In 2017, the world was rocked by a series of devastating natural catastrophes, such as hurricanes in North America, an earthquake in Mexico and wildfires in the western United States and Australia. One asset class that could have been hit hardest by these events – catastrophe bonds – showed no signs of losing its appeal. In fact, in 2017 a record number of catastrophe bonds were issued – more than $10 billion worth. In 2018, this momentum has continued; in February, the World Bank sponsored a record-breaking $1.4 billion earthquake catastrophe bond that offers protection to its Pacific Alliance members and supports development in emerging countries.
Catastrophe bonds, also known as cat bonds, are a type of insurance-linked security that transfer risks such as natural disasters from a bond issuer to investors. The latter accept the risk of a catastrophe – and the potential loss of principal (the money they initially invested) – in exchange for an attractive rate of return. Issuers such as insurance and reinsurance companies created this alternative investment asset class in the 1990s following the losses sustained from Hurricane Andrew and the Northridge, California, earthquake.
“Last year was a record year for this sector,” said Paul Schultz, the chief executive officer of Aon Securities, which is responsible for the securitization of catastrophe risk and its distribution to investors. “This year we would expect comparable levels to last year and hopefully higher. Investors still have a very strong appetite for insurance risk.”
What lies ahead for the ILS market and catastrophe bonds in particular? We explore the state of play, including how catastrophe bonds score as an alternative asset class for investors.
Aon estimates that alternative re/insurance capital, which ILS and catastrophe bonds are a part of, reached nearly $90 billion in 2017, having increased from $17 billion in 2006. Pension funds comprise 60 to 70 percent of ILS capital. Other investors are institutions, such as endowments, mutual funds and high-net-worth investors. The report by Aon Securities notes that the pension funds that invest capital in ILS solutions allocate between 1 and 4 percent of their total assets to the sector.
European pension funds were the earliest investors, Schultz said. “The US pension funds have lagged other regions in investing in ILS. What we see is that Europe is well represented; we see that some of the Pacific is represented – for example, Australia and New Zealand. Also, Canada is present. But for reasons about which we can only speculate, the United States is behind.” One suggestion is that US pension funds are tightly controlled by pension advisers who initially were slow to embrace this newer market.
Sovereign wealth funds and, more generally, large institutional investors such as pension funds, have taken big positions in alternative investment asset classes. According to the Public Plans database, pension funds doubled their allocation to alternatives from 9 percent in 2005 to 24 percent in 2015.
Responding to Disaster
At $353 billion, 2017 was the costliest year for insurers for weather disasters. Under those circumstances, investors might expect that the market for cat bonds would suffer. Indeed, after the hurricanes Harvey, Irma and Maria devastated parts of the United States and the Caribbean, there was uncertainty about the response of the capital markets.
The disasters affected the pricing of some catastrophe bonds and caused loss to others, but the market quickly snapped back, with several transactions closing successfully in the last months of the year. This display of resilience by cat bonds in the face of severe events was an important indicator for investors.
Catastrophe bond interest-rate spreads – the interest rate on top of a benchmark money market rate – in the past two quarters of 2017 ranged from 3.75 to 21 percent.
“The volume of catastrophe bond issuance seen in the first six months of 2017 – $8.5 billion – set a new annual record. That was before hurricanes Harvey, Irma and Maria hit,” Schultz said. “I would say that the level of catastrophes in 2017 will likely have a longer-term positive influence on the amount of securities that are issued into the marketplace, and we may see some of that impact in 2018, but it’s probably something that will affect the market over time.”
Furthermore, the possibility of rising interest rates, which should make other assets such as currencies and bonds more attractive, shouldn’t increase volatility in the ILS marketplace.
What influences behavior in the sector is that catastrophe bonds, according to Schultz, are a “noncorrelating asset strategy.” Simply put, natural disasters don’t happen according to what the interest rate might be, Schultz noted. “On a fundamental level, pension funds are investing in cat bonds because this asset class has a premium level of return that isn’t correlated to the other asset strategies. As a result, investors are actually lowering their overall portfolio volatility by adding insurance risk into that mix.”
Innovation in Cat Bonds
Entering 2018, one of the more interesting transactions involved the largest-ever earthquake catastrophe bond deal, structured by Aon for the World Bank. It is also the second-largest catastrophe bond ever, and the largest sovereign risk transfer in the history of ILS. World Bank Vice President and Treasurer Arunma Oteh publically remarked that the approach showcased the World Bank’s “unique ability to bring together sovereigns for a market transaction that transfers risk and will help support countries when the unforeseen does occur.”
“What’s interesting is not only the size of the deal – $1.4 billion – but also that for the first time the proceeds from the sale of cat bonds were not held in a trust to collateralize the reinsurance agreement,” Schultz said. “They were reinvested into the local countries that the World Bank was supporting – Chile, Colombia, Mexico and Peru – into sustainable projects and programs. If we structure more transactions of this type, it’s possible that we could incrementally increase our distribution into green funds, which would be significant from a social-impact perspective.”
Schultz added that he was hopeful the transaction would lead to other governments developing more resilient, risk-management programs for their uninsured exposures.
Evaluating Financial Performance
Over the longer term, ILS has out-performed other asset classes, Schultz said. “We’ve reviewed indices for mortgage-backed securities, asset-backed securities, US Treasury notes, the S&P 500, the high-yield sector. When you look at their historical performance and the volatility of investing in insurance risk compared with these assets, there’s a compelling case for continued investment in the sector.
“Likewise, industry leaders are confident that the ILS market will grow. According to Colorado State University researchers’ latest predictions, 2018 is set to be an above-average year in terms of hurricane activity. This has not dissuaded investors, who so far have demonstrated a commitment to cat bonds in the pursuit of long-term returns,” he added.
ILS and Alternative Investments
While a wide variety of investors have been attracted to ILS, sovereign wealth funds haven’t been among them.
“What I would say is that there’s plenty of evidence that interest in alternative investment is increasing, certainly within pension funds but also among institutional investors generally,” Schultz said. “These ultimate capital providers are continually reallocating funds from traditional investments into alternatives as they become more comfortable with the new asset classes. ILS has its own risk profile, and at some point this flow of capital will decrease, but we believe there is still room for growth.”
Catastrophe bond issuance in 2018 is forecast to be $9 billion or more, just under the level of 2017, but still representative of the longer-term increase in interest in the asset class.
The rise of cat bonds reflects a broader trend in the marketplace, as investors have sought to address uncertainty in the aftermath of the financial crisis a decade ago. The continued search for additional diversification strategies will likely make cat bonds even more of a household name in years to come.
World Bank Issues Record $1.4bn Catastrophe Bond – Financial Times, February 7, 2018
ILS Market Issuance And Innovation To Continue In 2018: Appleby – Seeking Alpha, January 25, 2018
Billion-Dollar Weather And Climate Disasters: Overview – National Oceanic and Atmospheric Administration, April 2018
Analysis – Hurricane-Hit Catastrophe Bond Managers Plan New Funds – CNBC, December 19, 2017
Insurance-Linked Securities: Alternative Capital Breaks New Boundaries – Aon, September 2017
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