Cat Bonds

Definition:

• During the life of the bond, the insurer pays investors a coupon interest rate. If nothing happens, the insurer returns the principal when the bond matures. If the bond is triggered (or the stated catastrophe occurs), investors loses all or part of the principal.
• Form of insurance linked security
• Sold in capital markets
• Also called Cat bonds

History:

• Very recent product (around 20 years)
• Only began in mid 1990s after hurricane Andrew hit Florida and the southern states in 1992

• Destroyed 15.5 billion dollars worth of insured property
• Caused 11 insurance companies to go broke and crippled 30 more

• Emerged from the need of insurance companies to alleviate risk from natural disasters
• Insurers and reinsurers (firms that insure insurers) were badly hit

• realized that they required more capital
• issued cat bonds to shift risk to investors

How it works:

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• Usually maturity range is 1-5 years and issue quarterly interest payments with a floating rate (usually LIBOR plus a fixed spread)

• Generally, maturity for cat bonds are 3 years

• Traditional rating agencies such as Moody’s, S&P, and Fitch have rated these bonds as BB
• Offers higher interest rates than similarly rated corporate bonds
• At times, the SPV may enter into a "swap" contract with another financial institution to assure investors receive their promised interest payments

• Typically the counterparty agrees to pay the SPV interest payments based on LIBOR, in exchange for the earnings on the collateral

• Can be designed to cover any catastrophe but most common ones are hurricanes and earthquake

• In the event the natural catastrophe mentioned in the bond occurs, the bond is "triggered" and all or a portion of the original principal can be used to pay those obligations. When this happens, investors lose their investment

• Triggers of cat bonds are very specifically defined
• "Typically, for a cat bond to trigger, you need a bull's-eye to be hit instead of a general shot in the right direction."

Triggers:

-can be triggered in multiple ways (depending on the contract):

 Indemnity

• Based on the actual losses of the sponsor (insurer/reinsurer)
• Typically pays the highest yield of the different trigger types, as it provides the best protection to the sponsor
• A long period of time can be needed to calculate total loss claims, leading to uncertainty for investors.
• a bond might be structured to trigger if the sponsoring insurer’s residential property losses from a single hurricane in the U.S. state of Georgia exceed $25 million, in the time period from April 1, 2012 to March 31, 2015.

 Industry Index

• Based on an industry-wide index of losses
• Bond is triggered when the amount of the overall industry loss from an event, usually determined by an independent third party, exceeds a certain amount.

 Modeled Loss

• Sponsor's "exposure," or expected loss, is calculated by computer models that use objective data, such as actual wind speeds or ground acceleration. Bond is triggered if the sponsor's exposure exceeds a specified dollar amount.
• Heavy reliance on computer modeling to determine when the trigger has occurred

Parametric Index

• Bond is triggered if specific, objective "parameters" are met (i.e. magnitude of earthquake or wind speed of hurricane)
• The most transparent and easiest to verify of the triggers
• Typically pays a lower yield than other trigger types

Hybrid

• Created by combining any of the above triggers, especially for cat bonds that cover multiple events
• Depending on the components of the hybrid trigger, can be complicated and difficult to understand or verify

Where it’s Traded:

• Traded in investment banks
• Not directly offered to individual investors

• But various funds, including mutual funds and closed-end funds, have purchased or are authorized to purchase them on behalf of individual investors.

• Have been increasing in popularity over past decade
• over $40 billion cat bonds issued in the past decade

• have approx. $19 billion still outstanding as of Oct. 2013

Benefits:

• Insurance Company/ Reinsurer

• hedge against potentially huge payouts due to natural calamities

• Investors

• Speculators

• People bet on the probability of a disaster occurring
• Cat bonds currently pay much higher interest rates than similarly rated traditional corporate bonds

• Hedgers

• relatively uncorrelated with fluctuations in the financial markets
• great way to diversify their portfolios and insulate themselves from market volatility.

Risks:

• Credit Cliff

• When the bond is triggered
• Cause the investors to rapidly lose most or all of their principal and any unpaid interest

• Modeling Risk

• Prices, yields and ratings of cat bonds rely almost exclusively on complex computer modeling techniques
• Extremely sensitive to the data used in the models
• Quality and quantity of data vary depending on the catastrophe

• Liquidity Risks

• Secondary trading for cat bonds is very limited
• so in a pinch an investor may not be able to sell
• pricing information is not generally available

• Counterparty Credit Risk

• Cat bond issuers commonly enter into swap agreements with third parties
• If the third party suffers financial distress, for example, and is unable to back these payments, investors would not receive the interest and principal amounts promised

Supply and Demand:

• The idea of taking on the risk of catastrophe loss is not appealing in itself (relatively fixed demand)
• Due to the huge pressure regulators are putting on insurers to divest catastrophe risk from their balance sheets, supply rather than demand is the primary driver both of the market’s growth and of bond pricing.
• This dynamic has been very positive for yields, which are usually between 5% and 15% above Libor, and around twice that of corporate paper with a similar risk rating.

References:

• Financial Industry Regulatory Authority. (2013). Catastrophe Bonds and Other Event-Linked Securities. Retrieved from https://www.finra.org/investors/alerts/catastrophe-bonds-and-other-event-linked-securities
• The Economist. (2013). Perilous paper: Bonds that pay out when catastrophe strikes are rising in popularity. Retrieved from http://www.economist.com/news/finance-and-economics/21587229-bonds-pay-out-when-catastrophe-strikes-are-rising-popularity-perilous-paper
• www.artemis.bm. (2012). What is a catastrophe bond (or cat bond)? Retrieved from http://www.artemis.bm/library/what-is-a-catastrophe-bond.html
• Wiedmeyer, J. (2012). Catastrophe Bonds: An Innovative Renewable Energy Risk Management Tool? Retrieved from https://financere.nrel.gov/finance/content/catastrophe-bonds-innovative-renewable-energy-risk-management-tool