03 June 2020
John Seo outlines the response of insurance-linked securities to the Covid-19 pandemic, explaining why they might be uniquely positioned to withstand the economic downturn and emerge relatively unscathed.
Although many aspects of the stock market are chaotic by nature, catastrophe (cat) bonds are less subtle in their connection to the unpredictable. In the cat bond market, natural disasters serve as the foundation for investment. Our market – the insurance-linked security (ILS) market – is built on acts of chance that, despite our best efforts, we cannot anticipate with the same level of certainty that, for example, an equity investor can when analysing a pre-announced IPO. By examining the ILS market as a whole, however, we are able to see a robust structural and long-term growth story for cat bonds that we believe is fundamentally independent from the current economic downturn and the turbulent global economy.
Investing in a rectangular world
Chart 1: Catastrophe risk profile
The ILS market was born in the 1990s after two events in the US – 1992’s Hurricane Andrew in suburban Miami and 1994’s Northridge Earthquake in suburban Los Angeles – caused a near collapse of the reinsurance markets in Florida and California. Reinsurers at the time had not appreciated nor modeled for the increasing concentration of property that had occurred in these fast-growing, high-risk zones in the preceding decades.
Reinsurance companies, like the insurance companies they support, are regulated and rated based on a risk spreading approach – so that no single risk threatens the capital adequacy of a company – and therefore must keep a rectangular risk profile worldwide (highlighted by the shaded blue area in Chart 1). A rectangular risk profile is one that is level across all risk zones. The problem is, however, that the real world does not fall into such quasi-uniform risk buckets, and some areas of the world need to buy significantly more insurance than others.
In the real world, societies and economies are inherently and increasingly concentrated, as people continue to congregate their property and wealth on coastal areas, such as Florida, or in seismic zones in California. This trend is fundamentally at odds with the horizontal remit of the reinsurance markets and has left insurers with an uncoverable amount of catastrophe risk – a ‘disaster gap’ – that cannot be reinsured at any price. This gap (highlighted by the grey area) was eventually exposed when Hurricane Andrew and the Northridge earthquake occurred, but it still exists today. We estimate that currently the disaster gap stands at approximately USD 500 billion and is doubling every 10 years.
ILS were created to provide an efficient solution to this disaster gap problem, with reinsurers willing to pay an attractive structural premium to transfer the risk off their balance sheets to the capital markets in order to continue providing coverage to the areas that demand it most. Today, ILS penetrate a mere 15-20% of this opportunity, offering significant growth potential, in our view.
It has been observed that the cat bond market functions much like the S&P 500. In metaphorical terms, ‘earthquake risk’ is our healthcare sector and ‘hurricane risk’ is our IT sector. This comes down to an issue of shape: capital markets are triangular, as is the risk profile of the cat bond market (Chart 2). As we have learned, the world is not flat, and the cat bond market mirrors this real world risk profile. While they may have emerged from a rectangular world, ILS and cat bonds create a triangular opportunity that can be absorbed by ILS managers and, after providing a structural capital solution to the reinsurance industry, could potentially reward investors with attractive, risk-adjusted returns.
Chart 2: Risk capitalisation of the ILS market
A miniature V-shaped recovery in the cat bond market
We believe the cat bond market’s innate independence from traditional market risk and ability to reap returns even in the face of economic meltdowns is exemplified by today’s Covid-19 crisis. In March, when investor panic reached its peak, multi-strategy investment funds sold off liquid assets in the secondary market. Cat bonds, being liquid, were affected by this rush to sell, with the price levels on some bonds decreasing by approximately 3%. Consequently, attractive secondary market buying opportunities were created for active cat bond managers and, soon after, the market stabilised with minimal long-term damage. We believe this illustrates the potential benefits of cat bonds – namely, their liquidity, which allows them to be traded in any environment, as well as their fundamental non-correlation to traditional markets. As we know, a market crash (or virus) cannot cause a hurricane or earthquake to occur.
With the market upheaval somewhat behind us, we are left with spreads at historic highs, indicating disrupted conditions in the insurance system. While we believe these attractive spreads will persist in the short-to-medium term, it is our opinion that such high yields cannot be called the new normal. Even after Hurricane Katrina, the most disruptive event in the history of the market, yields peaked around where they are now, but reverted down towards ‘normal’, structurally supported levels. We would anticipate this pattern – also seen in the wake of the global financial crisis – could repeat itself in due course.
Throughout the Covid-19 crisis, cat bonds have, again, preserved investors’ capital, just as they have done in past crises. With yields moving emphatically in investors’ favour, the next few months may offer, in our opinion, the most attractive entry point into the market in several years.
Having demonstrated their value to both investors and sponsors alike during these chaotic times, we believe ILS represent a permanent and growing source of capital for managing the world’s insurable risks, and may possess the dynamic needed for a substantial market growth trajectory ahead. With a unique set of drivers and the benefit of being fundamentally uncorrelated with the broader market and the economic turbulence, ILS are filling the disaster gap left by the reinsurance industry and can offer genuine diversification for investors in return.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.