Catastrophe bonds are an increasingly importantform of risk transfer for insurers.

Cat bonds are a peculiarity of the U.S. reinsurance market,where about 125 to 200 natural disasters occur yearly.

They were first sold in the mid-1990s, after Hurricane Andrew and the Northridge earthquakehighlighted the need for a new form of risk transfer.

The cat bond market has been growing steadily for the past 10years, and more than $25 billion in catastrophe bond andinsurance-linked securities are currently outstanding, according toArtemis. 

Dedicated ceded reinsurance system

Many insurers have moved away from managing their cededreinsurance program with spreadsheets, which are time-consuming anderror-prone in light of current regulatory and internal demands.More carriers have installed or are planning to install a dedicatedceded reinsurance system that provides better controls and audittrails.

Besides enabling reinsurance managers to keep senior managementinformed, a system helps carriers comply with the recent RiskManagement and Own Risk and Solvency Assessment Model Act(RMORSA). It also generates Schedule F and statutory reporting, anonerous job otherwise. In addition, technology prevents claimsleakage, meaning, reinsurance claims that fell through thecracks.

Cat bonds add a layer of complexity. The cat bond premium is a"coupon" that the insurer pays to the bond buyer. There are manypotential losses behind each bond and the potentially huge recoveryamounts — up to hundreds of millions of dollars for some insurers.Other complexities include a priority deductible, an hours clause,lines of business reinsured or excluded, and attachment criteria toautomatically identify subject catastrophe amounts. Withouttechnology, tracking all this can be overwhelming.

Managing cat bond premiums

The ceded reinsurance system can also be used to manage cat bondpremiums. From a system perspective, it's not terribly different.The same analytical split (per line of business and per insurancecompany in the group) applies to bonds just as it does toreinsurance treaties. With a little tweaking, a solid cededreinsurance system should be able to handle cat treaties and bondsequally well.

While ceded premium management for cat bonds shouldn't bedifficult, claims present bigger challenges, especially when tryingto automatically calculate the ultimate net loss (UNL) becauseadditional factors and rules are often used to determine it.

For instance, it may be necessary to apply a growth-allowancefactor, determine the number of policies in force when the catoccurs and calculate growth-limitation factors. This allows thecalculation of ceded recoveries in case of a catastrophe.Additionally, the calculation of UNL may be specific foreach cat bond and even for each corresponding peril.

Automation can reduce complexity

To automate all of this isn't necessary because few eventstrigger those complexities. Once a manual workaround incorporatingthe audit trail and justification of the subject amounts is done,the reinsurance system can handle the remaining calculations.

While it's not necessary to fully automate all steps tocalculate the UNL, it is still better to handle the whole processwith an integrated information system than with multiplespreadsheets that are unwieldy and labor-intensive.

Without the right technology, managing cat bonds is daunting.With automation, they can be managed far more effectively.

Related: Here's what 100 years' worth of hurricane data saysabout losses and CAT reinsurance [Report]

Grégory Moliner is CEO of Effisoft USA,Inc., an international reinsurance software vendor based inMiami. Contact him at [email protected]. Opinionsexpressed are his own.