What are CAT bonds I hear you ask? ‘CAT’ is short for Catastrophe.CAT bonds are risk-linked securities that transfer a specified set of risks from a ‘sponsor’ to investors. ‘Sponsors’ are typically re/insurance companies or other parties seeking to fund a financial risk from catastrophe.
CAT bonds were developed from a need by re/insurance companies to reduce some of the risk they would carry in the event of a major catastrophe. That is – risk which re/insurance companies would not be able to cover by the premiums, and returns from investments using those premiums, received from clients.
So CAT bonds act as a hedging instrument that offers multi-year protection without the credit risk present in reinsurance. They do this by providing full collateral for the risk limits offered through the transaction. For investors, CAT bonds are said to offer attractive returns and reduction of portfolio risk, since CAT bond defaults are uncorrelated to the possible defaults of other securities. However they are correlated to the weather! Bit risky, eh??
They were created and first used in the mid – 1990s in the aftermath of Hurricane Andrew and the Northridge earthquake in the USA. They have taken some time to become established.
The transaction begins with the formation of a single purpose vehicle (SPV) which acts as the reinsurer to the sponsor of the bond and which pays it a premium that is then deposited in a trust. This SPV then issues notes to its investors, whose principal is deposited in the same trust as collateral. If there have been no catastrophes then the investor will receive their principal at the date of bond maturity. This is normally a 3 year time frame. The single purpose reinsurer normally issues bonds to investors through an investment bank, and invests the proceeds in securities such as Treasury bonds. Embedded in the bonds is a call option that is triggered by a defined catastrophic event such as (typically) hurricanes, earthquakes or windstorms and floods. The risk is said to be able to be mitigated and is capped. However if the bond is triggered, the SVP transfers part or all of the funds in the trust to the insurer/reinsurer to cover the losses at the expense of the investor.
Understandably pension funds represent significant pools of capital. The New Zealand Superfund covers all hard-working New Zealanders. Around the world there is a movement away from safe Government bonds into hedge funds, private equity, real estate and derivatives. This is in part due to the fact that as the population ages, there is a need to see greater returns for investment. But there is a real risk that the liability in our pension funds begin to outweigh their assets. Are catastrophe bonds the way to protect our aging citizens? I do not think that this should be a mainstream asset class for pension funds.
In the article ‘Guardians appoint manager for investments linked to catastrophe insurance’, (posted Tuesday, 2 February 2010) on the Superannuation Fund website it states that,
“We have made an initial commitment to the strategy of USD125 million with potential to expand to USD250 million. This will mostly be invested in securities that cover US hurricanes and earthquakes, with some products covering European wind storms and Japanese earthquakes.”
Umm – Japanese earthquakes, US hurricanes??? Sounds like a really safe investment doesn’t it?? So has the Super Fund lost money as a result of Hurricane Sandy?
On the Good Returns Website in an article entitled “Super Fund invests in Catastrophe Bonds”, Eriksen says that usually you write over three types of catastrophe, so you might get one that happens, but it’s unlikely to get three catastrophes happening at once, “so normally it’s a very good investment and it’s ideal for the NZ Superannuation fund”. “I think it’s a shrewd move because to put it in context, the global financial crisis is not over yet and the equity markets are likely to be the most volatile asset class, but this type of investment carries on regardless”.
Yet in the first six months of 2011 a powerful series of earthquakes in New Zealand and Japan, combined with multi-billion dollar payouts from tornadoes and floods in the United States and Australia, meant the (re)insurance sector experienced the most costly first half on record in accident-year terms. Insured losses of around USD70 billion are estimated for the period, which is more than five times higher than the first half average for the past ten years and second only to the full 12-month loss of 2005.
The present climatic problems will be dramatically aggravated if the greenhouse predictions are true (I’m not going to venture into that debate). Processes in the atmosphere will increase the frequency and severity of heat waves, droughts, bush fires, tropical and extra-tropical cyclones, tornados, hailstorms, floods and storm surges in many parts of the world with serious consequences for all types of property insurance.
We simply have to find a more sustainable way of protecting our citizens. Investing in CAT bonds is not the answer. Let’s get back to basics New Zealand and remember that ..”if there has been a theme of modern Wall Street, it’s that young men with PhD.’s who approach money as science can cause more trouble than a hurricane”. (Michael Lewis, “In Nature’s Casino”).
What do you think??
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- Capital Markets: A Threat or a Complement for Reinsurers? (insurancejournal.com)
- Catastrophe Bonds Hit Peak Since Japan Earthquake (bloomberg.com)
- Munich Re eyes catastrophe bond fund (uk.reuters.com)
- Mexico increases size of cat bond issue after strong demand (uk.reuters.com)
- Cat Bonds Headed for Best Return Since 2009 With Storm Looming – Bloomberg (bloomberg.com)