News Excerpt:

Insurance companies in India have faced losses from recent floods, like the Sikkim floods in October and the Chennai floods in December. The insurance industry has, over the years, developed instruments to deal with such disasters: Catastrophe bonds or 'cat bonds'.

What is a Catastrophe?

• A catastrophe refers to a major event that causes extensive losses. 
• Recent destruction events, such as Cyclone Michaung, brought the insurance companies under stress.
• High claims from these floods will likely lead to reinsurance companies charging higher premiums, making insurance more expensive.

About Catastrophe bonds:

What is a 'cat bond'?

• It's a financial safety net for the insurance industry.
• Cat bonds provide insurers with quick access to funds during large disasters. 
• Investors benefit by earning interest on the bonds they hold. 
• Investors buy bonds, and if a major disaster occurs, like the recent floods, insurers use the money from these bonds to cover their losses. 

Benefit of Catastrophe bonds:

• Insurance and reinsurance companies use them to shift big risks to investors in the capital market. 
• This reduces their overall costs and frees up money for new insurance businesses.
• The bond might not need the insurer to pay interest or the total amount back. 
• Investors in cat bonds get regular interest payments, like regular corporate bonds. 
• If no disaster happens during the bond term, they keep the principal.
• Investors will lose their principal if the costs of the covered natural disasters exceed the total dollar amount raised from the bond issuance. 
• However, if the costs to cover the disaster do not exceed the specified amount during the bond's lifetime, investors would get their principal returned at the bond's maturity. The investor would also benefit from regular interest payments in return for holding the bond.

How can insurers reduce claims?

• Insurers can reduce claims through risk management, forming disaster pools, and issuing cat bonds, which could provide crucial financial support to insurers dealing with large-scale disasters. 

Where does India stand in terms of issuance and investors?

• Several discussions have occurred regarding approving these 'cat bonds', known as insurance-linked securities.
• India's protection gap is 92%, much higher than the global average of 54% in 2022. The economic losses were ₹52,500 crore from the 2020 floods in India, and premium cover could have been ₹13,000 to ₹15,000 crore if the government had insured it.
• The cat bond market is worth $40 billion, compared to the $133 trillion global bond market.

However, concerns exist about understanding the instrument, connecting it to specific events, and addressing the supply-demand dynamics. India is still some time away from adopting this, but as history shows, markets tend to open up once a step is taken.