22 August, 2015
In its Opinions of the State Council on Accelerating the Development of Modern Insurance Industry (the “Opinions”) dated 13 August 2014, the central government of China expressed its wish to build up its own catastrophe (or “cat”) insurance system and to promote the development of the cat insurance market, including building up a multi-layers cat risk sharing system through commercial insurance as well as exploring diversified ways to deal with the perils of typhoon, earthquake, landslide, mudslide, flood, forest fire and other disasters.
Insurance-linked securities (“ILS”) are an effective tool to allocate cat risk that is yet to be developed in China. In the ILS market, cat risk is typically transferred to investors through cat bonds and other securitisation tools.
In June 2015, China took the first step towards cat risk transfer by using a cat bond. The cat bond (“China Re Cat Bond”) was sponsored by China Property & Casualty Reinsurance Co Ltd (“China Re”), a wholly-owned subsidiary of China Re Group. The China Re Cat Bond was issued by Panda Re, a special purpose reinsurance vehicle established by China Re in Bermuda and which issued USD50 million in notes that are listed on the Bermuda Stock Exchange. The USD50 million raised in the China Re Cat Bond provides a single layer of protection for China Re against earthquake risk in China. In this cat bond, China Re ceded part of its earthquake risk to Panda Re, which provides collateralised reinsurance coverage through the proceeds from the sale of the notes. The China Re Cat Bond is on an indemnity trigger basis per occurrence.
What is a cat bond?
Cat bonds are a key segment of the ILS market. Cat risks written by insurers and reinsurers are transferred to capital market investors through the issuance of notes by a special purpose reinsurance vehicle (such as Panda Re). The special purpose reinsurance vehicle (“SPRV”) reinsures the insurer or reinsurer that sponsors the cat bond and collateralises its reinsurance obligations with the proceeds of the cat bond issuance. As a result, the sponsoring insurer or reinsurer is protected by the collateral and faces low counter-party credit risk. By obtaining such coverage, the sponsoring insurer or reinsurer is able to free capacity for writing new business.
For investors (typically institutional investors), cat bonds are attractive as they offer a relatively high coupon rate. Moreover, they are not correlated with other financial market fluctuations and therefore are a useful tool for investors to diversify risks of their investment portfolios.
How does it work?
As noted above, the cat bond issuance proceeds are placed in a collateral account for the protection of the sponsoring insurer or reinsurer. The interest and other income is paid to the investors as interest, and upon maturity the investors are repaid the principal. However, the payment of a cat bond’s interest and/or principal depends on the occurrence of a cat event that results in a loss in excess of an agreed amount or level. In other words, investors may lose part or all of their investment when a cat bond is triggered under a defined mechanism.
Triggers for a cat bond can be structured in many ways such as the following:
- Indemnity Trigger – An indemnity trigger is based on the sponsor’s actual loss. Sponsors may prefer this type of trigger so as to minimise the basis risk (i.e., the difference between the sponsor’s actual losses and the bond’s pay-out). It is the type of trigger used in the China Re Cat Bond.
- Industry Index Trigger – This type of trigger is based on industry-wide losses. Industry index trigger will be activated when industry-wide losses reach a designated level.
- Parametric Trigger – Parametric trigger is based on the physical parameters of a cat event, such as magnitude and/or location of an earthquake or location and/or wind speed of a hurricane. A parametric trigger may be combined with another index formula or designated measurement of weather or disaster conditions, which makes it a “parametric index trigger”.
- Modelled-loss Trigger – This type of trigger adds physical parameters into an agreed ex-ante model to determine loss from an event.
- Hybrid Trigger – This refers to the use of more than one trigger type in a single cat bond.
A cat bond can also be structured to provide cover on a per-occurrence or an aggregate basis which gives exposure to a single loss event or multiple loss events over an agreed time period.
Typical structure
As noted previously, the typical structure of a cat bond includes a sponsor insurer or reinsurer, SPRV and a collateral account.
The sponsor cedes risks to the SPRV under a reinsurance agreement, in return for which the SPRV receives premium from the sponsor for the reinsurance coverage. The proceeds from the issuance of the notes (i.e., the principal of the investors) are placed into a collateral account . The collateral account typically holds investments that earn income. The investment risk for the collateral account may be reduced through a swap with a counterparty.
Investors are paid interest on agreed intervals from interest on the collateral account and premium payments. If there is nothing to trigger a claim under the reinsurance agreement within the specified period for the cat bond, the investors’ principal remains unharmed and is returned upon maturity of the cat bond. If, however, during the specified period any qualified event triggers a claim, the SPRV will liquidate the required amount of collateral to pay recoveries to the sponsor company and the investors may lose a part or all of their principal. In this way, the SPRV functions like a collateralised reinsurer to provide coverage to its sponsor.
Summary
With the development of the Chinese insurance market, Chinese domestic insurance risks may finally be linked to the international capital markets. It is natural for this trend to start with the cat insurance and reinsurance market. Cat bonds are mature and valuable risk transfer tools which are yet to be meaningfully adopted in China. As China is now building up its cat insurance system, we anticipate that cat bonds may play a more important role in this process. It will also be very interesting to see if the much-anticipated China Insurance Exchange will focus on the development of the Chinese ILS market including cat bonds.
For further information, please contact:
Carrie Yang, Partner, Clyde & Co
carrie.yang@clydeco.com
