Complex Products: Event-Linked Securities
Overly complex products that masked risk were at the heart of the worst financial crisis in our nation’s history since the depression. Remember Derivatives...? Those mysterious financial products that had been sliced and diced so many different ways that nobody knew how much risk they contained or who was responsible for that risk. At any rate, the financial industry is always coming out with new products - some more complex than others. Event-linked securities are among the more complex instruments available to retail investors. And while complex in and of itself is not a problem (unless there’s some type of fraud going on), the issue here is about the suitability match between such products and the retail investors who purchase them (and the brokers and broker-dealers who recommend them). Suitability comes into play in several forms - for more on this issue, please visit our page dedicated to suitability issues.
Event-linked securities are one of several new generation financial products that have become increasingly common among retail investors in the past few years. Since they are difficult to understand and often contain more risk than one would presume, they have been the subject of numerous alerts and regulatory notices by securities industry regulators like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).
What are Event-Linked Securities?
Also known as Catastrophe Bonds, Event-Linked Securities are a special class of financial products that permit investors to speculate on a range of events, including catastrophes (hence the name) like earthquakes, pandemics, hurricanes, etc. Sounds pretty morbid, right? Well, human beings have been betting on everything that contains uncertainty for, it seems, as long as there have been human beings. Think about it. When was the last time you said to a friend, “I bet it rains today.” In your own way, you were making an event-linked speculation.
Event-linked securities help insurance or reinsurance companies obtain funding while reducing their risk against disasters. Holders of the bond effectively bet for or against the disaster happening within a certain period of time. If the event - often called the “trigger event” - does in fact occur, the holder of the security may lose all future interest payments and/or the principal.
According to FINRA, the securities industry’s watchdog:
One common type of event-linked securities, which will illustrate many of their characteristics, are "catastrophe bonds"—"cat bonds" for short. If a "sponsor," such as an insurance company or reinsurance company (a company that insures insurance companies), wants to transfer some or all of the risk it assumes in insuring a catastrophe, it can set up a separate legal structure—commonly known as a special purpose vehicle (SPV). Foreign governments and private companies also have sponsored cat bonds as a hedge against natural disasters.
What Are the Hidden Risks Associated with Event-Linked Securities?
What has regulator worried is the complexity of the impact the arrival of a “trigger event.” In other words, while retail investors may think they have bet on a simple “win/lose” proposition, the implications for their payout and principal may be much more difficult to figure out.
The actual risk level contained in an event-linked security is also notoriously hard to calculate. Big Data has allowed many firms that specialize in risk assessment and damage estimates to come up with a reasonable accurate figure of what might happen if catastrophe strikes - but Mother Nature is unpredictable.
Finally, because catastrophe bond holders face potentially enormous losses, these bonds are rated “non-investment grade” or BB or lower by most major credit rating agencies. In other words, event-linked securities are extremely complex and extremely risky products not suitable for most retail investors, and certainly not in large quantities.
Brokers Must Match Investors to Investments
If you found all that hard to grasp, you’re not alone. However, it is not the duty of retail investors to fully understand the complex products contained in their portfolios. After all, you are probably a novice when it comes to complex financial matters. Your financial advisor, on the other hand, must not only understand the product he or she is selling to you, but he or she must also ensure there is a clear suitability match between you as an investor and the investments in your accounts. Event-linked securities are not for everyone.
Pennsylvania & New Jersey Securities Litigation Law Firm
If you or someone you know has suffered financial loss due to event-linked securities or any other form of investment fraud or broker misconduct, please contact our experienced team of securities attorneys immediately to protect your legal rights by calling 1-855-462-3330 or by using our online contact form.