There are a lot of interesting dynamics in this market.
For example, CAT bonds are generally tied to the specific natural hazard ("this bond triggers if a hurricane of Category 3 or higher land falls in this segment of Florida") or to industry losses, as estimated by an agreed upon source.
This means that a CAT bond is correlated with, but not directly informed by an insurer's actual loss experience. Traditional reinsurance (so an insurer themselves getting insurance) will usually be tied to specific policies, so their experienced loss is what determines payout.
However, depending on the insurer's policies, traditional reinsurance may be unavailable or much too expensive (either due to the large limit needed, the risk level of the policies, or any number of other reasons). Depending on the trigger, a CAT bond can also pay out faster because you don't have to wait to see the claims from 100k home insurance policies.
From the technical side, most large reinsurers license CAT modeling software from one or both of the same two vendors: Moody's RMS or Verisk. The biggest reinsurers will develop their own models, and there
are other modeling vendors that they may license for particular perils (EQEcat for earthquake and KatRisk for flood come to mind), but the big two are pretty widely accepted in reinsurance markets.
That means if your policies are "odd" in some way (uncommon construction type, power facility, etc.), depending on how a reinsurers chooses to model them (or how the model specifically handles them) can have a big impact on your reinsurance pricing. If you know something about your policies that can't be incorporated into a vendor model very well, you may get better pricing on a CAT bond.
These are just some of the considerations! There are so many more things that go into it. But I think it's super interesting to think about.
Source: I work in this side of the industry, specifically in natural catastrophe modeling.
Correct on every point and great insight, hello fellow insurance person.
I will clarify that CAT bonds can have industry loss triggers OR actual indemnity triggers. If an indemnity trigger then the insurer has to prove the actual loss. But you’re right on ILWs (Industry Loss Warranty) in that there is additional model/basis risk considerations.
Insurance companies try to minimize this basis risk. Because while sure it’s great to be in the situation where your CAT bond recovers when you didn’t have large losses, it’s NOT good to be in the position where you had big losses and you don’t recover. Certainty of recover can affect things like how much regulatory credit you get for your reinsurance.
Curious what major trends you’re seeing in your line of work. Guessing global warming induced increase in weather related hazards in some places - anything that would be surprising to people outside the industry?
Having worked on reinsurance software in the 90s, one question that springs to mind, which came to light from the asbestos claims era, was brokers commission. What did happen was brokers would package up risks and sell those off (taking commission) which would see other brokers bundle those up and again package them and others up into a bundle and sell those off. So when a claim came down the line, that was huge, like the asbestos claim in period https://en.wikipedia.org/wiki/Lloyd%27s_of_London which saw such a diluted risk and brokers commission leaching all profit, brought many down financially due to exposure.
So interested how things are today regarding brokers endlessly packaging up risks they sell on, rinse repeat. I'm aware of certain changes that came about to reinsurance brokers in both the Lloyds and London Markets on the back of the asbestos claim era, but not sure of the the CAT model risks/insurance regarding brokers endlessly packaging up to offset risk exposure vs regulations limiting how much they can do that - more so the USA market.
So curious - is there a risk from brokers diluting risks for commission profits in this market or is that saftly covered against and regulated?
> CAT bonds are generally tied to the specific natural hazard ("this bond triggers if a hurricane of Category 3 or higher land falls in this segment of Florida") or to industry losses, as estimated by an agreed upon source.
A big part of the reason for this is that if payout is tied to actual loss, it starts to look a lot like actual insurance, which is specifically not what you want. Because while anyone* can buy a bond, only insurers or reinsurers can write insurance. This is something that needs to be considered whenever an insurer (or anyone, really) tries to transfer risk to a non-insurer.
I've asked two financial advisors about CAT bonds. One had never heard of them and the other said were about as risky as crypto. I guess this is such a niche product that there isn't widespread knowledge about it.
I wonder how much more diversified $ILS could be if it were larger. Would a 10x increase in assets under management give it significantly less volatility because it could do a better job spreading risk around the globe?
The lack of information was my inspiration for building Riskvest. I called my own broker and when I said catastrophic bonds they asked if I meant buying bonds already in default.
On the risk side - your comments here are part of the myth I’m trying to dispel and will have lots more to say in future posts.
Yes for a single CAT bond you are exposed to potential 100% principle losses. But if you buy a bundle of CAT bonds that focus on say California Earthquake, Florida Hurricane, Japanese Typhoon, and a Cyber Event, you can imagine the diversification benefit you get there.
I’ve already created a very very simple model for people to play around with and learn the intuition for CAT bond return patterns. A default means 100% loss and this is unique vs. other bonds. I plan in the future to build a much more robust model.
There are institutional funds but generally it’s a small market with very limited retail presence. Schroders has one. (Artemis is a great source of info in the space - niche trade publication.)
It has been growing slowly for the past 25 years. The limited market size is a reflection of the demand by traditional insurers and reinsurers, for alternative sources of capital. This is as it should be.. when traditional players start transferring risk to the capital markets motivated by the fees involved, or cheaper rates (premium), then you really start worrying about moral hazard i.e. ‘bad risks’ getting transferred to investors.
For the web designers here please let me know if you noticed anything amiss. Ive had particular issues getting captchas working so please comment if you run into that issue.
Thanks for sharing your insight. Wouldn't hurt from a proofread. There are some typos / wrong words, that detract from the sense of authority lent by the article. Eg:
"It's clear that we this structure" --> with
"with out those protections in place" --> without
"Investors would be best to limit their exposer to losses beyond their investment" --> exposure
There might have been others, I had to go back and skim to summarize for you.
So, did the Covid 19 pandemic force multiple insurance companies into insolvency?
Also, what does new product development look like for industries like this? How does one search for new financial products? Is it possible for a non-expert to come up with new products in this space?
Are there any books you can recommend for a novice?
While Covid 19 was certainly a "Catastrophe", the market for pandemic insurance in 2020 was minuscule and to my knowledge did not cause any insurer solvency issues. There were a few cases of insurers being instructed to pay out significant claims by the courts on Business Interruption losses which the insurers argued were not covered due to existing policy exclusion.
Product development is usually highly specialized as there are a lot of nuances and frictions within the insurance industry that outsiders may not fully understand. It helps also to be in the industry and have the network with insurers, reinsurers, brokers, etc. This is not at all to suggest there isn't room for clever people to bring innovation to the market though!
Book recs are hard to specify for CAT bonds but for insurance in general:
Against the Gods: The Remarkable Story of Risk - Peter L. Bernstein
The Black Swan - Nassim Nicholas Taleb
On the Brink: How a Crisis Transformed Lloyd's of London - Andrew Duguid
In the end there's always someone left holding the can. Lloyd's of London has underwriters with unlimited liability. Incredibly, a lot of these Names have historically been private individuals. In the 90s a lot of these lost their shirts (and their homes) when they dicovered that it wasn;t just an easy source of passive income. https://www.theguardian.com/money/2000/nov/04/business.perso...
I'm not aware that these currently exist but the concept of reinsurance on reinsurance is not new (it's called retrocession). I will do some digging and see what I can find - thanks for the suggestion.
antasvara|5 months ago
For example, CAT bonds are generally tied to the specific natural hazard ("this bond triggers if a hurricane of Category 3 or higher land falls in this segment of Florida") or to industry losses, as estimated by an agreed upon source.
This means that a CAT bond is correlated with, but not directly informed by an insurer's actual loss experience. Traditional reinsurance (so an insurer themselves getting insurance) will usually be tied to specific policies, so their experienced loss is what determines payout.
However, depending on the insurer's policies, traditional reinsurance may be unavailable or much too expensive (either due to the large limit needed, the risk level of the policies, or any number of other reasons). Depending on the trigger, a CAT bond can also pay out faster because you don't have to wait to see the claims from 100k home insurance policies.
From the technical side, most large reinsurers license CAT modeling software from one or both of the same two vendors: Moody's RMS or Verisk. The biggest reinsurers will develop their own models, and there are other modeling vendors that they may license for particular perils (EQEcat for earthquake and KatRisk for flood come to mind), but the big two are pretty widely accepted in reinsurance markets.
That means if your policies are "odd" in some way (uncommon construction type, power facility, etc.), depending on how a reinsurers chooses to model them (or how the model specifically handles them) can have a big impact on your reinsurance pricing. If you know something about your policies that can't be incorporated into a vendor model very well, you may get better pricing on a CAT bond.
These are just some of the considerations! There are so many more things that go into it. But I think it's super interesting to think about.
Source: I work in this side of the industry, specifically in natural catastrophe modeling.
rrjjww|5 months ago
I will clarify that CAT bonds can have industry loss triggers OR actual indemnity triggers. If an indemnity trigger then the insurer has to prove the actual loss. But you’re right on ILWs (Industry Loss Warranty) in that there is additional model/basis risk considerations.
Insurance companies try to minimize this basis risk. Because while sure it’s great to be in the situation where your CAT bond recovers when you didn’t have large losses, it’s NOT good to be in the position where you had big losses and you don’t recover. Certainty of recover can affect things like how much regulatory credit you get for your reinsurance.
rogerrogerr|5 months ago
Zenst|5 months ago
So interested how things are today regarding brokers endlessly packaging up risks they sell on, rinse repeat. I'm aware of certain changes that came about to reinsurance brokers in both the Lloyds and London Markets on the back of the asbestos claim era, but not sure of the the CAT model risks/insurance regarding brokers endlessly packaging up to offset risk exposure vs regulations limiting how much they can do that - more so the USA market.
So curious - is there a risk from brokers diluting risks for commission profits in this market or is that saftly covered against and regulated?
NoboruWataya|5 months ago
A big part of the reason for this is that if payout is tied to actual loss, it starts to look a lot like actual insurance, which is specifically not what you want. Because while anyone* can buy a bond, only insurers or reinsurers can write insurance. This is something that needs to be considered whenever an insurer (or anyone, really) tries to transfer risk to a non-insurer.
blakepelton|5 months ago
I wonder how much more diversified $ILS could be if it were larger. Would a 10x increase in assets under management give it significantly less volatility because it could do a better job spreading risk around the globe?
rrjjww|5 months ago
On the risk side - your comments here are part of the myth I’m trying to dispel and will have lots more to say in future posts.
Yes for a single CAT bond you are exposed to potential 100% principle losses. But if you buy a bundle of CAT bonds that focus on say California Earthquake, Florida Hurricane, Japanese Typhoon, and a Cyber Event, you can imagine the diversification benefit you get there.
I’ve already created a very very simple model for people to play around with and learn the intuition for CAT bond return patterns. A default means 100% loss and this is unique vs. other bonds. I plan in the future to build a much more robust model.
https://www.riskvest.io/data-lab/cat-bond-portfolio-simulato...
jbs789|5 months ago
https://www.artemis.bm/ils-fund-managers/schroder-investment...
bvan|5 months ago
olooney|5 months ago
rrjjww|5 months ago
For the web designers here please let me know if you noticed anything amiss. Ive had particular issues getting captchas working so please comment if you run into that issue.
rkagerer|5 months ago
"It's clear that we this structure" --> with
"with out those protections in place" --> without
"Investors would be best to limit their exposer to losses beyond their investment" --> exposure
There might have been others, I had to go back and skim to summarize for you.
bradly|5 months ago
The images some of the visuals do not show in reader view in Safari and Firefox. Other than that, the content is well laid out and very readable.
trevithick|5 months ago
Cool article, it's a clear explanation of something I never knew about.
nilirl|5 months ago
Also, what does new product development look like for industries like this? How does one search for new financial products? Is it possible for a non-expert to come up with new products in this space?
Are there any books you can recommend for a novice?
rrjjww|5 months ago
Product development is usually highly specialized as there are a lot of nuances and frictions within the insurance industry that outsiders may not fully understand. It helps also to be in the industry and have the network with insurers, reinsurers, brokers, etc. This is not at all to suggest there isn't room for clever people to bring innovation to the market though!
Book recs are hard to specify for CAT bonds but for insurance in general:
Against the Gods: The Remarkable Story of Risk - Peter L. Bernstein
The Black Swan - Nassim Nicholas Taleb
On the Brink: How a Crisis Transformed Lloyd's of London - Andrew Duguid
The last one is a personal favourite of mine
ascorbic|5 months ago
jbs789|5 months ago
Some businesses had business interruption insurance which paid out. Many policies exclude highly correlated events such as pandemics.
And then think about specific events which were cancelled, which may have bought policies protecting them if cancelled.
And of course life insurance and health care would have been affected.
SwissRe often produces public reports in the space if of interest:
https://www.swissre.com/risk-knowledge/building-societal-res...
quantum2022|5 months ago
I think you could also have specific pandemic insurance, and that paid out, but those were rare before Covid.
dan-robertson|5 months ago
cosmic_quanta|5 months ago
rubyfan|5 months ago
Mistletoe|5 months ago
nenenejej|5 months ago
fragmede|5 months ago
OgsyedIE|5 months ago
rrjjww|5 months ago
quantdev1|5 months ago
rrjjww|5 months ago
rrjjww|5 months ago
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