In the eye of the storm with cat bonds.
In 2022, Hurricane Ian wreaked havoc in Florida, resulting in widespread destruction, loss of life and one of the costliest disasters on record. Coupled with inflation not seen in 30 years, it was not surprising to see the reinsurance market come under significant pressure.
With reduced capacity and higher prices in traditional reinsurance, insurers have to consider alternatives. One increasingly popular way of seeking protection for an insurance company is to access the capital markets through “cat bonds” and other collateralised reinsurance products.
How does a cat bond work?
Catastrophe bonds (cat bonds) offer investors an intriguing alternative to government and corporate bonds. They work very similarly to traditional bonds, however, rather than being exposed to the default of a company or a government, investors are compensated for taking the risk of a natural catastrophe (or another insurance-related event) occurring during the lifetime of the bond. This provides them with a return source that is most likely not correlated with broader credit or equity market risk.
The proceeds of the bond go to a separate entity (the issuer), so the investor does not have to worry about the creditworthiness of the insurer. The insurer also benefits from this structure. If the catastrophe happens, the insurer receives the money from the issuer, not from the investor. This is a significant difference from traditional reinsurance, where the insurer must consider the financial stability of the reinsurance company before entering into a contract.
Simplified cat bond cash flow diagram
There are numerous ways to structure when and how losses are paid. Different triggers can be used to determine whether a qualifying event occurred. The trigger could be the actual loss to the insurer, an insurance industry loss estimate, or it could be physical measurements that indicates the strength of the storm or earthquake. This creates an additional layer of complexity for cat bonds compared to other fixed interest asset classes.
The role of cat bonds in a portfolio
From a portfolio management perspective, the main advantage of catastrophe bonds is the lack of correlation between different risks within the asset class. If an earthquake happens in, say Japan, it does not increase the probability of a hurricane in Florida, for example. The events are independent, creating great potential for portfolio diversification.
In contrast, a traditional bond portfolio typically has higher correlations between underlying risks. If one corporate issuer is in trouble because of a severe recession, there is a high probability that other corporate issuers in the portfolio are also facing challenges at the same time.
We believe there is merit in considering cat bond strategies as an alternative asset class. However, as always it is important to keep an eye on the basics. Diversification, transparency, and appropriate fee structures should be top of mind for investors interested in cat bonds.
Diversification: what is the maximum loss from one event?
Investors might be surprised to learn that one event can create a loss far greater than 30% or even greater than 50% in some cat bond strategies. We have even seen this number reach levels close to 80% in the past.
We doubt there are many investors who would be comfortable with investing in an equity strategy that has 50% or 80% in one single stock. But in the cat bond space, an undiversified strategy seems to be more acceptable.
When we ask managers with undiversified strategies to reveal the maximum loss, they often admit that it is high, but immediately point to how improbable such an event would be. However, low frequency does not mean that the event cannot happen in any particular year. It simply means that it is highly unlikely that two or more of these events will occur in a short time frame.
Regardless of the probabilities: an investment that can lose half of your money in one event is not well diversified, in our view.
It is also important to understand that there is no easy way of growing yourself out of the hole such an event could create. The share market can fall by 40% and rebound over the next five to ten years, as investors regain confidence in the market. In contrast, a severe weather event or earthquake cannot be reversed. As a result, we believe that demanding proper diversification is crucial. At a minimum, investors should always be aware of the loss potential from one event in a cat bond strategy.
Transparency: what triggers losses?
Cat bonds were originally structured to ensure that potential losses were determined by relatively transparent, independent and objective measures. Triggers included formulas that relied on data such as windspeeds for hurricanes or peak ground acceleration for earthquakes, for example.
However, insurers started to push for actual losses in their insurance book as the criteria for cat bond losses. That way, it mirrored the traditional reinsurance market. Insurers did not like to face the risk that the event measures were deviating from their actual loss experience. But investors lost a lot of transparency and are therefore faced with a new risk: bad underwriting. Investors then have to consider how well the insurer runs its business.
We believe investors should ask for more transparency in triggers, especially now, where the market environment is in their favour. It is unlikely that high yield investors would accept the elimination of debt covenants in corporate bonds. Similarly, we believe that investors and fund managers should now push for better terms – i.e., more transparent triggers – in cat bonds.
Fees: is there a performance fee?
Can cat bond fund managers influence the likelihood of a catastrophe occurring? Clearly not, however, managers may still charge investors a performance fee that would suggest they can.
In essence, performance fees in cat bond strategies are often paid to the manager for the simple fact that certain events did not happen. This should not be acceptable, whether it is for an institutional mandate or for a retail product.
Skilled security selection is close to impossible to measure in a market that is dominated by binary outcomes. And without the ability to assess skill, performance fees are meaningless: investors end up paying additional fees for the simple fact that managers got lucky.
As a result, we believe it is important that investors push back on performance fees in this asset class.
The eye of the storm
We believe there is merit in the asset class and welcome suitable funds for New Zealand investors. Our role as an investment consultant is twofold: assess whether the risk is appropriate for our clients (asset allocation) but also, determine whether we believe the products or strategies are well structured and managed (manager selection).
Cat bonds likely meet the first criteria, but in our view, the second hurdle is still difficult to overcome for most New Zealand investors. We encourage interested investors to push for better diversification, more transparency and appropriate fees for cat bond investments to stay in the eye of the storm.
Makao Investments is a New Zealand-based wholesale investment advisory business that was founded to lift investment advice to a higher standard.