The huge financial - as well as human - cost of disasters such as typhoons and flooding is driving demand for catastrophe-linked insurance. The "cat bond" market is set to expand sharply, so the author of this article argues.

Heavy flooding in the UK recently highlights the enormous insurance-related costs of such events, as does last month’s devastating storm in the Philippines. One insurance-linked investment area of note is that of the catastrophe bond market. In this article, Christophe Fritsch, who is head of insurance- linked securities at AXA Investment Managers, looks at the area of catastrophe bonds and explains why wealth managers should pay this area serious attention.

In the continued search for diversification, investors with a long term investment horizon are increasingly looking at catastrophe bonds (cat bonds), a growing market offering uncorrelated returns. While, traditionally, reinsurance firms were the primary providers of catastrophe risk coverage, this has started to shift to the capital markets, creating an opportunity for investors to potentially receive a premium for a risk that has not historically been included in their investment strategy.

In this article we examine how cat bonds work for those taking a first look at this asset class, and explore the risks and factors that need consideration when creating a diversified portfolio.

The “trigger”
Cat bonds are sponsored by insurers seeking to transfer some of their risk for covering damage caused by natural catastrophic events, such as earthquakes, hurricanes, windstorms and typhoons, to the capital markets. While occurrence is infrequent, when it does happen the impact could potentially be significant and maintaining capital on their balance sheet to cover the potential loss, as required by regulation, can be an inefficient use of an insurer’s assets. For this reason they are often keen to transfer some of this liability to others - investors.

Cat bonds are defined by a “trigger”, a precise event or set of events that determine the circumstances leading to an insurance pay-out and loss for investors. In some cases, a catastrophic event could occur but not fulfil the specific trigger conditions thus representing no loss for investors. However, in the event of a catastrophe fulfilling the trigger conditions, bondholders could lose part, or in the worst case the whole of the capital they invested in that particular bond.

The premium

Since January 2002 the cat bond market has delivered an average return of more than 8 per cent per annum with an average fluctuation in prices of 2.6 per cent on an annualised basis . Cat bond investors earn returns through ongoing premium payments in the form of a regular coupon, while accepting the risk of potential loss should a natural disaster occur, and in the absence of any catastrophe, they expect to have their principal returned at maturity.

The coupon is usually based on a reference rate, eg money market or Libor, and the bonds typically have a maturity of one to three years, which can appear attractive characteristics for investors concerned about a potential rise in interest rates and hesitant to lock into longer term bonds with fixed rates.

The perils
The main risk to cat bond investors is that part or all of their invested capital is lost due to a catastrophic event that meets all trigger specifications, which can be mitigated through diversifying the portfolio. Climate change and a potential increase in the occurrence and intensity of some of the catastrophes covered by these bonds is another risk in the long term which can be mitigated by ensuring that the premium paid reflects the potential impact of climate change. Moreover, the potential impact of climate change will be measurable over a very long period of time, while cat bonds are short duration solutions.

Investors need to understand the potential for losses and assign a value to this risk. This is where professional expertise and experience are key, to incorporate knowledge of pricing models, event probabilities, and trigger structures. Investors often rely on a team of actuarial, capital market, legal, and insurance specialists to design a diversified portfolio.

The portfolio
As extreme natural catastrophes are uncorrelated to macroeconomic or financial events, this makes the rationale for including a cat bond portfolio appear particularly compelling. It is hard to argue that the risk of a windstorm in Europe is related to the occurrence of an earthquake in Japan; thus, the return profiles and probability of loss across different bonds covering different risks are uncorrelated and investors should gain exposure through a diversified portfolio.

Cat bond funds tend to have minimum investment barriers, but are becoming more accessible through multi-asset class funds or fund-of-fund solutions.

Cat bond climate and the sunny outlook ahead

Over the past two years, the cat bond asset class has seen a notable increase in demand. As at the end of August 2013, the total size of cat bonds issued in 2013 reached $5 billion in the primary market (vs $4.2 billion for the same period in 2012). Today the cat bond market represents more than $20 billion in issuance.

The influx of capital led to a spread tightening on cat bonds, but also introduced diversification opportunities as new sponsors looking to securitise new risks, such as Turkish earthquakes, entered the market.

We expect the market to double in size by 2016 with growth driven by supply - insurers incentivised by regulation to sponsor new issuances and diversify their reinsurance capacity - and demand factors, with investors searching for uncorrelated returns.

Historically, the cat bond market has proven to be remarkably resilient, as shown by the stability of its performance throughout the past decade. Cat bond investing is not without its risks and requires an in-depth understanding of the underlying structures and models used to price these unique investments, but investors are in a unique position to consider adding an allocation to create an Insurance Linked Securities portfolio supporting their long term goals.