Way back in 1996, Morgan Stanley was about to market a Cat scheme forCalifornia Earthquake Authority (CEA) but National Indemnity, the insurancearm of Berkshire Hathaway hijacked the unique scheme at the eleventh hourand reinsurance thwarted the nascent market for these unique bonds.

Today, the picture is different. In 1998 more than $2 billion worth Catbonds were sold in the US. Some successful deals like the $477 million dealfor United States Automobile Association in 1997 and $115 million deal forSwiss Re have laid the standards for these innovative instruments. The CEAwas created by the state to insure California building owners who had becomeuntouchables of the insurance companies following the Northridge earthquake.

The original deal was to market one year bonds to big institutionalinvestors with a novel feature: Bondholders would earn a huge 10 per cent,but if any earthquake were to cause more than $7 billion in losses to theCEA, bondholders could lose their principal. This then is the basicstructure of such a deal.

To understand the rationale behind the success of these exotic instruments,we must know what Cat has that reinsurance does not. Major quakes, like theones in Uttarkashi and Latur need not necessarily spare New Delhi and Mumbaievery time. Bhubaneswar was hit yesterday, what if Chennai and Mumbai comenext? A comparison here would help. Were Hurricane Andrew, that hit Floridain 1992, to pass over Miami, claims, at today's costs, could well be to theextent of $50 billion, in the process, wiping out close to 20 per cent ofthe net worth of Americas insurance business worth only about $300billion.

Imagine this happening to GIC. However, when this amount is compared to thesize of the capital market where the value of securities traded is well over$20 trillion, it does not represent one standard deviation of daily tradingvolume. Thus the huge potential of diversifying catastrophe risk within thecapital market. In addition, reinsurance involves high transaction costsleading to the potential of offering hedging instruments to primary insurersthat are competitive with reinsurance. Moreover, catastrophe risks beingun-correlated with market indices, the benchmark for such investment is justrisk-free rate. Thus 10 per cent for such a deal is really huge.

Going a bit more into the details of these Cat bonds, these are typically ofone-year maturity. Investors who buy the bonds take a chance that, during aparticular period, a catastrophe won't strike the regions covered by theinsurance firm(s) issuing the bonds. If good weather prevails during theperiod in question (usually a year), investors win big. They get back theirprincipal plus a hefty interest payment. On the other hand, if acatastrophe occurs, investors lose all of their principle and get back onlythe interest earned on their money. Cat bonds are totally devoid of creditrisk to the issuer. Bondholders provide the hedge to the insurer byforgiving existing debt. In essence, the Cat bond is similar to areinsurance contract in which the reinsurer (ie, the bondholders) opens anescrow account equal to the maximum possible loss. This avoids default tothe primary. On the other hand, the risk to the bondholder is of interest.

Had the primary issued a straight bond, it would have been subject todefault risk in the event of the primary suffering a catastrophe-linkedloss. In effect, the Cat bond turns the default risk (ie, the implicitdefault put) into an explicit embedded option.

Catastrophe options resemble stop-loss reinsurance. As of now, these Catsare traded on the Chicago Board Of Trade (CBOT). The contracts are tied todifferent industry indices of property liability losses. When index lossexceeds the strike price, the contract fiats payment of the differencebetween the index value and the strike price. This basic instrument is usedto derive many trading strategies like spreads and strips. The tie-up withan index reduces moral hazard. If the primary is able to practice ex-antemitigation, it may even receive the benefit of reduced claims.

Though the Cats are still more expensive than reinsurance this will not beso for long. If these calamities become frequent that would make the priceof policy renewals hit the roof. Development of the Cat market couldtherefore lead to some amount of moderation of reinsurance prices. Thiscould even mean a shakeout in the reinsurance industry. Some reinsurers willhave to turn into consultants on risk management strategists. Thus, we canexpect a fair degree of resistance, in establishment of such a market forcats, from reinsurers. On the other hand, the reinsurers may give the Catssome thought.

However, the combination of high transaction cost and opportunity fordiversification, is not sufficient to ensure the success of these newinstruments. The relationship between primary insurers and reinsurersinvolve moral hazard. There is a lesser incentive for the insurer tounderwrite carefully or settle the claim efficiently. This necessitatesmonitoring of the primary insurer by the reinsurer. The apparently high costof reinsurance probably reflects this cost. If new instruments likecatastrophe bonds and options have to compete successfully they need toresolve these incentive problems.

There are ways in which these instruments or at least some of them can bemade popular. Small insurers can be made to participate in these markets. Asecuritiser can intermediate and combine the catastrophe exposures of a fewsmall insurers to resemble the portfolio of a large insurer. Cats can thenbe issued to benefit each of these small insurers. All this will definitelycome when the insurance industry in India sees more action.

There are however a few twists in the tale. Development of these instrumentsrequires sophisticated analysis of non-financial data and involvement ofmeteorological and other agencies is a must to develop suitable models thathelp measure these risks. The West has already developed a few models todeal with such data, so luckily by the time these instruments come to thiscountry, there will be some time-tested models available for implementationof such deals. Moreover, India is at least three steps removed fromexploiting the benefits of such innovations. First and foremost, thederivative market in India hasn't taken off yet. Despite recent moves bySebi, progress in this field is limited. These instruments harbour somesimilarity with credit spread options and credit default options. Theinvestment banking community in this country is not yet substantiallyevolved to engineer convertible bond schemes, leave alone design theseinstruments where pricing is the criteria for success. This however,complicates the problem. The absence of necessary agencies like reinsurersand financial engineers complicates diversification of substantial riskarising out of significant exposures by the insurance agencies in theever-evolving consumer market. Though the IRA is in place, there are no newinsurance companies in this country as yet. With the ground reality sodismal, there is a danger as well as an opportunity for the home bredreinsurers to switch mode and embrace the brave world of the Cats.

It is only a matter of time before insurance securitisation wipes away theexistence of reinsurance and similar instruments develop to cover risksassociated with satellite launches, airline crashes and such otherpredictable failures.

It is necessary to hasten our passage from the age of innocence to that ofcompetence, failing which we may only have ourselves to blame. Derivativescan wait, so can insurance agencies, but disasters will not.

The author is a consultant with PriceWaterhouseCoopers, Calcutta