CATBONDS


Introduction

Natural disasters are destructive events that cause considerable damagein terms of economic infrastructure but also in terms of human losses. Insurance and reinsurance companies have progressively gradually realized that they were financially unable to cover the risks linked to this type of major event due to an due to a lack of equity capital. 

The transfer to the financial markets, which have truly immense means at their disposal, would make it possible to better deal with the ex-ante management of risks. Securitization is an effective way to protect against the consequences of consequences of extreme risks.

Insurance-linked securities emerged in the early 1990s. These assets can take the form of the form of cat bonds, also known as catastrophe bonds. . These securities will be the subject of this article.


The coverage of natural risks and disaster obligations

The characteristics of Cat bonds


Parametric insurance


Parametric insurance is a type of insurance that does not compensate the actual loss corresponding to the amount of but ex ante commits to a payment upon the occurrence of a triggering event.

The triggering event is often a natural disaster that catastrophe that can typically precipitate a loss or a series of losses.

This parametric insurance principle is also used to applied equally to agricultural crop insurance and other weather risks determined by the nature of the loss  and whose risk outcome is correlated to  parameter or an index of parameters.

The indices are necessarily calculated from the consequences of the potential loss, and therefore itsnature. A risk of agricultural disasters can be covered by an insurance covered by an insurance policy that is triggered, for example, when a drought index has been exceeded. This implies upstream a study of the correlation between the geographical conditions conditions and the damage suffered by the crops.

The emergence of cats bonds


The phenomenon that triggered securitization was Hurricane Andrew in August 1992, which devastated Florida and caused an estimated to be worth about $20 billion.

This is how the need to develop the market for natural disasters became apparent. Thus, the first catastrophic risk to give rise to a securitization operation was established in 1994 and was initiated by the by the United Services Automobile Association (USAA), a Texas-based insurance located in Texas.

The insurance derivatives market has therefore not from the will of financiers but from the need of the insurance sector to better risk management. As a result, the insurance and reinsurance companies to cede part of these risks.  Cat Bonds thus represent an alternative to traditional major risk insurance for insurers and insurers and reinsurers as securitization of credit risk is for banks.

These instruments are traded over the counter. The catastrophe bonds are in fact traded on the OTC (Over The Counter) markets. The transaction therefore takes place between two counterparties: the buyer and the seller, and it is the banking institutions that generally serve as the intermediary.


Definition

The bond known as Cat bond is one of the traditional derivatives with the nature of a natural event as its support the occurrence of a natural event of major of major magnitude, in other words a natural disaster. Thus, the investor who wishes to hold such a financial asset pays the issuer the nominal value value, which is the value used to calculate the interest the calculation of the interest paid in the form of annual coupons. 

A catastrophe bond has the same characteristics of a conventional bond, in the sense that it has a nominal value, a nominal rate which can be fixed or variable. 

It is also accompanied by the a regular coupon payment, which corresponds to the interest, to the holder as long as the major loss to which it has been previously to which it was previously linked does not occur.

Thus, if the catastrophic event occurs, the issuer immediately ceases payment of the coupons and repayment of the and repayment of the principal is suspended. The nature of the underlying of these bonds currently involves earthquakes, hurricanes, storms and typhoons.


Practical operation of a catastrophe bond


Triggers 


When a natural disaster with disastrous consequences occurs, it is essential to be able to determine the moment when the Cat Bond can be triggered, in which the circumstances in which investors are "losers" and no longer receive a coupon.

This is based on triggering events that differ from each other in the waythe underlying of the bond has been realised. The triggers can thus be grouped by categories, i.e. according to the criteria used in the characterisation of Catastrophe bond. In this respect, various classifications have been operated: 

Real cost trigger 


This is the compensation trigger that takes into account the amount of losses suffered by the economic actors (private individuals, the State or companies), and on the other the other hand, the one relating to the insurance companies to trigger the CAT bond.

Trigger based on the use of indices

Insurance-type indices

They are quite complex, their use is not obvious.

 Meteorological (exogenous) indices

They cannot be manipulated but still raise the problem of a possible lack of correlation with actual damage.

Parametric model combining the two types of indices : 

Models based on the simultaneous use of insurance and exogenous indices.

They have the advantage of limiting their negative aspects by merging a measurable variable with a specific index so that the claim is not subject to a single which may not be neutral. It is this type of type of trigger that the insurance company AGF used in 2002 by combining the wind speed measured by Météo France with a model based on the possible losses that could result.

Risk bands


Hedging through Cat bonds concerns the most bonds concerns the highest risk bands.

Indeed, insurance companies are protected in different ways by backing each damage band with a of damage with a specific measure.

Example of bonds to protect against earthquakes in California: The first tranche of damage is covered by the insurance companies, which assume almost half of the of the liability for the damage covered (0 to 4 billion).

The second and third tranches correspond to the role of reinsurers (from 4 to 6 billion) and the State (from 6 to 7 billion) in catastrophic events.

Finally, coverage is provided by the financial markets (7 to 8.5 billion).