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Knowledge@Australian School of Business

Catastrophe Bonds: Sharing the Risk of Natural Disasters

Published: September 21, 2010 in Knowledge@Australian School of Business
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The aftermath of major disasters, such as earthquakes, floods and catastrophic storms is typically tragic devastation. But one particularly disastrous event – Hurricane Katrina in 2005 – firmed up the market for catastrophe bonds. Insurers who are often hard hit by "clusters" of disasters now can not only rely on reinsurers to cover their risk, but can also take it to the capital markets through these assets. They provide another option for diversifying risk in an investment portfolio. And, in the wake of the global financial crisis, investments with risks that are not linked to economic turbulence are proving popular, explains Morton Lane, the director of the Master of Science in Financial Engineering program at the University of Illinois. Even in the dark days of the crisis, catastrophe bonds were trading at around double the price of other fixed income securities, Lane tells Julian Lorkin of Knowledge@Australian School of Business. And issuance of these bonds is picking up again. Sure, there are winners and losers with "cat bonds", but they move the risk on to those who can absorb it.

An edited transcript of the interview follows.

 

Knowledge@Australian School of Business: Catastrophic events seem to be becoming ever more common, is the insurance industry as a whole worried?

Morton Lane: First of all, I'd question whether or not these events are happening more frequently. Some people think that they are because they're recent, but we have long stretches where there are no events. And, if you average them out over time, the frequency tends to be quite stable. Unfortunately, they cluster – and we seem to be having a cluster at the moment – but it doesn't necessarily mean there's a trend.

Knowledge@Australian School of Business: If we have a cluster, how does the insurance industry cope when so many of them occur in a short timeframe?

Morton Lane: The insurance industry is capitalised so that it can meet catastrophes and absorb catastrophic losses for a one-in-250-year event. That's a very rare event, and we haven't seen one of those in quite some time. The biggest one we saw was Hurricane Katrina in 2005, and that was closer to a one-in-70-year event. The losses from Katrina, were about US$40 billion, and if you add in the other hurricanes that took place that year – Rita and Wilma – the industry suffered a loss of US$85 billion in total. But it recapitalised itself within about 12 months. So the industry positions itself to absorb these big losses.

Knowledge@Australian School of Business: When insurance companies pay out to reconstruct buildings after a major disaster, does the economy get a boost from all the reconstruction? For example, in New Zealand where a lot of insurance capital is going into rebuilding after the recent earthquake, there's talk of a building boom.

Morton Lane: There can be a boost to the economy. And, certainly, if you didn't have insurance policy proceeds, the economy would suffer. Once you've got the proceeds from insurance coverage, then you can replace existing assets and houses, and that can boost employment and generate business for material buyers and so forth.

Knowledge@Australian School of Business: But the insurance companies will be taking that hit. They depend on their reinsurance, where other companies insure them for the catastrophic losses that they take on, don't they?

Morton Lane: There is a chain of risk transfer. When you buy an insurance policy for your house, you are transferring the risk to the insurance company. The insurance company – if it gets too many of those policies in one area – passes those to a reinsurance company, and there may be a third and fourth step along as well. But in that chain, each type of company is trying to manage its risk. So reinsurance is part of that mechanism for managing the risk. And, in the last decade or so, we've also seen the introduction of a new mechanism for transferring the risk – catastrophe bonds which transfer the risk into the capital markets. Not only do the insurance companies move it to traditional reinsurers, but they can move it to the capital markets as well.

Knowledge@Australian School of Business: And this must be what you're looking at as you direct financial engineering at the University of Illinois?

Morton Lane: It's one of the things that we look at at Illinois.

Knowledge@Australian School of Business: So what happened with the global financial crisis? Is it harder these days for reinsurance companies to get hold of the cash these days?

Morton Lane: It was hard for everybody to get hold of the cash during the financial crisis. But, insurance companies did extraordinarily well. Some of their values dropped, but this was not due to the insurance risks that they'd taken on, but because the assets on their books dropped in value, just as they did for every other financial participant. When the assets recovered, so did the insurance companies. During the crisis, these catastrophe bonds that provide a means of transferring risk to the capital markets also did extraordinarily well. They lost less in value than any other asset that was being sold in those dark days of the financial crisis in October and November 2008. They traded prices around the US$90 mark, whereas most fixed income securities traded around the US$60s, the US$40s and the US$20s. So these new instruments – that some people were afraid of – proved themselves quite well, and the issuance of these has begun to pick up again, as it did immediately after Katrina. They seem to be going from strength to strength.

Knowledge@Australian School of Business: Why are the catastrophe bonds so popular? Why do people prefer these bonds as opposed to other types, such as government bonds?

Morton Lane: Not everybody prefers them, but enough people like them because they are diversifying risks. If Ben Bernanke (chairman of the Federal Reserve, the US central bank) decides to tighten credit, all bonds will go down in price and stocks may suffer as well. But catastrophe bonds linked to hurricanes are not going to be affected by interest rates, and so they are diversifying asset that can be put into a portfolio. And everybody wants diversification in a portfolio.

Knowledge@Australian School of Business: But surely if people are investing in these bonds, they must be worried that there will be a series of hurricanes and the value of these bonds will go down?

Morton Lane: If there are hurricanes, you will lose money on the bonds. If you bought General Motors bonds, you lost money on General Motors because they didn't do very well. So when you buy a bond or any asset, there is a risk associated with it. The question is: is that risk correlated with all the other risks I'm taking? And catastrophe risk is an uncorrelated asset.

Knowledge@Australian School of Business: At the same point, we are talking about an area of risk that insurance companies traditionally weren't in. Previously, people would insure their house against it burning down and then you could see the risk being moved on; now it's moving onto bonds, more complicated financial instruments. By moving the risk around in this way, is there a chance that it becomes more obscure, less transparent and therefore inherently more risky?

Morton Lane: Just by moving it, it doesn't become more risky. It is the same risk; it's just that somebody else is taking it on. And the insurance business has been around for 350 years at least. One of the traditional ways risks moved was from insurance companies to Lloyds of London, a company with a long reputation for absorbing difficult risk. And so here is another tool in addition to traditional reinsurance. There's Lloyds of London, and now you have catastrophe bonds, which are going directly to the capital markets.

Knowledge@Australian School of Business: But surely risk has to stop somewhere. After all, if we look at the example of Lloyds of London, traditionally that was where the risk stopped for the old families of England. Around 20 or 25 years ago, suddenly these families incurred huge losses. Many had to sell off the family lands and the stately home, and they ended up virtually bankrupt. Is there a similar danger that people might lose their money with catastrophe bonds?

Morton Lane: What you say is correct. The people who underwrote the risk at Lloyds a few decades ago actually lost a lot of money, but the people who bought the policies never lost one cent. And so the people who were asking for protection, which is what you do when you buy an insurance policy, were very glad to be able to collect on that protection. And that would be true of catastrophe bonds as well. The money to secure that protection promise is put into a trust, and certainly the people who put the money in the trust – the people who buy the bonds – may ultimately lose. But the people who wanted the protection, who bought the policies, will be very glad to know that there is money there to pay them off. There are two sides to this situation: we don't destroy risk; we move it to people who can absorb it.

Knowledge@Australian School of Business: No doubt the insured people who are suffering loss due to an earthquake, a storm or a flood are very grateful to be covered.  But how can you get people to invest in catastrophe bonds if people realise that eventually they might have to pay up?

Morton Lane: Well, they are prepared to take a certain price. Let's go back to General Motors example. You can lose money on any bond. The reason that you buy bonds in General Motors is because you think the potential reward you will receive is commensurate with the risk you're taking. That's the way it is with catastrophe bonds too; people see the reward as commensurate with the risk – just as they do with any other financial investment.

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