Tuesday, June 5, 2012

Catastrophe Bonds – fear of the unknown?

This article appeared in the Edge in March 2012

By Jasvin Josen

Our planet Earth has experienced a major change since the 1990s. Before the 90s, occurrences of natural disasters like hurricanes, floods, earthquakes and tsunamis were occasional and less severe. After this period however, the occurrence and severity of these catastrophic events increased drastically.
Following this dramatic change, losses caused by catastrophic events have also spiked sharply. Chart 1 illustrates this historical pattern.

Chart 1: World Catastrophe Losses, 1970-2010

Insurance companies have suffered major losses following the protection given against these “Act of God” events. As these events become more common, insurance companies naturally get nervous and tend to increase their rates. Indirectly the burden is passed back to consumers. At the same time, insurance companies also have the other alternative, to “exclude” protection against these disasters, depriving society from protecting their livelihood and trade.

Reinsurance vs. securitisation of catastrophic risk
To avoid a major loss, insurers have traditionally utilised reinsurance contracts. Briefly, this is
when an insurance company purchases an insurance policy from another insurance company to protect against unforeseen or extraordinary losses. The policy can be structured in many ways, to target certain losses or insurance contracts.
However, when reinsurance is used as a means to transfer risk, the risk still stays within the industry. As the risk of catastrophic events increases, there is a strong motivation to get (or securitise) the risk out of the insurance industry and onto the financial markets.
Interestingly, in 2011, a new European Directive called Solvency II now requires insurance companies to maintain sufficient capital to cover catastrophic risks. It promotes risk mitigation techniques such as securitisations in managing this risk, to gain solvency capital relief.

Catastrophe Bonds
The first initiative towards securitising catastrophe risk was done after Hurricane Andrew (1992) in the U.S.A., with catastrophe bonds, better known as cat bonds. By the end of 2011, there were around USD10.7 billion in cat bonds outstanding. (source: GC Capital Ideas, Dec 7, 2011)
A cat bond is a bond that is linked to a catastrophic risk. Let us say an insurance company issues $40 million of Cat Bonds A with a five-year maturity. The bond pays a coupon of LIBOR  + 4%. The underlying risk securitised is a tsunami event occurring within 100 km radius from Aceh, in Indonesia.
If the tsunami does not occur in the five years, investors get back their principal plus the attractive returns. However if the targeted disaster occurs, investors lose their principal. The insurance companies will use these moneys to pay its claim holders.
When Hurricane Katrina bore down on New Orleans, a cat bond named Kamp Re, issued by the insurance company Zurich, was at risk. The bond was triggered when the insurance company’s net losses from U.S. hurricane and earthquake claims were more than the $1 billion.
Another cat bond called Mariah Re, is a three-year bond (with annual coupon rates around 7%) issued in Nov 2010 to cover a smaller but more frequent storms like tornados and severe thunderstorms in the U.S.

The sluggish market for cat bonds  
Although this product is almost 20 years old now and shows very attractive returns, investors still display reluctance in taking the market forward. A research paper by Bantwal & Kunreuther [A Cat Bond Puzzle, May 1999] attempts to discover the possible reasons. Some interesting results are discussed below.

i) Inferring default probabilities
Michael Lewis puts it very nicely in his article called “In Nature’s Casino” published in The New York Times in Aug 2007 – “An insurance company could function only if it was able to control its exposure to loss. Geico sells auto insurance to more than seven million Americans. No individual car accident can be foreseen, obviously, but the total number of accidents over a large population is amazingly predictable. The company knows from past experience what percentage of the drivers it insures will file claims and how much those claims will cost. The logic of catastrophe is very different: either no one is affected or vast numbers of people are.”
It is quite challenging to infer the level of risk in this market because of the absence of deriving a complete probability distribution of losses with default statistics that goes back a long way.

ii) Lack of Liquidity
Lack of liquidity could very well also be a factor in the market. This new asset class does not fit into the typical class products that investors are comfortable with; there is neither equity nor debt.

iii) Myopic Loss Aversion
Loss aversion is when investors are more sensitive to losses than to gains. Myopic loss aversion takes place when, despite the fact that the planning horizon is better represented by the 30-year return than the 1-year return, investors seem to be more concerned with the potential for a short term loss than in planning for the relevant time horizon and accepting periodic short-term losses.
For instance, a specialist investor in cat bonds should theoretically gain over a 20-year period because his total returns in the long term will be higher than the infrequent loses made when his cat bonds triggers when disasters actually occur.

iv) The worry factor
Events that have catastrophic potential are perceived to be dreadful and very risky even though statistical data suggest that people should not feel that way about them (Slovic, 1987). Cat bonds fit in this example. The cost of thinking of the potential losses with low probabilities may lead the investor to ignore the potentially high gain because of the haunting vision of losing the entire principal.
Investment managers may fear their reputation if he loses money by investing in this peculiar asset. Unlike other assets, the money in this asset can disappear almost instantly with little warning. This potential for a sudden, large loss can worry investors, despite the low probability of such event occurring.

v) Ambiguity Aversion
A paper in 1995 by Fox and Tversky showed in several experiments that “when people compare two events about which they have different levels of knowledge, the contrast makes the less familiar bet less attractive and the more familiar bet more attractive”. In the same way, investors and reinsurers tend to price unambiguous risk quite steeply.

Cat Bonds seem like the ideal instrument to distribute huge losses of catastrophe and perhaps even encourage insurance companies to provide more protection against natural disasters. However the investors appear to have issues with coming to terms with the risk and returns. The cat bond is and will continue to undergo more tweaks to make the instrument more palatable to investors.
In the next article, I go slightly deeper and discuss some aspects in pricing probabilities in connection with cat bonds.

1 comment:

  1. Market in consolidation mode, Nifty around 8950; Infy down 1.4% .capitalstars