After hurricane Andrew and the Northridge earthquake in the 1990s, it became apparent that the insurance industry would struggle to cope should the world be faced with a number of disasters in quick succession. As a result, catastrophe bonds came into being. Catastrophe, or cat, bonds form part of a range of specialist insurance-linked securities (ILS), which also includes the likes of industry loss warrants, direct reinsurance and retrocession agreements.

The cat bond is a risk-linked security that allows specific risks to be transferred from the issuer (often an insurer or reinsurer) of the bond to investors. Risks usually include natural disasters such as earthquake and hurricane, although more recently US insurer USAA made the headlines when it launched a meteor strike catastrophe bond. The investors then take on the risk of that disaster occurring, and are paid a rate of return. If the disaster does happen, that earthquake strikes or the meteor hits, for example, the investor loses their capital as the issuer of the bond takes it to cover losses incurred.

While they are not new on the scene, catastrophe bonds have certainly been grabbing more attention of late - the Financial Times reported that sales of catastrophe bonds had reached record levels in the first four months of 2014 - and developments over recent years in this area have made it possible for pensions to become involved in what had been a fairly niche area of the market, explains Leadenhall Capital Partners head of business development Lorenzo Volpi. “Insurance and reinsurance contracts are amongst the oldest in the financial markets, but it is only with the relatively recent development of insurance-linked investments that pension funds have been able to benefit from direct exposure to it,” he says. “Before then access was indirect and limited to holding insurance or reinsurance company shares.”

De-correlation

The evolution of the cat bond comes at a time when pension funds are looking for assets that fulfil their need for returns, but that avoid correlation with other key parts of the market. As PiRho Investment Consulting director Phil Irvine says: “There has been a general demand for alternative growth assets for pension schemes, to help them diversify away from their reliance on equities,” says Irvine. “With the path of returns of cat bonds likely to be different in most instances from equities the de-correlation benefits are of obvious appeal ... In a period of low yields due to quantitative easing, investors have been seeking replacements wherever they can.”

This idea of de-correlation is appealing to pensions, and it is prompting greater interest, not just in catastrophe bonds but in the ILS area more generally, says Towers Watson senior investment consultant Tom Brooke-Smith. “We believe that an investment in ILS can provide real diversity to return-seeking portfolios. ILS returns exhibit low correlation (close to zero) with those of other financial assets. This can be attributed to the fact that financial returns are not correlated to natural disasters, and vice versa unless in the very extreme.”

Indeed, while it may be the case that natural disasters are not directly linked to events on the stock market, there may be links following such an event, as Irvine points out: “It is hard to imagine an equity market crash causing a natural catastrophe such as an earthquake, tidal wave, hurricane, but the causality could work the other way round - a devastating earthquake could impact upon equities.”

Nonetheless, that effect is likely to be brief: “What you do get is a very short term link while working through insurance implications, but often the stock market will rebound because of the opportunities to gain from rebuilding,” argues Schroders head of UK strategic solutions team Mark Humphreys.

Brooke-Smith agrees: “Catastrophic disasters may well have shorter-term effects on capital markets through for instance losses in earnings, on property or declining credit quality.” But, he adds, once recovery is under-way: “Short-term mark-to-market volatility tends to recede, for instance government aid can prove a stimulus for earnings growth in companies involved in the clean-up effort.”

What’s more, he says, investors are not likely to bear the brunt of the losses: “Ultimately significant losses are likely to be borne by the insurance industry, therefore any short-term correlation should recede with time, which is more valuable for institutional investors. There is little evidence of lasting correlations to date as even large losses for the reinsurance industry are small compared to global economic output and the size of capital markets.”

Volpi suggests that a portfolio of cat bonds provides exposure to insurance returns with good liquidity, but says that one year private placements can provide higher risk adjusted returns and significantly increase the investment pool, or diversification over and above the circa $20 billion cat bond market.

“Today’s $50 billion global market in insurance-linked investments (a segment of a more than $300 billion traditional reinsurance market) opens up a range of new investment options to pension funds able to benefit from its characteristics. Pension funds do not need weekly or monthly liquidity and are more likely to look at the wider spectrum of opportunities rather than constraining themselves to cat bond only strategies,” he says.

It’s a point that many agree with. “We recommend a diversified exposure to ILS,” says Brooke-Smith. “This includes diversification amongst instruments, types of bonds and types of perils. At any point in time any of these markets can offer a relative value opportunity when compared to the others and so it makes sense to allocate to a wide opportunity set. Catastrophe bonds are a relatively small part of the reinsurance market.”

Risks

For some, the related risks are too concerning. Many trustees are worried that in the event that a disaster covered by a bond occurs, investors will be faced with serious losses. As Irvine explains: “The ‘devil is in the detail’ when investing in alternative assets, and pension schemes need to feel comfortable that they have a good understanding of the impact on their investment if the event they are insuring occurs. Some of these types of investments have been described as ‘picking up pennies in front of a steam roller’. That is, most of the time there are small, positive rewards, but the downside risk is large.”

Brooke-Smith argues that concern should be tackled by a creating a proper understanding of what is a complex and specialised area. “Context is key,” he says. “Whilst individual events cannot be predicted, funds can diversify their exposure so that risk of loss to any one peril is limited. One benefit of insurance loss is that it tends to be very local-ised, so for example the same perils can be uncorrelated within a country or even region – for example Florida Wind vs. East Coast Wind.” What’s more, he adds, institutional investors are likely to hold a relatively low allocation to ILS as a function of total fund size. “Therefore the impact of any one event is likely to be small when considered using this frame of reference.”

For Humphreys, making the right choice of manager is also fundamental. “Anyone can buy a cat bond but you find out if the manager knows what they are doing in a year when the disasters happen. It is the only real stress test.”

There may be some way to go before the cat bond becomes a staple in pensions investment, but for some in the industry, they are beginning to find their place, within a broader ILS context. “They are very attractive as an asset class,” says Humphreys, “and they are set to go from being niche to appearing in many pension fund portfolios.”

Sandra Haurant is a freelance journalist

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