CAT Bond Issuance as a Substitute for Holding Capital

Summary

The note frames a catastrophe bond from the insurer or sponsor’s perspective as a way to transfer catastrophe risk and reduce the need to hold capital against adverse events. The economic comparison is between the cost of issuing the bond and the cost of retaining that capital requirement.

The relevant issuance costs include the risk premium paid to investors and transaction expenses. Issuance may be advantageous when those costs are lower than the opportunity cost of holding capital. This is a conceptual decision rule, not a complete profit formula: estimating the comparison can require catastrophe models, exposure portfolio models, and applicable regulatory capital requirements. The note gives no numerical example or model specification, so it does not show how to quantify those inputs for a particular insurer or bond.

Key ideas

• A CAT bond transfers catastrophe risk and can serve as surrogate capital for an insurer.
• The sponsor compares investor risk premiums and transaction costs with the cost of holding capital.
• Issuance is economically attractive when its costs are lower than the relevant capital opportunity cost.
• Practical estimates depend on catastrophe exposure models and regulatory capital calculations.

Tags

# How to calculate CAT-Bond Profit


# How to calculate CAT-Bond Profit












I understand that a CAT Bond is supposed to be a high risk and high return for the investor and a risk transfer for insurer. But as the sponsor (the issuer of the bond), how can one calculate the profit ?

## Answer by g g (score 3)

https://quant.stackexchange.com/a/78852

A (re)insurer has to hold capital for adverse events. CAT bonds provide relieve in case of catastrophic events and thus can be seen as a form of surrogate capital. Issue of a CAT bond is advantageous if the opportunity cost of the CAT bond, i.e. the risk premium payable to investors into the bond and its transaction cost, is smaller than the cost of holding the capital. The logic is pretty much the same as it is for banks or traders hedging their positions or for retail clients buying insurance. The details may be complicated, as (re)insurers rely on in-house or vendor catastrophe models combined with portfolio models of their exposure and (regulatory) capital requirements. See this white paper for more infos.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.