Solvency reform could boost cat bond value for schemes

Catastrophe bonds are insurance-linked securities that allow insurers to hedge the risks of costly natural disasters to the capital markets. They have attracted pension funds looking for an uncorrelated source of returns.

“In general we’ve seen a rise in popularity,” said Tim van Duren, product manager for insurance-linked securities at asset manager Schroders.

Yields on catastrophe bonds have fallen as they have been growing in popularity, leading many funds to look to more diversified funds in the hope of gaining wider exposure, said van Duren.

Falling yields may be tempered by the introduction of Solvency II. Inflated capital requirements may cause insurers to transfer risk to investors, leading to increased issuance of insurance-linked instruments.

“The transfer of risk to the capital market is only just beginning,” said Adam Michaels, partner at consultant LCP.

Solvency II is a European directive requiring insurance companies to ensure they hold enough capital to cover all claims they are likely to receive. It comes into force in January 2016.

“When these get popular that can often bid up prices,” said Michaels. “We take comfort from the fact that Solvency II will drive supply to meet increased demands.”

As insurance-linked securities have grown in popularity, the way they have been fit into asset allocations has changed, said van Duren.

“More often, insurance-linked securities are being seen as an alternative to fixed income, whereas before it was seen as an alternative,” he said.

However, the unique characteristics of insurance-linked securities can make it difficult for investors and consultants to know how to use them.

“We’re continually debating [how to approach insurance-linked securities],” said Mette Charles, senior investment research consultant at Aon Hewitt. “It’s a balance between looking at the return and the lower correlation and diversification.”

“We have it classed as fixed income, but we do have hedge fund analysts looking at it,” she added.

Insurance-linked securities are increasingly used by investors looking to diversify away from government bonds, as investors look for investments that will not suffer in the event of financial downturn, said Michaels.

“One thing that’s attractive is that pension funds are looking to diversify and now they’re looking for different types of asset,” he said.

“Property and hedge funds are popular but are still financial assets and are still correlated. This is an instrument with returns driven by wind events or earthquakes.”