The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Thursday, August 09, 2007

Catastrophe Bonds

Catastrophe bonds -- or "cat" bonds -- are bonds (normally issued by insurance companies) that have high yields but lose their value when natural disasters (such as earthquakes, floods, hurricanes / typhoons, etc.) take place. In the past, the vast majority of cat bond investors were large institutional investors like pension funds and hedge funds. Recently, however, a mutual fund has allowed retail investors an 'opportunity' to gain exposure to this seemingly exotic alternative asset class.

The benefits of investing in cat bonds is that (a) it has yields that are substantially higher than most junk bonds and the sovereign debt of emerging countries, and (b) it (supposedly) has low correlation with other asset classes (of course, those touting cat bonds are tacitly assuming that natural catastrophes are not linked to market catastrophes). The problem is that these benefits come with a high price: Investors in cat bonds are implicitly writing (selling) options to insurance companies when they buy cat bonds.

If you know anything about financial options, you should know that the writers (sellers) of options -- which, counter-intuitively in this case, aren't the issuers of cat bonds, but the investors of cat bonds -- can lose their entire investment, and, in some cases, have virtually unlimited losses. If investments in cat bonds involve a lot of leverage -- which would not be surprising given that cat bonds are essentially another form of exotic financial derivatives -- then losses for investors can get quite ugly.

Cat bonds is another example of exotic derivatives and financial products that are finding their way to retail investors. Creators and marketers of these products are increasingly motivated to offer these products to the retail market because: (a) they have access to greater liquidity (thousands of 'little old ladies from Pasadena' can rival institutional investors when it comes to chasing liquidity), and (b) they provide a way to further (re-)distribute risk.

More on point (b) ... re-insurers -- who provide insurers with insurance against catastrophic risk -- are the obvious alternative to cat bonds. Unfortunately for insurance companies, re-insurers (and, for that matter, insurance companies) are like Mark Twain's proverbial bankers: "They give you an umbrella when it's sunny, but take it away when it's raining." In other words, re-insurance is plentiful when there aren't too many natural catastrophes, but they tend to dry up when it is most needed.

Cat bonds -- especially if retail investors get in on the act -- can be a way for insurance companies to obtain more 're-insurance' than they otherwise could. Unfortunately, for retail investors, these cats may not have nine lives when disaster strikes.

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