I write in response to on article by John Breusch and Marsha Jacobs of the Australian Financial Review on 7 July 2008, titled "Assistance review in drier times". The report by the Bureau of Meteorology and CSIRO found that extreme hot weather events are likely to take place every 1 - 2 years in coming decades while severe dry conditions will occur twice as frequently as the 20 - 25 year definition assumed in the Federal Government's so called "Exceptional Circumstances Relief Payment Program". The National Farmers Federation chief executive Ben Farrgher seeks an option to protect the reductive base in an exceptional event. One possible solution is Alternative Risk Transfers (ART), in particular, Catastrophic Bonds (Cat Bonds) which are a form of re-insurance for extreme weather events typically used to protect against hurricanes and earthquakes. The author suggests, that Cat Bonds could be implemented as a protection for farmers against drought damage as well as other extreme weather events, such as, flooding or fire.
Extreme weather events are not new and due to climate change are increasing in occurrence and severity. ARTs have been developed to exploit the capital markets' vast potential to spread catastrophic risk via securitisation (which means ways to package risk as securities that insurers and investors can buy and sell on the capital markets) and assisting insurers' ability to finance catastrophe risk. One of the main benefits of ART in comparison to traditional reinsurance is that, under the cover of traditional reinsurance, the insurance company may be saddled with a payout of billions and not have the capacity to cope if the 'once in a lifetime, multi-billion dollar catastrophe' hits. It is often quoted that ART is a 'definition by exclusion' — meaning that it includes anything other than covering conventional risk in the conventional insurance and reinsurance market.
Traditionally, insurers will raise capital from investors who offer coverage to clients whilst hedging excessive potential losses through the purchase of reinsurance. In practice, insurance companies can prudently write policies only to the extent that the companies have access to the capital necessary (via capital and premiums) to finance the risk they assume. An alternative means of increasing capital and spreading risk (rather than increasing investment from traditional sources) is where investors bear some of the risk by purchasing catastrophe or weather instruments (so called Cat Bonds, options, and Cat Swaps) offered through the capital markets.
Structure of Cat Bonds
The Cat Bond is an instrument designed to facilitate the direct transfer of catastrophe risk from corporations, reinsurers and Insurers to investors. The transaction will involve three parties:
- the cedent insurer,
- the investor, and
- a special purpose shell company (i.e. an SPV) that issues the bonds to the investor.
The issuer (the SPV) enters into a reinsurance contract with the cedent Insurer and simultaneously issues Cat Bonds to the investor. The SPV is structured as an independently owned trust that is licensed as a reinsurer in an offshore location, such as the Cayman Islands: Its sole purpose is to transform reinsurance risk into an investment security.
The funds provided by the investor are deposited in a trust account that earns Interest. The bond coupon paid comprises investment earnings on the deposit, as well as the premium that the cedant pays for the insurance coverage. Cat Bonds traditionally yield higher returns, since investors demand a premium to compensate for the investment's lack of liquidity. Some of these bonds are 'principle protected' where the investors can only lose the Interest, whereas others are 'principle at risk' where the return of the principle is linked to a specific catastrophic event, in which case a percentage of the capital, related to the severity of the event, can be lost as well as the Interest.
If there is no qualifying event during the time period specified (generally a 2 to 4 year term), the principal amount is returned to the investor along with the final bond coupon. If, however, a catastrophe takes place, causing losses:
- that surpass a specified amount (trigger);
- in the geographic region; and
- within the time period delineated in the bond,
the issuer of the Cat Bond pays the cedant's claim with the funds from the bondholder's funds, which can include the Investor's interest, a portion of the entire principal or both.
The Cat Bond will generally be tied to a 'Loss Index' (such as, total Insured losses from an earthquake in California) or to a 'Disaster Severity Index' (such as, paying amounts for earthquake damages based on the Richter-scale measurements at specific locations in Japan), rather than to the insurer's actual losses. If the index is Independent of actual losses (see the Severity Index), the insurer cannot manipulate the claims and eliminates any moral hazard issue and the requirement for an audit and adjustment process and claims to Insurers are able to be made immediately after the disaster rather than being subject to a time delay as in the case of reinsurance.
Detailed below is an example of a catastrophe bond payment structure.
How it could work
Logic dictates that the core characteristics of a Cat Bond are that it covers an extreme weather event and that any payment made out following such an event is based on a trigger. In the Australian context, if an agreed Loss Index is agreed upon nationally for drought, the payment mechanism for a Cat Bond could be calibrated so that an SPV could enter into an arrangement with a farmer that triggers a payment to the farmer in the instance of extreme dry weather for a period of 1-4 years where rainfall is below a pre agreed amount (i.e. the Trigger). Professor Garnaut (presentation of the Garnaut climate change review draft report at Paddington Town Hall Sydney on Thursday 10 July 2008) clearly stated that Australia was not a leader in climate change and had, in fact, been dragging the chain and impeding the international movement towards international targets. Professor Garnaut's Supplementary Draft Report 'Targets and Trajectories' released on Friday 6 September also reiterates Australia's criticial need for urgent action on Climate Change. It seems to me that this is an opportunity for Australia to adapt a financial derivative to assists its farmers deal with climate change as well as export its knowledge of this sector internationally.
If you would like further information on the operation of cat bonds please contact Dermot Duncan, Special Counsel, head of the Climate Change and Renewables practice Swaab Attorneys Sydney (firstname.lastname@example.org).
Swaab was recently named winner 'Best Law Firm in Australia (Revenue < $20m)' and 'Attribute Award for Exceptional Service (Australia Wide)' and at the 2008 BRW- Client Choice Awards.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.