Cat bonds stable during corona concerns
Many investors ask themselves how cat bonds are affected by the stock market falls following the spread of the coronavirus. As cat bonds are exposed to natural catastrophe risks and not to equity markets, ordinary cat bonds are not affected and hence make an attractive diversification option lowering the risk of equity and interest portfolios.
- Cat bonds offer “pure” exposure to insurance events. The completely dominant risks are predefined natural catastrophes, e.g. hurricanes, earthquakes, wildfires or floods. The probability of these is, of course, completely independent of the development of financial markets.
- Cat bonds are fully secured and construed to minimize counterparty credit risk. Ordinary corporate bonds offer the bond holder exposure to corporate credit risk. Holders of cat bonds have, instead, government risk (US Treasury or the World Bank).
- The risk premium is insured against interest rate changes. Cat bonds are priced with a risk premium above the three-month interest rate. The most commonly used rate is the US Treasury rate.
Cat bonds are not affected in the same way as insurers by the crisis
The equity market development in the past few weeks also illustrates the difference between insurance equity investments and cat bond investments. Since the turn of the year, the global equity market has returned approx. -30%, the insurance index approx. -40% and the cat bond market approx. 1%.
Since the turn of the year, the index for insurers has dropped more than the equity market as a whole. There are several reasons for this, including:
- Currently, there are large uncertainties about insured losses related to the pandemic. Many different kinds of insurance can be affected, including health, life, business interruption and event cancellation. The leading insurance risk modelling firms have as yet declined to indicate the size of the losses, reflecting the uncertainty.
- Insurers have, on the asset side, large exposures to the interest and equity markets that have now declined in value. In particular the interest markets are important for insurers and the downturn comes at an unfortunate time just when the market had begun to normalize following the financial crisis, and several years of low interest rates that have caused difficulties for property and life insurers alike.
Cat bonds are not affected by this, as cat bond investors have pure exposure to specified natural catastrophe risks, whereas insurance equity investors are also exposed to other insurance risks as well as system and company specific risks.
Cat bond investors can, however, be exposed to pandemic risk. There is today one cat bond on the market covering pandemic risk. Though Entropics does not hold this bond, it is interesting. It was structured by the World Bank and covers pandemics in the 77 poorest countries. The market valuation indicates that the bond will pay out as a result of the coronavirus pandemic. Provided that it does pay out, the released funds will be used by WHO and other actors to limit the impact of the virus in these countries.
Continued strong cat bond market
Cat bond returns are determined by the pricing of risk on the reinsurance market. In the past year, this risk premium has increased strongly, and the market is today described as “hard”, i.e. characterized by relatively high premiums. The most important drivers have been the costly events of 2017 and 2018. Premiums continued to increase at the beginning of 2020.
There are currently no indications of a weakening of the hard market and premiums are expected to remain high. A global recession as a result of the coronavirus is, of course, an uncertainty for all asset classes. It is possible that volatile equity markets will cause an inflow of new capital to the cat bond market and hence increase demand, On the other hand, it is just as likely that the need for collateralized reinsurance increases due to the capitalization needs of re/insurers due to the volatility of financial assets and decreasing interest rates, which would drive an increased supply of cat bonds.
The cat bond market has demonstrated good liquidity during the turbulence of the equity and interest markets in March. The trading volume and the number of transactions have largely doubled in the past four weeks compared to the same period last year. The pricing index has to date in March decreased by approx. 1%, hence there are good opportunities for long-term buyers to purchase bonds temporarily being traded below par.
We now face the fourth large downturn of equity and interest markets in the 21st century. During the latest downturn in 2008, the global equity market returned -40% and the cat bond market slightly more than 2%. From 2002 until March 20, 2020 the global equity market has returned 156%, and the cat bond market 249%.