Catastrophe Bonds

Catastrophe bonds are issued by insurance and reinsurance companies. These are risk linked securities whose purpose is to transfer catastrophe risks from the insurance companies to the capital markets. The benefits accruing to an investor in catastrophe bonds are linked to the occurrence of a predefined catastrophe within a given period. Therefore, occurrence of a predefined catastrophe within the stipulated period culminates in the loss of the investors principal, which is subsequently transferred to the insurance company that goes to pay the claims that arise as a result of the catastrophe. Meanwhile, if the predefined catastrophe does not occur within the stipulated period, the investor realizes a significant return of the catastrophe bond investment.

These bonds are designed to cover the occurrence of any natural disasters, where coverage includes earthquakes, hurricanes and windstorms. Some notable issuances have covered European windstorms, US hurricanes and earthquakes in Japan. In some cases, they have been issued to cover catastrophes which do not occur naturally. The rating of catastrophe bonds uses complex models, which incorporate factors such as predicated and past population density, weather patterns and Asset prices. Given that there is a probability of investors losing their principal investment; catastrophe bonds have a tendency of not being the investment grade. However, Multi-peril Bonds, which are initiated, by unlikely combinations of events, are exempted from this rule since the minimized possibility of losses results to their being rated favorably.

Development

Catastrophe bonds were initiated after the resulting disaster of Hurricane Andrew in august 1992, when insurance costs amounted to $20 billion. Meanwhile in 1994, Los Angeles was hit by the Northridge Earthquake which caused significant losses estimating to $12.5 billion. It is after this event that the Hanover Re issued the first catastrophe bond. In 1995, Swiss Re incorporated Swiss Re Capital Markets Corporation, which sponsored SR Earthquake Ltd in 1997, an advance catastrophe bond transaction (Chansky 2). In 1996, Georgetown Re issued the first rated catastrophe bond transaction which was launched by Goldman Sachs.

Meanwhile, Swiss Re New Markets and Goldman Sachs launched in 1997, the first securitization in Asia for earthquake-based catastrophe bonds for Tokyo fire and marine Insurance. The 1998 B rated catastrophe bonds were the first to be issued by Mosaic Re, which paved way for a broadened tranching securitization market. The terror attacks of 9/11 incurred $20 billion in estimated insured losses, in spite of the recorded underwriting rates being the lowest in this period, catastrophe bonds managed to earn returns at 9.45% for the period, subsequently performing better than the Merrill Lynch High Yield Master II Index by an estimated 500 basis points (Chansky 2).

In 2002, the Swiss Re implemented a rule where the prices of catastrophe bonds would be predetermined, but the issue volume would be left for the market to decide. This rule negated the previous protocols of issuing catastrophe bonds prior to March 2002. In 2003, Atlas II provided a $150 million as coverage for the disaster resulting from European windstorm, Japanese earthquake and California earthquake. As a result of Hurricane Katrina, the transaction made in 2005 by Kamp Re amounting to $190 million suffered a loss to publicly disclosed catastrophe bond. In 2006, FIFA was issued with the first terrorism catastrophe bond by Golden Goal Finance Ltd aimed at covering the cancellation of World Cup in 2006 (Chansky 2). The catastrophe bond market has experienced significant development and growth with bonds amounting to more than $2 billion being issued as far as 2006, in contrast to $2.3 billion issued in 2005. The observed characteristics of catastrophe bonds indicate that they evolve at a progressive rate towards a higher level of standardization. Previously, the catastrophe bond market faced criticism for the negligible investor interests. However, the market has since attracted significant interest among institutional investors such as pension funds and corporations.

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Risk Analysis

Investment in securities such as catastrophe bonds is characterized by some degree of risk. For instance, a catastrophe bond may face insurance risks or credit risks. This is a result of the insurance risk assumed by the catastrophe bond and the collateral account respectively. Investors should ensure that the limitations on the collateral account qualify as sufficient protection; in order to ascertain that there is a certainty of the return of their principal investment in the absence of an insurance event.

Significant numbers of current catastrophe bonds have been observed to limit collateral account investment to United States Treasury Money Market Funds. However, other observed solutions include uniquely issued puttable Structured Notes from the European and International Banks for Reconstruction and Development. Meanwhile, catastrophe risks are triggered by several factors, which include indemnity triggers, industry losses and parametric transactions. In the case of an indemnity trigger, risks are triggered by the loss suffered by the sponsoring insurer after the occurrence of a predefined catastrophe event, in a defined geographic area, for a defined nature of business.

Indemnity Triggers

A catastrophe bond characterized by indemnity risk requires significant legal definitions of terms, such as recognition of loss, what a hurricane constitutes and the book of business. Indemnity and other risk transfer dynamics triggered by direct reinsurance or insurance losses have a clear advantage to the transactions sponsor. As a result of the sponsors loss experience being used as the trigger, the recovered funds from the catastrophe bond aligns with the underlying claims closely, mitigating the basis risk incurred by the sponsor which is essentially the difference between bond payout and incurred losses (Shear 71).

However, these risk transfer dynamics depict the underlying risk as minimal to investors, as the access to detailed information is limited on every judge or policy measuring the integrity of the sponsoring insurance companys loss adjusting or underwriting. Additionally, indemnity transactions may take a considerable amount of time to settle in the event of a catastrophe as the insurer must first tally and assess all claims, which can consume a considerable amount of time. In some instances, the bond extends beyond the predetermined maturity allowing the insurer determine total claims, more so if a catastrophe occurs near the end of the predetermined period. This extension period can be a liability to investors as their investments are locked up at relatively lower rates than during the bonds risk period.

Industry Triggers

In Europe and the United States, the recognized providers of insurance loss estimates are PERILS and Property Claims Services, respectively. These firms provide estimates of the total loss suffered by the insurance industry after a significant catastrophe. Catastrophe bonds based on industry loss function under the assumption that the sponsors portfolio is pegged with the industry; therefore, the sponsor can recover a substantial percentage of total losses suffered by the industry. Industry loss-based structures are in essence indemnity solutions which are pooled together. Hence, the collective loss experienced by companies is used in determining the industry loss estimates (Shear 72). Industry loss triggers indicate significant transparency when compared to exclusive indemnity transactions. This results when first industry loss projections from modeling companies are availed within a short period after the event. However, it can take more time for the actual loss to be determined and released. Meanwhile, the extension of the bonds risk is estimated to be at the same level as that of a bond characterized by indemnity triggers; however, it is higher when compared to those indicated by parametric triggers.

Parametric Triggers

A parametric transaction is characterized by the physical features of a catastrophic event as the trigger. For instance, a parametric bond may be triggered if an earthquake whose magnitude is greater than 7.1 in Tokyo within a radius of fifty kilometers. A significant number of parametric transactions are premised on the event parameters index, where essential weights are applicable to measurements from a significantly large area designed to counter the actual losses estimated for the sponsoring insurer. Since event parameters are observed immediately after the occurrence of a catastrophe event, the settling of parametric transactions is more rapidly in contrast to other triggers, hence mitigating the risks of bond extension.

However, since parametric triggers do not refer to insured loss, there is an inherent possibility that the sponsor will not receive the actual loss amount suffered from a catastrophic event. In order for this risk to be mitigated, the indices applied in the bond trigger are tuned significantly to the sponsoring insurers exposure to risk. Parametric triggers have been preferred by investors due to the triggers transparency. For instance, the possibility of an area experiencing winds with speeds of 100 mph is easily understandable than the possibility of a given insurer suffering $1 billion in losses (Shear 2). However, it is difficult to determine definitively the optimal trigger for bond risks since the balance of bond issues varies depending on whether supply by issuers or demand by investors is the critical market driver.

Since catastrophe bonds began being issued in the 90s, they have been extensively tested by financial and natural disasters, however, every time their performance remained robust. Since the launch of Swiss Re bond indices in 2002, the catastrophe bond market has attractive and stable returns with significantly reduced volatility when compared to traditional assets. Meanwhile, market dynamics for catastrophe bonds continues to fortify with expected positive growth over time.

The regulatory requirements for investors to diversify investments in catastrophe risk from their books of account, the bond market, are significantly characterized by supply in contrast to demand. This aspect worked in favor of the catastrophe bond yields with an indicated advantage of 5-15% beyond Libor performance (Lamb). This indicates a return of approximately double the rate indicated by corporate paper with the same risk characteristics. Additionally, since catastrophe bonds are not priced on the basis of corporate or economic events, there are significantly uncorrelated to conventional bond markets; therefore, making them agreeable to investors searching for portfolio protection and diversification from extensive market volatility is extremely crucial. The issuance of catastrophe bonds is essentially structured around disaster or catastrophes: events with extreme severity but low probability of occurrence. These less likely risks factor significant concern on re/insurers books, and as such offer the highest degree of return to investors.

Interest Rate Risk

Catastrophe bonds are high yield instruments with a significantly shorter maturity period ranging from 3 to 5 years. Their coupons comprise of a fixed spread which indicates the compensation of the risk assumed by the insurer and a floating interest rate determined by the securities market, essentially Libor. Therefore, catastrophe bonds are exposed to minimized interest rate risks in contrast to other mainstream financial securities as a result of financial market component being adjusted at small intervals.

Credit Risk

Catastrophe bonds are collateralized fully with transparent dynamics and stringent collateral regulations aimed at limiting counter-party risks. Thus, the counterparty risk to sponsors is reduced and limited to a short period; meanwhile the principal investment is not exposed to risk. In the event that a sponsor defaults on coupon payments, the bonds mature early at par without additional exposure to risk. However, in cases where a sponsor defaults from payments, the bonds are likely to be performing below market value, therefore, early maturity at market value would be positive. Similar to other fixed income instruments, a significant number of catastrophe bonds rely on rating organs for rating.

In a catastrophe bond mechanism, the issuer creates a specific purpose vehicle, where amounts realized from the initial investors are held as collateral within which cash raised by the bonds initial investors is held as collateral in securities or cash. The coupon paid out by these notes is funded through a combination of generated returns by securities and premiums paid into the Special Purpose Vehicle by the bond issuer (Lamb). In light of this, the coupon levels are determined taking into consideration the possibility of defaults as the catastrophe risk modeling companies designate.

In the event that the given disaster criteria defined in the bonds prospectus is met, the money held in such securities is paid to cover potential liabilities associated with the bond by the insurer. Meanwhile, the criteria in the event of a bonds default are narrowly defined; therefore, the occurrence of the designated catastrophe occurs frequently and does not trigger default. Additionally, bonds are issued with several event default triggers, which essentially need more than a single catastrophe to take place before incurring losses.

Asset Demand Theory

Since there is no correlation between catastrophe bonds and other asset; the expected yield on catastrophe bonds should theoretically be less than the yield of other bonds indicating similar credit rating. However, the market indications are contrary: catastrophe bond spreads have been observed to exceed those for corporate bonds with similar ratings. Investors in catastrophe bonds earn both liquidity and premium for assuming insurance risk. The spreads are mostly high for catastrophe bonds bringing extreme disasters to market such as hurricanes in the United States and slightly lower for low disasters such as earthquakes in Turkey; since investors prefer to diversify within the comfort of their insurance exposure and willing to take lower spreads for those disasters.

Therefore, market prices are set by dedicated insurance funds and not by diversified investors who have no intention of reducing their returns from a diversifying investment. Although catastrophe bonds are risky, making it possible for the principal amount to be exhausted once the triggering event has occurred, they have been observed to offer significant returns. The catastrophe bond market has been observed to be profitable even in periods with multiple catastrophic event occurring; meanwhile, negative returns have never been observed for a whole year to date. Avoiding bonds, which are poorly structured, has been attributed as the key to success in the catastrophe bond market.

The catastrophe bond market base is expanding progressively with more global capital being drawn in the sector every financial year. Meanwhile, dedicated Insurance Linked Securities fund managers continue to remain the largest group of investors. These catastrophe bond investments have continued to attract money managers, institutional investors, and pension funds. They are attracted to the catastrophe bond market because of the high returns observed in the insurance linked securities during the financial crisis and the bonds liquidity profile. For instance, the European debt crisis particularly made investors turn their attention to Insurance Linked Securities. The market for catastrophe bonds and other insurance linked securities has been observed to attract more institutional investors since the inception of catastrophe bonds.

Conclusion

There have been reported considerable investments of institutional capital being invested in Insurance Lined Securities catastrophe bonds. These are aimed at taking advantage of the diversification potential illustrated by market and the high probability of increased returns of investments. In spite of the increased interest, catastrophe bonds continue to be a niche asset class which is yet to integrate into the mainstream portfolios. It is evident that for those investors with an affinity for a significantly attractive risk return profile, adapting to new classes of alternative assets like catastrophe bonds is a viable option, especially bearing in mind the high spreads indicated by catastrophe bonds in contrast to conventional and mainstreams security assets. The catastrophe bond market has continued to indicate a growing trend characterized by a stable supply of offerings.

In spite of the probability of natural catastrophes occurring being low, their impacts are crucially devastating and destructive. The economic, social and environment impacts of such occurrences have extreme consequences. Therefore, in a financial perspective, the occurrence of natural catastrophe especially in a densely populated region can be detrimental to the capital base of an insurance company. In spite of insured events occurring independent of one another, a significant percentage of insurance claims arising from these events such as car accidents, can be predicted accurately since they are normally distributed.

However, natural catastrophes such as hurricanes have infrequent occurrences, but when they occur, they result in a large number of insurance claims being made at the same time. Therefore, the extensive variability of the potential payouts which insurance companies are obligated to pay in the aftermath of a natural disaster makes them pass a percentage of the risk to reinsurance companies or other third parties. This enables them to underwrite significant risks, which they lack the capacity cover. Meanwhile, investors in catastrophe bonds are assured of considerable returns given the reduced volatility in contrast to other mainstream securities. In light of this, it emerges that while catastrophe bonds mitigate the claims payout burden for insurance companies, they offer a significantly lower risk high return investments to investors who are willing to divest their portfolios.