Cat Bonds: Managing event risk

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Cat Bonds: Managing event risk

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The 100-year natural disaster that no one expects to happen appears to have become a more frequent event, at least, in the most recent time frame.  From Hurricane Katrina, earthquakes in Japan and Haiti, to the most recent F5 tornadoes in Oklahoma Mother Earth appears to be under attack by Mother Nature. 

Oklahoma’s damage has been conservatively estimated at $2 billion dollars and that doesn’t seem to come close to the disruption in business and life that result from such a massively destructive storm.  Most of us cannot even imagine living through and recovering from the floods, wind and storm damage left by nature’s forces but increasingly business must consider the possibility.  This is where cat bonds come into play.

Catastrophe bonds are an example of insurance securitization to create risk-linked securities which transfer a specific set of risks (generally catastrophe and natural disaster risks) from an issuer or sponsor to investors.  Like other derivatives, the terms used to create cat bonds must be negotiated to reflect the triggers which would cause an event to activate based on specified losses.

Cat bonds have been around since the 1990’s but has not taken off broadly as a risk transfer tool.  As property and casualty insurance rate accelerate due to increased risk exposure the lower cost of cat bonds may rekindle interest in these products to mitigate event risk.

Robert Shiller, of Case-Shiller Index and Professor of Economics at Yale University, has long been an advocate for creating new risk tools to manage a variety of risks that impact our homes, livelihood, and even the income of countries.  None of these ideas have resulted in markets for pools of risk outside of insurance, options exchanges, or credit markets…so far! 

As the cost of tail events increases the frequency of these events may prompt new and more creative solutions to recover from catastrophe.  Imagine a diversified pool of risk traded on an exchange, used as a hedge, or even originated by corporations or industries to manage a variety of business risks.

Turning risk into opportunity an exciting new approach to managing risk and adding value!

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