Asset Management What’s Behind The Cat Bond Craze? How the deluge of private capital is transforming the reinsurance industry.
by Angelo John Lewis
hen the $1.5-billion ket investors. Cat bonds are a major Everglades Re catastro- segment of the ILS market. Key Points First, the bond was priced at a W phe bond transaction ▼ The Trend: New sponsors and was completed earlier this year, it rate on line of 7.5%, which was investors are expanding the cat bond was the biggest such transaction in less than half the 17.75% charged market.
the history of the insurance-linked for the previous Everglades bonds ▼ Behind the Trend: Improvements in securities market. issued in 2012. Overall, cat bond climate modeling have boosted investor Three aspects of the bond, spreads have declined across the confidence.
which provides reinsurance cov- board, as have corresponding costs ▼ The Future: Because ILS is non- erage for Florida’s state-created of traditional reinsurance coverage. correlated, it’s an asset class that’s property insurer, Citizens Property According to an April report by Wil- likely to remain in hedge fund and Insurance Corp., provide a window lis Re, reinsurance pricing rates as pension portfolios. into recent developments in the observed by the January renewals multibillion-dollar market for catas- had softened by as much as 20% this form of attachment point. In the trophe bonds, the risk-linked secu- across the board on almost all lines. early days of the market, many of the rities that transfer a specified set of Second, Citizens’ involvement deal structures were index-based, and risks from a sponsor to capital mar- heralded the recent emergence of sponsors were left with basis risk quasi-governmental or state-spon- and with a mismatch between their Catastrophe Bond Issuance sored entities, an arena histori- actual losses and an index. P/C Related Risks cally dominated by large insurers “The use of indemnity triggers % Change and reinsurers. Although the lat- negates any calculation of basis Amount From Prior ter group still initiates the major- risk, although certain companies Year ($ millions) Year ity of transactions, each year the still use purely non-indemnity 2014 5,436.4* number of the emergent group triggers,” said A.M. Best Senior 2013 7,313.8 24.42% grows. Examples include last year’s Financial Analyst Asha Attoh- 2012 5,878.1 37.36% Bosphorus 1 Re Ltd. $400-mil- Okine. “I wouldn’t be surprised 2011 4,279.4 -0.45% 2010 4,298.8 26.50% lion catastrophe bond for trans- if indemnity triggers remain the 2009 3,398.4 24.54% ferring earthquake risks in Turkey dominant form.” 2008 2,728.7 -63.27% on behalf of the Turkish Insur- The increased use of indem- 2007 7,429.6 58.30% ance Catastrophe Insurance Pool; nity triggers is significant because 2006 4,693.4 135.72% and this year’s Hannover Rück SE they mirror the trigger types of 2005 1,991.1 74.23% $300-million instrument to cover reinsurance coverage and thus 2004 1,142.8 -33.93% 2003 1,729.8 41.85% Texas named storms on behalf of remove what ceding insurers 2002 1,219.5 23.83% the reinsured Texas Windstorm might view as an obstacle to con- 2001 984.8 -13.54% Insurance Association. sidering the issue of cat bonds as 2000 1,139.0 17.80% Third, the Citizens deal used an a risk transfer mechanism. 1999 966.9 14.28% indemnity trigger, or one which The expansion of the catas- 1998 846.1 33.67% would pay out on the cedent’s actual trophe bond industry, marked by 1997 633.0 n.a. *midyear loss. By June of this year, about 75% record new issuances in the first Source: A.M. Best Company of triggers or attachment points used half of this year (see chart), is one
Copyright © 2014 by A.M. Best Company, Inc. ALL RIGHTS RESERVED. No part of this report or document may be distributed in any electronic form or by any means, or stored in a database or retrieval system, without the prior written permission of the A.M. Best Company. For additional details, refer to our Terms of Use available at the A.M. Best Company website: www.ambest.com/terms. “I think a lot of the traditional insured catastrophe-related losses in recent years. [reinsurance] markets have come to the “I think there’s a certain amount realization that if you can’t beat them, you of complacency out there right should join them.” NOW v SAID 3HINJI 5EDA VICE PRESI- —Shinji Ueda, dent of Holborn, a New York-based Holborn reinsurance brokerage firm. “There have been a few losses in the cat- bond space, but there haven’t been manifestation of the influx of capi- Stamford, Conn.-based TigerRisk any significant events in highly cat- tal from third-party investors, such reinsurance brokerage. bond exposed areas, like a Florida as hedge funds and pension funds, “There’s a multitude of reasons CAT EVENT !ND WHEN YOU HAVENT into the reinsurance space. for it, not the least of which is the had a loss and you’re in cat bonds, fact that historically there has been you feel like you’re investing safely Coming Through Many Doors little correlation to other asset as a result.” Investors have entered into rein- classes. Hurricane events and earth- Cat-bond investors haven’t expe- surance in multiple ways. These quake events don’t correlate to rienced major bond losses since include buying shares of reinsur- stock market changes, so the uncor- -ARCH WHEN THE 4OHOKU ance companies, starting up new related risk helps with the diver- EARTHQUAKE IN *APAN CAUSED ones, hiring ILS-oriented manage- sification of some of these larger million in losses for securities ment teams or participating in cat investment portfolios.” issued by Muteki Ltd. that helped bond or other ILS transactions. Factors that drive increased cat cover earthquake risks taken on by “The reinsurance space as an asset bond investment include advances 'ERMAN REINSURER -UNICH 2E class is becoming more and more in climate modeling, higher rates To date, there have been no acceptable to more and more people,” of return versus other asset class- reported cat bond triggers for Hur- said Chris Dittman, a partner with es, and the relatively low level of ricane Sandy, which struck the East Catastrophe Bonds Transactions Closed by Mid-Year, 2014 - Property and Casualty Related Risks
Capital Amount (US$ Vehicle Sponsor millions)1 Peril Type Modeler Trigger Residential Re 2014 Ltd. USAA 130.00 U.S. tropical cyclones, earthquakes, severe thunderstorms, winter AIR Indemnity storms, wildfire, meteorite impact, volcanic eruption Sanders Re Ltd. - 2 Allstate 200.00 Florida named storms, earthquakes, severe thunderstorms AIR Indemnity Nakama Re Ltd. Zenkyoren 300.00 Japan earthquake AIR Indemnity Aozora Re Ltd. Sompo Japan & Nipponkoa Ins. Co. 98.782 Japan typhoon AIR Indemnity Sanders Re Ltd. Allstate 750.00 U.S. named storms (excluding Florida) and earthquakes AIR Non-indemnity Armor Re Ltd. American Coastal Insurance Co. 200.00 Florida hurricane (named storms) AIR Indemnity Everglades Re Ltd. Florida Citizens Property 1,500.00 Florida hurricane AIR Indemnity Market Re Ltd. Unknown Florida-domiciled Insurer 10.00 Florida named storms Indemnity Kilimanjaro Re Ltd. Everest Re 450.00 U.S. named storms and U.S. earthquakes AIR Non-indemnity Lion I Re Ltd. Assicurazioni Generali 262.623 European windstorms RMS Indemnity Citrus Re 2014-2 Heritage Property & Casualty Ins. Co. 50.00 U.S. named storms (Florida) AIR Indemnity Citrus Re Ltd. Heritage Property & Casualty Ins. Co. 150.00 U.S. named storms (Florida) AIR Indemnity Riverfront Re Ltd. Great American Ins. Co. 95.00 Named storms, earthquake, severe thunderstorms, U.S. and RMS Indemnity Canada winter storms Merna Re V Ltd. State Farm 300.00 U.S. earthquake (affecting designated states) RMS Indemnity Kizuna II Re Ltd. Tokio Marine & Nichido Fire Ins. Co. 245.00 Japan earthquake AIR Indemnity Gator Re Ltd. American Strategic Ins. Group 200.00 U.S. named storms and severe thunderstorm AIR Indemnity East Lane Re VI Ltd. Chubb 270.00 U.S. named storms, earthquakes, severe thunderstorm and winter RMS Indemnity storms Queen Street IX Re Ltd. Munich Re 100.00 U.S. hurricane and Australian cyclones AIR Non-indemnity Skyline Re Ltd. Cincinnati Insurance Co. 100.00 U.S. earthquake and severe storms Indemnity Shima Re - Omamori Tokio Millennium Re AG 25.00 U.S. earthquakes and U.S. named storms Non-indemnity (Second Event) Total 5,436.40 Notes: 1 Capital amount includes both rated and unrated debt. 2 U.S. dollar equivalent of ¥10.125 billion debt at closing date. 3 U.S. dollar equivalent of €190 million debt at closing date. Source: A.M. Best Company research
BEST’S REV)%7 s !5'534 21 Asset Management
“It’s not just that the [catastrophe] models Securities. “It’s going to be expan- sion of risk beyond just property have evolved, as much as the market cats, and it’s going to be expansion is evolving to get comfortable with the of ceding companies beyond just models.” reinsurance and insurance clients.” —Rob Newbold, AIR Worldwide Expansion Plans Another factor that drives the evolution of the ILS and cat bond Coast as a post-tropical storm in increased geographic reach and industry is advancements in catas- 2012. Sandy caused $18.75 billion range of perils covered. trophe modeling, which has led in insured property losses, exclud- Although the vast majority of to increased investor comfort in ing claims covered by the federal 2013-14 issuances have been in participating in indemnity trigger flood insurance program, accord- the United States, the period also deals. “Over the past three to five ing to the Insurance Information saw new cat bonds for European years, detailed modeling to support Institute. windstorms, Japanese earthquakes indemnity trigger transactions has Despite the tightening of and Australian cyclones. become more increasingly adopted spreads—for example, U.S. wind cat The same period saw a small across all areas of the insurance bonds with a 2% expected loss were number of new perils, beyond the value chain,” said John McIlwaine, trading at roughly 600 basis points usual hurricane and earthquake vice president of AIR Worldwide, a at year-end 2013, as compared to risks: these included MetroCat Re catastrophe modeling firm. 850 basis points 12 months earlier, Ltd. (Series 2013-1), which provides AIR Worldwide’s senior vice according to Munich Re—investors the New York Metropolitan Trans- president John Newbold believes keep pouring money into the cat portation Authority with $200 mil- continued developments in the bond space. lion of coverage for storm surge industry will likely lead to new “From the investor’s point of risks, and Residential Reinsurance types of catastrophe bond transac- view, it’s probably not as great of 2014 Ltd. (Series 2014-1), a $130 mil- tions, possibly involving perils such an investment as it was a few years lion bond sponsored by USAA. as India tropical cyclone and Austra- ago, but at the same time, it’s yield The latter includes coverage for lian bush fire. and it’s non-correlated, and that’s U.S. losses from meteorite impacts “The market is still dominated an attractive thing right now in and for volcanic eruptions. by U.S. hurricane risk, but people a low interest rate environment,” “I think it’s going to be an are seeing the availability of capac- Ueda said. expansion of perils, beyond just the ity in these other perils. It’s not just The growth of the cat bond peak perils,” said Chi Hum, global that the models have evolved, as space is also evidenced by its head of ILS distribution for GC much as the market is evolving to get comfortable with the models,” Amount of Catastrophe Bonds Issued by Quarter he said. (For more on modeling, see US$ millions “The Rise of the Supermodels” on Quarter/Year 2014 2013 2012 2011 2010 2009 2008 2007 page 16 of this issue.) 1st Q 1,335.00 581.20 1,343.00 1,015.00 300.00 575.00 614.66 482.50 “At this point, there are inves- 2nd Q 4,101.40 3,353.49 2,117.78 592.00 2,050.00 810.60 1,794.00 3,545.20 tors who have been investing 3rd Q 1,505.00 529.14 685.59 232.12 411.80 320.00 1,355.85 4th Q 1,874.09 1,888.19 1,986.81 1,716.67 1,600.98 0.00 2,046.00 since 1995 and 1996,” Hum added. “And they have enough years’ Total 5,436.40 7,313.78 5,878.11 4,279.40 4,298.79 3,398.38 2,728.66 7,429.55 experience so that they’re going Source: A.M. Best Company research beyond property cat and looking at other lines of business and other Percentage of Catastrophe Bonds Issued by Quarter risk. It’s really our challenge as dealers to find a way to match up Quarter/Year 2013 2012 2011 2010 2009 2008 2007 the interests that are expanding 1st Q 8.8% 30.8% 18.2% 9.5% 16.7% 23.1% 9.4% beyond peak perils.” 2nd Q 44.1% 30.8% 18.2% 38.1% 33.3% 61.5% 53.1% Despite the growth of the catas- 3rd Q 23.5% 11.5% 22.7% 9.5% 11.1% 15.4% 9.4% 4th Q 23.5% 26.9% 40.9% 42.9% 38.9% 0.0% 28.1% trophe bond and ILS industries, that growth is greatly exceeded by the Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 market capacity of the traditional Source: A.M. Best Company research Note: Numbers may not add to 100 due to rounding. reinsurance industry.
22 BEST’S REV)%7 s !5'534 “We estimate alternative capac- “It’s going to be expansion of risk beyond ITY TO BE APPROXIMATELY OF the overall market capacity, which just property cats” and an “expansion of means that traditional reinsurance ceding companies beyond just reinsurance IS OF THE OVERALL MARKET v SAID and insurance clients.” #ORY !NGER GLOBAL HEAD OF ),3 STRUC- —Chi Hum, TURING FOR '# 3ECURITIES IN AN INTER- GC Securities view with Best’s Review last year. "UT THE ENCROACHMENT OF ALTER- native capacity into traditional bonds, while others sponsor their Well, the bond markets used to REINSURANCE TURF IS DRAMATICALLY OWN CAT BONDS )M SEEING A TRANSI- ACT THAT WAY YEARS AGO IN FACT THE CHANGING THE DYNAMICS OF THE REIN- TION WHERE REINSURERS ARE TRYING TO expression, ‘my word is my bond,’ surance industry. USE THEIR RATED CAPITAL AS EFFICIENTLY CAME FROM THE BOND MARKET 4HEY h4HIS EXTERNAL THREAT OF VAST AS POSSIBLEv would just shake hands and not CAPITAL IS CONCERNING AND COULD BE !T THE SAME TIME TRADITIONAL HAVE DOCUMENTS v (UM SAID A GAME CHANGER v WAS THE VERDICT REINSURERS HAVE THE ADVANTAGE OF h4HAT EXISTED FOR A WHILE UNTIL IT RENDERED BY THE .OVEMBER LONG TIME RELATIONSHIPS WITH THEIR GOT TO THE SCALE THAT THE PARTIES NO !- "EST 3PECIAL 2EPORT Stuck in clients, and the concurrent percep- LONGER KNEW EACH OTHER THAT WELL the Middle: Reinsurers Face Con- tion that because they value these ANYMORE !ND ) THINK THAT WERE GET- verging Capital, Rising Retentions. RELATIONSHIPS THEYLL COVER ANY GRAY TING TO THAT POINT IN THE REINSUR- h4HE HEIGHTENED INTEREST AND THE OR VAGUE AREAS OF COVERAGE THAT ANCE WORLD WHERE ITS OUTGROWN PACE OF ENTRY WITH REGARD TO THIRD MIGHT ARISE AFTER LOSS THAT PHASEv PARTY CAPITAL HAVE GAINED MOMEN- h)F YOU LOOK AT A TRADITIONAL REIN- 4HE ISSUE OF WHERE ALTERNATIVE TUM ESPECIALLY GIVEN THE LOW YIELD surance contract, it’s relatively CAPITAL BEST FITS WITHIN REINSURANCE ENVIRONMENT THAT CURRENTLY PLAGUES SHORT )T MIGHT BE AS SHORT AS IS FAR FROM SETTLED investors. This external capital is PAGES 7HEREAS WHEN YOU LOOK Where it will eventually sort out, VAST AND BECOMING MORE COMFORT- AT CATASTROPHE BONDS CONTAINING (UM BELIEVES IS THE RECOGNITION able with (re)insurance risks. It is THOUSANDS OF PAGES OF DOCUMEN- that alternative capital instruments very likely to continue to increase TATION YOU REALIZE THE DIFFERENCE are better equipped than traditional ITS PRESENCEv in perspective between a reinsur- reinsurance to deal with tail risk. Traditional reinsurers have ER AND AN INVESTOR IN A CAT BOND v h)TS A DIFFERENT STAGE OF THE REIN- RESPONDED IN A NUMBER OF WAYS 5EDA CONTINUED SURANCE MARKET !ND JUST LOOKING 4HEYVE LOWERED PRICES OFFERED “With traditional reinsurance, AT THIS BUSINESS ITS BEEN PROFITABLE CAT BOND LIKE FEATURES AND THERE IS THE UNDERLYING PRINCIPLE OF AND GREAT FOR REINSURERS BUT THERE EXPANDED THEIR OWN FOOTPRINT IN UTMOST GOOD FAITH "UT WITH THE CAT has to be a market element in terms THE ),3 SPACE bond market, there’s the sense that OF COMING UP TO GLOBAL STANDARDS “I think they’ve reacted in an it’s more transactional in nature. 7ERE NOT GOING TO REPLACE THE REIN- AGGRESSIVE FASHION v $ITTMAN SAID 7HAT HAPPENS IF THERES SOMETHING surers, because the reinsurers have h7E SAW LAST YEAR A LOT OF REINSURERS as simple as a typo? Can the inves- INCREDIBLE KNOWLEDGE ABOUT RISKS TRYING TO OFFER CAT BOND LIKE PROD- TOR GET OUT OF PAYING A LOSS 7ITH A AND THE BEHAVIOR OF REINSURANCE UCTS WHERE THEY WOULD OFFER UP reinsurance transaction, that’s less markets that they can capture in multiple-year solutions, one limit OF AN ISSUEv THEIR PRICINGv OVER MULTIPLE YEARS AND MORE FLEX- 5EDA ADDED h4HERES A GENERAL Hum continued: “But there’s a IBLE TERMSv UNDERSTANDING OF WHAT YOURE INSUR- HUGE PART OF THAT RISK TOWER THAT h) THINK A LOT OF THE TRADITIONAL MAR- ING OR REINSURING AND WHAT YOULL BE THEYRE NOT EFFICIENT AT WRITING AND kets have come to the realization that PAYING OUT FOR )F THERES A MISTAKE THATS THE REMOTE STUFF THE MORE IF YOU CANT BEAT THEM YOU SHOULD in the contract, the reinsurer and CAPITAL INTENSIVE STUFF !ND THAT JOIN THEM v 5EDA ADDED cedant should be able to resolve works really well in the context h!ND ) THINK WITH THE EXCEP- THE ISSUE IN LIGHT OF THE ONGOING OF A MUCH LARGER CAPITAL MARKET TION OF ONE OR TWO PUBLICLY TRAD- RELATIONSHIPv POOL )F YOURE WRITING A REMOTE ED REINSURERS OUT THERE RIGHT NOW (UM LOOKS AT THIS ISSUE A BIT DIF- LAYERA ONE IN YEAR EVENT THEY ALL HAVE SOME SORT OF VEHICLE FERENTLY THATS WHERE THE BIG ONE HITS 4HATS FOR ACCESSING CAPITAL IN THE FORM OF “There’s this perception that where counterparty risk matters, cat bonds, sidecars or direct invest- EVEN IF ITS NOT COVERED WELL PAY where collateral matters, that’s ments. Some actually invest in cat YOU BECAUSE OF OUR RELATIONSHIPS WHEN SIZE MATTERSv BR
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