EIOPA report highlights risk of underpricing catastrophe bonds

The European Insurance and Occupational Pensions Authority (EIOPA) has again mentioned catastrophe bonds and insurance-linked securities (ILS) in its latest Financial Stability report update, highlighting the risk that investors are underpricing cat bonds.

The financial stability report is updated twice yearly. EIOPA mentioned catastrophe bond and ILS when it last published the report in December, saying at the time that it had a concern that not all investors are capable of modelling and fully analysing the risks they assume, adding; “Without adequate supervision, such developments could cause systemic risk.”

The European regulator has not changed its position in the latest version of the report, saying that there is a risk that excess demand for catastrophe bonds, caused by the low yield environment in other asset classes, could risk investors buying into transactions that they do not fully understand.

The EIOPA report notes that investor acceptance of catastrophe bonds continues to grow, helping the sector to record near record levels of issuance in 2013. As new capital continues to pour into the reinsurance market, both into collateralized reinsurance, ILS and cat bonds as well as into new traditional vehicles, the pressure on catastrophe reinsurance rates continues and catastrophe bonds have approached pricing levels the same as, or even better than, traditional reinsurance.

This new pricing environment, as well as increasingly flexible coverage available under cat bonds and the increase in use of indemnity triggers, promises to keep the flow of cat bond and ILS issuance coming. ILS and cat bonds are becoming increasingly attractive to both new and repeat sponsors, notes the EIOPA, which could result in further market growth and greater volumes of deals issued.

New and existing investors have committed new capital to the market in dedicated funds and alternative capital vehicles. The influence of this capital is spreading into new business lines, said the EIOPA, but it remains largely targeted on U.S. hurricane risk which still dominates ILS.

Despite this the ILS market and catastrophe bonds remain a limited and complementary part of the overall reinsurance market, but with the broader economic environment remaining sluggish EIOPA expects the ILS and cat bond space to gain market share. Further positive growth will be driven by investors demand for returns that still outpace many other assets in the continued low-interest rate environment.

EIOPA warns that there is a risk that the excess demand for catastrophe bonds creates a market of risk origination which underprices the risks involved and passes them on to investors who do not have the capabilities to correctly price them and to properly include them in their risk management.

The risk that investors underprice cat bonds will largely be restricted to those that choose to invest directly. The majority of investors in cat bonds and ILS use specialist investment managers and funds to gain exposure to the asset class, where the managers of those funds and vehicles are largely sophisticated and capable of analysing and pricing these risks.

As we’ve said before, with any asset class there will be a risk that some investors participate who do not fully appreciate the risks they are assuming. In ILS we would imagine that this is a very low percentage, given the sophisticated nature of the instruments, probably a much lower percentage than in many more mainstream asset classes.

The scrutiny from regulators such as the EIOPA is set to continue as the asset class grows and is positive as regulatory oversight can help to prevent issues emerging within a growing market. Again we would reiterate what we’ve said before on this. Engage with the regulators, help them to understand the asset class and to speak to investors so they can get a better feel for the levels of sophistication in the market.