 | Custom Search |
◄ Share or bookmark this page on several major sites.
Home | Archives | Blog | Bonds | Credit & Debt | Forex | Futures | Insurance | Mutual Funds | Options | Real Estate | Stocks | Taxes | Other Investment Topics | New Money Articles
Many people would like to have insurance against catastrophes, but catastrophes are generally not considered an insurable risk because the frequency and the magnitude of the losses cannot be forecasted accurately using the law of large numbers, which is how insurable risk is usually calculated, and, thus, premiums cannot be calculated. Thus, private, for-profit insurance companies will not cover catastrophic risks, although some government programs provide catastrophe insurance. Although insurance is the main form of risk transfer, other methods of transferring risk have arisen to transfer not only the pure risk of catastrophes, but also speculative risks, such as certain financial transactions. Insurance companies have started to use these financial instruments—which, in essence, securitizes risk—that does not depend on the law of large numbers—to insure and transfer risks for catastrophes.
The 3 financial instruments that insurance companies have used to transfer catastrophic risk to investors in this so-called alternative risk transfer market are contingent surplus notes, catastrophe bonds, and exchange-traded options.
The alternative risk transfer market is like reinsurance, but instead of transferring risk to other insurance companies, the risk is transferred to investors in the form of risk-linked securities (aka insurance-linked notes). The advantage to the investors is a higher rate of return for the increased risk, and a more diversified portfolio, since catastrophes are not correlated to the financial markets directly.
Contingent surplus notes (CSN) allows an insurance company to pay for a catastrophe over an extended period of time rather than actually transferring the risk of loss, and under better terms than it might get if it issued the notes when a catastrophe does occur.
The insurance company hires an investment bank or other financial intermediary to set up a trust that buys U.S. Treasuries, then issues trust notes to investors, who receive not only the interest paid by the Treasuries, but also receive additional interest paid by the insurance company. The insurance company must pay this interest because there would be no incentive for an investor to buy the trust notes, since he could just buy Treasuries directly without any risk of default.
If a catastrophe occurs, then the insurer has the legal right to substitute its own notes—contingent surplus notes, or in some cases, its preferred stock—for the Treasuries, giving the insurance company immediate liquidity to cover losses. The insurance company continues to pay interest and principal on the notes through the trust, but now the investors are assuming a financial risk of default.
According to statutory accounting standards, the cash, or other liquid assets, received from the issuance of the surplus notes increases the net worth of the company (hence the surplus designation), but the notes are subordinated debt and are illiquid assets, making it a higher risk for investors.
Unlike CSNs, catastrophe bonds actually transfer the risk of loss from the insurer to the investor of the cat bonds. Like other bonds, they pay interest to the bondholders, but, in the event of a catastrophe, they can skip or defer payments of interest and even principal, depending on how the bond is structured.
To issue cat bonds, a trust called a special purpose reinsurance vehicle (SPRV) is created, which issues the bonds. The insurance company buys reinsurance from the SPRV. The SPRV receives money from the investors of the cat bonds and from the reinsurance premiums, which, in turn, is invested in U.S. Treasuries or other high quality assets.
Most cat bonds are based on the severity and location of the catastrophe rather than the actual losses sustained by an insurer, but if the catastrophe is covered, then the SPRV can suspend payments of interest, and possibly the principal, to the bondholders, and pays the insurance company for its risk.
Cat bonds pay higher interest rates than other bonds, because of their risk of interest and/or principle. A cat bond that guarantees the repayment of principal pays a lower interest rate than bonds that do not guarantee repayment of principal. Cat bonds that guarantee repayment of principal are generally based on long-term zero-coupon Treasuries that will repay the principal—without interest, if a covered catastrophe occurred—when the Treasuries mature, which could be as long as 20 years. The foregone interest would represent a significant opportunity cost to the investor.
Cat bonds are only sold to institutional investors and cannot be directly purchased by retail investors. The main disadvantages of issuing cat bonds for insurers are the relatively high yields that must be paid, and the administrative costs of the SPRV. The main disadvantage for investors, besides the risk of not being paid interest and possibly principal, is the illiquidity of the bonds.
In addition to potentially costing hundreds or thousands of lives, a natural or terrorist catastrophe in the United States could place enormous financial demands on the insurance industry, businesses, and taxpayers. Given these financial demands, interest has been raised in bonds that are sold in the capital markets to diversify catastrophe funding sources. GAO was asked to update a 2002 report on "catastrophe bonds" and assess (1) their progress in transferring natural catastrophe risks to the capital markets, (2) factors that may affect the issuance of catastrophe bonds by insurance companies, (3) factors that may affect investment in catastrophe bonds, and (4) the potential for and challenges associated with securitizing terrorism-related financial risks.
The market for catastrophe bonds, as discussed in our 2002 report, has transferred a small portion of natural catastrophe risk to the capital markets. From 1997 through 2002, a private firm has estimated that a total of 46 catastrophe bonds were issued or about 8 per year. Another firm estimated that the nearly $3 billion in catastrophe bonds outstanding for 2002 represented 2.5% to 3.0% of the worldwide catastrophe reinsurance market. Some insurance and reinsurance companies issue catastrophe bonds because they allow for risk transfer and may lower the costs of insuring against the most severe catastrophes. However, other insurers do not issue catastrophe bonds because their costs are higher than transferring risks to other insurers. Although some investors see catastrophe bonds as an attractive investment because they offer high returns and portfolio diversification, others believe that the bonds’ risks are too high or too costly to assess. To date, no catastrophe bonds related to terrorism have been issued covering potential targets in the United States, and the general consensus of most experts GAO contacted is that issuing such securities would not be practical at this time due in part to the challenges of predicting the frequency and severity of terrorist attacks.
Exchange-traded catastrophe options and futures were products first offered by the Chicago Board of Trade in 1992. These options were purchased by insurance companies and sold by speculators, which gave the insurance company the right to a cash payment if a specified index of catastrophic losses reached a certain value within a specified time. However, these options have been discontinued in 1999 because of a lack of a viable market, although weather derivatives continue to be sold. Several over-the-counter risk exchanges (catex) have been established to trade weather derivatives and other risk exposures among insurers, intermediaries, and trading groups.
| Custom Search |