What Is Reinsurance?

Reinsurance is insurance that is purchased by an insurance company (insurer) from another insurance company (reinsurer) as a means of risk management, to transfer risk from the insurer to thereinsurer. The reinsurer and the insurer enter into a reinsurance agreement which details the conditions upon which the reinsurer would pay the insurer's losses (in terms of excess of loss orproportional to loss). The reinsurer is paid a reinsurance premium by the insurer, and the insurer issues thousands of policies.

For example, assume an insurer sells one thousand policies, each with a $1 million policy limit. Theoretically, the insurer could lose $1 million on each policy  – totaling up to $1 billion. It may be better to pass some risk to a reinsurance company (reinsurer) as this will minimize the insurer's risk.

What Triggers A Catastrophe Bond?

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.^[5] 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.

Parametric Index: Many firms are uncomfortable with pure parametric bonds due to the lack of correlation with actual loss. For instance, a bond may pay out based on the wind speed at 50 of the 150 stations mentioned above, but the insurer loses very little money because a majority of their exposure is concentrated in other locations. Models can give an approximation of loss as a function of the speed at differing locations, which are then used to give a payout function for the bond. These function as hybrid Parametric / Modeled loss bonds, and have lowered basis risk as well as more transparency.^[6

How Are Catastrophe Bonds Structured?

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 protect 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, including Avalon, Bay Haven, and Fremantle, each of which apply tranching technology to baskets of underlying 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.