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Catastrophe bonds. Why you should look at this as an alternate investment

Catastrophe bonds. Why you should look at this as an alternate investment

A catastrophe bond is an instrument which insures the insurer in cases of special events. These events are natural disasters like earthquakes and Tsunamis. In simple terms, an insurance company in case of a natural disaster incurs a loss. This bond helps in getting the money equivalent to the loss or less or more. Insurance companies take Catastrophe bonds which give insurance related to property or land. The issue is given the money of the bond only when the event happens. In case the event happens, the payout and the interest due is either forgiven or it is postponed for the future. These bonds yield high returns than any fixed income bonds as the risk involved is even higher.

Economic catastrophe bonds are the bonds which incur only when certain kind of economic situation occurs. Like catastrophe bonds, they also insure when there are worst situations in the economy. They have high yields as there is a small probability of default. Further, they also have a price which is discounted compared to normal un-economic bonds. It is due to the variations of returns is different states are huge. This is important when the recent trends in financial securities are studied properly. This security is created by pooling different financial security. They have different risk factors to hedge against the risk of an economic situation.

 

CDO:

This is a type of asset-backed security which pools together different assets. It also generates cash flows into tranches which can be sold to customers. Collateralized debt obligation (CDO) has different kinds of assets which are according to different risk profiles. 

Asset Pricing

While fixing the price of the asset to invest, people usually look at the profits they earn. Or they look at the payoffs the asset is giving. But they forget that there is one more aspect that affects the pricing of the asset. It is the economic states and its state prices. People generally focus on factors like the credit rating while don’t give importance to the economic states. It is where actually the default occurs. Such investors are attracted to economic catastrophe bonds. This is because the defaulting probability is considered to be very low. As they consider that the economic catastrophe bonds only occur when there is an extreme economic condition.
For example, a bond has a credit rating of AA because of the low risks involved and high payoffs. But because of some economic state change, the payoffs get low. Also, they don’t give returns as much as they were expected to. 

How do catastrophe bonds work?

If an investor wants to invest in Catastrophe bonds, it invests in a pool of assets. These assets insure the insurance company from any natural disaster that could occur in the near future. The investors invest in these bonds and get a hefty interest in return. To insure the investor from the risk this bond is placed in a special purpose vehicle. It manages the bond and provides claims whenever the insurance is fulfilled. It also provides the terms and conditions stated with the bonds. The conditions of the bonds should are fulfilled to get a payoff.
The capital invested in SPV is then again invested in low yield a money market securities which give returns. This money and the premium earned are then given back to the investor. It is given as a return after the bond matures and also to the insurance company. This is because the insurance conditions have not yet met. It is usually of 3 years’ maturity but can also be for shorter or longer periods. There is a sponsor also which issues the CAT bond as the risk carrier does not invest on his own.

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