To limit dangerous exposure to a few big events, traditional (re-)insurers have turned to catastrophe bonds (or cat bonds). Tradable financial products, they offer (re-)insurers a way to pass on some of the risk underwritten in the event of an extreme natural catastrophe, such as a storm or an earthquake.

The bonds, which typically run for between one and three years, offer investors a relatively attractive rate of return, however investors lose everything if specified trigger conditions are met. As well as the potential for high return, cat bonds appeal to institutional investors because they typically show little correlation with market movements, says Insa Adena, head of Advanced Risk Intermediation at Allianz SE’s re-insurance division.

“Interest rates don’t move in line with earthquakes, and natural catastrophes do not follow financial markets. In light of the global financial crisis, investors such as pension funds are more interested than ever in a diversifying asset class unrelated to other financial events or trends.”

SO, HOW DO YOU PRICE A HURRICANE? There is no single way to create a cat bond, says Adena. “Cat bonds often do not exactly match the underlying portfolio that has been insured. In the traditional re-insurance market, if there is a European wind storm an insurer will incur losses in a number of countries and re-insurers assume a portion of exactly those losses.”

With cat bonds, on the other hand, there are a variety of trigger mechanisms, which means there will be a degree of mismatch between the risk covered by the bond and the actual content of the insurer’s portfolio. In some cases the mechanisms triggering payments are based on parametric indicators such as wind speed, only triggering payments if the storm reaches specified speeds in particular areas, for instance. This is in contrast to an indemnity trigger, which is related to the insurer’s actual losses and closer to traditional re-insurance.

According to Adena, the different approaches reflect the differing needs of (re-)insurers and investors. “Investors tend to have a preference for triggers that can be very accurately described,” she says. Understandably, investors want as much information as possible about what will trigger their bond not to repay in full.

(Re-)insurers, on the other hand, prefer coverage that closely matches their underlying portfolios. Since these portfolios are derived from a multitude of individual insurance policies, they are by nature complex and difficult to describe.

OF COURSE, THERE IS NO SUCH THING as the perfect trigger. “It all depends on where the market finds the best compromise,” comments Adena. “But as the cat bond is a traded product, investors are seeking as much transparency as possible.”

The market is set to grow. Given the likelihood of more extreme events caused by climate change and other factors, demand for cat risk cover should rise. The world’s growing urban population is another increasing trend, creating greater exposure in earthquake zones like Santiago, Istanbul or San Francisco, and in areas at risk from cyclones, such as in Asia.

“There is a limited number of (re-)insurers in the market and their capacity is constrained, so it seems natural cat bonds will be something (re-)insurers will make more use of in the future,” explains Adena.

To meet these challenges, the relatively young cat bond market, which started out in the 1990s, will need to evolve. Standardizing as many components of cat bonds as possible is one way forward. Simplifying the process and reducing the cost and time involved in their creation will make them easier to buy and sell.

Currently, cat bonds require dense, highly detailed documents that are a challenge for investors to digest. Although Adena says a certain level of complexity cannot be avoided as, “by their nature these phenomena are difficult to describe,” she believes the amount of documentation required for each transaction should be reduced. 

THE NATURE OF THE COLLATERAL used to guarantee these bonds is also evolving, and there are various means of deciding what happens to the cash put into a bond and how it can be invested. “In the recent past, the rules and mechanics change from one transaction to the next,” comments Adena. “There are lots of different moving pieces, and the sooner market standards develop, the better.”

Pricing cat bonds accurately will also depend on the ability of the probability models underlying them to reflect changing reality. When Hurricane Katrina struck in 2005 its unexpected ferocity caused modelers to reassess the likelihood of such an extreme event occurring to be twice as likely as previously thought, causing turmoil in the market.

It is a reminder of the inherent difficulties involved in predicting extreme events and of the risks in investing in them, Adena stresses. “There’s always work to be done on the models. Global weather phenomena are incredibly interdependent, and no one would assume we have mastered them fully. With climate change, the world itself is changing and reacting.”

Published by PROJECT M in April 2010

(Photo: National Geographic/Joel Sartore)