Liquid Alternatives: Insurance-Linked Securities Attractive Amid Covid-19 Economy

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The Covid-19 crisis has brought the uncorrelated nature of catastrophe (Cat) bonds and insurance-linked securities (ILS) into sharp focus.

S&P Global Ratings said in a recent report that the COVID-19 pandemic had “showcased” the value of publicly traded catastrophe bonds (cat bonds) to investors. The bonds formed a liquid asset class that was not correlated with the current volatile financial markets.

Cat bonds as liquid alternatives, post-COVID

Catastrophe bonds are the most prominent and common type of insurance-linked securities. They are also a very liquid asset because they can be cashed in very easily. That’s because they have an active secondary market that is very efficient even though it is OTC.

This advantage of liquidity is especially attractive to institutions, particularly pension funds, who are often locked into longer-term private investments. Typically, they would hesitate to liquidate these investments at times of market volatility, which unfortunately, is likely to be a continuing problem given the economic uncertainty from the pandemic.

In the current situation, therefore, institutions such as pension funds may like to earmark funds in a liquid alternative strategy such as cat bonds. These offer a healthy balance between cash and long term investments in private markets.

In S&P’s view, therefore, cat bonds are likely to see rising demand from institutional investors, particularly when lockdowns are being lifted across the globe and a semblance of economic normalcy appears to be returning.

This rising demand is likely to be satisfied by a healthy issuance pipeline of new issuances this year when a large number of catastrophe bonds are scheduled to mature.

Other attractive features of cat bonds

Institutions may be attracted by the other plus points of catastrophe bonds:

  • A healthy and deep market
  • Not exposed to pandemic risks
  • Not exposed to commercial and business interruption risks (unlike some other ILS strategies)
  • Transparent triggers in the eventuality of a payout
  • Most catastrophe bonds are geographically specific, allowing an investor to spread risk
  • Prospect of higher returns because of recent years of catastrophe losses

Rising cat bond rates

For example, there was strong demand for Allstate’s (NYSE: ALL) Sanders Re II Ltd. (Series 2020-2) cat bond deal featuring $200 million of notes (size increased as a result from $150 million) dated May 2020. The notes have an initial expected loss of 0.61% and pricing has been fixed at the top-end of guidance, at 5.5%.

The transaction replaces the $200 million Sanders Re 2017-2 issuance, which had an initial expected loss of 0.73% and priced with a coupon of 3.25%.

Clearly, Allstate is paying a much higher rate of return to cat bond investors for the new coverage.

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May 21, 2020

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