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Catastrophe bonds are one of the most sophisticated tools used by the insurance company in order to protect itself from mounting losses. The fact that more than $12 billion worth of catastrophe bonds have been issued in the year 2019 is a testimony to their popularity.
Catastrophe bonds are a form of ultra-high-risk debt which help insurance companies to meet their obligations even if a catastrophe takes place.
In this article, we will have a closer look at what catastrophe bonds are and how they help the insurance market to function efficiently.
A catastrophe bond is a contract between a sponsor (usually an insurance company) and a set of investors (usually hedge funds and other high-risk investors).
The insurance company usually takes the help of investment bankers to create a special purpose entity which is different from the insurance company. This is done to shield the investors from the risks that may arise by directly investing in the insurance company. Also, this special purpose entity is set up in a tax efficient location. This helps reduce the overall cost of issuing these bonds.
In a typical catastrophe bond issue, hedge funds and other investors buy bonds which are issued by the special purpose entity. Normally, bonds are fixed income securities with no risks. However, the return provided by catastrophe bonds varies according to risk. The nature of these bonds changes according to external circumstances.
There are some pre-defined triggers like earthquakes in Florida or Typhoons in Japan which are identified when these bonds are issued. If these triggers do not take place, then the investors continue to get their coupon payments as well as their principal payments just like other bonds. However, if these triggers are breached, then the investors are likely to lose all or part of their principal. This principle will then be given to the insurer so that they can make good on the claims that they need to pay to their customers.
Catastrophe bonds can be segregated based on the types of events that trigger such bonds.
If these losses exceed a predefined amount, let’s say $500 million, then the catastrophe loss cover would apply. Hence, if the AIG faces, $700 million in losses due to claim payments, its losses will be capped at $500 million. The balance $200 million will be reimbursed by investors of catastrophe bonds
For instance, if the losses being suffered by the entire insurance industry amount up to $1 billion, then the catastrophe bonds will be triggered. A pre-defined percentage is usually set up to determine the extent of losses that these investors are willing to bear in different circumstances.
As mentioned above, the returns of the catastrophe bonds are unpredictable and may vary widely. Also, the returns are based on outcomes such as weather and natural calamities which are difficult to predict in the long run.
This is the reason that catastrophe bonds are issued for short periods of time with the maximum tenure being close to three years.
Also, the interest rates paid on catastrophe bonds have to be astronomically high. This is because investors are running the risk of losing all or part of their capital. This makes catastrophe bonds riskier than equity investments, and hence the return must also be comparable to that of equity investments.
It is because of this high risk that catastrophe bonds are rated B+ or below, i.e. below investment grade by all major credit rating agencies in the world. This is the reason why only high-risk investors such as hedge funds and high net worth individuals buy these bonds.
Catastrophe bonds are high-risk investments. Investors do not put their money in these investments to earn returns. Instead, these bonds are more of a hedge. This is because the returns from these bonds are not correlated to other investments in the market.
The interest rates on these investments are defined as LIBOR plus certain percentage points. Hence, even if the interest rates move up or down, the real return from these bonds remains exactly the same. Also, the return of these bonds bears no relation to stock market crashes or uprisings. Hence, portfolio managers find these tools useful in order to diversify their risks.
The bottom line is that catastrophe bonds are an important part of the insurance industry. It is these bonds that let insurance risk be distributed amongst a number of individuals. In the absence of catastrophe bonds, reinsurance companies would find it difficult to remain solvent in the event of a catastrophe.
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