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Comments (39)

Jun 22, 2021 - 9:52pm

Awesome post, definitely not an area I know I ton about. Who are the top firms in the Cat bond issuance space, and would the career path for an analyst at one of these firms be similar to a general FIG capital markets/investment banking role?

I assume this is a pretty recent innovation in the insurance space. What commercial insurance companies are likely most at risk?

Also, what are the risks of these cat bonds? That is, how can you lose money if you were to buy as an institutional investor, for example?

Jun 22, 2021 - 10:30pm

The top banks are basically Guy Carpenter, Aon, Swiss Re, Goldman, CS. There are a number of big hedge funds/asset managers that have specialty funds that invest in these too. It is a relatively small market still.

To answer your question about the risk, it is not very different than traditional insurance risk. Hurricane happens, company has a loss, and then they draw down on the proceeds from the issuance of the bonds to indemnify themselves. Basically investors principal isn't at risk from a credit standpoint, the principal is in MMFs in a trust and doesn't leave, but if a covered event triggers a payout the trust will release funds to the insurer/gov/corporate causing a loss to investors. I can't speak much to your other questions as I don't have any experience on that side of banking.

  • Research Analyst in HF - Other
Jun 29, 2021 - 2:02am

Used to work for the woman who ran the Insurance structured finance desk at GS after Mike Millette left to found Hudson Structured Capital. Nephila is a big player in the cat bond investing space - by far. There are a couple of other funds that invest heavily in ILS. Career path for an analyst is in the Structured Finance group, not FIG capital markets, although at Goldman they were both run by this woman. Reinsurance and captive reinsurance etc. is not a recent innovation. Munich Re, Swiss Re Gen Re. etc. have been around for a long time.

What are the risks of these cat bonds? Take a look at Cal Phoenix Re (CALPHO Corp on bbg if you have it) - this was a cat bond insuring PG&E against California wildfire risk.....

You lose money by hurricanes, wildfires, earthquakes, floods (it's mostly hurricanes that are the root tbh) that exceed certain parametric thresholds or dollar loss amounts. 

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Jun 23, 2021 - 12:04am

Is there a potential for cat bonds to almost go the same way of credit default swaps? CDS were originally intended to hedge credit risk, but naked CDS buying allowed investors to take risk exposure on securities they didn't even own. Using the same parametric method of payout, could certain investors anticipating increased disaster activity in a certain region issue cat bonds despite having no risk to actually hedge, thus using cat bonds to speculate on meteorological risk?

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Jul 17, 2021 - 10:20am

Yes that is absolutely possible just relatively uncommon. Players in the space (both insurers and funds who invest in these products) buy products that pay out when certain losses are exceeded ($10bn Florida Hurricane trigger, $50bn aggregate cover that covers Hurricane, Earthquake, Wildfire, over the USA, or worldwide, etc.) as a purpose of hedging losses against their own insurance portfolio. I'm not aware of investors that do buy these instruments similar to how naked CDS' were purchased in the past but they certainly may exist. My guess is that there are very few to none because the industry is just so esoteric to anyone who is not a catastrophe modeling or insurance expert.

  • Associate 1 in IB-M&A
Jun 23, 2021 - 9:51am

Contrarian view: these will be popular until rates go back up. Didn't the holders of the PGE Catbond get wiped after the Camp Fire? 

Don't get me wrong - I think the math is cool and there are some interesting structuring opportunities, but there's a reason that the market is so small and illiquid and mostly made by massive insurers stuffing these things into a GA -  it's impossible to make a market on these things. \So it effectively becomes what...some sort of alt-hedge for the insurers or another product with outsized risk in an environment with too many dollars chasing too little yield? 

What happened with COVID? Most insurance has a Force Majeure clause, but isn't a cat bond FOR the Force Majeure?  

I think it's a great business if you're a specialist, especially because with climate change catastrophe is only going to become more prevalent, I just don't think it has the ability to become as liquid as other products because of how nuanced it is  especially as rates go up and investors don't need to go as risk-on to make their hurdle. 

Jun 23, 2021 - 2:35pm

You make some good points, however, I disagree with most of what you wrote.

To answer your first statement, yes. These securities are incredibly risky and you can lose your entire investment quite literally overnight. But so is traditional insurance/reinsurance, cat bond or not PGE needed to insure themselves against wildfire risk. The loss happened regardless of who ended up paying it, unfortunate for those investors, but it is the reality of the market. If traditional reinsurance agreements were traded and a catastrophe occurs, anyone holding that paper would be wiped as well. It says nothing about cat bonds as a security, just the risks they cover. I'll add too many hedge funds are already heavily involved in the reinsurance/insurance industry outside of cat bonds through sidecars, joint ventures, and other structures so they are already well aware of the risks.

Secondly, you're right. This likely won't be a massive highly liquid market ever, but there has been significant increases in trading activity as well as investor demand for cat bonds. In fact something like 75% of issuances this year have priced well below initial guidance and have also upsized. They're little known securities with a lot of nuance which absolutely hampers the speed at which investors will get drawn into the market, but certainly investors are increasingly finding value here. Catastrophic events are random and very difficult to predict, however, this doesn't necessarily make cat bonds inherently more risky. It all depends on the underlying risks covered and the structure of the bond, many would be rated investment grade if they were rated by the agencies if you compare probabilities of loss. In many cases they are priced at a premium to traditional bonds given a specific probability of loss.

Sure, when rates go up investors purely chasing high yield instruments might take their money elsewhere, but that's not necessarily the largest benefit of allocating a portion of your portfolio to cat bonds. They are diversifying by nature. They are a near zero beta asset, hurricanes and the financial markets don't have a large correlation. Even in the event of default on premium payments, your principal is safe as the coverage is automatically canceled and you are still entitled to receiving the coupon payments that weren't paid.

COVID-19 is a tough example and frankly a lot of litigation is happening around the issue to determine if insurers should have to pay regardless of the language in their policies. That said, the World Bank successfully issued a pandemic cat bond, so it is certainly being used to cover that risk.

I think it will be interesting to see how the market develops, but I stand by my belief that the market will only continue to expand and gain traction. They change the way insurance works, of course it won't replace the traditional insurance industry, but there are many areas where I think you'll see increased use in the future.

Jun 23, 2021 - 3:57pm

Isn't this berkshires bread and butter basically? And essentially the foundation with which the company actually makes money eg through float. Or is what they do related but slightly different

Jun 30, 2021 - 8:11pm

Not at all related. BH underwrites risk, collects premiums, and invests in securities (money on the float). This is capital intensive, they still wear the insurance risk. What we're talking about here is risk transfer - actually securitizing that insurance risk and selling it to capital markets investors like you or me. So now even though we are not licensed insurance companies, we are still backing the insurance risk. We are effectively stepping into the shoes of reinsurers.

What I've never understood is why investors in this space think they can get an edge. The risk is being underwritten by an insurance / reinsurance company that presumably has access to advanced pricing and analytics engines, as well as public data sets and their own internal actuarial experience. What edge does some 'to the moon' Reddit clown have in pricing the risk of relative to, say, Travelers? The answer is they don't. Buyers of these securities are still a pretty small group who are highly specialized - AlphaCat, Nephila, Hudson Structured....these are not institutionals anyone outside P&C insurance nerds have heard of. Trying to build a book for these deals isn't a 4 week process, it's a 6 month roadshow and requires jetting all over the damn world.

  • Analyst 1 in IB - Cov
Jun 23, 2021 - 4:20pm

Super interesting, thanks for the write up! Is each SPV designated only for one catastrophe in which case the whole amount is given?

Something I can't wrap my head around is, who in their sane mind is investing on this knowing that they have a LGD of 100%? The margins you mentioned do not seem to compensate for this kind of risk. I assume though for a very large fund investing in multiple of this it could be profitable, given that the protected events have such a low correlation.

Jun 23, 2021 - 10:51pm

They don't. It was a simplification, I apologize for the miscommunication. The payout structure is very stratified, you can have a total loss, but in most cases this is not what occurs. Basically a map of the company's exposure is created and catastrophe events are modeled on top of it to give an idea of what losses would like in a given are for a given event. If the bond covers the entire state of Florida and a hurricane only clips the southern tip and only triggers a loss in that location, the bond will pay only a fraction of the original principal. There is often a balance between severity and location in the payout structure. And to answer your first question, no. Each SPV can issue multiple classes of notes in multiple series which cover as many perils as needed

  • Analyst 2 in IB - Cov
Jun 24, 2021 - 3:19pm

The only thing to note here is that while SPVs can continually issue new series of notes (i.e., 2021-1, 2022-1, etc.) many of them will only do a few issuances out of a certain SPV. The reason for this is that investors have constraints on how much capital they can allocate to a certain SPV. 

Jun 23, 2021 - 11:18pm

Really enjoyed this write-up and found it very interesting - thank you for your contribution.

You mentioned these bonds are exchange-traded instruments - do they rise and fall in value based on things like weather predictions? Can traders speculate on weather with these tools? 

STONKS
  • 1
Jun 24, 2021 - 9:45am

Very good post OP. Been doing this for about 5 years now and most of what you mentioned is spot-on. One interesting tidbit is that LPs have been shying away from more risky ILS instruments in the last few years (due to catastrophes) and have gravitated towards more risk-remote instruments in cat bonds. Thus, we have been seeing a lot of inflows in this particular area of the ILS asset class. Of course, risk-remote is relative when you are talking about low-probability, high severity that have the potential to blow your entire investment, but I digress.

Only part of your write-up I would kind of disagree with is the increasing diversification of perils resulting in materially more investment in the ILS space. Most ILS instruments flow through about ~$100bn in fund managers who are increasingly wary to such perils that are unmodeled (anything outside of established perils such as hurricane, earthquake, severe convective storms (thunderstorms), winter storm, etc.). This has been mostly driven by their experience of being burned (literally) by unmodeled wildfire and COVID losses over the last few years. The transactions you mention getting done for wildfire / terrorism pay a stupendous amount of money relative to the perceived risk and aren't particularly scalable for the ILS industry. As of right now, it's difficult to see the established fund managers who control most of the AUM rapidly expanding this since its unmodeled (or poorly modeled at best) and have been under pressure from their LPs to avoid "surprise" losses that aren't modeled. However, the pricing is so good in these unmodeled perils that we have been seeing increased activity from multi-strat and regular way financial investment firms starting to play in this space (albeit not at a meaningful scale), so its certainly possible this continues to grow.

If anyone has any further questions, please feel free to reach out.

Jun 25, 2021 - 11:31am

There are some hedge funds who do this stuff. Fermat and RMS come to mind first, they've got a lot of math guys working for them, and they hire the services of meteorological experts, oceanographers, etc. 

  • Prospect in HF - Other
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