A strategy that’s delivered specialist investors huge returns is now facing scrutiny, amid concerns that its risk-reward dynamics might be skewed against some issuers.
Catastrophe bonds, which are issued by insurers, reinsurers and governments seeking an extra layer of disaster coverage, have been handing investors double-digit returns. Issuers, meanwhile, have seen their costs soar.
Grievances surfaced in July, after it emerged that Jamaica’s catastrophe bond wasn’t triggered by the devastation wrought by hurricane Beryl. Though the entire Caribbean island was officially declared a disaster area, the carefully calibrated terms of the bond meant its holders were shielded from losses. In the event, it was decided that the precise level of air pressure required for a payout wasn’t achieved.
Caribbean heads of government within the group known as Caricom recently discussed the financial ramifications of Beryl. This month, the group said it will be seeking “an examination” of cat bonds and other insurance-linked securities, and wants the region’s finance ministers to take a closer look at which markets governments should choose and which they should avoid.
“We recognize that at the end of the day, investors need to make returns,” Jwala Rambarran, a former governor of the central bank of Trinidad and Tobago, said in an interview. “But at the same time, fairness and equity says it can’t be all the time that the investors are making the returns. It’s a one-way street.”
The Jamaican Ministry of Finance didn’t respond to requests for comment.
Cat bonds make it possible for issuers (also referred to as sponsors) to pass part of their risk over to capital markets. Sales of the instruments have soared lately, with factors including climate change, population density and inflation adding to their appeal. Investors face potentially substantial losses if a bond is triggered, but can generate market-beating returns if a predefined catastrophe doesn’t occur.
For the $47 billion cat bond market, Beryl proved an early win for investors navigating their way through a hurricane season that’s expected to be unusually active.
Issuers turning to cat bonds get a very specific type of coverage whose terms should be clear to all stakeholders at the point of purchase, according to the World Bank.
Cat bonds are “for tail events,” which are rare disasters outside the norm, said Michael Bennett, head of derivatives and structured finance at the World Bank treasury. “The parameter isn’t the fine print, it is the print.”
At Swiss Re, a regular issuer of cat bonds, those dynamics are well understood. The instruments “are typically remote covers that don’t pay out for each and every event,” said Jean-Louis Monnier, global head of ILS at the Zurich-based reinsurer. “It takes an extreme event for them to be triggered.”
Rambarran, the former Trinidad and Tobago central banker, recently co-authored a report by the Vulnerable Twenty Group — or V20 — which represents countries who are among the world’s most exposed to climate change. V20 says it’s time to overhaul the triggers that determine whether a cat bond investor will be called on to cover losses. The group’s concern is that thanks to skillful financial engineering, such triggers are becoming increasingly narrow and rigid.
In the case of Jamaica’s cat bond, investors were protected because the conditions for triggering a payout “are hard and specific,” the V20 report said. “This rigidity protects investors but leaves Jamaica vulnerable to catastrophic risk.”
The parameters that determine cat-bond payouts are unlikely to become softer in the future, according to analysts monitoring the market.
“We expect cat bonds to adjust the triggering criteria for a payout to cover only the most severe types of storms,” said Morgan Stanley strategists including Carolyn L Campbell. “The parametric bounds of today might become too common in 10 years; cat bonds of the future are likely to cover only those rarest, most damaging storms, with a frame of reference evolving constantly.”
First Published: Aug 19 2024 | 11:18 PM IST