The Japanese earthquake is set to be the first natural disaster that triggers a number of catastrophe bonds, surpassing Hurricane Katrina to become the event with the biggest impact on the alternative reinsurance sector.
But cat bond investors are still expecting only limited claims on their exposure, despite the seemingly huge impact of the disaster, and, if the hit turns out to bigger, it could call into question their future appetite for such investments.
Catastrophe bonds allow insurers to pass on extreme risks, such as those related to earthquakes or hurricanes, to financial market investors, and are seen as an alternative to reinsurance.
Cat bond issuers make regular interest payments to the bondholders, and, if no catastrophe-related losses are incurred, return the principal once the notes expire.
In the event of major catastrophe-related claims, however, the insurer uses the proceeds of the bond sale to absorb some of its losses.
Ten catastrophe bonds with a face value of $1.7 billion are exposed to the earthquake – with three bonds totaling $675 million in reinsurance capacity singled out as vulnerable to default by investors, brokers and credit rating agencies.
Only one cat bond has ever paid out to its sponsoring insurer because of a natural disaster – Kamp Re 2005, a $190 million deal triggered by Zurich Financial Services’ losses from Hurricane Katrina.
“With most cat bonds, the probability of default in any year is around 1-2 percent,” said Cameron Heath, a director with Standard & Poor’s.
“The transactions are designed to cover big events hitting areas with major exposures – if you don’t get the combination of both, you will not see many catastrophe bonds triggering.”
Investors are cautiously waiting on vital data from Japan’s earthquake reporting station network (K-Net) to calculate which bonds are likely to trigger. Although the magnitude 9 quake will go down in history as one of the costliest quakes in insurance industry history, it did not occur in an area deemed to be high risk by reinsurers.
“This would be a different story for the cat bond sector if this earthquake hit Tokyo,” said Heath.
Disruptions to K-Net’s reporting network after the earthquake meant that some offsite recording stations were unable to access the central database. Investors are still waiting for the complete data from K-Net site in order to calculate which bonds are exposed.
Three catastrophe bonds are structured with a parametric trigger – an insurance industry calculation which pays out on index figures linked to the size and location of an earthquake – which relies on data provided by the K-Net stations.
The bonds from Munich Re, SCOR and Platinum Underwriters are now all trading below par as uncertainty on the bonds potential loss exposures is yet to be determined.
“On average, bonds have been marked down by around 20 cents in the dollar,” said Paul Schultz, president of Aon Benfield Securities, a part of Aon Benfield, which is in turn a division of Aon.
“The market has traded down because of the potential of loss,” he said. “We are seeing sellers willing to trade at more distressed prices in order to take the uncertainty away.”
Swiss Re’s Cat Bond Total Return Index, which includes all of the 100 cat bonds in existence, has fallen 3.21 percent since the Friday prior to the March 11 Japan quake, a spokeswoman confirmed to Reuters.
In particular, a $300 million cat bond transaction from Munich Re called Muteki Ltd – issued in 2008 on behalf of Zenkyoren, the National Mutual Insurance Federation of Agricultural Cooperatives of Japan – looks almost certain to incur losses, according to investors.
Remaining data from K-Net could be vital in determining whether Muteki will incur losses.
“If K-Net reports significantly more stations, that should have a material impact on this particular transaction and could cause a trigger assuming the new readings are similar to the already reported stations,” Craig Bonder, head of insurance-linked securities trading at Rochdale Securities, told Reuters.
Muteki is currently trading at a wide spread – with investors willing to buy at a bid of 45 cents on the dollar (or 45 percent of face value), and sellers asking for up to 90 cents on the dollar, say investors and traders.
Bermuda-based Platinum Underwriters said last week it expected its cat bond Topiary Capital Limited to be triggered following the earthquake, which would see the reinsurer call in $200 million of reinsurance protection.
Standard & Poor’s placed a Swiss Re mortality bond, which covers life insurance exposure, on negative CreditWatch because of the uncertainty regarding the eventual death toll arising from the quake. But the death toll from the Japanese quake would have to hit 50,000 to impact the bond, and is seen as unlikely by Swiss Re.
CAT BOND MARKET TEST
Sponsors and investors will have to wait to see if the cat bond structure has performed according to expectations, in the markets biggest test since the Lehman Brothers bankruptcy in 2008.
“This is not like the default of Lehman Brothers,” said S&P’s Heath. “The losses on those bonds were not expected by investors, but the reason the natural catastrophe bonds were created is to protect issuers against specific large natural disaster events.”
The collapse of Lehman Brothers, which played a counterparty role in several cat bonds, caused four bonds to default as a result of misconceptions in the market that banks were safe guarantors of the bonds.
“We will have to wait and see if any of the Japanese exposed catastrophe bonds default as a result of the earthquake – then it ultimately comes down to the issuers and investors, and how they believe the bonds have performed against expectations,” Heath said.
According to modeling agencies, the quake was outside the area in Japan which most cat bonds cover, mostly to hedge insurance costs in the country’s most heavily insured areas, such as the capital.
“From the issuer perspective, it’s going to be interesting to see whether they believe their bond should have protected them against this or not,” added Maren Josefs, associate director at S&P.
Conversely, investors will not react well to a bond triggering for what is considered a low exposure event, said one U.S.-based investor.
“The big thing that will turn off an investor is if a bond is not modeled properly and triggers when we were not expecting it to,” he said.
(Editing by Toby Chopra)
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