Are Catastrophe Bonds a Man-Made Disaster Waiting to Happen?

Are Catastrophe Bonds (“Cat Bonds”) driving the possibility of a “collapse” in the $575 billion reinsurance industry?

In a new book, Making a Market for Acts of God, detailed in the Financial Times, Professor Paula Jarbzabkowski of Cass Business School and two other researchers make such an argument. But their case is incorrect on several levels.

Quoted in the FT article, the book argues that risks from major natural disasters are being bundled in Cat Bonds that “…obscure the underlying risks on which they were based….Such shifts in the underlying basis of a deal bear resemblance to changes that were linked to the subprime mortgage crisis of 2008.”

Really? Cat Bonds are a well-established form of financing that have been marketed for almost 20 years. They generally transfer one (or more) very specific Natural Catastrophe risk from an insurer to one or more investors. They, by their nature, do not obscure underlying risks, and associating their risks with that of subprime mortgages is simply inaccurate.

In its typical form a Cat Bond is structured such that:

(a) a Special Purpose Vehicle (“SPV”) is established,

(b) the SPV enters into a reinsurance agreement with a Sponsor (generally the insurer or a party acting on its behalf — the Cedent) whereby the Sponsor pays premiums to the SPV in return for coverage for this specific risk,

(c) the SPV issues notes to noteholders (“Investors”),

(d) the funds received from issuance are held in a Collateral Account, and

(e) interest (from the premiums paid by the Sponsor and earnings in the Collateral Account) is passed through to the Investors,

If a loss trigger event occurs during the term of the notes, the SPV liquidates collateral to make required payments to the Sponsor (resulting in losses to the Investors). Alternatively, if a loss trigger event does not occur during the term of the notes, the investors receive their regular interest and their principal back upon the notes’ maturity.
A basic illustration of a Cat Bond:

“If losses from [type of Natural Catastrophe] in [Country or Region or State] exceed $[             ] over the next [   ] years, Investors will lose $/€/¥ [     ] of their Principal.”

The range of Natural Catastrophes and locations that show up in Cat Bonds has been quite varied, including Florida named storms, U.S. hurricane, Japan earthquake, Swiss property catastrophe risks, and European windstorm, among others.

As with other types of securitization, they can provide an attractive alternative means for an issuer (in this case, the Cedent) to manage its risk and an attractive alternative investment option for sophisticated investors.

In the best case, (a) the Natural Catastrophe does not occur, (b) the Cedent will have decreased its risk while retaining premiums and returns beyond what it has paid out, (c) the Investors will have earned attractive returns for the risk they have assumed, and (d) the underlying policyholders will, thankfully, not have to make claims under their policies for losses.

In the worst case, (a) the Natural Catastrophe does occur and it triggers the loss trigger event in full, (b) all of the funds in the Collateral Account are given to the Cedent, (c) the Investors lose their entire investment, and (d) the Cedent uses the funds received to help pay the underlying policyholders’ claims under their policies for losses.

A Cat Bond serves as an alternative way for a Cedent to transfer and/or limit its risk to a Natural Catastrophe. As Cat Bonds do transfer real risks during their respective terms, the large majority have either been unrated or rated non-investment grade.

In a follow-up article in the Financial Times, John Seo, one of the pioneers of the Cat Bond market, is quoted as stating the book’s authors reach, “completely false” conclusions about the dangers in this market and that they, “[had adopted a] careless attitude [to catastrophe bonds]….”

While presenting an attractive alternative to reinsurance and retrocession for insurers, with well under $23 billion outstanding [1], Cat Bonds are only a small portion of the overall reinsurance market for Natural Catastrophe risk; they also constitute but a small fraction of the securitization market.

How can Cat Bond deals be compared to the “subprime mortgage crisis of 2008”? Their risks are so much better understood and presented clearly to the investors. They are rated properly. And the size of the Cat Bond market is orders of magnitude smaller.

The subprime mortgage market of 2005-2008, with its widespread poor and/or misapplied underwriting, rampant fraud, and foolish rating assumptions and methodologies that produced ‘AAA’ RMBS and ‘AAA’ CDOs that proved to be far from ‘AAA’ quality in reality, is not comparable to the Cat Bond market.

Avi Oster

Judicious Advisors LLC

 

 

[1] Artemis calculates that outstanding Catastrophe Bonds and Insurance-Linked Securities (“ILS”) total $23.204billion

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