Could cat bonds be used to hedge against oil spill liabilities?

Oil spill liabilities are a hot topic right now due to the environmental catastrophe that is the Deepwater Horizon oil rig. Having spewed millions of gallons of oil into the Gulf of Mexico and now cost BP over $2.5B to attempt to stop and clean up, oil spills of this magnitude are a risk to even the largest companies and need to be hedged against with more than just traditional insurance. The traditional insurance markets struggle to hold the capacity that is really required for these risks. Capital markets and oil spill cat bonds could provide a much better solution.

One catastrophe bond has tried to provide similar liability type cover before. The ill fated Avalon Re deal (which we’ve written about extensively) is still the only cat bond to try to cover non-natural catastrophes. The problems with Avalon Re unfortunately have meant that others are hesitant to issue similar deals.

Some of the concerns could be alleviated were parametric triggers utilised. A cat bond could be issued that covered oil spills above a certain volume, thus removing any ambiguity over when it was triggered and making it more predictable for investors. Oil spill catastrophe bonds would also have to take into account the geographical location of a spill as that has a bearing on the eventual size of loss.

The market has to adapt and innovate if it is to continue to grow, providing cover for a small range of natural disasters is not the way to make a healthy insurance-linked securities market. Broadening the scope of ILS and cat bonds to cover non-natural disasters like oil spills has to occur in the not too distant future.