Insurance-Linked Securities (ILS), also known as ‘cat’ bonds, have once again been having some time in the sun, which, given the nature of the investments – providing insurance against natural catastrophes - is infinitely preferable to stormy conditions. While normally flying under the radar, the asset class has attracted the attention of mainstream media outlets such as Bloomberg and the Financial Times, highlighting the high yields and returns on offer.
The benchmark index for ILS, Swiss Re’s Global Cat Bond Total Return, gained 20 per cent in 2023 - its best year on record. This was a notable return to form after prolonged lacklustre returns. Over the ten years previous (2013-22), the average annual return had been a meagre 4 per cent per annum with no year besting 7 per cent. That represented a dramatic cooling off from the 10 per cent per annum delivered over 2006-12 as the market grew in the aftermath of the major US hurricanes Katrina, Rita and Wilma. So, what’s been going on and is this sustainable?
Resilience and revival
The market has gone through a substantial capital cycle. The strong returns of 2006-12, combined with the evident diversification qualities of the asset class, which showed themselves in practice through the Global Financial Crisis, attracted a lot of institutional money into the area. Those flows continued, even as market yields fell precipitously and in the face of increased worries about the impacts of climate change. Lower returns were largely inevitable from that point. Our Long-Term Return Expectations work struggled to make a viable case for a meaningful holding, and we limited our portfolio investments, which had previously been a double-digit allocation to a broad set of perils, to a handful of individually attractive investments.
Over the last few years, we have seen opportunities pick up meaningfully. Many of the ‘tourists’ who had come into the market post-2012 have exited the market, disappointed by not making the returns that had enticed them. At the same time, insurers have found their capital more stretched by increasing losses from insurance claim events, including Hurricane Ian hitting Florida in 2022, several substantial wildfires, tornadoes/severe thunderstorms, and earthquakes in the Middle East. These losses have been an aggregation of many smaller events rather than one or two big catastrophes, but have contributed to four consecutive years in which global insured losses have topped $100bn. This increasing cost from smaller-scale high-frequency events is an expected consequence of climate change. It has sapped (re-) insurer balance sheets and seen premiums rise and terms harden across the industry.
However, investors have benefited from this as ILS yields have risen and have been further boosted by increased cash rates (since ILS are generally structured as floating rate notes). Catastrophe bonds issued over 2023 averaged a premium of 8.6 per cent, the highest in ten years, according to data from global reinsurance consultancy Lane Financial. Coming on top of US cash rates of more than 5 per cent made for a nearly 14 per cent yield. That compares to issue yields in 2021 of barely 6 per cent.
Nature’s roulette
Luck also plays an important part in short-term ILS returns. Over the long term, loss rates should be relatively predictable, but over the short term – certainly any particular hurricane season – an element of randomness is at play and the rough winds cannot be accurately foretold.
Exactly how many major hurricanes will form and where precisely they will land is the outcome of a complex and dynamic system. Hurricane Beryl was a perfect example of this. A typical early-season hurricane on formation, it strengthened unusually rapidly due to warm seas, high humidity and low wind shear in its path; it became the first Category 5 hurricane to form in July in almost twenty years as it moved into the Caribbean. Here, the eye passed just to the south of Jamaica, constrained by a higher pressure ridge to its north.
Many factors were at play in determining the central pressure of the storm – its destructiveness, its exact path – and each of these could easily have been a bit different. Had Beryl passed a few miles further to the north or had a pressure a few millibars lower than it ultimately did, the Jamaican ILS bond held in the portfolio would have suffered a loss. As it was, it narrowly avoided being triggered, allowing 2024 index returns a solid start in the manner of 2023.
The lack of a payout prompted some hand-wringing amongst commentators who could not fathom how Jamaica could suffer such a catastrophe and its insurance not payout. However, insurance contracts are, by necessity, very precise instruments. The risks covered are well defined in advance and the pricing is agreed accordingly, allowing the insured party to be clear about how much exposure it wishes to bear itself and how much it wishes to pass on. Beryl came in at the top end of what Jamaica was willing to self-insure through its reserves and contingencies.
While the aforementioned Jamaican bond was not triggered, almost a hundred different cat bond notes have paid out in the last twenty years. These catastrophes range from earthquakes in Japan and Peru, through 9/11, and floods in Italy to hurricanes Ida and Irma in the US, allowing insured parties – governments, corporations and individuals – to be compensated for their losses and confident in their planning. This latter point is a crucial facet of ILS, where the funds to pay compensation for losses are already secured and locked up, rather than relying on an insurer’s promise.
Linking insurance and sustainability
Considering these payments made and the confident planning knowledge they will allow, we believe that cat bonds are well-aligned with a sustainable economy for their significant socio-economic benefits. ILS mitigate the negative consequences of natural catastrophes by contributing to the rebuilding of societies and improving their long-term resilience.
They are designed to address the lack of availability and affordability of insurance cover for individuals and businesses and to provide a stabilising force for communities. Planning for these risks and recovering from such devastating events by directing capital to policyholders in times of need mitigates several of the adverse social and health impacts of disasters, accelerates reconstruction efforts and expedites a return to normality. By helping to make affordable insurance cover available, the reinsurance industry (including ILS) provides some protection for often poor communities in those regions most vulnerable to losses to catastrophes.
At the same time, the risk-based premium structure that comes from these capital market instruments encourages important mitigation and resilience measures by communities, governments and insurance providers. These may include: improving knowledge of climate risks through better risk modelling, upholding and raising building standards in imperilled areas, and retrofitting properties.
Of course, concerns over the changing climate heightened the demand for insurance in many of these areas. This higher demand creates the opportunity for good risk-adjusted returns from well-constructed reinsurance contracts, leading to investments that have the potential to genuinely benefit investors and the communities they help protect.
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The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in October 2024 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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