The history of Cat Bonds
Cat bonds were developed during the 1990s. One of the main reasons for their development were the huge losses for the insurance industry caused by hurricane Andrew in 1992. Many insurance companies who had previously been covering catastrophe risks decided to leave the reinsurance market. Eleven American insurance companies were forced into bankruptcy. There was obviously a need for new forms of capital to cover catastrophe insurance. The solution was to turn to the financial markets that are much larger than the insurance markets. The last 20 years with cat bonds can be roughly divided into four phases:
- 1990s – new development and an emerging market
- 2000s – cat bonds mature
- 2008-2009 – restructuring after the Lehman crash
- 2010 onwards – rapidly developing range of products and increased demand
In 1992 hurricane Andrew hit Florida and Louisiana. In terms of material damage this was then the worst natural catastrophe to affect the US (in 2005 hurricane Katrina created even more damage). Just in Florida the material damage was calculated at 25 billion USD (at 1992 prices). When the claims were regulated eleven insurance companies went bankrupt. Others only just avoided the same fate. The insurance industry had difficulty in handling the enormous claims. The biggest losers from the failure of the insurance companies were the policyholders who lost their coverage and who from then on had increased costs for similar cover. Insurance companies became restrictive about covering risks in Florida. Even if insurance companies reinsured themselves, with other insurers and with specialist reinsurers, the claims were too large to handle. The pressure on the industry was too great and many reinsurance companies withdrew from the market. After Andrew a process began where the insurance industry started to look for new ways to be able to issue insurance that would cover natural catastrophes. Insurance companies bought reinsurance from the reduced amount of reinsurers who remained in the business. State funds for catastrophe risks were formed but there was still a need to fill the gap left by the reinsurers whose capacity had left the market.
An important part of the solution was to turn to the financial markets, which are much larger than the insurance market. The financial assets in the world amount to 225 000 billion USD, or approximately 200 times the global insurance market.
Insurance companies started to offer investors the opportunity to take part of the insurance risk by issuing bonds linked to specific insurance risks. Cat bonds were born. In practical terms the investors were able to buy bonds in a specially formed company that then placed the funds invested in money market investments at low risk. As the specially formed company was separate from the insurer the investors were protected from credit risks and other insurance risks.
If a catastrophe occurred the claims were covered by the invested reserves and if the catastrophe was large enough the whole reserve could be used. During the life of the bond the investors received interest on their bonds, and assuming that a catastrophe did not occur then they received their investment back when the bonds matured.
From the end of the 1990s to 2005 the market for cat bonds grew by an average of 25% annually. In 2005 the most costly natural catastrophe yet hit the USA in the form of hurricane Katrina, which hit the Southern and Eastern coasts of the USA. The claims amounted to over 81 billion USD at 2005 prices. This was only part of the story though as 2005 was the most active hurricane season since 1944. In total claims were estimated at 160 billion USD at 2005 prices. But the effects on cat bonds were limited as the damage occurred outside the areas that had been insured using cat bonds. But the events of 2005 clearly demonstrated the risks in play. This insight led to a rapid increase in the price of current bonds, and between 2005 and 2006 their value increased by nearly 75%
Between 2006 and 2007 the value of outstanding bonds increased by another 65%. The value of current bonds increased by a factor of 3 between 2005 and 2007. Increased volumes, which also included the expansion to more regions and other types of catastrophe, meant that the market could now offer more diversified risks making it more attractive to investors. This created better conditions for a well functioning second-hand market that led to better liquidity, which together made trade in cat bonds easier.
In 2008 the investment bank Lehman Brothers crashed. The crash shook the global financial system. This had an effect on the cat bonds market as Lehman Brothers were a counterpart for the security of four cat bonds which all became worthless from 2008-2011. These events affected the second-hand market as confidence in the bonds sank and prices fell by 5-10%. Even if the market recovered relatively quickly this led to a re-evaluation of how security for cat bonds was secured. The aim was to provide investments in pure insurance risk. This requires that other risks are very low and close to non-existent. As a result of the Lehman crash the way security for cat bonds was arranged was re-designed. Today basically all security for cat bonds is placed in government bonds with high credit ratings, as these provide a hedge against inflation risks and minimise credit risks.
The two years following the Lehman crash showed less activity as a result, with fewer bonds issued and lower values on the second-hand market. The financial crisis also led to lower demand for insurance solutions via the financial markets. At the same time other possibilities were available for investors with cash to invest. But in 2011 the market picked up again. One reason was the large earthquake in Japan that led to huge costs for decontamination and reconstruction. The same year hurricane Irene hit the US East coast. These events led to an increased interest in issuing cat bonds. Between 2011 and 2012 the market grew by more than 20%. Despite the extent of the damage in Japan in 2011 only one cat bond was triggered, but this had to pay out the whole reserve. Other cat bonds were not affected as they covered the risk of earthquake in Tokyo, which was affected much less by this event. This reflects one of the basic mechanisms of cat bonds, namely that they apply to a specific risk (or combination of risks) within one or more defined geographical area. This can naturally be seen as both a strength and a weakness, but this is necessary in order to isolate specific risks and make them attractive to investors. As the market has matured the interest among institutional investors has increased. In 2013 the first major transactions in the UK occurred when pension funds bought large shares in mutual funds with cat bonds.