They may initially sound like a somewhat crass investment, but catastrophe bonds are far from that. Also called insurance-linked securities, this type of bond fundamentally helps reinsurers manage exposure to large risks such as natural disasters. Essentially, catastrophe bonds are an investment vehicle used by companies to spread risk – but which are event-linked. An investor pays a premium, and gets rewarded when a natural disaster does not happen. Events are pre-specified and bonds have a specific timeframe, usually up to three years.
Catastrophe bonds – or cat bonds – were first developed in the mid-1990s after Hurricane Andrew, which was (at the time) the most destructive hurricane in US history, causing major damage from Louisiana to the Bahamas, with the hardest impact hitting south Florida. Wind speeds reached 165mph and damages reached $26.5bn (roughly £34bn in today’s money). Two years later, the 1994 Northridge earthquake struck California, killing 57 and injuring nearly 9,000.
The asset class was subsequently created as a way for insurance companies to help alleviate the risks they face when major disasters happen, contributing towards paying damages not covered by premiums. Since inception, the industry has grown massively in size. According to Aon Securities, catastrophe bond issuance for the 2015 calendar year totalled $6.9bn (£4.7bn), although this contracted from 2014 ($8bn–£5.5bn) in response to the prevailing competitive landscape within the insurance market, it says. Despite the contraction, catastrophe bonds’ total value reached $24.4bn (£16.9bn) as at the end of 2015, an all-time market high. Ten catastrophe bonds were issued during the second half of 2015, as detailed in Table 1.
With the expansion of catastrophe bonds around the world, and them becoming an even larger asset class, the UK government has responded. In the March Budget last year, chancellor George Osborne set out his plans to make London a hub for catastrophe bonds and other esoteric vehicles in the insurance industry.
According to the London Market Group, the city’s share of the global reinsurance market has dropped in recent years (from 15 per cent to 13 per cent between 2010 and 2013). In an attempt to rebuild London as an insurance centre, the Budget document stated the government would work with the industry and regulators to develop a new competitive corporate and tax structure for allowing insurance linked securities to be domiciled in the UK. “This alternative form of reinsurance makes greater use of capital markets and is a key growth opportunity for the sector,” it said. Since then, an industry taskforce has been established to advise the UK government on the necessary changes.
Diversification
