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Wednesday, 23 November 2016

Catastrophic Bonds-An Alternative Risk transfer mechanism.

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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.

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