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, typically issue by insurance companies, which pay an attractive yield to investors. However should a specific predetermined event, such as a natural or human inspired disaster occur, bondholders suffer the loss of their income and potentially also their capital. The main difference between Catastrophe bonds and indemnity-based reinsurance contract is that the payment is usually not conditional on the actual loss of the insurer, but on the realization of a parametric trigger or an index. From the perspective of the bond issuer, catastrophe bonds spread some of, but not necessarily all of a particular risk to the buyers of the bond, in turn helping to protect their balance sheet from some of the impact of massive payouts associated with a catastrophe disaster. From the bond investor’s perspective, catastrophe bonds need to pay a sufficient yield premium (Usually between 8% and 15%) or be priced at a sufficient discount to, conventional bonds to compensate for the risk of losing their money entirely. Catastrophe bonds are generally issued via a special purpose vehicle (SPV) or a special purpose entity (SPE), both of which are companies created purely for transactions related to bond issue.
Catastrophe bonds can be designed to cover any natural disaster. Some popular issuances cover US hurricanes, European windstorms and Japanese earthquakes. Some have been issued to cover non-natural catastrophes. For example a large sporting event such as the World Cup. FIFA issued catastrophe bonds worth US$260 million to provide protection against the possibility of the 2002 FIFA World Cup being cancelled (Carr & May 2011).
Catastrophe bonds are rated using complicated mathematical models that take into account things such as past and the predicted weather events, property prices in an area and also the population density of an area. As there is a chance that the investors may lose their principle investment, catastrophe bonds tend not to be an investment grade. Bonds triggered by an extremely unlikely combination of events (Multi peril cat bonds) are the exception to this.
A big question possible investors must ask themselves would be why they should invest in catastrophe bonds? The returns from catastrophe bonds are largely uncorrelated with macroeconomics factors, which is very rare in the investment world. It allows investors to bring valuable diversification attributes to portfolios of more traditional asset classes. This would hold particular appeal when there is disharmony in the financial markets and during the recent world recession, catastrophe bonds were one of the few asset classes which provided positive returns over the period.
Another attractive feature of catastrophe bonds and other risk securities is that poor performance tends to be self correcting. Following a catastrophe disaster, a number of factors contribute to a rise in insurance premiums. This gives the investors an opportunity to recoup some, if not all their losses in a short time period. These events also increase demand for insurance, a reduced ability of insurance and reinsurance companies to take on risk, and upward revision of the probability models that are used to price insurance and catastrophe risk securities.
An example of this would be after the earthquake in 2011 which caused widespread destruction in Japan and one of the biggest natural disasters ever seen. After the event insurance premiums for earthquakes jumped 50% and for other catastrophe events it jumped by 20% (Marsh, Mercer, Kroll 2011). Although most people would be wary of entering the market, there is huge potential for a high return with the large increase in premiums which means it could be a good time to invest in Catastrophe bonds. With a small probability of numerous natural disasters occurring in a small time frame if you diversify your investment across many different Catastrophe bonds you will more than likely gain a return on your investments even if you suffer a loss on one catastrophe event. Also the chances of incurring extreme losses are far lower than the chance of benefitting from extreme returns.
Conclusion:
Investors shouldn’t be alarmed by the name, they are a kind of insurance securitization which transfer risk from issuers to investors, in return from a premium yield. Catastrophe bonds provide an alternative to traditional reinsurance, the development of cat bonds has forced re-insurers to become more competitive with pricing. They can also present opportunities for fixed income managers to gain a yield pickup, in return for a theoretically low risk of income and capital loss. Cat bonds also provide excellent diversification opportunities for bond portfolios given that Cat bonds insurance risk categorization shows little or no correlation with either equities or conventional bonds (Moyer, 2005)
However Catastrophe bonds do come with disadvantages, catastrophe bonds are only available to institutional investors. The market in Catastrophe bonds generally suffers from lower levels of liquidity relative to mainstream bonds. In recent times there has been growth in the Catastrophe bond market which in turn has spurred the launch of some new insurance related businesses which could potentially undermine the long term growth prospects of the Cat market.
Bibliography
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Carr, T., May, A., (2011) ‘Focus on alternatives: Catastrophe bonds explained’, Schroders- available:
- Grossi, P., Howard, K., Catastrophe Modelling: A new approach to managing risk. New York: Springer , 2005
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Marsh, Mercer, Kroll (2011)’ Reinsurance market review 2010’, Available:
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Modu, E. (2011) ‘Insurance linked securities: Gauging the basis risks of Catastrophe Bonds’ , A.M. Best methodology , available:
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Moyer,L.“Catastrophe bonds,” Forbes, available:
- Munich RE (2002). Topics : Natural Catastrophes 2002.
- Thau, A. The bond book. New York: McGraw-Hill, 2000
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Wickham, C. “New catastrophe bonds on hold pending reinsurance market hardening.” Insurance journal, Available: