Perils associated with natural disasters have become more intense since 1997. Just as the insurance-linked securities sector has adjusted to these changes by developing new structures to absorb risks associated with such events as winter/ice storms, floods and tornadoes, Moody's Investors Service recently unveiled its expanded approach to rating the bonds.
In a recent special report, Moody's said it extended the parameters of its prior analysis to include new perils associated with natural disasters and extreme mortality catastrophy (CAT) bonds.
A recurring problem in analyzing CAT bonds is that the models are calibrated using historical data. The events that might actually trigger losses to CAT bond investors, however, occur so rarely and are so extreme when they do happen, that "one cannot be comfortable that history fairly represents the likelihood of such events," wrote Rodrigo Araya, a senior vice president and Ricardo Viloria, an assistant vice president, in the report. Still, the rating agency continues to rate catastrophe bonds associated with familiar perils in new regions as well as completely new dangers.
Covered perils in CAT bond deals have previously been associated with highly developed regions such as the U.S., Western Europe and Japan, because the economics of issuing the bonds requires that the notes achieve a certain scale. Those areas have seen significant impacts of catastrophic risks to merit the issuance of insurance-linked notes.
As economic development marches on in previously underdeveloped countries, insurance markets are increasingly considering issuing CAT bonds to finance policies covering valuable properties in those areas. Examples include securitization risk of earthquakes in Mexico in 2003 and an earthquarke in Taiwan, plus risks related to typhoons and earthquakes in Australia. In addition, Moody's has received new proposals for notes linked to winter/ice storms, floods and tornadoes in Europe and the U.S.
When analyzing catastrophic risk stemming from natural disasters, Moody's begins with a set of basic assumptions that describe the making of the natural disaster that threatens insured property. If Moody's is familiar with the peril, then the assumptions might not require a lot of elaboration. However, Moody's allows for the fact that familiar perils might be modeled differently in regions where they have not previously occurred frequently. Next, Moody's estimates the parameters that define the natural process - the frequency and magnitude of the disasters, generally speaking. The modeling firm will offer a thorough discussion of the data from which the parameters are estimated, whether based on human records or natural history. Much of the discussion focuses on the reliability of the data and the extent to which different sources corroborate each other.
The treatment of uncertainty is a particularly important aspect of the modeling process.
"Since the natural phenomena cannot be perfectly modeled, and since the data themselves are generally imperfect, the residual uncertainty in the description of peril generation must somehow be captured," wrote Araya and Viloria.
In terms of defining stress scenarios, Moody's finds that no model accounts for all uncertainties in the generation of CAT bond loss distribution. Therefore, it asks that other modeling parameters, such as the frequency of events, be stressed to compensate for that gap.
"Recent developments in hurricane frequency modeling appear to have validated Moody's approach," said the analysts. After the intense hurricane seasons of 2004 and 2005, modeling firms have reviewed their estimates of the frequency of occurrence of hurricanes and incorporated a short-term estimate, which essentially increases the frequency of occurrence factors of up to 40%.
The rating agency will also ask analysts to put other modeling assumptions under stress tests, especially if they are subject to uncertainty.
When it comes to rating extreme mortality CAT bonds (EMCBs), Moody's takes an independent approach to modeling risks affecting the securities.
"In Moody's experience, the main driver of losses comes from the pandemic risk," said the report. Therefore, the rating agency will assume that no medical improvements exist and the frequency of occurrence, when factoring in the severity of a pandemic.
Two important differences between CAT bonds and EMCBs, compared to other securitizations, are extension periods and counterparty exposure. CAT bonds entail extension periods of between three months and two years to allow for usual delays in reporting incidents or developing claims. On the other hand, EMCBs might require as much as two and a half years, typically, to allow for government data to be gathered, processed and reported.
As for counterparty exposure, the ratings of typical CAT bond notes are significantly lower than the counterparty's credit rating, and established downgrade provisions and collateralization levels are generally not necessary, in contrast to CDOs and typical synthetics. Therefore, Moody's will incorporate counterparty risk in the analysis.
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