Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from the sponsor to the investors. They are often structured as floating-rate corporate bonds whose principal is forgiven if specified trigger conditions are met. They are typically used by insurers as an alternative to traditional catastrophe reinsurance. Securities are tradeable interests representing financial value. ... A corporate bond is a bond issued by a corporation. ... Insurance is the business of providing protection against financial aspects of risk, such as those to property, life, health and legal liability. ... Reinsurance is a means by which an insurance company can protect itself against the risk of losses with other insurance companies. ...

For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then they might wish to pass some of this risk on so that they can remain solvent after a large hurricane. They could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or they could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, they would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of LIBOR plus anywhere from 3 to 20%. If no hurricane hit Florida, then the investors made a healthy return on their investment. But if a hurricane hits Florida and triggers the cat bond, then the principal initially paid by the investors is forgiven, and is instead used by the sponsor to pay their claims to policyholders. This article is about weather phenomena. ... LIBOR stands for the London Interbank Offered Rate and is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale (or interbank) money market. ...

History

The notion of securitizing catastrophe risks became prominent in the aftermath of Hurricane Andrew, notably in work published by Richard Sandor, Ken Froot and a group of professors at the Wharton School who were seeking vehicles to bring more risk-bearing capacity to the catastrophe reinsurance market. The first experimental transactions were completed in the mid-1990s by AIG, Hannover Re, St. Paul Re and USAA. The market grew to $1-2 billion of issuance per year for the 1998-2001 period, and over $2 billion per year following 9-11. Issuance doubled again to a run rate of approximately $4 billion on an annual basis in 2006 following Hurricane Katrina, and was accompanied by the development of Reinsurance Sidecars. Issuance continued to increase through 2007 despite the passing of the post-Katrina "hard market" as a number of insurers sought diversification of coverage through the market, including State Farm, Allstate, Liberty Mutual, Chubb and Travelers along with long-time issuer USAA. Total issuance exceeded $4 billion in the second quarter of 2007 alone. Lowest pressure 922 mbar (hPa; 27. ... The Wharton School of the University of Pennsylvania is a business school at the University of Pennsylvania, USA. The school was founded by Joseph Wharton, who also was one of the founders of Swarthmore College (founded in 1864), in 1881 as the first collegiate business school in the United States. ... American International Group, Inc. ... Hannover Re, in German Hannover Rückversicherung AG, with gross premiums of around €10 billion in 2006, is one of the five largest reinsurance groups in the world. ... Please wikify (format) this article or section as suggested in the Guide to layout and the Manual of Style. ... 9-11 can refer to: The September 11, 2001 attacks A collection of interviews of Noam Chomsky by a variety of European publications and individual interviewers during the month after the September 11, 2001 attacks September 11 (month-day date notation) 9 November (day-month date notation) The North American... Reinsurance sidecars, conventionally referred to as Sidecars, are financial structures which are created to allow investors to take on the risk and return of a group of insurance policies (a book of business) written by an insurer or reinsurer (henceforth re/insurer) and earn the risk and return that arises...

Investors

Investors choose to invest in catastrophe bonds because their return is largely uncorrelated with the return on other investments in fixed income or in equities, so cat bonds help investors achieve diversification. Investors also buy these securities because they generally pay higher interest rates (in terms of spreads over funding rates) than comparably rated corporate instruments as long as they are not triggered.

Key categories of investors who participate in this market include hedge funds, specialized catastrophe-oriented funds and asset managers. Life insurers, reinsurers, banks, pension funds and other investors have also participated in offerings.

A number of specialized catastrophe-oriented funds play a significant role in the sector, including Clariden Leu Ltd, Credit Suisse Asset Management, Fermat Capital Management, Nephila, Stark, Securis, Coriolis, Banque AIG, Solidum, Pentalia, Goldman Sachs Asset Management and others.

Ratings

Cat bonds are often rated by an agency such as Standard & Poor's, Moody's, or Fitch Ratings. A typical corporate bond is rated based on its probability of default due to the issuer going into bankruptcy. A catastrophe bond is rated based on its probability of default due to an earthquake or hurricane triggering loss of principal. This probability is determined with the use of catastrophe models. Most catastrophe bonds are rated below investment grade (BB and B category ratings) and the various rating agencies have recently moved toward a view that securities must require multiple events before occurrence of a loss in order to be rated investment grade. Publications Standard & Poors publishes a weekly (48 times a year) stock market analysis newsletter called The Outlook, which is issued both in print and online to subscribers. ... Moodys Corporation (NYSE: MCO) is the holding company for Moodys Investors Service which performs financial research and analysis on commercial and government entities. ... Fitch Ratings, Ltd. ... Catastrophe modeling (also known as cat modeling) is the process of using computer-assisted calculations to estimate the losses that could be sustained by a portfolio of properties due to a catastrophic event such as a hurricane or earthquake. ... A bond is considered investment grade or IG if its credit rating is BBB- or higher by Standard & Poors or Baa3 or higher by Moodys or BBB(low) or higher by DBRS. Generally they are bonds that are judged by the rating agency as likely enough to meet...

Structure

Most catastrophe bonds are issued by special purpose reinsurance companies domicilied in the Cayman Islands, Bermuda or Ireland. These companies typically write one or more reinsurance policies to protection buyers (most commonly insurers or reinsurers) called "cedants." This contract may be structured as a derivative in cases in which it is "triggered" by one or more indices or event parameters (see below) rather than losses of the cedant.

Some bonds cover the risk that multiple losses will occur. The first second event bond (Atlas Re) was issued in 1999. The first third event bond (Atlas II) was issued in 2001. Subsequently, bonds triggered by fourth through ninth losses have been issued. Such transactions generally cover a the portfolio of a single cedant or fixed arrays of events. The first actively managed pool of bonds and other contracts ("Catastrophe CDO") called Gamut was issued in 2007 with Nephila as the asset manager.

Trigger types

The sponsor and investment bank who structure the cat bond must choose how the principal impairment is triggered. Cat bonds can be categorized into four basic trigger types. The trigger types listed first are more correlated to the actual losses of the insurer sponsoring the cat bond. The trigger types listed farther down the list are not as highly correlated to the insurer's actual losses, so the cat bond has to be structured carefully and properly calibrated, but investors would not have to worry about the insurer's claims adjustment practices.

Indemnity: 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 is $100 million excess of $500 million, and the total claims add up to more than $500 million, then the bond is triggered.

Modeled loss: 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.

Indexed to industry loss: 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, say $30 billion. The cat bond will specify who determines the industry loss; typically it is a recognized agency like PCS. "Modified index" 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.

Parametric: 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 windspeed (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. For example, if a typhoon generates windspeeds greater than X meters per second at 50 of the 150 weather observation stations of the Japanese Meteorological Agency, the cat bond is triggered.

Market participants

Examples of cat bond sponsors include insurers, reinsurers, corporations and government agencies. Over time, frequent issuers have included USAA, Hartford, Swiss Re, Munich Re, Liberty Mutual, SCOR, Hannover Re, Allianz and Tokio Marine & Fire.

To date, all direct catastrophe bond investors have been institutional investors since all broadly distributed transactions have been distributed in that format. These have included specialized catastrophe bond funds, hedge funds, investment advisors (money managers), life insurers, reinsurers, pension funds and others. Individual investors have generally purchased such securities through specialized funds. An institutional investor is an investor who is an institution like a bank, insurance fund, retirement fund, or mutual fund manager. ... A hedge fund is a private investment fund charging a performance fee and typically open to only a very limited range of qualified investors. ...

Examples of investment banks and other dealers that are active in the issuance of catastrophe bonds are ABN Amro, Aon Capital Markets, Deutsche Bank, BNP Paribas, Goldman Sachs, MMC Securities Corp., Lehman Brothers, Willis Capital Markets, and Swiss Re Capital Markets. Some of these groups also make secondary markets in these bonds. Most bond offering documents include an expert modeling analysis, with the bulk of these being prepare by AIR, EQEcat and Risk Management Solutions. To meet Wikipedias quality standards, this article or section may require cleanup. ... Deutsche Bank AG (ISIN: DE0005140008, NYSE: DB) (English: ) is a bank operating worldwide and employing more than 75,000 people (June, 2007). ... BNP Paribas (Euronext: BNP, TYO: 8665 ) is one of the main banks in Europe and France. ... The Goldman Sachs Group, Inc. ... Lehman Brothers Holdings Inc. ... 30 St Mary Axe - at 180 m, Swiss Res London headquarters is the 6th tallest building in London Swiss Re is the worlds second-largest reinsurance company (after Munich Re/ Münchener Rück), and the worlds largest life and health reinsurer. ...

Numerous law firms have been active in this space, notably Cadwalader, Wickersham & Taft LLP.

Patents

There are a number of issued US patents and pending US patent applications related to catastrophe bonds.^[1] These are examples of insurance patents. Insurance patents are a recent trend since the 1998 State Street Bank decision affirmed that business method patents were allowed by United States patent law. There are approximately 150 new patent applications filed each year on new insurance products and processes. ^[2] A patent is a set of exclusive rights granted by a government to an inventor or applicant for a limited amount of time (normally maximum 20 years from the filing date, depending on extension). ... A patent application is a request pending at a patent office for the grant of a patent for the invention described and claimed by that application. ... Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. ... The decision of July 23, 1998 of the United States Court of Appeals for the Federal Circuit in State Street Bank & Trust Company v. ... Business method patents are a class of patents and one of many legal aspects of business. ... The United States patent law is a first-to-invent patent legal framework in contrast to all other national patent laws. ...

References

External links

1. IQPC's 2nd Insurance Linked Securities Summit
2. General information website on insurance securitizations (by Okubo)
3. Article "Applications of Insurance Securitization" (UChicago Business School)
4. Article on Insurance Derivatives (by Alex Krutov)
5. Presentation by Diego Rangel
6. Mad scramble for capital fuels cat bond market
7. Conference on Insurance- and Risk-Linked Securities (the Bond Markets Association)

See also

• Catastrophe modeling
• Fixed income
• Reinsurance
• Risk management
• Reinsurance Sidecar
• Captive insurance
• Alternative Risk Transfer