Natural disasters occur all too often. Californians worry about earthquakes. Residents of Florida worry about hurricanes. Folks along the Mississippi River worry about flooding. The Midwest has its twisters, and the Rocky Mountain states have wildfires. Insurance companies worry about them all. In simple terms, insurance companies make money by charging customers premiums that exceed the amount expected to be paid out in claims. What are insurance companies doing? They are spreading the risks and costs across many people.
If your home is lost in a fire and you are not insured, you are responsible for paying to have your home rebuilt. If you are insured, all the policyholders of your insurance company chip in, in effect, to rebuild your house.
In the case of a mega disaster, there is a risk that insurance companies will not have the resources to cover all losses of policyholders. The insurance industry estimates that a worst-case disaster would result in $50 billion in losses—enough to force many insurance companies out of business. If a disaster of this magnitude were to occur, many insurance companies wouldn’t have enough policyholders over whom to spread the losses. So how do insurance companies deal with the enormous risks associated with “acts of God”? Disaster bonds!
Disaster bonds are a relatively new invention. These bonds allow insurance companies to share the risks of mega disasters with bondholders. In August 1996, Merrill Lynch & Co. began marketing the first major “act of God” bond issue. The bonds are issued by USAA, a car and home insurer based in San Antonio. These are the terms of the bonds: If USAA incurs over $1 billion in hurricane claims from a single storm over a 1-year period, investors in the disaster bonds will lose both interest and principal payments. Thus, if a huge hurricane hits the East Coast and claims from policyholders of USAA exceed $1 billion, USAA can use the money it would have paid to bondholders to pay policyholders. USAA is trying to do what insurance companies do best—spread the risk.
While yields for traditional bonds were around 8% in August 1996, the expected yield on disaster bonds was around 15%. Why do you think there is such a high yield on disaster bonds?