Key takeaways
- Catastrophe bonds using industry-loss triggers have become increasingly popular among ILS investors and cedant sponsors.
- Industry loss catastrophe bonds pose less adverse selection risk from the point of view of investors, but basis risk must always be factored in.
- Payouts under industry loss catastrophe bonds have the potential to be timelier given the inherent neutrality of the trigger than under an indemnity catastrophe bond, giving certainty for stakeholders.
Catastrophe bonds which use industry-loss triggers are becoming increasingly popular among ILS investors and cedant sponsors.
Industry loss cat bonds – overview of benefits and drawbacks
Catastrophe bonds which use industry-loss triggers are becoming increasingly popular among ILS investors and cedant sponsors. In Q4 2023, industry loss cat bonds increased their share of the overall cat bond market by 7% to 29%, with roughly $1.6bn in outstanding issuance. This compares to a year-on-year decrease in the use of indemnity cat bonds where total issuance fell from 75% to 67%, with around $3.7bn of outstanding issuance1.
ILS investors favour them because, unlike catastrophe bonds which use an indemnity trigger, any payouts on the bond are not linked to the cedant's underwriting. Where an indemnity cat bond relies heavily on the underwriting and claims management of the cedant sponsor, an industry loss cat bond focuses on the level of reported industry losses and the associated probabilities of those losses attaching. As a result, it can be said that an industry loss deal could pose less adverse selection risk to investors than in comparison with an indemnity cat bond.
The inherent neutrality in the payout of an industry loss deal by comparison with an indemnity deal is the reason why it generally takes less time with for an industry loss cat bond to see a payout to a cedant following a qualifying loss event. Avoiding any delays to recoveries is a significant advantage from a cedant's perspective, and it also gives earlier certainty to an ILS investor's position, giving them more time to make informed investment decisions.
What are the key features of the Bermuda transformer vehicle used on a cat bond?
For the transaction to proceed, a special purpose or transformer vehicle must be established. The vehicle of choice in Bermuda for cat bonds is usually the Special Purpose Insurer (SPI). SPIs tend to invite more flexible regulatory oversight by the Bermuda Monetary Authority (BMA) because (among other things) the reinsured liabilities of an SPI are fully collateralised and the investors participating on the transaction are sufficiently sophisticated. An SPI can be registered by the BMA in short order, with a three-business-day turnaround by the BMA for applications made to licence restricted SPIs whose cedants are specified to the BMA within the application.
The SPI acts as the conduit between the investors and the cedant sponsor. It acts as both the issuing entity for the notes under an indenture and the reinsurer or retrocessionnaire, depending on the underlying business of the cedant, to the cedant sponsor under a reinsurance or retrocession agreement.
The indenture provides that the SPI will issue notes to investors and pay interest on those notes, usually on a quarterly basis, into a note payment account held for the benefit of investors throughout the term of the notes. These interest payments are the premium payments made by the cedant to the SPI (as reinsurer) under the reinsurance agreement in return for the coverage provided to the cedant thereunder. The cash proceeds of the notes from investors are deposited into a trust account up to the full limit of reinsurance purchased, with such account being held for the benefit of the cedant and investors only being granted a residual interest.
The funds in the trust account are typically invested in relatively liquid assets, usually US Treasury Money Market Funds (MMFs). At maturity, providing there are no qualifying losses which give the cedant the right to hold back collateral, the investments in the trust account are liquidated and the outstanding principal amount is returned to investors by the SPI.
As the SPI is typically owned by an orphan purpose trust, it has the benefit of providing off-balance sheet protection to the cedant. It is also generally considered to be bankruptcy remote as SPIs will typically include limited recourse language in the relevant documentation which limits an investor's recourse to certain specified assets of the SPI, and with no right of action available against the cedant, and the directors of the SPI are independent of the cedant. Due to the orphan trust ownership of an SPI, neither investors nor cedant are likely to consolidate the SPI for accounting and tax purposes, though this will need to be assessed by relevant accounting and tax advisers in each case.
What is made up of the yield on an industry loss cat bond?
The yield an investor can expect to receive on a cat bond is made up of the interest received on the collateral in the trust account, usually a floating rate of interest from US Treasuries held in MMFs, and the risk premium paid by the cedant sponsor under the reinsurance agreement.
The risk premium is predominantly made up of two key facets:
- the expected loss on the bond (considering the industry exposure databases, the covered area, the franchise deductible amount, the payout factors used, the attachment and exhaustion points and the output from catastrophe models licensed by the cat modelling agency engaged on the transaction); and
- a spread over and above the expected loss which is derived from the outcome of the marketing and book building phase with investors.
The risk premium paid will be fixed in the first year, regardless of a loss event which has the effect of reducing the outstanding principal amount to zero. This mechanism enables investors to be guaranteed a full year of premium as compensation for their loss of principal.
In subsequent annual risk periods, unless the cedant elects to reset the layering of the bond, the risk premium paid will only be adjusted to the extent there are qualifying losses which reduce the outstanding principal amount on the notes. The risk premium payable by the cedant to investors is reduced in proportion to any reduction in the outstanding principal.
How does a cedant make a recovery under an industry loss cat bond?
Firstly, there must be a covered event within the risk period, such as a named storm or earthquake occurring within a specific territory or region), reported by an agency which collects industry loss data.
Secondly, the size of the covered event,as adjusted by payout factors, must equal or exceed a franchise deductible amount. The franchise deductible is set at a level high enough to prevent the bond from being exposed to attritional losses. For example, if the franchise deductible is set at $10m and there is an event reported which settles at $5m, there will be no qualifying event. It is only where loss event exceeds the franchise deductible threshold can they be counted for the purposes of any possible recoveries by the cedant within an annual risk period.
Thirdly, the covered event must exceed the applicable attachment level within an annual risk period. This is determined by the reports or catastrophe bulletins provided by the reporting agency and verified by the cat modelling agency. When it does, a payment can be made from the trust account into an account held for the benefit of the cedant, known as the 'excess account'. If the cedant can demonstrate that they have incurred ultimate net loss (UNL), which includes loss reserves and loss adjustment expenses, in addition to paid losses, they can make a recovery under the funds deposited in the excess account.
Importantly, the cedant need not demonstrate that it has incurred UNL in relation to the covered event in question and so it can be UNL arising from any covered event which occurs within an annual risk period to enable the cedant to make a withdrawal from the excess account. If there remains a balance in the excess account at the end of the risk period, the reinsurance coverage is automatically reinstated and kept open either for a predefined period or in perpetuity until the cedant can show it has incurred UNL in relation to any loss event occurring after the end of risk period.
Without the excess account mechanic in place, we understand that the cedant sponsor would have to account for the transaction as a derivative and so it is used mainly to give the cedant the desired accounting treatment that it needs to obtain regulatory capital relief, though this assessment will always need to be made by relevant accounting advisers.
Payout factors are used to better align the industry losses reported on by the reporting agency with the underlying exposure of the cedant. These factors are put together by the cedant sponsor in conjunction with the cat modelling agency at the outset of the transaction and they are designed to mirror the cedant's underwriting portfolio. When there is an industry loss event that qualifies for recovery under the bond, the monetary amount of such industry loss event is applied against these payout factors to deliver a result that is closer to the underlying loss experience of the cedant sponsor. Even though these factors enable the cedant to reduce its basis risk, it does not eliminate it entirely.
It is worth noting that when an industry loss occurs, it may take some time for it to eventually settle and there are instances where a reported loss ends up being lower than originally estimated by a reporting agency. When this happens it may mean that any funds which have been deposited into the excess account following a qualifying loss event will need to be returned to the trust account. Any shortfalls in the excess account must be made whole by the cedant but only to the extent that those shortfalls represent previous loss payments made to the cedant by the SPI under the reinsurance agreement.
What happens in a reset of an industry loss cat bond?
For the first annual risk period, the attachment and exhaustion level are usually set by the cat modelling agency working in conjunction with the cedant sponsor, the latter which is concerned to purchase protection that fits within its outwards reinsurance strategy. In a subsequent annual risk period, the layering is adjusted automatically by the cat modelling agency to take account of any changes in the industry loss data. If the exposure increases during the first annual risk period, the attachment level is commensurately increased to maintain the same level of risk that was agreed by investors at the outset of the transaction. The reverse is true if the exposure decreases.
Prior to each subsequent annual risk period, the revised layering is presented to the cedant by the cat modelling agency. The cedant is then given the option to adjust the layering as well as the payout factors. A cedant may wish to amend these features to ensure that the reinsurance provided through the cat bond is better aligned with its underlying portfolio as well as to ensure a better fit with its outwards reinsurance programme for that year.
If the cedant does elect such a reset, the attachment and exhaustion levels will be adjusted albeit subject to certain limitations: the attachment and exhaustion points must fall within a pre-agreed range and the modelled contribution to expected loss must be limited by certain pre-agreed risk tolerances. A typical example of a reset limitation would be limiting the modelled contribution to expected loss in certain regions/territories in any given reset. An example of this is a limit on the amount of expected loss that can derive from Florida hurricanes and California earthquakes – both of which are peak exposures in the reinsurance and ILS community. These limitations prevent the cedant from moving too far away from the original deal agreed with investors and it keeps the cedant honest by preventing any changes to the payout factors which align wholly to their Florida windstorm and/or California earthquake exposure.
Once the layering is set, the cat modelling agency will run a calculation of the risk premium that will be payable by the cedant for the subsequent annual risk period. The general rule is that the lower the attachment point, the more risk premium the cedant will be obligated to pay in the subsequent annual risk period because the probability of losses attaching will have increased. The reverse is true should the cedant opt to increase the attachment level. These premium calculations are subject to the updated expected loss on the bond being within a pre-determined range of the initial expected loss calculated at the outset of the deal. This ensures that the risk profile of the underlying exposure remains relatively consistent with the original deal terms from the investors' perspective.
What happens in an extension?
An extension will arise when there have been losses on the notes that require a portion of the collateral in the trust account to be held back beyond the maturity date of the notes to allow enough time for those losses to develop. It is the cedant that makes the election to extend and, often, a cedant will usually exercise the option if there has been a late loss event which occurs towards the end of the risk period.
The spread a cedant will pay on the notes during an extension is typically lower than the amount payable during the risk period because the risk period will have ended and so the bond will not be on risk. The amount of spread payable will vary however, and this will depend on the type of extension exercised by the cedant as well as the amount of remaining outstanding principal which is not loss affected.
In an extension, the qualifying loss event(s) are augmented by certain multiples (so-called 'Threshold Factors') to determine a notional amount of loss. These Threshold Factors decrease over time as the loss event develops. If the loss has the potential to either attach at the layer or it has moved into the layer, the cedant will be able to elect a type of extension which allows them to pay a lower spread on the amount of loss affected principal. This is usually 50 basis points for losses approaching the attachment point and 10 basis points for losses above the attachment point, albeit these spreads are subject to change based on market dynamics.
If there is no way of determining how a late occurring loss will settle - for example, a loss event occurs towards the end of the risk period and it is too early for the reporting agency to provide an event report showing industry losses for such loss event) - the cedant may choose to extend and pay a relatively higher spread on the outstanding principal. This isusually between 250 and 300 basis points depending on the market to allow for a potential recovery when the event is reported on by the reporting agency.
A relatively new extension mechanic was introduced in 2022 to deal with investors' concerns over trapped collateral. It requires cedants to pay a higher spread on the amount of retained collateral which is unlikely to be paid out. This is in turn derived from the application of the previously mentioned Threshold Factors. As the loss event, as augmented by the Threshold Factors, develops, the amount of loss impacted principal is gradually decreased because the Threshold Factors reflect a decreasing set of multiples linked to the duration of time since the date of such loss event.
The effect of these decreasing multiples is that portions of the loss impacted principal become unimpacted. In the investors' eyes, the cedant should be required to pay more for keeping the relevant unaffected collateral in the trust account. As a result, the unimpacted outstanding principal becomes subject to a relatively higher spread payable by the cedant, usually between 250 and 300 basis points depending on the market. The result of this new extension mechanic is that it encourages a return of principal by the cedant to investors thereby mitigating, to a degree, the trapped collateral concerns of investors.
Final thoughts
Industry loss cat bonds are fast becoming a vital tool in the ILS market thanks to advantages like faster payouts and reduced adverse selection risk compared to indemnity-triggered cat bonds. As their market share grows, so too does the opportunity for investors to use these bonds for greater returns.
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