The increased popularity of cat bonds in recent times has been the subject of much debate and coverage and so outsiders to the insurance industry could be forgiven for assuming that these securities are a new phenomenon.
Instead, when viewed in the context of regulatory change, coupled with the needs of the international insurance and capital markets, one will see cat bonds not as an overnight success, but the result of an evolution that was decades in the making.
In recent times, the rise of insurance-linked securities (ILS) (measured by number and value of issuances) owes much to the fact that they are a means by which insurance risk is transferred by insurers to the capital markets.
This convergence of the insurance and capital markets first began to gather momentum in the aftermath of the financial crisis of 2008/2009. However, the insurance industry was only able to satisfy the appetite of the capital markets because the seeds of this potential investment opportunity had been planted years in advance.
In fact, cat bonds had been around since the 1990s, when they were developed by the property and casualty insurance industry as a result of Hurricane Andrew and the Northridge earthquake.
In the years that followed the first cat bonds, laws and regulations were enacted to facilitate the insurance industry’s ability to meet the growing demand for catbonds.
A primary example of this development is the introduction in 2009 of a new class of insurer: the Bermuda special purpose insurer. A key facet of the Bermuda insurer is that it must be fully funded, and therefore perpetually solvent.
The fully-funded nature of the Bermuda special purpose insurer gives comfort to cedants and sponsors (who benefit from a purpose-built insurer with an impeccable credit rating), while affording investors an opportunity to diversify their portfolios by investing in instruments (e.g., cat bonds) that offered attractive returns (measured against other low-risk investments) that are uncorrelated with the risks associated with other asset classes.