A.M. Best to rate the “basis risk” of parametric cat bonds (September 25, 2006)

A.M. Best Co. has released a new methodology for rating the “basis risk” associated with parametric catastrophe bonds.The new methodology is designed to help the ratings agency determine the amount of reinsurance credit that can be claimed by the sponsors of such bonds.Insurers and reinsurers use “parametric” bonds to protect capital, and to share profits or losses with buyers of the bond. In contrast to index-linked and indemnity bonds, where the loss experience determines interest and principal payments, the payment on parametric bonds is linked to precise physical measurements such as the magnitude of an earthquake in a designated area, or the maximum speed of the winds in a hurricane during a time interval at a designated location.”Hurricane Katrina and other recent catastrophic events have made investors more cautious about the type of triggers they will accept in catastrophe bonds,” A.M. Best noted in a press release. “Investors have been shying away from indemnity catastrophe bonds and gravitating towards index-based parametric catastrophe bonds. (For the purposes of this press release, we consider non-indemnity catastrophe bonds as parametric catastrophe bonds).”A.M. Best believes that parametric catastrophe bonds come with ‘basis risk’ that must be considered in the financial strength ratings of the companies sponsoring the bond issues.”According to A.M. Best, basis risk, in the context of catastrophe bonds, “generally reflects the possibility that a catastrophe bond may not be partially or fully triggered (for covered perils), even when the sponsor of the catastrophe bond has suffered a loss.”A.M. Best’s new methodology determines how much reinsurance credit will be given to the insurance or reinsurance companies that sponsor catastrophe bonds with parametric triggers. “The methodology focuses on two distinct ways of measuring basis risk,” A.M. Best says. It includes: a scoring table that includes both quantitative and qualitative factors; and the impact of the parametric catastrophe bond on the aggregate exceedance curve of the sponsoring company.