Eurozone breakup could impact catastrophe bonds and insurance-linked securities

by Artemis on July 26, 2012

Just how uncorrelated catastrophe bonds and insurance-linked securities are with the wider financial markets is a point worth considering. We’re currently living in a time of unprecedented financial and economic upheaval due to the Eurozone sovereign debt crisis and U.S. economic issues, with many countries now officially in deepening recessions and the very real spectre of a country exiting the Eurozone a growing possibility. Of course, as any sensible observer realises, no financial instrument can be truly uncorrelated from market impacting events of this size.

In their latest quarterly ILS market report, Aon Benfield discuss the Eurozone crisis, and its impact on the insurance, reinsurance and cat bond / ILS markets. They note that contrary to the widely held thought that cat bonds and ILS are as uncorrelated a financial instrument as you can invest in, in the case of a Eurozone breakup, the catastrophe bond and ILS market will not be immune and there would be direct impacts.

The uncertainty that the Eurozone crisis has caused has had a negative impact on the insurance industry say Aon Benfield. There have been a number of downgrades of large European based re/insurers because they have direct exposures to sovereign debt and the weakening financial markets. Sovereign downgrades, where a country has its credit rating cut, also impacts insurers and reinsurers from the affected country, Spain, and Spanish insurers and reinsurers,is a notable victim of this knock-on downgrade phenomenon.

Counterparty credit risk is a growing issue once again in the insurance and reinsurance market, as there is now some fear among cedents of the ability of re/insurers to pay claims after a major catastrophe. Aon says that this fear of counterparties ability to pay is pushing risk managers and sponsors to be more prudent. Combine this growing credit nervousness of the re/insurance sector with the impending Solvency II capital requirements and Aon Benfield say they are noticing more sponsors considering collateralized solutions such as cat bonds and ILS due to the reduced failure-to-pay risk associated with products that transfer risks to capital markets investors.

If there was a partial or full break-up of the Eurozone area the catastrophe bond market will not be immune. Aon Benfield say that this could lead to the introduction of an early redemption event which would allow a cedent to terminate a transaction if the Euro no longer existed as a currency in its own right.

Aon Benfield’s report cites the international law firm Mayer Brown who say that a Eurozone breakup could also impact cat bond structures that provide their cover on an indemnity or indexed basis and insure losses in an existing Eurozone country. For example, a European cat bond could cover both Euro and non-Euro currency countries and as a result there are currency conversion requirements detailed in the offering document which should the Euro cease to exist could result in deal issues. Aon’s report gives some specific examples. A deal that uses a PERILS-based index tracking property losses in Europe and in other European countries that are outside the Euro currency union would see losses reported in local currency and they would then convert the amount of losses into Euros using the conversion rate at the time of the commencement of the loss event. Conversely some index-based catastrophe bond transactions will typically utilize a fixed conversion factor for these countries established at the outset of the transaction. To try to cope with these currency risks, some recently issued catastrophe bonds have included a provision to allow for the contingency of a departing country within the offering documents. Under these provisions, losses could be reported and determined in the new local currency and then converted into Euros at the rate established at the time of departure. PERILS have also indicated that they are ready should such an eventuality occur and would apply a conversion rate for any new currency of a departing state at the time of the loss event. The market is now considering how a conversion rate, that would be consistent with PERILS methodology, would be applied in other transactions.

Aon Benfield say that these developments do add a degree of currency risk to cat bond and ILS deals for investors. They note that any modelled risk analysis undertaken at this time will not be able to adjust for a currency change impact caused by a Euro breakup and they are not sure whether this impact will be positive or negative.

Aon Benfield close this section of their report by stating that if the Eurozone crisis is not resolved soon there will be impacts to the wider capital markets and as a result the catastrophe bond (and ILS) market will be affected. This is unavoidable under circumstances such as this when such major global events are playing out.

It should be noted that while there is an increased currency risk and a degree of Eurozone breakup risk in the cat bond and ILS market they remain one of the least correlated asset classes. While risk increases by a small degree in cat bonds, other asset classes which are much more correlated to the wider capital markets see their riskiness increase by a much greater degree. The current Eurozone crisis should serve to prove to investors that there is no such thing as a totally uncorrelated investment asset, there are just degrees of correlation, and all bets are off when major, potentially world-changing events occur.

Cat bonds and ILS remain a very good diversifying asset class for investors. At a time when all of the wider financial and capital market is seeing heightened risk, the amount of investor appetite being shown towards the ILS and cat bond space demonstrates that investors clearly understand this.

You can access the full report from Aon Benfield Securities via their press release here.

We’ve written about this sort of thing before:

European sovereign debt, U.S. default and the catastrophe bond market

In the current economic climate would political risk catastrophe bonds be viable?

Subscribe for free and receive weekly Artemis email updates

Sign up for our regular free email newsletter and ensure you never miss any of the news from Artemis.

← Older Article

Newer Article →