Catastrophe bonds: a storm in a teacup or a floody good opportunity?
Catastrophe bonds are a type of insurance-linked security. They offer an alternative to reinsurance policies and allow insurers and reinsurers to offload a proportion of their risk. As the name suggests, they are often triggered by damage that an insured suffers as a result of a natural catastrophe such as a hurricane, earthquake or flood, but can also be designed to respond to events such as a pandemic.
How do they work?
A typical catastrophe bond structure involves an insurer or reinsurer forming a special purpose vehicle (SPV) which issues bonds to capital market investors. The bondholder will sign up to a treaty of reinsurance for an underlying risk. The bondholder earns interest on the amount for the duration of the treaty. If the policy trigger (e.g. a hurricane or pandemic) occurs, then the money invested is paid from the SPV to the insurer, enabling it to deal with the relevant claims. If the policy term elapses without a trigger event taking place, then the initial sum invested is returned to the bondholder.
Why are they used?
Catastrophe bonds are attractive to insurers because they provide access to a different pool of capital. They give insurers an opportunity to distribute risk (as regulators require). If a reinsurer in the market is facing financial difficulties, the fallout will be less disruptive if some capacity that they might otherwise have reinsured is taken up by bonds (the funds from which are protected as a result of being held in an SPV).
Buyers that are interested in catastrophe bonds tend to include institutional investors such as pension and sovereign wealth funds. Catastrophe bonds are attractive to them as the returns do not (usually) correlate with traditional capital investments. Again, the bonds provide an opportunity to spread risk. Buyers reduce the chance of being severely impacted by a downturn in markets.
One exception to the rule appears to be the spread of COVID-19. The pandemic has triggered a number of WHO catastrophe bonds and has already caused significant downturns in markets. The impact of COVID-19 has challenged the conventional wisdom that catastrophe bonds do not correlate with more traditional financial products. Despite this, many consider a hit to financial markets less likely to occur in the context of more traditional triggers such as floods or hurricanes. The impact of natural catastrophes tends to be focused on a limited geographical area and therefore not to have a considerable impact on the wider trends in markets.
How have they been performing?
The market for insurance-linked securities has had a buoyant few years. More than $11bn worth of catastrophe bonds were issued in 2018, bringing the total value to a new high of $36bn. One consequence of the steady increase in the use of catastrophe bonds over the past decade had been downward pressure on reinsurance rates. Reinsurers and bondholders have not been able to impose the increase in rates usually associated with a big year of losses, as the capacity in the market has increased, ahead of demand.
However in 2019 following a series of expensive natural disasters in in 2017 and 2018, issuances are believed to have slowed by as much as 35%. As bondholder demand appears to have slowed in 2019, we may see this trend for reinsurance rates begin to reverse.
What does the future hold for them?
In the first quarter of 2018, 75.4% of all bonds were issued in Bermuda. The Bermudan regulator was one of the early adopters of a regulatory framework for ILS and has become the leading jurisdiction. Other newer markets are now vying for a piece of the ILS action by setting out their regulatory frameworks. For example, Singapore has passed legislation which aims to create favourable conditions for ILS, by giving the SPVs tax neutrality and providing a grant for the upfront costs of issuing.
As the ILS market becomes more mainstream, many insurers and reinsurers who are not yet offering bonds, have expressed their intention to launch SPVs. Whilst there may be price adjustments following a dip in bond issuances, the ILS market continues to be an important tool for insurers and investors.