Cat Bonds and RMBS: Safer

By John Macomber

Our class on property/casualty insurance and catastrophe bonds ended with several passionate comments about how Catastrophe Bonds are just like Mortgage Backed Securities. On a philosophical level they might both be financial instruments that lead to mischief and trading abuses; but in structure they are quite different. The key aspects should be understood.

Mortgages

The plain vanilla residential mortgage has been a bedrock piece of American home ownership for decades. As depicted in the James Stewart film “It’s a Wonderful Life,” a homeowner borrows from a bank to purchase a home. The homeowner has the means to pay debt service (classically about 1/3 of annual income) and the mortgage is written for about 80% of the value of the home. The bank holds the mortgage on its balance sheet. This system is sleepy and not very risky since there is plenty of debt service coverage and collateral and both the borrower and the lender care about what happens; they have skin in the game.

Residential Mortgage Backed Securities

In their initial iteration, residential mortgage backed securities were created by syndicators who purchased the loans from the banks and grouped them into bonds backed by the cash flow and collateral of the mortgages. They were sold as fixed income investments to cautious investors. The banks originated more loans. This was good for home ownership. So far, so good.

The abuses then came from many sources, including borrowers who could not cover the debt service, borrowers and banks who agreed to excessive loan to value ratios, parties who entered into contracts with onerous adjustable rates, and the packaging of all of these bad loans into bundles which were sliced and diced into very risky securities – but which were rated as investment grade. Swaps and other derivatives were created on top of all of this. This is the phase that basically led to or stoked the financial crisis of 2007-2010.

Catastrophe Bonds and Weather Linked Securities

Catastrophe bonds in their plain vanilla iteration are safer than plain residential mortgages. The Swiss Re case might not have been totally clear, but here is what happens: 1) An issuer (like Travelers) sponsors an event-linked special purpose vehicle to hold the bond. 2) an investor (maybe a fund) puts up the principal, say $10mm, and it’s held in escrow by the SPV. 3) Travelers pays interest to the SPV which in turn pays interest to the investor (the fund).

4A). If no covered event occurs during the term of the bond, the SPV returns the principal to the investor. The investor has earned interest and gotten its principal back. Travelers or other issuer has paid an interest-like fee to get coverage.

4B) If an event does occur, then the SPV turns the funds over to the issuer. An insurance issuer like Travelers can use the proceeds to pay insured property/casualty losses. The investor loses the principal. (An investor is likely to have a very diversified portfolio of event linked bonds, to spread the risk around. The trigger can be an explicit event triggering the payment of the whole amount, like a greater than 6.0 earthquake in a certain geography, or can be tapered around some measurement of actual losses, as discussed in the Swiss Re case).

It might be possible in theory to bundle together multiple cat bond investments and securitize the cash flow like residential mortgage backed securities. Depending on your faith in human nature or skepticism about finance types, there might then be a chance for mischief and misrepresentations but this is far from the situation in cat bonds today.

Safety

Catastrophe bonds in this format are substantially safer than both residential mortgages and traditional insurance because the cash is put up by the investor and kept in escrow. If there is a claim, the money is there. This means (assuming competence and good intent by all parties):

No default risk

No counterparty risk

No debt service coverage risk

No interest rate risk

No risk of failure of the insurance company (writing a regular property casualty policy). Properly used, catastrophe bonds can make insurance companies safer businesses and also draw more capital into the insurance equation.

There is still a question of whether it’s moral to bet on someone else’s catastrophe. But these weather and event linked derivatives are not like mortgage backed securities at the level of the contract.

Resilience, Reinforcement and Managed Retreat

With respect to climate adaptation, the interesting thing to me is how insurance underwriting can encourage resilience in structures and publicize risk-awareness in locations. This can be a very effective way to build resilient coastal cities – rather than rebuild them over and over again after the fact with federal funds. The climate related “edge” or ability for good cat bond investors to create alpha is a nuance in the bigger picture.

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About macomberjohnd

HBS Finance faculty interested in sustainability in the built environment including devices, structures, townships, and cities.

2 Responses to “Cat Bonds and RMBS: Safer”

  1. My understanding of cat bonds is that they involve the transfer of high risk (that is ordinarily “unpalatable”) from insurers to investors. The blog very aptly describes how the arrangement works. Whereas this escrow arrangement appears ironclad, there is still, in my opinion, reason to be concerned:

    First, as cat bonds grow in popularity with the promise of stellar returns, so also the pressure on some entities to pass bonds that have not gone through proper due diligence as investment grade to meet demand.

    Second, in view of the growth mentioned in the first point, the “competence and good intent by all parties” can no longer be assumed. This implies additional costs associated with vetting individuals and processes to preserve the integrity of the process. The SPVs have to be above reproach.

    Third, there are mixed signals out there. Some highly respected investors like Warren Buffett are sounding the alarm and avoiding high risk areas and not compromising on premiums. The proponents of cat bonds argue that even headline grabbing events like hurricane Sandy did not trigger any losses of note. (http://www.bloomberg.com/news/2014-06-17/buffett-warning-unheeded-as-catastrophe-bond-sales-climb.html).

    Fourth, the Travelers insurance case stresses the effects that climate change is having on the insurance industry; “in recent years, changing climate conditions have added to the unpredictability, frequency and severity of natural disasters.” This unpredictable behavior of natural disasters is a kin to both parties playing Russian roulette. Take a scenario where say, a fund that has 90% of its holdings in cat bonds and an insurance company that charges lower premiums because they have hedged themselves with the bonds. A big event occurs that cannot be covered by the combined resources of the cat bonds and insurance; both go under! I concede that this argument may be a bit extreme, but it is not outside the realm of possibility.

    From a designer’s point of view, the foundation laid by the blog appears to be sound. It is how the super-structure is constructed that concerns me.

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