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James bond or CAT bond, who is our saviour from catastrophic losses

In Banking, Finance, Insurance, Risk Management on October 22, 2012 at 7:17 am

 

“Shocking! Positively shocking!” – Sean Connery as James Bond in Goldfinger

In show business, it is easy to save humankind from catastrophe by James Bond. He can avert nuclear disasters, stop tsunamis and change course of meteorites. The real life is different. Catastrophe means loss to people, society and economy.

The biggest challenge today to the insurance companies is not mere fraud risk, low reserves or depression of the economy – it is the risk arising out of catastrophes, which can severely affect their solvency position.  In last 10 years, catastrophes like 9/11 attacks on WTC, hurricane Andrew, Katrina and Wilma have shaken the reserve and stability of the insurance industry in United States. According to Swiss-Re, a leading reinsurance firm, year 2011 witnessed losses from catastrophes totalled $35.9 billion, greatly surpassing the average of $23.8 billion for the years 2000 to 2010. The insurance company solvency is endangered, when losses increase up to a substantial level – to safeguard either insurance company has to raise the premium or its reserves will be gobbled up by single big catastrophe.

In past 36 years, catastrophic losses have hit the insurance companies’ very hard and resulted in insolvencies of small and large insurers (Stipp, 1997; Swiss Re, 2000; Mills et al., 2001). Between the year 1969 and 1998, nearly 650 U.S. insurers became insolvent (Matthews et al., 1999). According to Guy Carpenter (2007), if one considers the 20 most costly insured catastrophes that occurred in the world (1970–2006) – half of them happened in the United States. Thus, it does not come as a surprise that the Gulf of Mexico has become a world peak zone for the insurability challenge.

Insurers use many tools for reducing their financial vulnerability to losses (Mooney, 1998; Berz, 1999; Bruce et al., 1999; Unnewehr, 1999; III, 2000). These tools include raising prices, nonrenewal of existing policies, cessation of writing new policies, limiting maximum losses claimable, paying for the depreciated value of damaged property, non-actuarially based discounts instead of new-replacement value, or raising deductibles, better pricing & claim handling (Dlugolecki et al., 1996 & Born et al.,2006 ). The catastrophe events will also effect insurer’s pricing policies, shift the default risk indicator and change the risk assessment methods. Sometimes, insurance firms also face regulatory intervention to reduce insolvencies (eg: Solvency II, SOX).

Currently, few Insurance firms hedge their portfolio by catastrophe risk financing by going into equity market. Catastrophe risk securities are of two types – catastrophe bonds (CAT bonds) and catastrophe insurance options. Both types benefit insurers by making money available to offset catastrophic losses. Insurance companies issue CAT bonds to transfer extreme losses from natural catastrophes such as windstorm, earthquake and floods. Property and casualty insurers typically develop catastrophe risk management strategies that combine determination of risk appetite, measurement of exposures, pricing considerations, processes to limit exposure and utilization of reinsurance or capital markets to transfer risk to third parties.  Due to massive increase in insured losses from natural catastrophe, catastrophe bonds (CAT bonds) played a vital role in increasing the underwriting capacity and reducing probability of default for the insurance companies.  There is a wider chance that insurance companies who use securitization methods will be able to reduce or completely avoid the default risk.

There are many similarities between James Bond and CAT bonds. Like James Bond, CAT bond is the hero of Insurance and reinsurance world to save average person from natural catastrophes losses like flood, storms and typhoons etc. James bond will complete his mission by using modern gadgets; CAT bond use advanced equity market financial tools to get success. No doubt, the CAT bond is James Bond of financial world.

But ofcourse nobody entertains the way James Bond 007 does. Like you I am eagerly waiting for the new movie Skyfall. Comments welcome !

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