Low returns elsewhere prompt companies to consider cat bonds.
Long lasting low rates have prompted corporates to invest in catastrophe risk, a growing but still relatively obscure corner of the capital markets in which an investment can disappear in a flash but also provide a hedge against financial market swings. Some corporates may soon jump to the other side of the transactions and start buying catastrophe protection from Wall Street.
The investments generally take the form of catastrophe or “cat” bonds, securities typically issued in the private or Rule 144a markets, and collateralized reinsurance, which is reinsurance that’s fully collateralized by institutional investors.
“It’s a riskier proposition for them, but it’s apparently one that a lot of companies find acceptable,” says Tim Richison, CFO of cat bond sponsor and collateralized reinsurance pioneer California Earthquake Authority (CEA), a privately funded and publicly managed seller of earthquake insurance policies through participating insurance companies.
Mr. Richison, CFO when the CEA sponsored its first cat bond in 2006 and previously an executive at insurer USAA when it structured its first “act of God” bond in 1997, says the investors initially taking on CEA earthquake risk were hedge funds, followed by public pensions funds, and now there are more “bricks and mortar companies here and abroad.”
Insurers traditionally transferred risk by purchasing reinsurance policies from publicly rated reinsurers based in Bermuda and other offshore locations. The volume of cat bonds exploded during the twilight of the housing bubble, jumping to nearly $7.2 billion new bonds in 2007 from $1.5 billion two years earlier. Issuance plummeted to $3 billion in 2008 and it has climbed steadily since then and may top the record by year end, resulting in more than $21 billion in outstanding cat bonds.
Spreads, however, have plummeted. Catastrophe risk broker Willis Group recorded average cat bond spreads reaching a high of 12 percent in third quarter 2012 and falling since then to 6.1 percent as of third quarter this year. Collateralized reinsurance has followed a similar pricing pattern.
Nevertheless, catastrophe risk returns are still attractive compared to fixed-income alternatives such as high-grade corporates and government bonds, which are paying low single-digit rates, if that.
Cat bonds outperform riskier corporate debt as well. Last-resort state property insurer Florida Citizens, for example, issued $1.5 billion of single B-rated cat bonds in May for a coupon of 7.5 percent, compared to 17.75 percent for cat bonds holding the same rating that it issued two years ago. Effective yields on single-B rated high-yield corporate debt hovered over 5 percent then and were just over 6 percent in early October.
Competing brokerage Guy Carpenter shows cat bonds’ cumulative returns steadily climbing since 2002 and exceed other major asset classes, including the S&P 500, corporate bonds, and hedge funds. Commodities provided a marginally better return, but performance was very volatile. Perhaps the most attractive feature of catastrophe risk is that it is uncorrelated with financial investments such as stocks and bonds; when the financial crisis hit, most financial asset classes’ cumulative returns dove sharply, while cat bonds continued their steady rise (see chart below).
The performance of investments providing exposure to catastrophe risk has not eluded corporate finance executives. Chi Hum, global head of insurance-linked securities (ILS) distribution for GC Securities, a division of MMC Securities Corp., Guy Carpenter’s capital market brokerage arm, noted more inquiries from corporates. “It’s not just the money they’re handling but their pension operations as well,” Mr. Hum says, adding, “They’re saying most of our portfolio is being taken care of by an existing panel of managers, but we can take a portion of that and book it in reinsurance, an interesting opportunity from a diversification perspective.”
The CEA last sponsored cat bonds in 2012, using that deal’s low 5 percent rate to bargain down premiums on reinsurance and collateralized reinsurance since then. The latter provides the extra benefit of enabling the CEA to add the security of collateral to its risk-transfer programs.
In terms of investor interests he has spoken to, says Mr. Richison, “It’s really across all sectors, from technology to retail, to banking and material goods. It’s quite surprising that this is catching on fairly rapidly.” These investors typically gain the exposure through funds managed by Nephila Advisors, Leadenhall Capital Partners and other dedicated asset managers.
“Collateralized deals have grown rapidly via the mechanism of dedicated managers. It now represents almost as much as ILS coverage,” says Morton Lane, president of Lane Financial, a cat bond consultancy.
Mr. Richison says transferring risk to capital markets investors is attractive to the CEA because it lessens the concentration of risk placed with reinsurers, and because capital market returns and structures allow for lower rates than those required by reinsurers. In addition, should a catastrophic event trigger payment, the fully collateralized transactions guaranty funds delivery to the insurer, whereas bills must be sent to reinsurers providing traditional, non-collateralized coverage, and payment may face business delays.
Mr. Richison also says corporate investors he’s familiar with are generally investing 0.5 percent or less of their total portfolios into catastrophe risk, adding that CEA is looking for long-term investors. He notes that these newer capital market participants have yet to experience the partial or full losses that can result from reinsuring catastrophe losses, since they have been minimal since 2005, which saw a string of damaging hurricanes, including Emily, Katrina, Rita, and Wilma.
Mr. Richison routinely discusses the risk of earthquake catastrophes with investors and notes that while losses may be significant if they occur, using a long-term investment strategy and insurance-linked securities can provide higher returns than current fixed-income investments.
“That’s why I talk to these investors, because we want to make sure we develop partnerships with groups that want to stay around even after they’ve lost money; that they understand this is a long-term situation and not something to get in and out of,” Mr. Richison says.
Mr. Hum says Guy Carpenter has had numerous conversations with corporates about their risks that currently are unmet by the reinsurance industry. New York City’s Metropolitan Transit Authority (MTA) completed a $200 million cat bond in July 2013 to cover storm surge risk, following the flooding of subway tunnels and other facilities in the wake of Hurricane Sandy. Mr. Hum says the MTA was unable to find sufficient coverage from its reinsurance providers because they already held concentrated exposure to the New York area, giving cat bond investors the opportunity to act as a direct insurer.
Other companies where reinsurers already have concentrated risk, such as large manufacturers in California facing the threat of earthquakes, may be candidates for Wall Street providers of catastrophic risk coverage, Mr. Hum says. He added that Guy Carpenter has had discussions with corporates over the years about transferring risk to the capital markets, but pricing previously had been unattractive compared to traditional reinsurance, and the process of preparing deals too expensive and cumbersome.
“We’re within shouting distance now on pricing,” Mr. Hum says, adding progress has been made in terms of facilitating the transactions.