14 April 2014ILS

A whole new world

Developments in the cat bond space have been picking up steam.Bermuda:Re asks industry experts what the future might look like.

Pete Vloedman was there at the beginning. An elder statesman of the catastrophe bond world, he’s seen them develop from a novelty to a significant risk management tool. And catastrophe bonds aren’t done yet.

Vloedman told Bermuda:Re, “We’ve been doing this in terms of the bond world since about 1994. The first decade was relatively slow—then things started picking up pace after Hurricanes Katrina, Rita and Wilma in 2005. I think the biggest development between decade one and decade two is that you’ve got greater investor acceptance now.”

This greater investor acceptance—which has also been observed by EY’s Craig Redcliffe and Pete Cangany, along with Maria Marsh, principal and senior portfolio manager at Nephila Capital—has been the drive behind amazing and accelerating innovation in the space.

Redcliffe, partner at EY, said, “We’ve had dramatic growth in the last two years. We’ve also seen more investors entering into the space, with  a noticeable increase in investor sophistication. This shift has created a focus on structural innovation as investors become more comfortable in the convergence space.”

“As investors get comfortable they get ready to accept more risk in general,” Marsh said. But as hungry investors push the cat bond train to travel at ever higher speeds, the industry must take care that it’s travelling in the right direction.

Supply and demand

It’s been a decade since investor interest in cat bonds started picking up, according to Vloedman, and thanks to the economics of supply and demand issuers are currently at the wheel.

“So many investors are demanding paper today,” he said, “that they’re willing to accept it with an issuer-bias on terms such as trigger mechanisms. It may not be the best thing for the investor, but they want the paper and the issuers are getting it done.”

Cat bonds have seen exploration and innovation in triggers and risks alike—with investor appetite insatiable, issuers have become smart and moved from simpler indemnity triggers towards parametric triggers.

Marsh explained, “We’ve seen this trend in the traditional market, where the terms are getting looser and deals include broader coverage, clauses and reinstatements. This trend towards indemnity triggers for bonds follows along the same lines. Indemnity bonds minimise the basis risk for the sponsor compared to a parametric triggered bond. However, there is a cost differential—parametric triggers can be priced more efficiently in the market and you have to pay less for that as a sponsor, but there’s a trade-off between that and getting indemnity protection. When the market gets more competitive and the spreads come down, however, that differential gets smaller and as a result most sponsors seem to favour issuing on an indemnity basis.”

More than triggers, investor interest is pushing cat bonds further away from the peak-zone property cat risks they were developed to take on. Redcliffe said, “There is certainly investor interest in diversification, whether it’s from the product line or from the geography.”

He continued, “Historically cat bonds were primarily focused on peak zone wind risk and hurricane risk. Over time I expect casualty will be offered, but in the short term there are significant structural challenges that need to be overcome.”

Marsh said, “I definitely think there’s an appetite for casualty risk for some cat bond investors. The concern would be that investors become more willing to assume less familiar risks for the sake of meeting a certain return target. Ultimately, they may not be prepared to explain to their stakeholders what caused the negative performance, which is not a good outcome for the market.”

Cangany, partner and insurance leader at EY added, “Sophistication of investors is key to adding casualty as a peril because a really good understanding of the tail on these losses and the liquidity of these bonds is important. Most casualty lines will have five years or more of exposure. In order to see success, a tail would need to be put on the backside, which would then decrease the returns a bit.”

Vloedman pointed out Avalon Re, a $405 million bond issued in July 2005 to cover Oil Casualty Insurance’s casualty-related losses. Now held up by some as a catastrophe bond structure that was not well thought out, the deal was triggered and paid out to the tune of $12.69 million.

Vloedman said, “The Avalon Re bond covered general and other liability, and I think you can put a question mark on how successful it was. There were some elements of the bond that surprised investors, and as a result of that you saw less push in the non-property cat area for a while.”

“Certainly broker-dealers are talking about reversing that trend,” he said. “But for me it comes down to what a cat bond is best suited for. When we were working on the development of these structures back in the early 1990s, which I was a part of, the whole idea was that they increased capacity for property cat risk. We designed cat bonds to solve a problem—and we still haven’t solved it.”

He continued, “I would like to see us solve the property cat problem before we move on to other things. Workers’ compensation and commercial auto are interesting, niche products, but there is no current capacity need for them. The insurance industry can handle that risk. We don’t need to duplicate their efforts, or compete with them. We can all play really well in the sandbox together if we want to.”

The use of an indemnity trigger type is not always suitable, as Marsh pointed out that more complex risks and poorly-understood geographies could be better served by simple triggers. She said, “In terms of broadening the scope of cat bonds outside of pure catastrophe risk, you could have sponsors issuing a parametric triggered bond which captures the catastrophic element of whatever their underlying exposure is—if it’s workers’ compensation or something along those lines. That can then be used as a way to get investors comfortable that they are still providing protection to catastrophic events although the underlying exposure is something besides property catastrophe risk.”

Vloedman sees complex terms such as indemnity payout triggers as a potential barrier to investor growth. The large scale investors that the industry should be seeking to attract—major players such as Fidelity and Vanguard, for example—could be driven away from trading cat bonds by knowledge asymmetries between the investor and the issuer. He explained, “To unlock the potential of those investors we need simpler triggers, not more complex ones.”

While complexities exist, Cangany pointed out that the industry is invested in moving towards a balance. He said, “The industry offering these products isn’t going to do anything that would soil the reputation  built with investors over the last several years. By throwing innovative products into the offering, they could create additional basis points of profits for both sides of the party, and there is something to be said for the fact that those offering these products are careful not to chase away the investors they’ve worked so hard to attract.”

A world away

In April 2013 the Turkish Catastrophe Insurance Pool, a state-backed insurer which pools catastrophe exposure, issued Bosphorus Re I. The Bermuda-registered SPI uses a parametric trigger and provides reinsurance cover for earthquakes affecting primarily the Istanbul region of Turkey. Combined with Multicat Mexico 2009 and 2012, which were issued in collaboration with the World Bank and protect the Mexican government against earthquakes and hurricanes, the transaction could usher in a whole new world of possibilities for cat bonds.

“I don’t think investors necessarily want the US focus that we see with catastrophe bonds at present,” Marsh told Bermuda:Re. “I think they would love to see more diversified perils, and a lot of cat bond investors out there still have regional peril constraints. In order for them to grow the US component of their cat bond portfolio they need those diversifiers to balance it out.”

Cangany added, “It’s interesting that Turkey did something this past year given the political climate. It shows the level of comfort with economies that have historically been overshadowed by China and Japan. The statistical data has got to be first—once the data is in place, businesses getting comfortable with those markets will bring things along much quicker than some might think. Until now, the speed of development has surprised me, and I think it’s going to start moving even faster.”

While Vloedman sees Bosphorus as a novelty—a temporary pricing benefit in the bond market being taken advantage of by the Turkish Catastrophe Insurance Pool—there is one element of new geographies about which he feels strongly. He explained, “What is more interesting and I believe more important when it comes to secondary and tertiary geographies are bonds with a more humanitarian purpose.”

Vloedman sees huge potential for catastrophe bonds to provide funding to sovereign nations and non-governmental organisations (NGOs), much like they did for Mexico through the Multi Cat programmes. Catastrophe bonds can provide crucially important aid during the near-term recovery period, six to 24 months post-event, when victims of natural disasters need to be sheltered and fed at the same time that vital infrastructure must be rebuilt.

He said, “A real opportunity for the ILS sector is public-private partnerships—the private sector in this case being ILS managers, investors and broker-dealers partnering with NGOs such as the World Bank and sovereign governments to increase the use of tools such as cat bonds to handle disaster recovery financing in geographies where the domestic insurance industry is underdeveloped. If I look ahead to the next 10 years in terms of what my big goal would be, that’s something I would like to accomplish. As an industry we’re continuing to grow—we’re making money, which is good, but we can do more to be better global citizens.”

Redcliffe  sees potential in this area, but he also sees challenges. “It will be interesting to see if emerging markets realise the benefits of these mechanisms and if they decide to take them on. Opportunity exists when looking at the gap between insured and economic losses in these geographies. However, as long as there is a strong pipeline of deals, I don’t see a strong push to market deals in emerging markets. There needs to be sufficient volume in the area to justify the research and product development in a specific area before a deal can be consummated.”

“Education is an element,” Vloedman said. “There is a role for the World Bank there, but part and parcel with that is the willingness of the investor base. Right now, we develop ILS products and then develop the investor base to go behind them. It would be nice if we had a committed investor base ready to go.”

He concluded, “As an industry we need to take a broader view. We haven’t got there yet because we’ve been fighting for so long to survive—but now that we have become established as an asset class, we can look ahead and grow the business to the benefit of all parties.”