On catastrophe bonds and their potential wider applications

by Artemis on July 16, 2008

It’s interesting to read discussions about catastrophe bond type structures and their possible application to classes of risks other than natural perils. It regularly crops up in articles about financial risks with academics discussing the possibility of using a cat bond structure.

I found this blog post by Jim Peterson, a U.S. based lawyer, which discusses the use of catastrophe bonds for auditor liability. It makes for an interesting read and while he dismisses the potential I think there could be something in the idea; this type of liability is so huge but has such a low frequency of loss that investors may be tempted to take on the risk.

Interestingly; the UK Council of Mortgage Lenders are proposing a new initiative to help stimulate mortgage take-up under the current economic climate. They want the Bank of England to provide a guarantee for a market in mortgage-backed securities and covered bonds. They hope this guarantee will encourage investors back into that market and thus make funds available for mortgage lending. Now this market has existed for quite a while but actually bears a remarkable similarity to cat bonds and the proposed solution for auditor liability. At the end of the day it is investors who are assuming the liability in return for coupon/interest payments, and the risk therefore gets passed to the capital markets (in this case with the Bank of England acting as an additional backstop).

Perhaps what puts people off when the term catastrophe bond is used is the connotations with disaster. Is it time to come up with a better term for the financial structure that cat bonds use? Your thoughts welcome?

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