Question

How does the capital market make money on Hurricanes?  Describe the securitization process and give an example based on hurricanes.

Answer 1

Answer of the above question is given below.

Capital market make money on Hurricanes:

In addition to their often devastating human toll, natural disasters can have an extremely adverse economic impact on countries. Disasters can be particularly calamitous for developing countries because of the low level of insurance penetration in those countries. Only about 1% of natural disaster-related losses between 1980 and 2004 in developing countries were insured, compared to approximately 30% in developed countries. This means the financial burden of natural disasters in developing countries falls primarily on governments, which are often forced to reallocate budget resources to finance disaster response and recovery. At the same time, their revenues are typically falling because of decreased economic activity following a disaster. The result is less money for government priorities like education or health, thereby magnifying the negative developmental impact of a disaster.

To address this problem, the World Bank Treasury has been helping our clients protect their public finances in the event of a natural disaster. The most recent innovation is our new Capital-at-Risk Notes program, which allows our clients to access the capital markets through the World Bank to hedge their natural disaster risk. Under the program, the World Bank issues a bond supported by the strength of our own balance sheet, and hedges it through a swap or similar contract with our client. The program allows us to transfer risks from our clients to the capital markets, where interest in catastrophe bonds is growing.

Hurricane Andrew in Florida in 1992 (insurance claims, $15.5 billion); the Northridge, Calif., earthquake in 1994 (insurance claims, $12.5 billion) and the Kobe earthquake in Japan in 1995 (insurance claims, $1 billion but costs of uninsured repairs estimated at $100 billion). In the aftermath of Hurricane Andrew alone, nine U.S. insurance companies filed for bankruptcy.

Up until now, property and casualty insurers have protected themselves by buying policies from reinsurance companies designed specifically to cover losses from a catastrophic disaster. But these kinds of disasters have traditionally been defined as anything involving claims up to $1 billion. The magnitude of events since 1992 clearly exceeds that figure.

“Insurance companies got a big shock with Hurricane Andrew,” says Neil Doherty, Ronald A. Rosenfeld Professor of Insurance and Risk Management. “They realized that a single catastrophic event could lead to phenomenal bankruptcies.”

Just look at the numbers. America’s insurance industry holds approximately $250 billion in equity. Yet given substantial increases in populations and property values in hazard-prone areas, “it’s not unrealistic to expect that one major catastrophe could result in $70 billion or even $100 billion of claims,” says Howard Kunreuther, Cecelia Yen Koo Professor of Decision Sciences and Public Policy and Management, and co-director of Wharton’s Risk Management and Decision Processes Center.