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At the last March’s Budget just before the General election, George Osborne the Chancellor of the UK Exchequer announced that the government will explore options to attract more reinsurance business to the UK.

London is already the world leader in the global insurance and reinsurance market. However, its position is starting to be challenged by the growth of the regional hubs such as Bermuda, Singapore, Zurich and Dubai.

In response, the London Market Group (LMG), an organisation that promotes the modernisation agenda of the insurance market, has recently set up a task force to help the government explore initiatives to make London a more attractive hub for Insurance Linked Securities (ILS) and catastrophe bonds (also known as cat bonds).

What are catastrophe bonds

Catastrophe bonds are simply a form of insurance securitisation. Their purpose is to raise money in case of natural disasters such as earthquake or hurricane by transferring those types of risks from their sponsors (mainly insurance or reinsurance company) to private investors. If a triggering event occurs, the sponsor obligation to pay interests or repay the principal is deferred or forgiven to cover for the event’s losses.

The first Cat bonds were issued in the early 1990’s when major catastrophe events such as Hurricane Andrew hit the US causing over £15 billion of insured losses. This resulted in a shortage of reinsurance capacity which prompted the reinsurers, banks, and academics to investigate new ways of transferring catastrophe risks outside the traditional reinsurance capital pool. Today the catastrophe bonds market has reached a record size of over £13billion.

Most catastrophe bonds are designed to cover natural disasters but there were few exceptions. For example FIFA issued catastrophe bonds worth £164 million to the capital markets to insure itself against the possibility that the Football World Cup 2006 held in Germany being cancelled.

Other unusual transaction was the UK betting company MyLotto24 which raised last year over 70 million Euros (£46 million) worth of reinsurance cover that would trigger in the event of customers winning more that 22.5 million Euros in a year.

Issuance of a Cat Bond

The process of issuing catastrophe bonds is fairly standard with some variations that are subject to the bond’s trigger type and the complexity of its structure.

Typically, the process begins with a modelling agent (a catastrophe modelling company such as RMS) and a structuring agent (an investment bank like Goldman Sachs) that provides advice on designing and placing the bond.

The sponsor and the structuring agent, together, select the mechanism by which the bond will pay out or trigger. Once the trigger type and the level of protection have been worked out, the structuring agent will then assist the sponsor to place the bond with investors.

In case a triggering event occurs during the life of the bond the sponsor will receive a payment of appropriate amount. However, if no event occurred then the investors will be redeemed of their principal plus interests.

Trigger types

The Catastrophe bonds are categorised into three main trigger types – Indemnity, Industry loss and Parametric.

The Indemnity trigger is based on the sponsor’s actual losses. For example in a scenario where a sponsor has issued an indemnity-triggered cat bond of £10 million with an excess of £50 million, and then experiences losses amounting to more than £50 million. The £10 million will be paid first and then the bond is triggered.

The Industry loss bond-type is triggered when the loss to the Insurance industry as a whole reaches a pre-determined threshold. The overall loss of the industry from an event is usually determined by independent third parties such as ISO’s Property Claims Services and PERILS.

The Parametric trigger type is based on objective physical characteristics measurements caused by nature. For example, the speed of the wind in a windstorm or the magnitude of an earthquake

This type of trigger is extremely popular with investors because not only it is very transparent but also because transactions are settled much more rapidly as the event parameters are available shortly after it occurs.

Why investors buy them

Despite Warren Buffett, the multi-billionaire business magnate, warning investors last year to steer clear of Cat bonds, investors are embracing them. This year saw a record continued growth of the cat bonds and other ILS issuances and it is forecasted to hit again the £5 billion mark.

Cat bonds appeal to investors because they offer higher returns than the current ultra-low yields on risky corporate bonds. They also allow investors to diversify their portfolios for the simple reason that natural disasters occur randomly and therefore they do not get affected when the economy bellies up.

The Challenge

Whether the London Market Group task force succeeds in coming up with initiatives to cement London as a Catastrophe bonds and ILS hub or not will be a challenging task with many hurdles.

Because competing against the regional hubs that offer great incentives such as tax advantages and the expertise to convert those insurance products into the capital market instruments won’t be an easy task.

However, London which has the biggest speciality insurance, Lloyd’s of London is without a doubt the global insurance hub and with a couple of regulatory changes, faster processing and good linking with catastrophe modelling agencies that provide expert transactional data will certainly be able to pull it off

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