When Hurricane Irma tore through the Eastern Caribbean, laying waste to the island of Barbuda and advancing west towards Florida via the British Virgin Islands and Cuba, insurers were not the only financial institutions braced for heavy losses.
As the category-five hurricane — the most destructive level — approached the coastal cities of Miami and Tampa, pension funds and asset managers also watched nervously for the fallout from what one portfolio manager described as “the catastrophic combination of wealth and peril”.
Their concerns were much greater than in 2005, when Hurricane Katrina swept a path of destruction through the sunshine state and beyond. In the 12 years since that disaster, which cost the insurance industry US$82bn, an alternative insurance-linked securities market has also put mainstream asset owners in the line of fire.
The catastrophe bond market, where investors trade the risks of large natural disasters, has attracted portfolio managers eager to diversify their holdings with assets that are uncorrelated to broader markets. Fifteen per cent of total reinsurance capital now comes from pension funds, endowment funds and sovereign wealth funds, mainly through asset managers, according to Aon Benfield, the insurance broker.
Hurricane Irma is the first significant catastrophe since the market gained traction with investors.
“This is a market-changing event in terms of pricing, but also in terms of dynamics,” says Daniel Ineichen, fund manager of insurance-linked securities at Schroders, the UK’s largest listed asset manager. “We are coming out of a 10-year period with hardly any hurricanes. This season [we have] already see[n] two category-four hurricanes, which is exceptional.
“The catastrophe bond market has been tested for the first time,” he says.
Before Hurricane Katrina, the risk from natural disasters in the developed world was almost entirely borne by insurers and governments. Companies providing cover for the destruction of homes and businesses during the Atlantic’s notorious hurricane season sold parcels of this risk on to reinsurers, but the fallout from a “one-in-200 year” catastrophe — as described by regulators — was expected to be severe.
Hurricane Katrina, which hit the US with its largest-ever insurance bill, prompted a rethink. Insurers and reinsurers such as Swiss Re, Munich Re and Allianz began to issue more insurance-linked contracts and securities, or catastrophe bonds, to offload the risk from improbable but devastating catastrophes.
The bonds, which are relatively liquid, pay an attractive interest rate and can be triggered in the event of a severe natural disaster, forcing holders to shoulder heavy losses.
After the financial crisis, which pushed interest rates to record lows, pension funds, endowment funds and sovereign wealth funds hungry for returns ploughed money into the sector. The alternative market for insurance ballooned from just US$17bn in 2006 to $89bn in the first half of this year, according to Aon Benfield.
“There were a handful of catastrophe bonds around in the late 1990s, but they were unusual as a form of cover,” says Ben Brookes, vice-president of capital markets at RMS, the catastrophe modelling group. “The influx of capital from pension funds and big investment funds has changed the dynamic of the market.”
Asset managers rushed to grab a slice of the growing pie. Last year, Schroders became a majority shareholder in Secquaero, a Swiss-based asset manager specialising in insurance risk, after first taking a 30 per cent stake in 2013 with the aim of “cementing its commitment to the insurance-linked securities business”. Nephila and Credit Suisse Asset Management are among the largest holders of insurance-linked securities, according to a list compiled by InsuranceLinked, an industry website.
“This is a proof point for the market. It will and should be a demonstration to investors that the market has done what it was designed to do,” Mr Brookes says.
Now they will be watching to see how many catastrophe bonds cause losses. Zeba Ahmad, investment director of insurance-linked securities at Schroders, expects Hurricane Irma to trigger between seven and 15 of its bonds, causing losses of between £52m and £78m, but a positive return overall this year. Analysts at RMS estimate that two-thirds of expected losses to catastrophe bonds in a given year come from US hurricanes, with half of that from Florida alone.
Pension funds are also on the line. The Royal Bank of Scotland invested £378m in reinsurance through Nephila last year — an increase of 46 per cent on the previous year. PKA, which manages the retirement income of 300,000 Danish workers, owns 23.6 per cent of the Yderst Catastrophe fund and 23.4 per cent of the ILS CO2 Segregated Portfolio.
Losses for the wider market are expected to be greater than after Harvey last month, according to analysts, because that hurricane caused most of its damage through flooding. In the US, flood protection is covered by the government-run National Flood Insurance Program and is usually excluded from reinsurance contracts and catastrophe bonds.
“Some of these investors who are naive investors haven’t really understood the risks that they were standing for when they invested their money,” says Antonello Aquino, associate managing director of financial institutions at Moody’s, the rating agency.
“If something big happens, then there will be part of this alternative capital that will be hit. But then the traditional reinsurance companies would say, ‘We are seeing big claims coming in, so we need to raise prices’.
“Irma is the first test for alternative capital,” he says.