By MATTHEW BRODSKY, senior editor/Web editor of Risk & Insurance®
One big explanation for why the catastrophe bond market has been slower to develop than perhaps some people had hoped, besides price, is its complexity. Just trying to figure out what would cause a bond to trigger, and then default, can be a tricky proposition.
That's especially true in the United States, where a majority of catastrophe bonds are based on what's called an indemnity trigger. This is set up based on the issuer's--the insurer's or reinsurer's--losses, which are determined by the underlying insurance contracts.
During claims, it can take an army of hundreds of adjusters, lawyers and judges to figure out what caused a loss and what insurance contracts say about it, so how can we expect capital-markets investors to understand these indemnity triggers?
That's the problem. CAT bonds have been an issuers' market in the past, set up to be convenient for insurers and reinsurers and not so easy for the investors, according to Peter Nakada, managing director and head of the RiskMarkets group at modeling firm Risk Management Solutions Inc. Nakada believes the market needs to move toward simpler structures to make it easier for mainstream investors to get in.
Simpler structures such as parametric triggers. These bonds are based on catastrophe modeling and measurable physical metrics.
"For a parametric bond, all you need to know is what are the odds that the winds blow 110 mph in Miami," Nakada explained.
Or, say, that a Magnitude 9.0 quake would happen near Seattle.
"When you do a parametric deal, it could be a cleaner deal for the investor," agreed Chi Hum, managing director of GC Securities at reinsurance intermediary Guy Carpenter & Co. Inc., who added that these derivatives-like deals minimize the investors' risks.
THE BASIS OF THE INSURERS' CASE
But insurers can, and do, say that parametric deals increase their basis risk, or the difference between their actual losses and what their payout would be from the bond.
Such was the sentiment of Mike Murphy, senior executive vice president at Arch Insurance Group.
"I'm a big fan of CAT bonds because they take a lot of pressure off the pricing in the reinsurance market," he said, but he added: "We're better off with an indemnity trigger."
Why? Arch has a book of complex property business, full of large industrial and energy risks with business interruption exposure, said Murphy. "These are not the sorts of risks about which the readily available models can confidently estimate losses, versus, say, residential property losses. And at this point, we haven't seen an indemnity trigger deal that's priced better than traditional reinsurance," he added.
Hesitation toward the catastrophe bond market comes down then, in part, to price and to modeling.
"There's a big educational push we need to make today ... that you can trust the models," said Nakada.
But it also simply comes down to what type of property book an insurer has. As Jonathan W. Hall, executive vice president at FM Global, explained to Risk & Insurance®, each insurer must look at what's more effective for its balance sheet--indemnity or parametric.
Or both. Which brings us to compromise, or hybrid, triggers--those that can combine the event-based odds of parametric with industry losses: i.e., if a hurricane with a certain wind speed hits a given area and industry losses top a certain threshold according to ISO Property Claims Service, then the bond would default.
"You can really design them to fit a niche, a spot," said Hall.
One such hybrid trigger--the relatively new long-term aggregate zonal reinsurance (LAZER)--blends together modeling and industry losses down to the state and county level, according to Pascal Karsenti, senior risk consultant at AIR Worldwide Corp. These triggers have been used in 2009 bonds such as Liberty Mutual's Mystic Re II and Scor's Atlas V.
April 28, 2009
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