THEEDGE MALAYSI A | APRIL 2, 2012 capital 42

What t|t|e??
US$ bil
100
80
60
40
20
0
Natural
'70 '80 '85 '95 '05 '75 '90 '00 '10
Man-made
10 year moving average
O
ur planet Earth has seen a dras-
tic change since the 1990s. Be-
fore the decade,natural disasters
such as hurricanes,floods,earth-
quakes and tsunamis were less
frequent and less severe. How-
ever,the number of these catastrophic events,
and their severity,has increased dramatically
since. The losses caused by these events have
also spiked sharply. The chart illustrates this
historical pattern.
Insurance companies have suered major
losses following the protection given against
these Act of God events. As such events be-
come more common, insurance companies
naturally get nervous and tend to increase their
rates. And the burden is indirectly passed on
to the consumer.
However,insurance companies have the al-
ternative of excluding these disasters from
their coverage, thus depriving society of pro-
tection from the elements that impact their
livelihood and trade.

Reinsurance vs securitisation of
catastrophic risk
To avoid a major loss,insurers have tradition-
ally utilised reinsurance contracts.This is when
an insurance company purchases an insurance
policy from another insurance company to
protect against unforeseen or extraordinary
losses. The policy can be structured in many
ways so as to target certain losses or insur-
ance contracts.
However, when reinsurance is used as a
means to transfer risk,the risk remains within
the industry.As the risk of catastrophic events
increases, there is a strong motivation to get
(or securitise) the risk out of the insurance in-
dustry and into the nancial markets.
Interestingly, 2011 saw a new European
directive called Solvency II, requiring insur-
ance companies to maintain sucient capital
to cover catastrophic risks. It also promotes
risk mitigation techniques, such as securiti-
sations, to manage the risk, to gain solvency
capital relief.
Catastrophe bonds
The rst initiative towards securitising catas-
trophe risk was done after Hurricane Andrew
(1992) in the US, with catastrophe bonds, or
better known as cat bonds. By end-2011, there
was about US$10.7 billion worth of cat bonds
outstanding (source: GC Capital Ideas, Dec 7,
2011).
A cat bond is a bond linked to a catastrophic
risk. Lets say an insurance company issues
US$40 million worth of Cat Bonds A, with a
ve-year maturity.The bond pays a coupon of
LIBOR + 4%. The underlying risk securitised
is a tsunami event occurring within a 100km
radius from Aceh, Indonesia.
If the tsunami does not occur in the ve
years, investors get back their principal plus
the attractive returns.However,if the targeted
disaster occurs, investors lose their principal.
The insurance companies will then use the
monies to pay its claim holders.
When Hurricane Katrina bore down on
New Orleans, a cat bond named Kamp Re, is-
sued by insurer Zurich, was at risk. The bond
was triggered when the insurance companys
net losses from US hurricane and earthquake
claims were more than US$1 billion.
Another cat bond called Mariah Re is a three-
year bond (with annual coupon rates around
7%),issued in November 2010 to cover smaller
but more frequent storms like tornados and
severe thunderstorms in the US.

Sluggish market for cat bonds
Although this product is almost 20 years old
and shows very attractive returns, investors
are still reluctant to take the market forward.
A research paper by Bantwal & Kunreuther (A
Cat Bond Puzzle,May 1999) attempts to discover
the possible reasons.Some interesting results
are discussed below:
i) Inferring default probabilities
Michael Lewis puts it very nicely in his article
called In Natures Casino published in The
New York Times in August 2007 -- An insur-
ance company could function only if it was
able to control its exposure to loss. Geico sells
auto insurance to more than seven million
Americans. No individual car accident can be
foreseen, obviously, but the total number of
accidents over a large population is amazingly
predictable. The company knows from past
experience what percentage of the drivers it
insures will le claims and how much those
claims will cost. The logic of catastrophe is
very dierent: either no one is aected or vast
numbers of people are.
It is quite challenging to infer the level of
risk in this market because of the absence of
deriving a complete probability of distribu-

Jasvin Josen
Catastrophe bonds fear of the unknown?
derivatives world
SWISS RE, GUY CARPENTER & COMPANY, LLC
Jump head
J UMP HEAD
Higher crude oil prices will have a nega-
tive bearing on the construction sector as it
will translate to higher prices of steel bar,
cement or aggregates and diesel, RHB said,
pointing out that steel bar and cement or ag-
gregates generally make up 7% to 8% each of
total construction cost, while diesel used to
power equipment could account for about 5%
of total construction cost.
Construction costs, in turn, are typically
about 40% of gross development value for the
property players.
Meanwhile, rubber glove makers may also
be indirectly aected by higher fuel costs,
where any sudden cost increases could be hard
to pass on to consumers immediately,analysts
say.For synthetic glove makers,the raw mate-
rial is a petrochemical by-product.
That said, RHB sees opportunities in the
market. Its top picks or recommended core
holdings are Petronas Chemicals Bhd, Sime
Darby Bhd, Public Bank Bhd, Malayan Bank-
ing Bhd (Maybank), Multi-Purpose Holdings
Bhd (MPHB), Jaya Tiasa Holdings Bhd and
Telekom Malaysia Bhd.
Others like CIMB Group Holdings Bhd,DRH-
Hicom Bhd, Genting Bhd, KPJ Holdings Bhd,
Tenaga Nasional Bhd,Dayang Enterprise Hold-
ings Bhd,DiGi.Com Bhd,Unisem (M) Bhd,Dialog
Group Bhd and TRC Synergy Bhd are included
under RHBs list of tactical holdings.
On the external front,concerns over Main-
land Chinas economy and potential risk of an
oil-supply shock would weigh on market sen-
timent, RHB wrote in a note last Friday. Be-
yond near-term pullbacks,RHB reckon market
sentiment would gradually improve as global
economic uncertainties clear out.
As central banks in advanced countries
have unveiled more quantitative easing pro-
grammes and pledged to maintain extremely
loose monetary policy to support economic
growth,global nancial markets are still likely
to be awash with liquidity. Consequently,we
are maintaining our end-2012 FBM KLCI tar-
get at 1,650 based on 14.5 times 2013 earnings,
RHB wrote in the March 30 note.
The research house recommends that inves-
tors buy on dips to outperform the market,
though defensive stocks will provide greater
stability for the portfolio, particularly in the
2Q. RHBs key sector overweights are still tel-
ecommunications,gaming,plantations,oil &
gas and consumer.
For CLSAs Chin, an early general election
is high on the wish list.
Locally, there doesnt seem to be much
conviction from investors who are mostly
waiting for the elections [to be called and
done with first], says Chin, whos recom-
mending that clients stick with a-political
big caps like Genting Bhd, Maybank, Public
Bank Bhd,Axiata Group Bhd, Maxis Bhd,Tel-
ekom Malaysia,Sime Darby and Petronas Gas
Bhd, for now.
Plantation stocks would benet from high-
er oil prices,which also drives up CPO prices,
she adds.
Notably, the Invest Malaysia 2012 (IM2012)
conference starts May 29 this year, an annual
event for institutional investors now in its
eighth year since introduction in 2005.Thats in-
cidentally at the start of a two-week school holi-
day break that lasts through June 10 here.
This year, apart from a status report on
Malaysias transformation journey,organisers
are introducing an Asean sub-theme as the
region moves towards greater integration by
2015, according to the IM2012 website.
World Catastrophe Losses, 1970-2010
tion of losses with default statistics that go
back a long way.
ii) Lack of liquidity
Lack of liquidity could also very well be a fac-
tor in the market. This new asset class does
not t into the typical class products that in-
vestors are comfortable with; there is neither
equity nor debt.
iii) Myopic loss aversion
Loss aversion is when investors are more sen-
sitive to losses than to gains.Myopic loss aver-
sion takes place when,despite the fact that the
planning horizon is better represented by the
30-year return than the one-year return,inves-
tors seem to be more concerned with the po-
tential for a short-term loss than in planning
for the relevant time horizon and accepting
periodic short-term losses.
For instance, a specialist investor in cat
bonds should theoretically gain over a 20-
year period because his total returns in the
long term will be higher than the infrequent
losses made when his cat bonds trigger when
disasters actually occur.
iv) The worry factor
Events that have catastrophic potential are
perceived to be dreadful and very risky even
though statistical data suggest that people
should not feel that way about them (Slovic,
1987).Cat bonds t in this example.The cost of
thinking of the potential losses with low prob-
abilities may lead the investor to ignore the
potentially high gain because of the haunting
vision of losing the entire principal.
Investment managers may fear the loss of
their reputation if they lose money by invest-
ing in this peculiar asset. Unlike other assets,
the money in this asset can disappear almost
instantly with little warning. This potential
for a sudden, large loss can worry investors,
despite the low probability of such event oc-
curring.
v) Ambiguity aversion
A paper in 1995 by Fox and Tversky showed in
several experiments that when people com-
pare two events about which they have dier-
ent levels of knowledge,the contrast makes the
less familiar bet less attractive and the more
familiar bet more attractive.In the same way,
investors and reinsurers tend to price unam-
biguous risk quite steeply.

Conclusion
Cat bonds seem like the ideal instrument to
distribute huge losses of catastrophe and per-
haps even encourage insurance companies to
provide more protection against natural dis-
asters. However, investors appear to have is-
sues with coming to terms with the risk and
returns.The cat bond will continue to undergo
more tweaks to make the instrument more
palatable to investors.
In the next article,I will go slightly deeper
and discuss some aspects of pricing probabili-
ties in connection with cat bonds.
Jasvin Josen is an ex-investment banker
from Europe, specialising in valuation
and risk in financial derivatives. She is
currently back in Malaysia, providing
consultancy and training. Readers can
follow her at http://derivativetimes.
blogspot.com or send their comments to
Jasvin@souqmatters.com.