A reader of this publication, the president of an insurance agency, recently wrote to say he kept hearing about catastrophe bonds but had little knowledge of what they were. He was curious if these instruments would replace traditional reinsurance and was particularly concerned about a scenario that would result in the catastrophe bond market’s collapse, resulting in widespread financial problems for primary insurers and economic calamity.
His timing was excellent. Catastrophe bonds, also known as cat bonds and insurance-linked securities (ILS), passed an important threshold in 2017, successfully weathering Hurricanes Harvey, Irma and Maria, three of the five costliest hurricanes in U.S. history. Altogether the storms produced $217 billion in damage-related costs, of which $92 billion was insured, according to Swiss Re’s research publication “sigma.”
“The final loss total will only be known once all claims have been processed, but even so, 2017 is likely to go down as one of the costliest North Atlantic hurricane seasons on record,” the publication stated.
While exact figures are unavailable on the losses endured by investors in the exposed catastrophe bonds, ILS analysis organization Artemis stated in April 2018 that the market had endured its largest losses to date. But it was the market’s ability to take a hit and recover that testified to its ongoing viability.
“In the first quarter of this year, a record $4.24 billion in new catastrophe bonds was issued in 17 separate transactions,” said Robert Hartwig, associate professor and co-director of the Risk and Uncertainty Management Center at the University of South Carolina’s Darla Moore School of Business. “What this says is that cat bonds are no longer the interloper or the disrupter. They’ve become a mainstay fixture.”
Where There’s a Need
So, what are catastrophe bonds? First, a bit of history: In 1992, Hurricane Andrew caused $17 billion in insured losses in Florida—a loss figure double the modeling estimates at the time for the financial costs emanating from a severe hurricane. Several insurers were forced into bankruptcy, and reinsurance capacity dried up for the remainder. A new source of capacity outside traditional reinsurance was needed to fill the void. In 1996, according to Aon Securities, the first catastrophe bond drawing risk-bearing capital from the capital markets to satisfy this need was developed by St. Paul Re UK.
Two main parties are involved in the issuance of a catastrophe bond—a sponsor and investors. Sponsors include insurance companies, reinsurance companies, large multinational corporations and even governments, all looking to spread the risk of loss from hurricanes, earthquakes and other natural disasters. Investors generally are pension funds and hedge funds looking to diversify their investment portfolios with a new asset class.
For sponsors, catastrophe bonds are a complement to traditional reinsurance, presenting the opportunity to hedge the risk of loss from a natural disaster. The bonds function just like a reinsurance contract structured over several years or a single year. When the sponsor’s property damage losses exceed a specified indemnity trigger ($2 million, for instance), the bond kicks in to absorb the financial impact up to a stated limit (say $3 million), making it similar to traditional reinsurance, in which reinsurers assume layers of risk within a so-called tower.
Other catastrophe bond losses are pegged to parametric triggers like earthquake magnitude or wind speed. When a hurricane exceeds a 7.4 magnitude, for instance, the bond would kick in to pay losses up to the stated limit. Issuers have experimented with other payout scenarios, but most bonds involve an indemnity trigger. As a result of the development of this sector, there is now an additional option to spread catastrophic property damage losses.
“For insurers and reinsurers, cat bonds fill an ongoing need to spread catastrophic property losses,” said Hartwig. “They’ve allowed for an important extension of capacity on a global scale for a type of risk where capacity has historically been constrained.”
Catastrophe bonds also present value to investors. The yields generally are higher than traditional bonds like Treasuries, exceeding 5 percent in 2018, according to emailed comments from Daniel Ineichen, head of insurance-linked securities at Schroders Investment Management.
The bonds’ returns also trade at a slight premium to other investments like asset-backed securities and commercial mortgage-backed securities, said Paul Schultz, CEO of Aon Securities.
Catastrophe bonds generally have maturities of three to four years. The premium to acquire the bond funds are invested in high-quality securities like U.S. Treasury Money Market Funds and held in a collateral trust. These investment returns, in addition to the initial premium paid by the issuer, constitute the coupon payment to investors, assuming there are no losses.
Institutional investors are particularly interested in catastrophe bonds because of their portfolio diversification benefits, since catastrophic property damage risks do not correlate with the risks of other asset classes. “A hurricane or earthquake is not correlated with movements in interest rates or the stock market, making them a valuable hedge for investors,” Schultz said.
Added up, the bonds have legs. “With more than $100 trillion, the capital markets have the potential to be the most efficient provider of catastrophe reinsurance the world has ever seen,” said John Seo, co-founder and managing principal of Fermat Capital, an investment management company specializing in structuring catastrophe bonds.
A Long Time Coming
For investors, on the other hand, their hunt for yield played a major role in the growth of catastrophe bonds following the 2008 collapse of the subprime mortgage market, ushering in the financial crisis and Great Recession.
“When all other markets like fixed income and equities were going south fast, a huge uptick in capital suddenly flowed into cat bonds, which offered more attractive yields,” said Judy Klugman, managing director and global co-head of the ILS team at Swiss Re Capital Markets. “After that, the market really took off and hasn’t lost steam since.”
Others agree. “It took 10 years for investors to accept cat bonds as tried and true,” said Seo. “Finally, after 20 years, the ILS market is accepted and appreciated by both parties—investors and insurers/reinsurers. Their sound performance through the 2008 financial crisis was the reason.”
Since then, the market has been on a tear. Aon Securities’ 2017 year-end report tallied 35 catastrophe bonds issued by 31 different sponsors during the year, hitting a total capacity of $10.7 billion—a first-time achievement. If the remaining quarters of 2018 duplicate the first quarter’s record catastrophe bond figures, the year will be the best by far in the ILS market’s history.
“At present, total reinsurance capacity including cat bonds is at record highs with stable pricing, despite last year’s hurricane losses,” said Hartwig.
The exact amount that catastrophe bonds paid out last year has not yet been tallied, although Artemis posited that the losses were heavy. Why then has pricing remained stable?
“There are two ways to read this: either the ILS market is well structured and priced to pay out only in truly extraordinary circumstances, or the modeling associated with cat bond risks has dramatically improved to become quite accurate,” Hartwig replied. “In either case, investors can have some confidence in terms of understanding the risks they’re assuming.”
These risks are not for the fainthearted, given the ferocity of recent storms. Investors must proceed with caution.
“Insurance-linked investment funds span the full spectrum of risk—from ‘you could lose it all’ to a high level of protection for investment principal to everything in between,” said Seo. “Most catastrophe bonds absorb catastrophic risks modeled with a 1-in-50-year risk of loss, although there is a material part of the cat bond market that absorbs risk at the 1-in-10-year level.”
More than 600 catastrophe bonds have been issued since the first one in 1996, according to Aon Securities. Given the record issuance of catastrophe bonds in the first quarter, it is obvious that the hurricane losses of 2017 have not deterred demand from investors.
“We assumed everyone would trade forward, but the speed and quantum of dollars was much faster and bigger than what we had anticipated,” Schultz said.
Seo agreed. “Despite the financial impact of the three major hurricanes, the active returns helped offset the losses to deliver a net positive return [to investors],” he said.
For Klugman, who has been structuring catastrophe bonds since Swiss Re unveiled one of the first ones in 1997, the market’s robustness is especially sweet. “I was hired from Morgan Stanley in 1999 to find an institutional investor base for this,” she recalled. “When I sat down with investors, they had no idea what a cat bond was, much less reinsurance. I had to give them a primer. Today, the investors know what this is, how it works, understand the risks and realize there will be losses. This hasn’t diminished the value they see in the asset class.”
A similar optimism prevails among sponsors, with issuers running the gamut from insurers and reinsurers to big corporates and governments. The latter include Mexico, Colombia, Chile and Peru, among others. Some insurers have sponsored multiple bonds. USAA, for instance, has sponsored dozens of catastrophe bonds through the years to spread its risks from natural disasters in different indemnity layers. The company’s most recent $175 million bond included aggregate protection for automobile policy flood losses—an industry first.
Too Good to Be True?
All the interviewees (other than Hartwig) are engaged in the ILS market, so their optimism must be leavened with a pinch of skepticism. Yet, Hartwig, a finance and insurance professor with a Ph.D. in economics, also believes catastrophe bonds fulfill a unique need for issuers while presenting an alternate class of investments for investors.
“There’s little question that the catastrophe losses of 2017 put cat bonds to the test and they performed admirably, with record issuance in the aftermath,” he said. “This speaks volumes about their value.”
Returning to the reader’s query about the possibility of insurance-linked securities causing a global financial calamity along the likes of the 2008 financial crisis, the interviewees downplayed the risk, citing fundamental differences between catastrophe bonds and credit default swaps and subprime mortgages.
“For one thing, carriers own their policies and are forbidden to sell them onward, whereas mortgage originators are allowed to sell their mortgages into the securitization markets,” said Seo. “As a consequence, carriers use cat bonds to manage their risk, not to rid themselves of all responsibility for all time.”
Unlike mortgage-backed securities portfolios that were leveraged 30 times and more, catastrophe bonds are not generally leveraged.
“In the cat bond market, leverage financing is not widely available,” said Seo. “Even when it is, the gearing is modest—maybe no more than two times capital on a practical basis.”
Schultz noted that catastrophe bonds are collateralized entirely with high-grade collateral solutions like U.S. money market funds. The bond offerings also are “very transparent” in terms of risk assessment and documentation, and an independent assessment of risk is included in the offering materials, he said.
“With no leverage in the products, risk-free types of underlying collateral, and transparent and independently assessed risk analysis, we don’t see any way that an analogy could be made to highly leveraged derivative products with minimal to no disclosures,” he concluded.
Hartwig concurred that these fundamental differences create a sound foundation for catastrophe bond market stability. “While it’s true that a mega-catastrophe or series of mega-catastrophes could produce losses across a broad range of cat bonds, the losses would be confined to these securities for the year in which they occurred—unlike credit default swaps and mortgage-backed securities that mushroomed as the contagion spread,” he said.
Effects of Rising Interest Rates
A more likely challenge to the ILS market is rising interest rates, he said. “There’s a case to be made that the surge in interest among investors in cat bonds over the years was due to the global collapse in interest rates,” Hartwig explained. “Institutional investors in search of yield found what they were looking for in the ILS market. For several years running, they enjoyed relatively high yields with very few bonds being triggered. It seemed like a money-making machine.”
This machine may grind down as interest rates continue to turn upward, encouraging institutional investors to take a closer look at rising yields in both government bonds and corporate bonds.
“I wouldn’t call it an existential threat,” said Hartwig, “but it may result in diminishing interest in 2019.”
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