Analyzing Insurance‐Linked Securities

Abstract

Insurance‐linked securities can benefit both issuers and investors; they supply insurance and reinsurance companies with additional risk capital at reasonable prices (with little or no credit risk), and supply excess returns to investors that are uncorrelated with the returns of other financial assets. This article explains the terminology of insurance and reinsurance, the structure of insurance‐linked securities, and provides an overview of major transactions. First, there is a discussion of how stochastic catastrophe modeling has been applied to assess the risk of natural catastrophes, including the reliability and validation of the risk models. Second, the authors compare the risk‐adjusted returns of recent securitizations on the basis of relative value. Compared with high‐yield bonds, catastrophe (“CAT”) bonds have wide spreads and very attractive Sharpe ratios. In fact, the risk‐adjusted returns on CAT bonds dominate high‐yield bonds. Furthermore, since natural catastrophe risk is essentially uncorrelated with market risk, high expected excess returns make CAT bonds high‐alpha assets. The authors illustrate this point and show that a relatively small allocation of insurance‐linked securities within a fixed income portfolio can enhance the expected return and simultaneously decrease risk, without significantly changing the skewness and kurtosis of the return distribution.

Sovereign Cat Bonds and Infrastructure Project Financing

“…In the event of a catastrophe, the investors will receive no coupon payment and some, or all, of their principal may be distributed to the issuer. 5 The major benefit that these instruments offer to the issuer is an instantaneous inflow of cash (here, to 4 Particularly for emerging-economy governments, high capital costs, representing large opportunity costs of future investment and consumption if the nation's capital base is depleted by a catastrophe, may make the role of "insurer of last resort" unattractive. 5 For structures and conditions of recent cat bonds, see Reference 5. the government) immediately following a prespecified catastrophic event (such as a flood, earthquake, or hurricane).…”

“…(9) ture, rather than self-insuring as most governments do. 4 These infrastructure investments, almost by definition, have the characteristic of offering high social benefit but diverse/scattered individual benefits, and so cannot be efficiently organized by the private market. Although the expected capital requirements for completing these projects are completely known ex ante, the stochastic character of the capital requirements (which we will term "emergency repair costs" in our example) requires some contingency planning to ensure that needed project funds are available.…”

“…(1,2) Although private enterprise has already begun to find catastrophelinked securities useful in reducing the variation of its costs, this hedge against disaster comes at a price: 100% of the expected cost of these catastrophes, plus a generous premium for assuming the risk, is paid to investors. (3)(4)(5) To our knowledge, there has been neither a theoretical analysis nor even a compendium of potential motivations for sovereign governments to use such instruments. Given this lack of analysis, it is not surprising that no sovereign governments (or third-party infrastructure project funders, such as the World Bank) have issued such securities to protect themselves against catastrophe.…”

Can Entropy Model Explain the Cat Bond Premium Puzzle?

“…Previous literature explores little cause to of exceptional high spreads associated with cat bond but focuses more on the theoretical pricing of them (See, e.g., Canabarro et al (1998), Froot et al (2002). For example, Canabarro et al (1998) show that, under certain assumptions, the cat bond stochastically dominate the high yield bonds.…”

“…For example, Canabarro et al (1998) show that, under certain assumptions, the cat bond stochastically dominate the high yield bonds. Although mean-variance analysis testified the existence of the cat bond high premiums, the studies based on the classical theory cannot explain the cause for the high premium of cat bond perfectly.…”