Financial Market Meltdown Pulls the Indemnity Trigger

Two recently released studies show that the catastrophe bond market has all-but- abandoned indemnity triggers as confidence eroded in the financial health of individual sponsors during the market’s meltdown.

Now investors and underwriters are focusing on index-based products, including industry-wide loss indexes on catastrophe bonds and niche products tied to indexes such as industry loss warranties (ILWs) and weather derivatives.

The reasoning — according to the studies — is investors’ need for transparency.

“In a new era marked by a demand for greater transparency, the indemnity trigger proved less popular with investors,” said Aon Benefield Securities in its annual Insurance Linked Securities report.

Industry-loss triggers are currently the most popular trigger mechanism for cat bonds, according to Aon Benefield.

The study said 41 percent of $1.71 billion in transactions completed over the past twelve months were built around an industry-loss index, where the bond is triggered based on a broad industry survey of claims made.

Indemnity transactions — where the bond’s recovery in set in motion by individual sponsor losses — represented only 23 percent of bonds issued during the same period.

That is a radical change from the previous year, where indemnity transactions represented 47 percent of $5.82 billion bonds issued.

The focus on index mechanisms in catastrophe bonds reflects investors’ lack of confidence in the underwriting and claims policies of the bond’s sponsor, especially during the throes of last year’s financial crisis.

Indemnity bonds “face a higher degree of uncertainty” from investors because of the triggers, according to the Aon Benefield report.

Other trigger mechanisms, including parametric, parametric-index and modeled loss, represented a smaller mix of new bonds issued, although multiple trigger bonds did experience an uptick, the report said.

Investor demand for transparency will cause a renaissance for index-based insurance linked securities, added a Sigma report issued by Swiss Re.

“[Index linked contracts] lessen moral hazard and adverse selection problems in addition to facilitating market market liquidity and transparency,” the Sigma study said. “For investors, indices are often easier to understand than individual insurance risks.”

As ILS investors more toward indexes, the obvious beneficiaries will be other index based products such as ILWs, weather derivatives and catastrophe derivatives.

“As investors’ understanding of these indices and the risks that determine them improves, the markets should grow.”

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