Trigger Happy

ILS products typically pay out when a specified trigger is tripped. Four kinds are common.

The drawdown of investors’ principal may be activated by actual losses that have hit the issuing reinsurer or the wider market whenever:

• A threshold of modeled losses is breached
• Certain climatic or geological conditions occur
• A combination of these measures of real and theoretical loss occurs.

The choice of trigger removes uncertainty for investors and is critical to pricing the instruments (since they determine when an ILS pays and how much). Buyers of ILS contracts are reassured, with some degree of confidence, about the probability that claims will be made against the reinsurance coverage they are funding. This gives investors an idea of the likelihood that some or all of their invested capital will be burned away.

“Obviously the closer to indemnity the trigger is, the better it is for cedants, as it minimizes the basis risk between actual loss and indemnified loss,” says Andre Perez, chief executive of Horseshoe Group. “Conversely, for investors, the closer the trigger is to index, the easier it is for them to understand and avoid having to rely on the individual cedant’s modeling.” Horseshoe Group facilitates securitizations, operates SPVs and manages $7.5 billion in the ILS space.

Big data is one of the key ingredients that have made the ILS sector viable. “For cat bonds, data is important to the extent that the trigger is more indemnity-based than index-based,” Perez says. Under most indemnity-triggered ILS, an external catastrophe modeler, such as AIR Worldwide or Risk Management Solutions (RMS), will crunch the cedant’s data and certify the resulting probability of loss and expected loss. For index transactions, which usually rely on industry losses, all parties use generic data. “Typically,” Perez reports, “agencies like PCS or Swiss Re will declare the quantum of the industry event.”

INDEMNITY TRIGGERS are pulled by actual losses incurred by the issuing risk carrier. They are now the most common, with 55% of catastrophe bonds triggered by the issuer’s losses and 31% based on an industry loss index, according to Swiss Re. Indemnity triggers make catastrophe bonds behave more like conventional reinsurance contracts. In December 2014, Zenkyoren, Japan’s National Mutual Insurance Federation of Agricultural Cooperatives, issued $200 million worth of catastrophe bonds through the SPV Nakama Re Ltd. The indemnity trigger will respond to the mutual’s ultimate net losses arising from earthquake shaking, tidal waves, floods, fire-following and sprinkler damage.

Industry loss triggers are activated by incurred, market-wide losses arising from the specified event type, such as Florida windstorm. Thus, such triggers do not respond directly to the reinsured company’s actual losses.

In December, the Lloyd’s-focused insurer Amlin issued a catastrophe bond with an industry loss trigger through its SPV Tramline Re II. The trigger point is based on figures produced by Property Claims Service (PCS) for U.S. earthquakes and named storms, and PERILS data for European windstorms. The two organizations were formed specifically to calculate such industry losses. PCS is owned by Verisk Analytics, a Nasdaq-listed insurance services company founded by the Insurance Services Office. PERILS was formed in 2009 by the reinsurers Allianz, AXA, Generali, Groupama, Munich Re, Partner Re, Swiss Re, and Zurich, along with Marsh’s reinsurance brokerage, Guy Carpenter.

MODELED LOSS TRIGGERS pay based on a computerized projection of the losses likely to arise from a specific actual event. In September 2014, the California State Compensation Insurance Fund acquired $250 million of reinsurance from the SPV Golden State Re II Ltd., which issued catastrophe bonds triggered when computer-predicted workers comp claims arising from one or more California earthquakes exceed an index value of 1,000, as calculated by modeling giant RMS.

PARAMETRIC TRIGGERS pay based on an experience, usually of some kind of weather or geological phenomenon, in a specified region. This could be, for example, wind speed during a storm that has made landfall in Florida. During the early development of cat bonds, they were the only mechanism that would trip the securities into payment, but today parametric triggers alone apply to only 7% of catastrophe bonds. One such example is a bond arranged by JLT Capital Markets and issued for an undisclosed reinsurance buyer in May 2014 through the SPV Market Re Ltd. The bonds will pay up to $30 million when triggered by North American earthquakes of a specified (but also undisclosed) magnitude.

HYBRID TRIGGERS have a combined switch that usually blends parametric and modeled losses. Complex ILS often employ such devices to determine when buyers receive payment under the instruments, but cat bonds sometimes use them too. A bond issued directly by the World Bank in June 2014 to reinsure the Caribbean Catastrophe Risk Insurance Facility (CCRIF) employs a hybrid trigger. It will respond to storm surges, cyclonic winds and earthquakes, with up to £30 million (US$45.2 million) of cover.

Source: Data from www.Artemis.bm, which tracks ILS deals, was used in compiling the details of some of these transactions.