ARE CAT BONDS RISKY?

ARE CAT BONDS RISKY?

Cat bonds have been described as “goldmines” but could very well be “land mines” if not understood properly.?

Cat bonds or Catastrophe bonds are basically a type of insurance-linked security (ILS) that provides coverage for natural catastrophic events. Here is the concept in a nutshell:

Investors provide funds to the bond issuer, which is usually an insurance or reinsurance company. This is in exchange for interest payments. If a pre-agreed catastrophic event occurs (eg. a hurricane or earthquake) during the bond's term, the issuer is not required to pay back the principal to the investors. Consequently, the funds are deployed to help defray the costs of the event.

Effectively, Cat bonds function similarly in some ways to Parametric insurance that pays out on a pre-agreed trigger using third party data. However, it can much more complex with multiple other conditions necessary for payout.

It's important to stress that even though a Cat bond is exposed to a natural disaster, losses for investors depends on the specific terms of the bond.

Risks

Cat bonds offer high returns but on the flip-side comes with high risks. Effectively no free lunch and one has to understand it well to make a buck from it.

1. There exists potential loss of the entire principal amount if a catastrophic event hits. For example, Hurricane Katrina (2005) resulted in huge losses for cat bond investors with certain bonds losing even 50% of their value. California wildfires(2018) and??Hurricane Dorian (2019) also resulted in losses for investors.
2. Cat bonds can be impacted by weather patterns which are difficult to predict. Extreme weather events like hurricanes, heatwaves, earthquakes and wildfires can have a serious effect on a Cat bond’s value . As Natcat events become more frequent and severe, Cat bond values could, in tandem, become volatile and highly unpredictable.
3. There is potential risk for moral hazard. This is occurs when the bond issuer does not take adequate measures to mitigate the risks associated with the catastrophic event, primarily because they know that the bond will cover the losses. This can result in increased risks for investors.
4. Profitability can be impacted by other factors including?basis risk, credit risk, and liquidity risk.?

Rewards

Historically, Cat bonds have offered higher returns compared to traditional fixed-income investments, such as government bonds or corporate bonds.

1. Cat bonds can be an attractive investment for certain types of investors, particularly those intent on seeking high yields. According to a recent report, the Cat bond market has delivered a total return of 10.9% since 2016, outperforming many other fixed-income investments.
2. Compared to most asset classes, the value of Cat bonds reacts independently of financial markets. Effectively this means better diversification for investors.

Outlook

Cat bond markets has primarily focused on mature economies like the US but with time it’s spreading across Asia too.

At home, Singapore issued out its first Cat bond in 2019 and is on track to establish itself as a global hub for Asian risk transfer. The bond was sponsored by Insurance Australia Group (IAG).

In Hong Kong, June 2022, Peak Re issued a USD150 million CAT bond via its special purpose insurer Black Kite Re. More recently last month, also in Hong Kong, The World Bank listed a US$ 350 M World Bank Catastrophe Bond that provided the Chile government with financial protection against severe earthquakes for three years.?

Not forgetting, Japan in 2022, Japan-based MS&AD Insurance Group sponsored catastrophe bond Tomomi Re which was for typhoon and flood reinsurance protection.

In reality, Cat bonds are complex instruments and therefore investors should consult with experienced advisors who can provide professional guidance on the suitability of these investments for their portfolios.

Clearly, Cat bonds can offer attractive returns for investors who are willing to take the associated risks. They provide valuable financial protection against natural disasters for issuers. With climate change at the forefront, we will only see the market for Cat bonds grow and grow.