Cat bonds and ILS are a fundamentally ESG-oriented investment

As long-time investors in catastrophe bonds (or cat bonds) and insurance-linked securities (ILS) portfolios, we are seeing by their very nature how these specialized investments can help actively promote environmental, social and governance considerations.

ILS are used by insurers and reinsurers as an economically attractive alternative to traditional reinsurance. With these instruments, investors put up collateral through the securitization and share in a portion of the reinsurance risk in exchange for an opportunity to earn premium income.

Cat bonds are a specific segment of ILS structured as floating rate 144A bonds to mostly transfer reinsurance risk associated with natural peril events that are remotely occurring but highly costly for the insurance markets. These may include hurricanes, earthquakes and other weather-related disasters that strike major cities, regions, or countries. These uncorrelated and diversifying investments further support the potential capital required of re/insurers to cover losses so that rebuilding can occur for those impacted by the events.

We believe there are a variety of key factors in cat bonds/ILS to consider from an investment standpoint that speak to an ESG mindset, including:

• Climate change trends now filter into the modeling and pricing of cat bond and insurance-linked securities.  This evolution gives investors opportunities to positively influence the behavior of insured parties, who must be increasingly cognizant of their climate footprint.
• The ILS market’s function of valuing of re/insurer underwriting policies fosters further alignment of re/insurer business models to ESG policies and practices.
• The role that ILS investors can play in helping re/insurers addresses the “protection gap”, the difference between insured losses and actual economic losses. The ability to close the protection gap could allow re/insurers to better allocate more insured capital in ESG-sensitive ways relative to economic loss, such as from potential weather-related damages that could increase in frequency or severity. 

Below we discuss some of the various elements of cat bonds/ILS and how the asset class can inherently promote ESG within each component of the framework.

Environmental

The cat bond/ILS market is a price indicator of climate risk and can serve as a market-enforcement mechanism that encourages better management of climate risk.

A large constituent of insurance-linked securities can play a role in how re/insurance address the impacts of climate change because trends such as rising temperatures and sea levels result in increased frequency and severity of the hazards created by hurricanes, tornados, winter storms, hail, and flooding. The insurance underwritten to help communities and economies deal with these events is priced according to the level of risk and modeling assumptions from weather and insured loss-based data. The greater the level of exposure that a community or property seeking insurance has to these risks, the higher the premiums for their insurance will be, potentially impacting capital levels available to protect these communities.

If a community or property has taken steps to manage or mitigate these hazards – through steps such as better engineering of structures or placing buildings and structures in locations with sustainability-based development plans – they will be rewarded with lower premiums. Alternatively, communities and properties will be penalized with higher premiums if they have not pursued sustainable development strategies that are geared toward handling the impacts of climate change. 

We believe that cat bond/ILS investors can be a market force to encourage more environmentally conscious development.  We also believe that this market force will grow as the cat bond/ILS market further expands.  In the last 10 years, the ILS market has grown rapidly to encompass approximately 20% of the global reinsurance market.  This expansion by ILS will continue as more re/insurers utilize reinsurance securitization as a viable alternative to traditional reinsurance.

Social 

The cat bond/ILS market promotes social and economic welfare.

Disasters such as hurricanes and earthquakes can wreak physical, social and economic havoc on a community. Cat bonds/ILS can help provide additional capital that ultimately goes to policyholders and enables communities to rebuild and helps people regain the standard of living they had before the disaster hit.

Twenty-five years ago, global reinsurance firms were the only providers of insurance that communities could rely on to address damages incurred beyond the amounts covered by their initial, primary insurance. Hurricanes Katrina and Harvey, as well Japan’s Tohoku earthquake, demonstrated the importance cat bonds/ILS can play in the ecosystem of insurance markets by providing an additional source of funding necessary to help people and communities rebound from a devastating event. 

The growth of the cat bond/ILS market has enabled the creation of public insurance pools, whereby local government entities and sovereign nations – mostly in developing markets – can transfer re/insurance risks to the capital markets. 

Developing countries such as Philippines and Columbia also issue catastrophe bonds through the World Bank that enable them to get disaster recovery capital and mitigate the setbacks to growth and economic development that a catastrophic event could create. In the case of Philippines, for example, catastrophe bonds are helping to lessen the impact of typhoons on the country’s economic output. 

Similarly, Mexico received a payout from a catastrophe bond issued by the World Bank after an earthquake in 2017. That money helped finance the reconstruction and rehabilitation of housing and public infrastructure in areas affected by the quake. 

Additionally, in Mexico several groups have come together to form a trust that purchased the first coral reef insurance policy to help support the rebuilding of coastal ecosystems following damage from hurricanes or severe storms. While this isn’t specific to cat bond/ILS currently, it is a potential first step in a new coverage market for the insurance industry. Third-party investors could eventually participate as new re/insurance programs expand to include such policies underwritten to help with protection for natural defense barriers relative to weather events across various regions or ecosystems.

In the United States, state-run pools in Florida, Texas, and California, to name a few, have been regularly issuing insurance-linked securities for as long as 10 years to provide insurance to communities that couldn’t obtain it in the private markets.

Governance

Many of the cat-bond/ILS instruments offer disaster-risk financing that is transparent and efficient.

A key feature of insurance-linked securities is that they have a quick and efficient mechanism for issuing payouts once an event triggers the insurance protection. These triggers are based on fully transparent measures, such as the scale of an event or losses exceeding a specific dollar amount. This design is deliberate and provides timely payouts in the wake of a disaster when the money is most critically needed. 

The World Bank has implemented these types of triggers successfully when partnering with developing nations to issue cat bond protection against impact from major hurricane, earthquake and pandemic-related events. In the current COVID-19 pandemic, two World Bank-sponsored bonds helped to provide financing to a handful of emerging markets in support of their efforts to handle the current crisis. 

These mechanisms are a vast improvement over the traditional governance of payments from private insurance markets, government, and non-governmental organizations, as those payments were not always issued in a sufficient and timely manner.

ESG factors in our cat bond/ILS investment process

Our investment process is two-pronged in that we combine quantitative and fundamental analysis in portfolio construction and security selection. 

In our quantitative process, we employ modeling techniques where we use datasets with different sea surface temperature assumptions – normal and warm - to evaluate how climate impacts are being viewed by underwriting sponsors. We will decompose and remodel the underlying components and methodologies to determine the quality of a deal structure relative to the potential implications reflected by the different data sets. Additionally, our analytics engine can factor in other research from weather, seismology and actuarial science that identify climate- and expected-loss-related factors that can also reflect ESG consequences within our model-view universe. 

At the fundamental analysis level, we also conduct in-depth analysis of the underwriting quality of a re/insurer’s offering. We’ll evaluate key characteristics that can include how they define event losses and the quality of the data used to assess risk. We also look at the re/insurers, by assessing their ratings and reputation for managing their portfolio or risk. We examine how they consider and integrate ESG into their own coverage models. The goal is to examine all idiosyncratic and economic factors that motivate issuers to cede various risks. Evaluating how they address or influence ESG concerns is part of this analysis.

ESG as a foundational principle for these investments

The insurance upon which these securities are based is designed to provide additional sources of capital to help the broader societal goal of helping countries and communities recover from disastrous events, thereby creating a category of investments with ESG goals as a foundational principle. 

Overall, climate change, health funding, food supply issues and compromised infrastructure can all magnify the severity of economic losses suffered by communities and nations. The result can further widen the “protection gap” as economic losses suffered from major events such as hurricanes, droughts, and pandemics cannot be adequately covered by re/insurance capital alone. 

Today, the presence of cat bond/ILS investors in this market helps provide a critical influx of capital to boost re/insurance capacity and increase the speed of access to capital. These beneficial results provide the insurers with more flexibility to address protection gaps. Closing these protection gaps is a key component of insurers’ ability to build out more resilient ESG-oriented programs. 

Our process in action: Evaluating bonds that provide hurricane, earthquake protection in Latin America

Our investment process involves evaluating a broad range of peril risks, many of which have an ESG theme. Examples include the World Bank-sponsored catastrophe bonds that enable governments in Latin and South America to secure disaster recovery insurance against earthquakes. In February 2018, the World Bank issued sustainable development bonds to collectively provide over USD $1.3 billion of earthquake protection for Chile, Columbia, Mexico and Peru. The issuance was divided into classes in which each bond supported a country’s exposure to earthquakes occurring in their region.

Our quantitative and fundamental analysis focused on determining how each of these bonds could serve to potentially improve our strategies based on a risk-adjusted return basis.