Insurance Linked Securities: Optimal Diversification of Catastrophe Bond and

Collateralized Reinsurance Portfolios Under Issuance Constraints

Seminar Paper at the Institute for Risk Management and Insurance LMU Munich

(Pro-)Seminar“Catastrophe Risk Management”

Winter Term 12/15

Instructor: Patricia Born, Ph. D.

First/Last Name Sean StephensTelephone Number 1-757-814-3946Address 1806 Westridge DriveCountry/State United States, FloridaPostal Code/City 32304 TallahasseeDegree BachelorNumber of Semesters 08

Submission Date 11/23/2015

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Contents

List of Abbreviations

1. Introduction

2. Accessing External Capital

2a. Types of ILS

3. Catastrophe Bonds

3a. CAT Bond Triggers

4. CAT Bond Market Overview

4a. CAT Bond Market History

4b. CAT Bond Market Size

4c. CAT Bond Issuances: Regions and Perils

5. Investor Perspective

5a. Investors in the ILS Market

5b. Investor Motivation for Purchasing ILS Products

5c. Returns and Price of CAT Bonds

5d. Liquidity

5e. Diversifying CAT Bond Portfolios

6. An Optimal Strategy For an ILS Portfolio

7. Summary

References

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List of Abbreviations

CAT bond Catastrophe bond

ILS Insurance Linked Securities

ILW Industry Loss Warranty

LIBOR London Interbank Offer Rate

SPR Special Purpose Reinsurer

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1. Introduction

The global insurance industry has become increasingly aware of the affect

that catastrophes can have on the insurance market and is constantly facing

increased exposure to natural catastrophes (Snyder & Horvarth, 1999). This

increased exposure is due to increases in property values and increases in the

number of properties in disaster prone areas (Wattman & Jones, 2007).

Catastrophes can have an undesirable level of predictability with respect to

frequency and severity, thus presenting the problem of insurers and reinsurers not

knowing how much capital to have in reserve to pay claims resulting from

catastrophes. Even if catastrophic loss events could be predicted, would the

insurance market have enough capital to finance a mega-catastrophe?

Past catastrophic loss events have demonstrated that traditional methods of

financing catastrophe risks do not cover the costs involved any more. As evidence

from the United States insurance market, ten record expensive catastrophes

occurred within quick succession between 1991 and 1995 decimating the bottom

line of insurers and causing the government to use tax dollars for disaster relief. To

further this claim, the Florida market following hurricane Andrew saw nine

insurance companies fail resulting in an estimated $500 million in unpaid losses

(Cashin, 1995). Even if these disasters were foreseeable it would prompt dramatic

increases in premiums, effectively rendering parts of the world uninsurable

(Mutenga & Staikouras, 2007).

From a paper written by Piccione in 1996, experts believed that reinsurance

capacity was grossly inadequate to cover large United States catastrophe losses. It

was estimated at the time that the amount of catastrophe reinsurance being

provided only accounted for 10% to 15% of the worst-case scenario.

An issue exists in providing coverage to serve the inadequate capacity;

insurers cannot always just buy more coverage because reinsurers often do not

have an appetite for large amounts of these catastrophic risks (Wattman & Jones,

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2007). This led to the realization that there is a need for new mechanisms to fill this

reinsurance capacity-gap (Piccione, 1996). As a result the insurance industry turned

to the capital markets for solutions.

2 Accessing External Capital

How can the insurance market access external capital? An innovative

solution to this problem has gained popularity in the past decade. Insurance-Linked-

Securities (ILS) are financial instruments that allow large investors the ability to buy

high layers of insurable risks in exchange for a return on investment. These financial

instruments include catastrophe equity puts, sidecars, catastrophe risk swaps,

industry loss warranties, and catastrophe bonds.

2a Types of ILS

Catastrophe equity puts provide the option to the insurer the ability to raise

emergency capital in the event of a catastrophic loss event. This financial device is

an option as opposed to an asset-backed security. In return for premiums paid to

the writer of the option, the insurer receives the option to sell preferred stock at a

pre-agreed upon price. The benefit to the insurer is they can issue the stock at a

favorable price when their stock price is likely to be depressed. However this

method can dilute the value of existing shares and is not common in the ILS market

(Cummins, 2011).

Sidecars more closely resemble traditional reinsurance. This method of

accessing the capital markets includes forming a special purpose vehicle that serves

to accept retrocessions from insurers and reinsurers. The sidecar is capitalized by

large private investors who subsequently receive premiums and pay claims based

on the contract. Sidecars allow insurers and reinsurers to move risks off balance

sheet, increase leverage, and increase capacity to write new business (Cummins,

2011).

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Catastrophe risk swaps are unique in the ILS market. Instead of having

investors provide capital, this risk-financing device is typically an agreement

between reinsures where they agree to ‘swap’ risks in the event of a loss. Reinsurers

try and find an agreement that achieves parity, meaning expected losses of the

swapped risks are equivalent. The benefit of this device is that reinsurers can access

more diversification through uncorrelated risks of the counterparty in the

transaction (Cummins, 2011).

Industry loss warranties (ILWs) do not traditionally provide liquidity in the

capital markets; however, they can be securitized and sold in the capital markets.

Reinsurers issue ILWs and payment of the warranty is based off of a dual trigger. In

order for the insurer buying the contract to get paid, the insurer’s losses most

exceed a certain threshold as well as an industry loss index exceeding a certain

threshold. One benefit includes being treated as traditional reinsurance for

regulatory purposes (Cummins, 2011).

Catastrophe bonds are the most successful alternative financing solution

compared to the previous methods. They are modeled after other asset-backed-

security transactions and provide event-linked coverage for high layers of

reinsurance protection (Cummins, 2011).

This paper seeks to provide a description of catastrophe bonds, an overview

of the catastrophe bond market, and an examination of catastrophe bonds from the

perspective of an investor; these topics have the goal of offering a basis to finally

suggest an approach for investors to optimally diversify a portfolio of catastrophe

bonds given the constraints in the catastrophe bond market.

3 Catastrophe Bonds

Catastrophe bonds (CAT bonds) are a security whose value is based on an

underlying insurable loss event and are issued primarily for high layers of

reinsurance protection covering catastrophic losses. High layer protection means

probability of occurrence is 0.01 or less. At this layer of protection insurers are

concerned with the credit risk of the reinsurers, CAT bonds are fully collateralized

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which effectively eliminates credit risk involved in the transaction. The protection

period for a CAT bond is typically three years compared to a standard reinsurance

transaction, which has a one-year policy. Insurers benefit from the multi-year

protection due to the ability to spread the fixed cost of issuing the bond over several

years as well as insulate themselves from fluctuating reinsurance costs (Cummins,

2011).

3a Catastrophe Bond Structure

The CAT bond begins by forming a special purpose reinsurer, or SPR. The

SPR is an entity separate from the insurer and the investor involved in the bond

transaction. Proceeds from the bond are invested into a collateral account, with

assets limited to the contractual constraints, but usually the assets are safe, short-

term securities such as government or AAA rated corporate bonds. The CAT bond,

which is held in trust with the SPR, is embedded with a call option that is triggered

by a specified catastrophic event. Investors are paid a premium spread in exchange

for holding the catastrophic risk exposure and the proceeds from the investments

are swapped for the floating London Interbank Offer Rate, or LIBOR, in order to

protect the investor and insurer from interest-rate risk. The principal in the CAT

bond is usually fully at risk, meaning that in the event of a sufficiently large defined

catastrophe, the investor could loss the entire investment (Cummins, 2011).

CAT bonds can be structured to pay out to insurers in several different ways

by having different types of triggers. A trigger, in the context of a CAT bond, is the

pre-defined criteria embedded in the bond that states under what conditions the

CAT bond begins payments to the insurer. Deciding on which trigger to use is

essentially a trade-off between moral hazard and basis risk (Cummins, 2011).

Although the market is continually evolving and new types and combinations of

triggers have been used, we will discuss the three most common triggers in the

market.

3b CAT Bond Triggers

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The first and most popular type of trigger, with $15.1 billion in CAT bonds

outstanding or 61% of CAT bonds outstanding (Artemis, 2015), is the indemnity

trigger. A CAT bond using this type of trigger will begin payment once the

sponsoring (re-)insurer’s losses exceed a certain level, from a specified event, in a

specified region, and a specified line. (Re-)Insurers prefer this method because it

reduces their basis risk, or the risk that their expected recovery from a risk transfer

method differs from the actual recovery (Willis, 2015, 2015). However, investors do

not favor this type of trigger due to the lack of transparency because they have

limited access to the insurer’s detailed book of business, as well as the existence of

moral hazard. With an indemnity trigger the insurer has no incentive to take care in

underwriting (MacMinn & Richter, 2007), and should a loss event occur and losses

come close to the defined threshold for payment by the bond, the insurer has an

incentive to overpay claims to reach the payment threshold (Cummins, 2011). Most

bonds do contain a copayment provision to control moral hazard but it is still a

residual concern for investors.

Coming in second place, at $4.6 billion in outstanding CAT bonds or 18.7% of

CAT bonds outstanding (Artemis, 2015), is the industry loss index trigger. CAT

bonds using this trigger payout based on losses exceeding a pre-determined

attachment point in an industry-wide loss index (Swiss Re, 2011, 2015). Sponsors

tend to dislike this type of trigger because it exposes them to basis risk if their losses

exceed that of the market. Investors on the other hand prefer this method for its

ability to reduce adverse selection because insurers cannot selectively cede its most

problematic risks and its ability to increase transparency because investors can

better predict losses for the industry compared to an individual insurer’s book of

business.

Lastly, with $1.95 billion in outstanding CAT bonds or 7.9% of CAT bonds

outstanding (Artemis, 2015), is the parametric trigger. CAT bonds using this trigger

payout based on the physical characteristics of a catastrophe, including severity and

location (Swiss Re, 2011, 2015); an example could be the CAT bond pays out if a

category-3 hurricane makes landfall in Florida. This type of trigger usually has the

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most basis risk and least moral hazard (Cummins, 2011). Basis risk can be reduced

by carefully defining geographic regions and catastrophic event severity that

corresponds to the sponsor’s book of business.

There are other types of triggers; examples include modeled loss indices and

hybrid triggers. Also variations of the triggers mentioned above exist, examples

include pure parametric triggers, parametric index triggers, and weighted industry

loss index triggers. Currently there is no consensus on which trigger type is optimal;

the amount of each trigger issued varies year-to-year depending on whether

investor demand or issuer supply is the key market driver (Risk Management

Solutions, 2012, 2015).

4 CAT Bond Market Overview

This section of the paper will provide an overview of the CAT bond market. It

will tell the story of the CAT bond market from a time series perspective, showing

its evolution from its inception to the current market conditions in mid-year 2015.

The overview will track the CAT bond market’s evolution by examining the early

history and motivation for its inception, CAT bond market size overtime, and

issuance trends overtime.

4a CAT Bond Market History

Interest in accessing securities markets for financing future catastrophic

events grew after the devastating impact of hurricane Andrew in 1992. Several

attempts to securitize insurable risk were met with little success. Eventually the

first successful CAT bond was issued, it was an $85 million issue by Hanover Re in

1994 (Cummins, 2011).

Several years later the 2005 hurricane season saw the first publicly

announced total loss of principal. A US$190 million bond issued in July 2005 by

Kamp Re apparently paid out its entire principal as a result of hurricane Katrina

claims. The bond was an indemnity trigger and the short-term affects of this

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wipeout caused investors to be increasingly wary of indemnity based transactions.

However, the long-term affects resulted in overall increased demand by both

sponsors and investors because the smooth settlement of the CAT bond reduced

uncertainty in the marketplace (Cummins, 2011).

Since its inception CAT bonds have seen robust growth (Risk Management

Solutions, 2012, 2015). In the initial years of the CAT bond market it was critiqued

for having low investor interest (Cummins, 2011). As the market matured investor

interest increased dramatically, in 2014 significant investor inflows resulted in the

highest issuance in market history, $9.4 billion, which is a 41% increase over the

previous year (Aon Thought Leadership, 2014, 2015).

4b CAT Bond Market Size

The market size of outstanding CAT bonds and issuances has shown

promising growth since its beginning. This section examines the size of the market

over time in order to provide investors with information pertaining to their ability

to assume the CAT bond market will still be available as an investment in the future.

Total volume of on-risk CAT bonds reached an all time high of $23.5 billion

at month end June 2015. This represents an increase of almost $1 billion compared

to last year. The total volume has increased every year since 2011 where total

volume was $11.5 billion (Aon Thought Leadership, 2015, 2015).

Issuances of CAT bonds during the 12-month period ending in June 2015 saw

the third largest annual issuance in market history totaling $7 billion dollars. The

issuance is ultimately down 26% from the previous year however due in part to

increased competition from traditional reinsurers and collateralized reinsurance

players reacting to the competition of the CAT bond market (Aon Thought

Leadership, 2015, 2015). Overall the CAT bond market is showing signs of maturity

and has proven to be stable over the course of its history.

4c CAT Bond Issuances: Regions and Perils

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Over time the CAT bond market has grown to cover various perils in various

regions. However CAT bond issuances have been limited in terms of the locations

and perils covered to so called ‘peak perils and regions.’ This section examines CAT

bond issuances over the past several years as it relates to trends in issuances, with

the purpose of providing investors with a basis to understand how they can

structure their portfolio of CAT bonds.

CAT bond coverage for United States perils continues to be a substantial

portion of the CAT bond market; US perils are considered to be the core of the CAT

bond market. A majority of all CAT bonds issued cover US perils, in fact 87% of total

new issuances in the 12-month period ending in June 2015 were US perils (Aon

Thought Leadership, 2015, 2015). Perils covered in the United States include

earthquakes in various regions, named storm and hurricane, winter storms,

windstorms, severe thunderstorms, wildfire, volcanic eruption, and even meteorite

impact.

Next we will look at CAT bonds issued for US perils from July 2011 to June

2015.

During the period of July 2011 to June 2012 the number of sponsors for CAT

bonds more than doubled from the previous year. 22 CAT bond transactions took

place during this period. Perils covered in these issuances include: two bonds for

California earthquake and one bond covering all United States earthquake, five

bonds covering a combination of United States hurricane and European wind, three

bonds covering United States multi-peril, four bonds covering United States

hurricane and earthquake as well as one bond covering United States hurricane and

earthquake in combination with European wind, other bonds were issued for

covering United States hurricane, Louisiana hurricane, Florida hurricane, Northeast

hurricane, North American hurricane and earthquake, and southeast hurricane and

severe thunderstorm (Aon Thought Leadership, 2012, 2015).

During the period of July 2012 to June 2013 many new and repeat sponsors

brought new issuances to market. 22 CAT bond transactions occurred during this

period. Perils covered in these issuances include: two bonds covering United states

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hurricane and European wind, three bonds covering United States, California,

and/or Canada earthquake, five bonds covering United States hurricane and

earthquake, three bonds covering United States multi-peril, six bonds covering

United States hurricane with two covering only Florida, one covering only Louisiana,

one covering all of the Northeast, and one covering the entire United states. There

were also some interesting combinations of perils, one bond covered United States

hurricane and Australian cyclone and one bond covered United States hurricane and

United Kingdom mortality (Aon Thought Leadership, 2013, 2015).

The period of July 2013 to June 2014 saw low pricing conditions led to strong

demand from investors and sponsors, with 75% of new property issuances

including United States exposures. 24 CAT bond transactions took place during this

period. Perils covered in these issuances include: seven bonds covering United

States hurricane including three only covering Florida and one only covering Texas,

eight bonds covering United States hurricane and earthquake, four bonds covering

United States multi-peril, two bonds covering United States earthquake or hurricane

and Australian earthquake or cyclone, one bond covering United States hurricane,

earthquake, and European wind, one bond covering New York storm surge, and one

bond covering New Madrid earthquake (Aon Thought Leadership, 2014, 2015).

Finally during the period of July 2014 to June 2015 pricing conditions have

stabilized around the lows of last year and demand from sponsors and investors

remained strong. 20 CAT bond transactions took place during this time period.

Perils covered in these issuances include: three bonds covering United States

earthquake, six bonds covering United States hurricane including three only

covering Florida, one only covering Louisiana, and one only covering Texas, two

bonds covering United States hurricane and earthquake, five bonds covering United

States multi-peril, two bonds covering United States hurricane, earthquake, and

European wind, one bond covering United States hurricane and Australian cyclone,

and one bond covering New Madrid earthquake (Aon Thought Leadership, 2015,

2015).

Next we will examine CAT bonds issued for Europe during the same time

period of July 2011 to June 2015.

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During the period of July 2011 to June 2012 four CAT bonds were issued

exclusively covering European wind, with one covering only France wind. Six bonds

were also issued that cover United States exposures in combination with European

wind (Aon Thought Leadership, 2012, 2015).

During the period of July 2012 to June 2013 only two CAT bonds were issued

for European wind exclusively and two bonds were issued covering United States

exposures as well as European wind. There was also one bond issued that covered

Turkey earthquake (Aon Thought Leadership, 2013, 2015).

During the period of July 2013 to June 2014 four CAT bonds were issued

covering European wind exclusively and one bond was issued covering United

States exposures in combination with European wind (Aon Thought Leadership,

2014, 2015).

During the period of July 2014 to June 2015 only three CAT bonds were

issued to cover European perils. Two bonds issued cover United States exposures in

combination with European wind while just one bond was issued covering

European earthquake (Aon Thought Leadership, 2015, 2015).

Next we will examine ILS transactions in the Asia Pacific region over the

same time period of July 2011 to June 2015.

During the period of July 2011 to June 2012, no CAT bond transactions

occurred in the Asia Pacific region. However, costly floods took a toll on Japanese

insurers who were having difficulty getting acceptable terms in their pro-rata

reinsurance treaties. Some Japanese insurers did broaden their capacity by

purchasing collateralized reinsurance coverage (Aon Thought Leadership, 2012,

2015).

During the period of July 2012 to June 2013 no new issuance of CAT bonds

took place in the Asia Pacific region despite increased sponsor interest (Aon

Thought Leadership, 2013, 2015).

During the period of July 2013 to June 2014 four CAT bonds were issued,

three of which cover Japan earthquake and one covers Japan typhoon (Aon Thought

Leadership, 2014, 2015).

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During the period of July 2014 to June 2015 two CAT bonds were issued

covering Japan earthquake. The issues resulted from repeat sponsors returning to

the CAT bond market (Aon Thought Leadership, 2015, 2015).

In addition to natural disasters, limited CAT bond issuances exist covering

life and health perils. These types of bonds typically cover extreme mortality risk

from events such as pandemics or health risks from a rise in healthcare utilization

or cost (Swiss Re, 2011, 2015). Currently there is $1.5 billion in outstanding risk

across the extreme mortality and longevity risks. ILS investors continue to show

strong demand for these investments due to their ability to act as a diversifying tool.

As the aforementioned data on issuances confirms, CAT bonds are

predominately issued to cover United States perils. Within the United States market,

CAT bonds are issued for both countrywide coverage and for more specific

geographic regions. United States CAT bonds also cover a wide variety of perils.

European CAT bond issuance accounts for a significantly smaller portion of the

market compared to United States issuances and generally covers either wind or

earthquake perils. Asia Pacific region CAT bond issuances are relatively new and are

very limited; however, Japanese sponsors are showing an increased interest in the

CAT bond market. In that region the CAT bond market faces increased competition

with other forms of alternative capital that more closely resemble traditional

reinsurance like collateralized reinsurance contracts (Aon Thought Leadership,

2015, 2015). It is also important to note that individual CAT bonds can be structured

to cover multiple perils in multiple regions or one peril in one specific region.

5 Investor Perspective

The increase in market size as previously discussed in this paper shows that

investor demand for CAT bonds have been increasing since the inception of this

product. This section will discuss what type of investor plays in the CAT bond

market and the broader insurance linked securities market, why they decide to buy

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CAT bonds, returns and price of CAT bonds, liquidity of CAT bonds, and

diversification of CAT bond portfolios.

5a Investors in the ILS Market

CAT bonds and other insurance linked securities typically require an investor

to invest large sums of money since a large portion of CAT bonds have a face value

of well over $100 million. Because of the large investment needed, investors in this

space are very sophisticated and capitalized organizations.

From the largest share of the ILS market to the smallest, the following types

of investors participate in the ILS market: catastrophe funds make up 47% of the

market, institutional investors make up 32% of the market, reinsurers make up 10%

of the market, mutual funds make up 9% of the market, and finally hedge funds

make up 2% of the market (Aon Thought Leadership, 2015, 2015). Now that we

know who the players are in this market, we can better understand their

motivations for buying CAT bonds and other ILS products.

5b Investor Motivation for Purchasing ILS Products

As we pointed out previously large, sophisticated, and highly capitalized

firms participate in the ILS market. With the exception of Catastrophe funds and ILS

funds that solely invest in ILS products, these investors have an already well-

diversified portfolio of capital market assets. Typically the goal of this type of large

investor is to maximize return on investment while keeping their investment risk

within an acceptable level. They accomplish this goal by maintaining a diversified

portfolio of investments; however, in the past diversification was limited to

spreading assets across different industries with the hope that should one industry

experience a downturn other assets will be unaffected. One problem with this is the

amount of systematic risk, which affects most asset classes, an investor experiences

cannot be completely diversified away (Swiss Re, 2011, 2015). An asset that does

not experience this systematic risk is very valuable to large investors.

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CAT bonds are largely uncorrelated with other asset classes, which reduces

their systematic risk (Swiss Re, 2011, 2015). This should make sense because a CAT

bonds’ value is based off of the occurrence or non-occurrence of a catastrophic loss

event. An inference we can make from this is that macroeconomic factors will have

little to no affect on the value of a CAT bond where as other asset classes will be

affected. For proof of this concept we can look at the performance of CAT bonds

during the 2008 financial crisis; during the financial crisis CAT bonds exhibited

stability and high returns relative to comparable investments due to the nature and

integrity of their structures. As a result of the CAT bonds’ power to be immunized

from economic distress, investors have been attracted to the asset class to improve

the overall risk profile of their portfolio (Swiss Re, 2011, 2015). According to

Romulo Braga, New York-based CEO of BMS Capital, “Despite the influx of capital to

the sector and falling yields and multiples, the yields remain higher than many other

fixed-income instruments and offer exposure to a different set of risks (i.e. natural

catastrophe risk) with low correlation to general market risks, so many investors

still find it attractive” (Lerner, 2015).

5c Returns and Price of CAT Bonds

Spreads on a CAT bond are used to measure relative price and

returns. The spread is the portion of the regular coupon payment that is over the

LIBOR and is expressed as a percent, the spread is meant to compensate the

investor for bearing the risk (Braun, 2014). Embedded in the spread is the expected

loss; the spread, or return, has to exceed the amount investors expect to lose or else

they would not buy.

Historically spreads have been relatively high compared to equivalently

rated corporate bonds (Risk Management Solutions, 2012, 2015). In theory the CAT

bond spread should be less than an equivalently rated bond because investors are

willingly to pay a premium for the diversification benefit (Swiss Re, 2011, 2015).

However, it appears investors are paid a novelty premium for investing in the new

type of product. Recently the CAT bond market has seen spreads narrow due in part

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to increased investor interest until mid-year 2015 where the spreads ceased to

narrow indicating a price floor in the market (Swiss Re, 2015, 2015).

Several factors affect the issuance spread. Spreads for peak perils, perils that

are likely to cause the most loss such as US hurricane bonds, tend to have the

highest spreads. CAT bonds covering peak perils are located in a select few

geographic regions and have the highest issuance volume. The high spreads reflect

the lower demand due to investors’ desire to diversify their CAT bond portfolio with

non-peak risks, which usually have lower spreads because investors are willing to

accept lower returns in exchange for the added benefit of having risk spread over

more geographic regions and perils (Risk Management Solutions, 2012, 2015).

Spreads also tend to follow the reinsurance pricing cycle, spreads tend to be

higher during a hard market and lower during a soft market (Risk Management

Solutions, 2012, 2015). Spreads following the reinsurance cycle may be an indicator

that CAT bonds are attempting to be competitive with the reinsurance market.

Another factor affecting spread is the type of trigger embedded in the bond;

indemnity triggers have been shown to have higher spreads due to the existence of

moral hazard causing investors to demand being compensated for the additional

risk (Swiss Re, 2011, 2015).

5d Liquidity

CAT bonds are designed to allow trading on a secondary market which lets

investors readjust their portfolio to reflect a change in risk appetite or free up

capital to purchase new issuances (Swiss Re, 2011, 2015). Bonds covering seasonal

storms display a seasonal price on the bond market. Prior to the US hurricane

season, bond prices often fall to reflect the risk of loss (Risk Management Solutions,

2012, 2015), investors seeking to increase the risk of their portfolio can buy these

bonds at discounted prices. After the hurricane season comes to a close prices

rebound to normal levels.

Liquidity is not always available on the secondary market. Investors have

shown a trend lately of desiring higher-yielding higher-risk bonds. Lower yield

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bonds are less attractive and more likely to be illiquid (Artemis, 2015, May 18,

2015). Conversely, an investor looking to purchase higher-yield bonds on the

secondary market might not be able to find a seller, as investors holding these

higher-yield bonds want to keep them for the higher returns.

5e Diversifying CAT Bond Portfolios

The majority of CAT bond issuances are concentrated in US hurricane and US

earthquake exposures with relatively few issuances in EU wind and Japanese perils.

Concentration of CAT bonds results in increasing correlation between individual

assets in an ILS portfolio, this is called tail risk and managing it is a key success

factor in ILS portfolios. Thus, over-exposure in a certain area is a threat for ILS fund

managers (Lohmann). Access to non-peak perils allows for more diversification but

their issuance in the form of CAT bonds are quite limited.

One method to limit tail risk would be to simply restrict allocation to the

asset class or to certain perils and regions (Lohmann). This method essentially

accepts the level of diversification present in the market and only allows risk to

accumulate to a certain level.

A better method involves tapping the wider universe of ILS and utilizing

private reinsurance contracts. Collateralized reinsurance contracts are methods of

providing reinsurance with the contract limit being fully collateralized and allowing

coverage without the investor having to get rated by a regulator. The collateralized

reinsurance coverage functions much the same as traditional reinsurance and can

be customized to fit a large variety coverage needs. To complete the transaction a

regulated reinsurer must issue the policy and the product must allow the investor to

pay in the collateral and receive the collateral back plus the premium at the end of

the reinsurance term (Sodium Partners, 2015). Due to this product’s flexibility it can

be used to selectively target non-peak perils such as life and health risks, which are

largely uncorrelated with catastrophic risks, and perils in non-peak regions that

have limited CAT bond issuance.

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Using collateralized reinsurance contracts to broaden the options of

investments available in combination with a CAT bond portfolio can provide

significant diversification benefits. A portfolio consisting of CAT bonds and

collateralized reinsurance has a higher expected return and a lower probability of

negative return (Lohmann).

6 An Optimal Strategy For an ILS portfolio

Before we can discuss a strategy for an ILS portfolio we must state the

hypothetical investor. The investor in the ILS portfolio is a large multi-strategy

hedge fund. For the example we assume the investor has little to no capital

constraints, in other words they have enough excess capital to invest in any asset

they desire. In addition the investor has the desire to take on additional risk in

exchange for a return on investment. The investor also has the ability to deploy

capital through a regulated reinsurer in the form of collateralized reinsurance. We

also assume that desired CAT bonds are available on the primary or secondary

market. The investor’s goal is to add assets to its portfolio that will reduce its

overall systematic risk while providing returns that exceed that of a similarly rated

capital market asset.

In order to achieve this goal the investor decides to enter the ILS market.

After examining the market the investor is attracted to the relatively high returns of

CAT bonds compared to equivalently rated corporate bonds but is concerned about

seeing a total loss of principal.

In order to mitigate the risk of losing the entire principal in the event of a

covered catastrophic loss, the investor buys various CAT bonds that are diversified

by different regions and perils.

The CAT bond portfolio consists of bonds that cover United States

earthquake perils in combination with Australian cyclone and earthquake perils; the

purpose of the combination is to reduce the relative cost of the bond because multi-

peril CAT bonds tend to have higher spreads. CAT bonds for United states hurricane

perils are bought in combination with European wind perils for the same reason as

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previously stated but the investor limits this type of bond and diversifies United

States hurricane perils by buying CAT bonds that separately cover different states,

the purpose for this is to limit the likelihood that the bond sponsor is affected if a

catastrophic hurricane does occur. To further elaborate on that diversification

method, if a hurricane does occur it is unlikely to cause losses in every state that

issues a hurricane CAT bond. In addition CAT bonds covering Japanese typhoon and

earthquake are purchased. Non-peak peril CAT bonds in other geographic regions

are also purchased in limitation, these assets will further diversify the portfolio but

the amount purchased will be limited due to the low spreads. Now that the investor

has diversified the portfolio of CAT bonds while still allowing for relatively high

returns, the investor now moves to tap the broader ILS market.

More non-peak perils are invested in through collateralized reinsurance

contracts. The collateralized reinsurance will be provided to life and health perils in

order hedge against the risk of a catastrophic event. The addition of these non-peak

perils will reduce the overall risk of the portfolio and increase expected returns.

Should the investor want to increase the risk of the portfolio while maximizing the

returns, the investor could buy ‘on-risk’ United States hurricane bonds while they

are at their seasonal low price. By purchasing the discounted bonds and holding

them, the investor can realize larger gains all while the collateralized reinsurance

contracts balance out the increased risk exposure.

6 Summary

In summary we have discussed ILS products, the structure and market for

CAT Bonds, an investors’ perspective, and an optimal strategy for an ILS portfolio.

To reiterate, ILS products and more specifically CAT bonds attract large investors

for their ability to add an uncorrelated asset class to their portfolio, which achieves

relatively high returns. CAT bonds are primarily issued in the United States meaning

diversifying a portfolio of only CAT bonds is limited. In order to increase the

diversification, an investor may choose to invest in collateralized reinsurance that

covers non-peak perils. Adding non-peak perils reduces the overall risk of the

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portfolio, to compensate for the lowered risk an investor may buy ‘on-risk’ US

hurricane CAT bonds at a discounted price.

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