Cat Bonds Demystified RMS Guide to the Asset Class

INTRODUCTION

Catastrophe (cat) bonds have government bonds offer ‘return-free attracted investor interest as one of risk.’ Investors looking for viable the few asset classes not correlated to uncorrelated alternatives to equities the global financial markets. who typically turn to investments in infrastructure or agricultural land will Cat bonds were first issued in the find that catastrophe bonds fit well aftermath of Hurricane Andrew and into an alternative strategy. Relative the Northridge Earthquake in the mid- to other alternative investments, cat 1990s and the market has grown bonds offer both low correlation to the robustly since. They are the best- market and higher yields for the same known example of a broader class of level of risk, as can be seen in the insurance-linked securities (ILS). Table 1.

Cat bonds are the most suitable ILS Many institutional investors are instrument for novice investors already successfully including ILS in because they are 1) rated and 2) their portfolios, either through freely tradable by qualified investors. outsourcing to dedicated funds or They are also an effective way to investing directly. enhance the risk-return profile of an investment portfolio. This guide explores the main features and considerations of a cat bond In the current low interest rate investment, including different environment, the value of cash is investment routes and key questions being eroded by inflation and asked by new investors in the space.

Table 1: Comparison of historical returns Index Historical Volatility and volatility since 2002 Annual Returns

Swiss Re Cat Bond Total Return Index 7.98% 2.97%

Dow Jones Credit Suisse Hedge Fund Index 6.38% 5.91%

S&P 500 Index 1.06% 16.24%

Dow Jones Corporate Bond Index 1.19% 6.70%

Private Equity Total Return Index -2.26% 30.23%

Cat bonds are a standardized method Mechanics of a cat bond of transferring insurance risk to the capital markets. The proceeds from The basic structure of a cat bond the sale of the bond are invested in (Figure 1) includes five key elements: near risk-free assets to generate money market returns, which 1. The sponsoring (ceding) combined with an insurance insurance company company’s premium, allow the bond to establishes a special purpose pay a substantial spread over money vehicle in a tax efficient market returns as a quarterly coupon jurisdiction. to the investor. If no insurance events 2. The SPV establishes a occur the investor enjoys the reinsurance agreement with enhanced coupon for the term of the the sponsoring insurance bond, typically three years, and company receives the principal back at maturity. 3. The SPV issues a note to If one of the designated events investors; this note has default occurs, all or part of the principal is provisions that mirror the terms transferred to the insurance company, of the reinsurance agreement the investor’s coupon payments cease 4. The proceeds from the note or are reduced, and at maturity there sale are managed in a is either zero, or a reduced amount of segregated collateral account principal repaid. to generate money market returns It is helpful at this point to delve more 5. If no trigger events occur deeply into cat bond structures, to during the risk period, the SPV explore the key features of any cat returns the principal to bond that need to be understood by a investors with the final coupon potential investor. payment.

Figure 1: Structure of a cat bond transaction

©2012 Risk Management Solutions 2 Cat bond risk reasonably sure of the return of their principal absent an insurance event. Those who invest in cat bonds are Most current cat bonds restrict subject to two distinct sources of risk, collateral account investment to U.S. the first being the insurance risk that Treasury Money Market Funds, but the cat bond assumes; the second is other common solutions include the credit risk associated with the specially issued puttable Structured collateral account. Investors need to Notes from the International and be sure that the constraints on the European Banks for Reconstruction collateral account provide sufficient and Development (IBRD and EBRD), protection so that they can be and Tri-Party Repos.

Lessons Learned – The Lehman Brothers Bankruptcy The significance of the collateral structures has been brought to light by the Lehman collapse. Originally the typical cat bond structure used a Total Return Swap (TRS) by which the counterparty guaranteed that the SPV will receive a return equivalent to LIBOR on its investments in the collateral account. Lehman Brothers was the TRS counterparty for 4 of 119 live cat bonds in the market at the time of its demise; while only a small number of bonds was affected, this caused the market to focus on the safety of underlying assets and design new, more conservative collateral structures that decreased the counterparty risk even further.

Turning now to the insurance risk inherent in a cat bond, we will discuss Indemnity transactions and other risk how the triggering events that would transfer mechanisms triggered by cause a reduction in the principal of direct insurance or reinsurance losses the cat bond are defined. have a clear benefit to the sponsor of the transaction. Because the sponsor’s The three trigger types commonly specific loss experience is used as the used in the cat bond market— trigger, the funds recovered from the indemnity, industry loss, and catastrophe bond will match the parametric—are described below. A underlying claims very closely, fourth type, modeled loss, is minimizing the sponsor’s basis risk essentially an expansion of the (the difference between incurred parametric concept and uses a model losses and the bond payout). in place of an index function. However, these risk transfer mechanisms make the underlying risk Indemnity less transparent to investors, as they cannot access detailed information on

every policy or judge the quality of the For an indemnity trigger, the triggering sponsoring insurance company’s event is the actual loss incurred by the underwriting or loss adjusting. Also, sponsoring insurer following the indemnity transactions can take a occurrence of a specified catastrophe significant amount of time to settle event, in a specified geographic following a catastrophe event, as the region, for a specified line of business. insurer must first assess and tally all

claims, which can take a significant For example, a bond might be time. In some cases the bond will structured to trigger if the sponsoring extend beyond the scheduled maturity insurer’s residential property losses to allow the sponsoring insurer total all from a single hurricane in the U.S. claims, especially if an event has state of Georgia exceed $25 million, in occurred near the end of the bond’s the time period from April 1, 2012 to risk period. This extension period can March 31, 2015. be detrimental to investors, as their

funds are locked up at significantly A bond of this type requires extensive lower rates than during the risk period. legal definitions of the key terms, such as the book of business, recognition of loss, and what constitutes a hurricane. Figure 2: Comparison of trigger types

©2012 Risk Management Solutions 4 Industry Loss catastrophe event as the trigger. For example, a pure parametric bond might trigger if an earthquake with a In the U.S. and Europe, the main magnitude greater than 7.1 occurs accepted providers of insurance within a 50-km radius of Tokyo. Most industry loss estimates are Property parametric transactions are based on Claims Services (PCS) and PERILS, an index of the event parameters respectively. Both firms undertake to whereby appropriate weights are provide estimates of the total loss applied to measurements from a larger experienced by the insurance industry area, which is designed to match the after a major catastrophe. Cat bonds actual losses expected for the based on industry loss operate under sponsoring insurer’s business. the assumption that the sponsoring company’s portfolio is aligned with the Because event parameters are industry and therefore the sponsor available shortly after an event occurs, recovers a percentage of total industry parametric transactions are settled losses. much more rapidly than other trigger types and the risk of bond extension is Industry loss-based structures are reduced. However, since parametric essentially a ‘pooled indemnity’ triggers make no reference to insured solution—the indemnity loss loss, there is a likelihood that the experiences of many companies are sponsor will not receive the precise used to determine the industry loss loss amount experienced from an estimate. Industry loss triggers are event. To mitigate this risk, the indices more transparent than pure indemnity used in the bond trigger are often transactions as first industry loss finely tuned to the sponsoring insurer’s estimates from modelling companies exposure. Parametric triggers have are usually available within a couple of proven popular with investors as the weeks after the event. It can, however, trigger is very transparent—the take more time for the official loss probability of a region experiencing amount to be released. As for the risk 100 mph winds can be easier to of the bond being extended, it is understand than the probability of a roughly at the same level as for a pure particular insurer incurring $1 billion of indemnity bond, and higher than for a losses. parametric trigger. There is no consensus as to which is the optimal trigger type, and the Parametric balance of issuance swings depending A parametric transaction uses the on whether investor demand or issuer physical characteristics of a supply is the key market driver.

What is an index formula?

In order to determine whether a parametric bond has been triggered by a cat event or not, the parameters of the event (typically wind speed or earthquake ground motion) are entered into an index formula.

Let’s take windstorm as an example: immediately after an event, the calculation agent will use this formula to apply pre-defined weights (wi – those are set at the time of issuance in line with the distribution of the sponsor’s exposure) to the wind speed measurements (vi) at each of n recording stations.

If the index value calculated in this process is above the pre-defined trigger level threshold, the bond is triggered. If the value is above the exhaustion threshold, the bond is exhausted.

Why Do Insurers Choose Cat most, in the aftermath of a major Bonds? catastrophe, there is a possibility that the entire insurance industry will be Traditionally insurers have turned to heavily affected and it can’t be the reinsurance market to offset risks guaranteed that their reinsurer won’t that exceeded their own carrying run into payment difficulties. capacity. Primary insurers are often strongly geographically concentrated, Another concern for primary insurers is typically limited by national or state the volatility of reinsurance pricing. boundaries; this offers reinsurers the Reinsurance losses are inherently possibility of gaining diversification unpredictable, but given the relative benefits by reinsuring primaries on a rarity of catastrophes, the industry global basis. Since these typically experiences several years of diversification benefits will accrue low losses followed by years with high most strongly to reinsurers who are losses (see ―What Affects Prices on p. able to diversify across multiple 8). Cat bonds allow insurers to deal countries and lines of businesses, the efficiently with both the problem of reinsurance industry has become reinsurance credit risk and with the strongly concentrated with the biggest volatility of reinsurance pricing. The five reinsurers (Munich Re, Swiss Re, funds resulting from the sale of the cat Berkshire Hathaway, Hannover Re bond are held in a segregated account and the Society of Lloyds) underwriting that is managed in order to minimize over 50% of worldwide premiums. credit risk. As a result the likelihood of an inability to pay claims after a At the same time, insured losses from catastrophe is considered very low. catastrophes have been rising faster than inflation for several decades. This Since cat bond deals are typically means that very large catastrophes three years or longer, insurers can use have the possibility of generating these instruments to lock in losses that exceed the reasonable reinsurance rates. carrying capacity of the reinsurance industry. The global reinsurance Given the advantages of cat bonds, industry has current capital levels of then, why isn’t issuance of these approximately $400 billion, after instruments higher? Primarily for two peaking at $470 billion at the end of reasons: first, the costs of cat bond 2010. To put these numbers into issuance are significantly higher than perspective, the largest historical for a traditional reinsurance contract, hurricane losses, which occurred in and are not economically viable for 1926, would if repeated today cause small principal amounts. Second, the losses of approximately $125 billion number of investors willing to buy cat greater than 25% of the reinsurance bonds is still limited, mostly due to lack industry’s capital base, although some of familiarity with catastrophe risk. of this loss would be retained by primary insurers. Given that there have only been rigorous, scientific hurricane observations since the Spreads and Returns beginning of the last century, there is Given the lack of correlation between no reason to expect that the 1926 cat bonds and other asset classes the hurricane losses could not be expected return on cat bonds should, exceeded; indeed RMS models in theory, be lower than the return of suggest that hurricanes with the corporate bonds with similar credit potential to cause loss at the $200 quality. However, the market has often billion level have a 1-in-125 year seen the opposite: cat bond spreads probability of occurrence (0.8%). have generally exceeded those for Primary insurers looking to hedge their corporate bonds with equivalent tail risk are aware of the fact that just ratings. Investors in cat bonds appear when they need this coverage the to earn both a liquidity and a ‘novelty’

©2012 Risk Management Solutions 6 premium for taking insurance risk. The In 2011 the overall cat bond market returns are typically in the range of 5- returned only 1%, and although 2011 15% above LIBOR, with the average was marked by higher than average spread for bonds issued in 2011 of insurance losses there were no events 8.85%. The spreads are usually higher extreme enough to trigger the majority for cat bonds bringing peak perils to of cat bonds. Even the Tohoku market (especially hurricanes in the Earthquake, while certainly large U.S.), and slightly lower for non-peak enough to trigger many cat bonds, had perils (for example, earthquakes in its epicenter located sufficiently far Turkey) since investors are keen to from Tokyo so that most Japanese diversify within their insurance earthquake bonds, which were exposure and are willing to accept designed to cover losses in Tokyo, did lower spreads for those perils. This not trigger. Yet in spite of the epicenter implies that market prices are of the event being away from where determined by dedicated insurance most cat bond exposure was located, funds not by already well diversified three bonds were affected, from which investors who would not want to one incurred a total loss; if investors reduce their returns from an already had avoided these bonds their returns diversifying investment. would have been several percentage points higher than the market. Although cat bonds are inherently risky, making it possible for the Even though past cat bond notional amount to be quickly performance cannot be used as an exhausted once the triggering event indicator of future performance, the occurred, they have historically offered class compares very favorably with excellent returns. The market other traditional and alternative asset performed well even in years with classes, which can be seen by looking multiple cat event occurrences—there at the past performance of the Swiss has not been a single 12-month period Re Cat Bond Total Return to date where cat bonds incurred a Index, a benchmark commonly used in negative return. Interestingly, historical the ILS industry. This index, as well experience suggests that one key to others in the Swiss Re Cat Bond success in this asset class is the series is based on secondary market avoidance of a small number of poorly data and tracks the price, coupon and structured bonds. total rate of return for cat bonds since 2002.

Figure 3: Performance of the Swiss Re Cat Bond Total Return Index compared to other asset classes.

©2012 Risk Management Solutions 7 Secondary market the costs of issuing a cat bond, sponsors might opt to seek protection Cat bonds can be traded through an through traditional reinsurance and active secondary market. Several retrocession. A soft market will continue intermediaries support the market by until the next catastrophe when the bringing the buyers and sellers together capital becomes a constraint again and as well as by providing indicative bid the cycle resets. and offer spreads on all traded catastrophe bonds. The fixed bond spread is determined at the time of issuance and chosen to While the secondary market has yet to provide appropriate compensation for be fully developed, as deals are the risk assumed by investors; i.e., it is normally made on a matched trade dependent on the expected loss of a basis, indicative bids provided by the bond. The spread will also be intermediaries are very useful when influenced by the point of time in the performing ILS portfolio valuation. reinsurance cycle: spreads tend to be higher in a hard market and lower in soft market, mirroring what happens in What affects prices? the traditional reinsurance space. The pricing of insurance linked securities will largely depend on In addition to this, cat bond secondary reinsurance pricing, and reinsurance market prices fluctuate throughout the pricing is mainly dictated by the year. Those movements are influenced frequency and severity of natural by a variety of factors such as shifts in catastrophes. It is not dependent on the aggregate supply and demand of the events in financial markets: a financial market (for example, prices in the crisis will not trigger an earthquake and secondary market can be depressed by an earthquake will typically not cause a an influx of new, well priced cat bonds), financial crisis. There are though but specifically because natural perils, indirect linkages between the financial particularly hurricanes, have distinct markets and the cat bond market which seasonal exposure patterns which are the investor needs to monitor. At times reflected in the secondary market pricing. when the overall market is experiencing It is often the case that prices fall in tight liquidity, investors may use cat anticipation of a hurricane season, bonds as a source of liquidity: this especially if forecasts predict above- happened in the immediate aftermath of average activity, and rise when U.S. wind the Lehman collapse in September bonds come off risk as the season 2008. Conversely, if reinsurers suffer closes. capital writedowns as a result of losses on their investment book, both reinsurance rates and the spreads on Market participants newly issued cat bonds will tend to The ILS investor base is continuously increase which will put downwards expanding, attracting more global pressure on the prices of already capital every year. While dedicated ILS issued cat bonds. fund managers remain the largest investor group (absorbing The reinsurance market is cyclical, approximately 70% of new issuance), which has a major effect on bond the asset class has recently attracted a spreads. The occurrence of a major cat large pool of institutional investors, event will significantly erode the amount money managers and pension funds of capital available in the insurance increasingly drawn to ILS because of industry, which can lead to a hard the market's returns during the financial market of low supply and high crisis and its liquidity profile. The reinsurance prices. During a hard Eurozone sovereign debt crisis has in market, cat bonds may be less particular made investors from different expensive than reinsurance and an market segments turn their attention to attractive option for sponsors, leading ILS. The convergence market has seen to increased volumes of bond issuance. a remarkable $3 to 4 billion of new fund In contrast, during a soft market, inflows at the beginning of 2012. reinsurance prices decline and given

ASSESSMENT OF CATASTROPHE RISK

The metrics that are most commonly thousands of possible catastrophe used when discussing risk associated events that could occur in a given area with a catastrophe bond are the and affect a given portfolio of risk. expected loss (EL) and attachment Based on the loss estimates for each and exhaustion probabilities. At the of those stochastic (simulated portfolio level investors examine the hypothetical) events and its probability return period losses, or the likelihood of occurrence, a set of metrics of exceeding different loss thresholds. including the expected loss and the These metrics are calculated through exceedance probability curve the use of catastrophe modeling (illustrating a range of return periods software, available from companies and corresponding losses) is like RMS. Models are essential to the calculated. evaluation of cat bonds or any other ILS, as there is usually no systematic The evaluation of the underlying claims experience for extreme events catastrophe risk is always carried out with such a low probability of by a modeling company as part of the occurrence and an actuarial approach cat bond preparation process, and the relying on historical data is results are published in the cat bond inappropriate. In order to assess the offering circular and the pricing likelihood that a given contract will supplement. trigger, models use a simulated set of

As with any other asset class, Direct investment exposure to cat bonds can be gained through an engagement with a Many investors choose to invest dedicated ILS fund, direct investment, directly. As with other asset classes, or a combination of the two. the advantage of direct investment is the ability to maintain full control of the portfolio and the investment Dedicated ILS funds strategy. The approach to There are a number of dedicated ILS diversification is an important factor: funds in the ILS market that accept the level of diversification a dedicated mandates from institutional investors. ILS fund will seek is often much They tend to be located in global higher than that needed for a small financial and insurance centers like allocation of cat bonds in a portfolio of the U.K., Switzerland, Bermuda, and alternatives. the U.S. The advantage of investing through a dedicated fund is instant It is often the case that institutional diversification: by choosing a pooled investors initially enter the space by solution, investors gain access to a engaging with a specialized investor share of a large ILS portfolio that they but at the same time start developing would not be able to take on quickly in house expertise and eventually on their own. The other advantage is bring all or a portion of the portfolio in expertise: dedicated ILS funds have house. market experience in performing due diligence on new investments and typically use ILS portfolio modeling and monitoring software that allows them to assess each individual investment as well as overall portfolio risk. The typical fee structure ranges from a base of 1-2% of assets managed plus performance fees of 10-15%.

CONCLUSIONS

The market for cat bonds and other ILS has been attracting more institutional investors over the years. Leading ILS fund managers report new waves of institutional capital being drawn to this space, eager to take advantage of the market’s diversification potential and possibilities of excellent return. Despite the evident increased interest, catastrophe bonds remain a niche asset class that has not yet found a way into most mainstream portfolios.

For investors with an appetite for a more interesting risk-return profile, being an early adapter of a new alternative asset class like ILS is an attractive option, especially while catastrophe bond spreads are high compared to other asset classes.

All sources indicate that the market is set for continuous growth – there is a steady supply of new offerings and additionally, the upcoming implementation of Solvency II regulations for the insurance industry will likely result in increased issuance by European sponsors.

Contact RMS To receive more information or to arrange a meeting to discuss how RMS could support your investments in cat bonds, please contact any of the individuals listed below:

Robert Stone Marta Abramska Senior Director, US East Coast Manager, RiskMarkets, London +1 201 912 8643 +44 207 444 7736 [email protected] [email protected]

Peter Nakada John Stroughair Managing Director, US East Coast VP, RiskMarkets, London +1 201 912 8644 + 44 207 444 7834 [email protected] [email protected]