Need for Catastrophe Bonds
Catastrophe Bond is another kind of insurance which transfers a specific type of risk from sponsor to the Investor. Catastrophe bonds are normally purchased by the insurance companies not by the individuals or other corporate units. If you are an individual, you can buy catastrophe insurance of your property. Catastrophe insurance covers loss of your property in case of all natural disasters e.g. Hurricane. If an insurance company insures several properties in any particular area for catastrophe insurance, there is a risk that they would not be able to pay off all the claims if a flood or storm hits that particular area. In order to reduce their risk, insurance companies have two options. They can buy Catastrophe Re-Insurance from a Re-Insurance Company or issue Catastrophe Bonds.
Functionality of Catastrophe Bonds
Functionality of catastrophe bonds is a bit different from other bonds. Insurance company issues catastrophe bonds through some investment bank to the general public. Catastrophe Bonds have a markup of around 3-20% based upon the area for which they are issued. For example, there are some states in USA where the risk of natural disasters is very low and in some states it is very high. Markup rate of catastrophe bond issued for the areas where risk of catastrophe is high will be more (20%) as compare to those areas where risk of catastrophe is low. Catastrophe bonds are issued generally for 3 years with the agreement that in case of any catastrophe in that area, principal amount of bond will be forfeited by the issuer and be used to pay off the insurance claims of the affected people. There is a risk of losing the principal amount to the general public, so extra markup rates are offered to the investors. Investors are induced to make investment to earn heavy returns with a chance of losing principal amount in case of catastrophic event. Generally these events are covered in Catastrophe Bonds;
- Volcanic Interruption
- Hydrological Disasters e.g. flood, Tsunami
- Meteorological Disasters
- Health Disasters
- Space Disasters
Issuers and Investors of Catastrophe Bonds
Catastrophe bonds are generally issued by the re-insurance companies. We have mentioned above that these are also issued by the insurance companies but on very few times. Normal insurance companies which are dealing with consumers don’t want to be involved in it unless their business is very huge. Re-Insurance Companies issue catastrophe bonds to cover their part of the risk.
Just like issuer of catastrophe bonds, general public is normally not interested in investing in Catastrophe Bonds due to clause of losing the principal amount of investment. Investors is greedy for more returns but not on the stake of their hard earned money from other sources. Normally, life insurance companies, investment banks, hedge funds, bond funds and pension funds are interested in catastrophe bonds. They have a huge capital to invest so they can separate a sum of money to risk for heavy returns. In other words, catastrophe bonds are not good investment for general public.