Article 6.11 Cat bond investors show their limits

By Alistair Gray

Financial Times July 1, 2014

The World Bank attracted attention last week when the development institution issued its first ever catastrophe bond, the latest instance of yield-hungry investors leaping into this hottest of asset classes.

Another $5.7bn worth have been issued so far this year, bringing the total outstand­ing to $22bn. ‘There’s still lots of money coming in, but people are becoming a little bit more sensitive about the yields,’ says James Vickers, of Willis Re International.

It is not hard to see the appeal of catastrophe bonds, which insurers, reinsurers and other institutions issue to minimise losses arising from earthquakes and hurri­canes. They are among the very few securities that appear to have genuinely little correlation with broader financial markets.

The returns have also been strong. The bonds have produced annualised returns of 8.4% since 2002. This, however, has pushed typical yields down about 30% over the past 18 months or so, to little more than 5%.

Niklaus Hilti, head of insurance linked strategies at Credit Suisse, says a ‘historic’ shift has taken place as the catastrophe bond market, once largely the domain of hedge funds and other specialists, has attracted more mainstream investors - from endowment funds to wealthy individuals. Higher prices are an inevitable conse­quence of a more mature market, he adds. About half of European and US pension funds now have some exposure to the asset class. Although most allocate less than 1% of their total funds under management, even relatively small allocations can have a big impact given the trillions of dollars at their disposal.

Insurance executives question whether such investors properly appreciate the risks they are running in buying the bonds, which incur losses only when especially

costly disasters - those expected to occur less frequently than once in 50 years - strike.

Even Hurricane Sandy, which caused almost $70bn worth of damage when it struck the US east coast in 2012, left the bondholders unscathed. Only about a dozen of the bonds - equating to less than 2% of the sums at risk - have ever incurred any losses.

FT

Source: Gray, A. (2014) Cat bond investors show their limits, Financial Times, 1 July.