Parametric Trigger

The Column Height Of The Ash Plume Is The Trigger

An important feature of CAT bonds that tends to differ across the issuer types is the trigger. The trigger is the mechanism used to determine when payouts must be made to the Danish Red Cross (the Sponsor).

There are three common types of triggers for a CAT bond:

  • Indemnity: triggers base payouts on the actual insurance losses 
  • Industry loss: triggers base payouts on aggregate losses
  • Parametric: triggers base payouts on the measured strength of the insured catastrophe (e.g. typhoon’s wind speed)

This CAT bond is being structured using a single parameter trigger that ensures rapid pay out when disaster does strike. This is vital to its function as a source of readily available funding to assist with the humanitarian response to a volcanic eruption.

Those impacted by an eruption are often in need of urgent assistance and financing, so utilising a parametric trigger, which pays out when pre-determined triggers are met, ensures the rapid disbursement of funds, especially when compared with a more traditional insurance policy that requires on-site visits and more comprehensive loss assessment.

The trigger for its bond is based on the occurrence of a volcanic eruption, as measured by the eruption column height of the ash plume (or tephra fallout hazard). The column height is related to eruption magnitude and subjected to real-time verification.

A long-term probabilistic model calculates the expected financial loss to investors in the event of a volcanic eruption. The higher the ash column the greater the expected loss so the greater payout; and thus, the payout is linked to the loss expectation.

While there are other characteristics of an eruption that can determine the severity of an eruption, the team landed on column height because of its simplicity to understand and validate.

However, there is another benefit of pegging the trigger to the height of the ash column that relates to the dissipation rate of the ash cloud falling to the ground that is unique to volcano CAT bonds. Indeed, counter to what intuition would lead one to expect about the ex-post relationship between the timing of the trigger, release of proceeds, and accumulated loss (i.e. proceeds released after a risk event has already created a loss) in an atypical CAT bond (i.e. earthquake, typhoon), a volcano CAT bond can potentially pay out before ash clouds falls to the ground and serious loss occurs.

In other words, the Red Cross would receive proceeds from the investors to implement mitigating interventions prior to the loss of lives and livelihoods resulting from ash raining down on communities, agriculture, and livestock.

Inadvertently, the team has created the very first blended CAT bond that allows for ex-ante (anticipatory) and ex-post (actual) disaster and catastrophe financing. And, by expressing this relationship in the form of an innovative financing solution is a real credit to the individuals involved in this program.

(Note: Eruptions are unpredictable, and in some case ash columns can rain down in a matter of hours as easily as the ash can remain in the stratosphere for years.)