Spotlight on Catastrophe Bonds

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Table of Contents

Introduction
Cat bonds overview and history
Cat bonds as securities
Risks associated with cat bonds
Cat bond risk triggers
Comparison between cat and other bond categories
Market participants in the cat bond market
Conclusion
Works Cited

Introduction

Disaster bonds or catastrophe (cat) bonds are income securities that are issued by insurers. The fixed-income securities pay a good return on investment, but these returns are predicated on catastrophes. This means that if a disaster occurs before the returns on the investment are realized, investors will potentially lose their returns or capital. Catastrophe bonds are a form of insurance securities that transfer the risk from insurers in case of monumental risks that may be brought about by natural or manmade disasters (Grossi and Kunreuther 32). Cat bonds are by definition not a form of insurance, and this makes them very relevant to the insurance industry.

Cat bonds overview and history

Cat bonds originated from the need by insurers to ease the burden of huge policy payouts in case a major disaster strikes. Before the advent of cat bonds, insurance companies had a difficult time remaining afloat after large payouts that were occasioned by disasters. This is because the massive payouts are not covered by either the premiums collected by the insurance companies or their returns on investments. The insurance company is the entity that is charged with issuing cat bonds through the usual avenues such as investment banks.

Cat bonds as securities

The reason why cat bonds appeal to investors is that they are usually priced at attractive discounts and offer good returns. These two factors ensure that cat bond investors overlook the fact that they can potentially lose their money altogether. In addition, cat bonds are one of the few types of investments that are not affected by global financial markets. Disaster bonds are issued through special purpose vehicles (SPV). The SPV is companies that are charged with the development and issuance of bonds. Cat bonds are usually rated per their investment grade. This grading takes into consideration several factors including the bonds’ regulations, structures, as well as accompanying risks.

The SPV is also responsible for the payment of interest to the bondholders (Thau 62). In return, the SPV receives premiums from the insured. In case of a disaster, the bondholders lose their money, and it is paid to the insured parties. In some cases, a single entity may require ensuring a huge risk and decide to do so in form of cat bonds. For instance, FIFA issued disaster bonds as insurance for the loss that could have been incurred if the 2006 World Cup was cancelled (Cummins 29).

Disaster bonds came into existence in the 1990s and they have been used since then. This initial use was triggered by two catastrophes, the Northridge Earthquake and Hurricane Andrew. The cat bonds are the brainchild of Kenneth Froot and a group of economic scholars from the Wharton School ((Thau 94). The group was seeking more ways to make disaster insurance viable. Some of the insurance companies that took part in the initial experimental cat bond offer include AIG, USAA, and St. Paul Re. The disaster bond market was slow at first but it has since grown tremendously. From 1998 to 2001, the cat bond market grew by an average of $1.5 billion per year.

However, after the 9-11 disaster the market grew at a very fast rate. For instance, the cat bond market grew by over $4 billion in 2006 due to the events surrounding Hurricane Katrina (Lakdawalla and Zanjani 458). Around the same period, a product that is similar to cat bonds known as Reinsurance Sidecars was developed. Currently, the quarterly value of the cat bond market stands at approximately four billion dollars. Since cat bonds were first developed, they have prompted the development of other similar products. In addition, there are calls to incorporate the architecture of cat bonds into other financial structures such as auditing.

Cat bonds belong to a group of securities known as Insurance-Linked Securities (ILS). Other than cat bonds, most of the other forms of ILS have been in existence for a longer period. However, cat bonds provide novice investors with a viable security option because they are freely tradable and they are rated. The ILS also provides investors with a simple way to develop risk-return investment portfolios. Investing in government bonds offers very low interest. This means that there is a chance of the investment being diminished by inflation. Cat bonds fall under the category of investments that offer an alternative to the normal equities such as agricultural land and infrastructure. These investment options are not usually correlated to equities.

Risks associated with cat bonds

Two types of risks accompany cat bonds; the insurance risk assumed by the bond, and the credit risk brought about by the collateral nature of the bonds. Cat bond investors need to be assured that they cannot lose their money unless the disaster specified in the bond structure happens. This is why most cat bonds cannot be invested in the usual money market funds. The insurance risk on the other hand is well defined and it is only realized after a certain catastrophe occurs.

The need to rein in the credit risk associated with cat bonds became apparent after the collapse of the Lehman Brothers Investments Firm. The firm lost investments that included cat bonds and eventually filed for bankruptcy (Cummins 35). After this incident, policymakers saw the need to protect cat bond assets by adopting conservative collateral structures. These structures reduce the counterparty risk to a bare minimum.

Cat bond risk triggers

The insurance risk that is associated with cat bonds is well defined using various risk structures. These structures define how the invested principal is affected by the defined catastrophes. Many trigger types can cause a reduction or loss of cat bond investment. The three most common trigger types include industry loss, indemnity, and parametric. The modelled loss trigger type is sometimes defined independently but it is an extension of the parametric trigger type.

The indemnity trigger type is realized when the sponsoring insurer suffers a loss after the specified disaster happens in the specified region and affects the specified line of business. For instance, a cat bond may be structured in such a way that it is only triggered after an insurer incurs residential-house losses of more than thirty million dollars after a hurricane. Indemnity triggers are characterized by complex legal definitions such as what constitutes a hurricane.

Indemnity triggers have a risk transfer mechanism that gives the bond’s sponsor a clear advantage. This is because once the trigger is in effect, the sponsor’s risk is automatically minimized. However, this risk transfer mechanism is a disadvantage to the investors because they have no way of knowing the exact risk. This is because investors cannot access the information of each policy or the insurer’s loss adjusting mechanisms. The other shortcoming that is associated with indemnity transactions is that they take a long time before they are fully settled. This is because before a trigger is declared, the insurance company has to first assess and tally all the losses caused by a disaster. If the disaster occurs near the end of the bond’s maturity period, the investor has to contend with dormant funds.

Bonds that are structured based on industry loss, deal with a group of insurance companies in a particular area. In the United States, two companies are charged with the estimation of losses after any major disaster hits the country. These companies are PERILS and PCS. These companies can provide estimates of the loss that the insurance industry incurs as a result of a certain disaster. This means that the cat bonds that are based on industry loss operate under the assumption that the insured companies’ portfolios align with those from the rest of the industry. The average loss experienced by various companies is used to determine individual companies’ estimated loss.

The main advantage of industry-loss based bonds is that they are more transparent than indemnity transactions. Industry-loss transactions also take a short time before they are settled because loss estimates can be released in a matter of weeks. It is argued that industry-loss based bonds have a more extended risk than indemnity bonds. However, the difference between both risks has been noted to be very small (Cummins 40).

Parametric based transactions utilize the physical attributes of a disaster as the risk trigger. For instance, a parametric based bond may trigger a risk if only an earthquake of over 7.2 in magnitude hits within a 50-mile radius of Los Angeles. Parametric-based cat bonds use indexes to define event parameters. This means there are no calculations required after a certain disaster hit because the event’s parameters are predetermined (Thau 124). Parametric transactions can be disadvantageous to the insurer because they do not focus on the actual financial loss occasioned by a disaster. However, these transactions are very popular with investors due to their transparent and straightforward nature.

Comparison between cat and other bond categories

Before cat bonds came into existence, insurers used re-insurers to help them settle losses that exceed their financial ability. This is because insurers are always limited by geographical and jurisdictional boundaries. On the other hand, re-insurers can diversify more and operate across geographical and jurisdictional boundaries. However, losses brought about by natural or manmade disasters are sometimes a burden even for re-insurers. This is the main reason why re-insurers take part in cat-bond markets. For example, the global re-insurance capacity stands at slightly over $400 billion (Lakdawalla and Zanjani 455).

The biggest insurance loss associated with a natural disaster resulted from a hurricane and it was worth $125 billion. This sum is greater than the re-insurance industry’s operating capital base. It is also expected that some hurricanes can cause damages of over $200 billion. These facts make cat bonds a viable alternative to re-insurance. Major disasters rarely occur but when they do, they can cripple the insurance industry. Without cat bonds, the industry would be volatile and subject to high credit risk. Money from disaster bonds is usually held in accounts that minimize the credit risk.

Cat bonds often exceed other bond categories in terms of returns. Cat bonds seem to offer an investor both an interest rate and a premium for accepting an insurance risk. The other forms of bonds such as treasury bonds carry an interest rate that is lower than that of cat bonds. Interests from cat bonds usually range between five to fifteen percent (Cummins 30). Treasury bonds on the other hand have an average interest rate of about five percent.

In addition, cat bonds are not subject to global financial markets and they are rarely affected by high inflation rates. The main disadvantage of cat bonds over Treasury bonds is that they carry a substantially higher risk. The rising incidences of catastrophes like earthquakes and hurricanes are also making cat bonds unattractive investment options.

Market participants in the cat bond market

The main participants in the cat bond market are catastrophe-oriented funds, asset managers, hedge funds, reinsurers, banks, life-insurers, and pension funds. Among the US based firms that extensively deal with cat bonds include Juniperus Capital, Credit Suisse, AXA investment managers, and Nephila Capital. Cat bonds are also very common in the Japanese Insurance Industry.

Conclusion

The cat bond market has been a major investment attraction to investors over the last few years. These investors are mostly attracted to the bonds’ high returns and their alternative diversification structure. Despite the cat bonds have been in existence for over two decades, they are yet to become part of the mainstream portfolios. Compared to other categories of bonds, cat bonds are among the most attractive categories. Cat bonds offer insurers an avenue of risk diversification. This ensures insurance companies are not wiped off by catastrophes. Financial scholars are looking into ways in which the architecture of cat bonds can be employed in other risk areas such as financial auditing. However, the future of cat bonds is dependent on the growth of the insurance industry.

Works Cited

Cummins, David. “CAT Bonds and Other Risk‐Linked Securities: State of the Market and Recent Developments.” Risk Management and Insurance Review 11.1 (2008): 23-47. Print.

Grossi, Patricia and Howard Kunreuther. Catastrophe Modeling: A New Approach to Managing Risk, New York, NY: Springer, 2005. Print.

Lakdawalla, Darius and George Zanjani. “Catastrophe Bonds, Reinsurance, and the Optimal Collateralization of Risk Transfer.” Journal of Risk and Insurance 79.2 (2012): 449-476. Print.

Thau, Annette. The Bond Book, New York, NY: McGraw-Hill, 2000. Print.

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