While Swiss regulator Finma looks at insurers’ natural catastrophe models, Switzerland remains a hotbed of the catastrophe bond market. InvestmentEurope reports.
Irma, Maria and Harvey were among big shakers of the catastrophe (‘cat’) bond market in 2017. None of these are firms or individuals but rather hurricanes since cat bonds, a pocket of the insurance-linked securities market (ILS), are issued by insurance and reinsurance groups to raise money in the event of a natural catastrophe.
2017 was particularly stressing for these instruments. The three hurricanes mentioned earlier, having hit the Caribbean islands and the US, together with earthquakes in Mexico resulted in insured losses of $95bn according to Swiss Re, which highlights an increase in the number of events causing insured losses of $1bn or more, “another contributing factor to higher insurance claims overall” last year.
Last February, Swiss financial market regulator Finma addressed a questionnaire regarding natural catastrophes to insurance companies, which have been regulated to develop internal models for this type of incident.
Finma has decided not to provide standard models for natural catastrophes but being the competent supervisory authority, it must nonetheless approve any proprietary models. The information collected through the questionnaire is intended to add efficiency to the approval process.
Switzerland’s role in the global cat bond market is significant as several asset managers run ILS strategies and a number of major insurers and reinsurers are based in Zurich. The market has grown rapidly in recent years, notes Credit Suisse AM’s head of Insurance Linked Strategies Niklaus Hilti (pictured left). Last year saw record annual cat bond issuance of $11.2bn.
That said, outstanding non-life cat bonds issued stood at $25.3bn at the end of 2017, a fairly small segment in comparison to the traditional reinsurance market (around $400bn), Hilti assesses.
“Looking at the risk exposures of the cat bond market, it is highly exposed to US wind events – approximately 70% of total market exposure – which makes it difficult to establish a broadly diversified pure cat bond portfolio and leaves cat bond investors largely exposed to single, very severe US wind catastrophe events.
“We estimate that about $3.5bn, or 14% of the outstanding market is cat bonds from so called residual/costal/ take-out sponsors with low quality underlyings where, in our opinion, the investor is not well compensated for incurred risk. A total of $7.2bn in cat bonds will mature in 2018. We expect a healthy pipeline of new issues for this year,” Hilti explains.
He adds: “As with ILS private transactions, cat bond investments that we consider, have to pass a rigorous investment analysis in order to gauge their attractiveness from an ILS portfolio point of view. This includes quantitative elements in order to assess and model the underlying risk but also a qualitative assessment of the counterparty.”
Simon Vuille, portfolio manager, ILS team at Lombard Odier IM, sees an increasing variety of risk types, structures and sponsors coming to the market.
“This allows us to offer our investors increasingly diversified portfolios of fixed income assets that are uncorrelated to the traditional markets and not subject to interest rate risk,” he says.
Zurich-based Twelve Capital manages over $1.2bn in cat bonds across public and private funds as well as managed accounts. Its head of Cat Bonds, Florian Steiger (pictured left), says investors globally are being attracted because of a relative attractiveness against other fixed income asset classes.
“Its inherent complexity, the importance of partnering with specialised and knowledgeable investment firms cannot be understated.
“Twelve Capital generally invests in all possible cat bond instruments, mainly depending on the individual bond’s characteristics as well as on the mandate for a given portfolio. Some portfolios might have restrictions on certain perils, which could restrict us from taking a position in a certain security, despite sometimes attractive economics.” Steiger adds.
How much do climate change and global warming issues affect the cat bond market? Steiger suggests the effects are not yet clear.
“Other factors, such as the availability of reinsurance capital or relative pricing have far more influence on issuance activity compared to climate change. Also, whilst there is little doubt that global warming will ultimately result in warmer sea surface temperatures, the scientific evidence on the probability of (Atlantic) hurricane formation and its strength is much weaker and not conclusive,” he pinpoints.
According to Steiger, if the role of climate change in last year’s hurricanes propelled debates in the media, the rise in damage profiles compared to previous hurricanes is more often attributable to urbanisation and extensive construction in flood-endangered areas over the past twenty years.
Lombard Odier’s Vuille (pictured left) says there is negligible impact of climate change on risks covered by cat bonds (earthquakes and hurricanes). He highlights most ILS maturity runs over one to four years. That compares with research suggesting the evolution of severe weather events affecting the cat bond market is likely to take decades or even centuries.
“There are a number of periodical meteorological phenomena such as the El Niño-Southern Oscillation (ENSO) or the Atlantic Multidecadal Oscillation (AMO) that have a much greater impact on hurricane activity,” Vuille estimates.
About catastrophes in Switzerland, Lombard Odier’s ILS portfolio manager points out that “fortunately, the Swiss territory is not prone to many large-scale natural catastrophes.”
“The two main risks are winter storms, for which we deem insurance penetration sufficient to good, and earthquakes, for which there is a very large insurance gap. The significant seismic risk characterising mostly the alpine regions could be a real threat.
“The low earthquake insurance penetration characterises both the residential as well as the corporate and public sectors, and market forces alone are unlikely to be sufficient to remedy this situation. While there has been a number of political initiatives to mutualise earthquake risk, they have so far been unsuccessful. It is our hope that ILS and CAT Bonds will play a role in closing this insurance gap in the future,” according to Vuille.
Credit Suisse’s Hilti sees climate trends like global warming as a common concern among investors in the ILS space. Greater media coverage may give the impression of more frequent hurricanes, although historic data suggest Atlantic hurricanes make landfall in the US on a relatively stable basis.
“There are seasons such as 2004 and 2005 with an extraordinary high number of hurricane landfalls, but the average has been fairly stable over time at less than two hurricane landfalls per season albeit declining. It cannot be proven yet that climate trends have increased the frequency of extreme events such as hurricanes.”
However, Hilti notes three of the four landfalls in 2017 were from major hurricanes category 4 or 5 leading to the exceptionally high insured losses for 2017.
“In contrast, all hurricanes in 2005 were category 3 or lower when they made landfall in the US. So, while empirical data does not confirm a higher frequency of extreme events, these few data points from past years indicate the occurrence of more extreme hurricanes,” Hilti points out, mentioning that the cat bond market has seen the strongest growth following large catastrophe years, such as 2005 and 2011.
Pre-2011, the market had a size of about $12bn. Following 2011, which had been a large loss event year due to earthquakes in Japan and New Zealand and other events, the market has seen strong issuance activity, he underlines. By the end of 2017, the cat bond market has more than doubled in size to $25.3bn. A similar development was observed following 2005 (hurricanes Katrina, Rita and Wilma).
And it is important to remember that other natural disasters, such as earthquakes can equally have an impact on the insurance industry – as seen in 2011.
Cat bond strategies form an alternative play for Geneva-based boutique Wealth Solutions Partners.
Co-founding partner and CEO Hervé Croset says the asset class has become popular in recent years, with stable returns (4-6% in dollar terms) having led many managers to launch related funds.
“The cat bond market remains tight for a bond segment with around $30bn of existing issuance currently. That has rendered us cautious in our selection since the asset class could be rapidly crowded. We favour investments in managers demonstrating long experience in the field and having good access to the primary market with pricing bargaining power,” says Croset.
“The asset class is decorrelated. We look for products whose returns are not or little exposed to the directional risk that is traditionally seen in the bond universe.
“Premiums are relatively appealing compared to other bond segments. You can get a premia of around 150 bps on a pure cat bond fund and one of around 210 bps on a fund blending cat bonds and industry loss warranties.
“In the aftermath of last year’s hurricanes, risk premiums will be renegotiated at a higher rate. This will be sensitive for industry loss warranties strategies as contracts’ maturity is one year.”
Risk models for natural catastrophes and manager experience are seen as key criteria by WSP. It believes asset managers owned by insurance groups benefit from an edge given the depth and the history of their databases. Hence the cat bond fund put forward by WSP is run by the asset management subsidiary of a French insurer.
Jonathan Naegeli, senior fund analyst at Union Bancaire Privée, says the experience of UBP’s multimanagement team with ILSs dates back to 2007 when it was looking for new asset classes offering low correlation with other segments.
“ILSs show limited correlation with traditional financial markets, low duration – because they are floating rate instruments – and relatively high yields, and so were recognised as very attractive. Since then, the asset class has evolved, both in terms of its widening acceptance among investors as well as its size.
“Higher demand for ILSs, combined with the relatively low frequency of major natural catastrophes over the past decade, diminishing opportunities for yield across markets and current excess capacity in the insurance industry, has led to a reduction in premiums and yields since 2009.
“As a result, the risk/reward profile of ILSs is not as attractive as it used to be, especially for pure cat bond funds. However, given the current market environment, we believe that a limited, long-term allocation to ILSs remains attractive relative to some of the more traditional fixed income asset classes, both in terms of returns and especially portfolio diversification.”
Naegeli adds that there is a key difference between ILSs and traditional assets in their return distribution. With cat bonds having a very low probability of sustaining a huge loss, it is therefore essential that a manager can properly model the inherent risks of each ILS and build a portfolio that is well diversified across regions and perils.
Hyposwiss’ head of Fund Selection Albert Philippe Brini says the team does not recommend any cat bond fund currently but thinks of maybe adding one to its buy list, given small client interest coming. ■
This is a longer version of the article published in the April 2018 issue of InvestmentEurope. Cat bonds managers commenting in this article also share their views on terrorism risk here and on their approaches on next page.
What is your general approach towards the asset class of catastrophe bonds?
Simon Vuille, portfolio manager, ILS team, Lombard Odier IM: “Our investment philosophy explicitly recognises the unpredictability of catastrophic events. Consequently, we regard optimum diversification across the various types of risk available in the cat bond market as crucial to achieving superior risk-adjusted returns in the long-term.
“The team is characterised by an interdisciplinary skillset (Finance, Reinsurance, Law, IT, Mathematics) and is therefore ideally equipped to take a holistic view. This combines a bottom-up approach reliant on actuarial concepts for security selection with top-down portfolio construction based on financial science.”
Niklaus Hilti, head of Insurance Linked Strategies, Credit Suisse AM: “Our investment strategy is to invest in a globally diversified portfolio of insurance-linked securities (catastrophe bonds) and insurance-linked OTC contracts (private reinsurance transactions) in order to establish a broad exposure to natural catastrophe risks and manmade risks.
“We focus on meaningful diversification with the aim to minimize the tail risk of the portfolio and generate attractive risk-adjusted returns throughout the reinsurance cycle. Given the high concentration of US wind risk in the cat bond market, we believe that a diversified ILS strategy can only be implemented with broad access to different reinsurance market segments in order to access attractive and diversified risks.
“In this context, the cat bond market has relatively low entry barriers and compared to ILS private transactions, the cat bond market has seen a more significant yield compression in the last years due to high interest from investors looking for alternative, uncorrelated risk premia.
“On the other hand, the traditional reinsurance market which we invest in via ILS private transactions, is a very conservative market with relatively high entry barriers. The Credit Suisse ILS team has been in the market for a very long time and thus has access to those parts of the markets where continuity and experience is important. Private transactions allow us to participate in all types of insurance risks and more importantly to diversify broadly.
“Nevertheless, the cat bond market is very important for ILS investments as it provides access to liquid ILS instruments which can be traded on a secondary market and thus provides liquidity to an ILS portfolio. In contrast, ILS private transactions are illiquid but mostly have maturities of only up to 12 months.
“Although the majority of our ILS investments is in private transactions, we at Credit Suisse ILS actively – but selectively – participate in the cat bond market.”
Florian Steiger, head of Cat Bonds, Twelve Capital: “Cat bonds, and also other ILS instruments, are a central part of Twelve Capital’s investment strategy. Twelve Capital manages more than $1.2bn of cat bond holdings across public and private funds as well as several managed accounts.
“Twelve Capital employs a top-down as well as a bottom-up portfolio construction investment process. As part of the investment process, an instrument’s quantitative as well as its qualitative characteristics are evaluated on a stand-alone, as well as on a relative value basis comparing cat bonds with other cat bonds as well as with private ILS instruments with similar characteristics.
“Once the attractiveness of an instrument has been established, it is reviewed under the aspect of portfolio optimisation and how that particular instrument would interact with the other portfolio constituents. Ultimately, it is Twelve Capital’s goal to construct the portfolio with the best possible risk return characteristics and hence the combination of single-instrument analysis and portfolio optimisation is key in the overall investment process.”