Cat bonds an attractive asset for EU insurers in a Solvency II world

Investing in catastrophe bonds is viewed as an attractive investment by some primary insurance companies, with the implementation of Solvency II meaning the assets can have certain capital benefits, depending on an insurers profile.

For a primary insurance firm which does not carry too much catastrophe risk on its balance-sheet, an investment in pure catastrophe risk can be seen as an attractive proposition, as under the Solvency II rules for capital requirements can mean that cat bonds do not attract a significant capital charge.

This isn’t true everywhere, of course. There have always been issues for German insurers that wanted to invest in catastrophe bonds and other insurance-linked securities (ILS), with the regulators taking a particularly conservative line here.

Insurance and reinsurance companies used to provide a significant portion of ILS capital, investing in assets which were deemed to help with the overall diversification of the balance-sheet, but in recent years that trend has slowed.

An insurance commission in the United States has been actively investigating how to treat life insurers that invest in catastrophe bonds and catastrophe risks, but so far progress in terms of enabling these huge investors to access the asset class has not clearly been made.

But in Europe we understand that there is a trend emerging whereby insurers from certain countries are looking at catastrophe bonds as an asset that will not be so detrimental to their solvency capital requirements if they are invested in, which alongside the benefits of a stable return and diversification is making catastrophe bonds increasingly attractive.

Under Solvency II, investments made by insurers in catastrophe bonds are supposed to take into account both credit and catastrophe risk, but with credit risk extremely minimal, due to their fully collateralised nature, that is perhaps less relevant in terms of capital charges.

Additionally, holding catastrophe bonds as assets at an insurance firm should be treated as though the underlying catastrophe exposure is being directly held by the investor, which suggests that therefore an insurer could leverage this to enhance its diversification under Solvency II rules as well, as an added bonus.

So for some European insurers there could be benefits to investing in ILS such as catastrophe bonds, over and above other types of alternative asset classes. The charges under solvency capital ratios could be lower and the benefits of diversification can also have some positive effects as well.

It’s important to note that this isn’t applicable to every insurer and different countries regulators have differing opinions on, or even an outright ban on, insurers investing in catastrophe bonds.

Belgian insurer Ageas was cited recently as one such European primary insurer that is actively looking at the catastrophe bond asset class, due to the potential benefits of an attractive return with not too much risk weighting for holding the assets.

If other large insurers find similar attraction to the asset class it could mean another level of interest in the asset class, which given the current flow of primary catastrophe bond issuance is not keeping up with demand from the existing investor base, could put further pressure on pricing as demand rises.

But for some insurers there may be benefits to looking to insurance-linked securities (ILS) for both sides of the balance-sheet, laying off risk efficiently to the capital markets, while investing in ILS or cat bonds that are diversifying versus the rest of its book.

Capital requirements have the potential to drive greater interest in ILS, and if an industry can discover additional benefits, such as enhancing their capital profile, to holding catastrophe risks as an asset class it could bring more capacity to this market.