Introduction
From melting glaciers in the polar regions to increased bushfires in Australia, we are witnessing more and more severe climate phenomena which are wreaking havoc everywhere. Climate change is a global reality now and it is adding to both the frequency and severity of natural catastrophes and weather- related disasters.
Though estimates vary, global economic losses from natural catastrophe events in 2020 were estimated at approximately USD 190 billion.
Even as awareness about climate change is growing and global initiatives are being made to slow down the pace and initiate corrective measures towards reducing the emission of harmful gases severe weather events are exacting a heavy toll on human lives and property.
Hence financial initiatives are also called for side-by-side with corrective measures to provide immediate financial relief for losses caused by natural disasters.
How CAT Bonds originated
CAT Bonds developed to help mitigate the heavy costs of severe natural disasters. They were developed and first used in the mid-1990s in the aftermath of Hurricane Andrew and the Northridge Earthquake in the USA.
Hurricane Andrew struck Florida and the Gulf Coast in the year 1992. It led to USD 27 billion in damages, of which USD 15.5 billion was covered by insurance. As Hurricane Andrew was the costliest hurricane to ever make landfall in the United States at that time,it led to one of the most difficult periods for the property and casualty (P&C) insurers. The financial upheaval it caused in the insurance sector can be gauged from the fact that it led to the failure of eight insurance companies and pushed many others to the brink of insolvency.
The insurance industry then created a new financial instrument called a Catastrophe Bond or Event Linked Security to increase capital. A CAT Bond is a security that pays the issuer when a predefined disaster risk is realized. The first CAT Bonds were issued in 1997, giving insurers access to broader financial markets. Since then, the CAT Bond market has grown steadily and they have been utilized to mitigate the expenses of severe natural disasters.
What are CAT Bonds?
CAT Bonds are a type of insurance-linked security (ILS)—an umbrella term for financial securities that are linked to pre-specified events or insurance-related risks.
They are thus a type of high-yield debt instrument that is designed to raise money for the insurance industry in the event of a natural catastrophe or disaster. The term natural catastrophe (Nat Cat) refers to a major adverse impact from either weather or geological-related events.
Basically, CAT Bonds allow insurance companies to transfer the risk of natural disasters covered by their policies to investors for a price.
When CAT Bonds are issued, the proceeds raised from investors go into a secure collateral account, where they may be invested in various other low-risk securities. The money raised with these bonds is set aside to cover potential losses. Interest payments to investors come from these secure collateral accounts.
A CAT Bond allows the issuer to receive funding from the bond only if specific conditions, such as an earthquake or tornado, occur. If triggers spelled out in the contract – insured losses from a hurricane reaching a specific level, for example – are met, the insurer gets to use the money to offset what it has paid out to policyholders.
If an event protected by the bond activates a pay-out to the insurance company, the obligation to pay interest and repay the principal is either deferred or completely forgiven and the holders of the bond lose their investment.
CAT Bonds have short maturity dates between theretofore years.
Individual investors do not usually buy CATBonds.The primary investors in these securities are hedge funds, pension funds and other institutional investors.
CAT Bonds are often rated by an agency such as Standard & Poor’s, Moody’s or Fitch Ratings. They are rated based on their probability of default due to a qualifying catastrophe triggering loss of principal. This probability is determined with the use of catastrophe models.
Most CAT Bonds are rated below investment grade (BB and B category ratings).
Natural disasters and Risk transfer through CAT Bonds
Many countries have insufficient protection against the financial impact of natural disasters. Failure to close this protection gap can divert funds away from other critical areas of need and drain state and national budgets. One way to build protection is to transfer the financial risk of natural catastrophes to third parties such as insurers.
This form of risk protection provides governments with the funds to respond quickly to disasters and helps strengthen their financial resilience.
Implementation of a successful risk transfer program requires coordinated effort by all stakeholders. Public-private sector cooperation is key in this equation with both parties playing a complementary role. The public sector has the breadth of distribution and ability to create a conducive operating environment, whilst the private sector brings products, technology and expertise.
A conducive regulatory environment is also required since it attracts the right public/private participants, facilitates prompt distribution of pay-outs and ensures a sustainable program.
How CAT Bonds help to mitigate the costs of extreme weather events
Disasters take a huge toll on individuals and larger communities. The financial fallout is generally handled by insurance and government support through mechanisms such as disaster response funds. The protection is inadequate because the available options are not good enough to meet increased natural risks.
Insurance against extreme events works best if insurers are able to spread the risk among a wide pool of investors. That way, neither will insurers be financially overwhelmed by a disaster, nor will they have to disproportionately raise premiums to cover increased risk of some events like floods or earthquakes.
It is with this understanding that solutions have emerged where one avails of a larger global basket of insurance-linked securities (ILS), particularly Catastrophe Bonds.
Foreign governments have sponsored CAT Bonds as a hedge against natural disasters and three such case-studies are elucidated below.
Case Study 1: Combating Natural Catastrophes in the Pacific region with the multi-country Earthquake Bond
The World Bank (International Bank for Reconstruction and Development) issued sustainable development bonds in the year 2018 that collectively provided USD 1.36 billion in earthquake protection to the South American countries of Chile, Colombia, Mexico and Peru. The World Bank issued the transaction as part of its broader work to support these countries in managing risk from natural disasters.
This is the largest sovereign risk insurance transaction ever and the second largest issuance in the history of the Catastrophe Bond market.
The issuance comprised five classes of World Bank bonds: one each for Chile, Colombia and Peru, and two classes for Mexico. Under the respective classes, Chile was to receive USD 500 million, Colombia USD 400 million, Mexico USD 260 million and Peru USD 200 million in risk insurance.
Each class has different terms and all are designed to cover earthquake risks. The triggers are parametric and depend on data provided by the US Geological Survey.
The classes for Chile, Colombia and Peru were intended to provide coverage for three years. The classes for Mexico were intended to provide coverage for two years.
Case Study 2: Combating Natural Catastrophes in Mexico with CAT Bonds
Mexico is highly exposed to many natural hazards such as hurricanes, storms, floods, earthquakes and volcanic eruptions.
In 2006, Mexico became the first country to utilize CAT Bonds.
The World Bank issued four catastrophe (CAT) Bonds in the year 2020 that will provide the Government of Mexico with financial protection of up to USD 485 million against losses from earthquakes and named storms for four years.
If a natural disaster occurs that is eligible for coverage, some, or all, of the bond proceeds will be made available to the Mexican Fund for Natural Disasters.
Pay-outs will be triggered when the earthquake or named storm meet the parametric criteria for location and severity set forth in the bond terms.
Case Study 3: Combating Natural Catastrophes in Jamaica with CAT Bonds
Jamaica is highly exposed to tropical cyclone events. The World Bank is helping Jamaica to develop resilience in this area through various financing instruments.
The World Bank priced a CAT Bond that will provide the Government of Jamaica with financial protection of up to USD185 million against losses from named storms for three Atlantic tropical cyclone seasons ending in December 2023.
Pay-outs to Jamaica will be triggered when a named storm event meets the parametric criteria for location and severity set forth in the bond terms.
The transaction includes an innovative reporting feature resulting in a quick pay-out calculation, within weeks of a qualifying named storm. It is also the first CAT Bond to use an innovative cat-in-a grid parametric trigger design for tropical cyclone risk.
How do CAT Bonds work?
CAT Bonds are usually issued by three different types of institutions: insurance companies, reinsurers, and state catastrophe funds. These three types of institutions employ CAT Bonds in their own distinctive ways to offload their specific insurance risks.
An important feature of CAT bonds that tends to differ across the issuer types is the trigger—i.e., the mechanism used to determine when pay-outs must be made to the bond issuer.This contractually agreed-upon threshold is also known as the bond’s attachment point.
There are three common types of triggers for a CAT Bond: indemnity, industry loss and parametric.
Indemnity triggers: base CAT Bond payouts on the actual insurance losses experienced by the issuer, and function similarly to traditional reinsurance.
Industry loss triggers: base pay-outs on aggregate losses to the insurance industry and employ a third-party modeler to provide an independent estimate of these covered losses.
And finally, parametric triggers base pay-outs on the measured strength of the covered catastrophe—such as an earthquake’s magnitude or a hurricane’s wind speed and barometric pressure.
Using an indemnity trigger ensures that the CAT Bond will pay out when the insurance company’s actual losses reach the bond’s attachment point, which gives the insurer greater precision in its risk-management strategy compared with other types of triggers. However, because actual losses must be observed and verified before the bond can be triggered, a bond with an indemnity trigger often takes longer to pay out.
On an average, CAT bonds with indemnity triggers take two to three years to pay out following a triggering loss, compared with three months for CAT bonds with industry loss or parametric triggers.That is the reason why parametric triggers as the attachment point are favoured in the CAT Bonds issued to provide relief for extreme weather events.
CAT Bond Sponsors
CAT Bond sponsors include insurers, reinsurers, corporations, and government agencies.
Over time, frequent issuers have included USAA, Scor SE, Swiss Re, Munich Re, Liberty Mutual, Hannover Re, Allianz, and Tokio Marine Nichido.
Mexico is the only national sovereign to have issued CAT Bonds (in 2006, for hedging earthquake risk and in 2009 and 2012, a multi structure instrument that covered earthquake and hurricane risks).
In June 2014, the World Bank issued its first CAT Bond linked to natural hazard (tropical cyclone and earthquake) risks in sixteen Caribbean countries.
Advantages of CAT Bonds
CAT Bonds are advantageous for both insurers and investors for a number of reasons.
CAT bonds offer insurers an alternative to traditional reinsurance and allow catastrophe risk to be transferred to a wider set of investors. Unlike traditional reinsurance where it is possible for the reinsurer to fail to pay out following a loss event, CAT Bonds are 100% collateralized and structured to eliminate counterparty risk
CAT Bonds also offer the possibility of multi-year commitments, whereas most reinsurance deals are for a one-year term. A multiyear commitment allows CAT Bond issuers to lock in prices over an extended period. Finally, CAT bonds have lowered the costs of diversifying insurers’ exposure to natural disaster risk
For investors, the appeal of CAT bonds is twofold. First, CAT Bonds are largely uncorrelated with the returns of other financial market instruments. The incidence of hurricanes and tornadoes is largely unrelated to economic and financial activity. However, it is possible that CAT Bond losses might happen at the same time as a downturn in the broader economy.
Second, historically, CAT Bonds have provided strong returns, helping to attract alternative sources of capital into insurance markets.
Risks associated with CAT Bonds
CAT Bonds are quite complex and their pay-outs may not be quite simple or predictable. The complexity of the trigger event or the attachment point of a CAT Bond is very crucial to the pay-outs. In other words, while retail investors may think they have a simple proposition, the implications for their pay-out and principal may be much more difficult in practise than it appears.
The actual risk level contained in an event-linked security is also hard to calculate. Big Data has allowed many firms that specialize in risk assessment and damage estimates to come up with a reasonable accurate figure of what might happen if catastrophe strikes but Nature is unpredictable.
Finally, because catastrophe bond holders face potentially enormous losses, these bonds are rated “non-investment grade” or BB or lower by most major credit rating agencies.
The way ahead
Catastrophe bonds have emerged over the years as a popular option for insurers, reinsurers, global corporations and even governments as a way to protect themselves against natural disasters.
India is vulnerable to climate change as the National Disaster Management Authority, Government of India (NDMA) estimates that 27 states and Union territories are disaster-prone.Hence it is time that India also explored this option to address the protection gap in India to mitigate losses from climate change.
Currently, the insurance industry is working to improve CAT Bond modelling to cover new types of risk—such as cyber attack and terror risks. So, it appears that the uses of CAT bonds will continue to grow, offering issuers new avenues to transfer a variety of risks.
Be that as it may, it may also be stated that it is high time we pondered on the fact that serious and concerted efforts are urgently required to gradually reduce our carbon emissions as this is the best solution to combat climate change in the long-term.
