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Catastrophe Bonds: opportunities in risk transfer

23 September 2021 Jan-Daan van Wyk, Senior Analyst at Stonehage Fleming Investment Management South Africa
Jan-Daan van Wyk, Senior Analyst at Stonehage Fleming Investment Management South Africa

Jan-Daan van Wyk, Senior Analyst at Stonehage Fleming Investment Management South Africa

The extended period of unconventional monetary policy employed by Central Banks following the Global Financial Crisis has eroded historic risk premiums – be it equities or bonds, not to mention the money market. It is not new knowledge that, as a result, one must now assume more risk than in the noughties to earn a similar return.

This is especially true in the realm of fixed income investing: the average yield of the US 10-year Treasury Bond from 2000 to 2008 was 4.59%, and from 2009 to 2020 it was 2.35%. At the end of August 2021, it was 1.30%[1]. A further symptom of this and exacerbating the situation is, globally, $ 16.5 trillion worth of debt is negative yielding[2].

Against this backdrop of ultra-low bond yields, asset allocators are naturally looking at alternative sources of return, such as commodities, hedge fund strategies and digital assets. In the fixed income asset class, one such opportunity lies within catastrophe risk, a subset of insurance linked securities (“ILS”).

Catastrophe risk is a sophisticated market where investors provide insurance coverage on damage caused by natural disasters such as hurricanes, tsunamis, floods, and earthquakes. Here, insurers, reinsurers, companies, governments and supranational organisations issue Catastrophe Bonds or “Cat Bonds” – paying an investor a premium to assume responsibility for covering losses from specific events.

Transferring risk is not new. However, insurers and reinsurers have regulatory capital and diversification constraints, and can only stand to absorb so much of a given loss.

This led to the development of the Insurance Linked Securities (ILS) market which has undergone significant growth in recent decades. The creation of this class of security has allowed a broader group of investors to absorb insurable risks and increase the capacity for risk coverage globally. In return, investors can earn the insurance premiums. At the end of March 2021, global reinsurer capital is estimated to have totalled US$ 650 billion[3]; of which US$ 96 billion (ca. 15%) comprised alternative capital, or ILS’s – up from US$ 28 billion (ca. 6%) in 2011. This is expected to further evolve, as urbanisation causes an increased demand for insurance, whilst capacity for risk on reinsurers’ books remains limited[4].

Uncorrelated risk and return

Compared with a plain vanilla corporate bond, where an investor assumes the risk of the borrower failing to repay interest or capital, with a Catastrophe Bond an investor assumes the risk of specified natural catastrophic events occurring. If the event does not occur, the bond “matures”, and capital is returned to the investor – having also earned the coupon(s), or insurance premium(s). If, however, there is an event, the capital invested is proportionally reduced by the value of insured loss.

As with any investment, risk diversification is vital. By combining exposures to different peril zones and different trigger events, one can arrive at a portfolio that reduces the risk associated with a specific event while earning a comparatively attractive premium, or coupon – average coupon of issuance in 2021 has been 5.75%[5] The added benefit of this, in the context of a traditional multi-asset portfolio, is that the drivers of risk and return for Cat Bonds are not tied to financial markets or the economic cycle in the way that other financial instruments are. Put differently, one’s risk (and return) is dependent on the occurrence of natural catastrophes – together with the dynamics of risk pricing in the reinsurance market.

ILS’s and specifically Cat Bond exposure can play an important role in an investment portfolio – particularly as an alternative source of return, providing risk uncorrelated with traditional asset classes. By way of example, the correlation of monthly US dollar returns of the global equity market and global bonds from the beginning of 2006 to the end of July 2021 was 0.40. Comparing each, in turn, to the SwissRe Global Cat Bond TR Index yields a figure of 0.21 versus global equities, and 0.16 versus global bonds[6].

An added benefit, and a perspective that has become more front of mind of late, is the benefit to society from increased capacity available for risk transfer. Increasingly investors view Cat Bonds as being naturally aligned to certain social needs that are fundamental to ESG investing. One area of growing need is the costs associated with climate change where the increased incidence and severity[7] of extreme weather events is driving increased usage of these instruments.

While pension funds and university endowments have invested in these securities for years, private investors have also been allocating through specialist managers. Having previously held exposure in portfolios, and viewing the space as relatively attractive at present, Stonehage Fleming recently allocated to the Cat Bond market in some of its global mandates.

In a world hungry for yield, and the construct of global developed market central bank policy expected to slowly exit from its current ultra-accommodative setting, an allocator would do well to evaluate a wider spectrum of investment tools. If this opportunity comes with the added benefit of lower correlation with traditional asset classes, all the better.

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