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
The name is 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.