Throughout 2022, the entire Asia region experienced a seemingly endless series of extreme weather events. These include catastrophic floods in Pakistan, a severe drought in western China, and deadly typhoons in the Philippines. Climate-related disasters cause immense human suffering and huge economic losses. The fear is that as climate change accelerates, Asia will be hit by even more disastrous weather.
“Extreme events are expected to keep increasing in severity and frequency, particularly heavy precipitation-driven flooding,” said Jeremy Waite, Head of APAC Catastrophe Centre of Excellence, Guy Carpenter.
Protection from disaster
The insurance industry has an important role to play in providing solutions that help protect against mounting climate-related risks. With significant assets at risk and rising demand for catastrophe insurance, insurers and reinsurers are increasingly accessing financial markets for additional capital to complement their underwriting capacity.
Catastrophe bonds, also known as CAT bonds, are debt instruments issued mainly by insurance and reinsurance entities that transfer insurance risk to institutional investors. CAT bonds are one of the insurance-linked securities (ILS) that offer investors opportunities to diversify into insurance risks. The principal of a CAT bond is at risk if a defined event occurs – such as a flood or typhoon.
ILS now represent a significant portion of global reinsurance capacity, with close to USD100 billion of so-called alternative capital that complements traditional reinsurance capital and underwrites risks across the world.1 This, however, is a tiny fraction of the global fixed income market, which has bonds outstanding worth USD127 trillion in 20212, suggesting that the transfer of insurance risk to the capital markets is still at an early stage and there is plenty of room to grow.
CAT bonds are bought by a diverse group of institutional investors – from hedge funds to pension schemes. In addition to attractive yields, these bonds are favoured due to the low levels of correlation to other asset classes. This is because the returns of a CAT bond are determined by risks related to the insured event, usually a natural disaster, and are therefore can be expected to be independent of capital market activity and the broader market environment.
“Investors like the fact that events in the capital market, such as a stock market crash, do not cause a hurricane or earthquake to occur,” said Janet Li, Partner and Wealth Business Leader, Asia, Mercer. “We now have nearly three decades of data demonstrating the low correlation of ILS performance to traditional financial instruments and showing that ILS have delivered good diversification under most market conditions.”
A landmark in reinsurance
The ILS market is still nascent in Hong Kong. A landmark CAT bond deal in the summer of 2022 not only highlights the city’s ability to raise capital across a broader range of financial instruments, but also its growing role as a centre for risk management.
In June, Peak Reinsurance Company (Peak Re) issued a USD150 million CAT bond via its newly created special purpose insurer Black Kite Re. This is to date the largest CAT bond issued in Hong Kong and the city’s first 144A CAT bond issuance.
“We believe there is strong interest among Asian investors for CAT bonds. This was validated by our ability to double the size of the issuance from the initial announced guidance,” said Franz-Josef Hahn, Chief Executive Office of Peak Re – a Hong Kong-based reinsurance company that has established a global footprint in the decade since it was established.
Dedicated ILS funds, traditional asset managers, pension funds, as well as insurers and reinsurers all participated in the deal.
In addition to investor demand, Hong Kong’s conducive regulatory environment was a key factor in persuading Peak Re to pick Hong Kong as the venue for its first CAT bond issuance. In March 2021, new rules came into effect that govern the trading of ILS in the city. There is also a pilot scheme that offers up to HKD12 million of subsidies to help cover the costs of ILS issuance.
“We found the Hong Kong special purpose insurer application transparent and straightforward, and that the Hong Kong Insurance Authority team was highly professional and pragmatic in their approach,” said Mr. Hahn.
A future in risk management
The development of a local CAT bond market will strengthen Hong Kong’s status as Asia’s leading risk management hub, highlighting the city’s capabilities in pricing, transferring and financing risk. Other factors that prime the city for success include: a large number of insurers and reinsurers that have global or regional headquarters in Hong Kong, a vibrant InsurTech sector, the presence of different intermediaries - such as insurance brokers, and a forward-looking regulator.
A CAT bond market, as well as the broader development of the local insurance and reinsurance sector, will also assist Hong Kong in realising its goal to lead the world in sustainable finance. The increasing frequency and severity of natural catastrophes is putting increasing pressure on individuals, societies, and governments. While insurance on its own cannot solve the issue of climate change, it does provide important tools to promote resilience, by helping people quickly recover from disasters.
“CAT bonds can provide institutional investors with the opportunity for an attractive, uncorrelated return while at the same time giving insurers a tool to deal with natural disasters including climate change,” said Mercer’s Ms. Li.
1Gallagher Re, Reinsurance market report.
2SIFMA, Capital Markets Fact Book