Summary

• Catastrophe bonds are a growing source of risk transfer for re/insurers.
• As a result, the cat bond market has expanded and the investor base broadened.
• Cat bonds provide a valuable source of risk capital diversification and post-disaster risk financing.

Catastrophe bonds, also known as cat bonds for short, are an example of capital market techniques being used to facilitate the transfer of risks from one party to another.

In the same way that for hundreds of years insurance contracts have enabled a risk, or portfolio of risks, to be packaged and transferred to another party willing to take on that risk in return for a premium, catastrophe bonds mimic this but using capital market structures.

Cat bonds are an example of insurance securitization. Using financial market securitization techniques to create risk-linked securities, enabling the transfer of a specific set of risks (most typically property catastrophe risks) from a cedent or sponsor to investors who are willing to bear that risk.

In this way investors take on the risks of a specified catastrophe or loss event occurring, in return for attractive rates of investment return. Should a qualifying catastrophe or event occur, which meets the pre-defined terms of the underlying contract, the investors will lose part or all of the principal they invested and the cedent (most frequently an insurance or reinsurance company) will receive that money to cover some of its losses.

Catastrophe bonds were first issued in the mid-to-late 1990s, Artemis has a comprehensive database containing the details of nearly every (over 350) catastrophe bond transactions.

A number of major natural catastrophe events which hit the U.S. in the early 1990s, such as the Northridge earthquake and Hurricane Andrew, were seen as events of such magnitude and potential loss that the insurance industry began to look for alternative methods to hedge its risks.

It was generally assumed that insurers and reinsurers alone could not manage the potential hit if a number of 1-in-100 year events all occurred in the same annual period. Imagine hurricane Andrew, a San Francisco earthquake, a New York storm surge and a Tokyo earthquake, all in the same year. The potential financial impact to traditional insurers and reinsurers could be enormous.

What was required was access to the deepest, most liquid and most efficient source of capital possible, in order to transfer some of the risk of such events occurring outside of the re/insurance market. The natural (perhaps only) home for risks of such magnitude is the global capital markets and the financing that the largest institutional investors could provide.

Through collaboration with capital markets companies, investment banks and legal experts made a number of attempts to create financial market instruments that could be used to hedge or transfer catastrophe risks emerged. These included the attempts to leverage options and swaps, to create traded catastrophe instruments, plus the use of derivatives to facilitate risks transfer.

However, securitization was seen as perhaps the most viable way to create a market that would allow investors to bear these peak peril risks and for there to be a secondary trading market, allowing for risks to be transferred between the investor community.

And so catastrophe bonds were born.

Today, the catastrophe bond market has grown to become a meaningful portion of the global property catastrophe reinsurance and retrocession market. Cat bonds have now been used to transfer more than just catastrophe risks, with life insurance risks, mortality, longevity, health insurance, and even lottery winning risks all having been transferred in what has become a $25 billion marketplace.

The typical sponsors of a catastrophe bond are primary insurance companies or reinsurers who are looking for a source of risk transfer and risk capital that diversifies their overall risk protection. With catastrophe bonds being backed by capital market investors, it diversifies insurers’ risk capital away from just the traditional reinsurance market.

Another benefit of sponsoring a cat bond is the fully-collateralized nature of the instrument. An insurance or reinsurance policy is backed by the balance sheet promise of a re/insurance company. With a cat bond, the notional limit of the contract is held in a trust account as highly-rated collateral. This means investors’ money is secure and that the sponsor can be confident that when it needs to claim on a cat bond, the collateral is readily available.

In the middle of a catastrophe bond transaction are the intermediaries. These include investment banks, the capital markets units of the leading reinsurance brokers, risk modeling firms, actuarial consultancies, trust banks, administrators and others. These firms come together to design, structure, market, facilitate and manage catastrophe bond transactions.

On the other side of a catastrophe bond deal are the investors. Investor capital is typically provided via insurance-linked investment managers, or ILS funds, which specialize in managing institutional investor capital in portfolios of catastrophe or insurance risks. These managers are sophisticated underwriters of risk, but with an efficient capital market model that results in a lower cost of underwriting capital than a traditional re/insurer. Some investors do directly participate in catastrophe bond deals, but these are typically the largest pension funds or institutional investors.

The catastrophe bond and ILS investor community is growing rapidly. Estimates suggest that approximately $62 billion of capital markets money is accessing insurance and reinsurance risks through catastrophe bonds and other structures today. $25 billion of this is in cat bonds, the rest in other forms of collateralized reinsurance structures. That is a tiny proportion of a global pension fund market that manages trillions of dollars of capital.

These investors are attracted to catastrophe bonds and re/insurance as a direct investment as it provides certain qualities that make it a desirable addition to their diverse portfolios. Primarily the fact that large catastrophe events are typically not correlated with movements in major financial markets or their other investment classes means that an investment in cat bonds complements a diversified investment strategy more than most asset classes. Cat bonds and ILS investments also exhibit low volatility and a high level of ‘beta’ according to investment specialists.

So while investors could lose their invested capital, if a catastrophe bond is triggered by a major hurricane or other disaster event and becomes a total loss, the returns, low-correlation and portfolio qualities provide a counter to that risk. Typically, cat bonds or ILS investments might only make up 1% or 2% of an investor’s total asset base, meaning they could lose much more due to a financial market crash. With a long-term view, an investment in cat bonds is a very attractive addition to a major pension funds portfolio.

The emergence of catastrophe bonds has been both positive and negative for traditional reinsurance companies. On the positive side, reinsurers can use cat bonds for their own risk transfer needs, sourcing their retrocession from capital markets investors.

However, catastrophe bond coverage can actually be cheaper, or more efficient, compared to traditional reinsurance or retrocession, which can be both positive and negative.

The negative side is that catastrophe bonds are a direct competitor for reinsurers’ capacity and a competitor that can be cost effective, more flexible and more efficient. So reinsurers are now facing competition from a growing cat bond market.

In fact, today, the reinsurance market is facing one of the largest threats to its status quo it has ever faced. With capital markets’ capacity growing, in the form of ILS and cat bonds, traditional reinsurers are facing a loss of market share from new, more nimble and efficient competitors in the growing ILS managers and their funds.

This has resulted in the alternative capital trend, where capital from outside of the reinsurance industry is increasingly interested in accessing the markets returns as an investment asset class. This is a trend that we, at Artemis, expect to continue growing, and the threat to reinsurers is real.

For reinsurers, the growth of catastrophe bonds and ILS now has to be responded to. Reinsurers are themselves managing capital markets money to augment their own risk capacity, a trend that is expected to continue to accelerate.

The catastrophe bond market is also expanding its reach, attempting to cover new classes of risk, bringing broader terms and coverage to cedents and looking to take an ever-increasing share of the reinsurance market. As the market approaches 20 years of existence, the first cat bond Artemis recorded was issued in 1996, this expansion is expected to grow.

Innovative companies are also looking at how the catastrophe bond structure could be suitable for other types of business risks. Essentially, a cat bond allows a risk to be packaged and sold to investors, with a trigger that pays out based on some pre-defined contingency. Some investment bankers believe that we could see cat bonds expanding their remit very broadly to cover many of the risks that threaten global corporations around the world.

Corporations directly sponsoring catastrophe bonds are another development that is expected to become more commonplace. This would allow large global companies to secure risk capital to protect against very specific events, say a magnitude 6 or greater earthquake in Tokyo, something many corporations would like to receive a payout after.

Another future development that we’re beginning to see is the expected use of catastrophe bonds for disaster-risk financing by increasing numbers of governments and sovereign entities around the world. Cat bonds can provide a valuable source of post-disaster risk capital, which could make the difference to the recovery of a country after very severe natural catastrophe events.

So the catastrophe bond market has now reached a level of maturity where it seeks to spread its wings and expand its remit. Cat bonds have often been cited in the mainstream press as a bet on disaster, a term often used with negative connotations.

However, we strongly feel this is a good bet on disaster, in fact one of the best available to those in need of post-disaster financing and risk transfer capital, and as a result expect to see continued growth of this innovative market.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.