Cat bond market shouldn’t give “free-ride” to secondary perils: Tenax

The catastrophe bond market needs to price appropriately for so-called secondary perils and stop giving them a “free-ride”, as there is a need to continue offering this type of typically frequency or aggregate style reinsurance protection, but investors must be adequately compensated for it, Tenax Capital has said.

“For insurance to fulfil its social mandate and to help close the protection gap, secondary perils must remain within the scope of coverage all along the value chain,” Tenax Capital, the London based hedge fund investment manager that operates a catastrophe bond strategy rightly explained recently.

But the investment manager also stated, “At the same time, they need to be structured both to maximise capacity and to adequately remunerate investors.”

It’s good to see a cat bond fund manager explaining the need for the market to provide the coverage cedents need, while also reminding those potential sponsors that investors expect to be compensated for taking on the type of frequency exposure that secondary perils can present.

While the reinsurance and insurance-linked securities (ILS) market has shied away from secondary perils over the last couple of years, the need for this coverage is just as apparent today.

Severe convective storms and weather losses have reached new highs in the United States, with around $60 billion in losses estimated to have fallen to the insurance market.

Tenax Capital said that part of making these more appealing to investors, so the cat bond and ILS market can provide reinsurance capital to support them again, is improving risk models.

“The crux of the matter is risk selection. Cat bond investors and underwriters understand that there is not much they can do to influence the loss outcome when a peak peril zone is struck by a major storm, irrespective of the underlying risk quality and selection. Yet, the same doesn’t hold true for losses stemming from secondary perils such as hail, tornadoes, and non-named storms,” Tenax explained.

Adding, “There’s no denying that modelling natural catastrophes poses a significant challenge. When there are cat bonds covering all natural perils (ANP) with an expected loss inside 1% and a mid-double-digit issuance spread, alarm bells should start ringing. We certainly don’t believe that cat bond pricing should be as simple as a spread over an expected loss, but it looks clear to us that the best proxy for a cat bond’s risk profile is the spread where it trades, more than the probabilistic indications of risk models. The disconnect between modelled risk probabilities and bond spreads, especially where secondary perils are involved, indicates that models have room for improvement.”

The Tenax ILS investment team analysed catastrophe bond issues and found that, the market does demand a higher premium to hold secondary perils, compared to a named storm only exposure.

Also notable is the fact they found here there does not appear to be a significant difference between aggregate and per-occurrence cat bond structures, in that respect.

As the contribution of secondary perils increase, in an aggregate structure, a more defined divergence becomes notable, they said, reflecting the nature of higher frequency associated with these perils, which can potentially be more harmful for aggregate cat bonds.

The findings are in-line with what the Tenax ILS team were anticipating, but they note that the question that needs to be asked is, “whether this is enough to compensate for the rising risk posed by non-peak perils.”

“We think the answer is not yet, and we fear this can hinder the market to grow at full potential,” they state.

The Tenax team see a risk that secondary peril loss trends could deter investors, even though the cat bond market is so attractive to invest in right now.

But still, the social purpose of insurance and reinsurance is to cover exposures like this, just the capital needs adequately compensating in order to put itself at risk.

Tenax Capital provides some proposed ways that the catastrophe bond market could structure coverage, so that secondary perils can remain and grow as an important feature of the market.

First, having dedicated non-peak perils classes of notes, which would mean giving investors the option to focus on the peak perils, or take on the secondary and frequency exposure.

On this Tenax said, “Pricing will more accurately reflect the risks, avoiding the “free-ride” that secondary perils have taken. Investors with more conservative and risk-averse strategies can maximize their participation in the peak-peril class without passing on the whole deal. Other investors, and perhaps even new, non-dedicated ILS capital, might see the case to invest at a likely +20% yield, adding diversification to their multi-asset portfolios. Overall, investors would be better off as they could structure their portfolios more tailor-made. Issuers may not achieve the same level of pricing compared to the all-in solution, but they would broaden the available capacity. ”

In addition, event caps and deductibles need to become the norm in the cat bond market, Tenax said, with a “defined maximum event loss contribution” a feature of cat bonds that cover secondary perils, to better protect investors from the kind of attritional losses that should fall to the working layers of reinsurance.

Inflation variability and volatility should also be considered, Tenax said, calling for better granularity around which factors are being applied, and where, as this would benefit investors in catastrophe bonds, the manager explained.

“After years of low inflation and low inflation volatility, we have now experienced several quarters of reversal in both trends. This can influence the development of claims and ultimately the net loss an investor would suffer. As the inflation regime has changed, so should the way inflation is embedded in cat bond structures,” the Tenax ILS team said.

Finally, the Tenax team also call for improvements to cat bond offering documentation, with better transparency of risk coding to help investors make more informed decisions, particularly around elements like construction quality, which they say is often omitted for cat bond investors, although included in traditional reinsurance submissions.

This is a timely call for the catastrophe bond market to carefully assess how coverage for secondary perils can be offered, as these are perils that traditional cedents are currently retaining much of the loss from and so there is a clear opportunity to innovate on structuring to return at least some coverage and begin to narrow what has become a reinsurance protection gap.

As ever, risk must be priced for and secondary perils had been almost given away for too long.

Now, the market has retrenched up and away from frequency exposure, but some work can be done to provide a more sustainable way to deliver on the reinsurance and retrocession protection that cedents are crying out for today.

Of course, this requires cedents to find pricing worth paying for the coverage and that is where the most work needs to be done, in defining products and structures that offer useful reinsurance protection at a price that is still affordable.