Economics of Disaster Bonds
A catastrophe bond, also known as a CAT bond, is an insurance-linked type of fixed- income securities by which the issuer transfers catastrophe risks to investors. There are no differences between traditional and CAT bonds except that (a) with the latter, the investor remains the bondholder as long as the issuer doesnt suffer a loss caused by a predetermined natural or a man-made catastrophe, and that (b) CAT bonds are only available for institutional investors. If a catastrophe occurs during this period (common maturity periods are 12, 24, and 36 months), investors suffer the loss of their incomes and principals ( CAT, 2010, p. 1 Catastrophe, 2001, p. 1 What They Are, 2009, p. 1).
The traditional mechanism for transferring insurance risk across other institutions is reinsurance, which is a form of insurance contracts in which an insurance institution (reinsured) purchases an insurance policy from another institution (reinsurer) in order to reduce the risks associated with its own underwritten policies ( Reinsurance, 2010, p. 1). Catastrophe reinsurance cant be completely reliable as a method of transferring catastrophe risks due to several interrelated challenges 1. The rapid growth of populations in areas vulnerable to natural catastrophes (e.g., Florida) leads to rises in the numbers of potential insurance buyers. The rapidly growing demand on insurance policies in those areas requires a large reinsurance market with enough capacity to meet that demand (Borden Sarkar, 1996, 1-2). 2. The capacity available for catastrophe risk transfers in the reinsurance market is limited due to the high costs of reinsurance policies and the insurance carriers limited willingness to assume such risks (Garven, 2005, p. 1 Johansmeyer, 2009, p. 1).
Although CAT bonds are primarily issued by insurance institutions as an alternative to investing in the catastrophe reinsurance market, other noninsurance institutions might issue bonds in order to take advantage of the protection benefits this type of bonds provides. For example, in summer 1999 Tokyo Disneyland decided to issue CAT bonds as a protection from the risk of losses caused by earthquakes (Tokyo is very vulnerable to earthquakes). The institution believed that issuing these bonds would be cheaper and more effective than buying a traditional insurance policy (Garven, 2005, p. 1).
How Do Issuers Issue CAT Bonds to Investors
CAT bonds arent directly issued from issuers to investors, but they are issued through intermediary special purpose vehicles (SPVs) or special purpose entities (SPEs). An SPV is a cosponsored separate entity that is purely created to serve a single, well-defined, and narrow purpose. This entity places the proceeds of CAT bonds issuance in a collateral trust, which is utilized by total return swap (TRS) counterparties for investing in high credit-quality securities. The TRS counterparties are contractually obliged to pay the SPV a stream of LIBOR rate investment returns (less the cost of the TRS) regardless of the profits generated by their investments in the financial market. The SPV, in turn, is obliged to ensure three-month payments to investors based on LIBOR (which is a floating rate) in addition to interest spreads (Bradley, Eng, Palmer, 2009, p. 1-8 Entity, 2010, p. 1 Vehicle, 2005, p. 1).
Insurance institutions prefer issuing CAT bonds through these entities over issuing them directly to investors in order to make use of several benefits this method offers 1. For issuers Usually, an SPV is sponsored by several corporations, and that helps issuers organize their activities in an improved manner. In this format, an issuer can issue bonds through the entity without being required to carry any of the associated assets or liabilities on its own balance sheet ( Off-Balance, 2005, p. 1). Being a cosponsor of an SPV prevents many inconveniences that the issuer might experience (a) when issuing bonds directly to investors, or (b) when being the sole owner of an SPV ( Catastrophe, 2001, p. 1 Off-Balance, 2005, p. 1). 2. For investors Issuing bonds through these entities protects investors investments from the effects of issuers credit risks ( Catastrophe, 2001, p. 1).Catastrophe Bonds Ratings Bond ratings are certain grades given to bonds as an evaluation of their credit quality. Rating services are provided by a number of specialized agencies such as Standard Poors and Moodys. In evaluating the bonds credit quality, rating agencies take into consideration several factors including the risk to which the bond is intended to cover for the issuer and the issuers financial strength ( Bond Rating, 2010, p. 1 What They Are, 2009, p. 1). There are four main levels of bond ratings (Standard Poors rating format) 1. Bonds with high credit-quality The grades included in this level are AAA and AA. 2. Bonds with medium credit-quality The grades included in this level are A and BBB. 3. Bonds with low credit-quality (also known as junk bonds ) Bonds in this level are classified as noninvestment securities. The grades included in this level are BB, B, CCC, CC, and C. 4. Bonds that went into default. The grade included is D, which is the lowest available. Despite the issuance of catastrophe bonds at relatively high interest rates, they are usually classified as low-quality investments due to the high risks associated with them. Rating agencies give most catastrophe bonds the rate BB ( Bonds Rating, 2010, p. 1 Catastrophe, 2001, p. 1 Lockyer, 2010, p. 1). Trigger Types
1. Indemnity The issuer is indemnified when it suffers a loss cause by a catastrophe. There is no difference between the concept of working of a CAT bond with this trigger type and that of a traditional insurance policy (Spry, 2008, p. 1). 2. Modelled loss The issuer determines its expected losses limit using certain models. The bond is triggered when losses caused by a catastrophe exceed that limit (Spry, 2008, p. 1). 3. Indexed to industry loss The bond is triggered when a catastrophe causes the insurance industry huge losses exceeding a certain limit. This limit is determined by independent institutions such as Property Claims Services (PCS), the limit varies among different regions and perils (Spry, 2008, p. 1). 4. Parametric The bonds is triggered depending on certain parameters of natural hazards. For example, if a hurricanes wind speed exceeds a certain limit the bond is triggered regardless of the caused damages (Moody, 2002, p. 1) How Do Catastrophe Bonds Relate to Different Types of RiskInterest-Rate Risk The risk that the value of investments will be affected by the changes in the level of interest rates. Usually, the changes in interest rates cause inverse changes in the values of securities (the values of securities drop as interest rates rise, and vice versa). Interest-rate risks can be avoided by applying a number of solutions including diversifying the investment portfolio (buying fixed-income securities with different maturity periods). Different types of financial assets are affected by this type of risks, but bonds in particular are the most sensitive and responsive to it ( Interest Rate Risk, 2010, p. 1).
Investors must pay attention to the unique nature of CAT bonds as investments. First, CAT bonds are fixed-income securities, and these securities are very vulnerable to interest-rate risk because their maturity periods are usually long (most CAT bonds mature in 36 months). Second, buying CAT bonds can help investors diversify their investments portfolios because these bonds are uncorrelated to other types of investments in the financial market, and also because these bonds are available with short maturity periods. Thus, they can help investors protect their investments from interest-rate risks ( What They Are, 2009, p. 1 Garven, 2005, p. 1 Interest Rate Risk, 2010, p. 1).Default Risk Its the risk that the issuer wont be able to pay the interests or the principals to investors according to the contractual obligations between the two parties. This risk affects all types of financial assets depending on different factors. There is an inverse relationship between default risk and bond rating with higher bond ratings the default risks are lower, and vice versa. Since most CAT bonds are given the rate BB which indicates low credit-quality, the default risk associated with these bonds is relatively high ( Default Risk, 2010, p. 1).Systematic (Market) Risk This type of risks affects all segments of the financial market, its also known as the nondiversifiable risk . Its contrasted to unsystematic risk, which affects a specific segment of the market and can be eliminated with diversifying investments. Rescission and wars are example of sources of systematic risks their effects on the market cant be avoided ( Systematic Risk, 2010, p. 1).
Catastrophe bonds advantages cant protect investors from systematic risks. The events that represent sources of systematic risks cant be predetermined as triggering events because they arent forms of catastrophes. Moreover, despite catastrophe bondholders ability to diversify their investments, they cannot avoid the effects of systematic risks because these risks affect all segments of the financial market, and thus affect all types of securities.Idiosyncratic Risk This type of risks is small, firm-specified, and only has effects on a very small number of assets of the institution that is vulnerable to it. Those effects, in turn, cause changes in the values of the institutions investments. An example on a source of an idiosyncratic risk A strike by employees. The idiosyncratic risk can be reduced or even eliminated with diversifying investments and, thus, buying CAT bonds is an effective method of containing this type of risks ( Idiosyncratic Risk, 2010, p. 1). Credit Risk The risk that the issuer will not be able to fulfill its contractual obligations due to TRS counterparties default. The CAT bond market provides investors with protection from this type of risks by establishing SPVs which are responsible for managing transactions from and to different parties (Borden Sarkar, 1996, 1-2). .
Why Might These Bonds Be Attractive to Buyers and SellersFor Buyers (Investors)
1. Interest rates on CAT bonds are high compared to those of other types of securities. Usually, interest rates range between 3 and 20 depending on several factors. The main concern that investors take into account when buying catastrophe bonds is the possibility of losing their principals and incomes in the case of the occurrence of a predetermined catastrophe ( CAT, 2010, p. 1 Tatum, 2010, p. 1). However, the high interest rates give investors more confidence in the bonds ability to compensate for the risk of losing their money entirely ( What They Are, 2009, p. 1).
2. There is no correlation between CAT bonds and other types of investments such as equities and conventional bonds and, thus, buying CAT bonds is an excellent means of diversifying investment risks ( CAT, 2010, p. 1 What They Are, 2009, p. 1). For Sellers
1. Issuing CAT bonds help insurance institutions remain financially solvent even in the times of catastrophes. In such cases, its important for the institution to have enough liquidity to meet its insureds demand for insurance coverage payments. The insureds who receive payments are traditional insurance policies buyers only ( What They Are, 2009, p. 1 Tatum, 2010, p. 1).
2. Unlike buying traditional catastrophe reinsurance, issuing CAT bonds doesnt require other parties and, thus, it helps issuers manage their catastrophe risks independently. What Role Do Catastrophe Bonds Play in the Insurance Market The demand on CAT bonds has rapidly grown over the last two decades due to the emergence of catastrophes as a serious challenge for insurance institutions. The size of the market was 1-2 billion per year in the late 1990s, but with the impacts of several catastrophes over the following years such as 911 attacks and Hurricane Katrina on the insurance industry, it has grown to more than 7 billion in 2007 (Spry, 2008, p. 1).
CAT bonds growing popularity plays a big role in changing the insurance and reinsurance markets conditions issuing this type of bonds increases the level of competitiveness from reinsurance institutions side and forces them to provide improved services with more attractive pricing and underwriting practices.