With recent hurricanes, tornadoes, and floods inflicting damages that amount to tens of billions of dollars, traditional means of dealing with large-scale risk have proven insufficient. Some businesses must operate in environments where these natural disasters have the potential to create havoc with infrastructure, production, and revenue. Catastrophe securitization is a viable alternative to insurance because it helps spread risk, saves companies from potential financial ruin, and even provides corporations and qualified investors a low risk security with a favorable return on their investment — a winning proposition for all.
Catastrophe securitization has grown to such a degree in recent years that it has caught the attention of Terry College risk management and insurance professors Rob Hoyt and Jim Hilliard and graduate student Bobby Bierley, whose latest research on the subject is contained in their recently completed working paper, "Catastrophe Securitization: A Multi-Factor Event Study on the Corporate Demand for Risk Management."
According to Hoyt, who heads the RMI program, the reason catastrophe bonds are a viable solution to spread risk is that, despite the recent downturn, the equity pool in the financial markets has trillions of dollars of potential capital compared to the estimated $512 billion in the U.S. insurance market. Thus, when catastrophes strike, traditional insurance markets and government-run risk programs cannot deal with the financial consequences.
"The Federal Flood Insurance program currently operates with an estimated deficit between $20-$30 billion dollars," says Hoyt, "and that probably doesn't even reflect the recent damage from Hurricane Ike."
Bierley, who worked in risk management consulting firms for the energy industry prior to enrolling in Terry's risk management program, notes that catastrophe securitization allows companies to acquire a sponsor to set up the bonds and get investors. The proceeds are deposited into a trust account that is 100 percent collateralized and then structured to operate like insurance.
"Instead of going to an insurance company to file a claim, they look over the triggers of the catastrophe bond; if the event triggers the coverage, they can draw from the proceeds they got from investors," says Bierley, who defines triggers as potential events written into the securitization that cause a payoff under the bond. If no triggers occur during the term of the bond, the investors get their principle back plus investment income.
The research idea originated with Hoyt, who recruited Bierley to collect the data and conduct initial analysis as a part of his master's thesis. Hilliard joined the research team shortly after arriving at Terry. He brought added value to the endeavor because, as Hoyt says, "He's an expert in the methodology we needed for our study."
Hilliard believes this research will benefit corporate risk managers everywhere. "This is a way of potentially saving money and also improving shareholder value across the board," he says. "What we're showing is that investors actually do recognize that these are cost savings and, at the same time, risk-reducing instruments. It's more than just an academic enterprise."
Hoyt has already presented the results of their research to a major insurance company that is debating whether to engage in more securitization.
"I think our message is that this is a market that has positives if you are on the issuer side and on the investment side," says Hoyt. "A number of companies are dealing with this question right now, and there is a lot of governmental debate about whether the federal government should be involved in natural catastrophe risk programs. This research provides additional information to the debate — information that the market sees this as a positive alternative and that the private market has a chance to come up with solutions."