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Corporate Jun 29, 2013

Uttarakhand flood losses: Why we need catastrophe bonds

By S Murlidharan

The Americans have a pat solution, bordering on panacea, for almost all problems: insurance. Obamacare, the universal medical access scheme, is rooted in health insurance for all citizens, with the rich subsidising the poor. There is credit default insurance to guard against the possibility of bond issuers reneging on their promise to pay coupons or redeeming the bonds on maturity.

The formidable AIG was brought to its knees and had to be bailed out with state funds when it mindlessly underwrote even junk bonds backed by mortgages that turned sour. The insurers, however, found the losses emanating from nature's fury too much to bear, especially in the aftermath of Hurricane Andrew in the nineties. Hence they thought of a devious game-plan - divert some of the insurance risks to the market.

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The tragedy in Uttarakhand underlines the need for insurance. High-coupon catastrophe bonds, which transfer risks from insurers to the super-rich, would be one answer. Reuters

The tragedy in Uttarakhand underlines the need for insurance. High-coupon catastrophe bonds, which transfer risks from insurers to the super-rich, would be one answer. Reuters

The result was another form of bond made available to the investors - catastrophe bonds, which prey on the greed of investors hungering for higher returns. To wit, an insurance company might have insured large properties in Uttarakhand sitting bang on the high seismic zone and prone to flood ravages. The premium, of course, would be high but should a disaster strike, it would prove to be woefully inadequate. Even reinsurance would not be able to lessen the debilitating impact on the insurer's profit and loss account.

Had an insurer issued catastrophe bonds, however, it could have possibly insulated itself against such crippling losses by transferring them to the market. Let us say the bonds are offered for five years, each with a face value of Rs 10,000 and carrying an attractive coupon rate of 15 percent per annum, subject to a rider: in case a specified catastrophe, narrowly defined, breaks out, the bond holders would lose their shirts. Not only would they not be paid any further interest from then on but, more gallingly for them, they would lose the principal as well.

The amount thus saved, by not redeeming the bonds, would be used to meet the insurance obligations. Effectively the bond holders pick up the tabs that were to be picked up by the insurers.

In the USA, the size of the catastrophe bonds issued has been steadily growing with the annual issue size now hovering around US $4 billion or so. In India, no attempt, it seems, has been made to tap this market. Bonds have always held very little interest for investors in India, unlike in the US, where investors make sure to have a healthy mix between equity and debt instruments like bonds.

Perhaps the equity cult was oversold in the nineties, so much so that the garden variety investor mistook investments only for equity. It is another matter that now he has lost interest in equity as well, following the bombing of several public issues on the bourses. Be that as it may, the point is policy wonks must seriously debate how catastrophe bonds can be popularized, especially among high net worth individuals and others having deep enough pockets.

The minutiae can always be worked out, with tax breaks acting as an additional sweetener. The tax sop could include allowing losses from the bonds on account of their non-redemption in the wake of a catastrophe to be written off against other sources of income. There could also be a generous eight-year carry-forward benefit in case the current year's income proves inadequate to absorb the whole impact of the loss. The resultant revenue loss to the exchequer would be for a worthy cause.

Will there be any takers for such bonds in India? Well, the foreign portfolio investors can be counted on to succumb to the temptation of mind-boggling interest rates, unheard of back home. With satellites zooming down on terra firma, weather forecasting has been registering a steady improvement over the years but earthquake and other natural calamities still defy precise prediction, especially on a long-term basis. In the event, investors in catastrophe bonds would be taking a calculated risk, with their fortunes in the hands of providence largely.

As far as insurance companies are concerned, they would look for heightened premiums in order to take higher interest rates in their stride in case the narrowly defined catastrophe did not break out during the tenure of the bond. The insured should not mind this because insurance against nature's fury comes with a high price tag.

Catastrophe bonds have been castigated by critics as a cynical, almost sadistic, product that passes the buck to the market. But to socialists, it should look like poetic justice - the pampered bourgeois elite would be unwittingly doing a social service by subscribing to such bonds whose proceeds ultimately help mitigate risks for society. The moot question is if investors would invest in bonds whose epicentre is Uttarakhand - or any of the cyclone-prone regions of eastern India. Probably they might pitch in if the epicentre were Delhi, less prone to natural disasters relatively speaking.

But it's worth a try.

The author is a chartered accountant


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