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With the expansion of population into areas often located in the natural catastrophe zones, governments face a possible risk of natural disasters occurrence.
While the events such as earthquakes are particularly tragic, governments can at least partially provide itself with the financial payment if such event takes place.
Indeed, the timing of such cash flow is particularly beneficial for the country, as capital markets being capital, could significantly increase the cost of financing for the disaster struck country. Issuance of the Catastrophe Bonds is hence particularly prudent.
The mechanism
Catastrophe bonds are risk-linked securities that transfer a specified set of risks from a sponsor to investors. They are often structured as floating rate bonds whose principal is lost if specified trigger conditions are met. If triggered the principal is paid to the sponsor. The triggers are linked to major natural catastrophes.
Generally, governments would issue securities, which might pay a coupon. In the event of the catastrophe, the issuer (the government) would no longer need to pay either the coupon or the initial capital. It is also possible, to structure the deal, so that in the event of the catastrophe, there is a fixed cash flow payment at the actual event.
History
Catastrophe risks became prominent in the aftermath of Hurricane Andrew, notably in work published by Richard Sandor, Ken Froot, and a group of professors at the Wharton School who were seeking vehicles to bring more risk-bearing capacity to the catastrophe reinsurance market.
The first experimental transactions were completed in the mid-1990s by AIG, Hannover Re, St. Paul Re, and USAA. The market grew to $1–2 billion of issuance per year for the 1998-2001 period, and over $2 billion per year following 9-11.
Issuance doubled again to a run rate of approximately $4 billion on an annual basis in 2006 following Hurricane Katrina, and was accompanied by the development of Reinsurance Sidecars. Issuance continued to increase through 2007 despite the passing of the post-Katrina "hard market," as a number of insurers sought diversification of coverage through the market, including State Farm, Allstate, Liberty Mutual, Chubb, and Travelers, along with long-time issuer USAA. Total issuance exceeded $4 billion in the second quarter of 2007 alone. It should be possible to adapt these instruments to other contexts.
Attractiveness to Investors
Investors choose to invest in catastrophe 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 (in terms of spreads over funding rates) than comparably rated corporate instruments, as long as they are not triggered.
Ratings
Catastrophy 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 an earthquake or hurricane triggering loss of principal. 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 occurrence of a loss in order to be rated investment grade.
Trigger events
Vision Finance will structure the trigger elements so that it is suitable to both the issuer, and the investors. Triggers can be parametric, when it is the nature that decided on the actual trigger, or can be modeled to include the actual damage caused by the event.
Tectonic Plates:
Tropical Storms:
source: http://www.learnnc.org
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