Investors cannot get enough of the catastrophe bond market, writes Charlotte Moore, but the potential for equilibrium, albeit at lower returns, is there.
The global financial crisis highlighted the advantages of investing in catastrophe bonds to the pensions industry. All other risk assets proved to be strongly correlated in the turmoil but these insurance-linked securities, which provide protection from extreme weather and earthquake events, remained immune from the shockwaves. They also generate a decent return, making them very attractive to institutional investors.
“Since January 2002 to February 2013, the Global Swiss Re Cat Bond index has generated a compound annual growth rate of 8.9%, with very little volatility,” says Judith Klugman, head of ILS distribution and sales at Swiss Re.
In addition to the general market’s favourable risk-return profile, the evolution of the cat bond market is also encouraging some ILS specialists to make more customisable products, allowing investors to have more control over particular risks. “They can choose two out of the following three criteria: the type of peril; the coupon level; and the loss trigger,” explains Bertrand Delarue, head of strategic advisory and solutions at BNP Paribas.
For example, the pension fund of a company that is based on the east coast of the US might steer clear of cat bonds because its sponsoring company would suffer a negative impact should there be an extreme event in that part of the world which could then be amplified by the cat bond. Such a pension fund may, however, be interested in a customised note that strips out east coast wind risk while still offering a high coupon.
According to Swiss Re, the ILS market had a banner year in 2012, with the second-largest issuance ever, of $6.3bn (€4.8bn) worth of bonds. The total value of outstanding bonds now sits at $16.1bn.
“The outlook for this year looks very optimistic,” notes François Divet, senior ILS portfolio manager at AXA Investment Managers. “Some brokers forecast bond issuance to reach $7bn in 2013.”
Nonetheless, issuance during the first few weeks of the year has been disappointing and demand is outstripping supply.
“There is an inflow of money into the asset class,” says Delarue “Many more investors, both institutional and private, have realised the benefits of the lack of correlation of this asset class with other financial assets.”
While some large institutional investors have the necessary resources and sophistication to invest directly in cat bonds, most will allocate money to this asset class via a specialist ILS fund, many of which are struggling to keep up with demand.