Pensions expected to flood cat bonds

The unprecedented run of earthquakes, cyclones and floods which has caused billions of dollars of damage to Japan, Australia and New Zealand in recent months has put catastrophe bond funds in the spotlight. Katie Holliday reports

Since the early 1990s, catastrophe bonds have been used by insurance companies to protect themselves against crippling payouts and as a way for investors to achieve attractive returns, but their appeal as a mainstream investment vehicle to the institutional market is a more recent phenomenon, with demand from pension funds expected to increase.

Although their value fell throughout March in direct response to the devastating earthquake and tsunami that hit Japan on 11 March, industry experts remain bullish on their potential to provide attractive returns to a growing number of pension fund investors.

Cat bonds, as they are known, are sold by insurers and re-insurers as a form of protection against the damage incurred by catastrophic natural disasters, with the most common forms protecting against US hurricanes, US earthquakes, European wind storms and Japanese earthquakes and tycoons.

Because their return is largely uncorrelated with the return on other investments in fixed income or equities, investors can use the product to diversify their portfolio risk. They also generally pay higher interest rates in comparison to rated corporate instruments, as long as they are not ‘triggered’ by a catastrophic event. Today, the market worth is estimated at $12.5bn.

Classification
The asset class can be categorised into four basic trigger types, some of which are more correlated to the actual losses of the insurer sponsoring the cat bond than others.

Indemnity structures are triggered by the insurer’s actual losses. If the layer specified in the cat bond is $100m excess of $500m and the total claims add up to more than $500m, the bond is triggered.

Non-indemnity structures will only pay out if the catastrophic event meets a specific level of damage, determined by an outside party, such as the US Public and Commercial Services union, which issues a public figure estimating the losses incurred by an event.

Parametric cat bond triggers are indexed to the magnitude of the natural hazard, such as a specific wind speed for a hurricane bond, or the ground acceleration for an earthquake bond. Parametric Index cat bonds are available to firms that are uncomfortable with the lack of correlation to the actual loss that parametric cat bonds offer. Models give an approximation of loss as a function of the speed at differing locations, then used as a payout function for the bond.

According to data compiled by Aon Benfield, an insurance intermediary owned by Aon, roughly 40% of demand for these products has come from pension funds, 40% from hedge funds and the remaining 20% coming from reinsurance firms.