Captive Insight Vol I | Page 10

CAPTIVEINSIGHT

require detailed disclosure documents.
Also as private placements, the role
of capital markets intermediaries
is significant.
Obviously all of this adds cost to the
transactions which translates to higher
premiums for the cedants. Some of
the earliest transactions were for one
year only. The move to multi-year
transactions
obviously
produced
savings by spreading these costs over a
number of years. In 1997, Parametric Re
issued ten-year bonds, but that was not
replicated by other issuers. The term of
cat bonds is now commonly set at three
years, with a potential extension period
for trigger events. The introduction of
shelf programs, designed to facilitate
consecutive issuances of bonds by
one issuer, also introduced economies,
and the opportunity for branding.

Expanding the Remit
Turning to the underlying risks and
their measurement, we see some of
the most interesting innovations to
date. A significant attraction of cat
bonds to cedants is the availability
of multi-year, fully collateralised
reinsurance. Traditionally, the risks
have been short-tail, that is property
loss and damage arising from a
catastrophic event such as a hurricane
or an earthquake. Initially, the
reinsurance coverage was indemnity
based. Property claims usually can
be measured relatively quickly, so
both the cedant and the investor know
where they stand. Advances in risk
modelling have played a huge role
in the growth of the cat bond market.
While we have more recently seen a
reversion to indemnity triggers, it has
been possible to structure transactions
to include modelled loss, industry

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loss index, parametric and parametric
index triggers. Amongst other factors,
the trigger type influences the
transaction tail, which is important to
the liquidity requirements of investors.
It also facilitates earlier settlement for
the cedant.

Trigger Types
Indemnity: impairment of the notes is triggered by the issuer’s actual losses, so the
cedant is indemnified, as if they had purchased traditional catastrophe reinsurance.
The trigger is directly correlated to the actual losses of the cedant.
Modelled loss: an exposure portfolio is constructed for use with catastrophe modelling
software, and then when there is a large event, the event parameters are run against the
exposure database in the model. If the modelled losses exceed a pre-determined threshold,
the bond is triggered. The trigger is highly correlated to the actual losses of the cedant.
Indexed to industry loss: impairment of the notes is triggered when the insurance industry
loss, as determined by a select recognised agency, exceeds a pre-determined threshold.
Modified index: the insurance industry loss calculation is customised to reflect the
cedant’s insurance portfolio by weighting the index results for various territories and
lines of business.
Parametric: the trigger is indexed to the natural hazard caused by nature, for example wind
speed for a hurricane bond or ground acceleration for an earthquake bond. Data for this
parameter is collected at multiple reporting stations and then entered into pre-determined
formulae, which determine whether the threshold for triggering impairment of the notes has
been exceeded. This trigger has the lowest correlation to the cedant’s actual losses, presenting
the investor with basis risk, for which the cedant will pay a higher premium.
Parametric index: To lower basis risk and increase transparency, a hybrid of the
Parametric/Modelled trigger may be adopted, whereby the model approximates losses
as a function of the parameter and produces a pay-out function for the bond.

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“ here now exists a number of catastrophe modelling agencies,
T
providing output for use not only by insurers/reinsurers but
by governments, corporations and investors to guide their
decision-making in relation to catastrophic risks.”