Publications

- June 1, 2019: Vol. 6, Number 6

Catastrophe bonds: An asset whose time has come

by Benjamin Cole

As bond investors know all too well, the world values capital less and less with each passing decade, perhaps due to the “global capital glut” famously assayed by Ben Bernanke in 2005, then-chairman of the Federal Reserve, and reiterated many times since.

Even after adjusting for inflation, interest rates on sovereigns have generally trekked lower and lower since the early 1980s, to nadirs previously unimaginable — indeed, bonds issued by a Germany, Switzerland or Japan today can offer negative interest.

At the same time, the insurance industry has pondered how to handle world-class natural or man-made catastrophes, such as earthquakes, runaway wildfires or hurricanes. Until relatively recently, the industry had one option, called “reinsurance,” in which insurers would “lay off” or re-insure some of the risk of a catastrophe-induced payout with global reinsurers, such as Munich Re, Swiss Re, or Berkshire Hathaway’s General Re.

THE CAT BOND OFFERS NEW OPTIONS

Nature and financial markets abhor a vacuum, and Wall Street has seized on the desire of some investors to obtain higher yields and diversification, and the needs of insurers to possibly obtain lower-cost or otherwise useful protection against huge catastrophe-related payouts.

In the 1990s, after the Northridge earthquake in California and Hurricane Andrew along the U.S. Gulf Coast, Wall Street invented the catastrophic bond, or “cat bond.” The cat-bond concept is simple: An insurer issues a special-purpose bond, usually rated noninvestment grade, that offers relatively high yield and matures in the medium term, such as three to five years.  The cat-bond covers a specific, triggering event, such as a major earthquake in California within five years. If the major earthquake hits within the specified time frame, and meets certain defining criteria, then the investors lose their principal, which is used to meet claims made on the insurer. If there is no relevant quake, then the cat-bond investors collect back their principal, after receiving hefty yields along the way.

RISKS

The business of balancing risks against rewards is one in which the insurance industry has centuries of experience. Given that, can investors expect to get good risk-adjusted returns when buying a cat-bond from an insurer?  Does not the institutional prowess of the insurers make it likely they have unduly “laid off risk” on bond buyers, without adequate compensation in terms of yield?

That may be, although most cat-bond issuers and underwriters also hire a “catastrophe risk modeler” such as Towers Watson, to evaluate the probabilities the trigger event or events will happen. Usually the risk-modelers are third-party information providers and thus ostensibly unbiased or not otherwise compromised. Thus, the cat-bond buyers can usually read in a prospectus the probable odds of a triggering event, such as earthquakes or hurricanes.  Moreover, cat-bonds are sold to and traded in the bond market, in which sophisticated institutional bond-buyers appraise value. If insurers are able to take advantage of bond buyers, the advantage is probably slight.

CAT-BOND CATASTROPHES

Speaking of catastrophes, sometimes losses for cat-bond investors can certainly be described as such, from a financial perspective.

For example, in May 2017, the Nationwide Mutual Insurance Co. issued the $75 million Caelus Re V Ltd. (Series 2017-1) Class D tranche of notes, which covered earthquakes, severe storms, wildfires, meteorite impacts, volcanic eruptions, other perils in certain geographic regions of the Unites States. The United States dodged volcanoes and meteorites, but was struck by Hurricanes Harvey and Harris, and California wildfires, among some other lesser disasters. As of April 2019, buyers of the Nationwide Mutual cat-bonds have faced losses between 90 percent and 100 percent, reported Artemis, a news-service devoted to cat-bonds and other insurance-linked securities.

Similarly, the Mitsui Sumitomi Insurance Co. in 2016 issued $200 million of Akibare Re Ltd. (Series 2016-1) cat bonds, but Japan was subsequently hit by a set of typhoons of the type the Akibare issue was to be applied. The Akibare losses cut the total cat-bond value to $40 million, for an 80 percent loss of principal.

Of course, most retail investors, or even high net-worth individuals, will invest in cat bonds through a fund, and thus diversify against the decline in value of any particular cat bond.

The cat-bond market is growing, but is still something of a novelty in global debt markets. As of early 2019, there were about $38.2 billion in cat bonds outstanding, reported Artemis. By way of comparison, in 2018 there was about $24.8 trillion of reinsurance contracts in force, reported Orbis Research. So even within the world of reinsurance, cat bonds are but a fragment if the market, and of course, but a sliver of global bond markets.

YIELD AND DIVERSIFICATION

In any event, most cat-bond buyers are probably interested in the higher yields, as well as diversification. The incidence of catastrophes is unrelated to stock and bond market cycles or trends.  As with gold, the addition of cat bonds to the investor portfolio increases the chance that some part of the nest-egg will zig, when markets zag. Especially for investors approaching retirement, there is a need to avoid large undulations in portfolio value; no one wants to retire just as the golden years portfolio suddenly slumps in value, just before they planned to move into much safer securities. The greater the portfolio diversification, the greater the odds the portfolio will stay on a steady course.

By some accounts, achieving investor diversification is becoming more difficult as financial markets globalize, market knowledge is immediately and widely disseminated, and the flow of capital between markets, either geographically or by industry, is increased. For example, in the global financial crisis of 2008-2009, world equities markets sank in unison, and property markets internationally struggled. Better-quality sovereign bonds performed well as interest rates fell, one of the few gaining asset classes, but in general there was scant refuge for investors during the recent financial crisis.

Cat bonds, in fact, also wavered during the global financial crisis, but for a reason not easily surmised: When investors buy a cat bond, proceeds are placed into a cat-bond trust, and reinvested into “safe” securities. There, in the trust, the funds are available either to handle payouts following a catastrophe, or to return to cat-bond buyers as principal at bond maturity.

But a cat-bond trust is only as safe as the investments made, and investors during the 2008 financial crisis worried that cat-bond trusts were not as safe as they could be. That problem has evidently been corrected, as cat bonds since 2011 have again had little or no correlation to the broader markets. The results suggest that “new and improved collateral structures created for cat bonds issued after 2009, have been perceived as effective by market participants,” reported The Geneva Association, in a paper entitled Subprime Financial Crises and the Effects in the Catastrophe Bonds Market.

In terms of total return, over the longer run the Swiss Re Cat Bond Total Return Index roughly matches that of the S&P 500 or certain types of high-yield bond funds, while giving the fillip of diversification.

THE CAT BOND MARKET

In general, cat bonds are purchased by institutions, such as hedge funds, mutual funds and pension funds, and not individuals. Indeed, a retail investor might be poorly served by investing in just one or even a clutch of cat bonds. For an individual investor, there would be a lack of liquidity, and also a great deal of risk.

Happily, Wall Street fills the gap, through a selection of mutual funds that invest in cat bonds. For example, there is the Oppenheimer Master Event-Linked Bond Fund, while Securis Investment Partners (a subsidiary of Northill Global Funds) offers several cat-bond funds. Nephila Capital, with offices in Nashville and San Francisco, is one of the largest operators of cat-bond funds and other insurance-
linked securities.

Interestingly, even some governments are issuing cat bonds. For example, in April the Federal Emergency Management Agency sold $300 million of cat bonds to offset possible payouts under the National Flood Insurance Program. FEMA actually worked through Hanover Re (Ireland), which will sponsor the issue of the $300 million in bonds to capital markets. In total, FEMA has transferred $2.12 billion of possible payouts incurred by flood damage to buyers of cat bonds.

OUTLOOK

Like much of the investment world, insurers and industry-pundits frequently discuss the huge volumes of capital seeking a home in modern finance markets, summed up with the near-obligatory commentary that, “There is too much money chasing too few deals.”

In early 2019, the commercial property insurance industry was defined by a “continued abundance of capacity, as insurance companies remain strongly capitalized,” reported Artemis. Translated, that means commercial property insurers have plenty of capital on hand to write more business, and still stay within regulatory guidelines regarding maintaining necessary reserves to meet payouts.

As capital has flowed into the insurance and reinsurance industry in the past 20 years, different carriers competed for business by offering lower rates to the insurance buyers. For “decades, we’ve heard calls for underwriting and pricing discipline from the carrier community,” reported Artemis, citing an industry denizen.

For buyers of cat bonds, this flood of capital into the insurance industry has relatively depressed yields. Cat-bond underwriters and investors, so to speak, compete against traditional reinsurers to capture a share of reinsurance market. Those who risk capital for the lowest cost win the reinsurance business.

Some industry critics have said the insurance industry is finally becoming disciplined in 2019 after scant returns and losses in recent years, although there is no guarantee such discipline will last.

The years 2017 and 2018 experienced heavier earthquake and hurricane losses than expected, resulting in setbacks for reinsurers and losses for cat-bond holders, even as a group. One metric of cat-bond values, the MiCRIX Monthly Performance Index, maintained by Mercury Capital, actually fell during the two years. But the two years of losses have had a curative effect on insurers and thus cat-bond issuers, who in 2018 are demanding higher rates before extending insurance coverage, say industry observers. 2019 might a good year for investors to add cat bonds to their portfolios.

Looking forward, the insurance and reinsurance industries, and cat-bond issuers must evaluate returns given what appear to be chronic gluts of capital globally. “Insurers are facing tough times as profitability continues to go down hill, thanks in part to overcapacity. As a result, there is an increasing pressure to control and reduce expenses,” recently reported Knect365, an online industry news portal.

The “overcapacity” has been enabled by the hefty flows of capital seeking a home in the insurance industry and, of course, supplemented by the smaller flows of capital into the cat-bond industry.  For better or worse, many global capital markets have become “commoditized” in recent years.

Investors in cat bonds and cat-bond funds, alongside buyers of sovereigns and high-yield funds, will have to scrutinize risks and rewards. But in general, cat bonds offer competitive yields while adding some diversity to investor portfolios. If Wall Street goes to the dogs, cat bonds might prove a rewarding refuge.

Benjamin Cole (7continents7@gmail.com) is a freelance writer based in Thailand.

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