Investing in cat bonds: it's going down a storm

Insurance linked securities (ILS) are a relatively new asset class which is developing quickly. ILS is a mechanism by which insurers and reinsurers protect themselves against major events and an asset class which provides investors with, not only a good rate of return, but also diversity from risks that affect other forms of investment. ILS risk is not correlated to the financial markets and therefore ILS provides a hedge against more usual investment risk.

ILS came into being after Hurricane Andrew in 1992 when insurers and reinsurers required capital protection against the risk of accumulation of losses arising out of a major natural catastrophe. It was not until Hurricane Katrina, however, in 2005, that the use of ILS products became commonplace. Not only was Katrina the largest insurance loss that had occurred, but its timing, shortly before the global financial crisis in 2008, proved opportune.

ILS was needed by insurers and their regulators to prevent insurer insolvency following a major loss. Reinsurance simply aggregates losses in a few pools of capital and is typically uncollateralised leaving a credit risk. ILS draws in investment from outside the insurance industry and is typically collateralised. With ILS, insurers could weather a Katrina plus event without imperilling their solvency; a benefit to both insurers and regulators as well as insureds.

At the same time, the returns offered by insurers and reinsurers to ILS investors has proved very profitable at a time when other markets have not performed as well. Additionally, ILS, being uncorrelated to other markets, provides a diversifier to an investment portfolio.

“While these storms will not cost ILS investors their investment and will still allow them to make reasonable returns in 2017, they will change the way in which ILS products are sold and the opportunities open to investors”

The years since Katrina have seen few major storms which have provoked claims against ILS instruments. The principal instrument is a so-called Cat Bond; a bond that pays an insurer if a natural disaster triggers a claim. Triggers can be based on market indices and be triggered when the insured loss to the market reaches a certain level or based on an indemnity and be triggered when the insurer pays a certain sum in claims. Finally, some Cat Bonds use parametric triggers based upon, for example, the strength of storm or earthquake.

To date, most ILS products have been focused on wind perils arising out of the Gulf of Mexico. Investors have been able to enjoy some diversity of risk within an already diverse investment asset as cat bonds and other ILS products are often very geographically focused. One bond may cover Florida and another the western Gulf. Other bonds are aggregators.

Cat bonds face their first test after years of high returns

Until the hurricane season of 2017, benign conditions in the Gulf of Mexico and Florida have meant that very few Cat Bonds have been triggered. Good returns have been enjoyed by investors. Indeed, such has been the level of return that prices for Cat Bonds were beginning to soften.

Hurricanes Harvey and Irma provided the first real challenge to the ILS market. As it happened, Harvey, despite its force and the destruction that it has reeked in Texas, appears unlikely to be a major issue for ILS investors. The damage and economic loss associated with the storm was mainly caused by flooding, a peril which is not covered by most insurance policies but protected by state and federal authorities. Irma threatened to be more costly and will be but not as costly as it originally appeared to be. The change of track of the hurricane away from Miami and its rapid loss of force after making landfall in the US, has meant that the level of insured loss is likely to be lower than Katrina.

While these storms will not cost ILS investors their investment and will still allow them to make reasonable returns in 2017, they will change the way in which ILS products are sold and the opportunities open to investors.

Despite significant claims not being made on ILS products, the threat that existed has shown insurers and their regulators that peace of mind and solvency protection can be bought. It has also shown governmental agencies that the protection open to insurers from ILS also exists to assist them in circumstances where they are the risk protector outside the insurance market.

“Perhaps the greatest benefit to investors comes from the increasing availability of ILS products to entities other than insurers and reinsurers” 

This has already met with considerable success and products have been developed protecting entities such as FONDEN, the Mexican disaster relief programme and CCRIF, the equivalent in the Caribbean. These projects have the support of the World Bank and the UN as they seek to close the protection gap and create resilience to natural disasters around the world. The storms, particularly the aftermath of Irma in the Caribbean, will only assist in emphasising the need for such protection.

Investment diversity in the face of diversity 

For investors, the storms have shown that additional diversity in investment is a way to protect one’s investment and ensure a profitable return.

Insurers are beginning to look to their other exposures beyond the Gulf of Mexico to see what benefits ILS can bring. This provides greater and more diverse opportunities for investment in a market in which available investment has, until now, outstripped demand for products.

Perhaps the greatest benefit to investors comes from the increasing availability of ILS products to entities other than insurers and reinsurers. Governmental agencies who are required to provide protection are looking to ILS to protect themselves and also to smooth out the impact of disasters over a number of fiscal years.

This development adds to the diversity of the investment as, by definition, the risks covered by governmental agencies fall outside the risks borne by the insurance industry.

The diversity goes further. In countries where the “insurance gap” is significant, governments are looking at ways of protecting their populace and economies without using insurance as an intermediate step.

Cat bonds provide an excellent means of achieving this. These bonds are necessarily based on parametric triggers. No indices exist as there is little insurance activity and no indemnity trigger can be calculated and so the trigger must be an objective one which allows for accurate modelling and pricing. This has additional benefits. There is no delay once an event has occurred. Payment is immediate. Disaster relief and reconstruction can commence immediately and the economy of the affected region protected.

“Hurricane Andrew gave birth to ILS which developed with Hurricane Katrina but it is Hurricanes Harvey and Irma that are likely to see it grow into maturity is a fully-fledged asset class”

A good example of a country which is investigating the use of cat bonds is Russia. The insurance penetration in this vast country is between 1.3% and 1.4%. The principal perils are wild fire, flood and far eastern typhoon.  A catastrophe can become a disaster very quickly as an economy is shattered as a result of an event. With a cart bond, the government is enabled to act swiftly to house victims and rebuild their lives and economy in a resilient manner. Indeed, the injection of cash immediately after a disaster can inject life into a moribund regional economy.

Russia is not alone. Other CEE states as well as many in Asia could benefit from the protection offered by ILS and a swift mechanism to close their protection gaps.

The spread of risk types that these developments will bring will be of enormous benefit to investors. A hurricane in Florida has no correlation whatsoever to a flood in the Volga basin. Greater diversity of risk and increased opportunities for investors.

Hurricane Andrew gave birth to ILS which developed with Hurricane Katrina but it is Hurricanes Harvey and Irma that are likely to see it grow into maturity is a fully-fledged asset class.

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