Cat Bonds

News: In India, low penetration of disaster risk insurance like Cat bonds, for individual property and livelihoods leaves much of the population exposed to irretrievable damage and loss.

About Cat Bonds

• These are a unique hybrid insurance-cum-debt financial product that transforms catastrophic insurance cover into a tradable security.
  • The term ‘cat bonds’ are a short for the ‘catastrophic bonds’.
• These are effective in transferring pre-defined risk to bond investors, ensuring quicker payouts and a much-reduced counter-party risk.
• Working
  • Bond creation: The sovereign nations can create the bonds, sponsor it and pay the premium, with the principal being the sum insured.
  • Intermediaries: The sponsor requires an intermediary to issue the bond to reduce counter-party risk. Intermediaries can include the World Bank, the Asian Development Bank or a reinsurance company.
  • Gain or loss: If a disaster occurs, the investor runs the risk of losing a part of the principal.
    • That’s the reason for higher coupon rates of such bonds, compared to regular debt instruments.
• Variation in coupon rates: There is much variation in coupon rates for a cat bond depending on the risks — earthquakes garner lower premiums, as low as 1-2%, compared to hurricanes or cyclones.
• Need for India
  • The unpredictability and increase in frequency of extreme weather events like cyclones, floods, forest fires and devastating earthquakes in South Asia have increased India’s exposure to disaster-risk.
    • India needs to ring-fence its public finances for post-disaster reconstruction.
• Disadvantages
  • A defectively designed cat bond could lead to no payout despite a significant disaster.
    • For example, an earthquake cat bond designed for a magnitude threshold of 6.6M for a certain grid may fail if a 6.5M event occurs and causes extensive damage.
  • Despite a contract if a disaster doesn’t occur, it could lead to questions on the desirability of such expense.