2016-01-28 - By Oskar Schyberg

Why you should care about the multiple of cat bonds

Cat bond investors will often refer to the “multiple” of a certain cat bonds. The term “multiple” is rarely used in other financial sectors, but is actually an important metric when evaluating a cat bond investment opportunity. It also reflects the fact that cat bonds are closely related to the traditional insurance industry, where a similar terminology is more common. So, why should you care about it?

The multiple of a cat bond on the primary market is defined as coupon (excl risk free rate)/Expected loss (EL), reflecting the quota between the expeced coupons and the expected loss. Thus, the multiple offers a definition of the risk adjusted return potential of a cat bond investment. The same measurement is applicable on bonds in the secondary market, by adjusting for the pricing of the bond: (Z + (100-p)/100 * (1/T-t))/EL, where Z = coupon, p = price relative to the principal, T = duration of the bond, and t = time between the issuance and the purchase.

The multiple is another way to express the commonly used concept “expected loss ratio” in the insurance industry. This is defined as total expected claims losses divided by total earned premium (and, thus, the “multiple” is the inverse of the “expected loss ratio”). A company with a loss ratio of 60% will make a 40% gross margin (and thus can be expressed as a  multiple of 1.67).

By dividing the coupon with the EL, a normalization effect of the expected return is achieved and we have a metric to compare different bonds with the same expected yield (coupon – EL). For example, if two cat bonds – “A” and “B” have the same expected return (r=coupon – EL), they will still be considered very different, depending on the EL itself:

Coupon EL Expected return: coupon-EL Multiple
A 4 % 1 % 3 % 4.00
B 7 % 4 % 3 % 1.75

Most investors will, for obvious reason, choose the less risky investment, as the target return of 3% is more probable. The multiple 4, in this example, thus describes a more attractive ratio between the expected return and the risk involved than the multiple 1.75.

In the past two years, decreasing premiums on risk have been a widely debated topic, not only among cat bond investors, but also among investors in traditional asset classes, such as corporate bonds. Due to a number of factors, not least a worldwide surplus of liquidity as a result of post-crisis central bank policy, risk premiums in all sectors have lately been under pressure.

While this pressure has been seen across the board, it is obvious that multiples on higher yielding cat bonds have been more affected then those on lower yielding bonds, where multiples have remained higher. The following chart illustrates the pricing on the primary market for all currently outstanding (January 2016) cat bonds. As can be seen in the chart, while there is a downwards pricing pressure in the entire range of cat bonds, the relative decrease is greater for bonds with higher EL (and, thus, usually with higher coupon).

annualmultiples

While decreased multiples can be noted also for bonds with a low EL, the relative attractiveness of these compared to bonds with higher coupons today seem even greater than in the previous years.

This trend seems currently reinforced by the introduction of bonds with a relatively high EL and coupons as a response to investor appetite for returns. To insurers this offers opportunities to transfer risks to the capital markets with an attractive pricing. To some investors, this presents an attractive opportunity to invest in bonds with more remote risk.

The Artemis news site recently highlighted this issue in an interview with our CEO Robert Lindblom.

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Oskar Schyberg

Oskar Schyberg

Underwriter

Licentiate of Engineering degree in applied/financial mathematics. At Entropics since December 2013.

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