Glossary - ILS & Cat Bond Terminology

A

Actuarial Pricing: The process of calculating insurance premiums based on statistical analysis of historical loss data and risk probabilities.
Aggregate Deductible: A deductible that applies to the total of all losses during a specified period, rather than to individual events.
AIR Worldwide: One of the three major catastrophe modeling firms, along with RMS and CoreLogic (formerly known as EQECAT). Provides risk assessment models for natural catastrophes.
Alternative Capital: Capital from non-traditional reinsurance sources, including cat bonds, collateralized reinsurance, and ILS funds. Also called "third-party capital."
Attachment Point: The loss threshold at which a catastrophe bond or reinsurance contract begins to pay out. Losses below this point are retained by the sponsor.

B

Basis Risk: The risk that the index or trigger used in a parametric cat bond does not perfectly correlate with the sponsor's actual losses.
Bermuda: A major domicile for cat bond SPVs and ILS funds due to favorable regulatory framework, tax treatment, and established insurance infrastructure.

C

Catastrophe Bond (Cat Bond): A high-yield debt instrument that transfers natural disaster risk from insurers to capital market investors. Principal may be lost if a specified catastrophe occurs.
Catastrophe Modeling: Computer simulation of natural disaster events to estimate potential losses. Used for pricing cat bonds and assessing risk. Major vendors include RMS, AIR, and CoreLogic.
Cedent: An insurance company that transfers (cedes) risk to a reinsurer or SPV. Synonymous with "sponsor" in cat bond transactions.
Collateral: Assets (typically high-quality securities) held in trust to secure payment obligations. In cat bonds, investor principal is held as collateral to pay the sponsor if triggered.
Collateralized Reinsurance: Reinsurance backed by collateral held in trust, providing security to the cedent. Often used as an alternative to traditional reinsurance or cat bonds.
CoreLogic (formerly EQECAT): One of the three major catastrophe modeling firms. Provides natural hazard risk assessment and modeling services.
Coupon: The periodic interest payment made to cat bond investors, typically expressed as a spread over LIBOR or SOFR plus investment income on collateral.

D

Diversification: Spreading investment across multiple cat bonds with different perils, geographies, and seasons to reduce portfolio risk.
Duration: The weighted average time until a bond's cash flows are received. Cat bonds typically have short durations (1-3 years), making them less sensitive to interest rate changes.

E

Event Trigger: A cat bond trigger based on the occurrence of a specific catastrophe event of defined magnitude (e.g., hurricane Category 4 or higher in specified zone).
Expected Loss (EL): The probability-weighted average loss over time. Key metric for pricing cat bonds, typically expressed as an annual percentage.
Exposure: The total value of insured property or assets at risk from a particular peril in a defined geographic area.
Extension Risk: The risk that a cat bond's maturity will be extended beyond the original term, typically due to uncertainty about whether an event has triggered the bond.

I

Indemnity Trigger: A cat bond trigger based on the sponsor's actual losses. Provides the most precise coverage but requires claims verification and may involve basis risk.
Industry Loss Warranty (ILW): A reinsurance contract that pays based on total industry losses from an event, rather than the cedent's individual losses.
Insurance-Linked Securities (ILS): Financial instruments whose value is derived from insurance loss events. Includes cat bonds, sidecars, collateralized reinsurance, and mortality bonds.

L

LIBOR (London Interbank Offered Rate): Former benchmark interest rate used for cat bond coupons. Being replaced by SOFR (Secured Overnight Financing Rate).
Loss Limit: The maximum amount that will be paid from a cat bond or reinsurance contract, also called the "limit of liability."

M

Modeled Loss: Estimated loss from a catastrophe event based on catastrophe modeling software, rather than actual reported losses.
Moral Hazard: The risk that having insurance or reinsurance coverage may reduce incentives for the insured party to prevent or mitigate losses.

P

Parametric Trigger: A cat bond trigger based on physical parameters of an event (e.g., wind speed, earthquake magnitude) rather than actual losses. Enables fast payouts but may involve basis risk.
Peak Peril: Natural catastrophes that cause the largest insured losses, typically hurricanes and earthquakes in developed markets.
PCS (Property Claim Services): Part of Verisk Analytics that provides industry loss estimates for catastrophe events in the United States. Often used for industry loss index triggers.
Perils: Types of catastrophic events covered by insurance or cat bonds (e.g., hurricane, earthquake, flood, wildfire).
Primary Market: The initial issuance of cat bonds to investors, as opposed to secondary market trading of existing bonds.
Probability of Attachment: The annual probability that a catastrophe will be severe enough to trigger a cat bond. Inversely related to the attachment point.

R

Rating Agency: Firms such as S&P, Moody's, and Fitch that assess and rate the credit quality of cat bonds based on expected loss and other risk factors.
Reinstatement: The process of restoring a reinsurance contract's coverage limit after a loss event, typically requiring an additional premium.
Retrocession: Reinsurance purchased by a reinsurance company to manage its own risk exposure. Cat bonds can be considered a form of retrocession.
RMS (Risk Management Solutions): One of the three major catastrophe modeling firms. Provides probabilistic risk models for natural catastrophes globally.
Rule 144A: SEC regulation allowing qualified institutional buyers to trade privately placed securities. Most cat bonds are issued under Rule 144A.

S

Secondary Market: Trading of previously issued cat bonds between investors. The cat bond secondary market has grown significantly, improving liquidity.
Secondary Perils: Natural catastrophes that individually cause smaller losses than peak perils but collectively represent significant risk (e.g., severe convective storms, wildfires, floods).
Sidecar: A special purpose vehicle that provides additional reinsurance capacity alongside a sponsor's existing business, typically for a single year or event season.
SOFR (Secured Overnight Financing Rate): Benchmark interest rate replacing LIBOR for cat bond coupon calculations. Based on overnight Treasury repo transactions.
Special Purpose Vehicle (SPV): A bankruptcy-remote entity created to issue cat bonds. Holds collateral in trust and makes coupon payments to investors.
Sponsor: The insurance or reinsurance company transferring risk through a cat bond. Pays premiums to the SPV and receives payouts if the bond is triggered.
Spread: The additional yield offered by a cat bond above the risk-free rate (LIBOR/SOFR), compensating investors for catastrophe risk.
Swiss Re Cat Bond Index: Widely-followed performance benchmark tracking total returns of a diversified portfolio of cat bonds. Maintained by Swiss Re.

T

Trapped Capital: Cat bond investor capital that cannot be returned due to uncertainty about whether a trigger event has occurred or losses will exceed the attachment point.
Trigger: The mechanism that determines whether a cat bond will pay out to the sponsor. Main types are indemnity, modeled loss, industry loss index, and parametric.
Tranche: A distinct layer or portion of a cat bond offering, often with different risk characteristics and pricing. Multiple tranches may be issued from a single SPV.

U

UCITS: Undertakings for Collective Investment in Transferable Securities. EU regulatory framework allowing cat bond funds to be marketed across Europe.

Z

Zero-Coupon: A cat bond structure where no periodic interest payments are made. Instead, returns come from appreciation of the collateral or a single payment at maturity.