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Just for fun: bonds anyone?

What is a 'cat bond?'

  • Total voters
I was reading something about this and I thought I'd share with you in a form of a question. I'll post the article (hints: from WSJ) later.
I'm not so sure the choices are worded correctly (A B )

From Investopedia:

A high-yield debt instrument that is usually insurance linked and meant to raise money in case of a catastrophe such as a hurricane or earthquake. It has a special condition that states that if the issuer (insurance or reinsurance company) suffers a loss from a particular pre-defined catastrophe, then the issuer's obligation to pay interest and/or repay the principal is either deferred or completely forgiven.

The first line tells me that these things pay a nice chunk of interest.

I would think this is priced as an option.

From Wikipedia

Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from the sponsor to the investors. They are often structured as floating-rate corporate bonds whose principal is forgiven if specified trigger conditions are met. They are typically used by insurers as an alternative to traditional catastrophe reinsurance.

For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then they might wish to pass some of this risk on so that they can remain solvent after a large hurricane. They could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or they could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, they would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of LIBOR plus anywhere from 3 to 20%. If no hurricane hit Florida, then the investors made a healthy return on their investment. But if a hurricane hits Florida and triggers the cat bond, then the principal initially paid by the investors is forgiven, and is instead used by the sponsor to pay their claims to policyholders.

I think our weather people (meteorologists?) may find a nice job pricing these bonds :)
My answer would be C. A structured product since the risk is "re-packaged" and re-distributed to investors for a premium.

Anyways, here is the article

Catastrophe Bonds Are Selling Briskly
As Insurers Seek Ways to Spread Risk
December 21, 2006; Page C1

Money managers are increasingly smitten with an unusual new asset class: hurricanes.

Hedge funds, pension funds and other money managers have invested more than $9.2 billion this year in disaster-related investments, including catastrophe bonds and "sidecars," which allow them to rake in millions of dollars if catastrophe losses are low, but can also risk the loss of their whole investment if hurricanes or earthquakes trigger massive claims.

This year's inflow to these securities more than doubles the $4.4 billion invested last year, according to preliminary figures from Goldman Sachs Group Inc. Trading volumes on so-called industry-loss warranties also are soaring.

Each of these quirky securities allows deep-pocketed investors to make bets on whether natural disasters will strike and cause large insurance claims.

Catastrophe bonds, usually issued by insurers or their reinsurers, pay investors above-average interest in return for the right to tap the cash behind the bonds if the disaster is severe or claims are high, according to preset yardsticks. Investors in sidecars backstop specific insurance policies -- agreeing to pay claims if needed -- in return for pocketing some of the premiums. A loss warranty is a contract that allows the seller to pocket a fee and in exchange pledges to make big payments to the buyer, usually an insurer, if claims industrywide exceed a certain level.

Wall Street's interest in these types of investments reflects, in part, demand among insurers for ways to spread their risks in the wake of the costly hurricanes of 2004 and 2005.

Reinsurers, who back the risks of insurance companies, found themselves needing capital to back big-ticket catastrophe policies this year, intensifying efforts to tap financial markets as another source of cash. For investors, catastrophes represent a shot at big returns that aren't closely correlated with other investments in areas like bonds and stocks.

"The rate of growth in the sector following Hurricane Katrina exceeded everyone's expectation," says Michael Millette, head of financial-institutions structured finance at Goldman Sachs in New York.

Sidecars, for instance, started up and quickly amassed billions of dollars.

And "wind risk" looks like an asset class that is set to grow. Recently, WL Ross & Co., run by billionaire investor Wilbur Ross, led the creation of a $360 million sidecar called Panther Re Bermuda Ltd. that will back a portion of policies written by an underwriting firm at the Lloyd's insurance market in London. It was Mr. Ross's second investment in a sidecar and the first ever approved by Lloyd's.

Although investments in the catastrophe-risk market have grown right through the recently ended, and tame, hurricane season, some forecasters say the coming season could be above average.

Of course, early forecasts can be off the mark -- there were similar fears about this year. And it's not clear that even steep losses would curtail interest in cat bonds, as they are known in the industry, and sidecars.

The cat-bond market dates to at least the mid-1990s. It has gone through several growth spurts, as other massive disasters spurred innovation and drew capital.

Cat-bond issuance wasn't slowed at all by record claims from Hurricane Katrina, which triggered losses on at least one cat-bond issued just a few months before the storm. In fact, cat-bond issuance over the following year set a record.

Insurers and reinsurers are looking for even more capital to back up policies. The steep price increases for catastrophe coverage that followed Katrina and other storms last year have made the chances of huge returns especially enticing for many investors.

While results vary, people in the insurance industry estimate some sidecar investors earned returns of more than 20% in the past year. Cat bonds now typically pay investors several percentage points above a benchmark interest rate known as the London interbank offered rate, or Libor. That rate is currently at 5.36%, with many investors earning yields up to -- and into -- the double digits.

With such high returns this year and hopes for high returns going forward, one concern is that funds might flock to the market and take on too much risk.

"Is there discipline among these investors? That's the question that we need to ask, and the one that will be answered," says Grahame Chilton, chief executive of British reinsurance brokerage firm Benfield, which has structured cat bonds for clients this year.

Indeed, executives at Lloyd's and elsewhere are quick to note that neither the losses in 2005 nor the lack of them this year is typical. "The guys who gambled this year have done well," says Rolf Tolle, who monitors the business plans and risks of underwriters at Lloyd's as the market's franchise-performance director. "But the first hurricane forecasts for 2007 have said they expect a higher-than-average storm season. So, we may not see the same returns on these securities."

Still, many investors are likely drawn by the cat securities' diversification benefits, as well as their potential returns. Cat bonds are "generally uncorrelated" with the financial markets, says John Brynjolfsson of Allianz AG's Pacific Investment Management Co., known as Pimco, a bond-investment firm that invests in cat bonds. By spreading their money across assets that don't move in lock step, investors can help insulate themselves from particularly steep losses in any single year.

Mr. Millette of Goldman Sachs says more and different types of cat securities may be on the way. His team is working on new structures for such securities, and others in the investment-banking and insurance worlds are doing the same.

Write to Ian Mcdonald at ian.mcdonald@wsj.com1 and Liam Pleven at liam.pleven@wsj.com2
I also voted C.

Insurance-linked structured notes are becoming very popular with investors, due to their uncorrelated nature w.r.t. to other securities in the capital market.
Cat Bonds and Other Insurance-Linked Securities

Cat bonds, or property catastrophe bonds, are fixed income securites. They are some of the first types of insurance-linked securities to appear in the marketplace. Now this seems to be a pretty hot area.

See a more detailed description of Cat Bonds on Wikipedia: http://en.wikipedia.org/wiki/Cat_bond. The info there is periodically updated and expanded by a number of contributors).

And no, these are NOT options, so the second choice is clearly incorrect. See more on it in the article referenced on the same Wikipedia page (Insurance Derivatives by Alex Krutov: http://www.fenews.com/fen51/one_time_articles/insurance-deriv/insurance-deriv.html).

Also, see website on Insurance Securitizations by Makoto Okubo (http://www.insurance-finance.com/re.htm). It is referenced on that same Wikipedia page too.

It is a structured product, so the third choice is correct.

Other insurance-linked securities seem to be growing faster than Cat Bonds. There has been a lot in the press about it lately. The WSJ article might not be a good example though. Too much hype.
Cat bonds, or property catastrophe bonds, are fixed income securites. They are some of the first types of insurance-linked securities to appear in the marketplace. Now this seems to be a pretty hot area.

See a more detailed description of Cat Bonds on Wikipedia: http://en.wikipedia.org/wiki/Cat_bond. The info there is periodically updated and expanded by a number of contributors).

And no, these are NOT options, so the second choice is clearly incorrect. See more on it in the article referenced on the same Wikipedia page (Insurance Derivatives by Alex Krutov: http://www.fenews.com/fen51/one_time...nce-deriv.html).

Also, see website on Insurance Securitizations by Makoto Okubo (http://www.insurance-finance.com/re.htm). It is referenced on that same Wikipedia page too.

It is a structured product, so the third choice is correct.

Other insurance-linked securities seem to be growing faster than Cat Bonds. There has been a lot in the press about it lately. The WSJ article might not be a good example though. Too much hype.
Munich Re Offers Synthetic Hurricane Notes
14 May 2007

Munich Re, a German reinsurance group, has closed a series of catastrophe notes, which synthetically transfer the risk of U.S. hurricane losses to global institutional investors. The series closed last week at $150 million--bringing the total securitization of hurricane risk to $200 million--and operates from a shelf structure that allows Munich Re to continually issue notes.

Rupert Flatscher, head of risk trading, said the securitization allows Munich Re to reduce exposure to extreme hurricanes, improve diversification in its portfolio and realize arbitrage gains. "It is important to securitize risks at the time it is executable," he said, explaining the timing was influenced by increasing investor interest for uncorrelated asset classes from U.S. and European institutional investors. He declined further comment on investor types. Munich Re also has securitized European windstorm risk and Flatscher said it would consider applying the strategy to other kinds of insured risks, but declined to specify which kinds it is considering.

The deal was arranged by Morgan Stanley and consists of total-return swaps on the note proceeds, referencing 26 eastern and southern U.S. states and Washington, D.C. The class E notes cover four storm seasons and pay an annual coupon of 1525 basis points over three-month LIBOR up to $35 billion losses. Losses between $35 billion to $45 billion result in scaled investment losses. Flatscher said Hurricane Katrina caused an insured market loss of over $40 billion in 2005.

Source: Total Securitization
It's from Business Insurance Magazine

`Mad scramble' for capital fuels cat bond market
By Rodd Zolkos
Though it's been slow developing, and some believed other alternative sources of reinsurance such as sidecars might supplant it, the risk-linked securities market is showing renewed vigor and increased interest in using bond structures to transfer risk to the capital markets.
Meeting last month in New York at the Bond Market Assn.'s Insurance & Risk-Linked Securities Conference, various parties involved in the market suggested activity in catastrophe bonds and other risk-linked securities has picked up due to last year's hurricane losses, a hardening catastrophe reinsurance market and, in general, more experience with the risk-linked security structures.
"The convergence of banking and insurance has started to happen," said Mark Azzopardi, chairman of the New York-based BMA's Risk-Linked Securities Committee and head of insurance and pensions within the global risk solutions team at BNP Paribas in London.
Alex Krutov, president of Navigation Advisors L.L.C. in New York and co-chairman of the conference, noted that while the BMA's last risk-linked securities conference 18 months ago focused almost exclusively on catastrophe bonds, this year-despite significant growth in that area of the market since last year's Hurricane Katrina-the 2006 conference also devoted considerable time to securitization of life insurance risks.
With regard to growth in the cat bond area, Christopher McGhee, managing director at Marsh & McLennan Cos. Inc.'s broker-dealer unit MMC Securities Corp. in New York, noted that when the group met in 2004, catastrophe bond volume was just over $1.14 billion. "Issuance was down, both in the number and in volume," Mr. McGhee said. At the 2004 conference, he said, "There was an informal theme from investors. It was, `Please bring us the deals.' There weren't enough."
In 2005 though, cat bond issuance rose to more than $1.19 billion, a record volume. And thus far this year, cat bond volume has already topped last year's record at nearly $2.10 billion.
The number of deals is up as well and more deals are in the pipeline, Mr. McGhee said. "I would guess we're surely at $3 billion in volume (in 2006), and we're more likely at the $4 billion level," he said.
Katrina effect
While there was just over $4.04 billion in cat bond principal outstanding at the end of 2004, by mid-June of this year, principal in the market stood at more than $6.1 billion.
"Why the sudden change? Obviously, it's Katrina," Mr. McGhee said. "But it's really the related effects from Katrina."
Changes in the way rating agencies are viewing insurer and reinsurer capital, changes in catastrophe models increasing the loss potential from hurricanes during the next decade and reinsurers reducing property catastrophe capacity while increasing price-with a particularly tight market for peak U.S. exposures-have all had an impact on ceding companies' search for cat capacity, Mr. McGhee said.
"We've seen the result that there has been a mad scramble for capacity," he said. "There has been this dramatic hunt and that has very much benefited the development of the cat bond market."
"There is a very large imbalance currently...in the supply and demand" for U.S. hurricane reinsurance, said Kevin Stokes, managing director at Guy Carpenter & Co. Inc. in New York. "The supply is going down by 25% and the demand is going up by a similar amount."
"The situation is that there is a huge need for additional capital, and everything is being explored: siAdecars, (industry loss warranties), swaps," Mr. Stokes said.
"The capacity shortage is there and there's a need for more capacity to satisfy clients' needs," Mr. Stokes said. In that environment, cat bonds are "certainly part of our conversation. It's building louder and louder," he said.
Transaction costs and complexity and basis risk-the risk that the coverage provided by the bond structure might not accurately match the issuer's loss experience-remain key stumbling blocks for many ceding companies considering the cat bond market, Mr. Stokes said. Still, for some, benefits such as access to new sources of capacity, the ability to obtain capacity for peak risk zones and the ability to lock in capacity and price over a multiyear period hold considerable appeal.
Offering the perspective he sees from small and regional insurers, Paul Little, executive vp and chief brokerage officer of Holborn Corp. in New York, said, "As we're sitting with a customer we'll certainly talk about the fact that there is basis risk involved that there isn't in traditional reinsurance."
"Obviously, traditional reinsurance is much more familiar to our clients," Mr. Little said. "But with so much that has been written about cat bonds, there is greater familiarity."
Relationships solid
While saying he sees a role for the risk-linked securities market to provide capacity for his clients to cover peak zone exposures, Mr. Little said he does not see it replacing the relationships his clients have developed with reinsurers that cover their many exposures besides property catastrophe. The loss experience of the next few years will determine how large that role will be, he said.
"The demand for capital markets participation in the insurance business is going to be directly tied, I think, to the events of the next 36 months," Mr. Little said.
MMC's Mr. McGhee noted that, in addition to increased volume in the risk-linked securities market, the market is broadening. While before this year it primarily consisted of U.S., Japanese and European exposures, this year there have been deals addressing Australian windstorm and earthquake and Mexican earthquake risks.
The market also has increased in sophistication, Mr. McGhee said, with increased use of shelf registrations and continued evolution of the indices that trigger bond payouts. "It's not all about cat bonds," he said in adding that other risks being securitized include third-party liability exposures, trade credit risks and auto insurance exposures.
Among the various risk-linked securitizations gaining interest on the life side are embedded value deals, according to Dan Ozizmir, managing director of Swiss Re Capital Management and Advisory in New York. While the embedded value deals are a small percentage of life securitizations to date, they are gaining momentum in Europe due to solvency capital rules, Mr. Ozizmir said, and are seeing increased interest in the United States.
"You're talking about transactions that really go to the heart of the business model of the life insurance company," Mr. Ozizmir said. The market will develop because of investor interest in the securities and the long-term benefits for a life insurance company, he said.
Those securities essentially involve determining the present value of a book of business, then structuring it in tranches and selling it to investors, explained John Kiernan, managing director and head of life securitization at Swiss Re Capital Markets in New York.
For life insurers, the transactions convert intangible assets to cash, improve capital adequacy and transfer risk to investors, Mr. Kiernan said.
A key benefit for insurers, Mr. Ozizmir said, is the ability to hedge excess mortality exposures, but "the market for the excess mortality right now is in a state of flux." Concern over an avian flu epidemic has increased the interest in the area, Mr. Ozizmir said. "I think what we're seeing in the extreme mortality market right now is we will see a very busy 2006," he said.
Investors speaking at the conference indicated that they'd like to see diversity in the types of risk-linked securities brought to the market continue to broaden.
"I think what we'd like to see now are second- or subsequent-event securities," said John C. DeCaro, portfolio manager at St. Francis, Wis.-based Stark Investments L.P.
Niraj Patel, a portfolio manager and investment leader at Genworth Financial Inc. in Stamford, Conn., agreed. "We'd like to see a more diversified slate of bonds," he said.
Nelson Seo, managing member and senior portfolio manager at Fermat Capital Management L.L.C. in Westport, Conn., said that while his firm doesn't focus on "pure diversification" in its risk-linked securities investments, he still thinks the market could benefit from more diversity in its offerings.
"Overall, the market, just for the health of the market, needs to see more non-U.S. wind right now," Mr. Seo said.
Asked if there are any risks he wouldn't take, Mr. Seo said, "We're pretty much open to any type risk."
"I don't know if the market is exactly ready for terrorism or things like that right now," he said. "It might take another year or two."
Regarding current cat bond pricing, which seems to be moving in step with catastrophe reinsurance pricing, Mr. Seo said, "Investors are profit-driven. A lot of the capacity now just moves between cat bonds and reinsurance."
While current cat bond yields are attractive vs. other comparably rated corporate debt, Mr. Patel said the market's still not large enough for investors to say "let's get out of corporate bonds and get into cat bonds."
Mr. Seo said he expects the risk-linked securities market to continue to see steady growth during the next five years, adding that it takes time to attract participants on both sides of the transaction to a new market.
Mr. Patel said he thinks that while it's difficult to predict the market's future, "I think one thing we can be sure of...is there's going to be innovative structures and structural improvements."
Stark Investment's Mr. DeCaro said he thinks Hurricane Katrina was a significant moment in the market's development. "Now we've reached the point where we've had a big property cat loss and I think the insurance and reinsurance markets have accepted the hedge funds and capital markets investors," he said.