Hur­ri­cane Irma tests the catas­tro­phe bond mar­ket

The Star (St. Lucia) - Business Week - - FRONT PAGE - BY FT COR­RE­SPON­DENT

When Hur­ri­cane Irma tore through the East­ern Caribbean, lay­ing waste to the is­land of Bar­buda and ad­vanc­ing west to­wards Florida via the Bri­tish Vir­gin Is­lands and Cuba, in­sur­ers were not the only fi­nan­cial in­sti­tu­tions braced for heavy losses.

When Hur­ri­cane Irma tore through the East­ern Caribbean, lay­ing waste to the is­land of Bar­buda and ad­vanc­ing west to­wards Florida via the Bri­tish Vir­gin Is­lands and Cuba, in­sur­ers were not the only fi­nan­cial in­sti­tu­tions braced for heavy losses.

As the cat­e­gory-five hur­ri­cane — the most de­struc­tive level — ap­proached the coastal ci­ties of Mi­ami and Tampa, pen­sion funds and as­set man­agers also watched ner­vously for the fall­out from what one port­fo­lio man­ager de­scribed as “the cat­a­strophic com­bi­na­tion of wealth and peril”.

Their con­cerns were much greater than in 2005, when Hur­ri­cane Ka­t­rina swept a path of de­struc­tion through the sun­shine state and beyond. In the 12 years since that dis­as­ter, which cost the in­sur­ance in­dus­try US$82bn, an al­ter­na­tive in­sur­ance-linked se­cu­ri­ties mar­ket has also put main­stream as­set own­ers in the line of fire.

The catas­tro­phe bond mar­ket, where in­vestors trade the risks of large nat­u­ral dis­as­ters, has at­tracted port­fo­lio man­agers ea­ger to di­ver­sify their hold­ings with as­sets that are un­cor­re­lated to broader mar­kets. Fif­teen per cent of to­tal rein­sur­ance cap­i­tal now comes from pen­sion funds, en­dow­ment funds and sov­er­eign wealth funds, mainly through as­set man­agers, ac­cord­ing to Aon Ben­field, the in­sur­ance bro­ker.

Hur­ri­cane Irma is the first sig­nif­i­cant catas­tro­phe since the mar­ket gained trac­tion with in­vestors.

“This is a mar­ket-chang­ing event in terms of pric­ing, but also in terms of dy­nam­ics,” says Daniel Ine­ichen, fund man­ager of in­sur­ance-linked se­cu­ri­ties at Schroders, the UK’s largest listed as­set man­ager. “We are com­ing out of a 10-year pe­riod with hardly any hur­ri­canes. This sea­son [we have] al­ready see[n] two cat­e­gory-four hur­ri­canes, which is ex­cep­tional.

“The catas­tro­phe bond mar­ket has been tested for the first time,” he says

Be­fore Hur­ri­cane Ka­t­rina, the risk from nat­u­ral dis­as­ters in the de­vel­oped world was al­most en­tirely borne by in­sur­ers and gov­ern­ments. Com­pa­nies pro­vid­ing cover for the de­struc­tion of homes and busi­nesses dur­ing the At­lantic’s no­to­ri­ous hur­ri­cane sea­son sold parcels of this risk on to rein­sur­ers, but the fall­out from a “onein-200 year” catas­tro­phe — as de­scribed by reg­u­la­tors — was ex­pected to be se­vere.

Hur­ri­cane Ka­t­rina, which hit the US with its largest-ever in­sur­ance bill, prompted a re­think. In­sur­ers and rein­sur­ers such as Swiss Re, Mu­nich Re and Al­lianz be­gan to is­sue more in­sur­ance-linked con­tracts and se­cu­ri­ties, or catas­tro­phe bonds, to off­load the risk from im­prob­a­ble but dev­as­tat­ing catas­tro­phes.

The bonds, which are rel­a­tively liq­uid, pay an at­trac­tive in­ter­est rate and can be trig­gered in the event of a se­vere nat­u­ral dis­as­ter, forc­ing hold­ers to shoul­der heavy losses.

Af­ter the fi­nan­cial cri­sis, which pushed in­ter­est rates to record lows, pen­sion funds, en­dow­ment funds and sov­er­eign wealth funds hun­gry for re­turns ploughed money into the sec­tor. The al­ter­na­tive mar­ket for in­sur­ance bal­looned from just US$17bn in 2006 to $89bn in the first half of this year, ac­cord­ing to Aon Ben­field.

“There were a hand­ful of catas­tro­phe bonds around in the late 1990s, but they were un­usual as a form of cover,” says Ben Brookes, vice-pres­i­dent of cap­i­tal mar­kets at RMS, the catas­tro­phe mod­el­ling group. “The in­flux of cap­i­tal from pen­sion funds and big in­vest­ment funds has changed the dy­namic of the mar­ket.”

As­set man­agers rushed to grab a slice of the grow­ing pie. Last year, Schroders be­came a ma­jor­ity share­holder in Sec­quaero, a Swiss-based as­set man­ager spe­cial­is­ing in in­sur­ance risk, af­ter first tak­ing a 30 per cent stake in 2013 with the aim of “ce­ment­ing its com­mit­ment to the in­sur­ance-linked se­cu­ri­ties busi­ness”. Nephila and Credit Suisse As­set Man­age­ment are among the largest hold­ers of in­sur­ance-linked se­cu­ri­ties, ac­cord­ing to a list com­piled by In­suranceLinked, an in­dus­try web­site. “This is a proof point for the mar­ket. It will and should be a demon­stra­tion to in­vestors that the mar­ket has done what it was de­signed to do,” Mr Brookes says.

Now they will be watch­ing to see how many catas­tro­phe bonds cause losses. Zeba Ah­mad, in­vest­ment di­rec­tor of in­sur­ance-linked se­cu­ri­ties at Schroders, ex­pects Hur­ri­cane Irma to trig­ger be­tween seven and 15 of its bonds, caus­ing losses of be­tween £52m and £78m, but a pos­i­tive re­turn over­all this year. An­a­lysts at RMS es­ti­mate that two-thirds of ex­pected losses to catas­tro­phe bonds in a given year come from US hur­ri­canes, with half of that from Florida alone.

Pen­sion funds are also on the line. The Royal Bank of Scot­land in­vested £378m in rein­sur­ance through Nephila last year — an in­crease of 46 per cent on the pre­vi­ous year. PKA, which man­ages the re­tire­ment in­come of 300,000 Dan­ish work­ers, owns 23.6 per cent of the Yderst Catas­tro­phe fund and 23.4 per cent of the ILS CO2 Seg­re­gated Port­fo­lio.

Losses for the wider mar­ket are ex­pected to be greater than af­ter Har­vey last month, ac­cord­ing to an­a­lysts, be­cause that hur­ri­cane caused most of its dam­age through flood­ing. In the US, flood pro­tec­tion is cov­ered by the gov­ern­ment-run Na­tional Flood In­sur­ance Pro­gram and is usu­ally ex­cluded from rein­sur­ance con­tracts and catas­tro­phe bonds.

“Some of th­ese in­vestors who are naive in­vestors haven’t re­ally un­der­stood the risks that they were stand­ing for when they in­vested their money,” says An­tonello Aquino, as­so­ciate man­ag­ing di­rec­tor of fi­nan­cial in­sti­tu­tions at Moody’s, the rat­ing agency.

“If some­thing big hap­pens, then there will be part of this al­ter­na­tive cap­i­tal that will be hit. But then the tra­di­tional rein­sur­ance com­pa­nies would say, ‘We are see­ing big claims com­ing in, so we need to raise prices’.

“Irma is the first test for al­ter­na­tive cap­i­tal,” he says.

View of the af­ter­math of Hur­ri­cane Irma on St. Maarten

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