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The rise of catastrophe bonds as an investment product

The new insight report from Timetric’s Insurance Intelligence Centre looks at the trends in natural hazards and a growing catastrophe bond market. On a global basis, there is significant underinsurance of natural hazards and almost 70% of economic losses resulting from natural and man-made catastrophes are from those uninsured. With reinsurers in some areas reluctant to undertake too much catastrophe risk, a lack of reinsurance capacity has acted as a constraint on coverage. However, catastrophe bonds have the potential to alleviate the risk diversification problems faced by insurers and therefore increase coverage of catastrophes.

Catastrophe bonds increase insurers’ catastrophes risk capacity

Catastrophe bonds are an alternative source of capital for insurers looking to expand their coverage against catastrophes. In the past, devastation wreaked by hazards has reduced the appetite of insurers for risk through the bankruptcies it has caused; it has also deterred reinsurers from the market. The introduction of catastrophe bonds helped to reduce the dependence on reinsurance capital, so that insurers could afford to take on catastrophe related risk. The increasing popularity of catastrophe bonds is demonstrated by the fact that in 2010 the size of global catastrophe bond issues was $4.6bn and by 2014 this figure had reached over $8bn.

What is the attraction for investors?

The bonds provide valuable portfolio diversification for investors. Catastrophic events tend to be quite random in their occurrence and relatively uncorrelated with the performance of the economy and risks that are prevalent in fixed income and equity markets. Furthermore, due to the high losses that are triggered in the event of the catastrophe the bond is tied to, the returns offered from these bonds are relatively high. In the current investment environment, investors searching for more lucrative returns may find catastrophe bonds an intriguing investment proposition.

Obstacles for further growth in this asset class

Catastrophe bonds will likely be of most use in developing countries which are significantly underinsured due to the absence of a developed insurance and reinsurance industry. However, issues of such bonds require the type of sophisticated financial markets that developing countries do not have. Knowledge and expertise in risk modelling and security underwriting is unfortunately not abundant enough in these countries in order to facilitate the issue of catastrophe bonds on the scale that is required to make up for the low risk appetite of reinsurers.

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