Question

Catastrophe Bond

A) What is the origin of catastrophe bonds?

B) How has the issuance of catastrophe bonds changed since 2010? What is driving that

change?

C) What activities does the SPV perform for a catastrophe bond?

Answer 1

Ans A)

Catastrophe bonds, also called cat bonds, are an example of insurance securitization to create risk-linked securities which transfer a specific set of risks (generally catastrophe and natural disaster risks) from an issuer or sponsor to investors. In this way investors take on the risks of a specified catastrophe or event occuring in return for attractive rates of investment. Should a qualifying catastrophe or event occur the investors will lose the principal they invested and the issuer (often insurance or reinsurance companies) will receive that money to cover their losses.

Catastrophe bonds were first issued in the mid 1990's, we have a comprehensive database containing the details of nearly every (over 280) catastrophe bond transaction. Major catastrophe events which hit the U.S. such as the Northridge eartquake and Hurricane Andrew were seen as events of such magnitude that the insurance industry began to look for alternative methods to hedge their risks and through collaboration with capital markets companies catastrophe bonds were born.

Ans B)

2010 was another year of substantial catastrophe losses globally. The industry suffered losses due to the New Zealand Christchurch earthquake, the Japan Tohoku earthquake and tsunami, flooding in Thailand and record-breaking severe convective storm losses in the U.S. Three catastrophe bonds (Muteki, Mariah Re 2010–1 and Mariah Re 2010–2) suffered losses of principal. RMS released an update to their U.S. hurricane model in 2011 which produced a significant increase in modeled expected losses. This led to a perception of higher risk and caused spreads to widen in the catastrophe bond market. Financial events, such as European sovereign crises caused a widening of high yield corporate bond spreads as well, but the events within the re/insurance industry described above were the primary drivers of widening of catastrophe bond spreads. Since 2012, catastrophe bond spreads have continued to tighten, consistent with the drop in reinsurance rates. This trend has been driven by an influx of alternative capital and increase in traditional reinsurance capital.

Ans C)

The special purpose vehicle (SPV) is necessary because otherwise investors would be directly offering insurance to the issuer, which they could not do without receiving regulatory authority – a license – to assume risk under a contract of insurance. The SPV is therefore also sometimes called a “transformer” because by being licensed itself to sell insurance, it transforms the investment of funds by the investors into a sale of insurance. When domiciled in an offshore location such as Bermuda or the Cayman Islands, it also provides ease of licensing and simplified and often lowered tax requirements.