Catastrophe and convertible bonds offer a calming influence

As investors continue to question the great rotation from fixed income to equity, and ponder emerging markets developments, it may be time for allocators to consider convertible and catastrophe bonds.

Last year, the financial district of New York shut down as flood waves lashed
the East Coast of the US. Superstorm Sandy, as it became known, was much debated as another sign of climate change. But for investors it was also a sign of the investment opportunity found in assets uncorrelated to traditional fixed
income and equity assets.

Catastrophe bonds were first created in the mid-1990s, driven by the need among insurers and countries to protect themselves against unexpected losses. 

Dexion Capital – a boutique investment bank that manages DCG IRIS, a London listed closed-ended investment company which feeds into into the IRIS Low Volatility Plus fund managed by Credit Suisse – quotes figures from Property Claim Services that Sandy caused some $18.75bn in losses, although other estimates of total losses across all countries affected by the hurricane that caused Sandy are above $60bn. Dexion cites estimates of flood damage in Central Europe this year resulted in an
insured loss of €6bn.

Market drivers

Increasing population density, wealth, insurance density and building quality are all factors leading to rising costs of catastrophes, Dexion says.

Paul Traynor (pictured), head of Insurance Segment, International at BNY Mellon, also notes the low correlation with other asset classes, and attractive risk and return compared with traditional assets. He adds that investors need to take a medium- to long-term view as the nature of the investment risk, which is low frequency and high severity.

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Catastrophe bonds (cat bonds) effectively represent the securitisation of insurance contracts. Thus those that package up the risk have to find the right price point to ensure the sale of the bonds.

One reason for the growing interest in cat bonds as an asset class is the
return that is possible in the current low-yield environment. Traynor says that insurers will charge some 250-300 bps over Libor for taking on catastrophe risk in a low yield environment. But the risk/reward balance can shift, and there will be those in capital markets who feel at times that there is too much risk for too little reward. By way of example of how the pricing can change, Traynor cites
the example of Turkey’s Bosphorus Re, which was being marketed with a coupon of 3.25% over Libor on an issue size of $100m, but when it issued the size had grown to $400m, and the coupon came in to a price of just 2.50% over Libor.

Seasoned catastrophe bond players may have seen this as too expensive, Traynor says. Meanwhile, the link to Libor makes this a market where investors may be sensitive to interestrate changes. If cat bonds are issued at Libor +2-300bps, then if interest rates go up they will still be Libor +2-300bps. The question investors would then pose is whether they still look interesting.

Diversification remains an argument, however. Traynor estimates the cat public bond market will increase from some $20bn to $40bn in the next five years, because investors see it as a diversifier. “It’s a diversifier that pays over Libor, normally you give up an amount of return to obtain an  effective diversifier,” Traynor says.

Issuance will meanwhile be driven by regulations such as Solvency II, he adds. “Primary Insurers look to offload risk as efficiently as possible and the catastrophe bond market is one such way to do this. They like cat bonds because of the collateralisation, which is more capital efficient than traditional reinsurance and not always collateralised.”

Big data

Nation states may issue cat bonds to protect infrastructure. Certain emerging markets are interested because generally catastrophes suffered there have been underinsured.

Traynor estimates that just $2/$10 has been sufficiently insured in emerging markets, against some $8/$10 in developed markets. The ability of the market to accurately price insurance risks is improving through the use of so-called Big
Data. This can use telecommunications data, satellite pictures and so on, which improves the ability for insurers to put figures on likely economic losses, also in emerging markets. Reinsurance also plays a role, because when countries such as Brazil come to market they end up dealing with panels of reinsurers, effectively resulting in a global mutualisation of risk, he says.

There are some key investors in the catastrophe bond market, such as endowments, pension funds, and family offices, Traynor notes: investors with long-term horizons. However, he adds that he would “not recommend cat bonds for retail funds”.

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