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Governments and institutions bet big on CAT bonds

By Ullattil Manranjith | CHINA DAILY | Updated: 2020-10-20 07:51
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There is something magical about the word bonds as it is closely linked with all facets of our life. But in the world of business, bonds are financial instruments that are used by governments and institutions to tide over funding difficulties in times of stress. And at no other time has it been more pronounced than at this juncture when businesses all over the world are reeling from the impact of the COVID-19 pandemic.

My interest in the topic was aroused when my old friend T.B.Nair, an independent analyst in the southern Indian city of Bengaluru, told me about how catastrophe bonds are gaining ground in the global marketplace. Nair told me that catastrophe bonds or CAT bonds are now becoming the instrument of choice for several countries to insure big transnational infrastructure projects from natural disasters. He even went on to suggest that CAT bonds would have been of great help for India to overcome the economic hardships arising from cyclones, floods etc.

CAT bonds are structured securities that allow insurers to move their risks to capital investors. Or in other words, insurers use the bonds to pay investors to take on major risks, such as enormous losses due to the biggest earthquakes and hurricanes.

China has already been speeding up its efforts to establish a catastrophe insurance system to protect life and property against natural disasters such as earthquakes, floods and hurricanes, said a report from Xinhua News Agency. Chinese reinsurance firm China Re issued a $50 million CAT bond in the international markets in 2015 to cover risks incurred from earthquakes in the country. The issuance helped create a diversified risk-sharing mechanism for catastrophe insurance by making use of the capital market, China Re said in a statement.

Ullattil Manranjith

But the real interest in CAT bonds comes in the wake of the Belt and Road Initiative as several transport corridors of the project pass through developing countries of Central Asia and Eastern Europe, some of which are prone to natural disasters.

Kirill Savrassov, a London-based Insurance-Linked Securities and Disaster Risk Transfer specialist, told me that with billions spent on logistics and critical infrastructure in the BRI transit countries, the issue of comprehensive protection or economic resilience unfortunately remains open. "This is a fundamental issue, as even a relatively mild natural catastrophe alongside the economic belt may bring broader contingent consequences by stopping the entire transport corridor until things are restored at the damaged location (s)," he said.

The use of parametric sovereign CAT bonds might be one of the best viable solutions for all parties, he said. "Based on successful examples from the other parts of the world, support from multinational agencies and international financial institutions and the uncorrelated nature of the asset class, CAT bonds, issued by transit states, could become an important instrument for the BRI, besides offering huge opportunities for institutional investors from the Chinese mainland."

Nair said he believes that CAT bonds offer huge investment opportunities as they are not linked to conventional bonds, equities, or the ups and downs of the market. These bonds were floated as insurance companies wanted to mitigate a portion of the risks that they would encounter if a major catastrophe occurred, which would otherwise create losses that they cannot cover with just the premiums.

While the insurance gap is a problem everywhere, it is far bigger for BRI transit countries between Northwest China and Western Europe, said Savrassov. That is because much of Central Asia, Turkey, Southern Caucasus and Balkans are situated in one of the most earthquake-exposed zones of Eurasia, if not globally. Down the west, the situation is exacerbated by addition of flood exposure. For both perils there it is not a question of if a disaster will hit, but when-and how devastating it will be. Historical track record with regards to that unfortunately speaks for itself, he said.

However, the overriding factor that supports the issue of CAT bonds comes from the increased macroeconomic stability it provides for the issuing countries and the comprehensive protection from natural disasters for the BRI transport corridors.

That said, CAT bonds are not without their risks. They are considered to be the riskiest yet most lucrative investment instruments next only to hedge funds, said Nair, adding that they are the "blackjack "of investments.

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