The increased likelihood of natural disasters due to climate change does not make investing in catastrophe bonds (cat bonds) any less attractive. On the contrary, experts say that due to the rising capital needs of reinsurers and higher premiums, returns can actually increase.
With catastrophe bonds, insurers transfer the risk of natural disasters to investors. Cat bonds are increasingly appearing in institutional investors’ portfolios, according to Edward Johnson, head of Business Development at Swiss Re. The low correlation with financial markets is particularly appealing. “Natural disasters determine the underlying risk and return,” said Johnson. “Cat bonds carry no interest rate risk or operational business risks and have minimal credit risk. This makes them highly suitable for investors looking to diversify their income.”
Since their introduction in 2002, the Swiss Re Global Cat Bond Total Return Index has delivered an average annual return of 7 percent. According to the reinsurer, the return is comparable to high yield, while volatility is significantly lower. “Cat bonds typically cover natural disasters that may occur once every fifty years,” according to Andy Palmer, a product specialist at Swiss Re. “If extreme events do not occur, cat bond volatility remains very low, as we have seen over the past twenty years. However, if the natural disaster is severe enough, bondholders can lose their entire investment.”
Palmer expects the negative impact of the wildfires around Los Angeles to remain limited, despite preliminary industry estimates of insured losses between 20 and 30 billion dollars. “A few cat bonds will have to pay out, but the overall consequences are likely to be manageable. The cat bond market generally only suffers when insured losses exceed 40 to 60 billion dollars and is primarily exposed to hurricanes and earthquakes,” said Palmer.
Climate change
The probability of extreme weather events is increasing due to climate change. However, Johnson believes this will not put pressure on returns in the cat bond market. “Climate change is a key trend, but it has already been factored into the models. If risk increases, the structure of cat bonds is adjusted to create more distance from the risk, or investors demand a higher return. Climate change may increase the risk of an individual catastrophe bond, but this is offset by a higher risk premium.”
Johnson believes climate change will likely lead to higher returns in the cat bond market, as demand for insurance rises and thereby increases the supply of cat bonds. “If investor demand lags behind, spreads will widen. This is one of the reasons for the higher returns in recent years,” Johnson explained. The current effective yield stands at approximately 12.5 percent, consisting of the risk-free rate and a risk premium of 7 to 7.5 percentage points. “With expected losses of around 2.5 percentage points, investors receive a return of 5 percentage points above the risk-free rate.”
Institutional investors recognise the benefits of this asset class but generally limit allocation to 2 to 3 percent, says Johnson. “Investors fear losing their capital after an extreme climate event and also find it a complex product.”
Risk diversification is challenging
For PGGM, complexity is not a reason to avoid catastrophe bonds. On the contrary, the pension investor has been investing in cat bonds since 2006, collaborating with major reinsurers and specialised fund managers. Since 2010, catastrophe bonds have been placed in a separate investment category, Insurance Linked Investments, says investment manager Eveline Takken-Somers at PGGM.
This category represents approximately 3 percent of PGGM’s invested assets, with a quarter allocated to cat bonds, amounting to roughly 2 billion euros. “We are a major player in a relatively small market of less than 50 billion dollars. Given that these are complex products with significant tail risk, we have built up internal expertise and acquired a catastrophe risk model,” said Takken-Somers.
For PGGM, the primary appeal lies in diversification benefits. “There are few asset classes with such a low correlation to financial markets.” Additionally, Takken-Somers highlights the attractive risk-return profile of cat bonds. “For each unit of risk, we receive an appealing return. The risk is comparable to high yield, but there is tail risk. Volatility remains low until a major natural disaster occurs.”
If an extreme event such as an earthquake in San Francisco were to occur and insured losses approached 100 billion dollars, the cat bond market would be severely affected, she explains. This is also due to the fact that catastrophe bonds are primarily issued by major reinsurers and insurance companies. A significant natural disaster impacts all issuing institutions, making risk diversification difficult, said Takken-Somers. “There is less correlation in private insurance-linked securities, as smaller insurers are also involved. A local insurer in Florida, for example, would not be affected by an earthquake in California.”
Despite several medium-sized disasters, PGGM has achieved an average annual return of around 7 percent on cat bonds over nearly twenty years. “The risk premium of 4 to 5 percent above the short-term interest rate meets our expectations,” said Takken-Somers. Over the past two years, returns have even ranged between 17 and 19 percent. “After multiple medium-sized natural disasters between 2017 and 2022, reinsurers were undercapitalised, leading them to raise premiums and reduce risk. This explains the fantastic returns.”
The risk level of cat bonds can be adjusted annually based on market conditions. “If the consensus is that climate change will lead to more hurricanes, for example, cat bonds will adjust to account for this additional risk,” concluded Takken-Somers.