According to Property Claim Services, they think that the sponsors should be able to use the kind of structure that they find in favorable when dealing with their risk and capital management. With this, we are able to derive the top five advantages that come when they consider using an index trigger.
Some of these advantages include:
- The efficiency- compared to index indemnity it is considered easy since it has a few steps to understanding it while the index indemnity one has to collect, review and go through the previous agreements in order to understand.
- The Analysis- They do not require an understanding of the investors' underwriting philosophy while in index indemnity one has come up with a complete write up about handling the claim and the underwriting philosophy before they can engage ( Hunt, 2011).
- The lower cost- when it comes to acquiring an index there is a cost on it, which most times are low. Sometimes it is dependent on the quality and quantity and when the size of the event on catastrophe bond is likely to trigger settlement it tends to be processed faster.
- Data quality- when using the index, it is possible to get data about the capital market and the method used to get the data and to analyze and store the data does not affect the knowledge and usage of the data (Ciumas, Oniga, and Popa, 2015).
- Security on information on proprietary- this means that the index triggers gives the sponsors the ability to protect proprietary information that they may consider an advantage on their side from the competition.
The largest single catastrophe bond issue ever sold was by done by the use of a special purpose vehicle, the $750 million hurricane risk catastrophe bond after the Everglades Re Florida, making it an extraordinary year for catastrophe bonds with almost the record aggregate amount of risks placed. Contrary to the investor's belief that catastrophe bonds exist mainly for their benefit, the main goal of a catastrophe bond is to transfer risks off the books of ceding insurers. Most traditional indemnity-based reinsurance was given for one year coverage periods and thus ceding insurers have the task of re-negotiating with their insurers annually with the possibility of capacity and pricing uncertainties from year to year. Catastrophe bonds are on the other hand issued for two or three year maturity period with full provision of collateralized coverage at a fixed price for that time period. Catastrophe bond gives investors the multi-year capacity and certainty used in setting prices with respect to the considerations used in pricing when the catastrophe bond is sold to investors which can be gorgeous to an insurer (Hunt, 2011).
Catastrophe bonds were mainly based upon parametric or other non-indemnity triggers but the majority of recent catastrophe bonds provide indemnity-based reinsurance cover. From the above insurer's standpoint, the reinsurance coverage provided by indemnity-based cat bonds may seem similar to their traditional reinsurance rather than index trigger catastrophe bonds. This similarity may facilitate a cadent regarding catastrophe bonds as an alternative risk transfer mechanism thus eliminating what most ceding insurers would have seen as an obstacle while considering the use of catastrophe bonds as an alternative risk transfer mechanism. The overall risk-transfer program can also be improved by including the indemnity-based programs that enable the investors to make more profits (Elkhoury, 2008). Ceding insurers also find it easier to train staff members on how to manage an indemnity-based catastrophe bond reinsurance agreement instead of training them on other covers.
Due to some consolidations, the reinsurance company has gone through after and after major events; the Model Credit for Reinsurance Model Act and Model Regulation and other statutory and legal options by a number of states can help to improve the way the bonds are bought (Wang, Zhou, and Zhou, 2013). In order to fund the payment of reinsurance claims submitted during the term of the bond, the money received from the bond purchasers are deposited into the reinsurance trust bank accounts. The reinsurance trust payments are restricted to claims from the ceding insurer until the maturity date of the bond (Elkhoury, 2008). This structure enables the ceding reinsurer to claim full credit for the reinsurance provided by catastrophe bonds and also possibly prevent the ceding insurer from incurring losses from the reinsurance in case of a reinsurer's insolvency.
With the proper drafting of the documentation and appropriately administered facility, the ceding insurer should be exposed to relatively minimal risks when collecting reinsurance claims in catastrophe bonds. The catastrophe bonds are collateralized to ensure minimal losses are recorded by the parties involved in the business (Feinberg, Shelor, Cross, and Grossmann 2006). Ceding insurers consider the claims-paying or other financial strength of a reinsurer for various reasons. For example, in relation to reinsurance which is not fully collateralized, ceding insurers consider the only reinsurers with certain minimum claims paying or financial rating. Furthermore, because of the reinsurer's rating demote, the ceding insurer is allowed to terminate the reinsurance agreement anytime during the term (Elkhoury, 2008). Catastrophe bond has a structure in that the claims-paying or another financial strength rating of the insurer is irrelevant and thus a ceding insurer does not have to be concerned with potential rating downgrades of its insurer.
Increased market capacity
Catastrophe bonds are meant for investments by institutional investors. Ceding insurers would rather form a connection with several reinsurers in order to improve stable bases of risk transfer capacity annually. Hedge funds are considered as a source of risk transfer that can be used to fund the insurance for one year. The amounts may also vary from year to year. In comparison to traditional insurers, participants in hedge funds usually have different financial and documentation interests and requests causing a rise in transactional cost to a ceding insurer. The potential costs for depending only on the traditional reinsurance market may be greater than the increased transactional costs. Catastrophe bonds also ensure that investors have a rating that can be used to decide the ones who qualify for any investments (Baranoff, 2012). To a ceding insurer, the rating of the purchaser of a catastrophe bond is irrelevant provided the purchaser pays the purchase price for their portion of the bond issue in order to be deposited into the reinsurance trust account. Catastrophe bonds have been noted in several articles that they are being treated by some institutional investors as a separate asset class and are used to further diversify their portfolios by investors such as pension funds.
Lower long-term transactional costs
The duration of coverage of catastrophe bonds is longer compared to traditional reinsurance thus providing a ceding insurer the opportunity to spread some of its transaction costs of putting a risk mechanism in place over more than one year, possibly resulting in cost efficiencies. A large number of catastrophe bonds are issued as part of a bond series meaning that most of the documents and records available can be used. However, traditional reinsurance systems may have less similar features and records annually. Because the market is not developed enough, the transactional costs of catastrophe bonds and the ones from traditional reinsurance from empirical data is not currently possible (Elkhoury, 2008).
Risk transfer pricing considerations
Several questions have been raised in articles concerning whether there is a relationship between the pricing of catastrophe bonds and the pricing of traditional reinsurance and its extent. In some articles, writers have postulated that the additional risk transfer capacity provided by catastrophe bonds may have a moderate effect on the pricing for traditional reinsurance. Another speculation is that de-coupling of the pricing of catastrophe bonds and traditional reinsurance is becoming apparent since price considerations are different in those different risk transfer spaces.
Purchaser considerations and the role of modeling
A diverse combination of institutional purchasers, pension plans, life insurance companies, and reinsurers are attracted by catastrophe bonds. The returns of corporate obligations are more sensitive to the economic conditions than the returns of catastrophe bonds. When a two or three-year rate on catastrophe bond is obtained, an added stability, as well as diversification to the investment portfolio, is achieved.
A discussion on comments made by Goldman Sachs and others on the effect that investment returns on catastrophe bonds have been exceeding those on corporate debt due to low yields on corporate debts. Increasing reinsurance coverage and financial statements relief at a time when capital levels are under pressure are some of the other needs a catastrophe bond may serve. An example is after the March 2011 earthquake and tsunami hit in Japan, the Japan insurers were more interested in catastrophe bonds as a means to improve their capital position. Catastrophe bonds may also be useful in helping some insurance companies cope with increased capitalization requirements of Solvency II in the European Union.
One of the major developments in the catastrophe bonds has been the development of a methodology for risk modeling which is transparent, tested, relatively uniform and acceptable to investors. AIR Worldwide, a modeling firm has possibly provided more than 90% of the catastrophe bonds issued during 2011 and 2012. The cat risk model is assumed to be fully probabilistic catastrophe model that can be used to calculate the loss estimates for different scenarios. The model is a reliable way through which investors can make decisions. (Ciumas, Oniga, and Popa, 2015).
Risk modeling helps the investors to understand the risks they are exposed to and how they can make money of lose money from the investment (Feinberg, Shelor, Cross, and Grossmann, 2006). Risk modeling is also useful in determining the attachment point for coverage after the first coverage year in a multi-year bond. Some commentators consider the maturity of the modeling to have contributed to better investor acceptance of these assets. AIR has gained a greater breadth of experience and data which may inform its catastrophe bond-related modeling by providing modeling services to some insurers for their own use.
Insurance-linked securities for life and annuity related risks
The market for property and casualty catastrophe risks is more developed than the insurance-linked securities market for life and annuity-related risks.
Life and annuity-related risks which might be securities
Mortality risks and longevity risks are the main risks that are identified when analyzing the risks in companies that deal with life and annuity policies (Von Thadden, 2004). The predominant trigger for catastrophe bonds changed from being various indices to being predominant a fairly traditional indemnity concept while the predominant trigger for mortality and longevity risk bonds has remained a form of index-based trigger.
Mortality and longevity risk bonds to date.
Actuarial techniques are applied to medical and social research and data points in the latest modeling for both longevity and mortality risks. The trigger for mortality risk bonds can be based upon a mortality index, with payments to the ceding insurer triggered with an increase in age and gender-weighted mortality rates that are beyond the agreed-upon percentage of a predefined mortality index value of the term of the bonds. A trigger based on the increase in mortality measured against an index using predef...
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