In the aftermath of Hurricane Andrew and the Northridge earthquake catastrophe bonds were first created. These are risk-linked securities that transfer a set of risks from a sponsor to investors.
Insurance companies needed help in alleviating some of the risks they would face if a major catastrophe occurred. A catastrophe that would not be covered by premiums received. An insurance company issues catastrophic bonds through an investment bank which are then sold to investors. These catastrophe bonds have maturities of less than 3 years. If no catastrophe occurred, the insurance company would pay a coupon to the investors, who made a healthy return.
On the contrary, if a catastrophe did occur, then the principal would be forgiven (deferred) and the insurance company would use this money to pay their claim-holders.
Investors include hedge funds, catastrophe-oriented funds and asset managers. If triggered the principal is paid to the sponsor. The triggers are linked to major natural catastrophes. Catastrophe bonds are typically used by insurers as an alternative to traditional reinsurance.
For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe bonds, which would pass the risk on to reinsurers.
Or it could sponsor a catastrophic bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon or LIBOR (London Interbank Offered Rate) plus a spread, generally (but not always) between 3 and 20%.
If no hurricane hits Florida, then the investors would make a healthy return on their investment. But if a hurricane were to hit Florida and trigger the catastrophe bonds, then the principal initially paid by the investors would be forgiven (deferred), and instead used by the sponsor to pay its claims to policyholders.
Since Hurricane Andrew, which blew through Florida and other southern states in 1992, left insurance firms licking their wounds. Reinsurers were particularly badly hit; capital markets swooped in to provide capacity. Since then each major catastrophe has boosted catastrophe bonds further, from Hurricane Katrina in 2005 to the 2011 Japanese earthquake and tsunami.
Over $40 billion in cat bonds have been issued in the past decade with $19 billion now outstanding. This is a small fraction of the $300 billion in catastrophe-related payouts that insurers are theoretically on the look out for. But it is up from $4 billion a decade ago and the market could quadruple in the next 10 years.
Investor demand is strong. Pension funds and other institutional investors are on the hunt for assets generating decent yields, particularly if the returns are uncorrelated to stock markets. Large institutional investors buying cat bonds directly or via specialist funds now account for perhaps 80% of the market.
CATASTROPHE BOND MODELING
Also known as cat modeling, this is the process using computer-assisted calculations to estimate the losses that could be sustained due to a catastrophic event such as a hurricane or earthquake. Cat modeling is especially applicable to analyzing risks in the insurance industry and is at the confluence of actuarial science, engineering, meteorology and seismology.
The input into a typical cat modeling software package is information on the exposures being analyzed that are vulnerable to catastrophic risk. The exposure data can be categorized into three basic groups:
Site location information, referred to as geocoding data (street address, postal code, county)
The physical characteristics of the exposures (construction, occupation/occupancy, year built, number of stories, number of employees).
information on the financial terms of the insurance coverage (coverage value, limit, deductible)