How Insurance Risk Is Transformed Into Investable Assets

The lack of information was my inspiration for building Riskvest. I called my own broker and when I said catastrophic bonds they asked if I meant buying bonds already in default.

On the risk side - your comments here are part of the myth I’m trying to dispel and will have lots more to say in future posts.

Yes for a single CAT bond you are exposed to potential 100% principle losses. But if you buy a bundle of CAT bonds that focus on say California Earthquake, Florida Hurricane, Japanese Typhoon, and a Cyber Event, you can imagine the diversification benefit you get there.

I’ve already created a very very simple model for people to play around with and learn the intuition for CAT bond return patterns. A default means 100% loss and this is unique vs. other bonds. I plan in the future to build a much more robust model.

https://www.riskvest.io/data-lab/cat-bond-portfolio-simulato...

CAT bonds are typically restricted to institutional investors. I would be very surprised if you could even buy one without being a QIB.

There are institutional funds but generally it’s a small market with very limited retail presence. Schroders has one. (Artemis is a great source of info in the space - niche trade publication.)

https://www.artemis.bm/ils-fund-managers/schroder-investment...

It has been growing slowly for the past 25 years. The limited market size is a reflection of the demand by traditional insurers and reinsurers, for alternative sources of capital. This is as it should be.. when traditional players start transferring risk to the capital markets motivated by the fees involved, or cheaper rates (premium), then you really start worrying about moral hazard i.e. ‘bad risks’ getting transferred to investors.

Correct on every point and great insight, hello fellow insurance person.

I will clarify that CAT bonds can have industry loss triggers OR actual indemnity triggers. If an indemnity trigger then the insurer has to prove the actual loss. But you’re right on ILWs (Industry Loss Warranty) in that there is additional model/basis risk considerations.

Insurance companies try to minimize this basis risk. Because while sure it’s great to be in the situation where your CAT bond recovers when you didn’t have large losses, it’s NOT good to be in the position where you had big losses and you don’t recover. Certainty of recover can affect things like how much regulatory credit you get for your reinsurance.

Curious what major trends you’re seeing in your line of work. Guessing global warming induced increase in weather related hazards in some places - anything that would be surprising to people outside the industry?

> CAT bonds are generally tied to the specific natural hazard ("this bond triggers if a hurricane of Category 3 or higher land falls in this segment of Florida") or to industry losses, as estimated by an agreed upon source.

A big part of the reason for this is that if payout is tied to actual loss, it starts to look a lot like actual insurance, which is specifically not what you want. Because while anyone* can buy a bond, only insurers or reinsurers can write insurance. This is something that needs to be considered whenever an insurer (or anyone, really) tries to transfer risk to a non-insurer.

Having worked on reinsurance software in the 90s, one question that springs to mind, which came to light from the asbestos claims era, was brokers commission. What did happen was brokers would package up risks and sell those off (taking commission) which would see other brokers bundle those up and again package them and others up into a bundle and sell those off. So when a claim came down the line, that was huge, like the asbestos claim in period https://en.wikipedia.org/wiki/Lloyd%27s_of_London which saw such a diluted risk and brokers commission leaching all profit, brought many down financially due to exposure.

So interested how things are today regarding brokers endlessly packaging up risks they sell on, rinse repeat. I'm aware of certain changes that came about to reinsurance brokers in both the Lloyds and London Markets on the back of the asbestos claim era, but not sure of the the CAT model risks/insurance regarding brokers endlessly packaging up to offset risk exposure vs regulations limiting how much they can do that - more so the USA market.

So curious - is there a risk from brokers diluting risks for commission profits in this market or is that saftly covered against and regulated?

Thanks for sharing your insight. Wouldn't hurt from a proofread. There are some typos / wrong words, that detract from the sense of authority lent by the article. Eg:

"It's clear that we this structure" --> with

"with out those protections in place" --> without

"Investors would be best to limit their exposer to losses beyond their investment" --> exposure

There might have been others, I had to go back and skim to summarize for you.

> For the web designers here please let me know if you noticed anything amiss.

The images some of the visuals do not show in reader view in Safari and Firefox. Other than that, the content is well laid out and very readable.

Very minor nit: "It's clear that we this structure,..."

Cool article, it's a clear explanation of something I never knew about.

I'm not aware that these currently exist but the concept of reinsurance on reinsurance is not new (it's called retrocession). I will do some digging and see what I can find - thanks for the suggestion.

(Margot Robbie)

This topic feels closely related to GFC.

I don't think so. I'm pretty sure it was considered an 'act of G-d', not an act of China :)

I think you could also have specific pandemic insurance, and that paid out, but those were rare before Covid.

Why would it? I don't think that much pandemic insurance is written and obviously you model all the contracts as being very highly correlated.

The impact was nuanced, and depended on the specific policies in place.

Some businesses had business interruption insurance which paid out. Many policies exclude highly correlated events such as pandemics.

And then think about specific events which were cancelled, which may have bought policies protecting them if cancelled.

And of course life insurance and health care would have been affected.

SwissRe often produces public reports in the space if of interest:

https://www.swissre.com/risk-knowledge/building-societal-res...

In the end there's always someone left holding the can. Lloyd's of London has underwriters with unlimited liability. Incredibly, a lot of these Names have historically been private individuals. In the 90s a lot of these lost their shirts (and their homes) when they dicovered that it wasn;t just an easy source of passive income. https://www.theguardian.com/money/2000/nov/04/business.perso...

While Covid 19 was certainly a "Catastrophe", the market for pandemic insurance in 2020 was minuscule and to my knowledge did not cause any insurer solvency issues. There were a few cases of insurers being instructed to pay out significant claims by the courts on Business Interruption losses which the insurers argued were not covered due to existing policy exclusion.

Product development is usually highly specialized as there are a lot of nuances and frictions within the insurance industry that outsiders may not fully understand. It helps also to be in the industry and have the network with insurers, reinsurers, brokers, etc. This is not at all to suggest there isn't room for clever people to bring innovation to the market though!

Book recs are hard to specify for CAT bonds but for insurance in general:

Against the Gods: The Remarkable Story of Risk - Peter L. Bernstein

The Black Swan - Nassim Nicholas Taleb

On the Brink: How a Crisis Transformed Lloyd's of London - Andrew Duguid

The last one is a personal favourite of mine

Thank you! As an Actuary I'm not exactly known for my design skills so it was a lot of effort to get things looking the way I wanted.