INSIDE VIEW: A different kind of risk

WavesThe catastrophe bond market has attracted new institutional investors who recognise the benefits of the low correlation natural catastrophe risk premium, but spreads are tightening quickly. Harald Steinbichler of axessum explains the evolution of the market.

Insurers and reinsurers purchase about $300 billion of catastrophe protection each year.

Insurance companies needing re-insurance can either buy re-insurance protection from a re-insurance company or transfer the risk by sponsoring a catastrophe bond.

As a catastrophe bond is a collateralised re-insurance, the insurance company sponsoring the catastrophe bond has no counterparty risk. Therefore, it does not burn capital for counterparty risk.

Besides that, catastrophe bonds offer another market segment to insurance companies looking for re-insurance.  Competition between the traditional re-insurance companies and catastrophe bonds does occur, which improves the premium level for insurance companies buying re-insurance capacity.

The disadvantage for the sponsor is the high volume needed for sponsoring a catastrophe bond. While it is easy to conclude a re-insurance contract of about $10 million, $50 million is needed to issue a catastrophe bond. 

Re-insurance and direct insurance companies wrap the risk of natural disasters in a bond structure and investors like pension funds and asset management companies have now the possibility to participate in the re-insurance business. 

The duration of these catastrophe bonds is typically three years and the coupon consists of the three-month Libor rate, plus a premium. The premium depends on the risk inherited in the bond, ranging from 2% to 20% per year. 

Spreads on catastrophe bonds have tightened quickly, as the market has attracted new institutional investors who recognise the benefits of the low correlation natural catastrophe risk premium. The risks of catastrophe bonds covered are peak risks, such as hurricanes, typhoons and earthquakes, but only a low percentage cover terror and mortality risk. 

Catastrophe bonds have to date mostly securities protection for peak perils; capital charges, the amount of capital a reinsurer must hold per amount of coverage limit provided, are quite low for non-peak perils. 

Catastrophe bonds are designed to cover these peak risks of (re)insurance companies. 

Peak risks occur in areas of high population density, with valuable actuarial-building stock, and where insurance penetration remains high.

Therefore, catastrophe bonds currently cover US, Europe, Japan, Australia and New Zealand. 

Insurance penetration is low in Philippines, for example, but high in Japan. This explains why typhoons, such as Haiyan in Philippines last year, had no impact on catastrophe bonds, but the Tohoku earthquake in Japan in 2011 did. 

In fact, the Tohoku earthquake caused a default in one catastrophe bond. Japan is an important area for catastrophe bonds and fulfils all conditions for an active catastrophe bond area.

Catastrohpe bonds boxWell over 50% of the amount invested in catastrophe finance by the capital markets comes from pension funds, endowments and sovereign wealth funds, generally through specialised insurance-linked investment funds.

More than 25% of such investment capital comes from hedge funds, private equity funds, money managers and life insurers.  Approximately 10% comes from reinsurers themselves and a small percentage of the capital comes from high-net-worth individuals who invest in the sector through insurance bond funds.

Investors who decide to invest in catastrophe bonds have a typical allocation of 1% to 7% of total investment allocation in this asset class.

A direct investment in insurance is an investment whose outcome exclusively depends on the outcome of some insured events – and this is also the main difference to an investment in insurance equities. 

The main advantage for most investors is that catastrophe bonds extrapolate new risk/return profiles, which are in turn then not correlated to any traditional asset classes. 

Since 2002, catastrophe bonds returned 8,6% per year, with a volatility of 2.9%, as measured by the Swiss Re Cat Bond Index. 

The worst month for catastrophe bonds was March 2011, during the earthquake in Tohoku. Catastrophe bonds lost 3.9% in this month. 

The main risk for the catastrophe bond investor is a qualified event, meaning that an event, which is covered by the catastrophe bonds happens during the lifetime of the bond. This causes a partial or total loss for the catastrophe bond. 

Harald Steinbichler is managing partner at axessum

©2014 funds global asia

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