Catastrophe Bonds

I can't get my head around this mad world sometimes...

Excerpt from The Ecologist, 1 September 2009

'The reinsurance - as opposed to insurance - industry offers a revealing insight onto how our environment is changing. And bound up in that are hurricanes. The way insurers have traditionally dealt with the prospect of a seriously big payout, such as to the thousands who lost their homes in New Orleans, is to take out reinsurance – essentially an insurance policy against having to pay for the insurance policies people have taken out with them. Without reinsurance such a payout could be crippling - in 2005, hurricanes Katrina, Wilma and Rita wiped out about $55 billion in insured losses. Last year's total was about $30bn. (I'm not pretending this is anything next to the human toll. Over 1800 people died during Katrina and in the floods that followed).

For years, the system worked. The big insurers relied on a few big reinsurers and everyone made money. But 2005, and Katrina, nearly brought the industry to its knees. Too much damage was caused, at too great a cost, and too few reinsurance companies were forced to foot the bill. As a result, they almost couldn’t make the payments. Once the waters receded, the question remained, could it happen again? When the insurers and reinsurers looked, they decided yes, it could. Our environment is changing, with both the number of hurricanes and their ferocity expected to increase. So what to do? Business moves faster than politics and the insurance industry soon settled on a response.

Catastrophe bonds are, depending on who you talk to, either a smart way to spread the insurance risk around to ensure the market doesnt buckle under another Katrina, or a way of making money by trading on others' misfortune...

Essentially, rather than taking out reinsurance, an insurer offers to sell a specific catastrophe bond. The buyer (say, a trader at an investment bank) puts down his money on the understanding that he will get it all back over time, plus a high rate of interest. The only catch is that he will lose it all if some specified bad thing happens within a specified number of years (say, Bermuda being wiped out by a hurricane). If it does, the insurer keeps the lot.

Catastrophe bonds are in their infancy, but you can measure their development against specific human tragedies. Between 1998-2001, the market grew to $1-2 bn of catastrophe bonds being issued per year. After 9-11, the market broke the $2 bn barrier. It doubled again, to roughly $4 bn a year, in 2006, after Hurricane Katrina. And having found its feet the market continued to grow, with over $4 bn being issued in the second quarter of 2007 alone...catastrophe bonds are one sure signpost to our new, climate-changed, world.'