What Is an Extreme Mortality Bond?
Events such as an earthquake, a pandemic, or a hurricane that lead to a large-scale loss of life are called extreme mortality events. Such events cause a risky situation for insurance companies because the companies end up paying heavily for a large number of insurance claims. To mitigate the risk, insurers securitize their issued policies in the form of bonds called extreme mortality bonds (EMBs). These are sold with a maturity period of three to five years, although they come with a condition linked to extreme events. It states that if the issuing insurance company faces a loss due to the occurrence of a particular extreme mortality event, then the issuer may no longer be obligated to pay the interest or the principal amount, or both.
Understanding Extreme Mortality Bonds (EMB)
Essentially, extreme mortality bond (EMB) buyers may fully or partially lose their investment if an extreme mortality event occurs. The EMB issuer (insurance company) uses that amount to offset the losses from the high number of insurance claims it needs to settle. If no extreme event occurs during the investment period, investors receive the interest and principal amount. The insurer pays the high interest from the insurance premiums collected from insurance buyers.
EMBs offer a win-win situation for both the bond issuer and the bond investor. The issuing company mitigates the risk of high payments in the case of extreme events, while the bond buyer benefits if a disaster does not occur. For example, in 2018, the Ebola virus was linked to almost 2,300 deaths in the Democratic Republic of Congo, but the casualty amount did not meet the criteria necessary for World Bank's EMB to pay out.
Since extreme mortality bonds are not linked to the stock market or other economic conditions, they offer a way to diversify. The offered interest on EMBs is usually high because disasters are rare. Some EMBs require mortality for a specific region to increase as much as 20% to 40% beyond what is normal for that region before investors lose capital. In the United States, that would mean an additional 500,000 deaths a year. That would require a major mortality event such as a pandemic on par with the 1918 Spanish flu pandemic, a world war, the detonation of a nuclear bomb, or a massive climate event or terrorist attack. Only some of the victims of such an event would be insured by a given EMB’s issuer, further reducing the risk to investors.
Investors benefit from high returns on an EMB if all goes well, but also face the risk of losing principal and interest if a disaster does occur. Investors add EMBs to their portfolios in limited portions to benefit from diversification.