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Financing Natural Disaster Risk Using Charity Contributions and Ex Ante Index Insurance - page 9 / 15

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Incorporating CAT bonds into a relief system could overcome some of the problems associated with free disaster aid. The decision to provide international disaster aid is most often made ad hoc without any conditions or criteria for proper use and equitable distribution of resources. Without planning, corruption and politics can negatively influence the flow of disaster aid (Skees, et al., 2002). Transferring the risk to capital markets would theoretically relieve international aid organizations of some of their fundraising obligations, allowing more time and resources to be spent on their primary concern—disaster relief (Freeman, et al., 2002). However, the cooperation (and endorsement) of international relief organizations and participating governments may be essential to the effectiveness of this concept.

The advantage of CAT bonds over traditional reinsurance lies in lower transaction costs and the absence of default (credit) risk. Nell and Richter suggest that, in theory, CAT bonds should be less expensive than purchasing reinsurance. They conclude that the high premiums for reinsurance reflect the risk aversion of the reinsurer, as witnessed by higher premiums charged for higher levels of loss. At the moment, however, premiums on commercial CAT bonds are quite high, generating returns of 4-8% above LIBOR1.

Bantwal and Kunreuther (1999) examined the reasons behind high premiums on CAT bonds. They determined that in terms of Sharpe ratios2 CAT bonds are more favorable than bonds of comparable risk. In fact, they suggest that an investor would be highly risk averse to not invest in CAT bonds. However, the justification for high rates for catastrophe reinsurance equally justifies the high yields on catastrophe bonds. The uncertainty surrounding the probability and magnitude of loss creates a demand for large returns on bond investments. Bantwal and Kunreuther also point to myopic loss aversion on behalf of investors as a factor restricting market size. The notion of sudden and total loss of principal, even at very low odds may limit investor interest in catastrophe-linked securities. Additionally, the cost of education to investors for researching and understanding new catastrophe-linked securities may be large. Standardization of these products over time should help reduce this constraint.

Technological improvements have allowed researchers to develop improved weather models which can help to assess the risk exposure of specific locations regarding specific natural events. Construction of these models will be limited by the availability of historical and reliable country weather data. Still, it is expected that as disaster loss models become more accurate and as experience with CAT bonds grows, premium rates will decline and demand for these products will grow. Development of new bond structures that limit risk exposure, such as a pooled portfolio of global CAT risks, will also further the market interest in these instruments.

Methodology & Results

A Monte Carlo simulation was used to illustrate the structure of a charity catastrophe bond representing coverage of both a single event and a portfolio of potential events. Random numbers between 0 and 1 were generated in a matrix representing 1000 possible outcomes for independent geographic regions for a single year. A value less than or equal to 0.01 was used to represent occurrence of a 1-in-a-100-year event, triggering a payment of 100% of principal. For a CAT bond covering a single region/event, the expected return is calculated by weighing the probability of no triggering event, p0, against the probability of a triggering event, p1, where Pt is

1 The London InterBank Offered Rate, the lending rate between banks, is a common benchmark for short-term interest rates. As of September 3, 2002 the 12 month rate was USD 1.89, down from 3.56 in August Sharpe ratio=return over the risk-free rate/standard deviation of returns 2

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