Financial History Issue 117 (Spring 2016) | Page 19
By Gregory DL Morris
During the recession of 2009–10, the
term “financial engineering” got a very
bad reputation. It became synonymous
with deliberately opaque and convoluted
instruments designed to fool investors and
regulators. But not all financial engineering is deceptive and daedal. Every element
of finance, from fiat money to common
stocks, had to be invented.
That invention continues. One of the
more recent innovations was designed to
reduce risk, rather than increase it, and
has been by all accounts very successful.
Catastrophe bonds, or cat bonds, were
developed in the 1990s to address several
important needs in the risk-transfer sector.
A series of monster events severely
stressed the capacity of even the largest
underwriters and the reinsurance companies that backed them. They sought not
just ways to increase their capacity, but also
ways to apportion risk beyond traditional
markets. At the same time, smaller firms
were interested in participating in larger
markets and risks, but in limited ways. Further, capital markets were eager for noncorrelated, alternative investments.
“There had been attempts to create a
market in exchange-traded index instruments on the Chicago Board of Trade in
the early 1990s,” said Dirk Lohmann, CEO
and managing partner of Secquaero Advisors, based in Zurich.
The galvanizing event for what became
cat bonds was Hurricane Andrew in 1992.
“That was a market-changing event,”
Lohmann said. “A lot of insurers and reinsurers did not use probabilistic models in
those days, although they did exist and
were available for commercial license.”
Hannover Re was an early adopter of
such models under Lohmann’s guidance.
Today the global market for cat bonds
is about $25 billion. There is an even
larger market, about $70 billion in broader
alternative capital for risk transfer. That
Cameron Davidson
The catastrophe bond is
financial engineering that
does what it should
Aftermath of Hurricane Andrew,
which hit Florida in 1992 and sparked
the idea for catastrophe bonds.
Spring 2016 | FINANCIAL HISTORY 17