Currently showing: Climate/natural disasters > Disaster risk

16 Aug 17 15:52

August 24, 1992 will be a day many Floridians will never forget. Hurricane Andrew was a truly devastating event and Florida had seen nothing like it before. Hurricane Andrew struck as a Category 5 storm and wind gusts of up to 175 mph were recorded. The storm destroyed 26,000 homes, damaged 101,000 others and left 250,000 people temporarily homeless. It killed 44 people and it caused USD $26.5B (1992 dollars) of insurance losses in Florida alone. The losses were twice the figure the industry had expected. In the wake of Hurricane Andrew 11 insurers were forced to file for bankruptcy. Some others survived but barely. Post event, insurers and reinsurers cut back coverage. In other words capacity dried up significantly.

Against this backdrop and out of the rubble from this historic event a market was born. The few catastrophe models for hurricanes in existence at the time could no longer be trusted and with capacity all but dried up it opened up an opportunity for the capital markets. The financial markets are so much bigger than insurance with so much more capital at their disposal. The birth I am referring to is Insurance Linked Securities (ILS) and specifically the catastrophe (cat) bond market.

The gestation period may have been longer than some had anticipated but in 1996 we saw our first cat bond emerge. The first cat bonds were small and tended to cover U.S. peak perils such as North Atlantic hurricanes and California earthquake. These first cat bonds from the late 1990s were predominantly based on PCS and parametric triggers. From these humble beginnings, the ILS market would not only grow, but thrive, as cedants saw value in collateralized multi-year protection and investors viewed this asset class as a diversifying one.

Like any child approaching their teenage years it was not surprising there were growing pains along the way. The financial crisis of 2008 was one of them. Lehman Brothers crashed and shook the global financial system. Lehman Brothers was the counter party for four cat bonds that all became worthless during the period from 2008 – 2011. The child learned from this episode and this scenario would not play out in 2017, as all counterparty risk was eliminated via a collateral trust. Today proceeds from a cat bond issue flow through a collateral trust which then invests mostly in government Money Market funds thereby eliminating counterparty or credit risk.

There has only ever been one bond to incur a total default due to a natural catastrophe and that was due to the March 11, 2011 Tohoku earthquake in Japan. The ILS market showed its resiliency and held up incredibly well in 2005 when the U.S. was battered by Hurricane Katrina, Rita, Wilma (KWR) and others, which caused over $80B in insured losses. Only one bond suffered a partial default from Hurricane Katrina. KWR caused capacity to dry up in 2006 much like in 1992 resulting in a hard market on the traditional property reinsurance side and increased spreads (returns) in the cat bond market. Conversely, it seems likely that today’s over abundant capital and surplus has not only resulted in a soft traditional market but in historical low spreads in the cat bond market.

The baby has grown into an adult and today the ILS market is a mature one. In 1H 2017, nearly all new issuance records were shattered. Issuance volume in 1H 2017 totaled more than USD $8bn, nearly 40% larger than any previous half year, and just USD $230m shy of the full-year issuance record (a mark surpassed in the first week of July).

Today catastrophe bonds go beyond U.S. peak perils such as North Atlantic hurricanes and California earthquakes. Today they cover everything from European windstorms to Japanese earthquakes and typhoons, wildfires, volcanic eruptions and severe convection storms. Cat bond triggers have moved beyond indemnity based ones and include parametric, industry loss, modelled loss, etc. Cat bonds have also moved outside the realm of natural catastrophe perils that are usually associated with it. Cat bonds cover the esoteric and have also moved into the life insurance space and cover extreme mortality that may arise from pandemics. The baby has grown into an adult and has become a true complement to traditional reinsurance.

Category: Climate/natural disasters: Disaster risk, Floods/storms, Resilience


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