The article presents the difficulties insurance companies face when they are issuing catastrophe bonds. Do they efficiently hedge against large-scale disasters? It is very difficult hedging against catastrophic losses. Japan’s March earthquake, tsunami and nuclear disaster threat could cost the insurance industry between $21 and $34 billion. The catastrophe bonds are not helping much the insurance companies, although they were designed to do so. Catastrophe bonds have limits on type and location of the disaster they will cover.
A large number of catastrophe bonds covered the losses only in Tokyo, although the actual losses occurred far away from there. In 1990s these risk-linked securities where designed to spread the risk to financial investors after Hurricane Andrew hit Florida and the quake in Northridge, California. The market works in the following way: an insurance company issues bonds to financial investors. During the life of the security the insurer is paying to the investor a coupon interest rate. If the loss is not occurring, the insurer returns the amount paid when the bond matures.
If the loss occurs, the insurer is not returning any money and is using the funds paid by the investor to cover the losses. Many investors are satisfied with the returns on catastrophe bonds which results in unsatisfactory results of financial hedging to insurance companies. Despite the fact that catastrophe bonds are not providing the protection that the insurance companies would like to see on their books, there are no signs that the insurers might drop that option. According to Credit Suisse’s head of Insurance Linked Strategies Niklaus Hilti the long-term future of the catastrophe bonds in unpredictable.
He also added that from the outlook of insurance companies, traditional reinsurance is a better hedge. Investors bet on Catastrophe Bonds The article portrays the growing trend and growing level of interest on catastrophe bonds, even if the interest for risk- linked securities declined during the financial crisis. The investors are actively purchasing catastrophe bonds. They are continuously seeking new investment possibilities that do not move together with equities and fixed-income products.
The market for catastrophe bonds first came into sight in 1990s after a few colossal losses were faced by the insurance companies. The insurer is issuing a bond which is tied to the probability that one or more natural disasters will occur in a certain region in a certain period of time. The investors receive a coupon payment from the insurer every period. At the maturity date, the investor receives the amount invested if the loss did not occur. If the loss occurs, the funds invested are not paid back and are used to cover the loss.
The market for catastrophe bonds includes coverage for losses as crop damage to terrorist attacks. During the financial crisis many investors found the market for catastrophe bonds less attractive. In 2008, the Swiss Re catastrophe bond index raised significantly comparing to huge decrease in Standard and Poor’s 500 stock-index. According to Aon Benfield’s investment banking division president Paul Schultz, the increased returns on catastrophe bonds helped getting new funds injected into the risk-linked securities market.
Analysis: Do Catastrophe Bonds efficiently hedge against large scale-disasters or traditional reinsurance is a better option for insurance companies? Despite the fact that the catastrophe bonds are not providing the protection that the insurance would like to see, they are continuously issuing new risk-linked securities. Catastrophe bonds are linked to the probability that the colossal loss will occur in a certain region over a certain point in time.
The insurance companies need to analyze the maximum possible loss very carefully, so they can set the premiums accordingly and have enough funds in case the disaster occurs. In the articles above risk management officers are stating that the issuance of catastrophe bonds are providing the investors with high returns, therefore the real financial hedging of insurance companies is questionable. Considering all the risk stated above, the insurance companies are still issuing the catastrophe bonds. In my point of view the issuance of catastrophe bonds by insurers is a successful financial hedging technique.
Even though the investors are having large returns on risk-linked securities and only a small number of them lost their principle, the purpose of these instruments is to provide coverage for highly improbable risks. The benefit of these bonds is that they allow the insurance companies to secure a layer of coverage for their worst case scenarios, which may not be available if traditional reinsurance is used. Catastrophe bonds help to diversify the protection capacity and supplement traditional reinsurance.
The insurance companies are transferring major risks and thus have more capital to underwrite new business, therefore using the bonds to diversify their sourcing of reinsurance. The issuance of risk-linked securities is a great strategy in supplementing traditional reinsurance, but these bonds still need to prove their value in the long-run. In conclusion, I would not agree with Mr. Niklaus Hilti’s words: “from the perspective of insurers and reinsurers, traditional reinsurance is clearly the better hedge. ” The catastrophe bonds are carefully designed to provide insurers and reinsurers the capital they need for risk management.