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Investing in Cat Bonds

Tuesday, April 19, 2016

Can you tell us about cat bonds?
Cat bonds are corporate bonds. The issuer is typically an insurance company operating in a catastrophe-exposed region. Cat bonds structurally utilise an exchange-like mechanism for transferring risk. This allows any issuer and investor to participate in cat bond risk transfer without concern for counterparty credit risk. In this sense, its structure tears down all regulatory barriers and credit concerns – that normally stood between well-paying catastrophe risks and investors looking for attractive, high yield returns that are fundamentally uncorrelated with broader markets.

It’s a long-only market, fully-collateralised with cash. This helps to keep the asset class clear of contagion risks, which occur when investors unwind leveraged positions in the midst of a crisis. Second, there is no credit, interest rate or broader market exposure inherent to cat bonds. The risks are predominantly event-driven, which are surprisingly easy to model, especially in the natural catastrophe domain. We record a million earthquakes and an average of 90 cyclones (typhoons or hurricanes) across the globe every year. Also, there is fundamental non-correlation between the cat bond sector and the broader market (for example, a market crisis does not cause an earthquake to occur). And on top of that a strong diversification within the cat bond sector itself e.g., an earthquake does not cause a typhoon to occur. Normally, in an alternative investment strategy, non-correlation is achieved by hedging, but here it’s fundamental to the asset class.

Who are the cat bonds issuers?
7 of the top 10 U.S. insurance companies issue cat bonds, like Chubb, Travelers, AIG and USAA. Furthermore, 7 out of the top 10 global reinsurers issue cat bonds, including Munich Re, Swiss Re, Lloyd’s and China Re. The top 3 global government catastrophe schemes issue cat bonds, including Florida Citizens, the California Earthquake Authority and the Turkish Catastrophe Insurance Pool. We are beginning to see major corporations issue cat bonds as well—for example, Amtrak, the national rail carrier here in the U.S., sponsored a cat bond for the first time in 2015. Generally, anybody with major exposure to catastrophe risk is a candidate for cat bond issuance.

What are the recent developments in the cat bond market globally?
Historically, the global cat bond market has grown at a rate of 15-20% per annum. The market is currently taking a ‘breather’ at USD 7 billion per year after a couple of years of above-trend growth. We expect issuance growth levels to pick up in 2017 as new issuers come to market and as current issuers continue to expand their cat bond programs. The Asian market has been coming into life during the last two years. China Re issued a cat bond for the first time in 2015, but also Japanese issuers seem to have embraced the market more than in the past. From 1997 to 2013, Japanese issuers never broke the USD 500 million issuance volume ceiling in any given year. From 2014 to 2016, the average annual issuance from Japanese issuers, even just using year-to-date numbers for 2016, is well above USD 650 million per year.

Cat Bond Market Size at Year-End: 2002-2015
 Cat Bond Market Size at Year-End: 2002-2015 
Source: Swiss Re Capital Markets and Fermat Capital Management, LLC

Why can catastrophe bonds be an option for investors in a low yield environment?

In this low yield environment, cat bonds are a legitimate option for any investors seeking immunisation from credit exposure and interest rate volatility without resorting to cash holdings which produce zero or negative returns in many instances. Cat bonds are not risk-free investments, but they allow an investor to earn a fair return against risks that are quantifiable and unaffected by volatile global market conditions in a low yield environment.

What are the potential risks in 2016?
The biggest risk in 2016 – as in any typical year – is a Great Miami Hurricane, similar to what was seen in 1926. Such an event is expected to cause a temporary loss of 25% in value to a typical cat bond portfolio. If, however, the investor is willing to stay with the investment, even with no further injection of money, a well-run cat bond portfolio is expected to recover such a loss within 2 to 3 years due to the increase in catastrophe re/insurance premiums after such a traumatic insurance industry event.

Some people argue that it is difficult for cat bonds issuers to specify the conditions of the catastrophic events under which investors’ principal can be wiped out. What’s your view on that?
From the investor point of view, the fact that cat bonds have specified terms of loss is not a problem. From the issuer point of view, it is understandable if coverage design is sometimes seen as a burden. Part of this is a perception problem and the other part is a technology problem, which is being addressed each year. The perception problem is that some, certainly not all, insurers are caught up in the fantasy that reinsurance covers everything, when experience tells us it clearly does not. Worse, what reinsurance does not cover is never completely apparent until it is too late. At least with cat bonds, what is covered and what is not covered is clear from the start. The technology problem has to do with so-called indemnity loss triggers, which allow cat bonds to provide coverage that is increasingly similar to traditional reinsurance coverage. As catastrophe modelling technology continues to improve and insurance risk disclosures continue to improve, indemnity loss triggers are becoming more commonplace in cat bonds, which addresses most of the concern around coverage design for issuers.

What is your investment strategy?
We take an active approach towards cat bond investing. We first construct the best investable portfolio of cat bonds using our CatAPM® model, a proprietary portfolio balancing system adapted to catastrophe bonds. Then we continuously adjust the portfolio using active trading to maintain optimality and to capture value. Bond-picking occurs around special situations, when we are sometimes able to develop a high conviction view. Unlike in many other markets today which are wildly driven by unstable human behaviour, the price trajectory of cat bonds remains firmly grounded in objective reality eg, an earthquake or a hurricane risk. This makes investing in our space an investment manager’s dream.

Nothing in this material constitutes investment, legal, accounting or tax advice and should not be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. The statements and opinions in this material are those of the author at the time of publication and may not reflect his/her views thereafter. The companies listed were selected by the author to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the author.
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