Journal Article Review
“What’s Behind The Cat Bond Craze”
Summary:

Covering catastrophe risk has traditionally been the domain of insurers and reinsurers. But it was not until recently that private capital began pouring into the reinsurance industry. In this article, the author talked about one specific ILS, namely the cat bond, managing to analyze the reasons behind its quick growth. He did that by talking from the sponsor’s perspective and investor’s perspective. From the sponsor’s view, declining reinsurance pricing rates for cat bond means the sponsor can transfer its risk to capital market at a much lower cost. Further, more forms of quasi-governmental and state-sponsored entities, rather than large insurers and reinsurers, are emerging. Last, indemnity trigger has remained the dominant form, making up about 75% of triggers or attachment points used by June, 2014 (Angelo John Lewis, 2014). This has helped to negate any calculation of basis risk and accounted for the actual losses endured by the sponsor. From the investor’s point, the author mainly proposed four explanations. First, investing in ILS offers additional possibilities for risk diversification. Since insurance risk is largely uncorrelated with credit or market risk, the risk-return profile of investors can be improved. Also, climate modeling has become more detailed and accurate, giving investor more confidence in participating in indemnity trigger deals. Third, cat bonds provide a relatively higher rate of return against a backdrop where interest rate remained low. Last, cat bond investors haven’t experienced large losses since Tohoku earthquake in Japan, giving them the complacency that they will always be investing safely. The article closed by picturing the future development of cat-bond. The author holds a positive view towards the consistent growth of cat bonds and believes the risk coverage, as well as ceding companies will expand.
Analysis and my thoughts: Despite on-going optimism about the future outlook of cat bond, I am not completely assured that it would be as good as it looks. For one thing, I think low-interest environment won’t last long. As U.S. economy recovers from the big crisis, “jobless claims are at a 14-year low and manufactures are bringing more space capacity back on line, two signs of strength in the U.S. economy” (Nick, 2014). My concern is once interest rate is raised, will cat bond continue being a more preferable choice for investors? Of course, the “Nephila people” said since they put all the asset to treasury bills, return rate will go up with the interest rate. However, I wasn’t totally convinced. When financial market is really good and people making tons of money, they are less likely to avoid risk by diversifying their portfolio (meaning they are less risk aversion), possibly resulting in less trade volumes in cat bond. With regard to the geographic expansion, I believe more factors need to be considered. For example, in Japan, nonadmitted insurance is not allowed because the law provides insurance must be purchased from locally authorized insurers. And brokers and agents must be licensed by the Financial Services Agency in order to conduct businesses in Japan. Likewise, I am concerned that other “big rising markets” out there might be regulated by political factors or economic policies. In class, we saw a chart of trade-off between basis risk and transparency . To be honest, when I first saw that chart, my preference would be somewhere between “modeled loss” and “parametric index”. As for indemnity, its nature of almost no transparency at all worries me. When I turn to a more traditional reinsurance deal, it’s mature and provisions are made explicit. But when I look at a indemnity trigger, I have to worry, for example, who decides what constitute a catastrophe? Is it decided by the issuer, or the PCS Catastrophe Loss Index? How is the cost calculated? As a cautious investor, I might be more comfortable with parametric index.

References:
1. Angelo, L. 2014. What’s behind the cat bond craze. Best’s Review: 20-23.
2. Nick, T. 2014. Industrial, Labor Gains Persist Amid Tumult. The Wall Street Journal: A2
3. Anonymous. 2014. Profile: Japan. Business Insurance: 10