Catastrophe bonds: It's time govt considers insurance-linked securities with increasing frequency of natural calamities

Catastrophe bonds (CAT) made their advent in the US in the wake of the devastating hurricane, Andrew, in 1992 which damaged properties worth $27.4 billion. It is common knowledge that insurance penetration is very high in the US. Small wonder, the insurance industry there woke up to the potential of CAT as a risk-mitigating measure and instrument.A typical CAT or cat bonds has a maturity of three years during which the period should be a tightly defined disaster say cyclone in Odisha occur, the investors in bonds lose their shirt i.e., they have to forego their principal and future interest. Naturally to entice investors, the coupon rates have to be much higher than the ones offered by corporate bonds and gilts. In the US, such catastrophe bonds are generally priced 200 basis points above the 10-year US treasury yield. CAT is like junk bonds in terms of riskiness and hence the high yield expected.General Insurance Corporation of India (GIC), the nation’s premier reinsurer, toyed with the idea of issuing CAT in the wake of Uttarakhand floods in 2012. It had to pay up about Rs 2,000 crore as claims settlement. Had it issued, let us say, Uttarakhand flood bonds in 2010 with a maturity of three years and had it been subscribed to the tune of Rs 1,000 crore, GIC would have had to pay only Rs 1,000 crore from its coffers with the balance being borne by the market i.e., the holders of CAT. Of course, it would have paid interest for the period since the issue till the disaster.[caption id="attachment_6568311" align="alignleft" width="380"]

Odisha's Puri was one of the areas worst affected by cyclone Fani. PTI[/caption]Those who have great appetite and capacity for risks are the ones who subscribe to CAT. Hedge funds and pension funds top the list naturally. It might also interest weather forecasters but it is certainly not for the small investors and mutual funds catering to small investors. In India, CAT carrying a coupon of say 12 percent per annum might catch the fancy of pension funds and high net worth individuals. Its riskiness and hence the yield can be reduced by reducing its duration from say three to two years.The insurance company itself must make sure that the funds mobilised through the issuance of CAT are not exposed to high-risk investments. It has a fine balancing act to do. It has to earn something from the funds to take care of the high coupon payable on CAT. At the same time, it has to have the funds ready and realisable so as to be able to settle claims. Otherwise, it will have to pay up from its general pool of funds thus defeating the very purpose of issuing CAT.One may wonder why CAT is issued mostly by insurers and reinsurers. The answer is it is a natural fit for them. It is a risk-mitigating measure for them. It is well possible that the insurance industry in India which charges very high premiums for natural disasters might reduce them if they were allowed to mitigate their risks or transfer their risks to the market through CAT. Fallout of CAT could be bonds in general finding favor with investors in India. As it is the bond market in India is both shallow and small.There is no reason why governments themselves cannot issue CAT. For example, Odisha is prone to periodic cyclone with the recent Fani cyclone wrecking havoc on properties though, thanks to high preparedness, loss of human lives was minimal. Odisha government itself can take the initiative and issue Odisha and cyclone-specific CAT. A longer duration bond would be beneficial to it i.e., instead of a three-year bond if it issues a five-year bond, the chances of cyclone hitting coastal Odisha is higher and hence the success of the exercise (loss mitigation) greater.But correspondingly the issue of CAT being a hit with investors diminishes with lengthening of the maturity period of the bonds. Indeed for a high duration CAT, the expected yield could be still higher. A sweetener for such government-issued CAT as opposed to insurer-issued CAT could be income-tax exemption for interest to the investors.(The writer is a senior columnist and tweets @smurlidharan)