Cat bonds have a short but strong record on claims payments

22-09-2016

Cat bonds have a short but strong record on claims payments

Gustavo Frazao / Shutterstock.com

Cat bonds might not have a long history, but so far they have paid out on claims from major events in a timely manner, according to Maren Josefs, associate director at S&P Global Ratings.

Over the past 20 years, cat bonds have made significant inroads into the reinsurance business. They offer longer-term protection to cedants, thereby reducing pricing uncertainty, and because the coverage is collateralised, mitigated counterparty exposure. The influx of cat bonds and other alternative capital in recent years has contributed to the significant decreases in catastrophe re/insurance pricing.

As reinsurers have sought to defend their positions in the industry from these relatively new competitors, many have claimed that cat bond issuers haven’t established a track record of paying claims after major events and that the bonds can’t be relied on in the same way that a relationship with a reinsurer can. Another claim is that the lack of relationship between the protection buyer and the cat bond investors could encourage the cat bond investors to contest legitimate claims following an event. The argument from the traditional reinsurers, in essence, is that protection buyers should view the reinsurance industry’s practice of paying claims to maintain relationships as favourable to relatively untested cat bonds.

We saw no evidence that cat bonds lack the ability or willingness to pay claims in a timely manner, which is a strong track record for a market that has been around for only 20 yearsSo is there any truth to the claims? To test the industry’s concerns, we identified 13 cat bond issues that made claims payments following the occurrence of covered events ranging from 1997 to 2015. Except for one case where the loss payment was dragged out by the reinsured, we saw no evidence that cat bonds lack the ability or willingness to pay claims in a timely manner, which is a strong track record for a market that has been around for only 20 years. Although one could argue that the market has not yet seen a major event that would trigger claims under multiple cat bonds, our investigation shows that there have been plenty of covered events, and cat bonds have demonstrated their ability and willingness to pay protection buyers.

When a cedant is looking to purchase reinsurance, arguably the most important considerations are whether the protection provider is willing and able to pay a claim, and whether they will do so in a timely fashion. A cat bond's ability to pay claims depends almost entirely on the quality of the assets in the collateral trust because the contractual obligations toward the cedant are fully collateralised. If the quality of the assets were to deteriorate, the cat bond's ability to pay would deteriorate too.

In our view, cat bonds have a comparative advantage when it comes to willingness to pay. The wording of the contract removes the issuer's discretion regarding whether to pay claims; instead, the loss calculation procedures are written into the transaction documents and performed by third parties. There are cases where investors may challenge which policies an indemnity cat bond covers, which may cause the ultimate payout to be delayed, but there is generally very little uncertainty as to the amount of the loss payment the cedant should receive following an event.

When you compare this process for calculating loss payments with that of traditional reinsurers, we see greater potential for contract uncertainty and disputed claims in traditional reinsurance due to the practice of underwriting risks tailored to specific clients, sometimes without agreeing detailed documentation until after the policy’s creation. Due to the contract uncertainty, the relationship issue becomes more important for reinsurers.

For both re/insurance contracts and cat bonds, the timeliness of payments is largely linked to the type and terms and conditions of the policy or bond. After looking into the payment record of the cat bonds, we would expect those with parametric triggers to pay the fastest, followed by industry loss triggers, and finally by indemnity triggers.

The cat bond industry has grown rapidly over the past 20 years, and has withstood some of the worst catastrophe loss years on record, including 2004, 2005, and 2011. Although the cat bond market has not had a significant test of its claims-paying ability, such as multiple bonds triggering in one year, there have been numerous triggering events around the globe over this period, and these have demonstrated the market's strong claims-paying track record. We consider that the quality of the collateral and the contract certainty provides buyers with comfort that claims will be paid after the next major event, and that timeliness of payment will be similar to payments from traditional reinsurers.

Cat bonds can provide a diversified source of protection and continue to help the industry to offload catastrophe risk to the capital markets, thereby strengthening the industry's overall ability to withstand any major losses in the future.

 

claims, catastrophe, bonds, record, timely, payments, major, loss, reinsurers, market, traditional

Intelligent Insurer