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Property Catastrophe Risk and Capital Markets Risk Transfer

Donald Riggin | August 1, 2008

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Will we ever be able to transfer nonproperty, noncatastrophic risk into the capital markets?

Before we dive into the topic, it's important that we define a few terms.

Nonproperty risk is of course casualty risk. It also may be characterized as frequency risk, which is the opposite of catastrophic risk. Frequency risk is best exemplified by workers compensation. Given enough historical loss data, actuaries can predict, with varying degrees of confidence, future loss activity. Insurance premiums are based on these predictions, which underlay a large portion of the insurance industry. Predictability begets premiums, which begets (sometimes) a little underwriting profit and (always) investment income. Property insurance is predicated on individual risk characteristics, (construction, occupancy, protection, and exposures—COPE), and usually a catastrophe loss model or two.

This brings us to property catastrophe risk and why it lends itself to capital markets risk transfer. Cat risk insurers and reinsurers do not rely on COPE characteristics to set rates; they use the underlying pricing and the aforementioned damage models to establish a probability of loss for a specific geographic region and/or specific perils. These data are used to set reinsurance rates as well as insurance-linked security (cat bonds, etc.) pricing.

The primary reason why cat bonds work is that the data used to set pricing is relatively transparent. I say relatively transparent because the average investor certainly does not understand the complexities of the damage models used to determine loss probabilities. They do, however, understand that an A rating from Standard and Poor's ensures that at some level, the creditworthiness of the bond has been vetted. Cat bonds usually exist in multiple tranches (French for "layer"). The tranches are similar to layers of reinsurance. The lowest tranche, the one closest to a loss, often does not earn an investment-grade rating. The excess tranches, however, are usually rated investment grade.

Loss Triggers

There are three commonly used loss triggers in insurance-linked securities: indemnity, index, and parametric. The indemnity trigger is identical to that which is found in every insurance and reinsurance contract—if a loss is covered under the terms of the contract it will be paid. An index is a single value that represents an aggregation of individual values. Those individual values, however, must be highly correlated, meaning that their values must all be susceptible to the same unpredictable forces. The best example of an index is the Dow—30 blue-chip stocks combined into a single value that fluctuates daily based on a variety of forces too numerous to mention here.

A cat bond's index is an aggregation of defined property losses within a specific period of time. A parametric trigger uses the magnitude of the event, such as a 7.5 magnitude earthquake (on the Richter scale).

Exchange-Traded Catastrophe Futures

Over the last couple of years, three new exchange-traded products for catastrophe risk have hit the scene. Identical to cat bonds, these futures contracts are designed to provide funding for catastrophic loss due to natural causes except earthquake. Unlike cat bonds, which are technically structured financial products, these products are true derivatives in that they are "contracts for difference." This means that they are traded anonymously and the traders can make or lose money based only on the price movements of the contracts and need not own the underlying asset, or in this case, the index. These products, however, only cover property damage losses above a $25 million loss threshold, as determined by their particular index.


So will we ever see frequency loss exposures traded in the capital markets? Two major obstacles are the lack of information transparency and the lack of information itself. Markets only work when investors are sure that the rules for determining settlement are clear and applicable to every participant, and there is a guarantor for each trade—the exchange platform. Moreover, catastrophe indexes can only exist because of organizations like Property Claims Services® (PCS®) that survey every natural disaster and assign a potential damage value. We have no way to document every general liability loss that occurs.

Another barrier to frequency losses being traded in the capital markets is the very nature of the loss exposures. While all insurable risks, frequency and catastrophe, create loss events, only catastrophe risk produces an event large enough to warrant an index based on a single, identifiable, event. Perhaps the National Council on Compensation Insurance (NCCI) could produce an index based on its knowledge of workers compensation losses, but where would such an index begin and end? Which industry classes would be included? These questions may not be insurmountable, however.

The biggest lack-of-information hurdle is the cause of loss. We know what happens in a natural catastrophe—a hurricane flattens real property. The problem with casualty losses is that the causes of loss are manifold. A tradable insurance-linked security needs a definitive peril such as windstorm. What peril would we assign to workers compensation bodily injury? Okay, then how would we deal with the multiyear loss development patterns for casualty losses in a tradable security? Property damage losses can be established fairly quickly, allowing for index settlement, but workers compensation loss values are moving targets.

We certainly may conclude that frequency-driven loss exposures may be too variegated and complex to be boiled down into a tidy futures contract. We have no access to reliable loss data, multiple causes of loss that magnify the loss possibilities, and multiyear loss payout periods. While I think that while these barriers could be surmountable some day, for the time being, insurance and reinsurance underwriter's jobs are not in danger.

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