Catastrophe Risk Analysis, Mitigation & Securitization

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Catastrophe Risk Analysis, Mitigation and Securitization

Please also see the Guide to Weather Risk Analysis Page.

NYMEX Catastrophe Risk (CAT risk) Index Futures - National Index

NYMEX Catastrophe Risk (CAT risk) Index Futures - Florida Index

Catastrophe insurance and reinsurance provides coverage for large-scale hazards / severe, widespread disasters. The interest and transfer of some of that risk to investors as an alternative to reinsurance companies has led to the growth of the catastrophe risk-linked securities market (the experience and acceptance by investors of the catastrophe market has also led to the securitization of life insurance risks). The market has grown in the past several years as reinsurers were reducing property catastrophe capacity but were increasing prices for the coverage they were writing: this attracted new capital sources into the market.

The issuers of catastrophe risk-linked securities includes insurance companies, reinsurers, corporations and government agencies.

The investors in catastrophe risk-linked securities includes large institutional investors, hedge funds, pension funds, bond funds and other insurance / reinsurance companies.

The cost to the issuer is the annual interest rate on the bond or cost of a derivative product. Secondly, it eliminates the credit risk that a reinsurer counterparty might defaulted on a claim in the future.

The primary risk for the investor is that the occurrence of a pre-defined natural or manmade disaster will "trigger" (indemnity, index or parametric) the full or partial payout of the principal in order to pay the claims. While the frequency of the actual occurrence of the event may be low, if it does occur then the result could be quite severe resulting in a substantial loss of life and property that would require the full amount of the principal. However, prior to the occurrence of an event, the security is usually collateralized by Treasury securities thus investors are exposed only to the risk of a disaster, not to the underlying credit risk of the issuer.

The loss probability index / model, which would be used to determine whether a principal loss to the noteholders has occurred, is usually developed by either RMS (Risk Management Solutions Inc.) or Equecat, both known as the Calculation Agent in the structure of the transaction. There may also be a separate Measurement Agent that collects data after the occurrence of an event.

Catastrophe Bonds

Catastrophe Bonds (CAT Bonds) are issued to investors who receive interest payments on the bonds but asume the risk that an event will not take place as scheduled (terrorism coverage) or a natural disaster will occur (hurricane, earthquake, typhoon, etc.), which results in a destruction of property. These bonds are sometimes issued by an insurance company who cannot purchase enough reinsurance for a particular coverage thus issues a Cat Bond for the balance. Reinsurers also issue Cat Bonds to cover some of the potential liabilities that they are holding. The bonds are also issued directly by a corporation or organization as an alternative to traditional insurance / reinsurance coverage when insurance companies decline to issue and insurance policy or the premium cost is prohibitive to the client. Thus, the capital markets step in to function as a long-term insurer / reinsurer. During 2004, hedge funds became very active investors in Cat Bonds.

Catastrophe securities have been issued to provide coverage for property damage, event cancellation or reinsurance of a portfolio of existing residential / commercial earthquake, flood, hurricane or windstorm property damage policies caused by:: Japan earhtquake; California earthquake; California fires; California landslides; European windstorms; North Atlantic hurricane; Japan Typhoon; U.S. hurricane; U.S. tornado; Extreme mortality; Terrorism

The bond(s) is sold to investors but is held by a Special Purpose Vehicle (SPV, usually an offshore location), as Trustee on the behalf of both parties.

Investors are typically paid LIBOR plus a spread compatible with the level of the risk of the potential event actually occurring. The pricing is derived by extensive financial modelling that attempts to predict the severity and likelihood / frequency of the event(s). As the risk is high the interest rate is high, approximately 5.0% to 15.0%, depending on the event covered, and investors in these type of instruments have a high tolerance of risk.

There is not a very active secondary market for this type of bond, sometimes there is some trading activity just prior to a storm making landfall but owning and trading these bonds requires very sophisticated storm / event modeling to determine if an event is really going to transpire or not.

The bond(s) also typically has a fixed maturity, approximately 3 to 5 years (on average 4 years). The payout of the bond is based on a "trigger event", which is a level of appraised damage reaches a certain index.

There can be more than one tranche of the bond with each tranche paying out only based on different damage indexes being breached (for instance, certain wind speeds being recorded by independent weather stations and exceeding an index or the recording of seismic activity by several independent stations), or there is an occurrence of more than one catastrophe(s) during the term of the bond issue (for instance, an earthquake occurs in year 2 and then another earthquake in year 4 of a 5-year term.

The payout structure of a bond could result in a partial or one hundred percent loss of the principal by the investor(s) if the event(s) occur. Thus, catastrophe bonds are also sometimes referred to as Principal-at-Risk Variable Rate Catastrophe-Indexed Note. Some SPVs securitize several types of natural catstrophe risk (earthquake, hurricane and windstorm) into a pool and bond issue.

Sponsors / Issuers of cat bonds have included: American Re, AXA Cessions, Converium Ltd., Hannover Re, Hartford Fire Ins. Co., Lehman Re, Montpelier Re, Munich Re, Oil Casualty Insurance, Ltd., PXRE, SCOR, Scottish Re, Swiss Re, USAA, Zurich Re. Two recent issues in 2007 include:

Blue Wing, Ltd.

Blue Wing Ltd. is a Principal At-Risk Variable Rate risk securitization program managed by Allianz Global Corporate & Specialty, which closed April 2007. The USD $150 million (rated BB+, 3 month Libor + 315 bp) has 2 tranches:

river flood events in the United Kingdom (first catastrophe bond that covers river flood in the United Kingdom; the index for flood is based on flood depths that will be calculated in more than fifty locations across the United Kingdom)

earthquake events in Canada and the US excluding California (first catastrophe bond that covers earthquakes in Canada)

GlobeCat, Ltd.

GlobeCat Ltd. is a Principal At-Risk Variable Rate risk securitization program managed by Swiss Re Capital Markets, which closed on December 31, 2007. The USD $85 million of securities has 3 tranches which cover:

CAQ - windstorm events in the United States (USD $25 million, rated Ba3; 3 month Libor + 210 bp)

USW - earthquake events in the United States (California; USD $40 million, rated B3; 3 month Libor + 925 bp)

LAQ - earthquake events in Central America (the first issuance ever linked to Central American earthquakes in Guatemala and El Salvador; USD $24 million, rated Ba3; 3 month Libor + 210 bp).

Property Catastrophe Risk Options

Each instrument trades a different type of catastrophe risk which can be specified by location (California, Texas and Florida being the three high risk areas), peril (hurricane, tornado or earthquake), and time of year.

Property catastrophe options are standardized financial instruments traded through the Chicago Board of Trade.

But with catastrophe options, an underlying asset does not exist, so an index is used in lieu of an asset price.

This index is an estimate of the industry's total claim payments for catastrophes occurring within the contract period and specified period.

The buyer of a call option receives a payoff if the industry claims exceed the amount specified by the strike price.

Liquidity risk is a concern with property catastrophe options due to low trading volumes.

The credit risk faced by all participants is minimized by the Chicago Board of Trade clearinghouse.

Catastrophe Risk Swap

In a Catastrophe Risk Swap, two insurers swap a set dollar amount of 2 different and separate types of catastrophe risk with eacother (for example, swapping $100 million of east coast U.S. hurricane risk for for an equal amount of Japan earthquake risk).

Industry-loss Warranty

An industry-loss warranty is a short-term form of insurance / reisurance, which can be written for a specific event (and within a specific geographic area). An industry-loss warranty can also be issued rather quickly such as when a storm is already approaching.

Catastrophic Risk Insurance Facility (CRIF)

The Catastrophic Risk Insurance Facility is a pilot program by the World Bank, which provides insurance coverage to small nations for natural disasters such as hurricanes and earthquakes.

Small nations, particularly island nations, are at a disadvantage as the entire island is affected thus it is not possible that one region of the nation could assist the affected region as geograpically larger nations are capable of doing.

Secondly, given the size of the small nation's economy, the small nation has limited means to access the international capital markets.

Thus, the CRIF is designed to provide insurance coverage by creating a fund that smaller states could draw on while they are waiting for direct bilateral and multilateral assistance.

The facility would be created with assistance from donor countries which would contribute to its initial capitalization and then the nations that partiicipate in the Facility are also required to pay an annual premium (based on their own specific exposure) in order to create additional reserves.

It is anticipated that the Facility would purchase additional coverage on behalf of the client countries through the reinsurance market or by issuing catastrophe bonds.

For instance, the United Kingdom, Canada, France, Japan and the EU provided the start-up capital for a facility, the Caribbean Catastrophe Risk Insurance Facility (CCRIF), to provide insurance coverage to Caribbean nations during the annual hurricane season. The purpose of the facility is to provide these nations (Anguilla, Antigua and Barbuda, the Bahamas, Barbados, Belize, Bermuda, British Virgin Islands, the Cayman Islands, Dominica, Grenada, Haiti, Jamaica, Montserrat, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Trinidad and Tobago and Turks and Caicos Islands) with an immediate cash payment after the occurrence of a major hurricane while traditional assistance from nations and international organizations is still in the developmental phase.

Information Sources

Please also see the Guide to Weather Risk Analysis Page.

Association of State Floodplain Managers www.floods.org/

California Department of Forestry and Fire Protection www.fire.ca.gov/index.php
California Department of Forestry and Fire Protection, Current Fire Information cdfdata.fire.ca.gov/incidents/incidents_current

California Earthquake Authority (CEA) www.earthquakeauthority.com/

California Governor's Office of Emergency Services www.oes.ca.gov/

Florida Division of Emergency Management www.floridadisaster.org/

U.S. Department of Homeland Security, Advisory System www.dhs.gov/xinfoshare/programs/Copy_of_press_release_0046.shtm

U.S. Department of Homeland Security, Daily Open Source Infrastructure Report www.dhs.gov/xinfoshare/programs/editorial_0542.shtm

U.S. Federal Emergency Management Agency (FEMA), 2008 Federal Disaster Declarations www.fema.gov/news/disasters.fema

U.S. Federal Emergency Management Agency (FEMA), Definitions of FEMA Flood Zone Designations msc.fema.gov/webapp/wcs/stores/servlet/info?storeId=10001&catalogId=10001&langId=-1&content=floodZones&title=FEMA%20Flood%20Zone%20Designations

U.S. Forest Service, Wildland Fire Assessment System (WFAS) www.wfas.net/

U.S. Geological Survey, Advanced National Seismic System (ANSS) earthquake.usgs.gov/research/monitoring/anss/

U.S. Geological Survey, Earthquake Hazards Program earthquake.usgs.gov/

U.S. Geological Survey, Earthquake Notification Service sslearthquake.usgs.gov/ens/

U.S. Geological Survey, Latest Earthquakes in the USA - Last 7 days earthquake.usgs.gov/eqcenter/recenteqsus/

U.S. Geological Survey, Latest Earthquakes in the World - Last 7 days earthquake.usgs.gov/eqcenter/recenteqsww/

U.S. Geological Survey, National Earthquake Information Center (NEIC) earthquake.usgs.gov/regional/neic/

U.S. Geological Survey, Natural Hazards Gateway www.usgs.gov/hazards/

U.S. Geological Survey, Seismic Hazard Mapping, Western United States earthquake.usgs.gov/research/hazmaps/products_data/2007/maps/wus/

U.S. Government Accountability Office (GAO), Climate Change: Financial Risks to Federal and Private Insurers globalwarming.house.gov/tools/assets/files/0088.pdf (.pdf format)

U.S. Government Accountability Office (GAO), Status of Efforts to Securitize Natural Catastrophe and Terrorism Risk www.gao.gov/new.items/d031033.pdf (.pdf format)

U.S. Government Accountability Office (GAO), U.S. and European Approaches to Insure Natural Catastrophe and Terrorism Risks www.gao.gov/new.items/d05199.pdf (.pdf format)

U.S. NASA, Earth Observatory, Natural Hazards earthobservatory.nasa.gov/NaturalHazards/

U.S. NOAA, NOAAWatch / All-Hazard Monitor www.noaawatch.gov/

U.S. NOAA, West Coast & Alaska Tsunami Warning Center wcatwc.arh.noaa.gov/

U.S. NOAA / National Weather Service, National Fire Weather Page fire.boi.noaa.gov/

U.S. NOAA / National Weather Service, Pacific Tsunami Warning Center www.prh.noaa.gov/pr/ptwc/

U.S. Support Anti-terrorism by Fostering Effective Technologies Act of 2002 (SAFETY Act) www.safetyact.gov/

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