The growing knowledge of catastrophe risk among investors and the successful development of software modelling of natural perils have increased dramatically capital market capacity for natural perils, and have led to more individual investors showing interest in cat transactions.

The frequency of disasters and the high exposed values increased the pressure on traditional reinsurance to handle new potential losses and have turned insurers and reinsurers towards the financial markets as a source of new capacity. Since 1994, capital markets have seen the emergence of new financial instruments, like catastrophe and weather derivatives, options and bonds.

Insurance and reinsurance companies, as well as some industrialists and governments, have issued catastrophe (CAT) bonds to protect themselves from natural catastrophe losses. Writers of cat reinsurance receive a predetermined premium in exchange for protection against a specified event, with a predetermined maximum loss for a specific period of time. On the other side of the equation, investors earn an annual return on the invested capital until the maturity of the bond - which varies from less than a year to ten years-, except if the bond is triggered.

The earliest bonds attempted to replicate a reinsurance or retrocession structure. The bond would be triggered by the issuer's actual losses - indemnification. That has its weaknesses, particularly for investors, and other types of triggers have been developed.

Currently there are three basic loss triggers:

  • Indemnification: the bond is triggered when the loss of an insurance company reaches a predetermined level. This type of trigger provides the lowest basis risk for the best coverage for the issuers, while providing the highest moral hazard - defined as risk or uncertainties in quantifying a trigger- to the investor.

  • Parametric: the bond is triggered when the event intensity reaches a given level. For example, if an earthquake reaches a certain magnitude in the Ritcher scale, then the bond is triggered. This structure provides the lowest moral hazard to the investor but results in potentially substantial basis risk to the issuer. This basis risk is the difference in correlation between the event intensity and the issuer's loss.

  • Index: the bond is triggered when an industry index, or for that matter any type of chosen index, reaches a given level. Industry losses are an index to which individual company contracts can be benchmarked; however, only the United States has to date recognised and established independent companies to assess market losses. This trigger provides the best balance between the moral hazard risk assumed by the investors and the basis risk carried by the issuer. The latest innovative structures have used this type of trigger.

    The issue here is defining an index as close as possible to an issuer's risk profile. One example of such innovation is the use of an index as a reference portfolio. This reference portfolio is defined a subset of an issuer's total portfolio, which meets given data quality criteria. This high quality subset portfolio forms the basis of the bond trigger and the issuer's risk lies in the difference in correlation between this reference portfolio and the overall portfolio. Other innovations include the coupling of parametric triggers along with traditional reinsurance contracts covering the issuers' basis risks. None of the CAT bonds issued up to date has been triggered, although it did appear initially this could have changed due to the European storms in December 1999, which heavily affected some of the French insurers and reinsurers.

    What make CAT bonds so attractive to the investors?,

    High yield risk takers have been the more inclined to invest in CAT bonds. As cat events are uncertain, and in most cases rating agencies' grade for “cats” are low -between BBB and B-, it comes as no surprise to see some of securitisation deals reaching up to 14000 basis point above LIBOR. Institutional investors, such as pension funds, have been investing in “cats” as they offer a high return, a low correlation to traditional investment tools, a high degree of quantification and the possibility of diversifying their portfolio.

    The risk of a large natural catastrophe is low, but the severity of these types of events can be enormous in terms of insurance losses. Modelling companies have played a major role in reducing cat loss uncertainties, and the loss scenarios have become highly transparent. Risk modelling experts can simulate the effect of natural catastrophes on corporate, insurer and reinsurer portfolios and quantify the probability of triggering the transaction.

    Since the first successful cat bond in 1994, the market has been changing so rapidly that there has been no standardisation in “cat” financial transactions. The emerging weather derivatives market is growing; earthquakes, windstorms, hurricanes and hail events have been securitised, and the financial market is still asking for more innovations.

  • Amalia Gonzales-Revilla and Jean-Paul Conoscente are with EQECAT, Paris.

    Tel: +33 (0) 144 79 01 01.