how do your odds really stack up in nature's casino?

By: Alexander Pui

How do your odds stack up in Nature’s Casino?

Global Catastrophe Losses (1970 – 2013)

H. Katrina (2005)

Japan/NZ EQ, Thai Floods

(2011)

Northridge EQ (1994)

Source :Swiss Re Economic Consulting and Research

Global Catastrophe Losses (2015)

Who pays for these losses?

• 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…)?

Who pays for these losses?

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

Outline

• 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?

Short Primer on Reinsurance

Primer on Traditional Reinsurance (TRI)

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)

Protection against adverse volatility

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%

Profi

t / L

oss

Probability

Holistic ApproachDistribution of Profit/Loss

Percentiles

Profi

t/Lo

ss

Caps Max loss at $400m

When does reinsurance make ‘economic sense’?

$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%

ILS instead of TRI‘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

Overview of the ILS Market

Growth of the Cat Bond Market

• 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)

Growth of Cat Bonds and Other ILS

• 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.

2015 ILS issuance by Peril

• 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

ILS growth outpaces traditional RI

• 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)

Pricing and Structuring of Cat Bonds

Idealized Cat Bond Structure

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

Agencies• Rating Agencies

Pricing of underlying peril risk*

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.

Relevant Catastrophe Model OutputEx

ceed

ance

Pro

babi

lity

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 estimatesXSAAL

Hypothetical Cyclone Based Cat Bond

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

Bond ‘Trigger’ considerations 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

Addressing Adverse Selection

• 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

Circumventing uncertainty in model loss estimates

• 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

Examples of ‘exhausted’ Cat Bonds

List of losses to investors

Source: Insurance Information Institute (Aon Benfield)

Failure of Swap Counterparty

Who pays for these losses?

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.

Muteki (USD 300m)

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

Muteki (USD 300m)

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.

Muteki (USD 300m)

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

Mariah Re (USD 200m)

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)

Mariah Re (USD 200m)

• 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

Mariah Re (USD 200m)

• 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.

Will investor appetite continue to grow?

Will impressive historical performance continue?

• 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

Factors impacting future prospects

• 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

Alexander PuiEmail: alexpui8@gmail.com

Linkedin : https://au.linkedin.com/in/alexander-pui-94a33821

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