For example, CAT bonds are generally tied to the specific natural hazard ("this bond triggers if a hurricane of Category 3 or higher land falls in this segment of Florida") or to industry losses, as estimated by an agreed upon source.
This means that a CAT bond is correlated with, but not directly informed by an insurer's actual loss experience. Traditional reinsurance (so an insurer themselves getting insurance) will usually be tied to specific policies, so their experienced loss is what determines payout.
However, depending on the insurer's policies, traditional reinsurance may be unavailable or much too expensive (either due to the large limit needed, the risk level of the policies, or any number of other reasons). Depending on the trigger, a CAT bond can also pay out faster because you don't have to wait to see the claims from 100k home insurance policies.
From the technical side, most large reinsurers license CAT modeling software from one or both of the same two vendors: Moody's RMS or Verisk. The biggest reinsurers will develop their own models, and there are other modeling vendors that they may license for particular perils (EQEcat for earthquake and KatRisk for flood come to mind), but the big two are pretty widely accepted in reinsurance markets.
That means if your policies are "odd" in some way (uncommon construction type, power facility, etc.), depending on how a reinsurers chooses to model them (or how the model specifically handles them) can have a big impact on your reinsurance pricing. If you know something about your policies that can't be incorporated into a vendor model very well, you may get better pricing on a CAT bond.
These are just some of the considerations! There are so many more things that go into it. But I think it's super interesting to think about.
Source: I work in this side of the industry, specifically in natural catastrophe modeling.
I will clarify that CAT bonds can have industry loss triggers OR actual indemnity triggers. If an indemnity trigger then the insurer has to prove the actual loss. But you’re right on ILWs (Industry Loss Warranty) in that there is additional model/basis risk considerations.
Insurance companies try to minimize this basis risk. Because while sure it’s great to be in the situation where your CAT bond recovers when you didn’t have large losses, it’s NOT good to be in the position where you had big losses and you don’t recover. Certainty of recover can affect things like how much regulatory credit you get for your reinsurance.
So interested how things are today regarding brokers endlessly packaging up risks they sell on, rinse repeat. I'm aware of certain changes that came about to reinsurance brokers in both the Lloyds and London Markets on the back of the asbestos claim era, but not sure of the the CAT model risks/insurance regarding brokers endlessly packaging up to offset risk exposure vs regulations limiting how much they can do that - more so the USA market.
So curious - is there a risk from brokers diluting risks for commission profits in this market or is that saftly covered against and regulated?
A big part of the reason for this is that if payout is tied to actual loss, it starts to look a lot like actual insurance, which is specifically not what you want. Because while anyone* can buy a bond, only insurers or reinsurers can write insurance. This is something that needs to be considered whenever an insurer (or anyone, really) tries to transfer risk to a non-insurer.
I wonder how much more diversified $ILS could be if it were larger. Would a 10x increase in assets under management give it significantly less volatility because it could do a better job spreading risk around the globe?
For the web designers here please let me know if you noticed anything amiss. Ive had particular issues getting captchas working so please comment if you run into that issue.
"It's clear that we this structure" --> with
"with out those protections in place" --> without
"Investors would be best to limit their exposer to losses beyond their investment" --> exposure
There might have been others, I had to go back and skim to summarize for you.
The images some of the visuals do not show in reader view in Safari and Firefox. Other than that, the content is well laid out and very readable.
Cool article, it's a clear explanation of something I never knew about.
Also, what does new product development look like for industries like this? How does one search for new financial products? Is it possible for a non-expert to come up with new products in this space?
Are there any books you can recommend for a novice?
On the risk side - your comments here are part of the myth I’m trying to dispel and will have lots more to say in future posts.
Yes for a single CAT bond you are exposed to potential 100% principle losses. But if you buy a bundle of CAT bonds that focus on say California Earthquake, Florida Hurricane, Japanese Typhoon, and a Cyber Event, you can imagine the diversification benefit you get there.
I’ve already created a very very simple model for people to play around with and learn the intuition for CAT bond return patterns. A default means 100% loss and this is unique vs. other bonds. I plan in the future to build a much more robust model.
https://www.riskvest.io/data-lab/cat-bond-portfolio-simulato...
A “2% risk of default” on an individual bond is something a retail investor might be able to understand, but no one should be buying a “diversified” bundle of these things if they cannot form a reasonable understanding of how correlated they are. Why should understanding the correlation risk be left up to individual investors building their own portfolios?
I also think forming an intuition for these more “all-or-nothing” type events is more difficult than e.g. understanding that if GOOG goes down 10% then AAPL might do too at the same time because they are both tech stocks.
Yeah, but imagine how bad a day you're having if all of those disasters happen at once, and then as a cherry on top you lose all your money.
https://www.artemis.bm/ils-fund-managers/schroder-investment...
Product development is usually highly specialized as there are a lot of nuances and frictions within the insurance industry that outsiders may not fully understand. It helps also to be in the industry and have the network with insurers, reinsurers, brokers, etc. This is not at all to suggest there isn't room for clever people to bring innovation to the market though!
Book recs are hard to specify for CAT bonds but for insurance in general:
Against the Gods: The Remarkable Story of Risk - Peter L. Bernstein
The Black Swan - Nassim Nicholas Taleb
On the Brink: How a Crisis Transformed Lloyd's of London - Andrew Duguid
The last one is a personal favourite of mine
Some businesses had business interruption insurance which paid out. Many policies exclude highly correlated events such as pandemics.
And then think about specific events which were cancelled, which may have bought policies protecting them if cancelled.
And of course life insurance and health care would have been affected.
SwissRe often produces public reports in the space if of interest:
https://www.swissre.com/risk-knowledge/building-societal-res...
I think you could also have specific pandemic insurance, and that paid out, but those were rare before Covid.
"Yeah, but imagine how bad a day you're having if all of those [stocks drop] at once, and then as a cherry on top you [enter a recession]."
I'm not saying this is exactly like buying an index fund. I'm very un-knowledgable about CAT bonds. I'm just saying that your criticism holds for _every_ diversified bundle of risks.