PCS identifies five considerations for indemnity cat bond investors

Property Claims Services (PCS), a division of Verisk and the leading source of data on insured property losses from catastrophes in the U.S., has published an interesting report on indemnity catastrophe bonds today. The report highlights, what PCS considers, five key issues that investors in indemnity cat bonds need to be aware of.

The five issues are very relevant to any investors thinking about deploying capital into cat bond transactions which use indemnity triggers and they are also relevant to those investing in indemnity reinsurance contracts on a fully-collateralized basis.

While indemnity triggers, which are now the dominant trigger in the outstanding cat bond market, have seen increasing take-up by cat bond sponsors in recent years, as they can offer a sponsor more flexibility and a better way to fit cat bond coverage within their overall reinsurance program, they come with additional issues for investors to consider.

For sponsors, the mitigation of basis risk is a key factors, as they know that with an indemnity trigger in their cat bond protection they will receive protection for the claims they actually suffer. But for investors, PCS notes that indemnity triggers require additional evaluation effort as investors need to understand the sponsors underwriting and the underlying book of business as well as the sponsors claims handling process.

PCS makes a good point that the quality of a sponsors claims handling can influence the probability that a cat bond will attach, as well as the amount of time that will pass between a qualifying event and an eventual payout settlement or otherwise.

The report from PCS details the five key considerations it believes investors need to assess when thinking about investing in an indemnity cat bond. We’ve summarised them below, along with the mitigating actions PCS suggests, but download the full report for the full details (link at the foot of this article).

1. Catastrophe designation

Clearly defining which catastrophes qualify under the terms of a catastrophe bond transaction is one way to remove, or lessen, ambiguity over which claims are included, a key concern of investors in any cat bond deal. By using a third-party source of catastrophe designation the risk of non-catastrophe claims being included, or moral hazard leading to claims being incorrectly counted, as part of a transaction can be reduced.

2. Settlement and payment cycle time

Ensure that you understand the claims operations of the sponsor, including the experience of the teams involved, the processes in place and any supporting technologies. A slow claims process can lock up investor capital for longer periods and also result in a risk of higher claims payments. Insist on information explaining the sponsors use of adjusters, catastrophe response plans and who will be involved in closing claims.

3. Catastrophe claims tracking

PCS advises that investors understand the systems that sponsors of cat bonds use to track claims, particularly from catastrophe events. The ability to report on claims in a timely manner, as well as track and aggregate them by catastrophe event is important. The better the systems and processes in place, the faster the data will be available and the more reliable it will often be. Having reliable and fast access to data on claims for catastrophe events will help to identify trigger events and facilitate quicker settlements.

4. Dispute resolution

An indemnity trigger catastrophe bond transaction has the potential to be messy were it to go to an arbitration where a dispute resolution is required to enable a settlement. Providing common definitions for what events qualify and which claims are attributed to an event, by using catastrophe designation, is one way to mitigate this issue.

5. Fraud detection

Claims fraud can increase the likelihood of an indemnity cat bond attaching. PCS notes that as much as 10% of claims payments and loss adjustment expense can be attributed to fraud, according to the Insurance Information Institute’ s fact book for 2013. Levels of fraud this high would have a meaningful impact on the likelihood of attachment for an indemnity cat bond. Ensuring sponsors use claims fraud detection processes and technology can help to protect an investment.

The report from PCS provides more detailed information and recommendations to mitigate for each of the five considerations. As with many issues in the cat bond market the key is to ask the right questions before investing and ensure that transaction documentation is provided with enough detail to help you get comfortable enough in an indemnity cat bond deal and its sponsor to allocate capital to it.

Visit the PCS website to download a copy of the full report ‘Five Claims-Handling Considerations for Indemnity Bond Investors‘.