Spotlight on catastrophe bonds
For around 15 years, Insurance Linked Securities (ILS) have helped reinsurers manage their exposure to very large risks such as natural disasters. Over this time, ILS as an asset class has also proved to be very attractive to pension funds and other institutional investors. In this paper we discuss the most well known type of ILS, catastrophe bonds (nicknamed ‘cat bonds’).
For around 15 years, Insurance Linked Securities (ILS) have helped reinsurers manage their
exposure to very large risks such as natural disasters. Over this time, ILS as an asset class has also proved to be very attractive to pension funds and other institutional investors. In this paper we discuss the most well known type of ILS, catastrophe bonds (nicknamed ‘cat bonds’).
Catastrophe bonds, like most ILS, are almost entirely uncorrelated with macroeconomic variables - a characteristic which makes them highly relevant for those seeking diversification away from equities. Returns have been higher than equities and many other major asset classes, with less volatility1. Here, we explore the characteristics of this lesser known asset class and look at the benefits that investing in catastrophe bonds can bring to UK pension schemes.
- Catastrophe bonds are an instrument used by insurance and reinsurance companies to spread the risks associated with insuring the consequences of natural disasters or catastrophic events.
- Catastrophe bonds are event-linked securities, which pay a premium to an investor. If a pre-specified catastrophic event occurs within a given timescale, the investor’s principal passes to the insurance company and helps them pay claims arising in the aftermath of the disaster. The strong investment case for catastrophe bonds lies in their diversification properties.
- Since the inception of the market, the returns on catastrophe bonds have compared favourably to many other asset classes.
- UK pension schemes can access catastrophe bonds through a variety of pooled funds.
What is the need for catastrophe bonds?
The devastation caused by natural disasters has risen dramatically over recent generations. Population growth has increased the concentration of property in areas susceptible to natural hazards. In addition, a rise in extreme weather conditions associated with climate change may increase the frequency of large-scale disasters. Superstorm Sandy, which ravaged New York and areas of New Jersey in 2012, is just one example of this, along with the recent forest fires which spread across parts of California.
Natural catastrophes occur relatively rarely, but can be devastatingly destructive when they do. The societal and environmental consequences of such events are often tragic, and from a financial viewpoint all it takes is for one disaster to hit a highly populated area, and an insurance company’s capital base can be completely wiped out. When hurricane Andrew hit the coast of Florida to the south of Miami in 1992, it destroyed US$15.5 billion dollars worth of insured property (from total losses of close to US$30 billion)2, and caused 11 insurance companies to go bust. Estimates of the damage caused by the 2011 Japanese earthquake lie between US$110 and US$200 billion –US$12 to US$35 billion of that to insured property3.
Most insured events tend to take place independently of one another. The number of insurance
claims arising from incidents such as car crashes follows a normal distribution, and can be predicted with a good degree of accuracy. In contrast, natural disasters occur relatively infrequently but cause a substantial number of claims to be made together. The high variability of the payouts insurance companies must make in the aftermath of ‘act of God’ events drives them to pass some risk onto third parties, such as reinsurance companies. This allows them to underwrite large risks they would otherwise lack the capacity to cover.
However, in some cases the reinsurance companies themselves may wish to spread their risk. In addition, reinsurers may be less willing or able to take on risk from insurance companies in the aftermath of large-scale catastrophic events, and this leads to increased reinsurance costs. Catastrophe bonds provide an alternative to traditional reinsurance in enabling insurance companies to prepare for the possibility of natural disasters without having to limit the coverage they provide to policy holders or increase the premiums they charge.
What are catastrophe bonds?
Catastrophe bonds, which were developed in the mid 1990s, are risk-linked securities issued by insurance or reinsurance companies. The return an investor receives from holding these bonds is linked to the incidence of a pre-specified catastrophe within a particular time period. The occurrence of the catastrophic event triggers the loss of the investor’s principal, which passes to the insurance company and helps them pay claims arising in the aftermath of the disaster. On the other hand, if the insured event fails to take place within the predetermined period (a more likely scenario) the investor earns a good return on their bond – usually between 8% and 15%.
Catastrophe bonds can be designed to cover any natural disaster. Some popular issuances cover US hurricanes, European windstorms and Japanese earthquakes. They have even been issued to cover non-natural catastrophes. For example FIFA issued catastrophe bonds worth $260 million to provide protection against the possibility of the 2002 FIFA World Cup being cancelled.
The catastrophe bond market currently has over $13 billion4 of capital outstanding – a mere fraction of the total debt outstanding on the worldwide bond market. Despite the limited market depth, there is a secondary market in catastrophe bonds which trades daily and provides a reasonable level of liquidity.
An aside on private transactions
Private transactions are bespoke, collateralised, reinsurance agreements which are drawn up between the reinsurer and individual investors.
These are similar in structure to catastrophe bonds, but are typically shorter in length (usually one year term compared to around three years for a catastrophe bond) and non-tradable in contrast to catastrophe bonds.
Private transactions broaden the universe of investible insurance linked assets, providing diversification beyond the catastrophe bond market.
They require more resources for modelling and structuring, but can provide higher premiums and attractive risk-return characteristics.
1 Please see Figure 1 on page 3
2 Catastrophe Insurance Risks: The Role of Risk-Linked Securities and Factors Affecting Their Use. United States General Accounting Office – Report to the Chairman September 2002
4Source: Secquaero estimates, May 2013
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