CATASTROPHE BONDS – Fortune From The Disaster

Catastrophe Bonds simply were known as the “Cat Bonds” is a financial instrument where the issuer issues bonds for re-insurance against the natural disaster or a catastrophe. The insurance company issues bonds as collateral against the catastrophe insurance. Cat bonds have a high yielding feature with a duration of 2 years to 5 years. Cat bonds transfer the risk of insurance into the capital market.

History for development of cat bonds can be traced back in the 1990s when the claims filed by clients against hurricane Andrew couldn’t be acknowledged and the insurance industry suffered humongous losses. Many insurance companies that earlier provided catastrophe risks decided to leave the insurance sector and about eleven insurance companies filed for bankruptcy. Therefore, there was a need to cover the capital by catastrophe insurance-linked bonds.

Working of the CAT Bond:

As this bond transfers the risk from insurance company to the financial markets. The amount which is pooled out from the investors is transferred to the Special Purpose Vehicle (SPV). There is a reinsurance agreement between the SPV and the insurance company which dictates the terminology and clauses for the amount to be paid during the catastrophe. The SPV invests it into the capital market and to manage the security. The returns from the financial market are further passed to investors of cat bonds. They are mostly invested in money market instruments with low risk. They are high yield debt instruments. These SPVs fulfill the claims of the risk carrier i.e. insurance company if any catastrophe occurs or as the terms of an agreement are fulfilled.

For instance, a family living in Florida where hurricanes are most likely to happen they approach for Hurricane insurance from the General Insurance Company. The insurance company will provide such insurance since they get good premiums but still hang back because if the hurricane occurs they will have to pay a huge amount as indemnity. The solution to the problem is by issuing cat bonds they won’t incur huge losses. If the event is not triggered at the maturity then the collateral account by SPV will be liquidated and the proceeds will be returned to the investor. But if the event triggers then the collateral is liquidated where some or all the proceeds are passed on to the sponsor.

Figure 1: Process of CAT Bonds
Source

Investor’s Perpective:

A cat bond is a lookalike corporate bond with a pre-determined coupon rate. These bonds are not related in any way to the global markets. A financial crisis has nothing to do with the trigger of a natural disaster or catastrophe. They are built on floating rates notes where the investor benefits the return not only from the risk premium of the cat bond sponsor but also the returns from the money market where the pooled amount is invested. Since these bonds are not linked with capital markets, investors view such bonds to diversify their portfolios to minimize the risk related to markets. Over the years the cat bonds have shown great growth and seemed to be a lucrative investment option. Performance of cat bonds Index, Insurance-Linked Securities-Hedge Fund (ILS-HF), Equities and Bonds Index is shown below. Figure 2 to Figure 4 shows why cat bonds are considered to diversify their portfolio and have been alluring over the years.

Figure 2: Performance of Cat Bond Index versus other Financial Instruments Index
Source


 

CAT BOND

ILS HF

EQUITIES***

BONDS****

INDEX*

INDEX**


 


 

Total Return

166.4%

89.9%

124.3%

55.9%

Volatility

3%

3%

15%

5%

Annualized return

7.9%

5.1%

6.50%

3.5%

Sharpe Ratio

2.39

1.69

0.45

0.69

Figure 3: Comparing Returns and Volatility ( Source )


 

CAT BOND

ILS HF

EQUITIES***

BONDS****

INDEX*

INDEX**

Cat Bond Index*

1


 


 


 

ILS HF Index**

0.87

1


 


 

Equities***

0.18

0.1

1


 

Bonds****

0.17

0.14

0.39

1

Figure 4: Correlations ( Source )

Benefit for the Economy:

It is next to impossible to bear the shock of catastrophe alone by the insurance companies. The financial markets are stronger and capable to bear the economic effect of the catastrophe. So, to benefit the quantum of financial markets for the effect of catastrophe, was when the establishment of catastrophe bonds came into existence after Hurricane Andrew 1992.

The use of cat bonds is mainly to protect and manage risk associated with the disaster. The development of cat bonds is growing rapidly over the years for developing economies as well. Countries and regions in the risk-prone areas are many a time not insured or is backed by government funding for the upliftment of the economy.

This new insurance-linked product has led the World Bank providing a framework for the same known as the “MultiCat Program”. This has given aid to Mexico’s Caribbean islands to issue cat bonds by structuring themselves using the framework provided by the World Bank. The intrinsic value of these bonds is to provide for the recovery of the loss incurred and transfer the risk to those willing to take the risk. Financial investors have turned around to this investment option as an asset class with higher returns and low or no correlation with the financial markets. But today cat bonds are proving themselves as a social-driven investment instrument and new breed for this cat bonds are coming are known as the pandemic bonds which will help to combat the life-threatening diseases.

Indian Scenario about Cat Bonds:

When the world is booming and progressing on different financial products India cannot step back but indeed tries to be in the race. Yes, it is trying to come up with the debutant of its cat bonds in the Indian Economy. General Insurance Corporation of India (GIC), is the country’s foremost reinsurer that has come upon the thought of issuing cat bonds on the wakeup call of the Uttarakhand floods in 2012. GIC had to pay approx. 2000 crores of claims settlement from their treasure chest. E.g. If GIC issued cat bonds worth 1000 crores in 2011 with the maturity of three to five years, on triggering of the event they would have to shed only 1000 crores.

India being a developing economy, many parts of the country are risk-prone areas like aforesaid floods, cyclones, landslides and very rare symptoms of earthquakes in the regions of Rajasthan, etc. Let’s assume India agrees to pay at 12% – 14% coupon on cat bonds in India, it would likely get the subscription of Pension Funds, Hedge funds or high net worth individuals since they are attracted to benefiting from high-interest yields over the short tenure of the bonds. The government should try and come out with such bonds and mitigate the losses for its own.

Thus, Catastrophe Bonds a savior to the economy by passing on the risk to the risk bearing financial investors.

Author
Lorretta Gonsalves
Team Member- Alternate Investments (M.Sc. Finance, NMIMS – Mumbai. Batch 2019-21)

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Is RLLR the long lost saviour?

Before we get into the topic lets know what repo rate is. It is the rate at which the central bank of a country (RBI) lends money to the commercial banks in event of any shortfall of funds.

Now people are excited about the new repo linked lending rate (RLLR) which has come into the market but let’s just roll back a few months back to December 2018. RBI in its fifth bi-monthly monetary policy review on December 5th made a big announcement (by N.S. Vishwanathan – Deputy Governor) that many bank customers were waiting for and that retailed loans will be linked to external benchmarks instead of various internal benchmarks produced by banks.RBI had instructed the banks to start the process the linking the new repo rates from 1st April 2019.

By adopting a single benchmark, the home loans for example which are linked to the marginal cost of funds will now be linked to the repo rates. This makes the banks bound to revise the rates of the home loans instantly as and when there is a change in the RBI repo rate. These changes are welcomed by the customers because it has been long sought out as RBI reduced the repo rates to control the inflation but the benefit never reaches the consumers but now because of this, the consumers will get the benefit of at least some lower interest rate to be paid. The benefit of Repo-rate linked home loan scheme is that it is transparent compared to existing loans linked to marginal-cost-of-fund based lending rate (MCLR). The interest rates on loans will change upwards or downwards in line with the movement of the repo rate announced by RBI.

The RBI had stated that banks should benchmark the rates to either the RBI policy repo rate or Government of India’s 91 or 182 days Treasury bill yields as developed by the Financial Benchmarks India Private Ltd (FBIL) or any other external benchmark developed by the FBIL but still several banks opposed the decision of linking lending rates to an external benchmark, indicating that their cost of funds was not linked to those external benchmarks and delayed the implementation indefinitely.

By March 2019 the only bank to realize this directive was SBI, the largest public sector bank but it too took some time and made it effective from July 2019. Following the same footsteps, Bank of Baroda too introduced RLLR home loan scheme from 12th August 2019 and Syndicate Bank. Allahabad Bank, Canara Bank & Union Bank of India and other banks will announce their plans to launch RLLR soon.

To be eligible for the SBI repo rate linked home loan scheme, the borrower should have a minimum annual income of Rs 6 lakhs and tenure of the loan is up to 33 years. In the case of under-construction projects, the maximum moratorium period up to two years is offered over and above maximum loan tenor of 33 years. So, in such cases, the total loan tenure cannot exceed 35 years.

In this home loan scheme, the borrower needs to repay a minimum of 3 per cent of the principal loan amount every year in equated monthly instalments. If you take a home loan of Rs 50 lakhs, you need to repay a minimum of Rs 1.50 lakhs as principal plus the interest cost every year.

The interest rates in this scheme are not directly linked with the repo rate figure announced by the RBI. The interest on the loan is 2.25% points more than the repo rate. On July 1, the repo rate was 5.75 per cent, so the repo-linked lending rate is 8 per cent. But, the repo-linked lending rate may change effectively from September 1 as we had a repo rate cut of 35 basis points (bps) announced by the RBI in August.

Currently, RLLR is at 8 per cent. Banks will maintain a spread over and above RLLR of 40 to 55 bps. So, the effective rate for home loans up to Rs. 75 lakhs range from 8.4 per cent to 8.55 per cent. For home loans above Rs 75 lakhs, the effective rate is 8.95 per cent to 9.10 per cent (i.e. spread of 95 to 110 bps on RLLR of 8 per cent). With effect from 10th August, the home loan rates linked to MCLR would be 8.6 per cent to 8.85 per cent at SBI, which is more than RLLR.

Similarly, for Bank of Baroda MCLR linked home loan rate starts at 8.45 per cent, while the repo-linked rate starts at 8.35 per cent. At present its 5 bps cheaper than SBI’s repo-linked home loan scheme. Repo rate linked home loan scheme will be beneficial to borrowers with immediate savings when the interest rate goes down.” For instance, with a further 50 bps rate cut as expected in the next year, there will be further savings for borrowers on interest.

Let aside the interest rates alone, if you choose to switch for an RLLR home loan there are more added costs to be noticed, for instance, SBI levy’s transfer and processing charges of 0.35% on the amount of loan plus GST. The minimum fees shall be Rs 2,000 and the maximum can go up to Rs 10,000 plus GST. These charges may vary from bank to bank

One should wait a bit longer as other banks are also coming up with this scheme so one can choose a home loan from the bank of his choice and preference but also take into consideration the charges and extra paperwork, hassle and time to keep a tab on both accounts one home loan and other accounts (savings, joint etc). One has to take into consideration the fact that if you choose another bank apart from your savings bank look at the spread (margin) the bank is charging over and above RLLR. Check the impact of the spread between RLLR and the final rate of interest offered. Stick to the ones which offer the least spread as it reflects RBI’s repo rate policy correctly.

It’s also to be noted that the RLLR is effective from the following month after RBI monetary policy announcement. But, the borrowers also need to be aware and prepared that RBI can increase the repo rate due to the economic factors.

As far as the private banks are concerned; from Axis Bank, Mr Rajiv Anand, executive director for corporate lending said, “It’s not necessary to use only external benchmarks; there are multiple avenues to meet the requirement that the RBI wants us to do… What RBI is essentially looking at is that the rates are being cut and there should be better transmission”. More details on this weren’t revealed whether Axis bank is planning to offer RLLR but he did mention “Axis Bank’s asset-liability committee will take a call on the same.”

Hence, this scheme is to target customers & borrowers who reside in Tier 1 or Tier 2 cities and having an annual steady income of Rs.6 lakh. So before switching your home loan take note of the above points as to charges, the spread between RLLR and final interest rate and also if the central bank may increase the repo rate due to economic scenario.

Author
Rishi Khanna
Team Member- Equity Research & Valuation
(MSc Finance, NMIMS Mumbai. Batch 2019-21)

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Rate Cut, Who is the Winner?

In the recent Bimonthly Quarterly statement, RBI Governor announced a rate cut of 0.25 basis points, thereby shifting the rate from 6% to 5.75%. Who is going to benefit from the same ? Let’s do Economics! Like, Share & Subscribe to Areesha Fatma on YouTube!
Areesha Fatma
(M.Sc. Economics, NMIMS – Mumbai 2018-20)

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Find out how much return your investment should give to retire at your desired age in just 2 mins

The other day I received an SMS saying invest Rs. 5,000 every month till the age of 60 and get Rs. 30,00,000 lump sum and Rs. 25,000 every month post the age of 60. I am sure every one of us is bombarded with these kinds of messages every other day. There are several online calculators available to check how much you should invest now to get the desired amount at the age of retirement. But what if you don’t have that much amount to invest in? Also, do you know much return your current investment should earn to generate a corpus for your retirement?  To be honest, I didn’t know so I guess we are sailing on the same boat.

So without wasting any time, let’s see how can you use our tool to know the Return on Investment (RoI) required on your current investment to generate a corpus for your retirement in just 3 steps. Download the sheet from here.

What are the objectives of this sheet? 

The whole purpose to build this sheet is to tell you how much return your investment should earn so that you can generate the desired corpus for your retirement. 

What are the questions will be answered by this sheet?

You will know how much RoI needs to be earned on your investment. You will also know the amount you require to retire with. It also calculates your per annum post-retirement expense.

For illustration purposes let us assume there’s someone called Mr. X. He is 25 years old. He wants to retire at the age of 60 and expects to live till the age of 85. His current salary is Rs. 95,000 per month.

Follow the below steps to get your questions answered:

Step 1: Enter your personal details

Here, you are required to enter your current age, age at which you want to retire and age till which you are expected to be alive. Please note, this sheet is designed for a person who is more than or equal to 25 years old and expected to live till the age of 99.

Step 2: Enter your per month income and expense

In this step, you are required to enter your current per month salary. Expected every year increment in salary and bifurcation of a monthly expense. Please note: It is required that saving as a percentage of income to be more than or equal to 15% (Otherwise person either has to increase his salary or reduce his expense)

Step 3: The easiest step among all

One only has to press submit the inputs enter by one.

The output of the sheet:

The Output indicates how much person has invested till retirement and what RoI he should target on his investment. If a person manages to get the RoI calculated by this sheet, he can achieve his corpus by the time he retires. ( Basically, in this case, Mr. X has invested Rs. 1.44 Cr. till 60 years and he has managed to get RoI of 12.44% on his investment. So at the age of 60, he has generated a corpus of Rs. 20.26 Cr. which will take care of his post-retirement expense.)

This graph indicates how generated corpus will be depleted over a period of time
This graph indicates the proportion you have invested and corpus generated by your investment with RoI calculated by the sheet

So those who are interested to know the math behind this, here we go!

Following are the few assumptions made by me while preparing the sheet. Please refer the same.

Let’s look at the Expense tab:

Expense sheet indicates how your expense will grow over a period of time. To be on the safer side I have considered 13 months as annum. I have also considered growth rates of each expense heads will remain the same for a decade and will be revised by 0.5% compounded annually (Can be edited as per your requirement). 

Salary and investment tab:

We know our annual salary and annual expense. Annual saving is just a difference between income and expense. I have kept 5% (editable input) aside as an emergency fund which will be kept aside in savings account. Available per month funds to invest is remaining funds in hand after the emergency fund is kept aside. Now, Corpus generated is a sum of funds in hand and money parked in a savings account. (Note: Funds in hand should fetch min. RoI as shown in the output box)

Corpus tab:

Corpus sheet indicates post-retirement annual expense and how that corpus will be depleted over a period of time to cover your expense. Here I have considered the generated corpus will fetch 3% post-tax return on the corpus (Pre TAX savings return is 4% -editable input).

Hope this article has helped you to understand your target RoI on current investment and required corpus to retire on desire age. Let me know topics you would like me to cover in next post in the comment section below.

Author
Kartik Tripathi
Forerunner- Finvert
(M.Sc. Finance, NMIMS – Mumbai 2018-20)

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