With Hurricane Irma expected to make landfall in Florida sometime on Sunday according to the latest NHC forecast, investor attention is shifting to Catastrophe Bonds, which at least in some cases already, have lost as much as 50% of value in the past few days.
For those unfamiliar, Catastrophe bonds (or CAT bonds) are a major category in the security class known as insurance-linked securities or ILS. Their purpose is to securitize, or crowd-source in the parlance of our times, reinsurance coverage, in order to reduce reinsurers’, insurers’, and self-insurers’ reserve requirements and reduce their cost of coverage. At the same time they are attractive to investors, because the risks they cover are virtually uncorrelated with other risks such as equity market risk, interest rate risk, and credit risk, and effectively offer a "prop bet" on catastrophic events taking place over a given time horizon, usually three years.
Catastrophe bonds - which are typically used by insurers as an alternative to traditional catastrophe reinsurance - emerged from the need by insurance companies to alleviate some of the risks they would face if a major catastrophe occurred, which would incur damages that they could not cover by the premiums. An insurance company issues CAT bonds through an investment bank, which are then sold to investors. These inherently risky bonds are usually rated BB, and have maturities less than 3 years. If no catastrophe occurs, the insurance company pays a coupon to the investors. However, if a catastrophe does occur, then the principal would be shaprly reduced or forgiven and the insurance company would use this money to pay their claim-holders. Traditional investors in CAT bonds include hedge funds, catastrophe-oriented funds, and various other return starved asset managers.
The bonds are often structured as floating-rate bonds whose principal is lost if specified trigger conditions are met. If triggered the principal is paid to the sponsor; the triggers are usually linked to major natural catastrophes such as a hurricane.
Exhibit 1 shows the structure of a CAT bond transaction. The special purpose vehicle (SPV) is necessary because otherwise investors would be directly offering insurance to the issuer, which they could not do without receiving regulatory authority – a license – to assume risk under a contract of insurance. The SPV is therefore also sometimes called a “transformer” because by being licensed itself to sell insurance, it transforms the investment of funds by the investors into a sale of insurance. When domiciled in an offshore location such as Bermuda or the Cayman Islands, it also provides ease of licensing and simplified and often lowered tax requirements.
An example of a typical structure from the General Accounting Office: an insurer who has built up a portfolio of risks by insuring properties in Florida (appropriate at the moment), might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of LIBOR plus a spread, generally (but not always) between 3 and 20%. If no hurricane hit Florida, then the investors would make a positive return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially contributed by the investors would be transferred to the sponsor to pay its claims to policyholders. The bond would technically be in default and be a loss to investors
In short: a CAT bond is vaguely comparable to selling volatility (aka collecting pennies in front of a steamroller): collect a modest IRR if all works out according to plan, or suffer up to a total loss if, well, a catastrophe occurs.
And for a whole lot of CAT investors, it now appears almost certain that a major catastrophe is about to take place in Florida where "monster" Hurricane Irma is set to make landfall over the weekend.
As a result, a number of secondary catastrophe bond trades took place yesterday, of which Citrus Re Ltd. (Series 2017-1) was the most glaring, leading prices lower by as much as 50%, in effect discounting 50% on the possibility of an Irma loss for sponsor Heritage.
For the back story on the Citrus Re bonds, we go to Artemis.bm which writes that Heritage Property and Casualty Insurance sponsored the Citrus Re 2017-1 catastrophe bond in March this year, securing $125 million of U.S. named storm and hurricane protection. Heritage has its highest concentration of risk in the Florida peninsula, where hurricane Irma is on track for, and is a heavy user of collateralised reinsurance products including catastrophe bonds, so is likely seen as one of the primary insurers at most risk of losses.
It wasn't just the CAT bonds that took a pounding: as we discussed yesterday, Heritage’s share price fell almost 17% yesterday following a Barclays report projecting record losses for Reinsurers as a result of Irma, and reflecting market expectations that the insurer is particularly exposed to the hurricane. Well, catastrophe bond investors clearly agree and and Tuesday 5th September the above mentioned bonds plummeted, when one investor sold $1 million of the notes at a price of 50, down from the previous secondary trade price (according to Trace) of 100.55.
Some additional details from Artemis: the Citrus Re 2017-1 cat bond notes have an attachment point at $40 million of losses and cover $125 million of Heritage’s losses up to an exhaustion point of $165 million, which gives an attachment probability of 5.33% and an expected loss of 3.08%. The notes sit on top of reinsurance arrangements that Heritage has in place, so these would need to be eroded before the cat bond comes into play.
What is notable is that other Citrus Re catastrophe bonds (so Citrus Re Ltd. (Series 2017-2), Citrus Re Ltd. (Series 2016-1) and Citrus Re Ltd. (Series 2015-1), all sit beneath the 2017-1 deal so are at greater risk of loss. All of these are per-occurrence bonds.
So, as Artemis notes, it looks like the Citrus Re 2017 trade at 50 was a case of an investor wanting to avoid being caught with a potentially exposed position in their portfolio, rather than this being the riskiest bond in the market based on hurricane Irma’s threat.
Other names are similarly exposed: a Galilei Re Ltd. (Series 2016-1) Class E-1 trade was seen at 95, a cat bond that had previously been priced at 100 or greater. This could be as sponsor XL Group has one of the highest PML’s for a Florida wind event, but again this looks like one investor offloading any potentially exposed bonds as there are other tranches of Galilei Re notes which have a higher expected loss.
Expect dumping of CAT names to pick up: while selling activity was relatively brisk on Friday and Monday, it slowed down on Tuesday reflecting the uncertainty that remains in the hurricane Irma forecast, with many believing it’s still too early to predict specific cat bond losses. Of course, a worst case scenario would imply that complete losses on principal are quite realistic.
Activity will likely pick up as certainty increases, especially now that Florida landfall over the weekend appears guaranteed.
A list of representative CAT bond deals issued YTD is shown below, courtesy of the latest Swiss Re ILS market update:
A list of the Top 25 issuers of CAT bonds and ILS outstanding by sponsor is shown below courtesy of Artemis:
But more interesting than the sellers of CAT bonds - after all they will suffer zero losses upon "defaulting" on a trigger event - are the buyers: those who bet that the most powerful hurricane in Atlantic history would not hit Florida over the next few days. It is here that the losses will be most concentrated; and within the universe, one particular name emerges more frequently than any other: that of Stone Ridge, and its various Reinsurance Funds, most notably the aptly named "High Yield Reinsurance Risk Premium Fund."
How long after Irma strikes, we wonder, until Stone Ridge issues a "force majeur" announcement that it is gating investors for the greater good... and how many others will follow?