Catastrophe Bonds: Five Questions to Ask about Indemnity Triggers

By Gary Kerney September 10, 2012

The catastrophe bond market has matured since its inception about 15 years ago. Sponsors have more resources at their disposal for designing structures that deliver the specific protection they need, and investors have responded with an increased appetite for this form of risk. What’s next? An increase in the variety of triggers available, as the rise of indemnity triggers for some large catastrophe bonds this year demonstrates.

Yet the recent moves obscure some of the limitations of indemnity triggers. Before issuers plunge ahead — and investors commit their capital — they should ask five straightforward questions:

1. Who makes the call? The definition of a catastrophe is crucial to indemnity triggers. While some catastrophe bonds effectively leave this up to the issuer, several sponsors have opted for the PCS Catastrophe Loss Index for catastrophe determination to ensure that a reliable and independent third party is part of the process.

2. How are catastrophe losses counted? Even when a transaction uses an outside source such as PCS for catastrophe declaration, investors should still make certain they understand the internal process for aggregating catastrophe losses as well as the role of an outside auditor in protecting investors. Ultimately, the process for measuring catastrophe losses should be clear.

3. What experience does the sponsor have? Repeat sponsors that have strong track records with indemnity triggers may not be the same as first-time catastrophe bond market participants. For new players, starting with the PCS Catastrophe Loss Index, for example, could make investors more comfortable.

4. What is the cost impact? In evaluating the cost to issue a catastrophe bond, sponsors should determine whether there are any additional costs associated with an indemnity trigger, particularly soft internal expenses to create and market the transaction, not to mention tracking and measuring catastrophe losses.

5. What is the future of indemnity triggers? The last big year for indemnity-triggered catastrophe bonds was 2007, the most active issuance year in the market’s history. This year is set to be nearly as robust and may even break the 2007 record. But what’s ahead? If 2013 doesn’t see the same large transactions that lately have used indemnity triggers, investor perception may shift, leading to a resurgence in demand for industry loss-triggered bonds. Potential sponsors need to be prepared for this possibility.

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Gary Kerney

Gary Kerney, one of the most prolific contributors to this blog, retired from Verisk in 2013. Mr. Kerney served as assistant vice president, Property Claim Services (PCS). Since joining PCS in 1981, he worked on catastrophe identification, loss estimating, and catastrophe response and mitigation.