Corporate natural catastrophe bonds: are they an alternative to traditional insurance? Amalia Gonzalez-Revilla and Jean-Paul Conoscente look at the possibilities.

The beginning of the 1990s was characterised by the struggle of insurance and reinsurance companies to find efficient ways to access untapped capital sources. After Hurricane Andrew, it become clear that the risk transfer system in place was not as efficient as expected. Insurance companies were not using their capital efficiently, as they were retaining large exposures to catastrophe risk and therefore using their own equity to finance their catastrophe risk. It also became clear that the reinsurance industry did not have the capacity to absorb the majority of the financial risk.

In the mid 1990s, the capital market began to take on some of the risks traditionally borne by the insurance and reinsurance industry, leading to the first successful placement of catastrophe or cat bonds. The insurer or reinsurer passes the catastrophe risk to the capital markets through the establishment of a special purpose vehicle (SPV), which issues the bonds. The proceeds of the bond issue go to the SPV, which will provide protection to the insurer or reinsurer if the event occurs. As the market develops, the number of cat bonds applications increases.

As a matter of fact, the insurance industry is not the only one interested in the use of cat bonds. The launch of the first corporate specific cat bond by Oriental Land Co., the owner of the Tokyo Disneyland theme park, which was structured by Goldman Sachs and modelled by EQE International, has added an additional layer of complexity to the ever changing insurance market.

In a sophisticated insurance market, why would a corporation decide to access directly the capital markets, through cat bonds, instead of relying on the traditional insurance vehicles? The main reasons are as follow, although they may vary according to the type of industry and local market conditions:

• Easier access to capital: For many corporations the loss of business or business interruption (BI) due to a catastrophe event is a main risk. A corporation like Tokyo Disneyland, whose main source of revenue is its visitors, would suffer greatly if the number of visitors dropped following an earthquake. Although BI coverage is available through traditional insurance, the coverage extent and settlement terms tend to be tedious. BI coverage entails judgmental factors – what should and should not be included – and settlements in case of large losses, usually require heavy negotiations and interim financing until an agreement is reached. Cat bonds provide an attractive solution for risk coverage, especially bonds based on an industry loss index or on a physical parameter. Concurrently the role of the corporation changes, as it does not have to perform the functions of an insurance underwriter, but rather that of a financial professional.

• Innovation: For a large corporation the placement of a cat bond can also trigger a positive PR effect, as the company positions itself as an innovative risk finance company. It also may spur added interest from Wall Street and City of London analysts.

• Know-how: Many companies are eager to gain familiarity with these mechanisms to face the future better should market condition change.

• Transparent markets: As more deals take place, the cost of issuing cat bonds will drop, creating a more efficient risk pricing system. Pricing will, therefore, be set in a more competitive marketplace.

In the next decade we will see a dramatic change in the corporate arena specially in what pertains to the role of corporate risk managers as they are faced with sophisticated risk transfer markets and ever evolving complex financial tools.

Amalia Gonzales-Revilla and Jean-Paul Conoscente are with EQECAT.
Tel: +33(0) 144 79 01 01;
Fax: +33 (0) 144 79 01 05.