Catastrophe bonds as a reinsurance mechanism

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Catastrophe Bonds as a reinsurance mechanism

A great natural catastrophe is defined as one where the affected region is “distinctly overtaxed, making interregional or international assistance necessary. This is usually the case when thousands of people are killed, hundreds of thousands  are made homeless, or when a country  suffers  substantial economic losses, depending on  the  economic circumstances generally prevailing in that country” (Munich Re, 2002).

Natural catastrophes occur relatively rarely, but can be devastatingly destructive when they do. The societal and environmental consequences of such events are often tragic, and from a financial viewpoint all it takes is for one disaster to hit a highly populated area, and an insurance company’s capital base can be completely wiped out. Catastrophic events, such as hurricanes and earthquakes are one of the main risks that insurers and reinsurers face. When hurricane Andrew hit the coast of Florida in 1992, it destroyed $15.5 Billion dollars worth of insured property (total losses close to $30 billion) and caused 11 insurance companies to go bust as they were unable to pay the claims. Also in the 1990’s a Japanese earthquake cause damages between $110 and $200 billion, $35 billion which was insured (Carr & May 2011).

Catastrophe events differ to most insured events as most insured events tend to take place independently of one another. Insurance claims like car crashes and follow a normal distribution and can be predicted to a good degree of accuracy. However natural events such as hurricanes, earthquakes occur relatively infrequently but cause a massive amount of claims to be made together. The huge amount of claims after an ‘act of god’ drives the insurance companies to pass on some of the risk to third parties for example reinsurance companies. This allows them to underwrite large risks they would otherwise be unable to cover. However in some cases the reinsurance companies themselves may want to spread risk or in the event of a catastrophe event may be less willing or unable to take on risk from insurance companies and this leads to increased reinsurance costs. This is where Catastrophe bonds (Cat bonds) provide an alternative to traditional reinsurance in enabling insurance companies to prepare for the possibility of a natural disaster occurring without having to limit the coverage they provide to policy holders or increase the premiums.

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What are Catastrophe Bonds?

 Since their first appearance in the capital markets in 1997, publicly disclosed catastrophe bonds with ratings increased in annual issue volume from $643 million in 1997 to a peak of $7.33 billion in 2007. The annual issue volume then decreased to $2.73 billion in 2008 and stood at about $4.28 billion in 2010. Catastrophe bonds’ total risk capital outstanding has increased from $4.0 billion at year end 2004 to approximately $12.0 billion at year end 2010 (Modu 2011).

Catastrophe bonds which were developed in the mid 1990’s are fixed income securities, ...

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