Stockholm (HedgeNordic) – In 2023, the catastrophe bond market achieved a record return of 20.1 percent, as indicated by the Swiss Re Global Cat Bonds Index. This return reflects higher spreads compensating for insurance risk, higher short-term rates automatically passing through to cat bond coupons, a rebound of some cat bonds post-Hurricane Ian in late 2022 that proved less impacted than initially feared, and equally important, the absence of major catastrophes in 2023. These factors shaped the cat bond market’s performance in 2023, establishing a hard-to-beat benchmark for future years.

However, 2024 holds the promise of another year of double-digit returns, underscoring the imperative for investors to comprehend the intricacies of the cat bond market. At its core, a catastrophe bond is a high-yield debt instrument designed to help insurance and reinsurance companies manage risk concentration and capital cost related to natural disasters. “The payout profile of cat bonds is linked to the occurrence of insured events, mostly natural disasters such as windstorms, hurricanes, earthquakes, wildfires, and flooding,” explains Ralph Gasser, an investment specialist at GAM Investments, a major player in the cat bond market.

Understanding the Mechanics

Sponsors, typically insurance and reinsurance companies, issue cat bonds to offload peril risk associated with insured catastrophes. Gasser illustrates this with the example of a Florida hurricane, stating, “Florida is relatively densely populated compared to other states in the U.S., and has a very high concentration of high-value property. So if a hurricane hits, it can cause quite a lot of damage with high insured losses in a small area.” Such ‘peak perils’ are economically burdensome for insurers to retain on their balance sheets, leading to the issuance of cat bonds for “risk and capital management purposes,” as Gasser describes.

“The payout profile of cat bonds is linked to the occurrence of insured events, mostly natural disasters such as windstorms, hurricanes, earthquakes, wildfires, and flooding.”

When sponsors seek to transfer insurance risk to other investors, cat bonds are issued through a distinct legal structure known as special purpose insurance (SPI). Gasser elaborates on the process, “The SPI enters into a reinsurance contract with the sponsor to transfer the risks and issues the bonds to investors to raise capital to back them, with the proceeds from the bond issue invested in high quality short-dated notes, typically U.S. treasury bills.”

Despite the typical average maturity of three years for cat bonds, “the interest rate duration risk consequently is close to zero and has no traditional credit risk as the SPI is legally delinked from the sponsor,” according to Gasser. One return stream for cat bond investors stems from the yield earned on these low-risk securities.

The second return stream emanates from the insurance premium, the spread that compensates investors for insurance risk, presently amounting to about 900 basis points for a broad-based cat bond portfolio, according to Gasser. Investors reap the collateral and spread returns from cat bonds for as long as the covered natural disaster doesn’t occur during their bond ownership period, with the collateral returned at maturity.

“If an insured event under the reinsurance contract happens, then the sponsor can partially or fully draw on the collateral, depending on the severity of losses.”

“If an insured event under the reinsurance contract happens, then the sponsor can partially or fully draw on the collateral, depending on the severity of losses,” further explains Gasser. If the specified event occurs, it triggers the sponsor’s right to access the collateral. “There are different triggers, in terms of measuring the risk or the loss that has occurred,” notes Gasser. The most common trigger is the so-called “indemnity trigger,” tied to the actual insured loss resulting from a catastrophe. Gasser estimates that over 60 percent of cap bonds are linked to an indemnity trigger. Other triggers can be linked to industry-wide losses or can be parametric, and can be linked to a single or multiple insured events.

Hurricane Ian and the Supply-Demand Mismatch

Hurricane Ian in late 2022 was one of the biggest insured events, comparable to Hurricanes Katrina and Sandy in loss severity. “It led to the shakeout of some leveraged high-risk, high-concentration portfolio players that took too much concentrated risk in Florida,” according to Gasser. “But overall, for the industry, even in such a severe loss scenario like we had in 2022, overall actual capital losses for diversified cat bond portfolios were only just about 4 percent,” says Gasser.

“We have more cat bond issuance, and at the same time we have fewer dedicated strategic cat bond investors still around.”

The historical context of Hurricane Ian, now incorporated into risk calculations and models, serves as a catalyst for increased issuance from insurance companies. Gasser explains, “We have more cat bond issuance, and at the same time we have fewer dedicated strategic cat bond investors still around.” This dynamic has led to a supply-demand mismatch in the cat bond market, resulting in a rise in premiums for investors. 

Looking ahead to 2024, Gasser predicts, “When we look at 2024, we think that about $20 billion of new issuance will come to the market and at the same time we will have maturities and coupon payments of about $15 billion.” This creates a $5 billion gap that needs to be filled by opportunistic buyers. The supply-demand mismatch in 2023, with a $2 billion shortfall not picked up by dedicated or strategic investors in cat bonds, led to elevated spreads. “The good thing about this supply-demand mismatch is that the insurance premium, i.e., spreads, remain very elevated,” emphasizes Gasser. This presents an advantageous scenario for long-term strategic investors, who continue to benefit from very high spreads without a significant change in the risk.

“The good thing about this supply-demand mismatch is that the insurance premium, i.e., spreads, remain very elevated.”

In addition to the 900 basis point spread from premiums, the other good news is that the return on the collateral has risen significantly over the last two years due to changes in monetary policy. “Obviously there’s a high likelihood that we will see cuts starting in 2024, probably more leaning towards the second half of the year. But still, even in that case, with inflation coming down even further, investors get a very attractive collateral to carry these days also in real terms,” says Gasser.

“…if nothing major happens, this asset class is steady as a rock. It just plucks along, clipping coupons on credit spreads and clipping collateral return.”

In conclusion, the primary risk – and source of returns – in the cat bond market remains a major natural disaster, exemplified by the impact of Hurricane Ian. Gasser cautions, “When you look at mark-to-market, price corrections were much steeper when Hurricane Ian hit. People were expecting much bigger losses than were in fact realized afterward.” Also, major events will be reflected in insurance premiums and the spreads of newly issued cat bonds quickly, and because cat bonds have a comparatively short maturity profile, you can reap these reasonably swiftly. This also explains why cat bonds typically have shorter recovery periods after major market events than traditional bonds.

Gasser explains, “Insurance premiums go up after a major event. It’s just as easy as that.” This surge in premiums following a major event enables investors to catch up quickly. “If you made losses after a major event, you can catch up very soon,” he elaborates. “So you have to be prepared for that because if nothing major happens, this asset class is steady as a rock. It just plucks along, clipping coupons on credit spreads and clipping collateral return.”