For catastrophe bond market to expand investors must be convinced risks are understood

Ratings agency Fitch have published an article which looks at the huge catastrophe events in Asia during 2011 and focuses on the challenges faced by the industry when making accurate loss estimates for events such as the Japan and New Zealand earthquakes and floods in Thailand. Fitch says that these events highlight the limitations in risk assessment and also offer a thought about how this impacts the catastrophe bond market and its potential for expansion to new geographic regions and classes of risk.

They note in the article that the upturn in reinsurance pricing of late has been cited as a possible contributor to the upsurge in catastrophe bond issuance which we’ve seen through the fourth quarter of 2011 and through the start of 2012. Fitch says that while this is encouraging to see that ‘additional financial flexibility’ is available to the reinsurance sector through the cat bond market, it remains the domain of a relatively small number of issuers and largely dominated by U.S. hurricane risk.

We can’t argue with those statements although we would highlight a number of new sponsors deals in 2012, which you can see in our Deal Directory, and also the fact that despite the dominance of U.S. hurricane risks in the cat bond market, innovations in structure and terms of deals are offering diversification opportunities to savvy investors.

Fitch note that cat bond issuance for exposures in the Asia Pacific region reduced in 2011. This was an effect of the earthquake and tsunami in Japan and the uncertainty around risks, rates and capacity in the region. There have been a number of Japanese exposed cat bonds since the event but the overall volume certainly dropped in 2011. This year is looking more promising with the issuance of a Japan quake and a Japan typhoon cat bond.

The interesting statement for us is where Fitch says that in order for the industry to fully utilise the capital markets to transfer a broader range of Asia Pacific risks through catastrophe bonds it will need to convince investors that the risks they are looking to transfer are properly understood. This is the same all over the world and certainly a factor holding the development of the cat bond and ILS market back. It’s not exclusive to developing regions of the world or even regions where risk modelling is not so pervasive, rather it applies to any sector where the potential exists for risk transfer through securitization but it hasn’t yet happened.

However, we believe that the continued innovation, support and perseverance of the key players in the cat bond market will ensure that once the data and risk models are available to help the risks be quantified, it won’t be long until we begin to see deals attempted for new exposures in the Asia Pacific region. A new focus on transparency in cat bond and ILS offering documents will also help to reassure investors. The magnitude of the potential losses associated with Asia Pacific catastrophe risks has become clearer since the Thai floods in particular and there is a generally accepted feeling that the reinsurance market alone may not be big enough to cover such huge exposures without help from the capital markets. This alone won’t guarantee an expansion of the cat bond market but if potential sponsors lobby risk modellers, brokers and industry organisations we should see progress begin to be made.

We should also note that there are people in the market who believe that the risks are never truly understood and that risk modelling is only indicative of the risks as we perceive them using technology and the available data at any one point in time. This suggests that investors may never ‘truly’ understand the exposure they are acquiring and don’t currently on risks that are frequently issued in cat bonds today. But with the application of technology, transparent and robust deal and contract language, innovative trigger and instrument design, a portfolio approach to investment and most importantly education it should be possible to get investors comfortable enough to buy into the returns a cat bond or ILS in a new type of risk could offer them.