explain how Catastrophe bonds are structured and how they are trigger (their should be different type of trigger). how it has impacted the insurance and reinsurance market. and how Citizens Property Insurance Utilizes Catastrophe bonds to reduce thier ris

Running head: CATASTROPHE BONDS 1

CATASTROPHE BONDS 2

Catastrophe bonds

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Catastrophe bonds also known as “cat bonds” are risk-linked securities that transfer a specified set of risks from a sponsor to investors. Catastrophe bonds emerge from a need by insurance companies to alleviate some of the risk would be faced if a major catastrophe occurred, which would incur damages that they could not cover by the premiums, and returns from investments using the premiums, received. An insurance company issues bonds through an investment bank, which are then sold to investors. These bonds are inherently risky, and usually have maturities less than 3 years. If no catastrophe occurred, the insurance company would pay a coupon to the investors, who made a healthy return. On the contrary, 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, catastrophe-oriented funds, 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 to the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds are typically used by insures as an alternative to traditional catastrophe reinsurance (Cummins and Mahul).

The typical catastrophe bond structure sees a special purpose vehicle or insurer enter into a reinsurance agreement with a sponsor or counterparty, receiving premiums from the sponsor in exchange for providing the coverage via the issued securities. The special purpose vehicle issues the securities to investors and receives principal amounts in return. The principal is then deposited into a collateral account, where they are typically invested in highly rated money market funds.

The investor’s coupon, or interest payments, is made up of interest the special purpose vehicle makes from the collateral and the premiums the sponsor pays. If a qualifying event occurs which meets the trigger conditions to activate a payout, the special purpose vehicle will liquidate collateral required to make the payment and reimburse the counterparty according to the terms of the catastrophe bond transaction. If no trigger event occurs then the collateral is liquidated at the end of the cat bond term and investors are repaid (Rasmussen).

One of the key elements of any catastrophe bond is the terms under which the securities begin to experience a loss. Catastrophe bonds utilize triggers with defined parameters which have to be met to start accumulating losses. Only when these specific conditions are met do investors begin to lose their investment. Triggers can be structured in many ways from a sliding scale of actual losses experienced by the issuer which is the indemnity trigger to a trigger which is activated when industry wide losses from an event hit a certain point which is known as the industry index loss trigger to an index of weather or disaster conditions which means actual catastrophe conditions above a certain severity trigger a loss which is the parametric index trigger to a trigger which is determined by inputting actual physical parameters into an escrow model which then calculates the loss. This trigger is known as the modeled loss trigger and finally the pure parametric trigger which is based on the actual reported physical event.

Indemnity is one of the triggers to catastrophe bonds. It forms the basis of most many insurance contracts. It is triggered by the issuer's actual losses, so the sponsor is indemnified, as if they had purchased traditional catastrophe reinsurance. If the layer specified in the cat bond

In pure parametric trigger, 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 wind speed 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.

Modeled lose trigger is another one of the catastrophe bond triggers. 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. If the modeled losses are above a specified threshold, the bond is triggered.

In parametric index trigger is a type of insurance that does not indemnify the pure loss, but agrees to make a payment upon the occurrence of a triggering event. The triggering event is often a catastrophic natural event which may ordinarily precipitate a loss or a series of losses. But parametric insurance principles are also applied to Agricultural crop insurance and other normal risks not of the nature of disaster, if the outcome of the risk is correlated to a parameter or an index of parameters (Rasmussen).

In Industry index loss trigger, 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. The cat bond will specify who determines the industry loss. Its 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.

In recent years, significant new capital is investing in reinsurance from sources that barely existed 15 to 20 years ago. While these alternative capital arrangements have little impact on the typical policyholder, they have significantly affected the way reinsurance is being written worldwide. Alternative reinsurance capital differs in two significant ways from traditional reinsurance arrangements. First, a new type of investor is seeking out the reinsurance market—hedge funds, sovereign wealth funds, pensions and mutual funds. Second, the deals are structured differently. The new arrangements—catastrophe bonds, collateralized reinsurance and reinsurance sidecars—tend to isolate the investment from the rest of the capital supporting a reinsurer, thereby allowing the capital to enter and exit the market quickly (Bruggeman)

One common type of event-linked securities, which will illustrate many of their characteristics, are "catastrophe bonds"—"cat bonds" for short. If a "sponsor," such as an insurance company or reinsurance company (a company that insures insurance companies), wants to transfer some or all of the risk it assumes in insuring a catastrophe, it can set up a separate legal structure—commonly known as a special purpose vehicle (SPV). Foreign governments and private companies also have sponsored cat bonds as a hedge against natural disasters.

The SPV issues cat bonds and typically invests the proceeds from the bond issuance in low-risk securities (the collateral). The earnings on these low-risk securities, as well as insurance premiums paid to the sponsor, are used to make periodic, variable rate interest payments to investors. The interest rate typically is based on the London Interbank Offered Rate (LIBOR) plus a promised margin, or "spread," above that.

Because cat bond holders face potentially huge losses, cat bonds are typically rated BB, or "non-investment grade" by credit rating agencies such as Fitch, Moody's and S&P. Non-investment grade bonds are also known as "high yield" or "junk" bonds. These ratings agencies, as well as sponsors and underwriters of cat bonds, rely heavily on a handful of firms that specialize in modeling natural disasters. These "risk modeling" firms employ meteorologists, seismologists, statisticians, and other experts who use large databases of historical or simulated data to estimate the probabilities and potential financial damage of natural disasters (Weber and Stöttner).

One particularly attractive feature of catastrophe bonds and other catastrophe risk securities is that poor performance tends to be self-correcting. Following a particularly destructive natural disaster, a number of factors serve to inflate insurance premiums (and thus the potential returns to catastrophe risk securities), providing investors with the opportunity to recoup some, if not all, of their losses within a relatively short time-frame. These factors include increased demand for insurance, a reduced ability of insurance and reinsurance companies to take on risk, and upward revision of the probability models that are used to price insurance and catastrophe risk securities.

In addition, while investors face the possibility of losing some or all of their principal investment in the event that a catastrophe does occur, their risk exposure can be dramatically reduced by diversifying across many different catastrophe bonds as the probability of numerous large-scale natural disasters occurring within the same limited time frame is very low. For example in 2005, in spite of heavy losses associated with Hurricane Katrina, many catastrophe risk funds still made money overall.

CAT bonds are a relatively new investment product, having been in existence for only a couple of decades. Very broadly speaking, they are risk-linked securities that seek to transfer risk from a particular sponsor, typically an insurance company, to capital market investors. The idea is relatively simple—insurance companies concerned about enormous calamities for which payouts could exceed premiums transfer a portion of the risk associated with a particular disaster by selling bonds through an investment bank to investors. If no disaster occurs, the investors will reap a healthy return on their investment. However, should a disaster occur, the investors could lose their upfront investment as well as any interest accrued to that point. Insurers will then use the proceeds to pay claims arising out of the disaster (Bruggeman).

There are a number of advantages to be derived from the use of CAT bonds. From the insurance company standpoint, the ability to shift some or all of the risk of a natural disaster to another group is not only prudent but essential—this is the foundation that reinsurance was built on. Say, for instance, a particular organization offers home insurance and their clients are predominantly located in Florida. It doesn't take a genius to see that this insurance company could literally face bankruptcy from a single devastating hurricane in Florida. Not surprisingly, CAT bonds were born in the aftermath of Hurricane Andrew in 1992. Similar potential CAT bond targets include earthquakes in California or tornadoes in the Midwest (Weber and Stöttner).

References

Cummins, J. David, and Olivier Mahul. Catastrophe Risk Financing In Developing Countries. Washington, D.C.: World Bank, 2009. Print.

Bruggeman, Véronique. Compensating Catastrophe Victims. Alphen aan den Rijn, The Netherlands: Kluwer Law International, 2010. Print.

Rasmussen, Tobias N. Macroeconomic Implications Of Natural Disasters In The Caribbean. Washington: International Monetary Fund, 2004. Print.

Weber, Christoph, and Rainer Stöttner. Insurance Linked Securities. Wiesbaden: Gabler Verlag, 2011. Print.

Catastrophe reinsurance – which protects insurance companies against the costs of disasters,has proved highly lucrative over the years.