The real-world allure of the ‘cat bond’

In an investment market riddled with volatility, catastrophe bonds are offering investors a degree of comfort and stability, says Fitch Ratings’ Jeff Mohrenweiser.

With wildfires raging in th US and two months of the hurricane season yet to go, you might think that catastrophe bonds are having a difficult time.

Yet, amid what could be deemed as something of a catastrophic year in many senses, these instruments are showing remarkable resilience.

Despite a drop off of issuance in the second quarter of the year, when global capital markets closed down due to the pandemic, we have not seen investors pulling their money out of the sector as they have elsewhere.

This continued commitment is down to the defining characteristic of the catastrophe bond. There is very little to connect a hurricane or earthquake to a plunging equity index. It is this low correlation to mainstream capital markets that has made this instrument popular with long-term, institutional investors. This group is keen on due diligence and only commits capital when they are sure of all the risks. These investors know the role this instrument plays in their portfolio.

For the sector, it is encouraging that investors have remained steadfast, despite the headline-grabbing years of 2017 and 2018. The higher frequency of this year’s hurricane season has been offset by lower severity as landfall has missed highly populated areas. However, there is still room to run in 2020, so the aggregation of these losses could be significantly above average for third time in the last four years and could trigger several cat bonds.

Balance of power

In this relatively small market of around $90bn in assets, we also see something of a balance of power between the parties at play. Recently, investors have been able to push back on attempts to change some of the basic terms of new issuances – from an annual aggregate to per occurrence basis – and even demand better pricing of risk.

It is clearly a market for experts and long-term relationships – irresponsible managers do not last long.

But if the catastrophe bond market appears to be stable, it could also be accused of failing to seek and capture opportunities to grow. While there remains appetite for the instruments, and ILS in general, we believe there is room for innovation.

With investors around the world pushing on environmental, social and governance issues, there is an opportunity for the ILS market to take a slice of this pie. Although not a perfect fit for environmental factors, the assistance and support pay-outs that these bonds provide to insurers and communities in times of need should not be underestimated.

As investors increasingly embrace the “S” of ESG, this is a key area for this market to show its value. And with just 30 percent of all losses from natural disasters covered, there is huge potential.

More generally, with the catastrophe bond and ILS market mainly confined to the US and Bermuda, we think other jurisdictions such as London, Hong Kong and Singapore could be tempted to push further into the fray.

“As investors increasingly embrace the “S” of ESG, this is a key area for this market to show its value”

We see new risks, such as mortgage-insurance or other casualty lines, can be securitized in this market. But with a higher correlation to the economy, we think the tenet of being a diversifying asset class is weakened.

However, we must also to understand the limitations of the market, as we encourage it to move forward. Much broader issues such as cyber-attacks, pandemics and climate change may contain some potential. But structural breakthroughs are needed with well-defined triggers and a true partnership between the public and private sectors being built over the long-term.

Equally, the sector needs to be aware of the damage that “loss creep” and “trapped capital” may do to its standing, as investor returns may be gnawed away even a couple of years after a major event.

Yet, the ILS sector is staffed by inquisitive and innovative experts and we believe there is a bright future ahead. While storm clouds still hover over delicately placed financial markets, the ILS sector – and catastrophe bonds in particular – can make the most of being connected to the real world.