The name's Bond, cat Bond

Catas­tro­phe bonds are noth­ing new in the rein­sur­ance game but re­cent years have seen an up­surge in the sale of these in­sur­ance- linked se­cu­ri­ties ( ILS) to ea­ger in­vestors in de­vel­oped coun­tries around the world. A mar­ket that is not known for mas­sive shi

RISKSA Magazine - - NEWS - Do­minic Uys

The name is Bond...

CAT Bond

At the end of last year, Wil­lis Re noted that there has been a steady flow of in­vestor cap­i­tal hon­ing in on nat­u­ral catas­tro­phe risk since late 2011. Ac­cord­ing to the com­pany, the re­sponses in the mar­ket have been quite di­ver­gent, with some mar­ket in­sid­ers warn­ing a bub­ble is de­vel­op­ing in the mar­ket, and oth­ers com­ment­ing ( al­beit some­what pre­ma­turely) that the tra­di­tional rein­sur­ance model is about to be pushed out com­pletely. The com­pany notes that the third quar­ter of 2013 saw $ 1.4 bil­lion of non- life catas­tro­phe bonds is­sued and a num­ber of well- known is­suers of these bonds, in­clud­ing Zenky­oren, Groupama and Swiss Re have once again started do­ing sig­nif­i­cant busi­ness. The first quar­ter of 2014 saw $ 1.2 bil­lion of non- life catas­tro­phe bond ca­pac­ity is­sued in six deals, and re­cently it was an­nounced that As­si­cu­razioni Gen­er­ali S. p. A had is­sued its first catas­tro­phe bond to Lion I Re, which saw catas­tro­phe bond mar­ket en­ter Italy for the first time. While this has mostly been con­fined to the Euro­pean and Amer­i­can mar­kets, Stu­art McMurdo, head of rein­sur­ance at San­tam, points out that the rest of the world also needs to take heed of what is tak­ing place.

Cat bonds in the South African con­text

McMurdo starts by ex­plain­ing that catas­tro­phe bonds have his­tor­i­cally not fea­tured on the South African mar­ket for a num­ber of rea­sons. “The cost of catas­tro­phe bonds has gen­er­ally been sig­nif­i­cantly higher than tra­di­tional rein­sur­ance in the South African con­text.” The sec­ond is­sue is that catas­tro­phe bonds op­er­ate un­der a para­met­ric trig­ger, as op­posed to an ul­ti­mate net- loss trig­ger, upon which the con­ven­tional rein­sur­ance model is based. Un­der an ul­ti­mate net- loss trig­ger, if the sum of the to­tal losses from a catas­tro­phe passes through the at­tach­ment point of the in­surer’s catas­tro­phe pro­grammes, the com­pany would make rein­sur­ance re­cov­er­ies. In the case of a para­met­ric trig­ger, the trig­ger point is sub­ject to a num­ber of spe­cific con­di­tions. If for in­stance, the bond cov­ers an earthquake event, the mag­ni­tude of the earthquake would typ­i­cally be pre­de­ter­mined. If an earthquake event of a lower mag­ni­tude does oc­cur, the bond is safe from hav­ing to pay out. As a re­sult, how­ever, the in­surer faces the risk of suf­fer­ing sig­nif­i­cant losses that he may not be able to re­cover. Tra­di­tion­ally, catas­tro­phe bonds can also not be reloaded like con­ven­tional rein­sur­ance. A catas­tro­phe bond’s in­vestors can ac­tu­alise their obli­ga­tions to avoid get­ting burnt by a loss and the bond is dis­solved af­ter a claim is in­stated against it. “Lastly these bonds have gen­er­ally tended to­wards mar­kets where there is widely used ven­dor modelling in place and in South Africa, this is still not the case,” McMurdo says.

Evo­lu­tion of an old model

Catas­tro­phe bonds have been around for many years and, while their pop­u­lar­ity in the mar­ket has fluc­tu­ated slightly in that time, the sec­tor does not tend to wit­ness big shifts. The con­cept of ILS has how­ever steadily been grow­ing in sig­nif­i­cance. Re­cently, and over the last year, it has re­ally come to the fore­front of the in­ter­na­tional stage. McMurdo tells RISKSA that there has been ac­cel­er­a­tion in their growth, off the back of meth­ods like quan­ti­ta­tive eas­ing. New de­vel­op­ments in the mar­ket are now oc­cur­ring al­most daily. “Some rein­sur­ers are now fronting catas­tro­phe bond struc­tures to in­sur­ers in the form of ILS ve­hi­cles. Sit­ting be­hind the ILS ve­hi­cles, are in­vestors or in­vest­ment funds look­ing for non- tra­di­tional cap­i­tal. When they look at the tra­di­tional places where they have in­vested, the yields they want are dif­fi­cult to find. A lot of in­vestors are turn­ing to­wards rein­sur­ance for those higher yields and we are def­i­nitely in a be­nign catas­tro­phe cy­cle that will al­low this,” he says. “These ILS ve­hi­cles have, to a large ex­tent, moved to­wards ul­ti­mate net loss re­cov­er­ies as well as of­fer­ing reload or re­in­state­ment. The re­in­state­ment is of course taken care of by the rein­sur­ers fronting these ILS ve­hi­cles. The rein­surer is there­fore on risk for a sec­ond catas­tro­phe event if there is a ma­jor loss, mak­ing the ILS ve­hi­cle much more at­trac­tive to ce­dents,” McMurdo continues. Ro­bust tax modelling is how­ever still a ne­ces­sity and catas­tro­phe modelling still has to be done by glob­ally recog­nised catas­tro­phe ven­dor mod­els. Sub­stan­tial progress has been taken place in de­vel­oped mar­kets like the United States, United King­dom and the rest of Europe. “The ben­e­fi­cia­ries of these ILS ve­hi­cles are typ­i­cally large US and Cana­dian pen­sion funds. In­vest­ment man­agers in these mar­kets have been hunt­ing for yield. The dan­ger is that in the hunt for yield, the additional ca­pac­ity that this cre­ates, drives down mar­ket prices. When a mega- event does oc­cur, there is a real risk that rein­sur­ance mar­kets and ILS ve­hi­cles will re­alise that there sim­ply wasn't enough pre­mium in the pot, and that the prices that they were charg­ing were in­suf­fi­cient,” McMurdo warns.

Leav­ing the de­vel­oped mar­ket

As stated, the catas­tro­phe bond mar­ket still does not have a foot­print in South Africa. That is not to say how­ever, that South Africa and the rest of the de­vel­op­ing world are un­af­fected. “Tra­di­tional rein­sur­ance ca­pac­ity in the US, UK and Europe is be­ing re­placed in cer­tain ar­eas by ILS ca­pac­ity. That tra­di­tional rein­sur­ance ca­pac­ity now has to find a home, so in the South African con­text we are see­ing that there is now an in­flux of additional rein­sur­ance ca­pac­ity to our mar­kets,” McMurdo says. “I be­lieve it is driven by three things. Firstly, it is driven by the ILS de­vel­op­ment in the de­vel­oped mar­ket where there is ro­bust ven­dor modelling. Sec­ondly, it is driven by large in­ter­na­tional in­sur­ers such as Al­lianz, Gen­er­ali, Axa who are ra­tio­nal­is­ing their global rein­sur­ance pro­grams and tak­ing large vol­ume ces­sions out of the mar­ket­place,” he continues. Lastly, McMurdo adds that large rein­sur­ance com­pa­nies are ap­proach­ing large home­mar­ket in­sur­ance com­pa­nies in de­vel­op­ing mar­kets, with the in­ten­tion of putting down sig­nif­i­cant lines of ca­pac­ity across their en­tire rein­sur­ance pro­gram. “What that means, is that you sud­denly have sig­nif­i­cant growth ca­pac­ity avail­able to the South African rein­sur­ance buyer. In that sense, ILS has an in­di­rect im­pact on our mar­ket.” This has re­sulted in a soft­ness in the South African rein­sur­ance mar­ket. “In fact I think you will find that if you go to places like China, South Korea, In­dia or any of the more sig­nif­i­cant de­vel­op­ing mar­kets to come out of the emerg­ing eco­nomic world, there is a soft­en­ing in those mar­kets, as well as tra­di­tional rein­sur­ers start to pull out of the US and Euro­pean mar­kets. Berk­shire Hath­away, to name but one ex­am­ple, has al­ready an­nounced that it would no longer write cat busi­ness in the US be­cause they no longer be­lieve that the US mar­ket of­fers the cor­rect level of pric­ing,” McMurdo says. “The ques­tion then has to be: so where do they de­ploy their ex­tra ca­pac­ity and whether [ or not] they are doubling up their lines in other coun­tries.”

Spec­u­lat­ing on the fu­ture

Look­ing for­ward, McMurdo states that one needs to take a les­son from his­tory. “There is no doubt that the cur­rent mar­ket cy­cle that we are in, from a rein­sur­ance point of view, is soft, just like it was be­fore the 911 catas­tro­phe. That mega- event changed the game overnight and pushed the rein­sur­ance mar­ket into a hard cy­cle once again. Mar­ket com­men­ta­tors are spec­u­lat­ing that for this to hap­pen again, the world would need about an $ 80 bil­lion loss,” he says. Bar­ring an­other mega- event, McMurdo states that large sin­gle losses over the course of a year may have thwse same ef­fect. “We might see that in­di­vid­ual mar­kets may turn to­wards a hard­en­ing po­si­tion as a re­sult of at­tri­tional sig­nif­i­cant large singlu­lar losses. Gen­er­ally one sees one large loss of real sig­nif­i­cance in a mar­ket due to a fire or some­thing like that,” he says. “A re­cent ex­am­ple in China is a loss called SK Hynix. It was a fire at a semi­con­duc­tor plant and the loss was es­ti­mated to be at around $ 1.2 bil­lion. Some rein­sur­ers had some sig­nif­i­cant lines on that, and if we were to have 10 or 15 or 20 of those size losses over the course of the year, it may be enough to shift the mar­ket. The real dan­ger is that the world could be ill- pre­pared for a loss of this size, be­cause the pot of pre­mium in the mar­ket­place has been eroded by the de­vel­op­ments in the ILS mar­ket,” McMurdo warns.

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