Written by: Orlando Crowcroft, businesslife.co
Posted: 19/11/2013
Catastrophe bonds not only provide an alternative investment class, but they can ensure the survival of insurance firms so that disasters are covered, as Orlando Crowcroft discovers
When insurance giant Amlin announced a 12.5 per cent drop in pre-tax profits in August for the first half of 2013, the firm blamed the weather. But this was no feeble excuse from a struggling company – Amlin paid out a whopping £32.3 million in claims to customers across Europe after the worst floods for a decade hit the region in May and June. The rain – particularly severe in Germany and Hungary – caused tens of billions of pounds worth of damage.
Natural disasters have long caused problems for insurance companies – paying out when a flood destroys a single house is one thing, but an entire city? That's something else. As far back as 1842 – when the city of Hamburg was destroyed in a fire, bankrupting every insurance company in Germany – insurers began selling some of their liabilities to reinsurers, but today even that is proving insufficient.
A 2012 report by US firm Risk Management Solutions pointed out that insured losses from natural disasters have been rising faster than inflation for several decades, which means that very large catastrophes could theoretically generate losses that exceed the capacity of the reinsurance industry – which it puts at around $400bn.
“To put these numbers into perspective, the largest historical hurricane losses – which occurred in 1926 – would, if repeated today, cause losses of approximately $125bn, which is greater than 25 per cent of the reinsurance industry's capital base,” the report claimed. “In the aftermath of a major catastrophe, there is a possibility that the entire insurance industry will be heavily affected and it can't be guaranteed that their reinsurer won't run into payment difficulties.”
Enter catastrophe bonds, a structure invented in the 1990s to package the risk from natural disasters and sell it on the capital markets. A bond is floated and investors buy in. If there is no natural disaster, investors receive what can be a substantial return; if there is, some or all the money goes to the insurance companies, who use it to pay their clients. This does mean that investors can lose a large chunk, if not all, of their cash.
“There is insufficient capacity in the insurance marketplace, yet insurers and reinsurers still need to protect their balance sheet,” says Richard Packman, Managing Director at Vantage in Jersey. “This has expanded the catastrophe bond market.”
Breaking new ground
The role of offshore centres in this relatively new sector originated in Bermuda, which with its proximity to the US served as a tax-free listing vehicle for catastrophe funds that protect US insurers from claims following earthquakes and windstorms. In some cases, US states are turning to catastrophe bonds as an alternative to conventional insurance.
When Superstorm Sandy hit New York in October 2012, the city's Metropolitan Transportation Authority (MTA) faced a bill of some $4.8bn. The MTA announced in July this year that as it had been unable to find insurance since the storm, it had instead turned to the catastrophe bond market.
The MTA pays less than regular property coverage by buying protection from MetroCat Re, a Bermuda-based special purpose insurer that is selling $200 million-worth of catastrophe bonds on the open market. To many investors, the returns will appear attractive, yielding 4.5 percentage points more than US Treasury bonds.
Deals such as these have piqued the interest of Guernsey, long a hub for the offshore insurance market. The island's first stride towards setting up as a jurisdiction for catastrophe bonds came in 2012, when Dexion Capital launched the London Stock Exchange (LSE) listed DCG Iris. Initially raising £40 million, it has since moved past £60 million after further rounds of fundraising.
Meanwhile, the Guernsey offices of risk management firm Aon and law firm Bedell Cristin were involved in a $52.5 million listing of insurance vehicle Solidum Re Eiger IC Limited on the Channel Islands Stock Exchange (CISX) last year. The listing made Solidum Re Eiger IC the first private catastrophe bond transaction to be listed on any exchange worldwide.
“Guernsey's advantage as a domicile for ILS [insurance-linked securities] is that it can demonstrate substance already present in existing structures. A number of major fund and insurance managers have offices and staff present in Guernsey and there is a large pool of qualified non-executive directors,” explains Fiona Le Poidevin, Chief Executive of Guernsey Finance.
Alternative asset
It has traditionally been institutional rather than retail investors that have looked into using catastrophe bonds, but there is an indication that this is changing as the structures become more mainstream. While ratings agencies such as Moody's and S&P tend to dislike catastrophe bonds – which generally attract B or BB ratings – investors are coming round as returns in the equity markets remain low.
“Investors like them as an alternative investment class, and pension funds, corporate investment managers and wealthy individuals particularly like them because returns are not correlated with the financial markets and thus can avoid impact from crises there,” explains Le Poidevin.
There has been criticism of catastrophe bonds, and not just because of their relatively low credit ratings. Some fund managers see the structures as little more than gambling, since – as the last few years have shown – it is relatively difficult to predict when an earthquake will happen or how bad it will be.
But Robin Fuller, Executive Director at Dexion Capital, doesn't agree. He points out that the bulk of catastrophe bonds relate to countries where reliable weather data is available and has been built up over many years.
“They only work for markets with a good history of good statistical returns. If you look at the type of risk – in North American wind there is a lot of good data, in Japan and New Zealand there is good earthquake data. You need the historic data to be able to model returns. So you only work in developed markets with clearly identified risks,” he explains.
In terms of the moral issues with making money on betting whether or not a natural disaster will decimate a city or country, Fuller believes it is quite the opposite. Catastrophe bonds help to ensure that in the event of a disaster insurance companies will be able to pay out.
“I think it provides a very useful social function. The whole point is that you are spreading risk across a population. It means those who suffer a catastrophe are fully compensated and paid out rather than insurance companies going bust,” he says.
Orlando Crowcroft is a freelance financial writer
Growth market
Changes taking place in the insurance industry across Europe could serve to boost the catastrophe bond industry
as well as the Channel Islands' role in it, experts say.
A recent report by Risk Management Solutions (RMS) found that as the Solvency II regulations being implemented by the EU will force insurers to raise their capital requirements, catastrophe bonds would become an even more popular way for firms to cover their backs.
“All sources indicate that the market is set for continuous growth – there is a steady supply of new offerings and the upcoming implementation of Solvency II regulations for the insurance industry will likely result in increase,” it claims.
Meanwhile, the Solvency II regulations will not apply to the Channel Islands, but will apply to competitors such as Malta and Gibraltar, presenting an opportunity for Jersey and Guernsey.
“Not being bound by the EU directive, there might be an attraction to come to the Channel Islands. There may be opportunities for a niche insurer that might want to set up a division because there is more flexibility over here,” says Richard Packman, Managing Director at Vantage in Jersey.