Parametric (flood & surge) cat bonds can benefit (mortgage) investors

Investors and funds with exposure to mortgage risks are carrying in some cases significant amounts of flood and storm surge risk exposure that is not covered by insurance and has not been transferred, presenting a potential opportunity for parametric risk transfer structures and perhaps catastrophe bonds or ILS.

A landmark catastrophe bond transaction from earlier this showed the art of the possible, when it comes to helping an asset manager with a significant allocation to mortgage-linked investments hedge the catastrophe risk embedded in that portfolio.

In that transaction, the $225 million Sierra Ltd. (Series 2019-1) catastrophe bond, investment manager Bayview Asset Management used an innovative parametric cat bond trigger to transfer some of the earthquake risks embedded in the portfolio of its flagship Bayview MSR Opportunity Fund.

Bayview is a specialist investor in mortgage credit, servicing rights, asset-backed securities and related equities, and was aware that its portfolio carried significant exposure to earthquake risks given the risk of default and delinquencies should a mjor quake occur.

So the forward-thinking asset manager approached the capital markets and leveraged the parametric trigger, to find a way to effectively secure insurance protection against earthquake related losses to its mortgage investment portfolio, covering what was previously uninsured with the help of the insurance-linked securities (ILS) market.

But mortgage investors and those with significant exposure to mortgage loans and related assets, are exposed to more catastrophe risks than just earthquakes.

An excellent recent study from flood risk analytics specialist KatRisk LLC and actuarial consultancy Milliman Inc. shows that flood losses, storm surge and rising sea levels all pose a significant and largely uninsured risk to mortgage holders and investors in mortgage-linked assets.

Flooding is a peril that could be particularly impacted by projected future changes in frequency, severity, and variety of weather-related catastrophes, the study explains.

Rising sea-levels means the risk of hurricane-related inundation to coastal properties driven by storm surge is rising. At the same time, changes to precipitation patterns are expected to change the risk profile of inland riverine flooding and urban flash floods and likely increase the risk of occurrence.

Flood risk is a well-known under-insured peril in the United States, with a significant protection gap existing that leaves homeowners exposed in many cases, or where insurance is in-force it can often be found to be insufficient in terms of coverage.

This has significant potential ramifications more broadly than just for homeowners though.

The study authors explained, “Beyond direct damages to property and communities, the flood insurance protection gap could have many downstream financial impacts. Because homeowners insurance is integral to protecting the collateral that underpins the U.S. mortgage system, coverage gaps could create adverse financial exposure to bearers of mortgage risk including mortgagees, insurers, reinsurers, federal underwriting agencies, and bondholders.”

Add in investors in mortgage related assets, such as Bayview, who will be carrying an element of exposure to flooding related risks, not least from storm surge, within their investment portfolios.

A risk that is likely rising, the authors said, “If the frequency or intensity of flooding were to increase, exposed American households could be at more risk in the future than they are today. Further, some areas historically considered to have low flood risk could become more exposed, extending the problem’s potential economic impact on the U.S. residential housing stock.”

The study looks at the current flood risk exposure, as well as surge, plus layers on assumptions related to sea-level rise and discusses how that could affect homeowners ability to meet mortgage obligations and the downstream impacts for other holders of mortgage related risks, including insurance and reinsurance carriers, but also investors.

The report presents its results largely at the Metropolitan Statistical Area (MSA) level and finds that underinsurance is a huge issue.

“69% of MSAs in the United States have 90% or more of their expected flood losses uninsured, with only 6% of MSAs having more than 30% of their expected flood losses insured,” the study suggests.

These losses are becoming more likely and more costly as well, as “Sea level rise will increase total storm surge losses 21% by 2050 in our medium sea level rise scenario, and 66% in our high sea level rise scenario. Local impacts can be much higher than these averages,” the study authors explained.

“Half of MSAs exposed to storm surge currently are expected to have losses from extreme “one-in-500-year” flood events increase by 10% or more in our medium sea level rise scenario. In our high sea level rise scenario, the increase is 17%.”

The under-insurance issue is not expected to go away any time soon, with an expectation broadly held that uninsured flood impacts will steadily rise.

The study looks at flood catastrophe risk modelling alongside a financial model to try and estimate the degree of mortgage impairment that could potentially result from catastrophic flood events.

The authors found that, “Increased credit losses due to extreme flood events increased by 24% and 72% using our medium and high sea level rise scenarios, respectively.”

Credit losses are expected to rise due to flooding and storm surge and while diversification can help in many cases, there could be mortgage investors and pools of risk that contain significant exposure to peak zone regions where a single event could cause a major financial impact.

The study authors explained, “The incremental credit loss impact estimates, while small on the aggregate pool, could deliver a more significant impact to investors in subordinate tranches of CRT mortgage securities. For a subordinate tranche of high loan- to-value loans, we estimated flood events could increase principal writedowns by 15% to 95% relative to a baseline scenario without a flood event. Thus, the relationship between catastrophic and economic concentrations of risk may be important to consider when evaluating and pricing these transactions.”

While federal and state assistance is almost always a key factor in major flood and storm surge scenarios and helps to mitigate and provide a buffer against significant credit losses in the mortgage space, the exposure is still significant and perhaps warrants looking at risk transfer.

While catastrophe bonds may be a stretch to begin, given their cost of issuance, it might be interesting to see whether mortgage asset managers would look to well-constructed parametric trigger insurance solutions to begin with, as a way to mitigate rising flood risk exposure.

But for some major investors, aware of the exposure they carry, the capital markets as source of reinsurance capital may be a viable avenue to look to. Just as we saw with Bayview and its parametric earthquake cat bond earlier this year.

Of course, the real story here is not the specifics of flood and storm surge parametric cat bonds, or mortgage investors specifically, hence those words being bracketed in the headline to this article.

Rather, what this study demonstrates very well, is that there are significant risks embedded in portfolios of (mortgage) investments that can be effectively transferred or hedged, and the ILS market is a viable route to capital for this.

Which of course applies much more broadly, as there are other investment asset classes that carry significant natural catastrophe and climate risk exposure, not least areas such as infrastructure funds and investment portfolios related to natural and physical assets.

Parametric triggers, combined with the capital efficiencies and structural sophistication of ILS and cat bonds, can provide a viable solution for carving out some of the natural hazard risks embedded in investment portfolios, just as they do in insurance and reinsurance portfolios. This goes for any portfolio that carries significant levels of uninsured catastrophe, weather and climate risks.

Investment managers owe it to their limited partners (LP’s) and other investors to make sure these risks are mitigated, transferred and effectively hedged. Options are readily available and this is an area of potential growth for risk transfer, insurance and ILS as well.