Sunday, 28 August 2011

Hurricane Irene and Cat Bonds

Hurricane Irene, is increasing the interest in Cat Bonds. It is too early to tell what the effect of the hurricane will be on the catastrophe-bonds market or the North East. Cat bonds are an interesting idea: insurance against catastrophic losses.The Cat bond market is, however, relatively small and hard to collect against.

"Typically, for a cat bond to trigger, you need a bull's-eye to be hit instead of a general shot in the right direction."

"At the end of 2010, there were $12.5 billion in cat bonds outstanding, according to Aon Benfield, the reinsurance broker of Chicago-based Aon."

According to business week, "The catastrophe bond market will provide only $300 million toward up to $34 billion in insurance losses from the Japanese quake."

As Felix Salmon has pointed out. 

The fact is that catastrophe bonds are the capital-markets security of the future, and they always will be: insurers will always accept lower returns on their capital than the kind of ROI that hedge-fund cat-bond buyers are looking for. And as I mentioned back in 2008, beyond that there’s a fundamental, endemic reason why cat bonds won’t take off: the difference between parametric risk and indemnity risk.

Bond investors want to pay out based on science: magnitude of earthquakes as measured by the modified Mercalli scale; hurricanes as measured by wind speed and the like. Insurers and insured, by contrast, want their payouts based on losses. The basis risk between the two is large: Everybody can think of large losses from relatively small events, or small losses from relatively large events. And it’s not easy how that basis risk can be reduced. Unless and until that gap can be bridged, catastrophe insurance will remain the domain of the insurance industry. And the bond markets will only be involved at the very margin."

For some interesting background on cat bonds, see here.

Here is an interesting map showing (prior to Irene), America's 5 worst hurricanes.


1 comment:

  1. On a related note, here is an old Canadian Investment Review piece on CAT bonds.
    CAIA program also covers this esoteric asset in its curriculum.