By Rishit Jain
In the field of finance, creativity is driven by the incentive of monetary gain. This leads to the development of many interesting financial instruments, an example of the same being the catastrophe bond, also known as the cat bond for short.
What exactly is a cat bond?
Catastrophe bonds are high-yielding bonds, or in other words bonds that provide investors with a high rate of interest. The essence of the catastrophe bond is that in the event of a calamity that causes destruction beyond the control of the harmed individuals, the issuer of the bond is forgiven all pending interest and even the initial principal payment.
This ingenious model allows builders protection from natural disasters by providing them with a mechanism through which they can be forgiven large amounts of debt. At the same time, risk-taking investors can hope to maximise off such opportunities through the high yield associated with the high risk of having to forgo the interest.
It is important to note that investors of this bond essentially bet against climate change. They believe there is little to no added risk to their investment as time passes by, which is why these long-term investments provide the same interest to investors across time too. Finance, in this context, has become a bookmaker for the rich willing to bet against nature.
Desi cat bonds
An interesting proposition would be to contemplate how the implementation of cat bonds would affect a nation like India.
One of the greatest benefits of the cat bond is that it can help amalgamate insurance and public funding of projects, eliminating one of the gravest and most unavoidable dangers to any realty project: natural calamity. The reduction of risk can allow a resultant boom in investments in infrastructure in regions that are avoided due to natural disadvantages such as susceptibility to damage from the natural disaster. According to the Wall Street Journal, India has the largest number of people exposed to natural hazards. One can only imagine the resultant loss of infrastructural investments due to the fear of such a statistic.
In a nation that witnesses strife in the form of economic disparity and concomitant division, infrastructure acts as another divisor between regions across the nation. Cat bonds can work to dissolve this boundary by reducing the risks associated with natural disasters, by insuring builders against these losses. According to the National Disaster Management Authority of India, the damage to property alone in these years (2015 and 2016) has been $4.4 billion.
Another issue that could be dealt with is the loss to the economy caused due to delays in infrastructure projects. As on November 2017, the cost over-run for delayed projects was an outstanding Rs 1.45 lakh crores. This is not necessarily to correlate all delays to natural disasters, but point out how large a problem infrastructural delays already are and how any factors that can exacerbate the same ought to be prioritized.
Therefore, with reduced risk to builders, infrastructural investment inflows insured by the structure of a cat bond could allow for rapid development of realty in under-developed states across the nation.
Additionally, India is also in a very poor phase in terms of activity in realty markets. New project launches, had between 2016 and 2017 as a result of this inactivity, decreased by 41% as sales dropped by 7%, with hundreds of thousands of unsold properties. Thus, it would be naïve to assume that cat bonds would stimulate much supply-side developments until demand for realty has been stabilized, but cat bonds are still a very useful instrument that presents many merits.
Rise of cat bonds
Despite being such a strange instrument capable of forgiving an entire bonds worth of repayments, in the midst of hurricanes and earthquakes globally, the market for cat bonds has increased immensely.
From around $10 billion outstanding cat bonds in 2011, markets have tripled that amount to $30 billion as of September 2018. This 200% rise in the size of a market when its already in the billions is a great feat, which is despite the prevalence of Hurricane Harvey, Irma and Maria, through the US with further earthquakes in Mexico and wildfires in Canada. In fact, even the World Bank initiated a $1 billion Pacific Alliance cat bond covering Chile, Peru, Mexico and Colombia.
Apart from the effective underlying mechanism through which the bond functions, another selling point for cat bonds is that it has little to do with economic oscillations of growth and development, making it a strong contender for investors looking to diversify their holdings.
While India has shown its acceptance to new creative models in finance such as through the introduction of Blackstones recent REIT, one can only wait and watch if cat bonds become a part of the future too. For a nation so prone to natural disaster, such cat bonds are not only pertinent for those who need investment but also a great opportunity for those who want to invest.
Rishit Jain is an analyst at Qrius