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Chapter 2 Different types of reinsurance 2/11

These capital market risk-based products are also designed to deal with catastrophe risks. Many are
specifically designed to fit the individual requirements of a particular organisation and need to have the
capacity and flexibility to cover a complexity of risk exposures or spread of risk. The following is a
general review of the market and its opportunities for transferring risk. Chapter

C1A Catastrophe bonds 2
Catastrophe bonds are capital market alternatives to traditional catastrophe reinsurance. Catastrophe
bonds are used by insurers to purchase supplemental protection for high-severity, low probability
events. They are risk-linked securities that transfer a defined set of risks from the sponsoring insurer to
investors through fully collateralised special purpose vehicles.
Catastrophe bonds are structured to offer beneficial yields that attract investors with higher risk
appetites. They usually include a limited range of perils, such as hurricanes, windstorms and
earthquakes. Key investors in catastrophe bonds include hedge funds, insurers, reinsurers, banks and
pension funds that receive a regular payment in the form of a ‘coupon’ in addition to the release of the
original investment when the bond reaches maturity.
The bondholder agrees that if a catastrophe costs the insurance or risk-bearing community as a whole
more than a pre-agreed amount, it will write off or defer payments for the capital and/or the interest due
on the bond. The company that issues the catastrophe bond can, in the event of a major loss ‘trigger’,
write down the value of the liability in its books and release funds to pay claims. The trigger can also be
activated by reference to a sliding scale of actual losses resulting from the defined catastrophic event
experienced by the insurer.
Although catastrophe bonds do not share the flexibility of conventional reinsurance contracts, their
attractiveness lies in the:
• lack of any close correlation with stock market or economic conditions;
• diversification benefits they offer; and
• strong returns compared to other investment opportunities.

They play an important role in bringing additional capacity into reinsurance markets thereby protecting Reference copy for CII Face to Face Training
an insurance company’s balance sheet.

C1B Contingent capital contracts
These are financing agreements, sometimes referred to as CoCos, arranged before a loss takes place.
Financing agreements
Should a named event or ‘trigger’ occur, the contract converts into equity as the financier provides the arranged before a
insurer with capital determined by the amount of the catastrophic loss. The terms of the contract are loss takes place
arranged during a prior time of normal benign activity when the insurer, who is not having to negotiate
from a position of weakness, can arrange access to funds at favourable rates. If no catastrophic events
occur, there is no exchange of funds. Such contracts provide balance sheet protection and place the
insurer in a strong position allowing it to benefit from premium increases after the named event has
occurred.

C1C Industry loss warranties (ILWs)
Industry loss warranties (ILWs) are reinsurance contracts where payouts are linked to a predetermined
trigger of estimated insurance industry losses. They are swap contracts that are based on insurance
industry indices rather than insurer actual losses. Payment of the warranty is made based on whether
the covered insurance industry, rather than the individual insurer, suffers a predetermined level of loss
due to natural catastrophes.

Example 2.3
An insurer has exposure to hurricanes in Florida. It could buy an ILW for hurricane activity in that region, which is
triggered if the total industry-wide insured loss is in excess of US$15 billion but less than US$25 billion. The insurer
pays a premium to the reinsurer or a hedge fund and in return could receive the limit amount if losses exceed the
predefined amount, or warranty.
An ILW can sometimes have additional clauses which must be met for a payout to be made, such as additionally to
the industry loss the insurer must also have experienced a specified amount of loss themselves.