On one quake-based catastrophe bond on the Asian side of the Pacific Rim, the sticking point was where an earthquake ended and a tsunami began. Claude Brown, partner in Reed Smith’s structured finance team, said there was a long discussion over when a tsunami became a land-based quake, because the deal had to pin down exactly what damage it covered. On a precipitation trigger, the line can be just three millimetres.
Precision matters all the more given where cat bonds sit, as long-tail cover behind reinsurance and retrocession, and Brown is not sure the whole market understands that. “You’re in a one to four percent tail. What that means is when that event comes along, it’s pretty spectacular on the loss.”
Whether that loss reaches investors comes down to triggers and exclusions. Weather-based bonds tend to define their geographic cover and triggers precisely rather than lean on exclusions, Brown said, but exclusions multiply as products move into other perils. That wording sits behind some of the reinsurance brokers’ clients depend on.
Where a disaster strikes matters just as much. The flash floods that struck Nepal and Tibet in August caused huge loss of life and damage but hit underinsured regions, so the losses never reached the bonds. “If you had that equivalent event, say in Florida, you’d be in billions of loss,” Brown said. Cat bond losses start to show where dense populations, high incomes and high-value property meet, because that is where insurers write much of their risk.
The real test is a severe event somewhere expensive. A major earthquake on the San Andreas Fault would have a profound impact on the quake cat bond market, Brown said. Whether it would inflict massive losses across the whole market is an open question, since hurricane exposure on the US East Coast or quake and typhoon risk in the Philippines would not necessarily be hit in the same way. A severe volcanic eruption in Italy or a huge hurricane would pose a similar test.
Some exposures are new. When a hurricane came in on Florida’s west coast two years ago, Brown was evacuated, and residents had to move electric vehicles out of garages and into parking structures above the flood level, because saltwater and lithium batteries are a volatile mix. A street of EVs catching fire at once, he said, would produce a very different result than historic hurricane flood damage.
When a severe event comes, investors feel it in their principal, which Brown thinks newcomers would miss. It is a key reason he does not expect retail investors to get access to cat bonds any time soon. The products are complex, he said, with a prospectus setting out how each bond is modelled, where the triggers sit and what happens when they are hit.
“The retail market would look at a double-digit coupon and look at the history of losses and miss the fact that running yield not only is coupon, it’s also principal,” he said. In an extreme case, losing 20% or 30% of principal would quickly make that yield look unhealthy. Most investors buy to hold, and Brown warned the secondary market could become very difficult to sell into if two or three cataclysmic events converged.
Professional buyers need specialist help too. Brown reviews the disclosure for some investors but leaves the modelling to teams with “more degrees between them than a protractor”, and he questions whether every UCITS holding cat bonds has that sophistication. Even buyers of catastrophe cover at sovereign level, he said, have been caught out.
Disasters also tend to arrive together. “Rarely is it the case that one catastrophe arrives on its own,” Brown said, pointing to floods followed by migration and then famine. Bonds built around one peril can behave unexpectedly once others are folded in.
The World Bank’s pandemic bonds, which Brown reviewed for an investor, show how. The bank sold $320m of the bonds through its Pandemic Emergency Financing Facility, which Brown said was primarily meant to provide surge funding for Ebola. The structure also covered other diseases, including coronaviruses. The bonds did not pay out during the long-running Ebola outbreak in the Democratic Republic of Congo, but COVID-19 triggered them in 2020. Class A holders lost a sixth of their principal, the most the structure allowed for a coronavirus outbreak, while Class B holders, whose notes also covered Ebola, lost all of it. The $195.84m payout, from the bonds and accompanying swaps, went to 64 countries. For an investor who bought in on Ebola, principal went to a different disease folded into the same bond.
When a severe loss does land in a heavily insured region, those trigger definitions, as much as the size of the event, will decide how much the capital at the back of the reinsurance chain absorbs and how much stays with the layers in front of it.
