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Cat bond boom raises capital flee fears

Major disaster: an event that triggered multiple cat bonds could spark a panic among ILS investors, an analyst claims

The boom in the catastrophe bond market is leading some experts to voice fears that investors do not fully understand the risks they are taking on — and so they could flee in a panic in the event of a major catastrophe that triggers losses.

Jay Patel, an insurance analyst with business information service Timetric, believes the market will continue to grow next year as asset managers seek returns that are not correlated with financial markets and business cycles.

“Although issuances have been at roughly the same level for the past two years, at around $7 billion, the size of the market currently stands at $25 billion with steady growth expected in the forthcoming years,” Mr Patel wrote in an article in online publication The Intelligent Insurer.

He added: “The speed at which institutional investors have placed their capital into the market has raised concerns among asset managers, insurers and academics alike, that investors are allowing the higher returns and diversification benefits on offer to obscure a more objective analysis and understanding of these assets.

“This has led to concerns that when a major catastrophe occurs that triggers a large number of catastrophe bonds, investors will face unexpected losses and this will lead to panic and a sharp outflow of funds from the market.”

Bermuda has been the centre of growth in the insurance-linked securities market that includes catastrophe bonds.

Last year saw a record 58 ILS listed on the Bermuda Stock Exchange with a capitalisation value of $6.16 billion.

The industry extra capacity for reinsurers — some of whom have established their own ILS management arms — as well as work for asset managers and law firms.

Cat bonds generally offer attractive returns, but investors can see their principal wiped out in the event of a specified catastrophic event.

Mr Patel said loose monetary policy in developed economies had driven down interest rates and made it difficult for investors to generate the rates of return they were used to making before the financial crisis.

This in turn caused capital to flow into sovereign debt markets, pushing yields down in this and the corporate bond markets.

This scenario had led more institutional investors into cat bonds in search of yield.

“The market structure of catastrophe bonds has changed over the past decade and a half, with the composition of investors being noticeably different from what it was at the beginning of the century,” he said, explaining that hedge funds chasing high-yield opportunities were the major investors in the early days.

“This is due to a combination of increasing knowledge of the catastrophe bond market as well as unprecedented monetary conditions. It is clear that as they invest more into catastrophe bonds, institutional investors are keen to increase their expertise in the market.

“The worry is that while they are becoming more knowledgeable, the rate at which they are investing far outstrips their ability to understand what exactly they are getting themselves into. This sounds eerily familiar to the way investors behaved towards another seemingly obscure bond market before the financial crisis.”