What is Catastrophe Bond? Know in Detail

6 mins read

Catastrophe bonds might seem complex at first, but that’s only because they have a couple of what one might call “moving parts”. This analogy might be a good place to start: Imagine a group of friends going out for dinner and drinks. Four of them enjoy drinking more than eating and, but the fifth – Rohan – lives to eat. Rohan’s friends tell him that they will pay for his starters all night in return for him not taking a drink, so that – just in case they can’t get an app-based driver – Rohan can drive them home.

It’s a long drive home. But it sounds like a good deal for Rohan. He gets free starters all night long and if they do get hold of a driver on the app, he won’t even have to drive them home.

Catastrophe bonds work somewhat like this. Except that instead of free starters, investors get interested.

Catastrophe bonds meaning:

Catastrophe bonds, like any other bonds, see bond issuers accept credit from investors. However, instead of a promise to repay the principal by a set date, the investor signs up for a deal where:

  • If a predetermined catastrophe occurs, his capital will be used and he may not receive any payout or might receive a partial payout of his principal (depends on how much the catastrophe costs the bond issuer).
  • If a predetermined catastrophe does not occur, he gets back his principal
  • Either way, the investor receives interest payments until maturity or until the catastrophe – if any – occurs.

From this catastrophe bonds definition itself, you may have guessed that the companies that issue catastrophe bonds are in the business of insurance. Very often, these will be property and casualty companies or reinsurance companies, that is companies who provide insurance to insurance companies.

Example of how catastrophe bonds work

Step 1: A catastrophe will be selected and then specifics will be added to it linked to the impact/level of the catastrophe, the number of catastrophes, geography and so on. For example, insurer W might issue a catastrophe bond that pays out if Mumbai experiences flooding more than 6 times and where water levels touch 6 feet in a span of one year.

Step 2: Catastrophe bonds are issued. Investors buy them.

Step 3: The proceeds are invested in low risk securities.

Step 4: The low risk securities start paying out dividends, which are paid to the investor.

Step 5:

  • Possibility A: Mumbai floods only twice in that year (because no floods at all in a given year, is unheard of and even as an example, would be laughable). The investors get their money back.
  • Possibility B: Mumbai floods six times in that year and water levels cross 6 feet. The insurance company gets the payout, but somehow the damage they need to cover is limited and they don’t end up using all the capital. The investors get some of their capital back at the maturity date.
  • Possibility C: Mumbai floods six times in that year and water levels cross 6 feet. The insurance company gets the payout and utilizes all of it to cover the extensive damage that occurs from the flooding. Investors do not get back any of their capital.

Benefits of investing in catastrophe bonds

  • High rates of interest:

Risk is typically directly proportional to potential rewards and since catastrophe bonds are high risk, bond issuers try to better the market average in terms of interest rates, so as to attract investors.

  • Regular income:

Like other bonds, investors like catastrophe bonds because of the promise of regular and guaranteed little payouts by way of interest payments (that they are sure to receive until a catastrophe – if any – occurs).

  • Portfolio diversification:

Natural disasters need not always correlate very strongly to the stock market and therefore investing in them might be a good way for investors to mitigate market risk. In our example above, you might expect some poor sentiment in the BSE on the very days of the flooding itself, but normalcy would most likely return quickly.

  • Investing route “for the soul”/ feel good investment

If you have ever been told, when you lost a phone or any other personal valuables, “maybe the finder needed it more than you” then you know what we’re talking about. For a lot of people, a loss might be easier to bear if it saved a life or did some real good for another individual (the sentiment seems to be linked to other people, not corporations). Since the loss, in this case, would be linked to a bigger catastrophe (and we can count on mainstream media for sensational photos), the loss might be easier to digest.

  • Liquidity

The investor might be in a position to enjoy some interest payments and then sell the catastrophe bond before anything goes wrong, especially if the bond is selling for a favourable price on the market. He can also sell the bond in case of an urgent need for capital. Because of the high interest rates, chances are that he will get a good rate.

Considerations when investing in catastrophe bonds

  • High risk:

The investor could lose his entire principal amount if the catastrophe does happen. Moreover, insurance companies are obviously going to make strategic decisions and will only insure themselves where they see a high risk of the catastrophe actually happening.

  • Double whammy can affect portfolio diversification:

What if a natural disaster sets of a recession, or occurs in the middle of one? Or even causes an economic slowdown for a few months (which is the precursor to a recession)? The whole idea of portfolio diversification by investing in a catastrophe bond is defeated in such cases.

Conclusion:

Investors should be extremely careful about weighing the risk against the rewards in the case of a catastrophe bond. They should definitely compare the interest rate to what they might earn in lower risk or at-par risk securities. Always remember that insurance companies are suave and will not be hedging risk in such an expensive fashion unless there is substantial risk in the picture.