Catastrophe Bond - Historical Background, Structure, and Modeling - Literature review Example

Catastrophe Bonds s Affiliation Supervisors’ Introduction­­­ The frequent occurrences of hazards anddisasters necessitated the science to intervene by assessing and managing risk due to natural attrition, hazards and disasters. The concept of managing the risks associated with hazards like fire, earthquake and storms destroying properties of investors originated from the insurance firms and the science of natural hazards (Lakdawalla & Zanjani, 2006). As a result, the insurance firms and financial institutions ­­­­­came together early 1800’s in effort to compensate for damages suffered by the investors due to phenomena fire, storms, floods ,drought amongst others. In the 1800’s, the insurance firms began to devise ways and mechanism to manage these risk by restraining and mapping out the properties under the insurance (Gorv­­­­­­­­­­ett,­­­­­­­­­ ­­­1999). The mapping out the structures and properties were marred with technical hitches since it was limited in assessing various aspects of risks which are very important. Commonly used mapping became obsolete in the 1960’s due to the cumbersome and time constraining in assessing the risks (Kozlowski & Mathewson, 1995). A more objective and better way to assessing the risks and compensation of the investors by the insurers was invented through a concept known as a catastrophe bond. Historical Background of Catastrophe Bond A Catastrophe Bond, commonly known as CAT is a risk and hazard compensation scheme that transfers a specified set of risks from insurance firms to the investors. The bonds came into existence due to the frequent major caused by natural hazards and disasters which were difficult to evaluate using the mapping technique used in the 1800s ( Froot, 2000 ). The catastrophe bond concept was borne after a heavy hurricane called Andrew and the earthquake destroyed several properties resulting to devastating impacts to the investors and insurance firms. Under the catastrophe bond, an investor purchases the bond from any insurance firm with an attached value between 3-20% return which varies from bond to bond. After buying the bond from any insurance firm, the investor earns his profit from the purchased bond unless a natural disaster occurs during the trading period. If a phenomenon occurs in a given country, that becomes the trigger and as a result the investor will forfeit the compensation. However if an event doesn’t occur, the investor will get back a large sum of money in form of compensation. In countries and developed Nations like United States, the occurrence of events such as earthquake and hurricane offers opportunities of great magnitude for the insurance firms to look for alternative methods to that can be used to eliminate or reduce risks and through collaboration with capital markets companies’ catastrophe bonds (Carr &Anja, 2011). The catastrophe bonds have shortcomings which the investors need to be aware before venturing into. One of the challenge is the fact that they risky and usually have maturities less than 3 years. For example during a certain period, the insurance company only compensates the investors depending on their returns. Similar if during the period no catastrophic event did occur, then the investor would be excused and the insurance company uses this money to pay their claim-holders. The catastrophe bonds are used by insurance bodies as an alternative to traditional catastrophe re-insurance (Froot, 2000). The catastrophe bond allows for adjustments in the set conditions of the insurance such that in an event of a catastrophic occurrence the investor remains the holder of the security and the company forfeits any benefits. The common approach employed is the security bond as an alternative to utilizing catastrophic reinsurance coverage for risk compensation. An investor in any property may want to issue catastrophe bonds that will act as a protection from a financial loss in the most unfortunate scenario that natural hazards and disasters occur. By passing on the risk to the investor, the insurer stands a good chance of remaining financially stable, even in the face of a major disaster (Litzenberger, et al., 1996). An important factor to note with the catastrophe bond is the conditions under which the securities experience a decline in its value. The bonds make good use of the occurrence of events under pre-defined set of rules to be met to start accumulating losses. Only when these specific conditions are met do investors begin to lose their investment. A trigger which is the occurrence of any event can be of many forms. One way is from a point of actual losses experienced by the insurer to a trigger which is activated when the insurance firm experience losses when insured catastrophic event struck. From another point, an index that measures the severity triggered from the industry and the losses are also applied. The bond provides early occurrence cover, so exposure to a single major loss event, or to provide aggregate cover, exposure to multiple events over the course of each annual risk-period. Some catastrophe bonds transactions work on a multiple loss approach and so are only triggered by second and subsequent events (Kozlowski & Mathewson, 1995) Catastrophe Bond Structure and Modeling According to Kozlowski & Mathewson,1995, the modeling and structure of the bond was necessitated due to many natural disasters that struck around the year 1992 in United States. The event was such serious that it sent alarming message to the public for the need to manage the risks associated with disasters. This resulted to the government taking the initiative to put measures for an accurate assessment of the impact of disasters for mitigation and emergency planning purposes. This gave birth to a concept known as the modeling of the risks. However the risk modeling requires the understating and analysis of various structures of the Catastrophe bond. The four basic components of a catastrophe model are: Hazard, Inventory, Vulnerability and Loss as shown in Figure 1. Figure 1: Structure of Catastrophe bond (Adopted from: Grossi et al., 2005) The first stage in the model is to allow the model simulates the risk of natural hazard phenomena. In the second stage the model characterizes the inventory of properties as accurately as possible. The most important parameter used to characterize the inventory is the location of each property that is insured.With a property’s location, other factors that could aid in estimating the vulnerability of a property are added to during the process (Grossi et al., 2005). The hazard and inventory structure enable the calculation of the vulnerability or susceptibility to damage of the structures at risk. This helps in the quantification of the physical impact of the natural hazard phenomenon on the property at risk. The loss is characterized as direct or indirect in nature where direct losses include the cost to repair or replace a structure. Indirect losses include business interruption impacts and relocation costs of residents forced to evacuate their homes (Kozlowski & Mathewson, 1995). The main reason therefore for a catastrophe model is to assess catastrophe risk and improve risk management decisions. The model output is quantified and presented in a way that is simple by the users. The alternate risk management strategy such as mitigation, insurance, reinsurance and catastrophe bonds can be assessed. Catastrophe modeling is vital to catastrophe bond transactions to provide analysis and measurement of events which could cause a loss as well as to define the exposed geographical region. Catastrophe bond structures have been used to eliminate risks of hurricane, earthquake, typhoon, European windstorm, thunderstorm, hail and even life insurance (Grossi, et al., 2005). Why People Invest in catastrophe Bonds There are reasons why people would consider investing in catastrophe bonds. The returns obtained from catastrophe bonds are not linked to the macroeconomic factors. This is not a very common thing to find in any investment environments since most investments world tend to find the relationship between returns or profits with economy. This is a peculiar characteristic that has allowed the existence of valuable diversification attributes to portfolios of more traditional asset classes. This attribute has also enhanced particular appeal in uncertain financial environments when investors may wish to protect themselves from market forces (Carr &Anja, 2011). Another unique attractive feature of catastrophe bonds and other catastrophe risk securities is that it does not allow the existence of poor performance as it will be eliminated. Occurrence of a particularly destructive natural disaster, triggers a number of factors to serve and inflate insurance premiums, provides investors with the opportunity to recover any losses suffered within a relatively short period. The effects that this has to the bond includes increased demand for insurance, a reduced ability of insurance and reinsurance companies to take on risk, and upward revision of the probability models that are used to price insurance and catastrophe risk securities ( Litzenberger, et al., 1996). When the investors suspect or face the possibility of running at a loss of their investment in the event of occurrence of a catastrophe, their risk exposure can be dramatically reduced when diversification across many different catastrophe bonds is done .This is possible since the chance of numerous large-scale natural disasters occurring within the same limited time frame is very low. Investing in catastrophe bonds is recommended because there are more benefits accrued in extreme returns than incurring losses during the extreme events (Carr &Anja, 2011). Advantages of Catastrophe Bond The acquisition of a catastrophe bond has many advantages to investors and to the insurance firms. The catastrophe bond represents a security with a high level of risk, the bonds of this type offer opportunities for high-yield returns to the customers. If no disaster occurs during the life of the bond, then an investor benefits by getting returns between 3-20%. However, should a covered catastrophe occur, the investor will lose the entire principal investment, which may amount to a substantial amount of resources (Carr &Anja, 2011). A catastrophe bond is also seen as one of the ways to diversify the investments and provide at least one investment that has the potential for a high level of return. The benefits of a catastrophe bond for an investor are best seen when the bond has more than one trigger, which makes it more likely that an investor will see a return on the bond (Kozlowski & Mathewson, 1995) For the reinsurer selling the bond, it gives them the money they need to give out in times of a catastrophe. These bonds make insurance safer for all parties involved, and allow investors to diversify their resources (Gorvett, 1999). Another advantage of the catastrophe bond is that it enhances multi-year commitments which results to capacity and pricing policy. The most traditional indemnity-based reinsurance has been always issued for one year period. The financial firms and insurers signs new deals each year and this enhances commitments between the Insurance firms. Since cat bonds are issued each year for 2-3 period of engagement, the multi-year capacity and pricing certainty offered by a cat bond is found to be attractive to insurance firms. The cat bonds provide an indemnity-based reinsurance cover. The reinsurance cover provided by indemnity-based cat bonds facilitates an alternative risk transfer mechanism to the concerned parties. To the insurance, it is much easier to position an indemnity-based cat bond as part of an overall risk transfer program than an index-based cat bond. Rating risk avoidance helps in claiming for payment of a reinsurer to a ceding insurer. This is true because, a ceding insurer may have a business practice of only contracting with reinsurers which have a certain minimum claims payment method (Kozlowski & Mathewson, 1995). Cat bonds also provide a structure in which reinsurers that do not have a claims paying or other financial rating sufficient to qualify for participation in a ceding insurer’s reinsurance program can participate. This structure therefore potentially expands the market for a ceding insurers risks to lower rated reinsurers and investors which do not participate in the traditional reinsurance market. The bonds also have less credit risk because the total amount of funds which can be called by the insurance firms if a catastrophe occurs are placed in trust. However, the firms do not hold funds equal to their maximum exposure, and thus reinsurers have insufficiency and funds at risk (Litzenberger et al., 1996). The bonds involve lower tax costs than equity capital. The catastrophe bond structure reduces financial distress costs relative to traditional subordinated debt; because the contingent payments are based on readily observable variables that are agreed upon. A catastrophe bond is seen as regulating body for reinsurance prices such that no reinsurance price can be increased abnormally. The introduction of cat bonds has encouraged competition between the insurers for pricing. Investing in catastrophe bonds could be recommended since they have presumably low or zero correlation with other currently traded assets and are therefore a promising instrument for portfolio enhancement. The profits from a catastrophe bonds are proven to be less volatile than the bonds (Carr &Anja, 2011). Disadvantages of the Catastrophe Bond Niehaus, 2002, indicates that investing in catastrophe has demerits and merits although the merits outweighs the demerits. The investment in bonds is affected by policy constraints that generally demands that the bonds be issued by an offshore special purpose vehicle. This implies that catastrophe bonds can involve substantial transactions costs. The transaction costs are estimated to be about 2 percent of the total coverage provided by a catastrophe bond. These costs cover: underwriting fees charged by investment banks, fees charged by modeling firms to develop models to predict the frequency and severity of the event that is covered by the security, fees charged by the rating agencies to assign a rating to the securities, and legal fees associated with preparing the provisions of the security and preparing disclosures for investors. The price of a reinsurance contract would not typically include such additional fees. Other institutions avoid purchasing catastrophe bonds altogether because it would not be cost-effective for them to develop the technical capacity to analyze the risks of securities different from the securities in which they currently invested. Catastrophe bonds are available only to institutional investors. The market in cat bonds generally suffers from lower levels of liquidity relative to mainstream bonds (Froot, 2000). There are several costs currently involved in catastrophe bond issuance. The continued development and future success of catastrophe bonds depends largely on the market’s ability to reduce some of these costs. The offered yields have proved to be rather high since the insurance securitization industry is still small. As the process further develops and matures, the yields decline. The second set of costs involves setting up the Special Purpose Vehicle and lastly is investment banking costs. An investment banks are compensated through advising fees and through the spreads between the prices at which they purchase issues (Gorvett, 1999). Summary and Conclusion The abrupt recent growth in the catastrophe bond market has resulted to the emergence of some new insurance related businesses which could potentially undermine the long term growth prospects of the cat bond market. Investing in cat bonds is not assurance of security of one’s money in insurance. Investor’s money can easily be finished within a short time (Niehaus, 2002). For instance the massive earthquake that erupted in Japan in 2011 led to direct losses in two major catastrophe bonds with funds worth over $300 billion. The chances of having a whole cat bond’s principal paid out in one night are as very common with investing in cat bond making it a risky a fair. The bonds are restricted to few institutional investors making it not accessible to the majority of people. The investment in bond is such limiting that even some wealthy individuals, are not able to directly buy catastrophe bonds (Gorvett, 1999). The catastrophic losses witnessed during the 1990s and the estimates of potential future catastrophe losses have led to a number of interesting developments. These includes the development of more sophisticated catastrophe models to measure catastrophe exposures, an increase in capital supporting catastrophe insurance-reinsurance, especially in tax-advantaged locations, the development of catastrophe bonds, the trading of catastrophe options. These developments can be viewed as attempts to provide more capital and to lower the cost of capital backing catastrophe exposures. The impact of catastrophe bonds is uncertain since they are used not most often but they provide competition for traditional reinsurance (Froot, 2000). The most important development in the catastrophic bond is the application of financial concepts and tools to the management of catastrophe risk. Previously, catastrophe risk was an issue for some selected institutions and individuals in insurance and reinsurance sectors. Currently, investment bankers, stock exchanges, and fund managers are interested in catastrophe risk. Catastrophe risk is increasingly being viewed as another asset class. An issue of concern still is the pricing of catastrophe risk in a portfolio context. The common assumption is that catastrophe losses are not correlated with returns on other assets (Litzenberger et al., 1996; Gorvett, 1999). The catastrophe bonds encourage diversification, which makes it a potential valuable addition to many portfolios. Investors are not supposed to be alarmed for anything; this is because its nature of uncorrelation between catastrophe bonds and numerous traditional asset classes helps divert disaster for many investors. One of the ways to gain exposure to catastrophe bonds is to treat them as part of a diversified alternative assets portfolio (Rick& Popkin, 2012). Additional development, and possibly broadening, of this market seems likely. The market for life and yearly permanence and mortality risks is much less developed. Therefore Investing in catastrophe bonds is a unique way to diversify one’s portfolio. However, it would be imperative to be alive with the risks that come with it some of which had been highlighted (Kozlowski & Mathewson, 1995). It is possible to gain or make profit from the bonds and at the same incur losses. Certain scholars are of the opinion that investing in cat bonds is full of uncertainty and could go either way. It is important to do a thorough research before potential investors can invest in cat bonds. Certain considerations to make before investments include whether the region is frequently hit by hazards and disasters like large hurricanes, tornadoes, tsunami, or earthquakes amongst others. The potential damages caused by theses disasters and the cost implications are amongst the key consideration before investing in catastrophe bond. This would help to decide how many bonds to buy and at what particular time (Niehaus, 2002). References Carr, T. &Anja, M.2011. Focus on Alternatives: Catastrophe Bonds Explained; Available at http://www.schroders.com/staticfiles/schroders/Products/Property/Eloqua%20Attachments/catastrophe-bonds-explained.pdf. Accessed on 13/5/2014. Froot, K., 2000. The market for catastrophe risk: A clinical examination. Journal of Financial Economics 60, 529–571. Gorvett, R.W. 1999. Insurance Securitization: The Development of a New Asset Class. The college of insurance 101 Murray street New York, NY, Casualty Actuarial Society. Grossi, P. Kunreuther, H.&Windeler, D. 2005. Catastrophe Modeling: A New Approach to Managing Risk, USA, Springer Print. http://www.schroders.com/staticfiles/schroders/Products/Property/Eloqua%20Attachments/catastrophe-bonds-explained.pdf. Accessed on 13/5/2014. Kozlowski, R. T. & Mathewson, S. B. 1995. Measuring and Managing Catastrophe Risk, 1995 Discussion Papers on Dynamic Financial Analysis, Casualty Actuarial Society, Arlington, Virginia. Lakdawalla, D. & Zanjani, G.2006.Catastrophe Bonds, Reinsurance and the Optimal Collateralization of Risk Transfers. NBER Working Paper Series, National Bureau of Economic Research, Cambridge. New York. Available: http://www.nber.org/papers/w12742.pdf?new_window=1. Accessed on 14/5/2014. Litzenberger, R. Beaglehole, D.Reynolds, C. 1996. Assessing catastrophe reinsurance-linked securities as new asset class. Journal of Portfolio Management, 76 -86. Niehaus,G. 2002.The allocation of catastrophe risk. Journal of Banking & Finance 26. Rick, M. & Popkin, M.2012.Reinsurance vs. Catastrophe Bonds Comparing and Contrasting Features across the Convergence Spectrum . 2012 Towers Watson — Proprietary and Confidential. Available at: http://www.towerswatson.com/assets/pdf/mailings/Towers-Watson-Convergence-Across-the-Spectrum.pdf.Accessed on 14/5/2014. Read More