Wednesday, 23 November 2016
Catastrophic Bonds-An Alternative Risk transfer mechanism.
Before
understanding Concept of Catastrophic Bonds let us understand the meaning of
Alternative Risk Transfer mechanism:
What is the Meaning of Alternative risk
Transfer mechanism (ART)?
The
portion of the insurance market that allows companies to purchase coverage
and transfer risk without having to use traditional commercial
insurance is ART.
What
is the Advantage of ART?
The
Advantage of Alternative Risk transfer mechanisms is in the event of loss, more than loss amount
can be realised i.e. Profit, which is unlike insurance contract where profit
can’t be realised in the event of loss as original loss is only indemnified by
the insurer.
What are
Catastrophic Bonds?
Catastrophic
Bonds are one of the Alternative risk transfer mechanism (ART). Catastrophe bonds emerged from a need by
insurance companies to alleviate some of the risks they would face if a major
catastrophe occurred, which would incur damages that they could not cover by
the premiums and returns from investments using the premiums, that they received.
The concept of Catastrophic Bonds were created and first used in the mid-1990s
in the aftermath of Hurricane Andrew and the Northridge
earthquake. Catastrophe bonds, also called cat bonds. Catastrophic 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.
How Catastrophic
Bonds work?
The typical catastrophe bond structure sees a
special purpose vehicle or insurer (SPV or SPI) enter into a reinsurance
agreement with a sponsor (or counterparty), receiving premiums from the sponsor
in exchange for providing the coverage via the issued securities. The SPV
issues the securities to investors and receives principal amounts in return.
The principal is then deposited into
a collateral account, where they are
typically invested in highly rated money market funds.
The investors’ coupon, or interest payments, is
made up of interest the SPV makes from the collateral and the premiums the
sponsor pays. If a qualifying event occurs which meets the trigger conditions
to activate a payout, the SPV will liquidate collateral required to make the
payment and reimburse the counterparty according to the terms of the
catastrophe bond transaction. If no trigger event occurs then the collateral is
liquidated at the end of the cat bond term and investors are repaid.
Why Investors Invest in catastrophic Bonds?
Investors choose to invest in catastrophic
bonds because their return is largely uncorrelated with the return on other
investments in fixed income or in equities, so cat bonds help
investors achieve diversification. Investors also buy these securities because
they generally pay higher interest rates than comparably rated corporate
instruments, as long as they are not triggered. In the approximately 20-year
history of the security, there have been 10 transactions that have resulted in
a loss to investors as of April 2016, according to the National Association of
Insurance Commissioners (NAIC).
What is the Term of catastrophic bonds?
The Term of Catastrophic Bonds is usually 3 to
5 years.
How Rating of Catastrophic Bonds is given?
Cat bonds are often rated by an agency such as Standard
& Poor's, Moody's or Fitch Ratings. A typical corporate bond is
rated based on its probability of default due to the issuer going
into bankruptcy. A catastrophe bond is rated based on its probability of
default due to a qualifying catastrophe triggering loss of principal/interest.
This probability is determined with the use of catastrophe models. Most
catastrophe bonds are rated below investment grade (BB and B category
ratings), and the various rating agencies have recently moved toward a view
that securities must require multiple events before an occurrence of a loss in
order to be rated investment grade.
What are the Previous Instances of issue of
catastrophic Bonds Throughout world?
Normally re-insurance companies acts as Special
purpose vehicle in the issue mechanism of Cat bonds.Few frequent issuers have
included USAA, Scor SE, Swiss Re, Munich Re, Liberty
Mutual, Hannover Re, Allianz, and Tokio Marine Nichido which are
major re-insurance companies throughout the world.
Mexico
is the only national sovereign to have issued cat bonds in 2006, for hedging earthquake risk and in 2009.In
June 2014, the World Bank issued its first catastrophe bond linked to natural
hazard (tropical cyclone and earthquake) risks in sixteen Caribbean countries.
Can Catastrophic Bonds be issued in India?
In India we have only one re-insurance company GIC(General
insurance company) has sought government's permission for issue of such bonds. However
such issue is subject to approval by IRDAI , to establish GIC as bigger player
in international re-insurance business.
K.Phani sasanka
B.com,CA-final
Reach me at: shashank.dhoni@gmail.com
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