Only one catastrophe bond has ever been triggered and the market has tripled since 2005. Could losses in 2008 put off investors who are not accustomed to paying out? asks Lindsey Rogerson.
After three consecutive record-breaking years for issuances, everyone agrees that the catastrophe bonds are now a mainstream capital market alternative to traditional reinsurance. Where commentators and participants disagree however is what will happen to the current love-in if disaster strikes in 2008.
Guy Carpenter’s annual review of the cat bond market espouses the view that the new wave of what it calls “hot money” will flee in the aftermath of the next major event. However, those involved in managing and issuing cat bonds disagree. In fact one insider, speaking off the record, told Global Reinsurance that he believes a major event in 2008 will likely see a flood of new money pour into cat bonds, not least from investors who wished they had jumped in, in the aftermath of Hurricane Katrina.
The cat bond market grew by 49% last year (see graph). Coriolis Capital, an investment management firm that specialises in cat bonds and weather derivatives, predicts growth of around 15% to 20% for the next couple of years, although a major event in 2008 could see this estimate revised. While cat bonds (see pie chart) now account for 8% of global property limits and 12% of US property limits, when viewed as a proportion of total reinsurance limits, there is still clearly room for them to take a bigger slice of the action.
A record $5.9bn went into cat bond issuances in 2007. Last year also witnessed the issuance of cat bonds for new risks, including UK flood damage and an increase in insurers and reinsurers placing risks with the capital markets, suggesting that innovation will keep tugging away at investors’ interest for the foreseeable future.
Gaining from subprime
“A major event in 2008 will likely see a flood of new money pour into cat bonds, not least from investors who wished they had jumped in, in the aftermath of Katrina
Quite apart from the regrets of investors who missed out in 2005 and 2006, the global credit crunch could also hand cat bond issuers business from disgruntled fixed income investors. One cat bond specialist, speaking off the record, said that the ongoing fallout from the US mortgage fiasco could actually channel fixed income investors in the direction of cat bonds.
The events of the last 12 months have highlighted the scope for “human mischief” in the corporate bond market in the minds of many investors. As a result, the absence of such a risk in the cat bond market gives that a refreshing appeal in the current climate. It is not possible to disguise a hurricane, flood, windstorm or earthquake. They either happen or they don’t.
The credit crunch has also provided verifiable proof for the first time of the low correlation between cat bonds and other asset classes. The significance of this for investors seeking diversification, especially pension funds, cannot be overstated. As Guy Carpenter’s report points out: “The credit crisis has offered a practical example of the benefits of cat bonds as a diversifying asset class.”
Defaults on corporate bonds are expected to increase five-fold this year. Indeed Ken Emery, director of corporate default research at Moody’s said that several issuers had already missed interest payments this year. This indicates there is indeed upward pressure on default rates. With corporate bond defaults more likely, the attractiveness of cat bonds for certain investors, especially those burned by the complex mortgage-backed securitisations, becomes even stronger.
Too much money chasing any particular investment though can spell disaster for uneducated investors. One experience cat bond investor expressed concern that a leap in investor demand, in the wake of a major event, has the potential to leave those who do not fully understand the dynamics of cat bonds out of pocket. He says: “There will be people who will take advantage of naive money.” Investors have to fully understand – or find an advisor or fund manger who fully understands – hurdle rates, indemnity triggers, and all the other intricacies of cat bonds, if they do not want to come a cropper.
“It is not possible to disguise a hurricane, flood, windstorm or earthquake. They either happen or they don't
A quick once over of recent issues highlights the danger for naive investors. The Blue Wings cat bond (structured and placed by Swiss Re on behalf of Allianz Global Corporate & Specialty) remained loss-free despite its exposure to last year’s UK summer floods. What concerns established advisors is that ill-advised investors in future issuances could find themselves exposed if the payout triggers for a particular cat bond have not been fully understood by those looking for a decent return on their money.
This will become all the more important as the cat bond market continues to evolve. Many of last year’s issuances packaged up different types of risk – both in geographical terms and trigger event.
Earthquakes in Canada were bundled up with floods in the UK (Blue Wings), while another wrapped in US earthquakes with European windstorms (Catlin’s Newton Re transaction). The point being that investors need to look at more than the diversification qualities of cat bonds if they are not to get caught out.
Investors also need to be aware of two further risks inherent in certain cat bond issuances. The first relates to modelling. The bonds being issued today are based on changes made to catastrophe models post Hurricane Katrina. Only time will tell if these revised models prove accurate, which could have consequences for investors. The other point to note is that not all risks can be modelled as closely as those for weather-related losses.
Coriolis Capital for instance avoids bonds relating to terrorist incidents or nuclear accidents, as they are less likely to conform to mathematical models.
The good news is that cat bonds have now proven their worth, not only in terms of their ability to generate investment returns, but also as an uncorrelated asset class. Their future, along with that of canny investors, looks set to blossom, especially if a major event triggers a change in both traditional and non-traditional reinsurance pricing.
Lindsey Rogerson is a freelance journalist.