1. Trust:
short-term
low default
paper
proceeds
interest
remaining
funds
reinsurance
premium
redemption
Insurance
Company
SPV
CAT
Bond
interest
insured loss
proceeds
proceeds equal maximum insured loss
redemption equals funds remaining after any insured loss

2. Benefits
capital markets allow greater risk sharing (Securitized Risk Transfer)
CAT bond is a new asset class that has low correlation with other financial assets

3. Terminology CAT loss reinsurance layers of coverage
excess-of-loss contract
limit: maximum covered loss
coinsurance

4. Terminology Rate on Line (ROL) = premium / limit
Price = (ROL / actuarial probability) – 1
= premium / (limit x probability) – 1
E[loss] ≈ limit x probability
So Price = premium/ E[loss] – 1
Price > 0 if premium > E[loss]
Price < 0 if premium < E[loss]

5. Calculation Assume (for simplicity) premium is paid at end of year
Suppose limit is invested at LIBOR
If no claim is made, end-of-year value equals: Limit x (1+LIBOR) + Premium
Promised CR = LIBOR + ROL

6. Exhibit 5: Layer 2 ROL Calculation
Coinsurance = 10%
Layer from $450 to $600 M
Premium = $16.9 M
Limit = .9x( ) = $135 M
ROL = Premium / Limit
= 16.9 / 135 = 12.5%

7. Exhibit 5: Layer 2 Price Calculation
ROL = 12.5%
Pr(loss > 450) = 4.5 % (from Exhibit 4)
Price = ROL / Probability
≈ 12.5 /
= 1.8
E[loss] ≈ .045 x 135
= $ 6.1 M < $16.9 M (premium)