141) Cat bonds: Investors as insurers

Cat bonds seek to transfer some or all of the insurance risks to the capital market, especially to the segment that hungers for greater rewards. This innovative product has not made its mark in India.

The redoubtable insurance major Allianz has pioneered an insurance product that saves its own skin as well as those of its ilk — catastrophe bonds or cat bonds.

Investors in these bonds are offered the attraction of higher returns with the quid pro quo being that they have to shoulder losses in the form of sacrifice of principal or interest or both, in the event of a catastrophe savaging a given locale.

The product, to be sure, is not for the faint-hearted. Nor is it for those who are not well-heeled. It is meant for high net worth individuals (HNIs), hedge funds and others with appetite and capacity for risks.

A cat bond has the trappings of a junk bond — it entices investors with higher rates of interest — but differs otherwise. While a junk bond is issued by a company condemned to a low credit rating, cat bonds are essentially meant to help insurers.

While a junk bond is a source of capital to bankroll a project or acquisition, cat bonds seek to transfer some or all of the insurance risks to the capital market, especially to the segment that hungers for greater rewards.

This innovative product has not made its mark in India. One wonders whether our regulations permit its issuance.
One also wonders whether our insurance companies would be enamoured of it given the fact that nature has been rather kind to India (except perhaps Assam which is annually ravaged by floods) unlike Indonesia, for example, which is routinely ravaged by earthquakes of high intensity bringing death and destruction.

An insurance company operating in Indonesia may lap up this financial product as a godsend.

But it may be forced to give it up at the end of the day, as investors may expect huge rewards as compensation for shouldering such great risks — the probability of occurrence of which is very high.

To be sure, even those having a penchant for risks will not touch such a bond with a bargepole when the prospect of a natural calamity striking within a prescribed time span is high. Bonds for Delhi?

The point is that in such a situation, the product will not take off. It would appeal to both the insurers and investors only when both of them stand a reasonable chance to gain. Delhi, for example, has never been hit by a quake of very great intensity even though seismologists of late have been warning that Delhi is in the high-risk seismological zone. Based on its comforting history, investors might be tempted to lap up a high income yielding cat bond.

In addition, the insurer catering to the Delhi region may successfully palm off his risks at no great cost to him. Should a catastrophe strike within the agreed time span in the region, he would save his skin because the higher interest he pays would be a fraction of what he would have to fork out as insurance compensation, which now would be borne effectively by the investors.

Should however, such a catastrophe not strike, he would have only to regret the higher interest paid to the investors who would of course laugh all their way to the bank.Ethical issues

There is an ethical issue involved in the context of cat bonds that need to be addressed by our regulators if and when they decide to permit our investors to indulge in such brinkmanship.

A contract of insurance is marked by and founded on the implicit “utmost good faith” clause — lack of utmost good faith on either side can mar it; the other side can cry off when it is revealed that the contract was entered into in bad faith.

If the insured is supposed to disclose all the risks to the insurer, it follows that the investors who effectively step into the shoes of the insurer too should be acquainted with the same risk factors.

Recently, the Supreme Court cavilled at the tendency of certain judicial forums to outsource certain work as that amounted to abdication of their responsibilities.

One wonders whether it would give its thumbs down to cat bonds for the same reason — abdication of responsibilities by the insurer.

S. Murlidharan

(The author is a Delhi-based chartered accountant.)