What is a Catastrophe Bond?

Catastrophe bonds are bonds that are linked to the designated catastrophe losses by issuing proceeds, transferring some of the catastrophe risk of insurance companies to bond investors. In the capital market, special intermediate agencies (SPRVS) are needed to ensure that insurance companies can receive timely compensation in the event of catastrophes, and to ensure that bond investors receive investment income that is linked to catastrophe losses. The important condition is conditional payment, the so-called compensatory trigger condition and exponential trigger condition.

Catastrophe bond

The compensatory triggering condition is expressed by the actual amount of compensation for losses. It was widely used in the early catastrophe bond market to reduce the company's

Unlike traditional reinsurance arrangements, catastrophe bonds are issued through the capital market, so for risk transferers, they have the following advantages:

Relatively speaking, the issuance of catastrophe bonds also has the following disadvantages:

High transaction costs. Because bond transactions involve investment banks, full financial guarantees, trusts, actuarial and pricing, etc., transaction costs are high.

May affect stock prices. The details of the bond transaction easily lead to the release of relevant information, which may affect the decline in the share price of the risk-taking company.

Low investment leverage. Catastrophe risk investors must provide a 100% guarantee.

The transaction relationship lasts only during the contract period. Unlike the traditional long-term relationship between reinsurance and reinsurance companies, all transactions are terminated during the period, and the relationship between buyers and sellers is also terminated. There is no subsequent relationship.

Investors are unfamiliar with catastrophe risks. Not all institutional investors are familiar with the reasonable price of catastrophe risk and the calculation of property insurance loss compensation, so they cannot fully spread to investors in the capital market.

In the 1990s, some investment banks, brokers, and reinsurance companies developed a derivative of OTC insurance. This type of security is not traded on an exchange. It is traded like forward contracts or options that meet customer needs. Some people view this securitized catastrophe reinsurance as a high-yield bond; others call it a similar single-term product. This product spreads catastrophe risks through the capital market, specifically, by issuing bonds that link income to a specified underwriting loss, transferring some of the insurance company's underwriting risk to bond investors. If the specified underwriting loss exceeds a certain limit within the agreed period, the principal and interest income of the bond investor will be used to make up for the underwriting loss of the insurance company exceeding the limit; if the specified underwriting risk loss does not exceed this limit, the bond investor may Get a higher return than the risk-free interest as compensation for bearing the corresponding underwriting risk.

An insurance company with catastrophe risk can choose a special purpose agency as the company's capital market intermediary. This special purpose agency is usually undertaken by an offshore reinsurance company to obtain tax and financial benefits. A Special Purpose Re-insurer provides reinsurance to an insurance company, and the insurance company pays the reinsurance fee to the Special Purpose Reinsurer, and issues bonds to the capital market through the Special Purpose Reinsurer. The special purpose reinsurer puts the funds from the bond issuance in a special account and invests in high-yield, low-risk securities. At the same time, it is responsible for paying the investors with interest from the reinsurance fees they receive. If an agreed loss occurs in the insurance company during the contract period, the special purpose reinsurer shall make corresponding compensation in accordance with the contract.

When an insurance company signs an agreement for the issuance of catastrophe risk bonds with the issuer, the bond issuance process can be divided into six stages.

Phase 1: Identifying / assessing risks

Define the catastrophe risks borne by bond issuance, and select an appropriate risk assessment model. In practice, it is usually carried out by professional risk assessment companies, such as EQE, AIR, etc.

Phase 2: Structure of Securities Issuance

According to the individual needs of risk transferers and the domestic or regional financial and insurance laws and regulations of the issuer, a bond issuance structure and form that meets regulatory requirements is designed, such as whether SPR is in the form of an insurance company or reinsurance company.

Phase 3: Review and assessment

Before the catastrophe bond issuance, an accountant or lawyer will make an assessment report on the financial status of the reinsurance company, the operating status of the original underwriting contract, the content of the reinsurance risk, and the financial status of the SPR company.

Phase 4: Document preparation

Write the contents of the bond contract issuance, the main contents include the rights and obligations of the issuer and investors, investment taxes, risk transfer content, loss calculation, etc.

Phase 5: Bond Credit Rating

International credit rating companies (such as Standard & Poor's, Moody's, etc.) provide catastrophe bond credit rating information as a reference for investors to contract and purchase bonds.

Phase 6: IPO

It is usually handed over to an investment bank or securities company, which is responsible for the underwriting of bond issuance and listing.

Since the launch of the catastrophe bond in 1994, the insurance securitization market has successfully launched several cases, and many of them have been unsuccessful after the launch. Under the promising future development prospects, large international investment banks, reinsurance companies, insurance companies, investors, etc. have actively invested a lot of manpower in research and development, hoping to create more attractive demand for risk transferers and investors Of commodities to expand the underwriting capacity of the catastrophe bond market.

Based on past advice from Marsh & Mclennan Securities in New York, successful catastrophe bonds should have the following:

First, the risk of bondization must be priced. Bonded catastrophe risks must be priced, and catastrophe risks must be priced by an impartial third party. Therefore, the orderer must be a reputable, professional, and fair pricing organization in the market, and at the same time be able to publicize the relevant catastrophe forecast report at any time, make the process of risk pricing transparent, and reduce the generation of moral hazard .

Second, the size of the bonds must be appropriate. The cost of the bond issuance process is high, such as the cost of setting up the SPR, professional consulting fees such as lawyers, accountants, actuaries, risk pricing costs of the pricing agency, and administrative costs. These costs are fixed costs, so regardless of the size of the bond, the related issuance costs required will not be much different, so how to find the appropriate issue unit under fixed costs is very important, that is, when The larger the number of issues, the lower the average relative cost.

Third, the design of bond issuance must meet the needs of risk transferers. The breadth of catastrophe risk underwriting and the design of risk underwriting claims mechanisms must meet the needs of risk transferers at the same time. Because the content of bond risk exposure directly affects the bond rating, and the level of bond rating is also an important factor in determining whether a buyer purchases or not, the appropriate risk commitment and bond rating must be determined at the time of bond issue design. For example, the catastrophe bonds issued by USAA, although issued in the same time, can be designed into two different ratings of ClassA-1 and ClassA-2 securities to meet investors with different needs.

In fact, judging from the contents of all catastrophe bond transactions in the market, almost all bond underwriting risks can be found in the traditional reinsurance market with alternative reinsurance contracts, and the underwriting conditions may be superior to catastrophe bonds. The price may also be lower, but the reinsurance company has the risk of insufficient solvency or even bankruptcy. Unlike catastrophe bonds, which are fully guaranteed, the credit risk of the transaction is almost zero.

Even so, when catastrophe markets show soft prices, catastrophe bond prices may be higher than traditional reinsurance, and underwriting conditions may be worse than traditional reinsurance. Market positioning should be limited to supplementing the deficiencies of traditional reinsurance. When a rigid market comes, it can be used as another channel and method to diversify catastrophe risks.

As mentioned earlier, SPR plays a very important role in catastrophe bond issuance. Therefore, it is very important for the competent authorities to regulate the operation of SPR through relevant regulatory regulations in order to achieve the function of management supervision at the same time, thereby simplifying the procedures for establishing SPR companies. As far as Bermuda, Cayman and other places are concerned, the relevant regulatory laws and regulations basically provide a low-cost and easy-to-setup legal structure for SPR founders to attract more international companies to establish SPRs here.

Taking the development of US catastrophe bonds as an example, compared with the laws and regulations in Bermuda, Cayman Islands and other places, US state regulators are also actively seeking the establishment of practitioners SPR, and have started to pass related laws, such as ) Insurance regulation has passed the Protected Cell Company Act, which allows insurance companies to issue catastrophe bonds on the market through the established Protected Cell Company Act, and this bill is also approved by the National Association of Insurance Supervisors (Insurance Commissioners, NAIc), therefore, in the future, insurance companies will be able to issue catastrophe bonds in the United States more easily without having to transfer to foreign countries such as Bermuda, Cayman Islands, etc., and the establishment of the protection unit company will be replaced by this The establishment of SPR in the past.

In addition, the National Association of Insurance Supervisors (NAIC) adopted a typical law for protection unit companies at the end of 1999. This model law will serve as the norm for future states to engage in catastrophe securitization procedures, which clearly set out the relevant specifications for the establishment of protection unit companies. Therefore, it is foreseeable that the issuance market for insurance risk securitization will grow rapidly in the future.

Catastrophe risk bonds have many advantages. For insurance companies, they are:

Potential resources are sufficient. Catastrophe risk bonds are an innovative tool in the capital market. It is issued to various investors who are active in the capital market. At present, investors in catastrophe risk bonds are basically large institutional investors. It is foreseeable that small and medium investors will become an important part of catastrophe risk bond investors in the future.

can solve the basis problem, this is an effective way to resolve the catastrophe risk of insurance companies. Insurance companies use catastrophe insurance options for hedging and cannot avoid the issue of basis spreads. For issuing catastrophe risk bonds, as long as the insurance company determines the appropriate "trigger conditions" (generally related to the catastrophe loss situation of the company that chooses to issue), the above-mentioned basis problem can be avoided.

For investors, the advantages of catastrophe risk bonds are:

Small risk and high yield. The "triggering conditions" stipulated in the contract have a low probability of occurring within the contract term, generally less than 1%. However, research shows that the yield of catastrophe risk bonds is generally 3-4 percentage points higher than that of corporate bonds with the same level of risk.

It helps institutional investors to further diversify risks. The yield of catastrophe risk bonds depends on the "trigger conditions" of catastrophe risk bonds (ie, the occurrence of specific catastrophe events, the magnitude of losses, etc.), which is not related to economic trends, changes in the economic situation, and catastrophe risks. Bonds have no effect. According to Markwitz's portfolio theory, the lower the correlation between various investment instruments in a portfolio, the lower the risk of the portfolio. Therefore, investing in catastrophe risk bonds can optimize the investment portfolio and stabilize investment returns.

Of course, catastrophe risk bonds also have shortcomings, such as higher costs and lack of liquidity, but the overall market prospect is relatively broad and the development potential is relatively large. The underwriting ability of a country's insurance industry, especially the risk of catastrophe risks, is one of the important indicators to measure the competitiveness of the country's insurance industry: the greater the underwriting ability, the stronger the competitiveness of the insurance industry; through catastrophe securitization, The insurance market and the securities market are interconnected, capital in the capital market is used by insurance companies, insurance risks are transferred to the capital market, and the underwriting capacity of insurance companies is therefore enlarged. China should adapt to international trends in the development of the insurance industry and implement catastrophe risk securities in a timely manner To improve the underwriting capacity of the Chinese insurance industry, and thereby enhance the international competitiveness of the Chinese insurance industry.