Catastrophe bonds: going down a storm

Hurricanes, typhoons, tornadoes and floods claimed hundreds of lives and caused billions of dollars of damage across the world in the first three months of this year, continuing the string of natural disasters experienced during 2011.

“You need to look at what cat bonds offer in their own right, but its not going to be your highest-returning asset class.”

Christophe Fritsch

During the space of just 72 hours in April, residents of Kansas in the United States endured 94 tornadoes affecting hundreds of homes and businesses and causing damage predicted to stretch into the hundreds of millions of pounds.

The month was no better in South America. Some 18 people were killed, 20 more injured and 32,000 homes were damaged when severe weather struck in Buenos Aries. And in China, hail and damaging winds affected six separate provinces during the month, damaging more than 45,000 homes and causing a $204m (£126m) economic loss.

These dramatic events followed the even more devastating Japanese and New Zealand earthquakes and the Thai flooding which blighted 2011, claiming thousands of lives and resulting in billions of pounds in damages and losses.

For those at the centre of such ruinous natural disasters coming to terms with loss of life is paramount, but there is no escaping the need to manage severe financial damage. To that end, the insurance industry provides a critical safety net for many millions of people across the world, but with so many extreme events happening simultaneously, insurance companies themselves must also seek their own protection.

Ever since the early 1990s when hurricane Andrew caused more than $20bn of losses across the southern US, swiftly followed by an estimated $25bn in losses created by the Northridge Earthquake in California, the insurance industry has been acutely aware of the need to pass insurance risk to thirdparties. While reinsurers are the first port of call, even these organisations cannot withstand such huge claims, and so capital markets have proved an invaluable refuge for risk. Catastrophe bonds (cat bonds) allow investors to take on the risk of these kinds of natural disaster for which they are rewarded with a pay-out from the insurer after a fixed period, so long as no events occur. Of course if disaster strikes the investor loses their money and the insurer uses the investment to pay premiums. Cat bonds are issued to cover specific events such as hurricanes or earthquakes, and are usually specific to geographical locations, although more diversified issuances are becoming available.

In the space of 20 years the cat bond market has grown to an estimated $15bn in size and as it continues to gather momentum, some commentators anticipate it will double by 2016. If 2012 is anything to go by, such predictions do not seem fanciful; the first quarter this year has already seen record levels of activity. Insurance intermediary Aon Benfield reports the successful closure of $1.49bn in cat bonds to end of March and notes that with an active pipeline and market movement in the first quarter, annual issuance is on track to exceed $5bn. Of course, such high levels of activity on the supply side must be met with a corresponding level of interest on the demand side and this is where pension funds make an important contribution to the burgeoning cat bond market. Jean-Louis Monnier, head of insurance linked securities Europe at reinsurer Swiss Re, says: “There have been a few pension funds active in the cat bond market for more than five years but participation was limited to a selection of the big schemes. It has become clear over the last two to three years that there is broader interest from pension funds in investing in cat bonds.”

This more recent interest in cat bonds can be explained by the correlation, or indeed lack of it, with other asset classes. Cat bonds offer investors much needed diversification, since this has proven thin on the ground in the wake of the financial crisis of 2008.

Monnier says: “There is recognition [among institutional investors] that any types of financial assets are highly correlated in a financial crisis. The nature of the cat bonds and insurance risk means that their underlying risk remains uncorrelated in an economic crisis since these do not trigger natural catastrophes.”