In late April, the Turkish Catastrophe Insurance Pool (TCIP) issued a $400 million cat bond, its first ever.
The deal surfaced at a time when the sector is experiencing rapid growth and drawing in new investors, with global cat bond issuance potentially coming within reach of 2007’s $7 billion record, observers say.
Conditions it would seem are ripe for other emerging markets to follow Turkey’s suit, and hedge the sorts of risk that are present everywhere.
But cat bond players said that insurance penetration would have to rise to much higher levels for emerging-market cat bonds to widen their share of the overall market, which has remained slight for years.
Still, it is likely to grow over the long-term as insurance levels edge towards the rates seen in the West, encouraged by both governments and multilateral banks such as the World Bank and the Asian Development Bank.
Young Turks
The Turkish transaction is not the first from emerging markets — there have been deals out of Taiwan and Mexico, while Turkish risk has been folded into another transaction. All the same, cat bonds outside the U.S. and Europe are remarkably rare.
“Generally speaking the cat bond market is heavily skewed towards U.S. peril,” said Paul Schultz, CEO of Aon Benfield Securities.
It is not as if transactions from emerging markets represent far more work for arrangers because they are radically different from what investors understand cat bonds to be.
TCIP, for instance, is analogous to the U.S. insurance pools that have issued cat bonds. State sponsored hurricane residual pools have been floating deals over the past few years, the first being Parkton Re in 2009, according to a Swiss Re report. Since then, pools in Massachusetts, Louisiana and Florida have tapped the capital markets for reinsurance.
Arranged by GC Securities, the cat bond benefitting TCIP provides three years of protection from earthquakes affecting the Istanbul region. The deal triggers are based on measurements captured at specific ground motion seismometers, some of which were placed specifically for the transaction.
“It’s a bespoke trigger structure,” said Cory Anger, global head of ILS (insurance-linked securities) structuring at GC.
In a sign that cat bond investors are open to this corner of the market, a range of buysiders snapped up the Turkish deal, which was rated ‘BB+’ by Standard & Poor’s. They included hedge funds, asset managers, endowments, mutual funds, family offices, and pension funds focused on ILS, according to Anger. The ILS-dedicated funds bought up 62% of the deal’s volume. The second largest group of investors was hedge funds, with 16%. In all, there were 26 investors in the deal, priced at a spread of 250 basis points over U.S. Treasury money market fund earnings.
Unlike other kinds of structured finance deals out of emerging markets, cat bonds from this part of the world are not perceived to carry currency risk for the investor.
“The cash flows are usually all in U.S. dollars,” said Maren Josefs, associate director of financial services at S&P. “It’s not something that we look at when we rate these deals.”
Indeed, the risk modeling is very similar to the approach for developed country cat bonds, Josefs added. But, as with any model, there can be elements that are untested.
In the Turkish deal, for instance, it was the first time the agency rated a transaction using Risk Management Solution’s model for predicting the frequency and severity of earthquakes in Turkey.
“We are not as familiar with this as we are with the U.S. models,” Josefs said. “[So] we spent more time with the risk analysis and adjusted our stresses accordingly to take this extra uncertainty into account.”
Multilateral Muscle
While this market remains undeveloped in emerging markets, multilateral development banks are keen to see it grow.
“Innovative forms of risk transfer, like catastrophe bonds, can play an important role in increasing resilience and helping recovery from major natural catastrophes,” said Arup Chatterjee, senior financial sector specialist with the Asian Development Bank’s office of regional economic integration.
Chatterjee said the ADB is exploring the possibility of using a guarantee from the bank to backstop catastrophe bonds issued within Asia, while it is looking into ways to advance catastrophe risk financing in the region.
But so far it has not been involved in cat bonds.
The World Bank, on the other hand, has already encouraged this market’s growth. It has done this through its own platform, the MultiCat Program, designed for governments seeking insurance via the capital markets. The program is open to a variety of structures, including the pooling of a variety of risks in more than one region.
So far Mexico has used the program in 2009 and 2012. The issuer in these cases was FONDEN, the Spanish shorthand for Mexico’s Fund for Natural Disasters. FONDEN is a disaster relief agency, as opposed to an insurance pool.
The proceeds are for the agency to tap in the event of a disaster, said Markus Schmutz, head of ILS structuring and origination at Swiss Re Capital Markets, which has led these deals.
The transaction in 2009 was a three-year deal totaling $290 million, and it came onto the market as FONDEN’s 2006 debut in the cat bond market, CatMex, was maturing.
FONDEN has used the MultiCat platform to cover both hurricane and earthquake risks on both coasts.
The deal from last year was a $315-million transaction with three classes: $140 million of Class A notes covering earthquake risk with an 8% coupon; $75 million of Class B notes covering Atlantic hurricane risk with a 7.75% coupon; and $100 million of Class C notes covering Pacific hurricane risk with a 7.5% coupon.
Along with Swiss Re, Goldman Sachs was a co-lead bookrunner and structurer, while Munich Re was a co-lead structurer.
“These transactions provide insurance to Mexico for earthquake and hurricane risk on a parametric basis,” said Michael Bennett, head of derivatives and structured finance at the World Bank Treasury.
He added that an additional way the World Bank supports cat bond issues is by providing putable bonds as collateral.
“Typically the proceeds of cat bonds are invested in liquid assets for collateral purposes, most of the time U.S. Treasuries or other liquid, well-rated assets,” Bennett said. “World Bank putable bonds have been seen as an alternative to these assets, since we are triple-A rated.”
Bennett added that the bank has issued $1 billion worth of this paper for cat bond collateral in the last three years.
Bennett said the World Bank is discussing cat bonds with several countries outside of Mexico, but that there was no immediate pipeline of transactions.
“We believe that cat bonds should be seen as one possible part of a larger disaster risk management framework for a country,” Bennett said. “We consider capital markets based solutions, such as cat bonds, as a product that is most useful for countries once they have developed such a framework and have gained some experience with the insurance market.”
Slim Coverage
But many parts of EM only have scant experience with insurance, and where the market has seen some development, the risk taken on by insurers or other entities is amply covered by reinsurance.
“We think there will be other cat bond deals from emerging markets but such issuances can be limited due to lower insurance risk concentrations in emerging markets and traditional reinsurance is efficient for smaller limits,” said GC Securities’ Anger.
The low level of insured losses in emerging markets suggests that, so far, there is not a pressing need for insurers to find other ways to hedge their risk. As seen in the chart to the right, during 2012 insured losses in regions outside the West have amounted to a fraction of the global total.
Indeed, according to Swiss Re, North America alone accounted for 83.6% of the globe’s insured losses, with Europe holding a 7.1% share. Hurricane Sandy alone, accounting for $35 billion of losses in North America, far outweighed losses for Latin America, Asia, Africa and Oceania/Australia combined.
Even in a giant landmass like Asia, insured losses only reached $3.4 billion in 2012. Yet in terms of victims, the continent dwarfed all other regions, with 7,177 fatalities.
The total cost of disasters in Asia surpassed $30 billion.
The relatively small figure for losses outside the U.S. and Europe is a direct reflection of scant insurance penetration in much of emerging markets.
Swiss Re’s Schmutz said that insurance penetration rates in emerging markets are, on average, tiny when compared to the U.S.
In 2011, an average of $118 per capita was spent on insurance in the emerging markets, versus $3,712 in advanced economies, according to a report from Sigma, a database managed by Swiss Re. Of this amount, $62 was spent on life insurance and $56 on non-life.
All of this points to the unlikelihood that EM will make more than a modest appearance in the current rash of cat bonds. But there are reasons to expect them to play a bigger role further in the future.
One is that penetration rates are tending to converge towards those of more developed markets.
In the less developed regions of Asia, perhaps the region with the most potential as the home of both China and India, estimating potential losses involves a lot of guesswork due to a lack of data, poor risk assessment capabilities, poorly regulated local insurance markets and other reasons, according to ADB’s Chatterje.
He added that while parametric triggers work well for risks like hurricanes and earthquakes, for floods, they are much trickier to devise for floods, which cause immense damage in Asia.
Nonetheless, Chaterjee said a combination of factors point to the growing use of use of catastrophe insurance.
Among them, he added, were “climate change, growing understanding of the value of protection, rising incomes…expanding businesses, and pressure on government budgets.”
What is more, the final investors, the ones who buy the cat bonds, are becoming more and more comfortable with different, and more complex, kinds of risk. In general, issuers in recent months have been able to use more indemnity triggers, which more closely reflect their ultimate losses in a catastrophe.
“There would be plenty of demand,” said Aon Benfield’s Schultz, referring to EM cat bonds. “There just isn’t a great amount of supply.”
With their relatively low correlation to financial markets, investors already see cat bonds as a good diversity play. And particularly for ILS-dedicated funds, EM could be a way to diversify within the segment, as the outstanding supply of deals skews heavily to U.S. wind exposure.
