Catastrophe Bond Alternatives – a Brief History and Growth Trend

What is a catastrophe bond (CAT)?

Also termed Insurance Linked Securities (ILS), CAT bonds are issued to investors and provide funding to the issuer in the event of specifically defined catastrophic events. As an example, those defined trigger-point parameters (termed attachment points) could include explicit wind speeds and pressure readings during hurricanes, or specified Richter scale levels for earthquakes, etc. When contractually defined disaster parameters are triggered, the CAT bond investors make payment to the insured group (not directly, but through a previously established Special Purpose Vehicle-SPV).  CAT bonds are generally shorter term in maturity thereby aiding to reduce investor volatility. This vehicle provides portfolio diversification to investors as its pricing and performance is not correlated with stocks or other fixed-income investments. Investors carefully underwrite specific CAT bond offerings to meet their risk level and tolerance. For example, in recent times investors have tended to underweight the wildfire and flood CAT markets because the risk premium simply does not appear adequate. So, the CAT bond issuers must rethink the risk profile to make the offering more risk palatable to incoming investors.

The 1992 Hurricane Andrew storm that struck Florida and the Gulf Coast, became the most expensive hurricane in U. S. history with $27 billion in damages. A total of $15.5 billion was covered by insurance and led to the failure of eight insurance companies with several others left in precarious financial condition. Andrew’s cost basis has since been dwarfed by 10 subsequent events (Katrina, Harvey, Helene, Ian to name a few), yet the Andrew incident became the wake-up call for the insurance community to begin the design of unique methodologies to cope with the increasing exposures.

Initially insurance companies turned to the reinsurance markets that were less affected by Andrew losses. Yet, available capacity limited the reinsurance full solution.  State insurance programs were introduced to cover losses, supported by public funding (e.g. California Earthquake Authority, Texas Windstorm Insurance Association, etc.) Again, capacity limited funding solutions. The investment markets offered significant potential funds, and designing minds began the development of a risk-based investment product to fund potential losses. The CAT bond market was spawned and made its initial entree into the marketplace in 1997. Though CAT bonds represent less than 10% of the total reinsurance market (according to Fitch Ratings), the market continues to have a rapid advance. The following chart provides the CAT market growth.

So, what’s the rub?

Increasing catastrophic exposures and resulting claim costs have created the growing need for additional capital capacity. The investment markets, hungry for the potential for diversified yields, came to the table and have attracted non-insurance-industry capital including hedge funds, mutual funds and pension plans.

From the financial/investor perspective, one might initially judge these vehicles as highly risky. Yet, the specificity of triggering parameters, coupled with the yield potential compared to traditional fixed income instruments, have made the risk/return attractive to the investment arena. The graphic below, from Artemis, a major player in the Alternative Risk Transfer market, provides a sample of return results for the CAT bond market.  Keep in mind that for much of the periods shown, interest rates were near zero, so the risk adjusted returns appear a bit tantalizing to the investor appetite. Returns are never assured, as some sponsored CAT tranches have lost 100% of principal.

Who are the primary users?  And what are some of the advantages and disadvantages?

The primary issuers of CAT bonds are insurers, reinsurers and publicly funded state insurance programs, with approximate fulfilment estimates of 60%, 25% and 15%, respectively. A key feature of the CAT bond market is the trigger or attachment point, which determines the timing and amount of payout to the bond issuer.  We do not delve in depth into the trigger options in this article but suffice it that these are key underwriting items that investors must carefully assess in relation to the modeled loss estimates.

Advantages for insurers and investors:

• An alternative option to the traditional reinsurance market
• Eliminates counterparty risk (reinsurer unable to pay) by providing 100% collateral
• Allows issuers to secure prices over an extended period rather than one-year increments
• Increased availability of capital in the marketplace introduces an alternative competitive pricing mechanism with the reinsurance markets
• Generally, provide better-than-average risk adjusted returns to investors
• CAT bonds are uncorrelated with the security markets

The evident disadvantage is entering tranches that incur substantial or full losses. The Law of Large Numbers, coupled with restrictive investor underwriting, tends to mitigate this risk. Yet, it is still present.

As the insurance arena continues to hunger for capital support, the markets are responding with continuing designs to satisfy the appetite. Complementary concepts such as collateralized reinsurance transactions are also growing in interest, but that is a topic for future discussion. CAT modeling improvements, particularly with the potential assistance of Artificial Intelligence, will open offerings for other casualty events such as cyber and terrorism risks.