Pricing in the Primary Market for Cat Bonds: New Empirical Evidence

• Author: Alexander Braun
• DOI: http://doi.org/10.1111/jori.12067
• Published date: 01 December 2016
• Date: 01 December 2016

©2015 The Journal of Risk and Insurance. Vol.83, No. 4, 811–847 (2016).

DOI: 10.1111/jori.12067

Pricing in the Primary Market for Cat Bonds:

New Empirical Evidence

Alexander Braun

Abstract

We present empirical evidence from the primary market for cat bonds,

which provides new insights concerning the prevailing pricing practice of

these instruments. For this purpose, transactional information from a mul-

titude of sources has been collected and cross-checked in order to compile

a data set comprising virtually all cat bond tranches that were launched

between June 1997 and December 2012. In order to identify the main de-

terminants of the cat bond spread at issuance, a series of OLS regressions

with heteroskedasticity- and autocorrelation-consistent standard errors is

run. Our results confirm the expected loss as the most important factor.Apart

from that, covered territory, sponsor, reinsurance cycle, and the spreads on

comparably rated corporate bonds exhibit a major impact. Based on these

findings, we then propose an econometric cat bond pricing model that is

applicable for all territories, perils, and trigger types. It exhibits a robust fit

across different calibration subsamples and achieves a higher in-sample and

out-of-sample accuracy than several competing specifications that have been

introduced in earlier work.

Introduction

Throughout the last decade, the market for catastrophe (cat) bonds has witnessed sub-

stantial growth rates. Cat bonds are securities that pay regular coupons to investors

unless a predetermined event occurs, leading to full or partial loss of capital. The prin-

cipal is held by a special purpose vehicle (SPV) in the form of highly rated collateral

and paid out to the hedging (re)insurer to cover its losses if the trigger condition, as

defined in the bond indenture, has been met (see, e.g., Braun, 2011). The success of

this type of insurance-linked security (ILS) is based on its popularity as an alternative

risk transfer technique for (re)insurance companies and on its reputation for exhibit-

ing an appealing risk–return profile as well as low correlations with traditional asset

Alexander Braun is at the Institute of Insurance Economics of the University of St. Gallen,

Switzerland. He can be contacted via e-mail: alexander.braun@unisg.ch.The author would like

to thank Keith Crocker, three anonymous referees, and the participants of the 2013 American

Risk and Insurance Association (ARIA) annual meeting in Washington, DC for their valuable

advice. In addition, he is deeply grateful to the Asia-Pacific Risk and Insurance Association for

the Harold D. Skipper Best Paper Award2013. This article has been supported by a postdoctoral

grant of the basic research fund (GFF-HSG) of the University of St. Gallen.

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812 The Journal of Risk and Insurance

classes. Particularly,institutional fixed-income investors are increasingly attracted by

the instrument, since it is fully collateralized and virtually offers a pure exposure

to natural disaster risk in a familiar bond format (see Swiss Re, 2006). Although the

cat bond asset class has withstood the major dislocations during the recent finan-

cial crisis fairly well, issuance volumes declined sharply in 2008. In the meantime,

however, the size of the primary market has returned to precrisislevels. Unlike other

securitizations, such as asset-backed securities (ABS), cat bonds still represent a niche

segment of the global capital markets, but are starting to reach a critical scale relative

to property–catastrophe reinsurance (see Cummins, 2008). Thus, it is safe to state that

these instruments have firmly established themselves as a permanent alternative in

the risk transfer domain. In addition, due to the securitization of new risk types, an in-

creasingly liquid secondary market, and an ever-expanding investor base, the future

perspectives look bright (see, e.g., Cummins and Weiss, 2009; Deutsche Bank, 2010).

Despite their growing importance, a relatively limited amount of scholarly research

has been devoted to the valuation of cat bonds so far. Most extant work in this regard

is concerned with contingent claims (see, e.g., Lee and Yu, 2002; Wu and Chung,

2010; Jarrow, 2010) or equilibrium models (see, e.g., Cox and Pedersen, 2000; Egami

and Young, 2008; Zhu, 2011). In contrast, pure econometric approaches, which are

commonly employed in the empirical asset pricing literature, have not been firmly

established yet. Although the latter may seem scientifically less satisfying at first

glance, if their specification is chosen carefully based on economic theory, they can be

a powerful means for the identification of major pricing determinants. Consequently,

a factor pricing model with a sufficient degree of stability and accuracy, as proven by a

battery of cross-sample and out-of-sample checks, may provide a valuable foundation

for more intricate theoretical models.

The persisting lack of applied research on cat bond prices is mainly attributable to the

scarcity of publicly available data. One of the earliest empirical studies is authored

by Lane (2000), who fits a power function with two parameters, the probability of

first loss and the conditional expected loss, to a small cat bond sample from 1999. Lei,

Wang, and Tzeng (2008), in contrast, rely on a linear model and extend their analysis

by the probability of exhaustion as well as transaction-specific characteristics such

as maturity, issue size, trigger type, and rating. Their data set comprises 177 primary

market deals, covering the period from 1997 to 2007. Similarly, Lane and Mahul (2008)

examine about 250 tranches that have been issued between 1997 and early 2008, il-

lustrating the impact of the underlying peril and the reinsurance cycle. Subsequently,

they reestimate their model with small cross-sections of secondary market prices at

two different points in time. Dieckmann (2009) considers secondary market data for

a cross-section of 61 cat bonds before and after the occurrence of Hurricane Katrina in

August 2005 to reveal significant spread drivers as well as the effect of mega-events

on the pricing relation. The impact of the 2005 hurricane season is also examined by

Ahrens et al. (2009), who draw on a Bayesian estimation technique to test the model of

Lane (2000) based on 199 observations between 2003 and 2008. Furthermore, Gatumel

and Gu´

egan (2009) aggregate market maker quotes for a few cat bond tranches into

an index time series, which they then employ to study the behavior of secondary mar-

ket spreads from 2004 to 2009. Another analysis of the primary market is provided by

Pricing in the Primary Market for Cat Bonds 813

Papachristou (2009), who explores factors that affect the cat risk premium by applying

a generalized additive model to 192 bonds launched between 2003 and 2008. Bodoff

and Gan (2009) rely on a sample of 115 transactions issued before 2008 to devise a

pricing approach, incorporating expected loss, covered territory, and reference peril.

Moreover,Jaeger, Mueller, and Scherling (2010) and Galeotti, Guertler, and Winkelvos

(2012) compare the fit of different models that have been broughtforward in the litera-

ture. In doing so, the former adopt both indicative cat bond and industry loss warranty

(ILW)prices as of August 31, 2009, while the latter use primary market spreads for 176

issues between 1999 and 2009. Finally,the most sophisticated secondary market study

to date has been conducted by Guertler, Hibbeln, and Winkelvos (forthcoming), who

assess the impact of financial market turmoil and large natural disasters on cat bond

spreads by means of panel data methodology.

Owing to these prior efforts, much is already known about the roleof the expected loss

in cat bond pricing as well as the suitability of different functional forms for premium

calculation models. Nevertheless, further determinants of the primary market spread

are still not sufficiently well understood. Apart from that, some of the earlier analyses

appear to suffer from drawbacks such as small sample sizes, inconsistent standard

errors, and selection bias. The article at hand is intended to address these issues by

providing new empirical evidence from the primary market. Our contributions are

threefold. First, we have compiled the most comprehensive cat bond data set consid-

ered in the literature to date, comprising 466 tranches that were issued between June

1997 and December 2012. Hence, our analysis is going to account for every impor-

tant stage since the inception of this market in the 1990s such as its takeoff period,

the hard market following Hurricane Katrina in 2005, and the global financial crisis

of 2008. Second, we identify the main drivers of the cat bond spread at issuance by

running a series of ordinary least squares (OLS) regressions with heteroskedasticity-

and autocorrelation-consistent (HAC) standard errors. Third, based on the respective

findings, we introduce an econometric pricing model for cat bonds in the primary

market and assess its in-sample and out-of-sample accuracy relative to other, rather

actuarially oriented specifications that have been suggested in the literature.

The remainder of this article is organized as follows. In the next section, we review the

typical characteristics of cat bond transactions such as the structure, the trigger types,

and the underlying perils, and derive a range of testable hypotheses. The empirical

analysis is conducted in the third section. Here, we describe our data set, document a

number of facts about the primary market for cat bonds, provide a multitude of de-

scriptive statistics, and test the significance of various potential spread determinants.

In the penultimate section, we then propose the econometric pricing model and eval-

uate its performance. Finally, in the last section, we summarize our main results and

draw our conclusion.

Background and Development of Hypotheses

Cat Bonds

Cat bonds have been developed by insurers and reinsurers to transfer natural disaster

risks to the capital markets. As depicted in Figure 1, at the heart of a typical transaction