Global pension funds bullish on cat bonds
Pension funds around the world are increasingly turning to specialist catastrophe bonds — a market that Bermuda currently lays claim to about one third of and continues to see strong growth.
Once considered an exotic investment for specialists, catastrophe bonds, or “cat bonds”, which bet on the likelihood of a natural disaster, have gone mainstream according to a report by the Reuters news service.
Investors interested in higher returns than what they’re currently receiving in the traditional equity market are helping to boost demand in catastrophe bonds. And they’re becoming increasingly more popular with traditionally conservative pension funds
Pension funds accounted for 14 percent of direct investment in new cat bonds issued last year, from zero in 2007, according to data provided to Reuters by reinsurer Swiss Re.
Asset managers including Baillie Gifford and F&C Asset Management now represent 17 percent of overall investment, compared to 12 percent in 2007.
“What has changed in the last few years is that the broader investment community has become much more aware of the asset class,” Adam Alvarez, senior vice-president at Bermuda-based insurer and reinsurer Hiscox, told Reuters.
Catastrophe bonds are a form of insurance-linked securities, financial instruments sold by insurers and reinsurers to share the risk they take on for natural catastrophes.
The bonds were developed after Hurricane Andrew hit the United States in 1992 causing more than $26 billion in damage, the costliest storm in US history at the time.
The buyers receive an income but forfeit their original investment if a natural disaster occurs, helping insurance companies raise funds for payouts for the world's most expensive risks — primarily storms and earthquakes in rich countries like the United States and Japan.
Interest in catastrophe bonds has been fuelled in recent years by investors drawn to market-beating yields of around 8.5 percent, compared to global government notes or corporate bonds yielding an average of 4.8 percent and 6.2 percent respectively.
The sector is still small — just $16 billion in size — but ended 2012 on a high note — with more than $6 billion in sales, the second highest total in the market's history.
Bermuda is increasingly becoming a global centre for the creation, listing and servicing of insurance-linked securities that are sponsored by Special Purpose Insurers (SPIs)
In a recent statement from the Bermuda Monetary Authority, Shelby Weldon, director of Licensing and Authorisations for the BMA said that of the 53 new insurers that set up in Bermuda, 27 of them were SPIs.
“Having put in place the regulatory framework for SPIs in 2009, we are pleased to see initial interest now translating into active business,” Mr Weldon said.
“The total volume of new ILS issued globally in 2012 was $6.4 billion with $2.5 billion, or 40 percent, of this total being sponsored by Bermuda-registered SPIs,” he said.
“Overall, SPIs provide another alternative risk transfer option, which builds upon Bermuda’s long-standing expertise in this area. The jurisdiction is committed to servicing this growing segment of the market,” Mr Weldon added.
Brad Kading, president of the Association of Bermuda Insurers and Reinsurers (ABIR) said: “Bermuda is playing a unique role in global catastrophe risk transfer. With the best cat reinsurance underwriters in the world, this risk is being assumed in traditional reinsurance, alternative reinsurance entities and ILS products.
“The cat reinsurance market is undergoing a historic transformation. ABIR’s members are evolving beyond traditional cat re underwriting. ABIR’s members, the BMA SPV regulatory option and the Bermuda Stock Exchange’s trading market are putting Bermuda front and center in this risk transformation. Truly Bermuda is the world’s risk capital.”
The ILS market is skewed towards US natural catastrophe risk — particularly in the highly populated and heavily insured areas of Florida and California.
The last really big event predates many current investors' participation in the market, and some are concerned that the market has not been truly tested.
It is rare for investors in a catastrophe bond to lose all their money. Only eight of around 210 deals issued since 1997 have been triggered — four triggered as a result of losses from a natural disaster and others by damage to collateral as a result of the 2008 financial crisis.
Cat bonds cover events that are so big they are thought to happen only once in every 100 or 200 years, and must hit specific regions of the world and cause millions in damage before a bond is dented. Nevertheless, sooner or later, they are bound to inflict losses.
"At some point that good run will be interrupted and it will be interesting to see how these new investors react to the kinds of significant events that these bonds were designed to protect," Hiscox's Alvarez said.
If a 200-year hurricane hit Florida it could cause $5 billion in cat bond losses, according to catastrophe risk modelling firm Risk Management Solutions (RMS).
"The worst scenarios are those that make multiple landfalls, striking Florida as a major hurricane, and then moving northwards to cause loss throughout the north-eastern states," Ben Brookes, senior director, RMS Capital Markets told Reuters.
"In these most extreme scenarios, whilst highly unlikely, it's possible that over 60 bonds could trigger, causing more than $7 billion in cat bond losses," he said.
A repeat of Katrina — the 2005 hurricane that now holds the record as the costliest in US history with more than $100 billion in economic damage — would trigger eight bonds, with a $500 million expected loss, according to RMS.
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