating scale. However, ratings assigned based on expected loss must be within two rating notches of the rating that would be assigned based on a frequency focus. Fitch's focus is on frequency alone in the investment-grade portion of the rating scale.