Create a market for catastrophe bonds

The rising incidence of extreme weather events nationally — severe cyclones have wrought havoc on both west and east coasts this May — calls for an institutional mechanism to finance the rebuilding and rehabilitation after a disaster, beyond the disaster management funds financed by the exchequer.

The way forward is to design an innovative market for catastrophe bonds by securitising calamity risks and duly dispersing them among savvy long-term investors. As climate change proceeds apace, the need will only grow. Typically, catastrophe bonds, or cat bonds, are sponsored by reinsurance companies.

The proceeds are kept in an escrow account and reinvested in low-risk products, and transferred to the insurance company that faces a large payout on account of a catastrophe, against which it has sold insurance and bought reinsurance. Cat bonds are designed to offer relatively high coupon rates, have limited maturity periods of 3-4 years, and stipulate that interest and principal might be forgiven wholly or in part, in the event of occurrence of the calamity that has been insured against. Why would anyone want to invest in such bonds? For one, such bonds would not be correlated with the business cycle.

For another, these offer attractive yields, and so can well be lapped up by long-term investors with the requisite risk appetite. A portfolio of cat bonds would make ample diversification sense. Pension funds, hedge funds, insurance companies and other large pools of capital in need of diversified deployment can not just afford but positively gain from cat bonds. In this fashion, the risk of calamities and the cost of financing the response can be borne by society at large. This is what happens when the government bears the expense from tax proceeds.

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Cat bonds use a market mechanism for risk transfer, that is all. And, they are a direct, transparent way of financing disaster relief, minus the difficulties the government has in collecting taxes, provided care is taken to prevent possible mis-selling of these instruments to retail investors.


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