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Increasing influence of CAT bonds

There is plenty of room for growth and Sandy provides the impetus

By Michael J. Moody, MBA, ARM


As this article is being written, the northeastern section of the United States is still trying to recover from the effects of Hurricane Sandy. Many millions of people are still suffering from the storm's effects, and significant work remains to get things back to normal. The commercial property and casualty insurance market was already poised for modest price hikes beginning January 1, 2013; however, recent events will undoubtedly affect those plans. More severe pricing in the property market, especially coastal property, is almost assured.

Insurers and reinsurers are determining the effects on their bottom lines and are beginning to consider a number of viable approaches to utilizing the capital markets to help shoulder some of these extreme risks. One of the approaches that will certainly be considered to access the capital markets is catastrophic (CAT) bonds.

CAT Bonds 101

CAT bonds are a relatively new investment product, having been in existence for only a couple of decades. Very broadly speaking, they are risk-linked securities that seek to transfer risk from a particular sponsor, typically an insurance company, to capital market investors. The idea is relatively simple—insurance companies concerned about enormous calamities for which payouts could exceed premiums transfer a portion of the risk associated with a particular disaster by selling bonds through an investment bank to investors. If no disaster occurs, the investors will reap a healthy return on their investment. However, should a disaster occur, the investors could lose their upfront investment as well as any interest accrued to that point. Insurers will then use the proceeds to pay claims arising out of the disaster.

In this manner, CAT bonds serve a similar function to reinsurance. However, rather than the counterparty being a reinsurance organization, the other side of the equation from the insurance company's point of view is a special-purpose vehicle (SPV). Special-purpose vehicles are formed specifically to securitize the risk. The ability of the organization to shift risk to another counterparty is a key consideration.

There are a number of advantages to be derived from the use of CAT bonds. From the insurance company standpoint, the ability to shift some or all of the risk of a natural disaster to another group is not only prudent but essential—this is the foundation that reinsurance was built on. Say, for instance, a particular organization offers home insurance and their clients are predominantly located in Florida. It doesn't take a genius to see that this insurance company could literally face bankruptcy from a single devastating hurricane in Florida. Not surprisingly, CAT bonds were born in the aftermath of Hurricane Andrew in 1992. Similar potential CAT bond targets include earthquakes in California or tornadoes in the Midwest.

For investors, there are also a number of major benefits to participating in the CAT bond market. First, the bonds are not correlated with traditional investment products like stocks and bonds. This uncorrelated effect is known as "zero beta" and that is one of the biggest incentives for investors to participate, since it allows investors to diversify their portfolios. CAT bonds are one of the few investments that are not related to how the U.S. economy is doing, or even how the global economy is doing.

A secondary benefit concerns the yields that are currently available in the traditional bond market. Currently, the average CAT bond yields about 9%, far better than almost any other bond. Even junk bonds are paying only about 6%.

These two advantages alone have caused organizations like Citizens Property Insurance Corporation, Florida's state-owned wind insurer, to more than triple its target amount of debt sale of obligations. Issued in April 2012, it represented the largest CAT bond sale on record, according to the investment banking community. Investment bankers point out that investors are looking for high-interest vehicles where they can park at least a portion of their investment portfolios, and they believe the CAT bond market could provide one solution. While the principal is at risk, for some investors the potential yields justify the additional exposure.

Despite the attractiveness of CAT bonds, this emerging market remains quite small compared to the rest of the insurance community. Currently, there is about $12.5 billion in global CAT bonds outstanding. When considering the net written premiums for the insurance industry are about $425 billion, the CAT bond market can be seen as minimal at best. However, many experts believe that the CAT bond market is destined to increase over the next few years. One reason for this anticipated increase is the development of the secondary market for CAT bonds, which will allow their owners to sell the investment prior to maturity, if needed. This increased liquidity should help the market grow significantly. Additionally, triggering mechanisms within the bonds themselves are becoming much more standardized. This should also allow for greater interest within both the insurance community and the capital markets. Bottom line, the CAT bond market is still in the early stages of its existence and it is now going through its natural growth pattern.

Current market conditions

Overall, the CAT bond market has been good to the investment community. To date, only eight bonds out of a total of 232 have paid out to issuing insurers because of a natural catastrophe. With regard to Hurricane Sandy, experts believe there are around 14 bonds totaling $3.6 billion that have any exposure to Sandy. Due primarily to the scope and scale of Sandy, it makes it unlikely that any of these bonds will be triggered solely by Sandy. However, if losses continue to mount or early estimates are proven wrong, some of these bonds could be at risk.

Investment professionals believe the chances of any CAT bonds being triggered as a result of Sandy are extremely low, currently estimated at around 1% to 2%. One of the reasons is that most of these transactions use the Industrial Loss Index to calculate ultimate losses. In this case, ILI is the U.S.-based data aggregator for Property Claim Services, which will provide a catastrophic loss estimate. This estimate will be used to define whether the event qualifies under the terms of the bond. From early projections from PCS, many think that the 14 bonds will not be triggered. Rather, the brunt of the storm's financial impact will more likely end up flowing to the National Flood Insurance Program, which may, in fact, have significant losses.

The insurance industry has long looked for a way to utilize capacity within the capital markets. The use of CAT bonds appears to have merit for both investors and insurers. The bonds allow insurers to be more aggressive in assuming catastrophic risk, while also allowing investors significantly higher yield rates than is currently available in the traditional investment marketplace. When this is coupled with the fact that CAT bonds are zero beta investments, you can understand why many investors are looking favorably on this type of high yielding diversification, especially when the economic conditions remain in flux.

Conclusion

As is so often the case following significant events such as Hurricane Sandy, insurers are still tallying their losses. Estimates of ultimate damage and insurable losses vary widely, but it will certainly be one of the top two or three costliest U.S. storms ever. Time will tell just how bad this really was. But this event has once again proven that the insurance industry must find a method to access the capital markets. As the concentration of values continues to grow within certain coastal geographic areas, the exposure grows significantly as well.

While it is still early in the evolution of CAT bonds, they appear to offer a method by which insurers can gain access to the capital markets. As insurers and investors become more accustomed to the details of CAT bonds, growth should continue. For the most part, this type of convergence could be a win/win situation for both the insurance industry and the capital markets.

 

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