Catastrophe bonds are expected to face increasing investor demand over the coming months, as during the Covid-19 pandemic these instruments have “showcased” their benefits to global investors once again, according to S&P Global Ratings.
Prime among the features of catastrophe bonds that have been showcased, is once again the relatively uncorrelated nature of cat bonds and broader insurance-linked securities (ILS) to movements of the wider financial markets and equities in particular.
Direct investments into insurance and reinsurance risk-linked returns holds little to no correlation.
Yes, at the far extreme tail of scenarios, correlations can always manifest, which is why ILS, collateralised reinsurance and cat bonds should always be explained to investors as relatively uncorrelated (nothing comes with a guarantee of zero correlation).
But even under the stresses of the Covid-19 coronavirus pandemic, catastrophe bonds have once again performed admirably through the decline of most other asset classes, being down only slight and largely on a mark-to-market basis due to selling pressure, most of which is now being recovered.
At the same time, the issuance market for new catastrophe bonds only paused for around two weeks, then recovered and since then rates have increased in alignment with the higher cost of global investor capital at this time.
This shows a healthy and functioning marketplace, something major institutional investors look for in asset classes, even the private or alternative classes that are gaining in popularity at this time.
S&P Global Ratings said in a new report that, “The COVID-19 pandemic has showcased the value of publicly traded catastrophe bonds (cat bonds) to investors, offering a liquid asset class that was not correlated with the current volatile financial markets.”
Another reason that the pandemic served to showcase the fully securitised catastrophe bond as an attractive investment asset, is the fact that cat bond triggers are generally not exposed to pandemic risks and also do not tend to cover commercial property exposures, so are remote from the business interruption (BI) risks that other areas of reinsurance and also some ILS strategies are facing.
S&P notes that, “Although there is a chance that pandemic risks could spill over into some reinsurance contracts, the transparency of the triggers in catastrophe bonds should protect investors.”
Catastrophe bonds, “Usually protect against specific named perils across different regions and cover predominantly residential risks, with limited exposure to commercial business. Hence, we do not expect investors in cat bonds to suffer significant losses as a result of COVID-19,” S&P further said.
Because of the strict terms and coverage that catastrophe bonds usually provide, investors in cat bond funds stand as some of the least exposed to any of the potential business interruption related litigation risks that could hang over certain ILS strategies and vehicles.
As we explained just last week, cat bond funds and investors continue to push for certainty in the coverage they provide, as evidenced by the updating of the latest catastrophe bond sponsored by insurer USAA to include a full pandemic exclusion in its terms.
Add to the lack of correlation and the generally greater certainty in terms of risks assumed and coverage offered, the fact that catastrophe bonds are also liquid and investments in them or positions in cat bond funds can be sold or cashed in far more easily than many other ILS and reinsurance linked investments.
As the pandemic outbreak began to intensify, investors, “realized the value of their cat bonds to pursue short-term opportunities in equity markets, or converted their cat bond investments into cash to meet liquidity needs for margin calls on foreign exchange hedges,” S&P explained.
The value of this cannot be understated as so many alternative asset classes are illiquid in nature, or extremely hard to find a market for when you want to liquidate some of your holdings.
Catastrophe bonds, meanwhile, have an active secondary market, which although it is over the counter (OTC) is still relatively efficient and offers investors an easier way to buy and sell outstanding securities than in many other investable classes.
S&P does note that the ILS market is likely to continue to expand its remit outside of pure named catastrophe perils, which could in time lead to more of a focus on pandemic risks.
As a result, the chances of correlation emerging at the tail would be likely to increase, should this occur, however the level of pandemic risk and return that is likely to be appealing to catastrophe bond investors would be reasonably remote, on the levels of a Covid-19 outbreak repeat, we believe.
Add to this the fact that pandemic risk would be considered diversifying against catastrophe risks, or other specialty lines insurance and reinsurance perils, and the way cat bond funds are constructed would likely ensure that expansion into pandemic cat bonds would not leave a risk of large drawdowns occurring.
The rating agency believes that investor demand for catastrophe bonds could well increase as the pandemic passes and the world enters a period of releasing lockdowns and getting back more towards some kind of normal.
“Initially, investors may make a trade-off between the lower correlated returns of ILS investments and the potential short-term opportunities in other asset classes,” S&P explains.
But as the need and opportunity changes, investors could flock back to catastrophe bonds it seems, while there could also be some switching of strategy away from the less-liquid private ILS and collateralised reinsurance structures.
“We could see investors’ interest turn from the less public part of the ILS market, such as collateralized reinsurance or sidecars, to the more liquid and transparent cat bond market, while demanding pandemic exclusion at contract renewals,” S&P believes.
With a significant number of cat bonds maturing this year and the pipeline still looking buoyant at this time, S&P believes issuance is likely to remain active through the rest of the year.
However, ILS and cat bond investors are likely to continue demanding higher returns, no matter whether issuance is strong or capital flows in, with the cost-of-capital now definitely higher thanks to the pandemic and the ILS investor market still digesting consecutive years of catastrophe losses.