Betting against catastrophe faces its first real test.
Catastrophe-bond (cat bond) issuance plummeted 44% in the most recent 12-month period, from $9.74 billion to $5.42 billion for the year ending June 30, 2019, Aon Securities reported.
Extreme events—including storms, Mexican earthquakes, Japanese typhoons and Californian wildfires—proved costly in 2017 and 2018, with cat-bond deal structures and recovery mechanisms “tested on a scale never before seen,” stated Aon in its annual Insurance-Linked Securities report.
Cat bonds are risk-linked securities in which investors are essentially betting against the occurrence of natural disasters like hurricanes, earthquakes and floods.
Prior to 2017, only seven cat-bond classes of notes were impaired by the natural catastrophes they were designed to cover, totaling just over $900 million, Aon notes. Since then, the market has endured anticipated impairments of 25 notes, leading to anticipated bond losses totaling $1.25 billion. When a cat bond is triggered by a disaster, investors lose their principal.
“Heavy investment losses in 2017 and 2018 are probably the main reason issuances fell in 2019,” Paul Schultz, CEO of Aon Securities, tells Global Finance. “Potential sponsors may have been advised: ‘less capital is coming into the cat-bond sector, repricing is afoot, so you may want to stay with traditional insurance coverage for now.’ But 2019 was also a light year for natural renewals [new issuances from expirations].”
Recent losses have arguably revealed some flaws in cat-bond modeling, says Robert Muir-Wood, chief research officer of Science and Technology at RMS Group, a risk consultancy. They fail to account for the fact that hurricanes often come in clusters, for instance. In 2017, three major hurricanes—Irma, Harvey, and Maria—hit the US in close succession.
Future modeling may be trickier, given climate change. “The [weather] extremes are changing,” says Muir-Wood. “Peak intensity is changing, such as [more] extreme rainfall events, as we saw with Hurricane Harvey in Houston.” The cat-bond sector hasn’t been as vigilant in its stress testing as reinsurers, who historically are more sensitive to long-tail events in their modeling.
“We expect to see renewed [issuance] activity in the fourth quarter of 2019 and in 2020,” says Schultz. “Our view is that this asset class is stronger over time from this retrenchment.”