Exploring the Catastrophe Bond Market with Twelve Capital

Posted by bedrock on 31st July 2024

A catastrophe bond (‘cat’) is a debt instrument that is designed to transfer catastrophe risk from an insurer (the sponsor) to capital markets (the investor).

Cat bonds enable insurers and reinsurers to offload excess catastrophe risk to capital markets, which has only become more important in recent years with the frequency of severe natural events seemingly on the rise. From an investor’s perspective, they can offer a return stream that is both attractive and uncorrelated from traditional financial markets, making them an interesting investment to include in any multi-asset portfolio.

To explore the opportunity set in this asset class, and discuss some of the dynamics that have pushed cat bond yields to near record highs, Ben Hancock from Bedrock’s Research team hosted a Q&A session with Etienne Schwarz, Head of Investment Management and Insurance-Linked Securities at Twelve Capital.

Twelve Capital is an independent investment manager specialising in insurance investments and is a leading provider of capital to the insurance and reinsurance industry.

Introducing Twelve Capital

Q: [Ben] Can you introduce yourself and provide some background on Twelve Capital?

A: [Etienne] Of course. I am Etienne Schwarz and have been with Twelve Capital for a little over 11 years. I started off mostly on the data analytics side, building tools to help with portfolio management, but was also involved in investment analysis on our equity and debt strategies. Then in 2016, I took over management of our multi-strategy fund, which combines catastrophe bonds with the equity and subordinated debt of (re-)insurance companies. I started co-managing our dedicated cat bond fund in 2018 and then became lead portfolio manager at the end of last year.

As to Twelve Capital, we are specialists in the insurance industry, with our investment activities spanning the full insurance capital structure. We have around 50 employees who combine deep insurance/reinsurance expertise with more traditional capital markets experience. Our geographical presence reflects this; our headquarters are in Zurich (where there is a substantial insurance and investment industry) but we also have outposts in London and Munich, with the former particularly important given the insurance talent pool that Lloyds of London attracts. Today, we manage around $5bn across the firm, of which around $3.5bn is invested in cat bonds.

The Origins of the Cat Bond Market

Q: [Ben] Could you provide some history on the cat bond market itself?

A: [Etienne] To understand the history of cat bonds, we have to go back to 1992 with Hurricane Andrew, which made landfall in Florida, causing massive damage and billions of dollars in insured losses. It was actually the largest insurance event that the US had experienced at that time. A number of insurance companies struggled, or were simply unable, to pay out the claims they owed, highlighting that they were not sufficiently capitalised to cover an event as severe as this. In response, the cat bond market was created to provide a mechanism for insurers to offload catastrophe risk to capital markets to ensure that they were sufficiently capitalised to withstand similarly severe natural events.

“The cat bond market was created to provide a mechanism for insurers to offload catastrophe risk to capital markets to ensure that they were sufficiently capitalised to withstand… severe natural events.”

Today, and based on data from Artemis, the cat bond market is around $50bn in size, representing around 1/12^th of total capital available to the insurance and reinsurance industry. The majority of cat bond risk is tied to Florida hurricanes and California earthquakes due to the concentration of insured assets in these areas and the potential severity of these events. However, other risks (or perils) are also covered, including wildfires, convective storms, and flooding, primarily in the US, but also across Europe and Japan.

Cat Bonds: Protected from Credit and Interest Rate Risk

Q: [Ben] What are the key structural features of a catastrophe bond?

A: [Etienne] A catastrophe bond is sponsored by an insurance company and is effectively an insurance agreement for the investor to cover the insurance company’s losses above a certain loss threshold that are related to a predefined natural catastrophe (e.g., a hurricane). If the predefined event occurs during the life of the bond, then the investor’s capital is at risk. If no such event occurs, then investors will receive a premium (i.e., a coupon) and their capital back. Importantly, investor capital is held in a special purpose vehicle that is completely remote from the balance sheet of the sponsor,, meaning there is no credit risk tied to the sponsor; the only risk an investor is exposed to is insurance risk. At the same time, the capital in the special purpose vehicle is invested in money-market instruments. As a result of this, an investor in a cat bond will receive a floating rate return, composed of the money market rate plus a premium (or risk spread), that is completely uncorrelated from traditional financial markets. As of July 2024, there is a money-market rate of c.4.5%, and we at Twelve observe a risk spread of 9%, meaning cat bond investors are receiving an all-in yield of just over 13% with no credit or interest rate risk*. It is also worth highlighting that the catastrophe risk covered by cat bonds is typically quite senior in the insurance tower, meaning an event has to be very severe for a cat bond’s capital to be impaired.

“An investor in a cat bond will receive a floating rate return, composed of the money-market rate plus a premium (or risk spread), that is completely uncorrelated from traditional financial markets.”

Functions of the Cat Bond Spread

Q: [Ben] How is the risk spread set?

A: [Etienne] The risk spread is ultimately set via negotiations between the sponsor and capital markets and reflects both (a) a risk assessment of the specific catastrophe being covered and (b) supply and demand dynamics. With respect to the latter point, it is important to consider what drives insurers to want protection from specific risks in the first place. Take the example of a US insurer that has the majority of their exposure in Florida hurricane risk; they will be happier to pay a larger premium to investors to offload risk tied to Florida hurricanes than they would be to offload risk tied to Japan earthquakes, which is actually helping them diversify their own books. As such, the highest premiums tend to be on offer where there is the largest concentration of catastrophe risk; US hurricanes and earthquakes. This creates an interesting dynamic from an investor’s perspective, where you have to sacrifice upside in order to diversify your underlying catastrophe risks. Different cat bond managers take different approaches to this, but we prefer to simply accept the concentrated catastrophe risk (which is already completely uncorrelated with traditional financial risk), harvest the higher premiums, and then approach diversification from a top-down perspective by sizing cat bond positions accordingly within a broader portfolio.

The Importance of Conducting Your Own Risk Modelling

Q: [Ben] How are catastrophe risks modelled?

A: [Etienne] There are two main catastrophe risk models used in the market: RMS and AIR. The sponsor of a cat bond will choose one of these models to estimate the expected losses related to the cat bond’s coverage (i.e., the average losses that the cat bond will be liable for across a full range of scenarios) and this risk analysis will be incorporated in the bonds offering documentation to inform investors. You can think of these models as playing a similar role to the credit ratings agencies in traditional bond markets. However, there is a clear conflict here, in that the sponsor will most likely choose the model that provides the lowest risk assessment. As such, it is crucial for any investor to conduct their own independent assessment of catastrophe risk, which is why having our scale and expertise in the catastrophe insurance market is so important. We have a team dedicated to quantitative risk modelling who adjust the assumptions used in these models (e.g., storm frequencies, air temperature, etc.) to ensure they adequately represent current climate conditions. In most cases, we find that our risk assessment is harsher than the provided one, which plays a key role in informing our decision to either push for a higher premium or avoid the bond entirely.

“It is crucial for any investor to conduct their own independent assessment of catastrophe risk, which is why having our scale and expertise in the catastrophe insurance market is so important.”

The Impact of Climate Change

Q: [Ben] How is climate change impacting this risk modelling and the insurance industry more broadly?

A: [Etienne] Significantly! We have seen a clear increase in the frequency and severity of catastrophic events over the last few years, notably with respect to wildfires and tornadoes in the US, as well as European wind and flood. A sudden increase in event frequency, particularly where the change seems to be accelerating, is challenging for the insurance industry to deal with because they are forced to rely on historical datasets when modelling these risks for regulatory reasons. As a result, they have tended to structurally underestimate some of the risks associated with climate change. We incorporate more forward-looking assumptions into our own risk modelling and are starting to see growing discrepancies with industry risk assessments. For investors, it just means that having your own in-house analytics capabilities is more important than ever.

More broadly, an increase in the frequency and severity of catastrophic events has increased losses for the insurance and reinsurance industries, eating into the amount of insurance capital available and driving the premiums paid by underlying customers up. If climate change continues to accelerate losses, we could well see insurance for certain risks in certain areas become unaffordable for the majority of people; we are already seeing the beginnings of this for California wildfires and Florida wind, but it will likely get worse.

“An increase in the frequency and severity of catastrophic events has increased losses for the insurance and reinsurance industries, eating into the amount of insurance capital available and driving the premiums paid by underlying customers up.”

Cat Bond Resilience in the Face of Severe Catastrophes

Q: [Ben] Speaking of severe events, Hurricane Ian made landfall in the US in late 2022 and ended up being one of the largest insurance events in history, yet the cat bond market held up relatively well and then went on to have a sound 2023. Could you go into some of the dynamics here?

A: [Etienne] Hurricane Ian was definitely a significant event and, according to Swiss Re, caused around $50bn of insured losses. However, this was just below the threshold at which cat bonds started to become meaningfully impaired (they cover a very senior layer of risk) so the losses realised by investors were minimal. Had insured losses been upwards of $70bn, then cat bond losses might have been in the range of 4-5%. Nonetheless, $50bn of capital – equivalent to nearly 10% of total global reinsurance capital – was still effectively destroyed overnight. This created a massive funding gap that insurers and reinsurers looked to fill via, amongst other things, issuing new cat bonds at wider spreads. Due to this, we saw spreads widen to 11-12% in the aftermath of Hurricane Ian and then gradually come down through 2023 to around 7.5%. High starting yields combined with gradual spread tightening resulted in a solid 2023 for cat bonds. Spreads have widened out moderately YTD as a result of further strong issuance. And just to highlight how intense cat bond issuance has been, we have seen the cat bond market expand from $40bn to $50bn over the last couple of years, and we could well be on track to be $60bn by year-end.

High Spreads Compensate Investors Well for Rising Catastrophe Risk

Q: [Ben] Do you think current spread levels offer adequate compensation for investors?

A: [Etienne] In short, yes. Catastrophe risk has certainly increased due to climate change, which can be seen in the moderate increase in the modelled expected loss on our portfolio. However, the increase in spreads seen over the last couple of years – a result of the previously mentioned dynamics – has more than offset this and cat bonds now offer great value; current spread levels of around 9% are nearly double their historical range of 4-6% and are well above those available in high yield bonds*. Attractive all-in yields of over 13% will inevitably attract new investors, particularly given the uncorrelated nature of the asset class, and we do expect spreads to tighten gradually from here. However, they could probably tighten 2-3% from current levels and still offer a great risk-adjusted return.

“Current spread levels of around 9% are nearly double their historical range of 4-6% and are well above those available in high yield bonds.”

Early Storms and Calm Seas: Hurricane Outlook

Q: [Ben] How is the current hurricane season shaping up?

A: [Etienne] We had a very early hurricane, Hurricane Beryl, which almost triggered a bond we held (though our overall exposure was minor). However, since then, the water has been quiet. Sea surface temperatures are warm, which is favourable for hurricane formation, but we also have a lot of steering winds, which counteract hurricane formation… It is tough to tell. We will have to wait until the end of September, when the worst is usually over, to make any judgements!

Conclusion

From the discussion with Etienne, there are 3 key takeaways for those considering actively investing in the Cat Bond space:

• The frequency of severe natural catastrophes has increased in recent years, partly as a result of climate change, and modelling catastrophe risk is becoming more challenging. Despite this, cat bonds have proved resilient, avoiding substantial impairments due to their seniority in the insurance tower.
• Nonetheless, cat bond spreads have widened materially as multiple years of heavy insured losses have eroded the global pool of insurance capital and cat bond issuance has picked up. Cat bonds are now offering investors low-teen yields with no credit risk, minimal interest rate risk, and a negligible correlation to traditional financial markets; this makes them an interesting investment for any multi-asset portfolio.
• It is important to invest via an experienced manager who is able to conduct their own independent assessments of the catastrophe risk each individual cat bond is exposed to.

If you have any questions about the themes discussed in this article, please do not hesitate to get in contact with us at info@bedrockgroup.ch

*Past performance is no guide to or guarantee of future performance.

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