Cat bonds: Make money on absent catastrophes
The Swedish newsletter Hållbart Kapital (Sustainable Capital) has published a piece on Entropics and cat bonds from a sustainability perspective. In the interview, I discuss the benefits to society from cat bonds, how we approach ESG issues and why the African Union fancies cat bonds. Read below for a full translation of the article.
The full article by Emma Sjöström is available (in Swedish) at the web site of Hållbart Kapital.
By Emma Sjöström (translation by Entropics)
In the autumn of 2015, hurricane Patricia sweeps over Mexico with a wind speed of more than 300 km/h. This is the strongest hurricane ever to be measured in the Western Hemisphere. Many roads, houses and a lot of agricultural land are destroyed in its path and the economic costs are enormous. After the storm has passed, the Mexican state needs to gather a large amount of capital for reconstruction.
In a beautiful old building on Karlavägen in Stockholm, earthquakes, hurricanes and storms feel very distant. But they are at the core of the business run from the office desks in this building. Entropics is presently the only Swedish manager of catastrophe bonds, or cat bonds. The fundamental idea is to transfer insurance risks to the capital market and thus to provide insurance protection against large natural catastrophes.
If a catastrophe occurs and the bond triggers, the investor will lose his or her investment. Historically, few cat bonds have triggered due to natural events: Four out of a total of approx. 200, in the course of 15 years. The latest was MultiCat Class C, providing the government of Mexico with funds for reconstruction after hurricane Patricia.
– We put funds in account as collateral for this insurance obligation, and in return we receive interest and premiums. If a catastrophe occurs, funds are taken from this account. This is partly the point of cat bonds, being fully collateralised, meaning that the funds are in an account, explains Henrik Sjöholm, Head of Communications and Responsible Investments at Entropics.
Entropics has today 38 positions globally, covering, among others, damages resulting from hurricanes and earthquakes in the US, Europe, Japan and Australia.
What would you say to those who believe it is cynical to invest in catastrophes?
– I tend to see it as a fantastic question, as it is exactly the opposite in my world. Without cat bonds, many people would be left without insurance. Possibly that is cynicism, saying that they should be left uninsured.
Only one in ten cat bonds with exposure to Japanese earthquake triggered as a result of the earthquakes in 2011. This is good for investors, but perhaps those in need of insurance would be better off if more bonds triggered. Whose side should you be on?
– It is a fairly good example of how cat bonds are supposed to work. One bond triggered and at least two others came close to triggering through reinsurance obligations, meaning that they would have triggered if the insurance company had had more indemnities. This demonstrates the importance of how the insurance contract is set up. Most Japanese cat bonds were, if I recall it correctly, constructed with so called parametric triggers, which is quite common. That means that you define the area covered against an earthquake. Tokyo is where the insurance protection was concentrated but this time the earthquake occurred a bit further from Tokyo so few bonds were triggered.
– It is really not any stranger than that if you have a summer cottage and a house and decide to only insure the house, hoping that nothing happens to the summer cottage. That is not really unfair; you have to draw a line somewhere. Thus, the areas covered by a cat bond are clearly defined.
Those buying the bonds must assume that a catastrophe occurring is rather unlikely?
– These things are modelled. In the prospectus we receive, we can see historical data as well as models indicating the probability of triggering on an annual basis or until maturity. There are cat bonds throughout a spectrum ranging from 0.1% to 14-15% in expected loss. Then you tell which premium you ask for to assume this risk.
Why are not more catastrophes insured? Earthquakes and floods occur all the time in a global perspective? There is no lack of catastrophes to seek insurance against…
– A lot of work is going on in creating more insurance. Several are in the pipeline. The World Bank has built a platform, the MultiCat program, of which MultiCat Mexico is one instance. The bank also works actively giving advice to countries in need of insurance. African cat bonds are due to be issued. China issued its first cat bonds last year, and a couple of South American countries have considered doing so. Among other countries, the Philippines have had such thoughts.
Is there a cat bond covering Swedish or Scandinavian catastrophes?
– Marginally. There are a number of cat bonds covering damages from European storms. Some of these have minor exposure to Sweden, but the large insurance obligations cover Continental Europe. We have discussed the opportunity to use cat bonds to provide insurance coverage to Swedish property, such as forest damages, a lot. But nobody has really caught on to that yet.
– Because of a lack of knowledge of how cat bonds work. Also, we presently see a rather “soft” insurance market that has low premiums. Also, cat bonds have been fairly complicated to structure in the past. Now, there is a thing called cat bond light and an on-going development of simpler structures that could be used by smaller entities, perhaps making it a more attractive option.
Could companies insure themselves against an accident?
– Yes, there have been such examples, though such a bond is not currently listed. There was a bond that had a constant history of problems, some ten years ago. It was an insurance policy covering responsibility for oil spills that triggered. It may not be considered a cat bond as such, but was at least cat bond-like, and has served as a warning example in several aspects. One such aspect was the badly constructed trigger that caused long legal processes and plenty of other problems. Another is the fundamental question to us as investors – are these risks that we wish to assume?
Could you insure yourself against a terrorist attack?
– Yes, there is an on-going discussion in the cat bond industry about this, and I believe there are also ethical issues to be raised. Many in the cat bond world have a genuine aversion to assuming risks for so called manmade disasters, partly because they are very difficult to model. Yet… if a terror group were to come into possession of weapons of mass destruction, there is a rationale for compensating the victims. However, today there is no such bond, but rather an on-going discussion. I guess I see both ups and downs from an ethical perspective.
– Fifa issued a bond before the World Cup in South Africa, protecting them against a cancelled event. That bond included, among other perils, acts of terror.
So anything that could be seen as “force majeure” can fall within the definition of a cat bond?
–Yes, things with low probability of occurring, but with devastating effects.
Henrik Sjöholm explains that cat bonds can be a more efficient alternative to donor conferences usually held after disasters:
– This year, if all goes according to plan, the first African cat bond will be marketed within the XCF – the Extreme Climate Facility – framework. Backing this is an organisation called ARC, the African Risk Capacity that is in turn set up by the African Union. An interesting aspect is the Swedish connection. The chairman of the ARC insurance company, Arc Ltd, is Lars Thunell, the former CEO of the leading Swedish bank group SEB. ARC has been very explicit about why they wish to issue cat bonds. With well-constructed cat bonds, using parametric triggers, you know beforehand that if the water level in Bangladesh rises two meters, that an amount of X will be paid out. The advantage of parametric triggers is that a decision can come fairly quickly. MultiCat took four months to settle. This is largely what the African Union is seeking. They see that when catastrophes occur in Africa, the world is upset. We read about it in newspapers, political leaders call for the world to unite and we arrange a donor conference. This conference is at least six months ahead, so possibly seven or eight months after an African catastrophe you have the conference. There people pledge money, but almost nobody pays these amounts on time. Subsequently, you are in a position where you still don’t know how much money you will receive. People have pledged 2 billion SEK, but nobody has made the payment, and it could be another year or even more before you receive any money at all. With cat bonds, ensuring quick payments, we talk about a timeframe of, say, three or four months. And, as Lars Thunell stated, this is often the difference between life and death. While we wait for the donor conference, people are dying. This is why the African Union is interested in cat bonds, ensuring quick payments when needed. This is a huge advantage, as it creates an automatic mechanism. If we wish to send aid to Africa, this could be used to buy cat bonds or for paying premiums enabling insurance.
Can you say that cat bonds as an asset class are part of sustainable investments, where the entire idea is sustainable, for example such as green bonds or social impact bonds?
– Precisely. I would put this on the result side. Green bonds can be used to decrease emissions, while cat bonds are more about building resilience. So they work on two sides of climate change, where much effort has been put into prevention, but the world is possibly in a situation where we must build financial resilience to the effects we have already caused.
There must be an interest when insuring against natural catastrophes to provide for them not to occur. I think that you would really engage in climate issues, for example, to create a safer world in all aspects.
– I think institutions would be take more care if they had a stake in the risk side, complementing preventive measures, and that is one way to assume a position. This is even more so if you are a climate sceptic. Last year, we saw plans for a cat bond with a seven-year maturity being withdrawn, as nobody was willing to invest with that kind of timespan. Three years is a considerable time and seven years is a very long time-span. But those that believe that climate change is a hoax should not be afraid to assume risks with seven, ten or twenty year maturities. Put your money where your mouth is!
You work with ESG in your investments; can you tell more about that?
– What we have seen with cat bonds is that our predominant risk is investing in causes, insurance obligations, that our shareholders do not sympathise with. Take a lottery bond, where the issuer insures the capacity to pay a large jackpot. If this has triggered, instead of MultiCat Mexico, my belief is that we would have seen shareholders fleeing the fund. Losing six or three per cent of your capital, only to make an individual unbelievably rich… So, we said that the reputation risk is, by far, our largest risk. That we engage in immoral insurance purposes. So that is our focus.
– We have a number of indicators. Our position is that all portfolio bonds should serve good purposes, and that no more than 10 per cent can be allocated to questionable purposes. Ineligible investments are, for example, offensive weapons, oil extraction or insurance for companies violating human rights. This is a standard list that I happily admit is modelled on the policy of the Church of Sweden, which believe has a very high moral standard. Then, there is a grey area, including companies making money indirectly on ineligible industries, such as distribution of alcohol and tobacco or production of defensive weapons. So, like many others, we have concluded that we can allocate up to ten per cent to these questionable purposes. The goal is, of course, to have as little allocation as possible to these causes.
– On the other side of these indicators, you find the large entities involved in a cat bond structure. The sponsor is the company initiating a cat bond. Here, we work more using traditional ESG indicators. You see that we have 2.27 % with a problematic sponsor, and I can say right away that this is Turkey. Turkey is a problem, and we have downgraded them a lot after the events in the past autumn. However, we still don’t believe that this justifies denying insurance to people in Turkey. They are downgraded due to an ESG risk, for social instability, as there is a risk of not paying their premiums. But having Turkey as sponsor is outweighed by the fact that this money is used to insure poor people in mountain villages.
Henrik Sjöholm explains that the ESG indicators also take into account risks associated with the domicile, that is where the special purpose vehicle holding the collateral is located, and to the currency where the collateral is invested.
– A governance-risk in the domicile is possibly the most serious ESG risk we have, that is the risk of corruption and money leakage. Then we have the currency, where almost all bonds utilise US dollars, and some bonds Yen. There is really no risk in that. But when the day comes to see bonds where the collateral is invested using Chinese Yuan, we are quite likely to look at the ESG risks associated with that.
The interview is over. The sun shines on Karlavägen. The earthquakes and floods still feel distant.