Advantages and Disadvantages of Catastrophe bonds

Merits of Cat Bonds

1. One of the attractive features of Cat Bonds that they operate independent of financial market variables and constraints and have no correlation with stock market.

2. Cat Bonds allows the investors to diversify their portfolio by investing in these insurance link securities.

3. Cat bonds huge rating agencies Standard & Poor’s, Moody’s and Fitch therefore; it has minimum exposure to credit risk.

4. Cat bonds minimize agency costs as compared equity capital, since the capital raised from issuing the cat bonds are held in trust and couldn’t be utilized by insurer until and unless a specified catastrophe occurs.

5. Cat bonds are subject to lower tax costs in contrast to equity capital, because overall debt financing has a tax benefits as compared to equity financing. The SPV are registered in offshore locations such as Bermuda or Cayman Islands and their services are mainly used for regulatory capital, legal and tax purpose reasons.

6. The catastrophe bond structure is designed in such a way that it lowers the chances financial losses, because the dependent payments are based on the incident of a catastrophe In contrast, debt financing usually comprises greater financial losses due to its volatile nature.

7. It has low or zero association with other existing traded assets in the financial market. Thus Cat bond is a favorable instrument for portfolio improvement and diversification. Furthermore, cat bonds have high return and low risk characteristics, especially for those giant investors they are designed which include but not limited to hedge funds, mutual funds, pension funds and reinsurers.

8. Yield on Cat bonds are less volatile in contrast to either stocks or bonds traded in financial market.

Demerits of Cat Bonds

[large]1. The size of Cat Bonds market is smaller as compared to traditional reinsurance market.

2. Pricing of Cat Bonds could be frequently fluctuate, because of increase or decrease in demand.

3. Cat Bonds are only available for in-house investors.

4. Cat Bonds liquidity is low relatively to Money market instruments.

5. In case a catastrophe occurs, an investor is at high risk of losing his entire principal.

6. Prices, rating and yields of cat bonds rely on complex computer simulations that are highly sensitive to the data applied in the models, the quality and quantity of which vary depending on the catastrophe. For example, there is more data available on earthquakes than on epidemics, which can be based only on the Spanish flu epidemic of 1918 in terms of real data. Nevertheless, before making the decision to buy these bonds, an investor should approach the fund manager’s expertise and other mandatory resources.

7. Cat bond issuers commonly enter into swap agreements with third parties that guarantee interest and principal payments to investors, as long as the triggering event does not occur. If the third party suffers financial distress, for example, and is unable to back these payments, investors won’t get the yield and principal promised.