Catastrophe bonds are an increasingly important form of risk transfer for insurers. Cat bonds are a peculiarity of the US reinsurance market, where about 125 to 200 natural disasters occur yearly. The cat bond market has been growing steadily for the past ten years, and ceded reinsurance systems should include features needed to manage these reinsurance bonds.
Managing cat bonds successfully is so complex it’s almost impossible without dedicated software. An insurer needs two systems. First, it needs actuarial software to model the cat bond.
Second, it needs a reinsurance administration system to handle premiums and claims. The latter is crucial because of the size of and complexity of cat bonds, including the number of potential losses behind each bond and the potentially huge recovery amounts—up to hundreds of millions of dollar for some insurers.
From a system perspective, managing a cat bond is not terribly different from managing a cat treaty. With a little tweaking, a good ceded reinsurance system should be able to handle cat treaties and bonds equally well, with special attention to bond claims management.
For cat excess of loss treaties, the reinsurance premium is calculated as a portion of the gross written or earned premium with application of a premium rate and a minimum and deposit premium. In contrast, the cat bond premium is a “coupon” that the insurer pays to the bond buyer.
Cat bonds have many complexities, including a priority deductible, an hours clause, lines of business reinsured or excluded, and attachment criteria to automatically identify subject catastrophe amounts. Nevertheless, these items can be accommodated by any solid reinsurance software package.
Ceded premium management for cat bonds shouldn’t be difficult. The same analytical split (per line of business and per insurance company in the group) applies just as it does for cat reinsurance treaties.
Bond claims present bigger challenge, especially when trying to automatically calculate the ultimate net loss (UNL). Management of subject paid losses, case reserves, incurred but not reported, and allocated or unallocated loss adjustment expenses is standard for a reinsurance software package. However, several additional factors and rules are often used to determine the UNL.
For instance, it may be necessary to apply a growth-allowance factor, determine the number of policies in force when the cat occurs, and calculate growth-limitation factors. This number-crunching allows the calculation of ceded recoveries in case of a catastrophe. Additionally, the calculation of UNL may be specific for each cat bond and even for each corresponding peril.
To automate all this would be a big challenge. Fortunately, few events trigger those cat bond complexities. Once a manual workaround incorporating the audit trail and justification of the subject amounts is done, a solid reinsurance software system can take it from there and handle the remaining calculations.
While it may not be necessary to fully automate all steps to calculate the UNL, it is still better to handle the whole process with an integrated information system than with multiple spreadsheets. Without the right technology, cat bond claims are dauntingly complex. With the right system, they can be managed effectively.
Grégory Moliner is CEO of Effisoft USA, Inc., an international reinsurance software vendor based in Miami.