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Thursday, December 30, 2010

Catastrophe Bonds

            Reinsurance is something you have read before but I think very few of us know about the catastrophe bonds which are similar arrangement as Reinsurance and Retrocession.

             Catastrophe Bonds commonly known as CAT Bonds are high-yield debt instrument that is usually insurance linked and meant to raise money in case of a catastrophe such as a hurricane or earthquake. It has a special condition that states that if the issuer (insurance or Reinsurance Company) suffers a loss from a particular pre-defined catastrophe, then the issuer's obligation to pay interest and/or repay the principal money is either deferred or completely forgiven. For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond. If no hurricane hit Florida, then the investors would make a healthy return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially paid by the investors would be forgiven, and instead used by the sponsor to pay its claims to policyholders.

             Insurers can use these as an alternative to reinsurance. Insurance or reinsurance companies can issue these bonds and place them with various investors. This helps them transfer a part of the risks to the investors. The insurance company can further invest the money generated from selling the bonds. Cat bonds can be issued by the Government or financial institutions. Investors can get a slightly higher return when compared to other securities and it also offers them an opportunity to diversify their investments. Cat bonds are popular in some of the markets abroad, especially in the United States, Japan and Europe.

             Major investment banks and other dealers that are active in the issuance of catastrophe bonds are Aon Benfield Securities, Inc., Swiss Re Capital Markets, Munich Re Capital Markets, Barclays Capital, Deutsche Bank, BNP Paribas, Goldman Sachs, Merrill Lynch, GC Securities, JP Morgan, and Willis Capital Markets.

Happy Reading

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