Will Catastrophe Bonds Wipe Out Pensions?
The $30 trillion global pension fund industry is starting to muscle in on traditional reinsurers, financing protection against earthquakes and tornadoes as interest rates near record lows spur the search for yield.
A record $10 billion of institutional money flowed into insurance-linked investments in the 18 months through June, and for the first time is directly influencing pricing of some catastrophe risk coverage, according to Guy Carpenter, the reinsurance brokerage of Marsh & McLennan Cos. Catastrophe bonds can yield as much as 15 percent, LGT Capital Partners AG says.
Coverage provided by alternative capital, as pension and hedge-fund money is known in the insurance industry, reached $45 billion at the end of 2012, about 14 percent of the total global property catastrophe limit purchased, Guy Carpenter says. While welcomed by nations seeking to spread disaster burdens, pension investment is pushing down prices, even as reinsurers press for higher rates to compensate for more frequent extreme weather.
“This is the biggest change to the reinsurance sector’s capital structure in the last 20 years,” said David Flandro, global head of business intelligence at Guy Carpenter in New York. “Catastrophe reinsurance is relatively high-risk, high-return. Pension funds are looking for direct access. Most of the capital is here to stay.”
In a catastrophe bond, insurers pay buyers some of the premiums collected for protection against damage from natural disasters. In exchange for above-market yields, investors assume the risk of a disaster during the life of their bonds, with their principal used to cover damage caused if the catastrophe is severe enough. The first catastrophe bonds were issued after Hurricane Andrew in 1992.
‘Coming of Age’
New Zealand’s Superannuation Fund said in May it planned to more than double its holdings in catastrophe bonds and other insurance-linked assets, while firms such as PGGM NV in the Netherlands and Royal Bank of Scotland Group Plc’s employee-retirement fund have stepped up their reinsurance investments. Pension assets have reached $30 trillion globally this year, according to estimates from J.P. Morgan Asset Management.
“This is a coming-of-age moment,” said Michael Millette, global head of structured finance at Goldman Sachs Group Inc., which managed a catastrophe bond offering for the New York Metropolitan Transportation Authority after Superstorm Sandy in 2012. “Some of the largest asset-management complexes in the world are becoming more engaged in the space.”
Catastrophe bonds can become even more attractive in the wake of a disaster as capital is depleted and insurance prices rise, said Eveline Takken, head of insurance-linked securities, or ILS, at PGGM, which oversees about 140 billion euros ($193 billion) in retirement savings for Dutch pension funds.
Bond Returns
PGGM is continuing to set up new investments in catastrophe insurance, eight years after its first forays following Hurricane Katrina, she said by phone from Zeist, Netherlands.
The Swiss Re Cat Bond Total Return Index, which tracks dollar debt sold by insurers and reinsurers, shows catastrophe bonds have returned about 10 percent this year. U.S. 10-year Treasuries currently yield 2.5 percent. Takken and other fund managers interviewed declined to disclose their returns.
Pension funds like reinsurance because of its low correlation to equity and bond markets. They can invest directly in the securities or allocate funds to specialist asset managers, such as Secquaero Advisors Ltd. and Nephila Capital Ltd., firms that sold stakes to Schroders Plc (SDR) and KKR (KKR:US) & Co. respectively this year as interest in the asset class increased.
Falling Prices
More than 80 percent of catastrophe coverage is still provided by the Lloyd’s of London market and traditional reinsurers, of which Munich Re is the world’s largest. Munich Re said on Oct. 21 that rates in Germany need to rise following this year’s weather events, which included a “centennial” flood coming just 10 years after the last one.
Standard & Poor’s said in a presentation in London last month that the new capital threatened the industry’s earnings and is depressing pricing for property-catastrophe coverage.
“Pension fund money is what everyone is talking about,” said Maciej Wasilewicz, a London-based analyst at Morgan Stanley. “The funds involved have all done the due diligence, hired the right people and trained themselves up. They have the infrastructure to invest in this in the future.”
Wasilewicz said the inflows had begun to drive pricing most noticeably in U.S. hurricane and tornado coverage, which makes up more than 50 percent of total ILS issuance.
Canadian regulators last month urged the nation’s insurance companies to issue their first catastrophe bonds in the wake of flooding that inundated downtown Calgary, the nation’s most costly natural disaster.
‘Extremely Watchful’
According to Goldman Sachs, which estimates sales of catastrophe bonds to reach a record $8 billion this year, Canadian insurers had relied exclusively on reinsurance to help bear risks.
Guy Carpenter’s Flandro said the new money dominated discussions at the industry’s annual meeting in Monte Carlo last month, where reinsurers gathered with brokers and their clients to negotiate next year’s policies.
John Nelson, chairman of Lloyd’s, the world’s oldest insurance market, called on regulators in London last month to be “extremely watchful” of alternative capital, saying the new entrants could pose a threat by pricing risk too cheaply.
“Pension funds and other long-term investors are probably here to stay, so long as we can provide them with a decent return over the long term,” said Stephen Catlin, who founded Catlin Group Ltd. (CGL), a Lloyd’s insurer, almost 30 years ago.
Direct Investment
Pension funds’ impact on the reinsurance market has been felt even though most are allocating just 1 percent to 2 percent of their portfolio to the asset class, according to fund managers and analysts. Schroders, Europe’s largest independent money manager, started its first ILS fund this month after buying a 30 percent stake in Secquaero.
“It’s not a mainstream financial asset class,” said Daniel Ineichen, a former Secquaero partner who is lead manager of Schroders’s new ILS fund, which has raised $56 million. “It’s like a hybrid” between reinsurance and a traditional bond, he said.
KKR, the buyout firm run by Henry Kravis and George Roberts, agreed to buy 25 percent of Nephila in January. Greg Hagood, Nephila’s co-founder, said 75 percent of its $9 billion in assets comes from pension funds.
LGT Capital, a Swiss-based manager of about $121.5 billion in assets, bought Clariden Leu Ltd.’s ILS unit and its team of 10 specialists in 2012. Michael Stahel, a partner at LGT, which has about $2.5 billion in insurance-linked investments, said that almost all the capital raised this year was pension money.
Yield GapIt doesn't surprise me that Ontario Teachers and PGGM are invested in catastrophe bonds. They typically are first-movers and then the rest of the pension herd follows suit.
LGT says returns for a given catastrophe bond can vary from 2 percent to 15 percent, while some customized contracts between two parties can yield as much as 40 percent.
The New Zealand Superannuation Fund, which manages about $22.5 billion for the government, said in May that it plans to invest up to $275 million in reinsurance, its second mandate in the asset class since 2010. RBS (RBS)’s pension fund for employees boosted its holdings by more than 34 percent in the past year to 521 million pounds ($842 million), according to the Edinburgh-based bank’s 2013 annual report.
The Ontario Teachers’ Pension Plan, which manages C$129.5 billion ($124 billion), has been investing in catastrophe bonds since 2005, said Philippe Trahan, director of the firm’s ILS group, who declined to disclose its specific allocation.
As long as investors look for higher yield in a record low interest-rate environment, more opportunistic investors, including pension funds, will allocate to ILS, said PGGM’s Takken.
“In the end it’s all about convergence of price, and if it’s not attractive people will move away,” she said.
Catastrophe bonds have been around for a long time. I remember doing research on them back in 2006 when I was working at PSP Investments in the asset mix group. It was still early days back then but the market has mushroomed since as yield-hungry pensions look for the next big thing uncorrelated to stocks, bonds, real estate and private equity.
According to the Wall Street Journal, investors seeking increasingly novel ways to boost returns amid low-yield environment are turning to catastrophe bonds:
Investors are buying bonds that bet against natural disasters such as earthquakes and storms at the fastest pace in six years, a sign that debtholders are seeking increasingly novel ways to boost returns amid the low-yield environment.I understand the appeal of investing in catastrophe bonds but like any new asset class, get very nervous when the pension herd moves into uncharted territory. Some know what they're doing but most are going to get burned investing in perilous paper and their collective action could increase systemic risk in the insurance industry:
Sales of so-called catastrophe bonds—which unload insurance risk onto investors, and can be completely wiped out in the event of a natural disaster—have topped $6 billion this year and are set to be the highest since 2007, according to Artemis, a deal tracker.
That demand isn't showing any signs of slowing either: this week, a unit of French insurer AXA SA raised €350 million ($473.3 million) from selling catastrophe bonds that provide insurance cover against European windstorms, the largest ever such deal sold in euros.
The appeal for investors is threefold. First, catastrophe bonds offer chunky returns when compared with other fixed-income asset classes. Between the start of this year and the end of September, total returns on catastrophe bonds were almost 9.5%, according to a Swiss Re index. By contrast, investment-grade corporate bonds issued in euros had clocked up returns of about 1.3% over the same period, according to Markit.
Second, the bonds typically have floating-rate interest payments, meaning they offer some protection against rising benchmark interest rates. Third, unlike other bonds, their performance is largely independent of wider financial-market sentiment.
"A stock market crash isn't going to cause a U.S. hurricane," said Rishi Naik, head of insurance-linked securities trading at BNP Paribas.
For insurance companies, catastrophe bonds can also be more appealing than the traditional method of buying cover through a reinsurance provider. By selling bonds, insurers can lock in a fixed price over a set number of years, Mr. Naik said. Reinsurance contracts, by contrast, are typically renewed annually, so are vulnerable to price hikes.
Another advantage the bonds offer is that because the cash has already been raised from investors, insurance companies don't have to worry about the risk of a reinsurer failing to make good on its commitments after a catastrophic event, Mr. Naik said.
Calculating the likelihood of such events is the tricky bit. Investors largely rely on computer models to assess the probability of different catastrophes and therefore the chance a bond could default.
This week's deal from AXA, for example, provides the insurer protection against claims on windstorms that have a probability of occurring once every 100 years.
Bondholders can also use slightly more prosaic methods for predicting if a catastrophic event might occur, such as checking weather reports.
"We look at seasonal forecasts, forecasts for five days and short-term forecasts, so depending on how the forecast is we would use this information advantage and our experience to trade on it," said Niklaus Hilti, head of insurance-linked strategies for Credit Suisse's asset management business. "But obviously we can't do that with an earthquake."
Such default events are by their nature random, but they are also extremely rare. Since the catastrophe-bond market was founded in the late 1990s, only a handful of bonds have defaulted because of a natural disaster, according to Artemis. Those included bonds covering payouts on Hurricane Katrina and the 2011 Tohoku earthquake in Japan, which led to the Fukushima Daiichi Nuclear Power Plant meltdown.
That means investing in catastrophe bonds is all about timing, Mr. Hilti says.
"It's not a question of if the events will happen, it's a question of when," he said.
Mr. Hilti says his firm would consider all new issues, but the decision to buy will often depend on what type of insurance risk the bonds cover.
"We don't like taking such a huge concentration risk on U.S. hurricanes, which is about 70% of the market," he said.
To be sure, some market participants are concerned some new investors might not fully understand the risks of buying catastrophe bonds.
Swiss Re, a reinsurer, warned last month that this new cash is yet to be tested in the event investors suffer large losses from a natural disaster.
That is unlikely to stop the market from growing. The total amount of catastrophe bonds outstanding globally is currently just shy of $20 billion, Artemis data show. That figure could potentially quadruple over the next decade, reckons Paul Traynor, head of insurance at BNY Mellon.
Investors are likely to scoop the deals up too.
"We have a very strong view that the market is just about to take off," said Daniel Ineichen, a fund manager at Schroders, whose funds manage $300 million of insurance-linked assets.
"We've seen more investors get involved this year that hadn't participated before. On the supply side we've also seen new issuers this year, so both sides are developing and will likely continue to grow," he said.
Over $40 billion in cat bonds have been issued in the past decade, with $19 billion now outstanding (see chart below). This is a small fraction of the $300 billion in catastrophe-related payouts that insurers are theoretically on the hook for. But it is up from $4 billion a decade ago and the market could quadruple again in the next decade, thinks BNY Mellon, a financial group. Most cat bonds cover natural disasters in developed economies, particularly in America, where insurance is prevalent and losses from hurricanes, earthquakes and the like are well understood. But a broader range of risks, like Turkish earthquakes and Caribbean wind damage, are slowly coming to market.
Investor demand is strong. Pension funds and other institutional investors are on the hunt for assets generating decent yields, particularly if the returns are uncorrelated to stockmarkets. As recently as last year cat bonds paid up to 11 percentage points over Treasuries, for risks equivalent (at least according to the ratings agencies) to holding speculative-grade corporate debt. Large institutional investors buying cat bonds directly or via specialist funds now account for perhaps 80% of the market, says Bill Dubinsky of Willis, a broker.Indeed, man-made disasters are just as frightening as natural ones and the influx of money into cat bonds could seed a new crisis which is why UK regulators are speaking out for the first time about risks to the insurance industry.
The rise of cat bonds and other “insurance-linked securities” is starting to affect the price of insurance, particularly on the reinsurance side. The inflow of money from capital markets has helped push reinsurance premiums down by 15% this year, denting profits in the sector. Some weathered insurance executives are warning that naive investors are distorting prices, creating a frothy “shadow insurance” sector with systemic implications.
They are quietly hoping a well-timed calamity or two will lead to losses big enough for newbies to reconsider their approach. So far, however, the hurricane season in the Atlantic has been notable for its calm, delivering no August hurricanes for the first time since 2002, and only two in September. Even when catastrophes do occur, they do not necessarily wipe out cat-bond investors: only three of the roughly 200 bonds issued in the past 15 years have been triggered, says William Donnell at Swiss Re, a reinsurer.
Investors may lose interest if prices get too high. Yields on cat bonds have plunged to just six points over Treasuries in recent months, their lowest in a decade, amid an influx of new money and a dearth of catastrophes. “Pension funds are here to stay, but not at any cost,” says Luca Albertini of Leadenhall, an investor in the sector.
Many insurers and reinsurers say that the new investors are more a complement than a threat. Just as banks can profit either by lending money to a company or by arranging for it to tap capital markets, reinsurers can benefit from cat bonds. Some use capital markets to offset their own risk portfolio, leaving them more capacity to underwrite fresh risks. (There are equivalent products in the life-insurance business, paying out if fatalities spike because of a pandemic, for example.)
Cash pouring into insurance makes it cheaper—good news for those who need cover. The risk for insurers is that cat-bond investors keep swooping in just after a disaster, when firms usually put up prices; that would cut into the fat margins insurers have used to rebuild profitability. Britain’s financial regulator this week warned that the influx of new money into cat bonds could push insurers towards underwriting dicier business to keep profits up. Man-made disasters can be just as frightening as natural ones, after all.
Once again, my biggest fear is that many pensions investing in catastrophe bonds are underestimating the risks and they will feel the pain once a natural disaster strikes. Just like in financial markets, natural disasters are becoming less rare than in the past (global warming is undoubtedly the main reason). Also, pensions pouring money into these cat bonds are creating problems for the insurance industry and drawing close scrutiny from regulators. This too is something worth considering before investing in these bonds.
(Read Matthew Klein's Bloombeg article, Is Your Pension Courting Catastrophe?)
Those of you who want to read more about catastrophe bonds can download an excellent primer from RMS by clicking here. You can also track the latest news on catastrophe bonds, insurance-linked securities, reinsurance and weather risk transfer on the Artemis website.
Below, Huffington Post's Rick Camilleri assembles a few industry experts to discuss why catastrophe bonds are gaining popularity. Good discussion, well worth listening to but some risks outlined above are not mentioned in this exchange.