Modeling Fundamentals: So You Want to Issue a Cat Bond
Aug 26, 2016
Editor's Note: In this article Jeff Boyd, CCM, revisits our 2011 primer on the catastrophe bond issuance process to reflect changes in the cat bond market landscape and AIR offerings.
Insurance-linked securities, such as catastrophe bonds, are mechanisms through which catastrophe risk is transferred from one party (the sponsor) to the capital markets. These securities are known for providing full collateralization and multi-year coverage and, increasingly, they are becoming a standard part of risk transfer strategies employed by insurers, reinsurers, corporate entities, and public agencies, as a primary or supplemental vehicle for insurance, reinsurance, or retrocession cover.
Cat bonds protect against virtually every peril for which established catastrophe models exist. AIR Worldwide has modeled the risk profile for bonds in North America, Europe, Oceania, and Asia that protect against property damage resulting from hurricanes, earthquakes, typhoons, cyclones, extratropical cyclones (winter storms), severe thunderstorms, and wildfires. In 2015, AIR was the modeling agent for more than USD 4.5 billion of all property catastrophe bond capital publicly issued. In addition to modeling property exposures for catastrophe bonds, AIR recently worked with the World Bank to establish the Pandemic Emergency Financing Facility (PEF). Designed to accelerate global and national responses to future outbreaks with pandemic potential, this innovative financing program provides up to USD 500 million in coverage for up to three years for the most common pandemic-causing pathogens.
With models covering more than 100 countries worldwide and experience working with all types of bonds, AIR can help potential sponsors understand their global exposure to catastrophe risk and explore securitization options.
Issuing a Cat Bond
The issuance process for catastrophe bonds is well established, with some variations that depend on the complexity of the structure and the bond's trigger type. In general, the process begins with the selection of an independent modeling agent (a catastrophe modeling firm such as AIR), legal counsel to assist with regulatory compliance for a securities offering, and a structuring agent (usually an investment bank or the capital markets arm of a major broker or reinsurer) that provides advice on designing and placing the bond.
Together, the sponsor and the structuring agent select the mechanism by which the bond will pay out (the trigger). The modeling agent will then employ catastrophe models to estimate the risk to which the sponsor is exposed. It is in the sponsor's interest to provide accurate exposure information for the analysis, since good correlation between modeled and actual exposure will tend to reduce the bond's basis risk—the difference between the sponsor’s losses and the bond's payout—should it trigger. The result of the risk analysis is an estimate of potential losses at various probabilities and return periods. This can be used directly to estimate the risk profile of indemnity or modeled loss bonds. As will be discussed later, industry loss index and parametric bonds may require an additional step to express losses in terms of industry loss or event parameters, respectively, while further minimizing the basis risk to the sponsor.
After the portfolio's risk profile has been identified, the sponsor works with a structuring agent to identify the most appropriate level of risk against which to obtain protection. The structuring agent will often assist the sponsor in placing the bond with investors, much as a broker would for a reinsurance contract.
Once the trigger type and level of protection have been selected—for example, USD 200 million excess of USD 500 million with a modeled loss trigger—AIR creates a series of exhibits in the offering documentation detailing the risk to the proposed bond. The purpose of these is to educate rating agencies and potential investors. The exhibits typically include:
- Probability of attachment, or the likelihood that the bond will suffer some losses. In our example, this is the probability that the sponsor's book will suffer modeled losses of USD 500 million or higher.
- Probability of exhaustion, or the likelihood that the bond will suffer a complete loss. In our example, this is the probability of a modeled loss of at least USD 700 million (that is, USD 500 million + USD 200 million).
- Expected loss, or the amount investors should expect to lose on the bond in any given year. It is typically expressed as a percentage of the issue size, which is USD 200 million in our example.
- A loss distribution and sample modeled loss scenarios, to give investors some information about the types of events (location, magnitude, etc.) likely to cause a loss to their investment.
- A set of historical simulations showing how the bond would fare if past catastrophic events were to happen today. Examples include Europe's windstorm Kyrill (2007), Hurricane Katrina (2005), Hurricane Sandy (2012), the Great San Francisco earthquake (1906), and the Tohoku earthquake and tsunami in Japan (2011).
- The distribution of loss to the bond among the various perils and regions covered. For example, if the bond covers perils across multiple regions, the modeling agent will provide exhibits illustrating the sources of loss.
- Sensitivity analyses showing, for example, the impact of more frequent hurricanes than were experienced historically over the long term.
Since the market’s inception in the mid 1990s, the sophistication of investors in catastrophe bonds has greatly increased. As a result, investors often seek additional disclosure with new issuances, including details about the underlying exposure basis, and modeling assumptions and results.
Credit rating agencies use the information outlined above to review the proposed bond's quality, expressing their opinion as a letter rating such as BB– or B+. These agencies, which act as independent third parties, review all aspects of the bond. When they issue their rating, AIR's risk analysis is one of the most important elements they consider.
After the bond receives a rating, the sponsor and structuring agent embark on a "road show," during which they introduce the bond to potential investors. AIR (as modeling agent) accompanies them to answer any questions that might arise concerning either the model(s) or the risk analysis performed. This road show typically lasts three to four days and spans the main capital market centers in North America and Europe.
By the end of the road show, pricing is finalized and the bond is sold to qualified investors. Once the bond is in the market, investors are free to sell it to investment banks (broker-dealers), who engage in secondary trading of cat bonds. The ownership of the bond at any given time has no impact on the sponsor because cat bonds are fully collateralized; that is, the entire amount of promised protection has been provided up front and placed in a safe account that can only be accessed to pay losses emanating from that specific bond. This mechanism greatly reduces the counterparty risk inherent in traditional reinsurance contracts, particularly if the bond provides protection for an extreme event.
Should a triggering event occur during the life of the bond, the sponsor will receive a payout for the appropriate amount. For example, if a catastrophe event causes USD 600 million in modeled losses to the USD 200 million excess USD 500 million modeled loss bond described earlier, the sponsor will receive a recovery of USD 100 million (USD 600 million–USD 500 million), or half of the bond's original principal amount.
The following section provides more details on the way a cat bond is structured and the different trigger types available.
Cat Bond Structure
A cat bond is structured as a reinsurance contract between the sponsor and a special purpose reinsurance vehicle (SPRV). The SPRV obtains the capital necessary to underwrite and fully collateralize the reinsurance contract by selling a bond to capital market investors. This bond is an exact mirror of the reinsurance contract; it is valued at the same amount at issuance and can only lose money according to the terms of the reinsurance contract. Because this bond is issued directly by the SPRV, it is not affected by the sponsor's credit rating, nor is it considered to be a debt of the sponsor.
The proceeds from the sale of the bond are placed in an account—the collateral account or reinsurance trust account—that can be used for no other purpose than paying claims on the reinsurance contract to which it is linked. The collateral account is then insulated from interest and currency fluctuations by exchanging the bond’s cash proceeds for government-backed debt notes that are typically highly rated, stable, and liquid.
The SPRV thus functions like a fully collateralized reinsurer with the sponsor as its sole client and the proceeds from the bond as its source of financing. This is a valuable feature, as it eliminates the risk that the reinsurance contract would not be honored by a reinsurer bankrupted by other obligations in a truly catastrophic event.
Investors are compensated for their risk by receiving a coupon, usually paid quarterly. The coupon is funded by a combination of reinsurance premiums paid by the sponsor and the proceeds of investing the bond's principal. The coupon rate is typically set based in part on the amount of loss, as determined by AIR, that the bond can expect to incur due to a covered catastrophe event. The coupon rate is also based on market factors such as the supply of similar insurance-linked securities and investor demand.
Figure 2 illustrates the financial flows for a typical reinsurance contract. These can be compared with the financial flows for a typical catastrophe bond, shown in Figure 3. Note that in the case of the reinsurance contract, the reinsurer would have similar relationships with numerous other cedants. Because most reinsurance contracts are not fully collateralized, cedants may find themselves in competition for the reinsurer's surplus when collecting recoveries after a catastrophic event.
Investor obtain further confidence in all aspects of the bond's structure through the rating process. Since the first large-scale cat bond issuance in 1997 (the AIR-modeled Residential Re), investor and rating agencies have become sufficiently knowledgeable and comfortable with cat bonds' risk modeling and trigger mechanisms to expand these instruments' range across much of the risk spectrum. Bonds now provide protection all the way from working layers to the most remote levels of risk.
Should a defined event occur (the so-called "trigger" event), the SPRV will use part or all of the funds lent to it by investors to pay the appropriate recovery to the sponsor. If no loss-causing events occur, the bond's principal is returned to investors after the bond's scheduled lifetime elapses. Most bonds last from one to five years, which also allows sponsors to leverage favorable interest rates.
Trigger mechanisms vary from bond to bond. Various trigger types are intended to balance the preferences of the sponsor and the investor. For example, the payout from an indemnity bond is based on actual losses to the sponsor. Sponsors appreciate this type of trigger because it eliminates basis risk—the difference between their losses and the bond's payout. However, this situation creates a moral hazard from the investor's point of view, as the sponsor could become less vigilant in settling claims or write new, riskier policies. Also, the final loss to the bond may not be known for many months as claims develop, creating uncertainty. Basis risk is an important issue for most sponsors, and AIR can help clients understand, quantify, and minimize the basis risk associated with each trigger type.
A bond's trigger type and level of protection are often determined through an iterative process conducted between the sponsor and the structuring agent. AIR can assist in this process by providing interim risk analyses. Triggers typically fall under one of five broad types defined below, although these can be customized to match the transaction's needs. All trigger types are in widespread use. Selection should be based on the specific risk transfer objectives of the sponsor. AIR has extensive experience working with all trigger types, and has modeled some of the most innovative structures in the market.
Recovery is based on the sponsor's actual losses, just as in most reinsurance contracts. The modeling agent estimates the transaction's risk based on the sponsor's actual portfolio of exposure.
The loss to the bond is determined by the modeling agent by collecting actual events' parameters, such as magnitude and epicenter location for earthquakes, recreating them in its catastrophe model, and estimating their financial impact on the portfolio of exposure originally used to estimate the bond's risk. This portfolio may or may not be similar to the sponsor's actual exposure.
Industry Loss Index
The bond is triggered based on actual losses to the insurance industry as a whole. In the U.S., the loss is typically measured by Property Claims Services® (PCS®), which is why this is often referred to as a "PCS trigger." The equivalent in Europe is PERILS AG, an independent organization that collects and reports loss data from insurance companies following major windstorm, earthquake, and flood events. For industry loss triggers, the sponsor does not need to divulge the details of its portfolio to investors; instead, the modeling agent uses its own database of insured industry exposure to estimate the bond's probability of being triggered. A risk analysis of the sponsor's portfolio can also be performed to estimate correlations between the sponsor’s and the wider industry's risk profiles, and to thus select an optimized industry loss trigger that will minimize the quantified basis risk.
Recovery is based on objective measurements, such as a hurricane's maximum wind speed and landfall location, or the ground motion measured by multiple seismometers after an earthquake. To minimize the sponsor's basis risk, a detailed risk analysis of the sponsor's portfolio is performed before deciding on the parameters of a qualifying event.
Hybrid triggers comprise innovative applications of elements found in traditional catastrophe bond trigger mechanisms. Bonds with this type of trigger can reduce basis risk and at the same time limit the impact of potential moral hazard on the transaction. For example, to increase the trigger resolution to a more accurate, granular weighting, a sponsor can derive their county-level market share of potential losses through a modeled loss analysis of a notional portfolio of exposures, and, should there be a triggering event, the county-level market shares can be multiplied by the state-level PCS-index to disaggregate industry losses to the county-level. This structure allows sponsors to manage basis risk at a more granular level, while providing investors with a transparent index with which to measure potential losses.
Most cat bonds provide protection against losses over multiple years. However, the risk to non-parametric bonds is estimated based on the exposure (the sponsor's or the industry's, depending on the trigger) in force at issuance. The combination of a fast growing exposure base and an indemnity or industry loss trigger could expose investors, over time, to a substantially greater risk than that for which they are being compensated. Similarly, the growing disconnects between the risk analysis and the exposure in later years will cause the sponsor's basis risk to increase over time. Sponsors can prevent this by maintaining a close fit between their risk and the bond's trigger. This is done by regularly remodeling the bond based on the most current exposure, adjusting the trigger to maintain the bond's probability of loss at the level defined at issuance. For transactions lasting three or more years, resets are typically performed on an annual basis, as this is sufficient time for the original risk analysis to become materially removed from the sponsor's actual risk profile.
Most reinsurance contracts underlying catastrophe bonds require an independent assessment of potential loss to the bond. AIR serves investors and sponsors alike as an independent calculation agent following a potential triggering event. AIR can support loss determination by performing exposure growth calculations, determining related earthquake events to a denoted principal earthquake, reconciling event reports to parametric trigger requirements, or, for Industry Loss Index triggers, disaggregating state-level industry loss reports to county level.
More than USD 6.5 billion in property catastrophe bonds were issued in 2015, and all indications suggest that 2016 will be an active year. As the market has matured, the process of issuing a catastrophe bond has become easier and companies considering securitization rely on AIR’s unparalleled efficiency and expertise. AIR is committed to continuing to develop innovative solutions that facilitate transactions that are attractive to both issuers and investors by enhancing transparency and minimizing basis risk.
Want to learn more? Register now for AIR’s So You Want to Issue a Cat Bond? webinar on October 19.
For the Investor
AIR's extensive consulting and modeling capabilities are also available to insurance-linked securities (ILS) investors. Investors who use AIR's CATRADER® can obtain, upon request and at no additional fee, detailed instructions for remodeling all of the public property cat bonds currently in the market, regardless of whether AIR was the original modeler of the bond. Investors use this information to analyze bonds' suitability and correlation with their existing portfolio(s) of cat risk, just as they would any reinsurance contract. Reinsurers and specialist cat bond investors alike have used this feature to both control their cat exposure and make decisions to cede their own risk to protect portfolios of reinsurance contracts, industry loss warranties (ILW), and cat bond investments.