Swiss Re Insurance-Linked Fund Management

PCS - Emerging Risks, New Opportunities

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


With the world experiencing turbulent times economically this year including the concerns over European sovereign debt and the spectre of the U.S. government debt ceiling being breached effectively putting the U.S. into a default position, we felt it was time to ask one of the rating agencies whether they felt there was likely to be any impact on the catastrophe bond market.
The risks posed by sovereign debt issues are currently the main source of concern for the insurance and pension sectors in Europe according to the recent financial stability report published by the European Insurance and Occupational Pensions Authority. They say that the extent of the impact of sovereign debt will depend on the ability of nations globally to lower the debts towards more sustainable levels.

With an issue the size of sovereign debt there is bound to be a knock on effect for the re/insurance industry and also for the capital markets. We’ve already seen some investors dumping Eurobonds and attempting to move into safer assets. Obviously insurance-linked securities and more accurately catastrophe bonds offer one of the best alternative investments for investors seeking a safe harbour and this is likely at least part of the reason for high demand from investors recently.

With all the above in mind we spoke with Gary Martucci, Director, Financial Institutions Ratings at Standard & Poor’s and asked him whether the two big financial and economic issues of the moment (Euro sovereign debt and the U.S. debt ceiling) were likely to have any effect on the ratings of existing cat bonds, investor perception of the asset class and the market itself.

First we discussed the sovereign crisis in Europe and the investor flight from assets like Eurobonds and asked Gary whether he felt investors would seek to find a safe harbour for their funds in ILS.

Gary responded “It might be an overstatement to say ILS, specifically natural peril cat bonds, would be a safe harbor. While the likelihood of an occurrence of a natural peril is not correlated to the European credit environment, you cannot eliminate the potential for a both a credit event and a covered peril to occur at, or event close to the same time.”

Of course it has become obvious recently that issuance of cat bonds isn’t sufficient to satiate investor demand anyway, so whether investors want a non-correlated alternative investment opportunity or not, at the moment catastrophe bonds can’t really provide that in any volume.

We then moved on to discuss the U.S. debt ceiling and the impact that could have on catastrophe bonds. The U.S. government is approaching their debt limit and are going to be voting on whether to approve raising it again soon.

“Many cat bonds are collateralized with U.S. Treasury money market funds, which may be impacted by the issues surrounding the U.S. debt ceiling. However, Standard & Poor’s position is that ‘we believe the debt ceiling will be raised as it has been more than 70 times since 1962, and that the government won’t default'”, commented Gary.

Ratings agencies have threatened to downgrade U.S. Treasuries should the debt ceiling agreement fail to be reached, which will essentially count as a default in their eyes. We asked Gary whether that could result in a downgrade on any current catastrophe bonds.

He explained “To be clear, it’s U.S. Treasury money market funds that have used as collateral for cat bonds. If the U.S. sovereign rating were to be lowered, then we would expect the rating on the money market fund to be lowered as well. Pursuant to our criteria for rating natural peril cat bonds, if the current rating on the cat bond were higher than the rating on the money market fund, we would expect to lower the rating on the notes to the rating on the fund.”

So it’s unlikely that there would be any impact on catastrophe bond ratings, as the majority of cat bonds are rated around the ‘BB’ region while Treasury money market funds used as collateral assets tend to be as highly rated as possible, often ‘AAA’, to reduce likelihood of any collateral issues. Even if the U.S. experienced a sovereign default, which is by no means a certainty, it is likely that Treasury money market funds wouldn’t be downgraded to a lower rating than a cat bond anyway.

Our thanks to Gary Martucci from Standard & Poor’s for his time and input.

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