Dabbling in Disaster: Stability through Catastrophe Bonds?

By Matthew Findlay
Correspondent, Mathematics Undergraduate

After a record hurricane season, investors in catastrophe bonds are counting up their losses.  Catastrophe bonds, also known as Cat bonds, are debt instruments that pay attractive interest rates, typically issued by reinsurers to cover their liabilities in the event of huge damages that may be caused by larger but less frequent risks.  They constitute an expanding market: as of July 2017, $10bn worth of Cat bonds had been issued in this year alone.

The market for such bonds started to take shape after hurricane Katrina caused $82bn worth of damages. They are a way of passing natural disaster risk to the capital markets, and to those investors who are prepared to carry such risks.  An investor will typically buy a Cat bond for a two or three-year term. The bond then pays a high interest rate over the course of its term.  Upon maturity, if no catastrophe occurred, the investor recovers the principal of the bond, on top of their interest payment. However, in the event of a hurricane, or other natural disaster included in the contract, the bond is “triggered” and the investor loses all or part of the principal, which goes to the reinsurer.

So why would anyone wish to take on such risks? There are two main reasons that stand out.  The first is due to the higher than average expected returns: some bonds yield over 5% for example. If the risk shouldered by investors is deemed small, the latter can make a healthy expected return on their investment. In a period of historically low interest rates, institutions such as pension funds have been looking for ways to work their funds harder, so as to be able to meet their future payments. Indeed, pension funds and sovereign wealth funds now account for 15% of total reinsurance capital.

The probability of a hurricane striking the coast of America bears no correlation to how well the market in general is performing.

The second reason has to do with the very nature of disaster risk. This is unrelated to general market performance; the two are in fact completely independent.  The probability of a hurricane striking the coast of America bears no correlation to how well the market in general is performing. (Of course, it is worth noting that companies that contribute to climate change acceleration such as fossil fuel firms may well be indirectly contributing to the heightened risk of a hurricane striking.)

Cat bonds are thus, in theory, a way of diversifying one’s portfolio. Even if the market is performing poorly, so long as the bond is not triggered, the investor will reap a handsome reward.

Cat bonds are, in theory, a way of diversifying one’s portfolio.

Although Cat bonds may be unpalatable to some, and appear to constitute little more than gambling on others’ misfortune, it is clear that a triggered bond is of benefit to nobody. The issuer would clearly have preferred not to have suffered the tragedy that triggers the bond, but by issuing the latter, they have insured themselves in the event such a tragedy does occur.

So are Cat bonds a viable solution to protecting entire regions against huge sums of damages?  The flaw lies not so much with the theory itself of spreading risk, but with the wording of contracts.  For example, in Mexico, 71% of whose GDP is vulnerable to natural disasters, no Cat bond has ever been triggered. The agency in charge of determining whether or not the conditions for a bond to be triggered have been met has so far never ruled in Mexico’s favour.  If the wording of the contract is not watertight, investors can shirk their responsibilities and avoid losing their principal if the bond is triggered.  If trust in the solidity of the contract erodes, countries no longer have an incentive to issue new bonds. After all, why do so if investors will wriggle out of their obligations?

If trust in the solidity of the contract erodes, countries no longer have an incentive to issue new bonds.

This raises several questions over the future of the Cat bonds market. The first concerns who should decide whether the bond has been triggered. On the issuers’ side, there is little point issuing such a bond if there is a strong likelihood that they shall not receive the principal of the bond when a disaster strikes because of a biased legal interpretation.  Much better would be for an impartial third party to rule on whether the conditions for the bond to be triggered have been met or not. On the investors’ side, however, the attraction of investing in a Cat bond is only as good as the reliability of the mathematical model. Basing one’s predictions of future catastrophes on the past is not necessarily an effective way to predict the future. As the frequency and severity of such events are likely to increase due to climate change, Cat bonds will have to pay an ever-higher yield to maintain demand amongst investors.

However, since August’s hurricane season, prices have tumbled. After Harvey, the first hurricane to rival Katrina, and Irma almost immediately afterwards, the Cat bond market is being tested for the first time. Even bonds that are unrelated to hurricanes have seen their prices slip. For instance, a bond issued by the California Earthquake Authority fell by a cent to the dollar in early September.

Nonetheless, the idea behind these bonds has also spread to other areas. Having recently issued a $360m Cat bond on behalf of Mexico, the World Bank has taken step towards transferring other kinds of risks to the capital markets.  For instance, through its Pandemic Emergency Financing Facility (PEF), it has recently issued $425m in “pandemic bonds”. These are intended to cover the world’s poorest countries from six different viruses.  The bond is triggered if one of these viruses reaches a predetermined level of contagion.  A separate system to cover against unknown viruses has also been set up.

Demand for these pandemic bonds was high: the transaction was oversubscribed by 200%.  Indeed, having agreed to provide $500m to cover developing countries against outbreaks of these viruses, the PEF’s initiative succeeded in transferring $425m of risk to the market.  Although donors committed $7bn to resolving the Ebola crisis in 2014, these funds would have saved some of the lives that were lost had they arrived quicker.  With the PEF’s new system, it is hoped that in the event of a new viral outbreak, funds will be available a lot more quickly, thus enabling a swifter, more effective response.

Overall, these instruments are an illustration of how private and public interests can be aligned.  In the same way that we all purchase home insurance, a carefully worded Catastrophe bond can pass the risk of severe natural disaster damage to those willing to bear it. In the event of the bond being triggered, such a contract can save the taxpayer billions of pounds.  However, for such a transaction to be fair, while investors should indeed be adequately compensated for shouldering risk, it is imperative that issuers be confident about receiving compensation should the bond be triggered.

Photo credits: David Rydevik/Wikimedia Commons

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