Review of ILS Market and 'Exhausted' Catastrophe Bonds

1. By: Alexander Pui

2. H. Katrina (2005)
Japan/NZ EQ,
Thai Floods
(2011)
Northridge EQ
(1994)
Source :Swiss Re Economic Consulting and Research

4. • Self insurance?
• Insurers (IAG/ Suncorp/ QBE… ) ?
• Reinsurers (Swiss Re/ Munich Re/ Warren Buffett…)?
• Alternative Capital (Investors in Insurance Linked Securities
(ILS)?
• Governments/ Tax payers ( 2011 Queensland Flood Tax
Levy…)?

5. Source: Dahlen and Peter, Natural Catastrophes and global reinsurance: Exploring the Linkages, BIS Quart. Review, 2012
Actual losses from natural
catastrophes and risk transfer
in 2011

6. • Short Primer on Reinsurance
• Overview of the ILS Market
• Pricing and Structuring of Cat Bonds
• Examples of ‘exhausted’ Cat Bonds
• Will investor appetite continue to grow?

7. Short Primer on Reinsurance

8. Reinsurance purchased to protect against risk of ruin (smooths volatility) but
only if it makes economic sense.
8
Retained by Insurer
Absorbed by Reinsurer
Reinsurance decisions reflect a firm’s risk
appetite and shareholder expectations
(RoE)

9. (800.000)
(600.000)
(400.000)
(200.000)
-
200.000
400.000
600.000
800.000
1,000.000
1%
4%
7%
10%
13%
16%
19%
22%
25%
28%
31%
34%
37%
40%
43%
46%
49%
52%
55%
58%
61%
64%
67%
70%
73%
76%
79%
82%
85%
88%
91%
94%
97%
Profit/Loss
Probability
Holistic ApproachDistribution of Profit/Loss
Percentiles
Profit/Loss
Caps Max loss at
$400m

10. $11bn
Capital
$1.5bn Profit
Mooncorp
RoE = 13.6%
(1.5 / 11 bn)
$3.7bn
Capital
$900m Profit
$600m Expense
Perkshire
(International Reinsurer)
$600m reinsurance
cost for $7.3 bn of
capital ‘relief’
$3bn
Capital
RoE = 20%
(0.6/3 bn)
$600m Profit
$4.3 of
Diversification
Benefit
Backed by
$1.5bn Profit
Mooncorp reinsured by
Perkshire
$7.3bn
‘Saved’
Capital
RoE = 24.3%
(0.9/ 3.7 bn)
$7.3bn
Capital
$600m Profit
Hence ‘value’ of reinsurance is
an improved RoE of 10.7%

11. ‘Hedge Fund Re’
(Special Purpose Vehicle)
$7.3bn
Capital
$11bn
Capital
$1.5bn Profit
Mooncorp
RoE = 13.6%
(1.5 / 11 bn)
$3.7bn
Capital
$900m Profit
$600m Expense
$600m
reinsurance cost
for $7.3 bn of
capital ‘relief’
$1.5bn Profit
Mooncorp reinsured by
Perkshire
$7.3bn
‘Saved’
Capital
RoE = 24.3%
(0.9/ 3.7 bn)
$600m Profit
Hence ‘value’ of reinsurance is
an improved RoE of 10.7% !
$7.3bn
Capital
RoE = 9.58%
(0.6/7.3 bn)
$600m Profit
Backed by
Investors

12. Overview of the ILS Market

13. • Growth punctuated
by significant
increases when RI
markets harden.
• Bond durations are
getting longer.
Source: Artemis
H. Katrina (2005) Japan/NZ EQ,
Thai Floods
(2011)

14. • Collateralized Re*
growth has accelerated
in last 6 years
• Coll. Re and Cat Bonds
now dominate the ILS
market
Source: Insurance Information Institute (Aon Benfield)
Collateralized Re* is similar to cat bonds where investors participate directly in (for
e.g.) reinsurance programs but are private transactions and non-tradable.

15. • Key Perils such as US Wind and EQ continue to dominate
• Emergence of international perils + non CAT related – life and mortgage insurance losses (?!?)
Source: Artemis

16. • ILS has doubled its share of
the global RI market since
2010 (5.4% to 11.5%)
• Changes are more
pronounced in property
catastrophe space.
Source: Insurance Information Institute (Aon Benfield)

17. Pricing and Structuring of Cat Bonds

18. Other parties typically
involved in a Cat Bond
transaction include:
• Risk Modelling Firms
• Investment Banks
• Loss Reporting
Agencies
• Rating Agencies

19. Simulated Hurricane Tracks Simulated Earthquake Events (Epicenters)
Sources : Franco, G. (2010) “Minimization of Trigger Error in Cat-in-a-Box Parametric Earthquake Catastrophe Bonds “
* For Natural Peril premised bonds, catastrophe models are used to assess underlying base risk through
stochastic simulation of natural disasters and associated economic costs.

20. ExceedanceProbability
Loss
p
RP Loss
AAL
• Average Annual Loss (AAL) or ‘area
under the Exceedance Probability
Curve’
• Return Period Losses (i.e. 1 in 200
year loss for any given year , p =
1/200 = 0.005)
• XSAAL ~ contribution from events that
exceed a certain loss
• Uncertainty in loss estimates
XSAAL

21. Estimated
based upon
cat model
output +
loadings for
uncertainty,
expenses and
profit margins.
Upper Layer
(Cat Bond)
Lower
Layers (TRI)
Retention
(Mooncorp)
L0
L1
0
10m
100m
150m
Loss ($) Return Period
500
100
5

22. Parametric:
• EQ Richter Scale,
Cyclone Peak Wind
Gust/ Central Pressure
Industry Index:
• Losses sustained by
‘market portfolio’
affected region
Modelled Loss:
• Losses for portfolio est.
by Cat Models
Indemnity:
• Actual Claims
experience of indvd.
insurers
Source: Swiss Re Capital Markets

23. • Issuer/Sponsor participates
in its own product to avoid
perception of shipping out
the duds’
• Limits losses to account for
portfolio growth
Source: Canabarro et al., Analyzing the pricing of ILS, Journal of Risk Finance 2000

24. • Complex underlying
commercial portfolio means
high uncertainty in
modelling results
• Parametric trigger that
accounts for distance to
major EQ circumvents this
issue.
Source: Canabarro et al., Analyzing the pricing of ILS, Journal of Risk Finance 2000

25. Examples of ‘exhausted’ Cat Bonds

26. Source: Insurance Information Institute (Aon Benfield)
Failure of Swap
Counterparty

27. USD 300m
Source: Dahlen and Peter, Natural Catastrophes and global reinsurance: Exploring the Linkages, BIS Quart. Review, 2012
Actual losses from
natural catastrophes and
risk transfer in 2011.

28. 984
1420
0
Dropdown
Trigger Vaue
Event Attachment
Index Value Exceedance
Probability
0.6%
1.02%
4%
Event Exhaustion
Key Features/Details:
• Principal Amount: USD 300M
• Event: Japanese EQ
• Cover: Per Occurrence
• Trigger Type: Parametric
• Risk Period: 2 May 08 – 1 May 11
• Moody’s Rating: Ba2
• Modelling Agency: AIR
• Issuer: Muteki Ltd.
• Reinsured: Zenkyoren
• Reporting Agent: K-NET
Source: Artemis, Strong Motion Networks: K-Net Japan

29. Source: Twelve Capital, Cat Eye
While a number of bonds were deemed ‘at risk’ after 2011 Tohoku EQ &
Tsunami, Muteki was the only bond to exhaust completely.

30. Sources: Twelve Capital, Cat Eye
• Did parametric index reflect
best view of seismic risk?
• Was bond spread of 4.4%
commensurate with high
uncertainty in underlying
risk?
• Investors were not ‘spooked’
and retained appetite for
Japanese EQ risk

31. Key Features/Details:
• Principal Amount: USD 200M
• Event: US Severe Thunderstorm
• Cover: Aggregate
• Trigger Type: Industry Index
• Risk Period: Nov 10– Nov 11
• S&P Rating: B
• Modelling Agency: AIR
• Issuer: Mariah Re
• Reinsured: American Family Mutual
• Reporting Agent: Property Claims
Services (PCS)

32. • Initial estimates from PCS suggested losses unlikely to reach
exhaustion point
• PCS revised its estimates months later, resulting in complete
exhaustion – prompting disgruntled investors to sue AIR and
PCS.
• The legal action threatened to open ILS Pandora’s box,
challenging touted benefits of catastrophe bonds such as :
– East of Settlement
– Counterparty Risk
– Impartiality of loss modelling and reporting agents

33. • Courts found no impropriety in execution
of contractual obligations
• Issues with aggregation and weighting
methods were flagged by certain funds
(who chose not to participate)
• Onus on investors to perform proper due
diligence
“Having gambled and lost on the weather
……Mariah now attempts to convert its
unsuccessful risk venture into a game of
“gotcha” on the contracts.” Sullivan J.

34. Will investor appetite continue to grow?

35. • Cat Bonds have historically performed well as an ‘uncorrelated’ asset
class
• Issues with swap counterparties (i.e. Lehman Bros) have been
addressed.
• Onus on investors to perform proper due diligence

36. • Low interest rate environment
• Influx of longer term investors
(Pension Funds)
• Increased investor comfort with
product?
• New range of products beyond
natural catastrophes (ie.
Longevity/ Operation risk)
• Efforts to bridge protection gap
/under-insurance in developing
countries could push up
demand

37. Alexander Pui
Email: alexpui8@gmail.com
Linkedin : https://au.linkedin.com/in/alexander-pui-
94a33821