Bermuda: The Epicentre of the Catastrophe Bond World
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Bermuda is now the epicentre of the catastrophe bond/insurance linked security world. With $7 billion of these securities now listed on the Bermuda Stock Exchange, the island can claim almost half the value of the global market. Catastrophe bonds (also known as cat bonds) are risk linked securities that transfer a specified set of risks from an Insurance company which acts as a sponsor to investors through the issue of cat bonds and the trading in derivatives based on the bond. They were created and first used in the mid 1990’s in the aftermath of Hurricane Andrew and the Northridge earthquake and emerged from a need by insurance companies to alleviate some of the risk they would face if a major catastrophe occurred, which would incur damages that they could not cover by premiums and returns from investment using the premiums that they received.
Typically an insurance company issues bonds through an investment bank which are then sold to investors. These bonds are inherently risky and are multi-year deals. If no catastrophe occurs, the insurance company pays a coupon to the investors who make a healthy return generally based on LIBOR plus between 3% and 20%. However if the catastrophe manifests itself the principal paid by the investors to purchase cat bond securities is forgiven and used by the sponsor to pay its claims to policy holders.
Most catastrophe bonds are issued by special purpose reinsurance companies domiciled in Bermuda, the Cayman Islands or Ireland. The contract can be structured as a derivative in cases in which it is triggered by one or more indices or even parameters rather than losses of the cedent.
Insurance companies use cat bonds as an alternative to traditional reinsurance. The insurer as sponsor sets up the special purpose reinsurance company which issues bonds through an investment bank which are then sold to investors. Investors choose to invest in catastrophe bonds because their return is largely uncorrelated with the return on other investments in fixed income or in equities so cat bonds can help investors achieve diversification. Due to the risk involved, cat bonds usually pay higher interest rates than comparably rated corporate instruments so long, of course, as they are not triggered.
The sponsor and investment bank who structure the cat bond must choose how the principal impairment is triggered. Cat bonds can be categorised into four basic trigger types:
- Indemnity: triggered by the issuers actual losses. For example, if a layer specified in the cat bond is $100 million excess of $500 million and the total claims add up to more than $500 million then the bond would be triggered.
- Modelled loss: instead of dealing with the company’s actual claims, an exposure portfolio is constructed for use with catastrophe modelling software. When there is a large event the event parameters are run against the exposure database in the cat model. If the modelled losses are above a specified threshold the bond is then triggered.
- Indexed to industry loss: Instead of adding up insurers’ claims, the cat bond is triggered when the insurance industry loss from a certain peril reaches a specified threshold, say $30 billion. The cat bond will specify who determines the industry loss, typically a recognised agency.
- Parametric: Instead of being based on any claims (the insurers actual claims, the modelled claims, or the industry’s claims), the trigger is indexed to the natural hazard itself. So the parametric trigger could be the wind speed for a hurricane bond, ground acceleration for an earthquake bond or rainfall for a drought bond.
As of the end of June this year there were 51 listed cat bonds and Bermuda’s market share of the cat bond market has increased due to amendments to the Insurance Act 1978 which allows a new class C licence to be granted to special purpose insurers specifically designed for cat bond issuers. Dublin had been competing for the cat bond market and in 2010 the Irish centre had nearly 20% of the market and was beating Bermuda, but this year the value of their market has entirely disappeared. The initial gains in market share by the Cayman Islands have also been clawed back and Bermuda emerges in 2013 as the Global leader for cat bond and Insurance Linked Security trading.