Brynjo: Know the Role of Cat Bonds and Hurricane Sandy

In the aftermath of Hurricane Sandy several catastrophe bonds issuers and insurance-linked securities managers gave quick notice that Hurricane Sandy was unlikely to trigger any outstanding bonds or impact market values, thus leaving the market unscathed.

However, in the two weeks following the storm several bonds — including tranches USAA’s Residential Re — were either put on credit watch or traded lower as loss estimates increased and creeped towards the structures’s attachment points.

In addition, ILS managers –such as Zurich-based Plenum Investments — initially said that there was “a 90% probability that there is no loss to any CAT bond in the portfolio.” Nearly a week later, however, the manager revealed that prices on some bonds in the secondary market had plunged 25% but they remained “optimistic to recover these mark to market movements as the uncertainty around actual loss amounts dissipates.”

Given the uncertainty Armored Wolf managing director John Brynjolfsson argues that understanding the “role” of catastrophe bonds will give investors hints as to the ultimate exposure of the market.

“The catastrophic bond market has a rather specific role in intermediating risk between the reinsurance industry and the capital markets,” Brynjolfsson argues. Below are his thoughts on understanding catastrophe bond market with minor edits for clarity.

What catastrophe bonds are NOT ideal for:

  • Underwriting idiosyncratic specific risks associated with underwriting small individual clients. For example “lack of snowfall at specific ski resort triggering loss.”
    • Underwriting complex risks, where ultimate indemnity payouts are function of a complex interaction of incentives that link homeowners, insurers, state commissioners and tradeoff’s regarding writing future business in a state. Examples include commercial business interruption and flood insurance.

What catastrophe bonds ARE ideal for:

  • Underwriting super catastrophic industry events — such as $50 billion and greater insured losses — to which insurers and reinsurers already have abundant exposure to, and can only allocate more capital to, if that capital is  getting “peak peril” premiums and returns.
    • Underwriting well understood, broadly studied, and nationally measured super-catastrophic phenomena, such as  Florida wind and California earthquake
    • Relying on parametric, or modeled loss, structures, where ambiguity regarding trigger and losses is minimized, and “development” period to make such determinations is measured in weeks rather than quarters.


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