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(CAT Bond) is a financial instrument which insures the insurer in cases of natural disasters. These events include tsunamis or earthquakes. The loss is transferred to the investors of the bond. In layman terms, these bonds insure an insurance or re-insurance company who is subject to loss in case of specified insurance risks. Pay-out to the insurance company is approved only if there is a series of natural events. For instance, the five hurricanes that hit Texas. The Insurance and re-insurance companies who issue Catastrophe bonds, are majorly involved in real estate or casualty insurance. If a disaster is witnessed, the pay-out and the interest due is either forgiven, or is postponed for the future. These bonds, yield higher returns than any fixed income instruments, as the investor is undertaking a higher degree of risk.

Economic catastrophe bonds are the bonds which trigger payment only when the economy experiences adverse situations. They possess lower risk of default being subject to severe economic conditions. This security is created by pooling different financial security. They have different risk factors to hedge against the risk of an economic situation.


Triggers that simulate a pay-out :

  • Indemnity : The sponsor or investor is indemnity against the losses of the insured in absence of actual losses. For instance the loss margin has been set at above Rs 500 million. Then the pay-out is obligatory only if the losses cross the threshold of Rs 500 million.
  • Modeled Loss : The deciding factor as to whether pay-out is eligible or not a model is adapted. The model is known as exposure model. In case of loss making specified event the database is run against the model. The outcome is final and accepted.
  • Indexed to Industry Loss : Here the underlying parameter is the industry loss. The index is determined by a recognized agency. If the loss crosses the specified limit a pay-out is inevitable.


Collateral Debt Obligation (CDO):

CDO is an asset-backed security which pools together different assets. It also generates cash flows into tranches which can be sold to customers. Collateral debt obligation 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. However due to economic fluctuation, the payoff is reduced. Also, their yield is lower than expected. 

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 secure collateral account. 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 has an average maturity period of 3-5 years 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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