There are multiple entry points into the catastrophe bonds market. The most obvious is the investment route. Institutional investors, both local and international, can take advantage of the above-average returns in the market.
Two North African countries, Morocco and Libya, suffered deadly natural disasters a few weeks ago. Between them, nearly 14,000 were reported dead or unaccounted for, with more than a million displaced. In the short term, oil prices spiked, tourist numbers dwindled, and exports were severely affected. However, beyond the short-term impact, questions remain on the preparedness of developing countries, especially in Africa, for what could be more commonplace. In the previous issue, we focused on parametric insurance and its role in mitigating the high cost and uncertainty faced by local insurance companies with regard to natural disaster insurance. This article focuses on the role of catastrophe bonds; another instrument aimed at helping insurers and reinsurers manage the high risk of natural disaster insurance.
A catastrophe bond is designed as a debt instrument. Like any bond, investors provide cash to the issuer in exchange for coupons that entitle each investor to periodic payment (interest) and the principal (face value of the bond) at the end of the bond’s life. Catastrophe bonds are issued by insurers (or reinsurers) to investors, usually institutional investors (hedge funds, pension funds, etc.). Each catastrophe bond has a fixed term (usually 2-3 years). Under the terms of the deal, investors raise a stated amount of capital, say $100 million, for a special purpose vehicle(SPV). In the event of a natural disaster that exceeds a predetermined threshold, say a 6.0 magnitude earthquake or a disaster that costs the insurance company above a stated amount ($300 million), the funds are released to the insurer. However, if no disaster occurs during the term of the debt, or fails to reach the predetermined threshold, investors receive their funds back, in addition to all interest payments.
So, what does each party get from a catastrophe bond deal? For the insurers, it’s fairly straightforward. A catastrophe bond offers the insurer a viable option for limiting extreme exposure to natural disasters that would otherwise threaten the solvency of the insurance company. The alternative would be to drastically cut down policy writing for disaster-prone cities; a decision that also leads to loss of business and profit opportunity. Thus, with cat bonds, insurance companies share or transfer risks while expanding their coverage. On the other hand, the investor enjoys above-average interest payments (significantly higher than market rates) with the possibility of receiving their principal back if the thresholds aren’t crossed. Secondly, the investor is able to diversify into investment instruments that are uncorrelated with other assets in their portfolio. This helps enhance overall return as well as reduce risks stemming from excessive correlation of assets. Of course, in the event that the threshold is reached, investors could lose all or a significant part of the money put into the bond. Nonetheless, the arrangement works for both sides. Finally, at the aggregate level, a well-structured catastrophe bond market, in addition to other instruments like parametric insurance, helps significantly reduce the long-term impact of natural disasters on cities, states, and countries, especially in Africa.
As reported in our previous issue, over 55% of global natural disaster damages, estimated at $148 billion, remain uninsured. In addition to the potential role of parametric insurance, especially in Africa, the catastrophe bond market could help reassure local insurance/reinsurance companies and help provide much-needed coverage for farmers, small business owners, and other vulnerable targets across the continent. There are multiple entry points into the catastrophe bonds market. The most obvious is the investment route. Institutional investors, both local and international, can take advantage of the above-average returns in the market. In addition to high returns, the opportunity to diversify existing portfolios by investing in uncorrelated assets is worth considering.
Beyond direct investments in cat bonds, opportunities exist for technology players. Among these include platforms that facilitate pricing, listing, and trading of these bonds, including primary and secondary issues. Similarly, increasing advances in climate intelligence by technology startups could help deepen understanding of the climate in many developing countries, thereby helping insurance companies and potential investors price insurance policies and insurance-linked securities like cat bonds. Globally, the cat bond market has enjoyed a steady increase since the first bond was listed in 1997. The market boasts nearly $40 billion in outstanding bonds in 2023. This figure is expected to increase as the frequency, intensity, and economic impact of natural disasters increase.
As the continent witnesses increased threats from large-scale natural disasters, there is a need for a robust set of strategies that ensures ample resilience to each episode of disasters. Large-scale insurance coverage is a key part of this resilience. However, in order to ensure the solvency of local insurance companies, various risk management strategies, including catastrophe bonds should be encouraged and expanded. A well-developed cat market could benefit the insurance industry, the local capital markets, the fintech and climate intelligence sector, and policyholders. Our team members are eager to work with you in any of the aforementioned opportunities in the cat bond market. Contact us!
Following months of coup activity and threats of invasion, there seems to be an uneasy quiet. We’re currently monitoring the recent selection of a new central bank chief in Nigeria. He has stated his commitment to stabilizing the currency and the economy. We’re closely watching what early steps he will take.
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