What Are Insurance Derivatives?

Catastrophe insurance derivatives refer to contract products developed with catastrophe as the underlying asset for insurance value changes.

Catastrophe Insurance Derivatives

Right!

Catastrophe insurance derivatives refer to contract products developed with catastrophe as the underlying asset for insurance value changes.

Chinese name

Catastrophe Insurance Derivatives

Presentation time

1973

People

Robert Goshay

Text

Journal of Business

In 1973, American finance experts Robert Goshay and Richard Sandor published "An Inquiry into the Feasibility of a Reinsurance Future Market" in "Journal of Business Finance". Risk securitization or insurance derivatives transfer risk to the capital market and solve the problem of insufficient underwriting capacity in the reinsurance market. In 1984, Svensk Exportkredit put a privately allocated earthquake bond on the market, stipulating that after a major earthquake hit Japan, investors would redeem the bond at the face value of the bond. Japanese insurance companies bought the bond and they accepted the debt The low interest rate is generally the right to return the bond after the earthquake to obtain the face value of the bond. This is the earliest catastrophe.

Since the catastrophe insurance derivative market was formally established in 1992, there have been catastrophe futures, catastrophe options, catastrophe swaps, industry loss guarantees, catastrophe risk credit financing, contingent capital instruments, catastrophe rights to sell rights, and catastrophes. There are more than 10 types of trading methods such as bonds, and the most active and representative are catastrophe bonds. Among them, catastrophe futures, catastrophe options, catastrophe swaps, and industry loss guarantees can provide hedging for other asset risks, which are asset hedging. Catastrophe risk credit financing, contingent capital bills and catastrophe rights to sell rights are financing contracts based on specific conditions. The capital provider does not bear the risk of catastrophe, and only provides funds to make up for the loss after the event occurs and causes losses , Belongs to financing after loss. Catastrophe bonds provide hedging in the form of liabilities, which is a kind of debt hedging. ^[1]

Catastrophe Future (CATFuture): A futures commodity that is subject to a catastrophe risk index or catastrophe loss rate. The most important condition is that the price changes of futures must have a certain degree of correlation with the spot price changes.

Catastrophe option (CATOption): is to give contract holders the right to buy or sell an asset at an exercise price on or before a specific date. An insurance company purchases an option contract by paying an option premium in the options market, which is equivalent to purchasing a price option in the future, that is, the insurance company can choose to trade at the market price or at the exercise price agreed on in the option contract. According to the catastrophe call contract, if the catastrophe loss index exceeds the trigger condition, the option buyer can get the difference between the current price and the exercise price of the option; if the catastrophe loss index does not meet the trigger condition within the expiration date, the option is voided and purchased The user may not execute the purchase right, and only loses the deposit paid in advance. Catastrophe options actually provide purchasers with comprehensive reinsurance for a certain loss range, which can enable insurance companies to find alternatives when traditional reinsurance is not available or the traditional reinsurance price is too high to compensate for retention insurance and traditional reinsurance. The difference between.

CatastropheSwaps (CATSwaps): It is a transaction in which the parties to the contract agree to exchange assets or cash flows that they believe have the same economic value in a certain period in the future. Catastrophe swaps use participants in the capital market as transaction objects, swapping potential catastrophe compensation liabilities of insurance companies with cash flows paid by transaction objects. For example, suppose an insurance company has reached a swap transaction with a seller. The insurance company regularly pays cash equivalent to interest to the other party. When an agreed catastrophe occurs, the transaction object pays the insurance company a predetermined amount. From the perspective of the insurance company, there is no essential difference between the regular cash flow paid to the other party and the payment of reinsurance fees, but in fact, the entire transaction has gone far beyond the scope of traditional reinsurance.

Industry Loss Warranties (ILW): Similar to catastrophe swaps, but in the form of reinsurance transactions. The risk transfer mechanism for industry loss guarantees is only activated when the insurance industry losses and the actual losses of the purchasers exceed the agreed levels. Due to the existence of claims, industry loss guarantees are viewed as reinsurance rather than swaps. Compared with the standard for industry losses, the standard for actual losses is set very low. In this way, once industry losses occur, actual losses are very likely to occur. Therefore, the pricing of industry loss guarantees is based on the risks associated with industry loss standards. ContingentSurplusNotes (CSN): Also known as emergency capital, generally refers to contracts signed by insurance companies and financial intermediaries. After the insurance company signs the contract, it must pay the premium to the intermediary. If the agreed catastrophe event occurs (such as the company's catastrophe loss meets the trigger conditions), the insurance company has the right to issue capital instruments to intermediaries to raise cash or other liquid assets. As a company's post-disaster financing instrument, contingent capital instruments increased the insurance company's surplus and enhanced its ability to pay claims. It differs from insurance in that it does not provide compensation, and the capital provided increases the amount of shares issued (impaired equity) or the required repayment amount. Due to the cumbersome procedures for issuing contingent capital bills, high transaction costs, unfamiliarity to most investors, and low liquidity, the contingent capital bills market has developed very slowly in recent years.

Catastrophe Equity Puts (CEPuts): Refers to options with equity as the subject of a transaction. The buyer and the seller formulate the content of the contract, the insurance company pays the right to sell, and purchases from the investor the right to exercise the right to sell to the investor when the catastrophe insurance loss of the insurance company exceeds a certain amount. Insurance companies usually arrange delivery through financial intermediaries, requiring investors to pay guarantees and deposit in the intermediary. Investors' selling rights are forfeited by insurance companies to ensure their obligations. But if the investor's credit status is good, the contract needs to be negotiated directly between the option buyer and seller through the intermediary. When the catastrophe loss stipulated in the contract occurs, the insurance company can exercise the right to sell, sell the company's shares to investors at the agreed issue price, and obtain funds for financing. The biggest difference between the catastrophe rights to sell rights and contingent capital instruments is that when dealing with credit risk, the holders of catastrophe rights to sell rights will require investors to deposit guarantees, or the contingent capital instruments are passed through Information.

Catastrophe Bonds (CATBond; Catastrophic Insurance Bonds; Act-of-Godbonds): is an over-the-counter bond derivative that uses the bond market to diversify the risk of securitization to insure insurance companies and reinsurers that suffer catastrophe losses The company transfers its own risk of catastrophe loss to market investors, and the investor's return depends entirely on whether the agreed catastrophe loss occurs. If the original insurance company wishes to reinsurer in this way, it is no different from buying a traditional reinsurance contract from the perspective of the spin-off company. Therefore, it is welcomed by insurance companies that are accustomed to traditional methods, and has become the most widely used catastrophe insurance derivative.

The key to catastrophe insurance derivatives is the trigger condition. Generally, there are three types: loss trigger, index trigger and pure parameter trigger:

(1) Loss trigger: The actual loss of the issuing company is used as the trigger condition. Catastrophe bonds provide protection only if the issuing company's losses meet the trigger conditions. For example, in 1997, a catastrophe bond issued by USAA through ResidentialRe stipulated a trigger condition of a hurricane of level 3 or higher, causing the company to suffer losses of more than $ 1 billion.

(2) Index triggering: Use independent institutions, such as the PCS Index reported by the PCS, as trigger conditions. Issuers gradually accepted the use of losses across the insurance industry rather than their own companies to determine default criteria. For example, the SwissRe California earthquake catastrophe bond issued by the Cayman Islands reinsurance company, in which the California earthquake risk is measured by the entire insurance industry's PCS index, solves the problem of moral hazard, but when the issuing company's own losses and the insurance industry Basis risk is introduced when overall losses are not coordinated.

(3) Pure parameter trigger: Some parameters of special catastrophe events that can be objectively evaluated (such as the magnitude, intensity and epicenter of the earthquake, wind speed, propulsion speed, and landing place of the hurricane) are used as trigger conditions. For example, in December 1997 Tokyo Marine & Fire issued a catastrophe bond worth US $ 90 million through ParametricRe. The selection of trigger conditions requires a balance between moral hazard and basis risk. The first trigger condition has a low basis risk and can best meet (re) insurers' requirements for full compensation for claims losses. It is most closely related to insurance technology, but for capital market investors, this trigger condition is the most difficult. Understanding, the most moral hazard. The second triggering condition is closely related to insurance technology, which reduces or dissipates moral hazard to a large extent, but brings a certain basis risk to bond issuers and cannot fully reflect the (re) insurance compensation principle. The third trigger condition has the largest basis risk. On the surface, it has no direct relationship with insurance technology and cannot reflect the (re) insurance compensation principle. In addition, there are trigger mechanisms such as model loss and parameter index. Among the catastrophe insurance derivatives issued before 2001, the first trigger conditions accounted for 56%, the second triggered 24%, and the third triggered 8%.