Catastrophe Bond Market Research Articles

Storm CAT Bond: Modeling and Valuation

The frequency and intensity of weather-related catastrophes, such as storms and floods, have been increasing due to climate change. This leads to rising storm catastrophe risks to the property–casualty insurance and reinsurance sector. In this article, we propose an index-based storm catastrophe (CAT) bond for reinsurers to hedge catastrophe risks related to storm losses. Storm loss data have a large portion of zero values and a continuous positive right-skewed distribution, together with high-dimensional spatial dependence. We address these unique properties by proposing a general two-part autoregressive (2PAR) distribution as the marginal model and a semicontinuous spatiotemporal vine copula as the dependence model. We investigate the CAT bond market equilibrium and endogenously solve for the optimal market price of risk and coupon rates. Our empirical results using historical loss data at the county level in Florida show that the proposed CAT bond can stabilize the reinsurer’s cash flows and create attractive returns to investors by offering high coupon rates. Our framework can be generalized to design and price other catastrophe financing facilities.

Catastrophe bond pricing in the primary market: The issuer effect and pricing factors

COVID pandemic has highlighted the importance of hedging against catastrophic events, for which the catastrophe bond market plays a critical role. Our paper develops a two-level modelling and uses a unique, hand-collected dataset, which is one of the largest and most detailed datasets to date containing: 101 different issuers, 794 different bonds, spanning 1997–2020. We identify issuer effects robustly, isolating them from bond specific pricing effects, therefore providing more credible pricing factor results. We find that bond pricing and volatility are heavily impacted by the issuer, causing 26% of total price variation. We also identify specific issuer characteristics that significantly impact bond pricing and volatility, such as the issuer’s line of business accounting for up to 36% of total price variation. We further find that issuer effects are significant over different market cycles and time periods, causing substantial price variation. The size and content of our data also enables us to identify the counter-intuitive relation between bond premiums and maturity, and bond premiums and hybrid bond triggers.

Trading and liquidity in the catastrophe bond market

AbstractWe provide first insights into secondary market trading, liquidity determinants, and the liquidity premium of catastrophe bonds. Based on transaction data from TRACE (Trade Reporting and Compliance Engine), we find that cat bonds are traded less frequently during the hurricane season and more often close to maturity. Trading activity indicates that the market is dominated by brokers without a proprietary inventory. Liquidity is high in periods of high trading activity in the overall market and for bonds with low default risk or close to maturity, which results from lower order processing costs. Finally, using realized bid–ask spreads as a liquidity measure, we find that on average, 21% of the observable yield spread on the cat bond market is attributable to the liquidity premium, with a magnitude of up to 141 bps for high‐risk bonds.

A random forest based approach for predicting spreads in the primary catastrophe bond market

We introduce a random forest approach to enable spreads' prediction in the primary catastrophe bond market. In a purely predictive framework, we assess the importance of catastrophe spread predictors using permutation and minimal depth methods. The whole population of non-life catastrophe bonds issued from December 2009 to May 2018 is used. We find that random forest has at least as good prediction performance as our benchmark-linear regression in the temporal context, and better prediction performance in the non-temporal one. Random forest also performs better than the benchmark when multiple predictors are excluded in accordance with the importance rankings or at random, which indicates that random forest extracts information from existing predictors more effectively and captures interactions better without the need to specify them. The results of random forest, in terms of prediction accuracy and the minimal depth importance are stable. There is only a small divergence between the drivers of catastrophe bond spread in the predictive versus explanatory framework. We believe that the usage of random forest can speed up investment decisions in the catastrophe bond industry both for would-be issuers and investors.

Mid-term Climate Change Risk in Catastrophe Bond Market

Mid-term Climate Change Risk in Catastrophe Bond Market

Глобальный рынок катастрофного финансирования и перспективы его формирования в РФ

The article is devoted to the development of instruments for catastrophe risk financing. The state of the global market for disaster risk financing is analyzed in order to identify the main development trends and the possibilities of using conceptual approaches in the Russian practice of the financial market. It is proven that the development of the catastrophe bond market has prospects in conditions of permanent instability, since catastrophe bonds are unique and highly attractive due to the lack of correlation with macroeconomic events. It is suggested that the instruments of catastrophe risk financing can be considered in the context of the development of sustainable finance. The paper identifies the main problems slowing down the development of the Russian catastrophe bond market, and formulates proposals aimed at developing the market for insurance-linked securities (ILS) in the Russian Federation. Pilot CAT bonds emission prospectuses should be based on structured bonds, with elements of a subordinated bond. There is a need to introduce into the Russian legal field a term defining ILS as a category. It is proposed to register special purpose vehicles (SPVs) and catastrophe funds in Russian offshores. The Russian analogue of catastrophe funds should be a closed-end investment fund with high funding for qualified investors. It is proposed to update the formula for calculating the creation of and the procedure for using reserve funds, in particular with the use of catastrophe risk financing tools. A pilot issue of CAT bonds is proposed to be conducted on behalf of VEB.RF, as bonds sponsoring regions exposed to high natural risks. In the process of developing socially responsible investor practice and tools for socially responsible investments, it is suggested to establish a Russian “Green Index” and to create green ETFs in Russia. Due diligence (DD) approaches are recommended for decisions on issuing catastrophe bonds.

Exploring Inefficiencies in the Primary Catastrophe Bond Market: Focus on the Issuer Effect

Most catastrophe bonds issued in the primary market are sold by the same issuers every year, and within each year. Significant similarities in the bond characteristics are therefore anticipated, which ultimately leads to similarities in pricing for these bond issuers over time. In this paper, using a very rich database with primary catastrophe bond data from June 1997 to March 2020, and proposing a novel random intercept model, the variations in catastrophe bond premiums introduced by the differences between issuers are captured, analysed and found to be significant. The issuer effect appears to be stronger for smaller issuers, based on issue size; for less consistent issuers, based on years of issue in the primary market; and for issuers primarily conducting insurance business, as opposed to reinsurers and other multi-line issuers. Further, we identify the three independent factors that have the largest impact on premiums. Our results give strong evidence that the primary catastrophe bond market remains inefficient, and that factors external to the underlying risk might still impact premiums.

Hard markets, hard times: On the inefficiency of the CAT bond market

This study explores the existence of inefficiencies in catastrophe (CAT) bond secondary markets by investigating the impact of sponsor characteristics on the CAT bond premium. We show that the CAT bond market does not satisfy the demand for catastrophe risk transfer efficiently by revealing a significant effect of sponsor-related factors on the CAT bond premium. This inefficiency is particularly surprising given that a CAT bond isolates the insured risk from other sponsor-related risks through a special purpose vehicle. Remarkably, this inefficiency is even present among non-indemnity CAT bonds, which determine the payout through a mechanism that is exogenous to the sponsor. Our findings also reveal that sponsor-related pricing inefficiencies vary over time and are more relevant during hard and neutral phases compared to soft market phases. Among the sponsor-related determinants of the CAT bond premium are the sponsor's tenure, market coverage, rating, credit default swap spread, and his ability to issue innovative “on the run” CAT bonds.

Measuring the liquidity impact on catastrophe bond spreads

This study measures liquidity in the catastrophe (CAT) bond market and the liquidity premium embedded in CAT bond spreads. The empirical results show that time to maturity, yield volatility, and yield dispersion from the primary market are the three most effective liquidity proxies. Given these three proxies, the average estimated liquidity premium in the CAT bond market is 67.57bps, accounting for only 9.42% of the average CAT bond spread (717.37bps) in the secondary market during the period 2002-2016. The average CAT bond liquidity premium is higher than the corporate bond liquidity premium of a similar risk class by about 35bps during the pre-crisis period. The more significant part of the high-yield spreads, 90.58%, is attributed to other risk natures of CAT bonds. Lastly, the liquidity premium increases dramatically after occurrences of severe natural catastrophes as well as during the 2008 financial crisis.

CAT BOND PRICING UNDER A PRODUCT PROBABILITY MEASURE WITH POT RISK CHARACTERIZATION

AbstractFrequent large losses from recent catastrophes have caused great concerns among insurers/reinsurers, who then turn to seek mitigations of such catastrophe risks by issuing catastrophe (CAT) bonds and thereby transferring the risks to the bond market. Whereas, the pricing of CAT bonds remains a challenging task, mainly due to the facts that the CAT bond market is incomplete and that the pricing usually requires knowledge about the tail of the risks. In this paper, we propose a general pricing framework based on a product pricing measure, which combines a distorted probability measure that prices the catastrophe risks underlying the CAT bond with a risk-neutral probability measure that prices interest rate risk. We also demonstrate the use of the peaks over threshold (POT) method to uncover the tail risk. Finally, we conduct case studies using Mexico and California earthquake data to demonstrate the applicability of our pricing framework.

Catastrophe bond spread and hurricane arrival frequency

Catastrophe bonds are the most successful alternative risk transfer tools in transferring catastrophic insurance risk to capital markets. This research provides empirical insights about the predictive power of catastrophe bond spreads in forecasting catastrophe arrival frequency as a test of the catastrophe bond market’s price discovery efficacy. Primary-market data for cat bonds, catastrophe arrival frequency data for hurricanes and windstorms, and climate variable data for Atlantic Multidecadal Oscillation, North Atlantic Oscillation and CO2 change rate are collected over June 1997 to March 2013 to examine this power. The calibration results show that cat bond spreads convey valuable incremental information as measured by the Akaike Information Criterion. Furthermore, in an out-sample test for hurricanes prediction, merging the conventional climate variables approach with our market-based forward-looking predictions reduces prediction errors by about 3% over the sample period. As the catastrophe bond market continues to grow with increasing trading volume, a needed ingredient to enhance market efficiency, we would expect this measure of improvement to accentuate.

CAT Bond Spreads via HARA Utility and Nonparametric Tests

After deriving a new utility-based model for pricing catastrophe (CAT) bonds under hyperbolic absolute risk aversion (HARA), we propose two specification tests that use nonparametric estimation techniques to test simultaneously for all possible misspecifications. Existing pricing models, including our new one, are then estimated and tested using CAT bonds primary market data. The utility-based model we propose not only is well-suited for explaining the risk-return relation observed in the CAT bond market but also delivers the best performance among the tested models. We also provide new empirical evidence that the aggregate utility function of CAT bond investors exhibits decreasing absolute risk aversion.

Cat Bond Spreads: A New Model with an Empirical Validation Using Nonparametric Tests

Previous empirical studies on catastrophe (CAT) bond premium calculations rely almost exclusively on actuarial models, and usually compare their accuracy strictly in terms of in-sample t and predictive power. We contribute to this literature by deriving a utility-based specification for pricing CAT bonds under Hyperbolic Absolute Risk Aversion (HARA), and by proposing two specification tests that use nonparametric estimation techniques to test simultaneously for all possible mis-specifications. Various pricing models are then estimated and tested with data from the primary market for CAT bonds. Our results suggest that the utility-based model we propose not only is well-suited for explaining the risk-return relationship observed in the CAT bond market but also delivers the best performance among the tested models. We also provide new empirical evidence that the aggregate utility function of CAT investors exhibits decreasing absolute risk aversion.

Catastrophe Bonds-Regulating a Growing Asset Class

As the severity of natural catastrophes continues to intensify, disaster risk management is becoming increasingly important. In order to expand the capacity of the insurance markets, insurers and reinsurers have utilized alternative risk financing mechanisms such as catastrophe (CAT) bonds. Although the CAT bond market has increased recently, past CAT bond defaults have demonstrated that there are still concerns relating to contract documentation and the collateral structure of the bonds. This article argues that additional regulation that addresses these contracting problems and financial risks would facilitate greater use of CAT bonds. Regulatory change should also include industry-wide accounting and tax reforms that will further support risk management objectives and the growth of the market. If the CAT bond market continues to experience the growth that was witnessed in the past year and additional regulation is implemented, insurers, reinsurers and governments can benefit from the cost-effective protection that the instruments may provide in the event of a mega-catastrophe.

Introducing Alternative Capital to LongevityRisk Transfer

For years, the catastrophe bond market has garnered considerable interest from a variety of capital market investors, such as endowments, sovereign wealth funds, and family offices. Although investment in these catastrophe-linked securities has increased significantly over the last two decades, to date, capital market investors have participated in only a handful of longevity transactions. By drawing on lessons from the development of catastrophe bond market and from the few successful longevity transactions with capital market investors, this article considers a format in which longevity risk may be sustainably transferred into the capital markets in the future. <b>TOPICS:</b>Fixed income and structured finance, foundations &amp; endowments, risk management

Geographies of Securitized Catastrophe Risk and the Implications of Climate Change

This article analyzes the drivers and implications of catastrophe bonds’ growing popularity as an alternative asset class. As investor demand for bonds outpaces their supply from reinsurers, the study asks how the place-based physical vulnerabilities of fixed capital have been rendered into assets deemed increasingly desirable by growing blocks of financial capital. Combining data from extended interviews with industry datasets and market reports, the study demonstrates how this securitization pathway allows mobile capital on a search for yield to reframe spatial liabilities as tradable assets, thus accessing new “returns on place.” By aggregating and analyzing data on approximately $37 billion in catastrophe bond transactions since 1997, the study reveals both the ongoing concentration of capital in so-called “peak perils” such as U.S. hurricane and earthquake risks, and the fragmentation and recombination of peak perils to create new risk/return profiles. These purposive, scalable, and selective financial engagements with catastrophic risks depend upon the avoidance of the fixed costs and relational entanglements borne by (re)insurers. This ambivalent relationship with geographical liabilities is reaching its logical apogee in recent proposals to expand the catastrophe bond market to capitalize on growing climate change risks. This movement to “underwrite to securitize” intentionally emulates the “originate to securitize” model pioneered in mortgage-backed securities. This study argues that such developments could ultimately yield a built environment that is both more dependent on the state as an insurer of last resort and less adapted to climate extremes.

The Shareholder Wealth Effects of Insurance Securitization: Preliminary Evidence from the Catastrophe Bond Market

Insurance securitization has long been hailed as an important tool to increase the underwriting capacity for companies exposed to catastrophe-related risks. However, global volumes of insurance securitization have remained surprisingly low to date which raises questions over its benefits. In this paper, we examine changes in the market value of insurance and reinsurance firms which announce their engagement in insurance securitization by issuing catastrophe (Cat) bonds. Consistent with the hitherto underwhelming contribution of Cat bonds to global catastrophe coverage, we do not find evidence that Cat bonds lead to strong wealth gains for shareholders in the issuing firm. More importantly, we report large variations in the distribution of wealth effects in response to the issue announcement. We show that the wealth effects for shareholders in firms which issue Cat bonds appear to be driven by explanations according to which Cat bonds offer cost savings relative to other forms of catastrophe risk management (and less by the potential of Cat bonds to hedge catastrophe risk). Thus, abnormal returns are particularly large for issues by firms which face low levels of loss uncertainty (which reduces the information acquisition costs in financial markets) as well as for issues during periods when prices for catastrophe coverage (including Cat bonds) are low.

The Shareholder Wealth Effects of Insurance Securitization: Preliminary Evidence from the Catastrophe Bond Market

Insurance securitization has long been hailed as an important tool to increase the underwriting capacity for companies exposed to catastrophe-related risks. However, global volumes of insurance securitization have remained surprisingly low to date which raises questions over its benefits. In this paper, we examine changes in the market value of insurance and reinsurance firms which announce their engagement in insurance securitization by issuing catastrophe (Cat) bonds. Consistent with the hitherto underwhelming contribution of Cat bonds to global catastrophe coverage, we do not find evidence that Cat bonds lead to strong wealth gains for shareholders in the issuing firm. More importantly, we report large variations in the distribution of wealth effects in response to the issue announcement. We show that the wealth effects for shareholders in firms which issue Cat bonds appear to be driven by explanations according to which Cat bonds offer cost savings relative to other forms of catastrophe risk management (and less by the potential of Cat bonds to hedge catastrophe risk). Thus, abnormal returns are particularly large for issues by firms which face low levels of loss uncertainty (which reduces the information acquisition costs in financial markets) as well as for issues during periods when prices for catastrophe coverage (including Cat bonds) are low.

Longevity Risk from the Perspective of the ILS Markets

This paper compares and contrasts the evolution of the longevity risk transfer market with the development of the Catastrophe Bond Market, more formally known as the Insurance Linked Securities (ILS) Market. The ILS market is small; the longevity market is potentially enormous. The ILS market has been around for some 15 years; the Longevity market less than 5 years. The ILS market has had a heterogeneous approach to loss measures; the longevity market has striven for homogeneity. The ILS market has used security, i.e. bond, structures; the longevity market uses derivative, i.e. swap, structures. Nearly all ILS transactions cover “event” risk; nearly all longevity structures are “aggregate”. The paper reflects on these and other differences and speculates on the nature of the two approaches. The Geneva Papers (2011) 36, 501–515. doi:10.1057/gpp.2011.18

By Force of Nature: The Catastrophe Bond Market and Katrina

By Force of Nature: The Catastrophe Bond Market and Katrina