Tuesday, August 12, 2014

Are catastrophe bonds worth it?


Earlier this year, the Wall Street Journal had an article on catastrophe bonds.  At the end of the article, they mention that over the lifetime of the market (since 1996) the cumulative total risk is $51 billion.  At Artemis, they estimate the total risk at about $61billion.

The WSJ reports that total losses from natural hazard events is $682 million.  Assuming that some losses came from somewhere else too the total loss over the last 15 years is likely somewhere between $682 and $1B.  The latter is a nice round number so I will use it.

Over the last 10 years, the average yield on catastrophe bonds has been about 8% (dat from same WSJ article).  That is the money paid to investors in the bond.

So, estimated total paid out to investors since 1996 is somewhere around $3B (taking into consideration the $1B loss).

Since 1996, for every dollar an insurer pays the investors to make the risk worthwhile, they have seen a return of about 25 cents (all unadjusted dollars).

Obviously, this seems a good deal for investors.  It is a nice trickle of money from policyholders, to insurers, to the capital markets.  But what are the opportunity costs policyholders?

In recent years, CPIC has offered the largest catastrophe bonds ever.  This year, the bond is $1.5 billion.

With the assumed average 8% yield, if CPIC doesn't end up needing the bond, then it pays investors somewhere around $120 million.  If they do need the bond, they get $1.5 billion.

With at least some possibility that CPIC will exhaust their total claims paying capacity (bonds and all), is there something more productive that can be done with $120 million of policyholder money (aka taxpayers)?

Where resources are limited, such is the case with policyholder pocketbooks, and public policy is to manage risk for the public welfare, policy makers ought to consider if this scenario is an effective use of public funds.

Especially considering that capital markets are fickle- what is relatively cheap and available now can become scant and pricey in a matter of moments.

Would $120 million invested elsewhere have an improved return, reduce the total risk in Florida and thereby contribute to social stability over a longer term?

Perhaps...

Mitigation, infrastructure and education come to mind.  I have no doubt there are innovative ideas that could arise if the question was critically examined.

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