Japan just marked the first anniversary of its devastating 9.0 earthquake and tsunami. Closer to home, in early March, off-season tornadoes wreaked havoc in Indiana, Ohio and Kentucky.
With Mother Nature on the warpath, it might seem like an odd time for catastrophe bonds to be making a comeback, but issuance of these short-term, high-yielding bonds linked to insuring against natural disasters may “break the $5 billion mark this year for the first time since 2007,” according to a report issued in February by Willis Capital Markets & Advisory, the investment banking arm of the New York City– and London-based global insurance broker.
And $5 billion “may be a little bit conservative,” says William Dubinsky, the head of insurance-linked securities at Willis, noting another estimate from one of the industry’s top investment managers, John Seo, the co-founder of Fermat Capital Management of Westport, Connecticut, which has $2.1 billion in insurance-linked assets under management. On March 2 at the Securities Industry and Financial Markets Association’s annual conference on Insurance- & Risk-Linked Securities in New York City, Seo said that with $3 billion to $4 billion “already committed to the cat bond market in 2012,” he had “no doubt” issuance could hit $7 billion this year. If it does, that would make for a 62.8 percent increase from last year’s $4.3 billion in the natural disaster category. (There is another type of cat bond linked to “life” risks like pandemics, but that is a much smaller and less active sector.)
Part of this year’s surge is pent-up demand. Last year was an off year due to the Japanese earthquake, which was such a major event the reinsurance market froze while the initial damage was being assessed. But there was another reason why issuance fell off last year. During the first quarter of 2011, one of the major risk-modeling agencies — Risk Management Solutions, or RMS, of Newark, California — instituted major revisions to its model for forecasting U.S. hurricane risk. “Global warming was one of the drivers in the RMS changes — the higher frequency of events coming out of warming waters,” says Luca Albertini, the chief executive officer of Leadenhall Capital Partners in London. The changes “threw the market into confusion and created uncertainty” about the pricing of both new and existing bonds, Dubinsky says, noting that U.S. hurricane risk is about 70 percent of the natural disaster cat bond market. It took time for the market to absorb the changes, and the new-issue market did not start to ramp back up until the fourth quarter, when $2 billion was issued.
But what is also driving greater issuance is that in a low-yield environment, there is more interest from investors and portfolio managers. Cat bonds “continue to pay generous yields” — on average, 500 to 800 basis points over LIBOR — but with a “low correlation to the traditional markets,” says Caleb Wong, the portfolio manager at Oppenheimer’s new Global Multi Strategies Fund, which is about 25 percent invested in cat bonds.
“After 2008 a lot of stuff became correlated that wasn’t supposed to be correlated,” says Greg Hagood, the co-founder of Bermuda-based Nephila Capital, which manages $5.5 billion in insurance-linked securities for accredited investors. “Pensions have been looking for diversifiers,” he says, adding that “today, about 80 percent of our investors are pension funds and that was not the case five years ago.” Last year two public pension funds announced investments in Nephila’s funds: The Pennsylvania Public School Employees Retirement System, with up to $250 million; and the Oregon Investment Council, which manages the Oregon Public Employees Retirement Fund, with $100 million.
The first natural catastrophe bond was issued in 1996. In the wake of Hurricane Andrew in 1992 and the Northridge earthquake in Los Angeles in 1994, insurers started thinking about new ways of raising additional capital that could be set aside to cover truly extraordinary losses.
“Traditionally, reinsurers purchase retrocessional coverage, which is just reinsurance for reinsurance,” explains Brenton Slade, the chief marketing officer at Flagstone Re, a Bermuda-based property and casualty reinsurer, which both issues and buys cat bonds.
Cat bonds add another layer of capital, which is the last to be tapped should claims from an event exhaust all the usual lines of insurance and reinsurance. The money raised by a cat bond issue is held in a trust — typically, for a three-year term, though some bonds mature in as little as a year. Usually, the bonds pay interest and expire without being triggered. “Cat bonds kick in at the top of the food chain,” Slade says, noting that the “risk of attachment” — that is, the risk the principal raised through a bond issue will actually be used to pay claims and investors will lose some or all of their money — is “very, very remote.”
But last year — for the first time — two cat bonds were total losses. Claims from the Japanese quake wiped out a $300 million Muteki bond issued in May 2008 by Munich Re on behalf of Zenkyoren, a large Japanese mutual, and two “severe thunderstorm” bonds worth $200 million, issued in November and December 2010 by Mariah Re on behalf of Wisconsin’s American Family Insurance Co., got cleaned out as well. With the later, “it was not one event, but multiple events,” says Dubinsky, including the tornado that hit Joplin, Missouri, along with other tornados, thunderstorms, hail, and wind. A third bond — a $68 million “U.S. earthquake and hurricane” issue from 2008 — is in arbitration over whether it will have to pay out against claims arising from Hurricane Ike.
Other than that, there have been only six other natural disaster cat bonds that have been tapped for capital, and those had partial losses. That makes for nine bonds that have been hit out of a total of 194 issued between 1996 and early March of this year, according to Willis’ statistics, which also show total issuance since inception at $38.5 billion, with $13.5 billion currently outstanding.
Since there is that risk of total loss, in the U.S., cat bonds are sold only as 144A offerings, and most institutional investors invest via managed funds, where the risks are diversified geographically and by the type of peril. “There’s something like 30 different perils with specific risk codes,” says Brett Houghton, a managing principal at Fermat. Even within the largest category — U.S. “wind” or hurricane risk — there are lots of variations, he notes. For instance, some bonds cover Florida, while others cover Texas, North Carolina, or the Eastern seaboard; and some are diversified with multiple risks, so-called multi-peril bonds.
Houghton also notes that despite the risks, over the five years ending in 2011, the Swiss Re Global Cat Bond Performance Index posted a total return of 9.09 percent.
In the post-2008 environment, cat bonds were one of the investments that “held up incredibly well,” says Albertini. “Lack of correlation is the key thing that pension funds are focusing on,” he says.
