Research & Commentary: Cat Bonds for State-Run Catastrophe Insurance

Published April 4, 2012

Catastrophe bonds are insurance-linked securities that offset major costs to taxpayers and insurers caused by natural disasters such as hurricanes and earthquakes. Cat bonds, as they are known, work differently from other types of bonds. Investors lose their entire principal in the event of a catastrophe that meets the terms set out by the bond, but interest rates on the bonds are much higher than on other types of bonds.

Increasingly, state-run entities such as the California Earthquake Authority (CEA) and Louisiana Citizens Property Insurance Corporation, which provide insurance to residents unable to obtain it in private markets, are turning to cat bonds to manage risk. Most recently, Louisiana Citizens issued a series of cat bonds worth $100 million through the Cayman Islands special-purpose insurer Pelican Re that will provide Louisiana Citizens with three years of indemnity-based coverage against hurricane damage. 

Proponents of expanding the use of cat bonds for state catastrophe insurance say traditional reinsurance (insurance for insurance companies) is not sufficient to cover major catastrophe losses. In such instances, insurers may have purchased insufficient reinsurance coverage, or reinsurers themselves—particularly state-run reinsurance entities such as the Florida Hurricane Catastrophe Fund—may have insufficient capital to meet their obligations. By issuing cat bonds, they can transfer risk to investors. Since these investments are traded on global capital markets, even a very large event has less of an impact on the markets than it would to an insurer itself. In addition, investors like cat bonds because they pay high rates of interest.

Opponents of expanding the use of cat bonds for state catastrophe insurance say that for state insurers and the taxpayers who fund them, the costs of cat bonds outweigh the benefits. A major reason the cat bond market has performed well in recent years is that it’s structured to favor investors. Since a catastrophe has to meet very specific criteria and incur extremely high losses in order to trigger forfeiture of investors’ principal, insurers end up not only paying high rates of interest to bondholders but also covering significant losses themselves. For states already under pressure to shrink budgets, paying interest on cat bonds and also paying high claims following a major disaster that isn’t quite large or extreme enough to trigger bond forfeiture increases the burden on taxpayers.

The following articles examine cat bonds from multiple perspectives.

Louisiana Citizens Latest State Insurer to Tap Cat Bond Markets
Writing for Heartland’s Out of the Storm News, R.J. Lehmann discusses Louisiana’s recent entry into the cat bond market, placing it in the context of other state-run entities already doing so: the California Earthquake Authority, North Carolina Joint Underwriting Association and Insurance Underwriting Association, and Massachusetts Property Insurance Underwriting Association.

For Catastrophe Bond, Nothing Could Be Finer than Being in Carolina: Catastrophe Bond Market Provides Hurricane Protections to the North Carolina’s Residual Market Insurer
Guy Carpenter and its capital markets affiliate GC Securities, “a global leader in providing risk and reinsurance intermediary services,” offer this brief yet technical report on how cat bonds have benefitted North Carolina since they were first issued in 2009.

In Nature’s Casino
In this in-depth New York Times piece, reporter Michael Lewis examines the history of cat bonds from an investor’s perspective. Focusing on the career of John Seo, founder of the hedge fund Fermat Capital Management, which began issuing cat bonds in 2001, Lewis explores both the weather forecasting and economic models that led to the development and evolution of cat bonds and explains why and how they appeal to investors. Lewis’s discussion of Florida and Louisiana helps explain why cat bonds might be a useful tool for state insurance entities.

California Earthquake Authority Completes Landmark Deal, Pioneering New Way to Manage and Diversify Financial Risk Posed by Natural Disasters
This press release issued in August 2011 by the California Earthquake Authority announces the CEA’s reentry into the cat bond market after a decade-long absence. The action “allows the CEA to obtain reinsurance from the capital markets rather than solely from reinsurers” and marks the establishment of the first ever earthquake-only cat bond, a risk management tool designed especially for California.

Does Japan’s Earthquake Show that Catastrophe Bonds Are Useless?
Daniel Indiviglio’s article in The Atlantic addresses the issue of whether insurers or investors ultimately come out ahead with cat bonds. Although he does not specifically address the value of cat bonds for state catastrophe insurance, he raises questions important to consider when deciding whether states should get into or stay in the cat bond market. He writes, “For now, investors seem to be doing a better job than insurers at determining criteria to make cat bonds lucrative,” but if and when “insurers begin to realize that they’re paying a lot of money for protection that rarely pans out, they could seek to loosen the criteria that cat bonds currently require for payout.” If that happens, investors may pull out of the cat bond market.

Catastrophe Insurance Risks: The Role of Risk-Linked Securities and Factors Affecting Their Use
This study examines the advantages and disadvantages of expanding cat bond use but does not make any recommendations or take a position on whether increased use of cat bonds (and other risk-linked securities) by either investors or insurers is good or bad. The study concludes simply, “If the ability of investors to evaluate the risks and rewards of risk-linked securities improves, or if catastrophe reinsurance price and availability becomes problematic, the risk-linked securities market has the potential to expand.”

The Trouble with Catastrophe Bonds
Written shortly after the Japanese earthquake in 2011, this article by Bryan Keogh, Oliver Suess, and Jesse Westbrook considers the limitations of cat bonds. They state that events in Japan were of a magnitude that should have, by reasonable measures, been just the sort of occasion cat bonds are designed for. However, they write, the “cat bond market won’t be of much help in covering Japan-related insurance losses. Such bonds often have covenants that strictly limit the type and location of a disaster they will cover.” The authors conclude, “Catastrophe bonds have done a far better job protecting investors than they have providing a financial hedge to insurers.”

State Residual Market Insurer Cat Bond Transaction Provides Per-Occurrence Ultimate Net Loss Protection for Massachusetts Hurricane Peril
Guy Carpenter announces the issuance of “the first-ever catastrophe bond program established via a transformer reinsurer to benefit the MPIUA (Massachusetts Property Insurance Underwriting Association).” The release highlights details of the bond and offers a snapshot of the relationship between a state reinsurer and the investment firm it works with to structure the bond program and transfer the state’s risk to global markets.