Financial markets are showing some signs of volatility these days after exceptionally low indicators since the start of the 2017. The Chicago Board Options Exchange Volatility Index, or VIX, is at its highest level this year. The VVIX Index, which measures the volatility of volatility, is higher than it has been since August 2015.
Rising volatility does not mean catastrophe is imminent. There is one asset class, however, that takes a literally catastrophic view on the future, and it is booming: catastrophe bonds. Last week, the World Bank issued its largest-ever cat bond, offering as much as $360 million in payouts to Mexico in the event of tropical cyclones and earthquakes.
Catastrophe bonds are akin to insurance contracts. In a recent interview with Bloomberg Radio, Daniel Stander of Risk Management Solutions described a cat bond neatly: “a risk-linked security which transfers a specific set of risks from the issuer to the investor. The investor obviously takes on the risk of a specified event occurring in return for a rate of return. Should the qualifying event occur, then obviously the investors lose their principal that they’ve invested, and the issuer would receive that money to cover their anticipated losses.”
What events can form the basis for a cat bond? Stander again: “anything that you can measure which can act as a reliable proxy for a loss can be turned into a securitized bond.”
Cat bond issuance is at an all-time high: more than $10 billion in 2017.
Total cat bond risk capital outstanding is also at an all-time high of nearly $30 billion.
And as an asset class, cat bonds don’t perform badly! The Swiss Re Cat Bond Total Return Index has outperformed the basic benchmarks for equities, bonds and private equity. Look closely, and you can see that even major events such as the Great East Japan earthquake in March 2011 and Hurricane Sandy in October 2012 register only as blips in an upward trend.
It’s not the volume or the total return on cat bonds as an asset class that I find most interesting, though. Rather, one characteristic and one new transaction allow us to imagine a different future of paying for and settling risks.
The important characteristic of cat bonds is that they can be parametric: An event within the parameters of the bond triggers a payout, rather than the results of that event initiating a process of insurance settlement. A cat bond on a Category 5 hurricane hitting Tampa, Florida, from Aug. 1 to Nov. 1 will pay out if a hurricane that strong hits that location during that period of time. Unlike an insurance contract for an asset, a parametric bond does not require a claims or investigation process before settlement … but it does still require settlement.
That’s where the new transaction – and the blockchain – come in. Last week saw the first-ever use of blockchain as the settlement mechanism in a cat bond. It is a neat and efficient use of blockchain’s distributed ledger capabilities (which allow settlement without an intermediary) and the parametric aspect of a cat bond (which triggers settlement without any claim). Settlement – should it happen – could take just seconds, and it would be transparent between parties.
There’s a final, and slightly scary, thought about blockchain settlement for cat bonds. We can think of blockchain settlement almost as a hedge against insurers themselves. In the event of a catastrophe so great that it disables even insurance settlement systems, the distributed ledger should still function without human engagement. Catastrophe bonds lay off the risks on assets; the blockchain lays off the risk on settlement.
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