On Disaster Bonds - Research Paper Example

Research on Disaster Bonds (also known as CAT bonds or Catastrophe bonds) CAT bonds are a form of insurance coverage that is issued by special purpose entity (SPE) or special purpose vehicles (SPV) to offer asset securities. The entities could be companies, organizations or trust groups who claim the beneficial ownership of properties on behalf of the clients. CAT bonds are insurance related and are meant to raise money to cover a disaster, with specific condition connecting the insurance company and the insured, in terms of payment procedures. The insurers and investors stand a chance to lose in case of a catastrophe. It involves risk taking; investors acquire disaster bonds for a principal and then enjoy the high rate interest accumulation as long as the disaster does not occur. According to leading experts in risk management, “Catastrophe bonds are fixed income securities, typically issues by insurance companies, which pay an attractive yield to investors, but with a provision that should a specific predetermined event…..occur, bondholders suffer the loss of their income and potentially all their capital” (197). Events may be due to natural damage or human induced disasters where the bond may cover either the whole or part of the damage preventing the buyer from reaching to unbalanced sheet. The risk is conveyed to the investors rather than the insurers. The structure of CAT bonds is expressed in CAT bonds demystified (See fig. 1). Fig. 1: CAT bond transaction structure from CAT bonds demystified RMS guide to the Asset Class, RMS. Com, n.d. Web. 24 October. 2012. These bonds are now used widely as they may forego interest and principle either in part or whole as stated in the condition. They require investors’ specialized knowledge and skills in judgment of where to invest. However, the jurisdiction of application affects the disaster bonds effect on parties involved. In the above structure, SPV or SPE are the established entities that insurance companies forward the reinsurance agreement to, which then relay’s the default provisions, as reflected in the agreement as a note; if the terms are approved, transactions are managed to generate money market returns where the SPV or SPE transfer back the principal and accumulated interests in cases of minimal risk involved (“CAT Bonds Demystified,” Rsm). The disaster bonds act like financial instruments; they were first issued in mid 1990s and most specific in 1997 in American history. American continent has had numerous attacks, U.S blizzard and tornadoes in 1993, Northridge earthquake in 1994 and especially the numerous hurricanes in Mexico, U.S, Caribbean, and Bahamas among others. Japan has also had its difficulty during the 1995 Hanshin earthquake and Typhoon Mireille in 1991. This natural catastrophe caused unexpected huge loose of nations property and human lives. After the birth of catastrophe bond market in early 1995, there were assets claims on insurances industries of nearly, sixty billion United State Dollars by 1996 from beginning of 1990. Catastrophe bond was issued first in 1997 for the USAA in US; the United Services Automobile Association (USAA) had intended to secure eighty percent of it’s looses by acquiring reinsurance coverage following the hurricane Andrews damage, the USAA served to finance personal management products for the military officers and their close dependent family (CBO 45). The evolution of catastrophe bond in the market has progressed with the increased knowledge and experience of the investors and its structure in the financial field. Before, bonds would cover different varying times as agreed between the participants, perhaps in a range of one to ten years. Today, the common period for the bond in the market is 3 years, not unless stated otherwise. The bond timings have been strategized to be effective for the involved parties. There have been progressive, demanding regulations on re-insurers for principal causing double demand of disaster capital invested. Countries, institutions, and organization have seen the need to secure their property in case of a tragedy. The western population has placed huge efforts on this than in Africa. Probably, it is because they have been hit hard by such natural events than other parts of the world. In 2006, Mexican government decided to use the Disaster bond to evade associated disasters of economic liability. Previously, it had experienced about 80 disasters in between 1980 to 98, impacting negatively on the land and its resources. As of 2007, a hundred and sixteen CAT bonds had been issued since mid 1997. The market as of 2005 was two billion US dollars, 4.7 billion in 2006 and 7 billion in 2007 which showed tremendous improvement in investment in CAT bonds. The latest market dynamics has produced a plat form where investors come in to boost property security. Since the inception, CAT bond has experienced almost twenty percent increase per annum. The growth has enabled the bonds to be applied in different financial assets like automobile, education and mortgage loans among others. CAT bonds can now have flexibility in terms of payment, the indemnity, hybrid and index triggers. How CAT bond relate with systemic risk: CAT bond are risk related securities that would see transfer of risk from sponsors to existing investors. Like any other bond, a systemic risk will cause decline in investors’ returns implying the decline of their other investments too. This risk is non-diversifiable and can be well solved by hedging. The aggregate market inherent risk arises from financial crisis, interest rates in the overall market, recessions and wars among others. It causes fluctuation of return with regard to the macro-economic issues affecting all risky investments. The risk is unavoidable and the CAT bonds will always have the returns affected by currency, liquidity, interest rates and inflation risk. The correlation degree of CAT bonds and I LS market in investment of assets to the wider capital market is lower degree than others. However, it does not exclude it from harm in the case of currency break up. The last Eurozone sovereign debt crisis and the US economic change led to global economic instability which did not spare even the catastrophe bond. The financial crisis of 2008 was a perfect test of CAT bonds market, when CAT bonds credit and equities registered a failure after the link between all assets was quite high. The intensity of correlation with the general market is what saved it loosing much lesser than other correlated financial institutions. Market risk can be avoided by including portfolio of CAT bonds to improve risk or return profiles of securities set. Most CAT bonds are zero-coupon bonds where the total return is made of capital gain or loss since there is no income. When the interest rates in the market are low, their returns decrease and vice versa the liquidity risk in the market could make CAT bonds value to plunge following the extension of bond’s maturity into worst period of time in the course of disaster occurrence. The liquidity of the bond is quite tight with limited trading where transactions are conducted away from the public scope. How CAT bond relate with idiosyncratic risk: Idiosyncratic risk follows from concentration of assets in a firm. Through diversification of resources, the risk can be controlled or eradicated too. Proper is attention is required to evaluate mismatches between the portfolio and benchmark for bonds with long period or large spreads while handling idiosyncratic risk. This risk in disaster bond depends on specific firm’s strategy which is uncorrelated with investments return and hence causes no outcome on balanced returns. According to Fabozzi, “CAT bonds do not carry the idiosyncratic or non-diversifiable risk associated with an investment with securities of an insurance or reinsurance company” (393). The risk limited to a particular industry highly evolves from internal factors like operational and technical mismanagement within a line of procedure in a company. CAT bonds may experience this risk in the beginning; as anew venture where research and development may put the investing companies in a critical position affecting them partly or wholly. As the bond investment grows, the investor escapes the risk since the business is getting mature. This risk would affect soft disaster bonds than the matured, hard disaster bonds. Portfolio risk management conclusion of the under diversified ventures in CAT bonds are likely to be affected by the unsystematic risk. How CAT bond relate with interest rate risk: Just like any other bond, CAT bond is affected by inflation and has to mature to acquire interest on capital invested. Long term bonds are greatly affected by interest rate risk than short term bonds; when interest rates fluctuate, long term investment bonds price are well felt by the investors than in short term investment. To minimize the risk the investor needs to acquire a debt obligation with varying rates of interest. Catastrophe bond carries quarterly coupons in two constituents; fixed spread and floating money market rate. The two provide adjustable money market component in short periods causing CAT bonds to experience minimal interest rate risks. “The returns are typically in the range of 5-15% above LIBOR, with the average spread for bonds issued in 2011 of 8.85%. The spreads are usually higher for CAT bonds bringing peak perils to market (especially hurricanes in the U.S.), and slightly lower for non-peak perils (for example, earthquakes in Turkey) since investors are keen to diversify within their insurance exposure and are willing to accept lower spreads for those perils”(“CAT Bonds Demystified,” 7). During issuance, the correct compensation method is chosen by investors in determining the fixed bond spread. The spread can be easily influenced by the timing in the reinsurance cycle which impact on general prices. The floating rate is equivalent to totals of LIBOR and a fixed bond spread. The ability to swap floating rates into fixed rates in disaster bonds through total return swap protects investors from being interest rate risk. In theory of asset demand, several factors influencing the demand of the asset are liquidity and risk relative to other assets, wealth and expected returns. CAT bonds have high liquidity comparing to other assets in the financial market, which makes demand increase. Investors for a long time have remained in the industry for this reason. Even after the recession period, bond demand remains high with the tight liquidity. In CAT bonds, “to justify the risk of loosing their principle and /or interest capital market investors demand a large enough risk adjustment return to invest in those bonds. This comes in the form of a higher than normal interest rates when no disaster occurs” (Daniels, Kettil and Kunreuther 193). When the prices of the bond are high, and the interest rates are low, there is bound to be low demand in at bonds which does not favor buyers or investors but the sellers or borrowers while the relative increase of bond riskiness to other assets causes the demand to fall (“The behavior of interest rate,” Umich). Today many investors prefer CAT bonds than other traditional insurance securities. There is no investing company that appreciate lose which arises from risk, but appreciate liquidity intensity, increasing expected return and massive wealth which seek demand increase of catastrophe bond. Who would buy these bonds and why? The governments, large organizations and companies are the largest group who buy the CAT bonds on behalf of the insurers. Mexican government was the first to invest in it following the numerous natural attacks. The buyers included investors that focus on catastrophe bonds, pension funds, organizational financial managers and re-insurers among others. The government is secured through CAT bonds with over 270 million dollars while covering for earthquake, Atlantic and pacific hurricanes. Some organizations would invest in CAT bonds because of the high yield in return and portfolio diversification (GAO 27). Any other organizations that want to protect themselves against future damages would also buy the CAT bonds for the security. Tokyo Disneyland and FIFA used them in place of risk against earthquake and terrorism respectively. All heavily investing companies or insurers, especially in severe areas, where damaging natural phenomenal is recurrent, are advised to securitize their assets against any loss in future. The advantages of CAT bonds to the buyers arises from the minimal interest rates risks in investment ranging between seven and nine percent. The underlying span of three to five years of the CAT bond provides high liquidity of the bond in the market. There is also low or no correlation with the entire traditional property classes which increases its stability in the financial field. Catastrophe bonds are issued by SPVs or SPEs programmed to facilitate transactions between the involved parties. “It provides reinsurance to a ceding insurance (or reinsurance) company and issue securities to an investor. At….the SPV gather funds from investors which are put in a trust….SPV receives premium from the cedant and in exchange underwrites reinsurance for the cedant” (Essvale Corporation Ltd 91). They could be in form of insurance and reinsurance companies or other trusted groups that have the capacity to handle risk reduction and do away with liabilities from the bearers’ balance sheet, shifting securitization risk to the investors. They put on the market the CAT bonds to the investor who finance the risk involved. Works Cited “CAT Bonds Demystified RMS Guide to the Asset Class.” Rms.com. n.d. Web. 24 October. 2012. < https://www.rms.com/PubliCATions/CAT_Bonds_Demystified.pdf> CBO. Feredal reinsurance for disaster. Diane publishing, 2002. Print. Essvale Corporation Ltd. Business knowledge for IT in insurance. London: Essvale Corporation Ltd. 2009. Print GAO. Catastrophe Insurance Risks status of Efforts to Securitize Natural Catastrophe and Terrorism Risk. Diane publishing. 2003. Print Handbook of Finance. Ed. Fabozzi, F. J. New Jersey: John Wiley& Sons. 2008. Print. Leading Experts in Risk Management. Approaches to enterprise risk management. London: Bloomsbury Information Ltd, 2010. Print. On Risk and Disaster: Lessons from Hurricane Katrina. Ed. Daniels Ronald, Kettl Donald, and Kunreuther Howard. USA: University of Pennsylvania Press. 2006. Print. “The Behavior of Interest Rates.” Umich.edu. n.d. Wed. 25 October, 2012. Read More