The changing world of catastrophe insurance
Is it a matter of 'if' or 'when' New Zealand earthquake bonds end up on Wall Street? Thomas Coughlan talks to insurers.
Last year was record-breaking for the most important financial instrument you’ve never heard of. Against all odds, catastrophe bonds (cat bonds) have maintained their allure, with a record year of issuances ($US11.8 billion or $NZ16.6 billion). That takes the total value of outstanding insurance-linked securities (ILS), including cat bonds, to over $US30 billion.
New Zealanders should take note — the global insurance industry is rapidly changing the way it mitigates the cost of catastrophic events. According to Aon Benfield, the insurance broker, nearly 15 percent of reinsurance capital now comes from pension funds, endowment funds and sovereign wealth funds investing in ILS.
Even our own NZ Super Fund, under the leadership of Adrian Orr, the new Reserve Bank Governor, got in on the action. In 2010, the fund purchased $US125 million of cat bonds, a holding it increased in 2013.
However, none of this wave of new investment will help New Zealand insurers diversify the risk on their books. Although our ever-present earthquake risk and high levels of coverage via the Earthquake Commission (EQC), a Crown entity, would seem to make New Zealand an ideal market for innovations in catastrophe cover, no insurers have sponsored ILS for their risks here.
New solution to old problem
ILS is just the latest solution to the perennial peril of the insurance industry: how to adequately diffuse risk. Today, insurance seems so quotidian that it almost obscures the genius at its heart.
In 1680, spurred by the Great Fire of London, Nicholas Barbon wrote the first modern property insurance policy. The idea was simple: premiums paid by policyholders would finance a pool of capital sufficient to pay out on policies in the unlikely event of a fire.
Ironically, considering it was a city-wide fire that sparked the idea, Barbon’s policies depended on an educated bluff. For his plan to work, he relied on the low probability that he would have to pay out on many of his policies at once.
It was not until the 19th century that the insurance industry was forced to grapple with this problem. In 1842, the well-insured city of Hamburg was razed to the ground by an immense fire. As the dust settled, insurers in the city were inundated with claims and many folded.
The solution to the plight of insurers was simple. If the basic principle of insurance is to diversify liabilities widely to minimise the likelihood of having to pay out on multiple policies at once, insurance companies simply needed to look further afield to hedge against a catastrophic event that triggered a high volume of claims. Reinsurance was born.
By the end of the decade, Hamburg insurers were reinsuring their liabilities through dedicated reinsurance houses in other cities. This model was replicated in other countries and soon a network developed linking local insurers with global reinsurer, based on the shared incentive of diversifying risk as widely as possible.
Yet even reinsurance doesn’t adequately diffuse the enormous and growing risks of insurers. As our populations grow larger and more wealthy, insurers have greater liabilities in both volume and value on their books.
The cost of insurance is meant to nudge consumers away from taking on liabilities they cannot afford — for example, learner drivers in expensive cars or new homes in a floodplain. However, institutions like EQC and its American equivalents have subverted this economy by allowing homeowners to take out policies against disasters that are both frequent and costly, increasing the global vulnerability of insurers and the clients they insure. Climate change is also a threat, increasing the frequency and intensity of catastrophic storms.
A solution to this subversion was born in the early 1990s after a series of costly earthquakes and storms in the United States. Confined to the relatively small world of insurance and reinsurance, these disasters threatened the stability of the entire industry. It became clear that insurers would need to find another layer of diversification. American insurers hit upon the idea of diversifying their risk throughout a far larger capital pool than the world of reinsurance. In fact, they set their sights on the world’s largest capital pool: Wall Street.
The idea makes relative sense. The world of insurance and reinsurance is relatively small. Wall Street, on the other hand, is massive. Global stock markets, today worth close to $US70 trillion, and which frequently suffer hits of 1 percent ($700 million) or more, could easily absorb losses that, left to the world of insurance, would threaten to overwhelm even the most robust insurer. Thus was born the cat bond, an innovative financial product that allowed insurers to access the greatest pool of capital ever to exist.
The process of issuing a cat bond (the most common ILS) is relatively simple. An insurer looking to diversify its liability for a certain event— a hurricane in Florida, for example — would create a special purpose vehicle (SPV) to issue bonds to investors. Investors would place capital in the SPV and in return they would be paid an annual coupon based on a calculation of the relative likelihood of the catastrophe occurring on top of a market interest rate.
If the catastrophe occurred, the SPV would liquidate all or part of the assets to transfer to the insurer; if it did not, the total value of the bond would be transferred to the investor upon maturity, earning them a healthy profit over the time they held the bond.
The markets loved it.
The last decade has seen incredible growth in ILS. According to Jean-Louis Monnier, Swiss Re’s global head of ILS structuring, ILS now makes up close to 20 percent of the total capacity of so-called cat XL (catastrophic excess of loss) reinsurance globally.
This is largely the product of good timing. Loose monetary policy since the global financial crisis has driven down yields for the types of bonds favoured by large, institutional investors. As a new and untested asset class, yields for catastrophe bonds remained relatively high, with coupons sporting antediluvian yields, sometimes up to 20 percent, proving intoxicating for investors making do with yields on government bonds in the low single digits.
By 2015, four-fifths of new cat bond issues were bought by pension funds.
Fund managers were also attracted by ILS belonging to the category of non-correlated assets, meaning that the bonds’ fortunes tend not to be tethered as strongly to the vicissitudes of the market as other financial products. Traders who specialise in cat bonds are more likely to spend their days watching the weather for signs of a hurricane than analysing financial data looking for a crash.
The frenzy has continued. As demand ramps up for catastrophe bonds from yield-starved investors, insurers have found a seemingly endless supply of catastrophe risk to repackage and sell them, especially as demand for the bonds pushed down the cost to insurers of issuing them.
However, real-world events towards the end of the year gave the market something of a reality check.
An orderly widening
“Following recent hurricane, earthquake and wildfire events, we are now seeing an orderly widening of spreads in line with reinsurance,” Swiss Re’s Monnier says.
“The factors behind the recent growth of the market are still in place. Investors continue to see value in ILS relative to other asset classes, and insurers, in turn, see ILS as an efficient complement to traditional reinsurance, particularly for US perils.”
Tim Richison, chief financial officer of the California Earthquake Authority (CEA), the Californian equivalent of EQC, is one of the insurers reaping the benefits of the current appetite for ILS. Richison was an early champion of cat bonds. He was associated with the team that put together one of the first cat offers in the 1990s. Now at the CEA, he is the third-largest sponsor of cat bonds in the world.
Interest for ILS has surged significantly since the financial crisis of 2008, giving Richison immense savings. This is because the cost of sponsoring a cat bond is more or less fixed. Establishing an SPV, consulting lawyers, and modelling the risk you are asking investors to take on is roughly the same whether a sponsor establishes a bond worth $50 million or $800 million.
Obviously the more risk an insurer can offload at once, the less significant those fixed costs become. The current high demand has incentivised insurers to sponsor far larger issues of bonds, allowing them to defray their high fixed costs over the large issuance.
Richison is himself partly responsible for the reason 2017 established a new record for cat bond issuance. In May, the CEA sponsored one of the largest issues of cat bonds in history, placing $US925 million worth of Californian earthquake risk into the capital markets.
One of the reasons for the size of the issue was that Richison and the CEA realised that the high demand for cat bonds meant they could diffuse their high fixed costs over a larger amount of risk.
“When we went out with our transaction, we priced it as if we were only going to do $500 million. The fixed fee was spread out over $500 million [but] there was such high demand that we were able to almost halve that cost by going from $500 million to $925 million, so that made it more cost efficient for us.”
Time for New Zealand?
So far, none of New Zealand’s insurers sponsor catastrophe bonds for New Zealand earthquake risk. Tim Grafton, chief executive of the New Zealand Insurance Council says this is mainly to do with the difficulty of establishing the right parametric triggers — like magnitude or velocity — that determine whether a bond would pay out.
“For instance, if in the case of Christchurch a 7.5 magnitude earthquake had been set at the trigger for the bond payment, there would have never have been any contribution at all to an event that cost in excess of $40 billion. Indeed, the most damage occurred … primarily because of the shallowness of the quake, the upward gravitational acceleration and the quality of the land, rather than the magnitude of the event.”
The problem with parametrics was brutally exposed by the 2011 Tōhuku Earthquake, which, in spite of being one of the most violent and costly disasters on record, did not trigger one of Munich Re’s cat bonds because the triggers stipulated the quake must be centred on Tokyo, leaving the insurer to rely on other capital to meet its policy obligations.
However, demand for cat bonds and investors’ fondness for bonds that are easier to understand has encouraged most sponsors to move away from parametric triggered bonds to indemnity bonds, which simply pay out after an insurer’s losses exceed a certain amount. This does not mean, however, that the bonds are any more likely to be used in New Zealand.
Monnier believes the high fixed costs of establishing cat bonds will mean that New Zealand insurers will continue to mainly rely on traditional reinsurance, as their liabilities are small by global standards and are most efficiently retained within a reinsurer's balance sheet. The cost of issuing cat bonds is still too great for New Zealand insurers to diffuse amongst what would inevitably be a relatively modest issuance.
He calculates that minimum ILS yields for less risky layers would be around 2 per cent for New Zealand earthquake risk. But at these levels, many New Zealand insurers would not contemplate sponsoring cat bonds. This means that New Zealand risks may need to be bundled with other perils in order to meet investors' minimum return hurdles and be attractive to the funds that sustain the market today.
Though the costs for New Zealand insurers would be relatively high, there is a market for our kind of catastrophe. Richison sees, in future, a strong investor appetite to purchase New Zealand risk to diversify portfolios that are heavily weighted towards US earthquake and wind events.
One body in New Zealand that could make a difference is EQC. In December, EQC notified the government that a succession of costly catastrophes, mainly the Christchurch and Kaikōura Earthquakes, had depleted funds to such an extent that it would probably call on the government to pay out claims on future events. This could encourage the commission to look at the most cost-effective way of managing its liabilities.
Currently, the EQC Act of 1993 prohibits EQC from using anything other than traditional reinsurance to diversify its risk portfolio. However, a Treasury review from 2015, commissioned to recommend changes to EQC following the Christchurch Earthquakes, suggested amending the Act to allow EQC to purchase alternative financial instruments to traditional reinsurance.
In June, the previous Government outlined some of the measures of the Treasury report it planned to implement in 2020. But it never got round to amending the Act. Labour also has plans for EQC, although it’s unknown which, if any, of Treasury’s changes it will adopt.
The biggest problem could be political. There is widespread ill-feeling towards involving financial markets in insuring people’s homes.
Sarah-Alice Miles, a Christchurch specialist in earthquake insurance, is skeptical of their long-term future.
“In the interim, we’ll see insurance passing all this risk to the investors and, while the risks are reasonable, those investors will pick up the risk. Eventually, as the risks increase, those investors will drop off and the insurance industry and the reinsurance industry won’t be prepared to pick up those risks, either.”
Although every insurer with whom I have spoken believes there's a theoretical ceiling to the amount of risk that can be placed in ILS, Miles’ essential point is a valid one: how do we insure ourselves in a world of ever-increasing catastrophe? For that is exactly the world we are rapidly heading towards. We still don’t know how to make insurance work in a world that calls Nicholas Barbon’s bluff. How does insurance work in a world where catastrophe is no longer rare or isolated enough to be diversified away?