NZ Super Fund paying out for Harvey

As insurers count the cost of Hurricane Harvey, New Zealanders might be surprised to learn that some of the millions or billions of dollars in payouts will come courtesy of the NZ Super Fund.

The fund’s exposure to American natural disasters is a result of its decision to invest a substantial amount of capital in Insurance-Linked Securities (ILS) in 2010.

In 2010, the fund announced that it would invest US$125 million in catastrophe bonds (or cat bonds, the most common ILS). By 2013, ILS comprised 2 percent of the fund and General Manager of Investments Matt Whineray signalled that it would look to increase its holdings to NZ$400 million, but this has since been scaled back and a spokesperson told me yesterday that cat bonds now constitute just 1 percent of the total portfolio.

A cat bond is an innovative financial product that emerged in the 1990s as insurers sought ways to further diversify their risks. A large catastrophe, like Hurricane Katrina or the Tōhoku earthquake, which affects a densely-populated and highly-insured area can trigger payouts that would severely destabilise the global reinsurance industry, which has a limited ability to diversify losses on that scale.

Insurers found that the best way to diversify these immense risks was not by turning to the reinsurance market as they had done in the past, but by placing the risk on the largest market they could find: Wall Street. 

It’s not a bad idea. With climate change making storms on the scale of Harvey ever more common and destructive, the insurance industry needs to find a way to diversify this ever increasing risk to maintain its viability. 

Gambling on disaster is never going to be good  PR and worse, with climate change wrecking ever greater destruction, the ongoing viability of any kind of catastrophe insurance is highly questionable.

A catastrophe like Hurricane Katrina, which cost US$149 billion, was a huge shock to insurers — even the Christchurch earthquake (thanks to the high rate of insurance in New Zealand) rattled the industry. Katrina-scale losses can shake the insurance industry to its core. The financial markets on the other hand — worth about US$69 trillion globally — would regard such losses as a blip.  

As the name suggests, a cat bond is quite different to traditional reinsurance. When an insurer wants to issue a bond, they will create a Special Purpose Vehicle, or SPV, which will hold the capital paid by the bondholder. This is also a huge improvement on traditional reinsurance — reinsurers often have to liquidate assets in order to pay out an obligation, making them much slower than cat bonds, which are fully collateralised and ready to be paid out as soon as the cost of the disaster is calculated.

But what’s in it for investors? And should pension funds be gambling our money on risks as fickle as hurricanes and earthquakes.  

The first question is easy to answer: yields. The popularity of cat bonds is partly thanks to the pretty dismal fortunes for similar asset classes. Since 2008, the world’s central banks have released hundreds of billions of dollars into the market, buying up corporate and government bonds, driving yields to record low levels. The yields on cat bonds, by contrast, have remained relatively buoyant — often reaching double figures at a time when 10-year US Treasury notes, a good benchmark, were averaging below 1 percent.

Pension funds, hungry for growth, but forbidden from investing in riskier equities, piled in to cat bonds. In 2015, four-fifths of new cat bond issues were bought by pension funds. As 2016 rolled around, demand couldn’t keep up with supply, even as cat bond yields dropped to around 5 percent. When the number of new issues plateaued towards the end of 2016, the spread (the difference between the bid and ask prices – a good indication of a product’s popularity) dripped as low as 10 cents a trade. 

Insurers will hope that a successful story from Harvey will enable funds like NZ Super to increase their overall holdings, whilst maintaining diversity across geography and risk type. 

Funds are still hesitant. Gambling on disaster is never going to be good  PR and worse, with climate change wrecking ever greater destruction, the ongoing viability of any kind of catastrophe insurance is highly questionable. Insurers are luring pension funds with simpler indemnity-only bonds and partitioning risk into multiple tranches, with the lower tranches more likely to be triggered in a catastrophe and the upper tranches far less likely. There’s a cat bond for everyone’s level of risk.

This strategy is working. 2017 is already a record year for CAT bond issues, with US$10.6 billion issued so far, taking the total outstanding value of the risk to US$28.9 billion, also a record. 

Earlier this year I spoke with Tim Richison, the Chief Financial Officer of the California Earthquake Authority (the CEA, California’s answer to EQC), the world’s third largest sponsor of cat bonds. This year, he placed US$925 million of Californian earthquake risk in cat bonds, one of the largest issues in history, taking the total value of the CEA’s outstanding cat bonds to US$2.1 billion. He shared with me his optimistic vision for ILS.

As disasters like Harvey show the bonds to work — to pay out promptly and to diversify risk effectively — more insurers will be tempted to place risk in cat bonds, bringing down their cost and allowing pension funds greater choice when they want to diversify their holdings. The more diversity there is in the market, the more funds can diversify their holdings by purchasing more of each individual risk class. Richardson told me that sponsors like himself are keen to see the market diversify so that they can themselves issue more bonds. 

A spokeswoman for the NZ Super fund told me over email that while the fund hadn’t yet been able to calculate its losses on Hurricane Harvey, they were likely to be modest. The fund’s cat bond holdings were diversified across several types of risk and geographical location – you’d expect nothing less from a fund that had returned an average of 10 percent p.a. since its inception in 2003. Insurers will hope that a successful story from Harvey will enable funds like NZ Super to increase their overall holdings, whilst maintaining diversity across geography and risk type. 

It's essential work. If there’s one certainty in the unpredictable world of global risk its that events like Harvey are going to become far more frequent and more costly.

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