Catastrophe bond market still overexposed to U.S. wind

As much as 68% of the outstanding non-life insurance linked securities and catastrophe bond market was exposed to U.S. hurricane risks at the end of 2011 according to the fourth quarter ILS market update from Willis Capital Markets & Advisory. And so continues the trend for the cat bond market to be U.S. wind top-heavy, a trend which worries some investors who are seeking diversification but not others who are seeking maximum returns.

The report from Willis Capital Markets & Advisory, which you can read about and access and full copy of on the Willis website here, contains two ways of visualising the U.S. hurricane dominated nature of the catastrophe bond market. Despite us having covered this topic a number of times in the last year we felt that the first graph was particularly worth sharing.

This first graph shows the dollar amount of on-risk capacity by peril. It’s not just the lack of diversification that becomes clear here, the concentration risk within the market is also apparent as a massive hurricane could wipe out quite a lot of the market it would seem. When you consider that Willis record the size of the outstanding cat bond market at the close of 2011 at $12.7 billion, it’s clear from the graph below that a lot of capital is exposed to any single massive hurricane, particularly if one struck Florida and made its way either up the east coast or along the gulf coast. A storm of this size and impact would wipe out the annual positive returns of pretty much every catastrophe exposed ILS fund we know of.

On-Risk Catastrophe Bond Capacity by Peril ($ In billions)

This second chart from the WCMA report shows the more traditional way of viewing the outstanding catastrophe bond capacity by peril as a percentage of the market. Again it’s clear that the market is overly dominated by U.S. wind risk still.

On-Risk Catastrophe Bond Capacity by Peril % (Dec 31, 2011)

So what can investors do to reduce this over exposure to U.S. hurricane? Well, as we said at the start of this piece it depends on the type of investor as some are more than happy to be exposed to the peak peril of U.S. wind and will consider their portfolio diversified as long as they have a chance to balance east coast with gulf coast with Florida risks. Other investors, and more particularly the funds investing or specialising in ILS and cat bonds, have to take a broader view and look to diversify by ensuring they invest in Asian and European risks. Some investors who enter the market aiming to specialise in catastrophe risk take to investing in life risks (such as mortality and longevity) as a way to diversify simply because their isn’t enough opportunity to do so in cat bonds alone (at times, it can depend on whether you are able to access the latest transactions).

Many investors and participants in the ILS and cat bond market will be hoping that 2012 will bring that percentage (68%) of exposure  down considerably as sponsors step forwards to issue cat bonds with exposure to other perils and geographies. The market conditions seem right for this to happen during 2012. It’s unlikely that the market would become less than 50% exposed to U.S. hurricane for quite a few years though as it makes up such a large piece of the reinsurance market which the ILS sector competes for.And as we said at the start, it’s not a bad thing for everyone, in fact some investors find it (and the returns it can offer) one of the factors that attracts them to the market.