status: draft

Trigger types

The trigger determines when you lose principal. This is arguably the most important structural feature of any ILS investment. Different triggers trade off basis risk (for the sponsor) against moral hazard (for the investor).

Indemnity triggers

You pay based on the sponsor’s actual incurred losses on their book of business.

How it works

The sponsor reports losses according to agreed methodology:

• Quarterly loss reports during the risk period
• Reserves plus paid claims
• Independent verification or audit rights
• Final commutation after development period

If cumulative losses exceed the attachment point, principal releases to cover the loss.

Advantages

• No basis risk for sponsor: They get paid exactly what they lose
• Clean hedging relationship: Perfect correlation between hedge and exposure
• Alignment with traditional reinsurance: Familiar to cedents

Disadvantages

• Moral hazard: Sponsor could under-price policies or relax underwriting knowing you’re backstopping
• Adverse selection: Sponsor knows their book better than you
• Long reporting period: Losses develop over 18-36 months
• Trapped capital: Principal locked during development period
• Requires transparency: Audit rights, detailed reporting, exposure disclosure

Reporting requirements

Report	Frequency	Content
Loss report	Quarterly	Paid + reserved losses, event details
Exposure update	Annual	Current book composition, geographic distribution
Event notice	Within 30 days	Preliminary loss estimate for qualifying events
Final commutation	End of development	Audited final loss determination

Watch for vague reserve estimation provisions, limited audit rights, or sponsor discretion in loss determination.

Industry loss index triggers

Payment triggers when an industry loss index exceeds a threshold. In the US, Property Claims Services (PCS) is the standard index. In Europe, PERILS provides windstorm indices.

How it works

1. Catastrophe event occurs
2. Index provider surveys industry losses
3. Index develops over 12-24 months as claims are reported
4. If index exceeds attachment, bond pays proportionally

US PCS example:

• Attachment: $40B industry loss
• Exhaustion: $55B industry loss
• Bond limit: $100M
• PCS final estimate: $50B
• Payout: $100M x ($50B - $40B) / ($55B - $40B) = $66.7M

Advantages

• No moral hazard: Sponsor’s behavior doesn’t affect industry index
• Faster settlement: PCS typically develops within 12-18 months
• Transparent: Third-party verification
• No exposure data required: Sponsor doesn’t disclose book details

Disadvantages

• Basis risk: Sponsor’s losses may not match industry proportion
• Index methodology changes: PCS can change how losses are calculated
• Small sponsor mismatch: Small sponsors may have losses uncorrelated with industry

Basis risk analysis

Sponsor Profile	Basis Risk Level	Why
Top 5 national carrier	Low	Large book tracks industry closely
Regional carrier	Moderate	Geographic concentration may diverge
Mono-line specialist	High	Product mix may not match index
New market entrant	Very high	Book too small to track index

Worked example of basis risk:

A Florida-focused insurer writes 80% of premium in Miami-Dade County. Industry losses are $45B from a hurricane that makes landfall in Tampa. The insurer’s losses are only $200M (below average market share) because the storm missed their concentration. The industry index triggers at $40B, but the sponsor doesn’t need the protection.

Conversely, a storm hitting Miami might cause $30B industry loss (no trigger) while devastating this sponsor.

Index development periods

PCS continues developing loss estimates for 18-36 months post-event. The development period in your bond determines when final payment is calculated.

Period	Characteristics
18 months	Standard for recent deals, may truncate late-developing claims
24 months	More conservative, lower basis risk
36 months	For long-tail events (rare in cat bonds)

If PCS is at $48B when your 18-month period ends and your $50B attachment wasn’t breached, you get principal back even if PCS later revises to $52B.

Parametric triggers

Payment based on measured physical characteristics: wind speed at specific coordinates, earthquake magnitude and depth, barometric pressure.

How it works

Define objective, measurable parameters:

• Wind speed > 110 mph at Station X
• Earthquake magnitude > 7.0 within 50km of Point Y
• Central pressure < 940 mb at landfall

If the reading exceeds the threshold, you pay. No loss assessment required.

Advantages

• Fastest settlement: Immediate data availability (hours to days)
• Complete transparency: Objective measurement, no discretion
• No moral hazard: Sponsor behavior irrelevant
• No adverse selection: Parameter is parameter

Disadvantages

• Highest basis risk: Strong wind doesn’t always mean big losses
• Measurement station reliability: Station failures, data gaps
• Model risk: Correlating physical parameters to losses requires modeling
• Location specificity: Storm that misses measurement point may still cause losses

Parametric trigger examples

Hurricane (wind speed):

Trigger activates if sustained wind speed exceeds 110 mph at any of the following NOAA stations within a 50km radius of [defined coordinates], with verification from NOAA official records.

Earthquake (magnitude and depth):

Trigger activates if USGS reports earthquake of magnitude 7.2 or greater with hypocenter depth less than 30km within the defined fault zone.

Typhoon (pressure):

Trigger activates if JMA reports central pressure below 940 mb at the point of closest approach to defined coordinates.

Measurement contingencies

What happens if the designated station fails? Contracts should specify:

• Backup stations
• Interpolation methodology
• Alternative data sources (satellite, reanalysis)
• Dispute resolution for contested readings

Modeled loss triggers

A catastrophe model runs the actual event parameters against the sponsor’s exposure data to calculate “modeled loss.” Payment based on model output, not actual reported losses.

How it works

1. Event occurs with known physical parameters
2. Event footprint (wind field, shake map) is input to cat model
3. Model runs sponsor’s exposure data through vulnerability functions
4. Outputs “modeled loss” for the event
5. Payment based on modeled loss vs. attachment/exhaustion

Advantages

• Faster than indemnity: Model runs in days/weeks
• Sponsor-specific: Reduces basis risk vs. industry index
• No loss development: No waiting for reserves to season
• Objective process: Model version and inputs are documented

Disadvantages

• Model is a black box: Model version and settings matter
• Exposure data accuracy: Garbage in, garbage out
• Disputes over inputs: Which event footprint? Which exposure file?
• Model changes: Newer model version might give different result

Model specification

Contracts should specify:

• Model vendor (AIR, RMS, CoreLogic)
• Model version (specific version number)
• Exposure data vintage (and any update requirements)
• Event footprint source (official agency, model vendor)
• Resolution settings (county, ZIP, lat/long)

Model vs. actual divergence

Scenario	Model Output	Actual Loss	Implication
Model accurate	$50M	$52M	Normal variance
Model underestimates	$40M	$70M	Sponsor eats $30M basis risk
Model overestimates	$60M	$35M	Investor pays more than actual

Sponsors accept modeled loss triggers when they trust the model and want faster settlement. Investors prefer them when they distrust sponsor loss reporting.

Trigger comparison summary

Trigger Type	Basis Risk for Sponsor	Moral Hazard for Investor	Settlement Speed
Indemnity	None	Highest	24-36 months
Modeled loss	Low-Moderate	Moderate	1-3 months
Industry index	Moderate	Low	12-18 months
Parametric	Highest	None	Days-weeks

Choosing the right trigger

Sponsor Profile	Recommended Trigger	Rationale
Large national carrier	Index or modeled	Low basis risk, faster settlement
Regional with concentration	Indemnity or modeled	Basis risk too high with index
First-time issuer	Indemnity	Investors demand visibility
Repeat issuer with track record	Any	Trust established
Sophisticated investor base	Any	Investors can model basis risk
Pension fund buyers	Index or parametric	Prefer objective triggers

Hybrid structures

Some deals combine trigger types:

Primary parametric with indemnity tail:

• Parametric trigger for initial payout (fast)
• Indemnity adjustment if actual losses diverge materially

Index attachment with modeled development:

• Industry index determines if layer attaches
• Modeled loss determines actual payout percentage

Hybrid structures add complexity but can reduce basis risk while preserving some settlement speed.

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status: draft

For how triggers interact with catastrophe modeling, see Catastrophe modeling. For overall cat bond structure, see Catastrophe bonds.