Disaster protection bonds

It’s time to learn about a unique type of bonds — so-called "cat bonds". But these are not “pussycat” bonds for the benefit of cats. This time the cat is not some kind of tabby — it is an abbreviation for catastrophe. Recently, disaster protection bonds have also started to cover pandemic risk.
Disaster protection bonds

(www.gotcredit.com, CC BY 2.0)

These instruments are almost a quarter of a century old and have different forms. They combine financial and insurance functions, so a common name has been developed for them, i.e. Insurance Linked Securities (ILS). They appeared following the initiative of insurance and reinsurance companies, whose aim was to dilute the risks and to invite large financial investors to the reinsurance market.

In 1992, a powerful tropical cyclone “Andrew” hit Florida. The damage was enormous. In the aftermath of the hurricane, several insurance companies went bankrupt which, faced with material losses of over the USD 27bn, lacked funds and were unable to pay compensation for active policies. The United States has immeasurable resources, so the State of Florida and its affected people have received significant support.

Things are much worse in Mexico. The country is plagued by numerous elements: hurricanes and tropical downpours are accompanied by earthquakes and volcanic eruptions. After each disaster, there are many deaths, injuries and huge material losses. The state is not wealthy, so there is a lack of resources, even when nature is not raging. Any money to mitigate the consequences of misfortunes is of great importance. Such is the background of the construction of cat bonds.

High interest rates for uncommon risks

Cat bonds differ from other bonds in terms of their very high interest rates, which ensure a high return on investment (in the form of a granted loan). This is compensation for the very high risk of losing even all the capital invested. The funds invested in the purchase of bonds are forfeited when the trigger conditions that link the specific bond issue to the consequences of a potential disaster are met.

High interest is not everything. They are very popular among investors since, unlike all others, they are based on natural phenomena and are not subject to the excesses of the global economy. It is a paradox that it is easier to believe in nature than in other people, but such is the case.

There are many indications that the precursors in December 1996 were Georg Town Re Ltd as issuer of cat bonds for the USD68.5m and St. Paul Re as a company It was noted that this was also an example of the first securitisation (i.e. the transformation of rights to cash flows into securities) in this sector. It is known that under the terms and conditions of the first cat bond issue, St. Paul Re society was paid the USD500,000 for the losses resulting from several hurricanes and very strong storms, floods in the United Kingdom and the destruction of the WTC towers in New York.

Currently, the issue of such bonds is primarily organised by the World Bank, while Mexico is the market leader, whereas investors, i.e. lenders, are usually large funds, including pension funds and other powerful financial market players. They always have a desire to make exceptionally high profits; however, to their own benefit. Unlike smaller players, they have great risk dispersion potential, since there are hundreds and thousands of different items on the list of working and earning assets.

Mexican experimental field

The first cat bonds placed on the market on the initiative and in favour of Mexico appeared in 2006. This was the result of cooperation with the reinsurance company, Swiss Re. The issue covering earthquake risk was worth the USD160m.

The second 2009 issue for the amount of the USD290m was already conducted with the participation of the World Bank. It intended to implement a single common cat bond scheme for many countries exposed to various risks. The scheme was named MultiCat; however, it failed. Greece, Singapore, Chile and Colombia had withdrawn their accession. Only Mexico remains onboard.

Another issue of USD315m was sold in 2012. In 2015, Mexico was hit by Hurricane Patricia and since the bonds were still active, the buyers of tranche C, with a nominal value of the USD100m, had to say goodbye to half of the invested capital. They were lucky in their misfortune, since if the atmospheric pressure during this cyclone had fallen even more, they would not have recovered a single cent of the money they had lent.

In the first days of August 2017, Reuters reported that the World Bank had issued disaster protection bonds with a nominal value of the USD360m on behalf of Mexico. The operation was carried out under a program called “capital-at-risk notes” in bank jargon. The name reflects the sense of the program as it is about shifting the risks of natural disasters from developing countries to the area of capital markets. It is also contrary because it also refers to the high risk taken by lenders.

To facilitate possible settlements, issues are divided into tranches. Tranche A is associated with one type of risk and loss (e.g. a hurricane over the Atlantic), tranche B — with the second one (a hurricane over the Pacific), tranche C — with the third one (earthquake), etc. The interest rate of each tranche is usually different since the scale and likelihood of occurrence of the specific risk is usually different.

In this case, the buyers of the issue were unlucky, since after just one month, in September 2017, Mexico was hit by an earthquake of 7.1 on the Richter scale with the epicenter near the capital. Over 300 people died and dozens of buildings collapsed. The investors clashed with the forces of nature and had to leave empty-handed. However, the tool fulfilled its role because substantial funds were received by FONDEN, the Mexican disaster fund.

Sustainable development as a new ancillary goal

The service artemis.bm, specializing in cat bonds and other ILS products, has recently announced a new offer of four-year cat bonds with a nominal value of the USD425m. The issuer is again the World Bank and the potential beneficiary is once again the Mexican FONDEN. Swiss Re is expected to act as the reinsurer.

This would be the sixth issue of such bonds in favor of Mexico. However, it differs from the previous ones. For the first time, it is to combine the element of disaster insurance with the so-called sustainable development. These bonds are said to be of a hybrid nature. In the meantime, the money raised as a result of the issue will be able to work for the development projects of the World Bank undertaken in poor and low-income Member States.

If nothing happens, after four years they will return with the previously contributed generous interest to the investors, but in the event of the occurrence of a natural disaster, they will be transferred to FONDEN.

The tool and the market in practice

The example of 2009 is an excellent description of the complicated formal structure of cat bonds. In 1999, a special fund for collecting funds in the event of natural disasters, Fideicomiso Fondo de Desatres Naturales (FONDEN), was established by the Mexican government.

The move was good, but the forces of nature were more powerful. In 2005, the equivalent of the USD47m was credited to the fund’s account, but expenses to cover the losses caused by the numerous hurricanes in that year amounted to as much as the USD722m. The fund was hard pushed to find resources.

What does FONDEN do? It signs a contract with the insurance company Agroasemex, which under another contract transfers the risk resulting from the contract with FONDEN to Swiss Re as the reinsurer. In connection with the new business, Swiss Re concludes an agreement with a Special Purpose Vehicle (SPV) established in a tax haven in the Cayman Islands. Although there will be no houris there, you will also not see crowds of officials who, if they do not do harm, will slow it down.

The SPV issues cat bonds, which it sells to investors since it must have coverage for potential liabilities towards Swiss Re. The money from the sale of cat bonds works in a very safe environment because the SPV buys American Treasury bonds for it. These securities are deposited in a special account and the interest due is transferred to the SPV, constituting one of the sources of interest payment for cat bond purchasers.

Complicated, but the world of modern finance is like a snake, where you can’t see where the head of one of the reptiles is and the tail of another. When one of the triggers works, the SPV transfers the appropriate amount of money to the “catastrophe account” from where it goes to FONDEN and the creditors (bondholders) receive information that they have also suffered misfortune, but they can survive since they have only lost money.

It is clear that every entity in the chain between the Mexican fund and the SPV must earn money, so the cost of such insurance is not small. According to some calculations, the benefits in the form of disbursements were higher for Mexico over a certain period.

A small market, although many of the risks are worth prudence

Artemis has included more than 650 cat bond issues addressed to the markets since 1996 in its lists. According to this observer’s estimates, the total value of such bond issues could reach the USD4bn, if not more, in only the Q1’20.

The same source estimates that the current value of working cat bonds and other ILS products exceeds the USD40bn. However, as early as two years ago, the Los Angeles Times wrote that it was even as much as the USD90bn. Either way, it is not a mind-blowing amount, but it is also hard to miss.

The cat bond market covers an increasing number of threats. In 1999, the SPV from the Cayman Islands, Kelvin Ltd., issued two tranches of bonds which were related to winter and summer temperatures measured in 19 locations in the USA. It responded to the impact of excessive cold or heat on the harvest and energy consumption.

The coupon of the first tranche amounted to 15.8 per cent, i.e. the interest due to the holder of a USD100 bond was as much as the USD15.8 per year. The coupon of the second tranche amounted to 8.7 per cent.

The very harsh winter of 2000/2001 released one of the “triggers” described in the terms and conditions of the issue and the beneficiary, i.e. Koch Energy Trading Inc., received a payment of the USD5.1m. The twist here is that the company belongs to the empire of the extremely rich, yet conservative Koch brothers. Greenpeace accuses them of spending at least USD127m in the years 1997-2017 on initiatives against climate defenders.

In December 2003, the first cat bonds related to health risk appeared on the market. The timing was not accidental, since the world was recovering from the fear caused by the SARS epidemic, i.e. severe acute respiratory syndrome, which had caused the deaths of about 770 people.

The issuer of the USD400m 4-year debt instruments was Vita Capital Ltd, a potential beneficiary of Swiss Re, while the trigger of the potential payout to the Swiss reinsurer was an extraordinary excess of mortality rates in five selected countries.

The latest project connected with the consequences of the potential epidemic/pandemic and their consequences in the form of deaths was arranged by Matterhorn Re for the benefit of Swiss Re. The issue of these cat bonds started in late February 2020. It aims to cover the risk of catastrophic storms on the east coast of the United States, from Texas to Maine, and increased mortality in Australia, Canada and the United Kingdom.

Securities worth USD255m have found buyers against the upper limit of supply fixed at USD275m. Issuers claim that the risk of investors losing money ranges from around 1 per cent for four-year class A bonds, linked to a mortality rate of almost 2.8 per cent. In the case of two-year class B (violent thunderstorms), the reward is an interest rate of about 5 per cent for class A and 6.5 per cent for class B. Compared to interest rates at zero and even below, such earnings are worth the risk for many.

Weaknesses of cat bonds

In the financial market, no one will leave the stall empty-handed. However, not every apple taste as good as it shines. A few years ago, a group of investigative journalists, including those from the Los Angeles Times, dug through piles of documentation on cat bonds. They concluded that beneficiaries could lose a lot due to the lack of transparency and manipulation of payout triggers, as well as drawn out payout procedures lasting many months, while victims need to be rescued immediately.

On the Mexican side too, there is no proper order because officials do not have the power to direct cat bond funds to help the victims of the particular disaster, while the government does not specify what they are spent on.

The triggers are obviously the most controversial. Formally, the data comes from the trustworthy US government institutions, such as the US National Oceanic and Atmospheric Administration, but they can be challenged. In 2014, Josh Morgerman, the rich owner of a Hollywood-based advertising company and storm chaser, did it, as he unconsciously asserts. In September of that year, Hurricane Odile was approaching the coast of Baja State on the Pacific Ocean. Mr. Morgerman was already there and set up his extensive measuring equipment in one of the hotels. Later it turned out that his meters showed an atmospheric pressure of 943.1 millibars. Some American institutions showed 21 and others 13 millibars less. The issue is that the lower the pressure, the stronger the wind and the damage is potentially higher. The triggers provided for 100 per cent payment for 920 mbar and lower or 50 per cent for pressures below 932 mbar. After the deliberations, Mr. Morgerman’s measurements were deemed correct and as a result, Mexico did not receive a single cent of the USD50m expected from the original reading of 930 mbar delivered to the US National Hurricane Center.

Cited by the Los Angeles Times, Robert Muir-Wood, head of RMS, a risk modelling company, pointed out that hobbyists’ readings may affect cat bond payments and that it cannot be ruled out that hurricane hunters are commissioned by interested parties. The retired Director of the US National Hurricane Center, James Franklin, said that his employees would probably not notice the manipulation of cyclone measurements by a few millibars.

Under certain circumstances, even the most powerful hurricane can surrender to the forces behind big money.

(www.gotcredit.com, CC BY 2.0)