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Magazine Issues » April 2014

FIXED INCOME: Counting the cost

Tide-outDespite Supertyphoon Haiyan that devastated the Philippines, last year was a quiet one for insurers. Stefanie Eschenbacher finds yields on catastrophe bonds are declining, as mainstream investors seeking uncorrelated assets and diversification are moving into the market.

More than 6,000 people were killed and millions left homeless by Supertyphoon Haiyan in the Philippines in November, but the most expensive event for the insurance industry last year was actually a hailstorm in Germany.

Haiyan was probably the strongest recorded cyclone to ever make landfall, with an overall loss totalling some $10 billion (€7.3 billion), equivalent to around 5% of economic output.
However, Munich RE says the insured loss will only be in the mid three-digit million ranges.

The world’s largest reinsurer says the most expensive event for the insurance industry was a hailstorm in north and southwest Germany that damaged cars, building façades, roofs and solar installations.

In July and August, these hailstorms – one hailstone found measured 14 centimetres – caused the insurance industry losses of $5.2 billion, of which $4.1 billion were insured.

Globally, Munich RE says losses from natural catastrophes were somewhat moderate last year. More than 20,000 people died, direct overall losses amounted to $125 billion and insured losses to $31 billion.

Harald Steinbichler, managing partner at axessum, which specialises in niche strategies, and other catastrophe bond investors have had a quiet year.

“The human aspect, how many people died and suffered, is a tragedy,” Steinbichler says of Haiyan. “But from the insurance side, it had no impact, because insurance penetration there
is so low.”

Catastrophe bonds are high yield debt instruments, usually insurance-linked, and a form of reinsurance. They raise money after earthquakes, hurricanes or typhoons, and, to a lesser extent, after terror attacks and mortality risks, such as pandemics.

When no such events occur, investors in those bonds get the premium. When no such events occur over a longer time, premiums become lower.

Steinbichler says the current yield in a diversified catastrophe bond fund is usually around 5.5% but after the 2011 Tohoku earthquake in Japan the spread was much higher.

It was one of the last events where a catastrophe bond defaulted, but just one because it was a unique sequence of events: the Tohoku earthquake resulted in a tsunami and then caused the world’s second-largest nuclear crisis at a power plant.

Steinbichler says while the damage after the event is estimated to be about $250 billion, the insured damage was only about $30 billion.

“The real problem was the nuclear catastrophe, not the earthquake,” he says, adding that catastrophe bonds only insured against effects of the earthquake, not those caused by the tsunami or the nuclear damage.

Steinbichler says there are many catastrophes that have no impact on catastrophe bond holders, especially when they happen in countries where insurance coverage is low. Hurricane Katrina in 2005 caused the most damage to insurers.

Christophe Fritsch, head of insurance-linked securities at Axa Investment Managers, says the development of the reinsurance market goes parallel with the development of the economy.

“Most of the risk is in the US, Europe and Japan,” he says. “There is less risk in less-developed countries because the insurance market is less developed.”

His Luxembourg-domiciled fund has 90% of its portfolio invested in catastrophe bonds.

Interest in the market has grown in recent years, mainly because performance is uncorrelated to other asset classes.

Fritsch says the risk profile is the most important difference.

Investing in a catastrophe bond means hedging an insurance company against a risk of making a loss after a natural catastrophe. Whereas investing in a credit asset means taking a more specific risk that is linked to the company.

Fritsch says while investors in conventional bonds take on both macroeconomic and microeconomic risk, this is not the case when it comes to investing in catastrophe bonds.

Another significant difference is the duration of these bonds. Durations of catastrophe bonds are much shorter, usually between one and three years, but longer credit duration means higher risk.

While uncorrelated to broader markets, there is concentration risk. Steinbichler says roughly 70% of all catastrophe bonds reinsure against hurricanes, almost all of which are concentrated in the US, mostly
in Florida.

Insurers only issue catastrophe bonds where they have a peak risk; apart from the US, the other regions with such peak risks are New Zealand, Japan and Australia.

Steinbichler adds that only specific types of risks are covered. After the Tohoku earthquake just one catastrophe bond paid out 100% – in this case a default, because investors do not get their premium back – and none after Hurricane Sandy in 2012.

The market was volatile after Hurricane Sandy, Steinbichler recalls, but in the end none of the catastrophe bonds’ triggers kicked in.

Catastrophe bond investors work with a measure of expected loss for each bond and have an average expected loss for the entire portfolio.  

Rated on average BB and currently yielding about 6%, the most similar asset class is corporate high yield.

Steinbichler says the typical catastrophe bond portfolio has an expected loss of between 1.5% and 2.5%. A catastrophe bond with an expected loss of 2% means that a payout is likely to be triggered by an event once in 50 years or twice in 100 years.

Since 1997, when the first catastrophe bond was issued, about ten catastrophe bonds have defaulted and the realised expected loss has been 0.7.

Over the past decade, there have been other corporate bond defaults on a grand scale: Italian dairy and food corporation Parmalat defaulted on $7.2 billion of corporate debt in 2004, for example.

Steinblichler says yields are falling now because last year was a quiet one and more investors are seeking to buy them.

With $20 billion of catastrophe bonds issued – compared to $250 billion in European corporate high yield bonds alone – the market is small.

Fritsch adds that the market has become more diversified as catastrophe bonds covering risks in Mexico and Turkey have been issued.

“This is good for investors because it provides them with diversification in the portfolio,” he says, adding that he would buy into these catastrophe bonds if the spread remunerates for the risk. “We are looking at it.”

Fritsch declines to say whether he has bought into these new issuances, only revealing that he buys where the spread remunerates enough for taking the risk.

Despite the limited opportunities, more investors are coming into the catastrophe bond market.

There are a few direct purchases from institutional investors and Steinbichler says most of his peers are asset managers with institutional money to invest. Over the past year and a half, hedge funds, which were once the dominant investors, have also made a comeback.

Steinblichler adds that the catastrophe bond market is likely tor receive further impetus from the European Union’s Sovlency II Directive, which is due to be introduced in 2016.

It requires insurers, which are the main issuers of catastrophe bonds, to adjust their credit risk to prevent balance sheet volatility. Unlike traditional reinsurers, catastrophe bonds do not expose them to counter-party risk.

Steinbichler forecasts that the market will grow by 20% each year.

Richard Boyd, who is responsible for business development and underwriting at Allianz Risk Transfer, says catastrophe bonds diversify counterparty exposure risk and credit risk for purchasers, which could be a significant capital issue under the new directive.

Boyd says catastrophe bonds have become an intrinsic part of the reinsurance purchase of most large insurance companies, including Allianz, and some reinsurance companies.

“Allianz is a regular participant,” he says. “We expect the market to grow modestly and continue to innovate.”

Akiyoshi Oba, president and chief executive officer, Tokio Marine Asset Management, recently told Funds Global Asia, Funds Europe’s sister publication, that he plans to bring catastrophe bonds to Europe.

Boyd says pension funds are bringing a different risk tolerance profile to the market.

The less risky and therefore lower priced bonds are becoming increasingly sought-after, he adds, because their exposures are diversifying perils.

“Pension fund investors are unlikely to be excited to see a single hurricane or earthquake wipe out a large proportion of their investment so they will be seeking more diversity and lower returns which should drive a different demand profile than previously seen.”

Daniel Ineichen, fund manager on Schroders’ catastrophe bond and insurance-linked securities products, says the allocation to catastrophe bonds in his portfolio has ranged between 25% and 65%.

At the moment, the team at Schroders is on the lower end of this band, with about a third invested in catastrophe bonds.

Ineichen says in the more flexible, broader and less liquid mandates, they have been reducing their allocation to catastrophe bonds over the last year because of relative value consideration. In turn, private transactions and non-catastrophe bond investments have increased.

Owing to relative value considerations, the team has increased private transactions and non-catastrophe bond investments. However, such a reduction does have an impact on the liquidity of the portfolio.

Ineichen says the best value is in less standardised opportunities that require a substantial amount of specialist knowledge, in particular when there are no external vendor models available.

“These opportunities are usually only accessible via private transaction and tend to be more illiquid,” he says.

“While our approach to the portfolio construction has not changed, we see the best opportunities in the more flexible products and believe that the illiquidity premium in the market has increased.”

Nevertheless, Ineichen adds, a pure catastrophe bond portfolio offers attractive returns, especially when compared against more mainstream asset classes.

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