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Asia offers fertile ground for cat bonds
Owing to its location and topography, Asia has been one of the world’s most disaster-prone areas both in the number of events and victims. While insurance penetration in many parts of the region is far lower than in more developed economies, the use of insurance-linked securities is fast gaining traction in Asia as governments, industry practitioners and investors see the enormous opportunities presented by the business. Catastrophe bonds, for example, offer a way for the insurance sector to share risks and secure more capital while capital markets see the instrument as a good source of higher returns. In a way, one could say it’s a two-way bet on natural disasters, with players on both sides of the table hoping the event never occurs
Piotr Zembrowski 10 Nov 2014

On March 11 2011, a magnitude-9 earthquake shook northeastern Japan, unleashing tsunami waves as high as 40.5 metres and causing widespread death and destruction. Up to now, many residents and businesses in the country are still recovering from the disaster. It was also one of the costliest events for the insurance industry, with some experts estimating economic losses at up to US$300 billion.


Insurance and reinsurance companies worldwide were stunned by the sudden surge in losses they had to absorb. On a brighter note for the sector, the Tohoku earthquake proved to be a pivotal moment for the business, which had been suffering from falling coverage prices.


In early 2014, or three years after the event, three Japanese insurance companies issued a combined US$645 billion worth of catastrophe bonds, a type of securities that allows insurers to transfer risks from natural disasters that they cover to investors (See sidebar). It was one of the biggest issuances of its kind in the country, surpassing by 50% the previous record in 2012.


Apart from Taiwan, Japan remains the only Asian country issuing catastrophe bonds, also known as cat bonds, with some regularity. In a report in August, Fitch Ratings said this type of alternative insurance is poised for emergence in Asia, as insurers and governments start looking for alternative funding to cover risks.


Although cat bonds arrived in the investment landscape almost 20 years ago, more than half of outstanding issues today still cover only US-based risk, mostly related to weather and earthquake, according to Artemis.bm, an industry website focusing on insurance-linked securities (ILS) and alternative reinsurance.


Investors looking for diversification of their exposure can find cat bonds covering European, Australian or Japanese risk, but most of the Asian countries, including those that frequently suffer from weather-related disasters or earthquakes, are conspicuously absent from the range of offers.


One of the reasons for this is that insurance penetration is lower in Asia, particularly in less developed countries in the region, than in the US, Europe or Japan, according to Steve Evans, the owner of Artemis.bm.


“The cost of buying insurance has been prohibitive in a lot of countries in Asia,” Evans tells The Asset in an interview. “It’s really been something that’s mainly been available for the middle and upper classes.”


The existing reinsurance companies have enough capacity to fulfil all reinsurance needs. “It will take some time for that to build up to the point when they need sufficient reinsurance to make things like cat bonds a viable product,” he explains.

 

Low penetration in Asia


Insurance penetration is not the only reason Asia’s ILS market is several years behind its US and European counterparts. Cultural differences and the way people rely on relationships in business also play a role. Nevertheless, “ILS managers build the same types of relationships, in the same way, and become just as trusted as the larger insurers,” says Evans.


Chinese regulators have recognized the tremendous opportunity for growth in the reinsurance sector and its alternatives. The China Insurance Regulatory Commission was earlier reported to be currently working on establishing a framework that will allow the issuance of cat bonds in China.


“The ILS fund managers would love more opportunity to come out of Asia,” points out Evans. The ability to add risk from other areas, such as Southeast Asia, China and India, would help diversify their investments. A few recent issues covering Turkey earthquakes as well as hurricanes and earthquakes in Mexico and the Caribbean saw high demand.


Catastrophe bonds first came out in 1996. “There was a belief in the reinsurance market that there was insufficient capital to cover very major peak risk,” he notes. On the other hand, capital markets had an appetite for additional return and were willing to take on the risk. Cat bonds would fulfil the needs of both sides.


By allowing reinsurers to offload peak risks – associated with large, rare events – the bonds would spread the risks and smooth the reinsurance cycle. “The capital markets obviously were seen as a sort of multitrillion-dollar source of potential risk capacity,” explains Evans.


Catastrophe bonds can be useful as an alternative to traditional insurance where insurance penetration is low. Much of Asia’s risk catastrophe is economic, fiscal or corporate, for which governments or corporations don’t buy insurance. “It’s a huge potential opportunity for cat bonds.”


Governments in countries where catastrophes are a constant threat and where much property remains uninsured would stand to benefit from issuing cat bonds, as would development banks. A few initiatives are aiming to exploit those opportunities.


“The World Bank and the United Nations have been working with some Asian governments to get them to embrace disaster risk financing,” says Evans. The governments of Thailand, the Philippines and India, in particular, have made some progress.


Another initiative aims to compel global corporations to disclose catastrophe exposure on their balance sheets and this could stimulate a whole new market in insurance risk and catastrophe risk protection.


The difficulty of quantifying potential losses in poorly documented areas remains a major obstacle. It can be circumvented by issuing securities with parametric triggers, in which the catastrophe payment is made based on physical parameters of an event rather than on actual losses suffered by an insurer.

 

 
Schmutz: Investor has to be comfortable with underlying company  

Even though returns have come down since their peak of 11.05% in 2009, averaging 4.5% this year, “capital markets’ appetite is very large for accessing this type of an asset class”, says Evans. “It provides diversification for the portfolio, with low correlation with broader financial markets, but it also provides a real source of additional return.”


One of the main benefits of ILS is that institutional capital can operate in a leaner way than traditional reinsurance. “If you compare an ILS manager who manages US$10 billion and has 50 employees to a reinsurer who commands US$20 billion-US$30 billion but has 3,000 employees, the actual cost of operating is much lower.” Many reinsurers are embracing ILS by managing pools of institutional capital, in addition to their core business.

 

Organic growth


During the nearly two decades of cat bond history, the sophistication of investors and the scope of coverage they are willing to provide have substantially increased, according to Markus Schmutz, head of global ILS structuring and origination at Swiss Re Capital Markets.


“In the early days of the market, most of the transactions were index-based,” says Schmutz, who joined Swiss Re’s ILS team in 1999. “A transaction would trigger based on the magnitude of an earthquake or the wind speed in a typhoon. Those triggers were easy to understand.”


For the issuing company, these parametric triggers carry a downside. Their actual losses often are not well correlated with the magnitude of an event. Nowadays, most cat bonds carry an indemnity trigger – based on the issuer’s actual loss.


“The investor has to be comfortable with the underlying company,” he adds. “They have to understand the business of the company, how it underwrites their policies, how these are priced, how claims are settled.”


The maturity of the market is also reflected in its reaction to large events. In 2005, Hurricane Katrina triggered a large transaction in the US, and so did the 2011 Tohoku earthquake in Japan, in which investors lost US$300 million. In all of these cases, investors have come to a better understanding of the risks involved. And most of these investors continue to buy in the market.


“There has been a lot of new investors coming into the market over the last few years,” says Schmutz. “The existing investors are becoming more sophisticated. That has resulted in the structures becoming a lot more sponsor-friendly overall.”


He sees the global ILS market growing organically at 10% annually in the next few years. He provides a caveat: “If the interest rates start to rise, then some investors will hold back because deals will be more attractive in other areas of the capital markets.”


Despite challenges, Evans and Schmutz agree that there is a significant opportunity in Asia for both the issuers of cat bonds and the institutional investors who buy them. “There’s no reason why suddenly Asia couldn’t catch up and overtake,”says Evans. “Asia does that in every other industry eventually. It seems that once it hits a critical mass, it often accelerates its development and comes up with new ideas and sometimes overtakes the traditional way of doing things.”

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