In the current economic climate would political risk catastrophe bonds be viable?

by Artemis on June 19, 2012

The world’s financial markets seem to be in a continual state of uncertainty and flux thanks largely to the economic crisis in the Eurozone led by fears about Greece, Spain and Italy, concerns about debt in the U.S., a possible slowing economy in China, the spectre of a slowing Japanese economy and the threat of pretty much any other nation falling prey to the current economic gloom and uncertainty. So it’s no surprise to read in the news that companies are seeking out sources of insurance cover to protect them against the crisis.

The problem for those companies is that it’s particularly hard to acquire insurance against the risk of a Greek exit from the Euro, for example. Or try insuring your multi-national company against the total collapse of the Euro currency, it will be harder and much more expensive than you think.

Naturally the reason for the lack of options to hedge against economic disaster or financial collapse is because the risk of that happening has risen and so insurers stop offering cover, partially because they cannot reinsure themselves at sufficient levels to keep the sale of insurance viable.

Reuters covered the lack of political risk cover for Greek issues here and explain that a Greek exit from the Euro falls into a grey area of insurance cover, somewhere between political risk and trade-credit insurance. The unusual nature of the current economic situation has left insurers without a clear definition as to what cover they could offer and they certainly won’t have the limits available just on the off-chance a European nations economy imploded.

The Reuters article also discusses the fact that many political risk policies only cover the ‘known’ or ‘potential’ events that were expected at the time the policy was underwritten. So for an exceptional event, which even five years ago may not have been thought possible, such as an exit from the Euro there may not be a case to claim on the political risk policy anyway.

This lack of available insurance options led us to thinking whether the experience of the current financial, economic and in some ways political crisis will increase the need and demand for covers against just these types of events. It’s likely that demand will increase but if insurers cannot supply it, partially due to an inability to reinsure themselves then could the capital markets be the best place to turn for capacity?

It would seem sensible to suggest that the capital markets may be the only source of capacity large enough to cover insurers against this type of peak risk, thus enabling them to sell insurance to companies who stand to lose should the worst happen. Catastrophe bonds are the type of instrument which could provide significant quantities of reinsurance capacity from the capital markets for just this type of risk. In a similar way to contingent bonds, which we understand are often discussed in relation to the financial crisis as they could provide a binary hedge against a sovereign default, catastrophe bonds could provide the kind of cover which could help insurers begin to take on political risks for these countries on the brink again.

It seems feasible for an insurer to issue an indemnity catastrophe bond which would have an attachment point set at a level where their ultimate net loss from political, or indeed economic, risks in Greece reached a certain point. Perhaps a political risk catastrophe bond could even work as a much more simple structure such as should a country exit the Euro then the political risk cat bond pays out in its entirety. It would also be possible to link a cat bonds payout factors to various indices or metrics which would denote a worsening of the situation in Greece and have a sliding scale of loss as those economic factors worsened (sort of like a parametric index cat bond). The options seem endless…

Of course, the one problem behind this would be the investors appetites to buy these political risk or economic catastrophe bonds. Would they be willing to assume risk based on a sovereign default? What level of coupon payment would they expect to be paid in return for taking on these risks?

One things for certain, cat bonds or insurance-linked securities linked to the economic and political climate would offer a very nice diversification for dedicated cat bond investors, but wouldn’t offer the same diversification for capital market investors that natural catastrophe risks do. There would be a much greater level of correlation between a political or economic catastrophe bond and equities for example. However they could also offer some investors a hedge against risks on the other side of the equation or in other countries.

We don’t have any answers on this topic but would be very interested to hear any thoughts you have in the comments below. One final thought for you on this topic, perhaps the European Central Bank (ECB) should be the issuer of catastrophe bonds for each of the threatened economies, these would provide a new source of bailout should the trigger conditions be met.

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