The Drivers of Catastrophe Pricing Catastrophe bonds provide means for to achieve Over the last few years, returns that are uncorrelated with the broader financial markets. companies have made increasing Niraj Patel, ILS Portfolio Manager, PartnerRe, explains how use of catastrophe bonds1 to transfer portfolio managers can make more informed decisions around insurance risk to capital markets. The capital allocation by understanding the attributes of pricing trends. first successful catastrophe bond was an $85mm issue by in In this paper he provides a comprehensive analysis of catastrophe 1994. This was followed by bond pricing over the last 15 years to determine the specific in 1995, Georgetown Re in 1996 and factors and conditions that drive pricing. financial services company, USAA’s first Residential Re catastrophe bond in 1997. These early transactions provided investors with an opportunity to assume catastrophe risk on a securitized basis for the first time. Since then, catastrophe bonds have evolved into valuable risk management and investment tools by incorporating elements from both the and capital markets.

From a ceding company’s perspective, catastrophe bonds operate as a substitute for property catastrophe reinsurance. More specifically, they provide an alternative means to capitalize a reinsurance transaction. The ceding company purchases reinsurance from a Special Purpose Vehicle (SPV), formed for the sole purpose of entering into a specific transaction; paying the SPV a premium as consideration for the exposure it is ceding. The SPV uses this premium to Yield to maturity and credit spread pay interest to the bond holders providing capital. The capital is invested in high Yield to maturity of a bond is the total yield resulting from all payments and quality collateral and is available should any gains/losses from appreciation/depreciation in the price of the bond an there be losses associated with the achieves upon holding the bond to maturity. This appreciation/depreciation is a result reinsurance transaction. of purchasing a bond at a discount/premium to face value. Understanding pricing to The yield of a bond can be broken down into two components: risk-free interest rate understand return (government bond yield) and credit spread. The difference between the yield on a bond From an investor’s perspective, the main and the yield on a matched maturity government bond is called the credit spread. attraction of catastrophe bonds is the fact that they provide relatively higher Credit spread of a corporate bond is affected by the default risk (expected loss of yields on a diversifying asset class. Unlike principal) and the risk premium demanded by investors for taking on this risk. Highly traditional reinsurance, catastrophe bonds leveraged companies are riskier, implying higher probability of default and therefore, can be traded on a , provide higher credit spreads. Thus, lower-rated or below investment-grade corporate introducing characteristics generally bonds (high-yield corporate bonds) provide higher spreads than high-quality associated with securities, investment-grade corporate bonds. such as duration, discount margin and yield to maturity.

1 For background on catastrophe bonds, reader can refer to a number of available primers. One such primer can be accessed at www.air-worldwide.com/Publications/ AIR-Currents/So-You-Want-to-Issue-a-Cat-Bond/ PartnerReviews October 2015 The Drivers of Catastrophe Bond Pricing continued

The payment a buyer of reinsurance must In addition to the company specific or Breakdown of bond yield make – otherwise known as the “premium” idiosyncratic factors, overall economic in insurance, or the “coupon” in bond and business cycles tend to affect credit markets – is generally fixed; however, the spreads. A slowing economy tends to spread achieved by an investor depends on widen credit spreads as companies are Risk the price of a bond, as well as its coupon more likely to default, and a growing premium payment stream. Specifically, the spread economy tends to narrow the spread, achieved by investors is inversely related to Spread as companies are theoretically less the price of the bond. likely to default. Finally, risk premium or margin demanded by investors also Expected Drivers of catastrophe bond spread changes over time and is affected by, loss Similar to other risky bonds, catastrophe among other things, cross-asset relative bond spread is a function of modeled value considerations and changing expected loss and risk premium. perception of risks. The higher the Modeled expected loss, also known as uncertainty associated with risky assets, loss cost or average annual loss, is Risk-free the higher the risk premium demanded the average value of losses over a full rate by investors. Note that different range of scenarios2. The risk premium market participants may have forward is the required margin. These two factors looking views of the expected loss that drive the spread of a catastrophe bond. often differ from each other and from Not to scale. Thus, catastrophe bond spread is similar For simplicity, any optionality embedded in the bond statistically derived historical estimates. (for example a call feature) is not considered here. to premium or rate on line in the traditional reinsurance market. Catastrophe bond spread Catastrophe bonds are issued as floating rate securities, in which the investor The risk premium or margin is not constant; receives a set coupon spread over an index (or return on high-quality collateral, rather it is a function of peril zone and which is typically invested in short-term money market funds). The index (or collateral modeled expected loss. Moreover, return) is intended to compensate investors for holding their money and is not changing perceptions of risk and relative affected by riskiness of the bond (i.e. embedded insurance risk). It resets periodically value considerations mean that risk based on the prevailing short-term interest rates. The spread of a catastrophe premium changes over time. Note that bond is intended to compensate investors for the insurance risk. true underlying value of expected loss is not known; rather modeled expected Discount margin of a floating-rate bond loss values are just estimates of the true Discount margin of a floating-rate bond is the return earned over and above the expected loss. This uncertainty in estimating index underlying the bond. If the bond’s price is equal to par (or face value), its discount expected loss manifests itself in margin margin is equal to the coupon spread over index. If the price of the bond is less than par, being a function of the expected loss itself. the discount margin is greater than its coupon spread. This is because of the tendency Peak peril zones (e.g. Florida hurricane) of the bond price to converge to par as the bond reaches maturity. Thus, an investor typically demand higher margins due to can make additional return over the coupon spread for a bond priced at a discount. concentrations in investors’ ILS portfolios Conversely, for a premium bond, discount margin is less than the coupon spread. compared to diversifying peril zones (e.g. Turkish earthquake). Moreover, given Duration and interest-rate sensitivity comparable loss costs, the market charges Duration is a measure of the sensitivity of the price of a bond to change in interest rates. a higher margin for complicated, or less homogeneous risks, such as commercial Since catastrophe bonds are floating-rate securities in which the index (or collateral properties vs. personal lines. Again, this return) resets periodically to prevailing short-term interest rates, the interest-rate is due to higher uncertainty in estimating sensitivity of catastrophe bonds is rather low. Corporate bonds, on the other hand, expected loss for complex risk, which results are often fixed-rate bonds, in which the coupon yield is fixed at issuance. Thus, as in the market demanding higher margin. interest rates change, corporate bond prices change even if nothing else changes. That is, the interest-rate sensitivity of corporate bonds is higher. The risk premium (and therefore, spread) is also influenced by trends across

2 Catastrophe bonds provide excess of loss (or aggregate excess of loss) reinsurance cover and are similar to securitized products, such as asset-backed securities or mortgage- backed securities. A catastrophe bond suffers a loss only if a qualifying event results in losses in the subject business that exceed a certain threshold (attachment point). If the subject business losses are high enough to reach the exhaustion point, a catastrophe bond loses100% of the principal. Expected loss referenced here is based on losses suffered by catastrophe bonds taking into account the attachment and exhaustion points, rather than the ground up subject business losses.

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years, so called soft and hard markets. In a soft market, the cost of coverage drops, while in a hard market it rises. Historically, hard markets have followed years with significant loss activity resulting in depletion of reinsurance capital. Sometimes this increase is localized to a specific area impacted by loss, while at other times it can raise the cost of reinsurance across the entire market.

The spread can also shift due to a change in perception of expected loss. For example, during a very active hurricane season or when a hurricane is approaching the U.S. coastline, the market perceives a higher probability of loss. In these types of scenarios, the spread widens due to increase in expected loss.

Finally, in recent years, broader market trends have had a significant influence on the price of risk (risk premium) and “Live cat” trading consequently catastrophe bond spreads. A hypothetical example to illustrate changing perception of risks is the behavior of a As we will show, spreads can also widen Florida hurricane bond as a category five storm approaches Miami. In this scenario, if during periods of extreme economic the storm looks as though it will maintain its track and strength, the probability of loss – turmoil, unrelated to natural catastrophes. triggering a payout on the bond – would rise. This would result in a drop in the price of the bond and an increase in the spread. If conditions change – either diverting the storm Catastrophe bond spread into open water or losing strength – and thereby averting a loss, the price would rebound performance since 2001 and the spread would decrease again. Trading of catastrophe bonds as a potential event We examine historical spread is unfolding (e.g. a storm is approaching U.S. coastline) is often referred to as “live cat” performance of catastrophe bonds to trading and is only possible because there is a secondary market for these bonds. illustrate its drivers. Exhibit 1 (below) shows

16% QE1 announcement QE1 Beginning of European completed sovereign crisis 14% Aftermath of tech bubble Four hurricanes Lehman 12% of 2004 bankruptcy RMS model update 9/11 WorldCom Tohoku earthquake bankruptcy European 10% crisis-related Hurricane market Katrina 8% sell-off

6%

4%

Christchurch earthquake 2% Superstorm Sandy tornadoes Hurricane Irene 0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Catastrophe BAML HY BB corp. Financial market event bonds spreads bonds spreads Insured loss event

Exhibit 1: Catastrophe bond and high-yield corporate bond spreads

12% QE1 announcement QE1 PartnerReviews October 2015 completed Beginning of European Aftermath of sovereign crisis 10% tech bubble Four hurricanes Lehman Tohoku earthquake of 2004 bankruptcy European 9/11 WorldCom crisis-related Hurricane 8% bankruptcy stock market Katrina sell-off 6%

RMS model 4% update Superstorm Sandy Christchurch earthquake 2% US tornadoes Hurricane Irene 0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Catastrophe Catastrophe Bonds Trailing 12 mo. avg. Financial market event bonds spreads modeled expected loss catastrophe bonds spread Insured loss event

350 YoY change 40% Global ROI Index 300 30%

250 20%

200 10% 150 0% 100

-10% 50 Cumulative ROL Index (Base 1989 = 100) 0 -20%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1/1/2015 16% QE1 announcement QE1 Beginning of European completed sovereign crisis 14% Aftermath of tech bubble Four hurricanes Lehman 12% of 2004 bankruptcy RMS model update 9/11 WorldCom Tohoku earthquake bankruptcy European 10% crisis-related Hurricane stock market Katrina 8% sell-off

6%

4%

Christchurch earthquake 2% Superstorm Sandy US tornadoes Hurricane Irene 0% The Drivers of Catastrophe Bond Pricing continued 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Catastrophe BAML HY BB corp. Financial market event bonds spreads bonds spreads Insured loss event

12% 16% QE1 announcement QE1 QE1 announcement QE1 Beginning of European completed Beginning of European Aftermath of sovereign crisis completed sovereign crisis 14% Aftermath of 10% tech bubble Four hurricanes Lehman Tohoku earthquake Four hurricanes Lehman of 2004 tech bubblebankruptcy European 12% of 2004 bankruptcy RMS model update 9/11 WorldCom crisis-related 8% Hurricane 9/11 WorldCom Tohoku earthquake bankruptcy stock market European Katrina bankruptcy 10% sell-off crisis-related Hurricane stock market 6% Katrina 8% sell-off RMS model 4% 6% update

4% Superstorm Sandy Christchurch earthquake 2% Christchurch earthquake 2% Superstorm Sandy US tornadoes Hurricane Irene US tornadoes Hurricane Irene 0% 0%

2000 2001 2002 2003 2004 2005 20002006 20012007 20022008 20032009 20042010 20052011 20062012 20072013 20082014 20092015 2010 2011 2012 2013 2014 2015 Catastrophe Catastrophe Bonds Trailing 12 mo. avg. Financial market event bonds spreads modeled expected loss catastrophe bondsCatastrophe spread InsuredBAML loss HY eventBB corp. Financial market event bonds spreads bonds spreads Insured loss event Exhibit 2: Catastrophe bond spreads and modeled expected loss

catastrophe bond and high-yield corporate After12% an initial spike, catastrophe bond 2005–2006: HurricaneQE1 announcement Katrina in AugustQE1 Beginning of European bond spreads.350 Exhibit 2 (above) shows spreadsYoY change and reinsurance rates started40% 2005 was the costliest catastrophe completed Aftermath of sovereign crisis catastrophe bond spreads along with rolling a longGlobal10% decline ROI Indextech through bubble the third quarter Four hurricanesin reinsurance history, andLehman it had an Tohoku earthquake 300 of 2004 twelve-month average spreads. The modeled of 2005. During this period, high-yield30% immediate impact onbankruptcy the supply of European 9/11 WorldCom crisis-related Hurricane expected loss is also included in this chart. corporate8% bonds experiencedbankruptcy another reinsurance capital at the precise time stock market 250 Katrina Exhibit 3 (below) shows the property period of spread widening during 20% that demand increased, causing an sell-off 6% catastrophe200 rate on line (ROL) index. 2002–2003 but the downward trend in imbalance in the reinsurance market. reinsurance rates and catastrophe bond10% Post-Katrina models were recalibratedRMS model Over the150 last 15 years, there have been spreads4% did not subside. Not even the to include increased assumptions for update Superstorm Sandy four episodes of significant spread active 2004 hurricane season altered 0% severity and frequency of hurricanesChristchurch and earthquake widening100 across the entire catastrophe the course,2% because it did not impact the enhancement in loss modeling. Perception US tornadoes Hurricane Irene bond market. This is easier to see in amount of reinsurance capital available.-10% of risk and modeled expected loss 50 Exhibit 2, which smooths out short-term 0% increased. Moreover re/insurers’ capital Cumulative ROL Index (Base 1989 = 100) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 volatility0 by plotting rolling 12-month Throughout this period, apart from a -20% requirement for a given rating increased. average spreads. Note that this averaging small impactCatastrophe from broader economicCatastrophe Bonds CatastropheTrailing 12 mo. bond avg. spreads widenedFinancial market along event 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010bonds 2011 spreads2012 2013 2014modeled expected loss catastrophe bonds spread Insured loss event introduces approximately six months of conditions, the driver of spreads1/1/2015 remained with reinsurance rates. The first major lag in the timing of spread movements. the reinsurance cycle and the availability of catastrophe bond default, Kamp Re, These trends are examined in greater detail reinsurance capacity. reinforced the trend. During this period on the following page.

350 40% 2001–2002: The first observable incidence YoY change st Global ROI Index of spread widening occurred just as the 21 300 30% century began. There were two notable events at the turn of the century that had an impact 250 on the price of risk or risk premium: the 20% implosion of the technology bubble and the 200 September 11th terrorist attacks. The latter put 10% a strain on the reinsurance market that had 150 already sustained large casualty losses in 0% 100 the late 1990s and two sizable European -10% catastrophes in December 1999 (Windstorms 50 Lothar & Martin). While rates went up in the Cumulative ROL Index (Base 1989 = 100) reinsurance market, and spreads widened in 0 -20% both catastrophe and high-yield corporate 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1/1/2015 bond markets, the rise was most pronounced Exhibit 3: Guy Carpenter Property Catastrophe Rate on Line Index in reinsurance and catastrophe bonds.

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of turmoil in the re/insurance market, the great that it caused a liquidity crunch across RMS released an update to their U.S. economy was experiencing a housing- all markets as investors liquidated any assets hurricane model in 2011 which produced driven boom and high-yield corporate bond they could to meet financing and margin a significant increase in modeled spreads remained stable. call requirements. This led to significant expected losses. This led to a perception repricing of risk (increase in risk premium) of higher risk and caused spreads to This period demonstrated a distinction across all asset classes, even those like widen in the catastrophe bond market. between the market for reinsurance and the catastrophe bonds that were not directly broader economy, thereby highlighting the impacted by the crisis. Both catastrophe and Financial events, such as European uncorrelated nature of catastrophe bonds. high-yield corporate bonds spreads widened sovereign crises caused a widening of significantly. The rise in catastrophe bond high yield corporate bond spreads as well, 2008–2009: The housing market bust and spreads occurred with a slight time delay but the events within the re/insurance financial crisis altered this relationship for the and the increase was not as pronounced. industry described above were the primary first time. The financial market stress was so In general the catastrophe bond market drivers of widening of catastrophe bond demonstrated a remarkable liquidity and spreads. relative price stability (compared to other Impact of Lehman Brother’s asset classes). This may have been due Since 2012, catastrophe bond spreads bankruptcy on catastrophe bonds to the fact that a significant portion of have continued to tighten, consistent While catastrophe bonds were not catastrophe bonds was held by “ILS only” with the drop in reinsurance rates. triggered by any insurance events funds which did not face the level of liquidity This trend has been driven by an influx during the financial crisis in 2008– calls other funds endured. of alternative capital and increase in 2009, some of did lose value traditional reinsurance capital. due to distress of the counterparty Traditional reinsurance rates increased (specifically Lehman Brothers and to slightly in 2009, but not to the same extent Large losses and financial market some extent Merrill Lynch). Prior to the as widening of catastrophe bond spreads. shocks will continue to impact returns financial crisis, catastrophe bonds Towards the end of 2009 and beginning Based on historical experiences, one can were structured with a total return of 2010, as the crisis was coming to an draw the following conclusions: swap that was intended to minimize end, spreads for both catastrophe and credit risk of the collateral (i.e. to high-yield corporate bonds began to Conditions in the reinsurance industry isolate and transfer only the insurance tighten. Reinsurance rates also declined. have a direct impact on catastrophe risk). The proceeds of the bond bond spreads. Large insured losses have issuance were placed in secure trust This period showed the first evidence that historically led to a reduction in available accounts and were invested in high- the market for catastrophe bonds was not capital and therefore an increase in quality/highly rated collateral. The as decoupled from the broader financial risk premium demanded by investors/ collateral was managed by a highly market as previously perceived. The fact counterparties. Change in perception of rated counterparty that converted the that it took a financial event of the scale of risk due to unexpected losses has also return on the collateral assets into the Great Recession (generally considered led to widening of spreads. a benchmark interest rate (typically to be the largest economic downturn LIBOR) payable to investors. Overly since the Great Depression) to trigger this Broader financial market events, if aggressive management of the correlation, simply highlights the excellent severe enough, can also have an impact collateral account by Lehman, the diversification catastrophe bonds can on spreads. An increase in the risk and severity of the credit and liquidity crisis, provide in a portfolio. liquidity premium demanded by investors and Lehman’s bankruptcy, resulted in causes insurance-linked securities’ severe distress in certain catastrophe 2011–2012: 2011 was another year of spreads to widen based on relative value bonds. In the aftermath of the substantial catastrophe losses globally. considerations. This linkage with broader financial crisis, a number of structural The industry suffered losses due to the financial markets is not surprising and enhancements were introduced to New Zealand Christchurch earthquake, the may increase in importance as the role of make collateral safer. The market Japan Tohoku earthquake and tsunami, alternative capital in re/insurance grows. seems to have settled on treasury flooding in Thailand and record-breaking money market funds as the preferred severe convective storm losses in the U.S. This has important implications for the collateral solution thereby significantly Three catastrophe bonds (Muteki, Mariah future of reinsurance and catastrophe reducing credit risk. Re 2010–1 and Mariah Re 2010–2) bond pricing for both ceding companies suffered losses of principal. and investors. For ceding companies,

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catastrophe bonds provide more In order to make optimal allocation Data source and calculation methodology Catastrophe bonds spreads data: immediate (i.e. real time) transparency decisions, a portfolio manager must • The catastrophe bond spread data is based on regarding the risk pricing in the broader therefore be able to discern the attributes secondary market prices and spreads of individual bonds provided by Swiss Re capital markets. markets. A reinsurance buyer no longer of pricing trends and to distinguish The following calculation methodology was used has to wait for annual renewal discussions between those emanating from within and to construct catastrophe bond universe spread to have a realistic sense of market shifts; outside the insurance market. Further, time series: • Entire universe of natural catastrophe P&C catastrophe bond pricing provides this. a manager must recognize the dangers catastrophe bonds issued under rule 144a is Recognizing drivers of risk pricing outside posed by broader markets to avoid being considered. • No adjustment for seasonality is made. However, of insurance provides a savvy reinsurance caught in a liquidity crunch during periods all bonds with time to maturity of less than six buyer with information that informs the of turmoil by drawing resources from both months are excluded. allocation of purchases across products for insurance and debt capital markets to • The spread at a given date is market value weighted average gross spread of the entire optimal pricing and . make informed decisions. P&C catastrophe bonds universe. No risk- adjustment is made. • The rolling 12-month average spread on a given For investors, the case for uncorrelated Helping you to make more informed day is arithmetic average spread for the prior total returns remains compelling and has capital allocation decisions twelve months. High-yield corporate bond spreads data: persisted over the last two decades as PartnerRe provides innovative reinsurance • Time series of Bank of America Merrill Lynch BB financial catastrophes are fundamentally to insurers through both traditional corporate bond index OAS (option-adjusted spreads). uncorrelated to natural catastrophes. The reinsurance solutions and alternative Property catastrophe rate on line index data: • Guy Carpenter global cumulative property correlation of risk premiums, however, capital solutions including ILS. PartnerRe catastrophe rate on line (ROL) data with 1989 ROL during the same period has been greater has managed ILS funds, seeded with chosen as a base of 100 and subsequent years shown relative to this base. than zero. All else being equal, a low- its own capital, since 2006 and unlike yield environment will result in softening independent ILS managers, we have a Author reinsurance pricing. substantial, long-term economic interest in Niraj Patel, ILS Portfolio Manager the performance of our funds. PartnerRe controls its exposure to ILS in a manner To find out more about how PartnerRe can consistent with its other catastrophe help you, contact one of our ILS experts by exposure by applying disciplined pricing visiting our website at www.partnerre.com/ and underwriting processes and by risk-solutions/ils-trading leveraging PartnerRe’s industry-leading modeling, research and underwriting resources to assess risk.

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