The Impact of the Financial Crisis and Natural Catastrophes on CAT Bonds

• Date: 01 September 2016
• DOI: http://doi.org/10.1111/jori.12057
• Published date: 01 September 2016

©2014 The Journal of Risk and Insurance. Vol.83, No. 3, 579–612 (2016).

DOI: 10.1111/jori.12057

The Impact of the Financial Crisis and Natural

Catastrophes on CAT Bonds

Marc G ¨

urtler

Martin Hibbeln

Christine Winkelvos

Abstract

This article employs secondary market data to examine how natural catas-

trophes or financial crises affect CATbond premiums. We find evidence that

both the financial crisis and Hurricane Katrina significantly affected CAT

bond premiums. The premium increase resulting from natural catastrophes

can primarily be attributed to an increased coefficient of expected loss calcu-

lated by catastrophe modeling companies. Furthermore, our results indicate

a positive relationship between corporate spreads and CATbond premiums.

Thus, CATbonds should not be regarded as “zero-beta” securities. Moreover,

our results indicate that deal complexity, ratings, and the reinsurance cycle

are significant drivers of CAT bond premiums.

Introduction

In recent decades, severe natural catastrophes have led to a substantial increase in

insured losses. This increase has caused the problem of insufficient traditional rein-

surance due to a shortage of capacity.Several alternative instruments have been devel-

oped to remedy the capacity shortage in reinsurance markets (Cummins and Weiss,

2009), with CAT bonds being of particular importance. These bonds transfer the risk

of catastrophe for a defined event, such as a certain natural catastrophe in a certain

region, from a sponsor to investors. The sponsor pays a premium for this protection,

while investors in CAT bonds receive coupons and the principal payment if no event

falling under the trigger mechanism leads to the default of the bond.1In 2011, the total

risk capital of CAT bonds was USD11.89 billion (Carpenter, 2012), and the CAT bond

Marc G¨

urtler is at the Department of Finance, Braunschweig Institute of Technology and

Martin Hibbeln (contact author) is at the University of Duisburg-Essen. Hibbeln can be con-

tacted via e-mail: martin.hibbeln@tu-bs.de. Christine Winkelvos is at Volkswagen Financial

Services AG. [Correction added on 13 January 2016, after first online publication: the affiliation

of Martin Hibbeln has been changed from “Department of Finance, Braunschweig Institute of

Technology” to “University of Duisburg-Essen”.] We thank two anonymous referees, Keith J.

Crocker (the editor), Martin Halek, as well as the participants of the 2013 annual meeting of the

American Risk and Insurance Association for interesting and helpful comments.

1For example, the structure of CAT bonds is described in detail in Cummins and Weiss (2009).

579

580 The Journal of Risk and Insurance

market is expected to continue to grow in the future (Cummins and Weiss, 2009).

However, Barrieu and Louberg´

e (2009) find that the growth in CAT bond volume

is limited by investors’ aversion to downside risk and ambiguity resulting from the

link between the financial markets and the CAT bond market. This link between the

financial markets and the CAT bond market is often discussed in the literature.While

the sponsor’s motivation to issue a CAT bond is to obtain catastrophic risk insurance,

it is often stated that it is advantageous for investors to buy CAT bonds due to the

diversification effects that they provide. These effects result from low correlations to

other securities that are traded on capital markets. However, the events of Hurricane

Katrina and the recent financial crisis call this assumption into question.

It is widely accepted in the literature that if a huge natural catastrophe occurs, both

the CATbond market and the capital markets are affected and the correlation between

these two markets increases (Cummins and Weiss,2009). However, it is not clear how

the CAT bond market reacts to huge natural catastrophes. For example, CAT bond

premiums for all types of perils could increase due to a general increase in the risk

aversion of market participants. Theremight also be an increase in premiums for bonds

that insure against perils of the same type as the catastrophe that occurred because

investors adjust their expectations for that type of peril. The relationship between

financial crises and the CAT bond market is also unclear. The CAT bond market

might remain independent of developments in the capital market even in the event

of a financial crisis because the probability of a natural catastrophe is independent

of economic developments. Alternatively, a financial crisis could affect not only the

capital markets but also the CATbond market, for example, due to a general increase in

the risk aversion of market participants. Against this background, this article analyzes

how natural catastrophes and financial crises influence CAT bond premiums.

We analyze this question using a broad data set of secondary market CAT bond pre-

miums from 2002 to 2012. This is virtually the entire data set available for secondary

market CAT bond premiums. We find a dependence between the CAT bond market

and capital markets measured by means of the credit spreads of corporate bonds. This

dependence increased significantly over the course of the recent financial crisis. Thus,

we can conclude that the financial crisis has an important influence on CAT bond pre-

miums. Moreover,we find that after the natural mega-catastrophe Hurricane Katrina,

the premiums for hurricane perils increased significantly. This increase can mainly be

attributed to a higher multiple of the expected loss calculated by catastrophe model-

ing companies. This finding suggests that market participants reacted to Hurricane

Katrina with mistrust in the expected losses calculated for hurricanes.

In addition to the question of how CAT bond premiums react to natural catastro-

phes and financial crises, it is challenging to determine how to accurately price CAT

bonds because CAT bonds arenot standardized. The determination of accurate prices

is an important condition for the successful trading of securities. Moreover, greater

transparency in the mechanism of price discovery could facilitate the evolution of the

CAT bond market. Various factors influence the risk premium required by investors.

For instance, the trigger mechanism or peril is usually assumed to affect the CAT

bond premium. However, the literature only contains a few empirical studies with

The Impact of the Financial Crisis and Natural Catastrophes on CAT Bonds 581

relatively small data sets investigating which factors influence CAT bond premiums

(Berge, 2005; Lane and Mahul, 2008; Dieckmann, 2011; Galeotti et al., 2013). The small

sample sizes of these studies lead to some degree of uncertainty about their empirical

findings and could be one reason for their conflicting results.For instance, Berge (2005)

does not find any significant influence of the trigger mechanism on CAT bond pre-

miums, whereas Dieckmann (2011) finds that CAT bonds using an indemnity trigger

have higher risk premiums than nonindemnity-triggered CATbonds. Only one study

analyzes the pricing of CAT bonds on a larger data set (Braun, 2012). However, this

study only considers primary market data. Thus, additional analyses of larger data

sets, particularly regarding pricing by investors in secondary markets, can provide

new insights on the factors that influence CAT bond premiums.

We study secondary market data and find no significant influence of the applied

trigger mechanism on the premium. This is in contrast to the widespread expectation

in the literature, but it could result from a special payment structure included in most

indemnity-triggered CAT bonds (Cummins and Weiss, 2009), whereby the sponsor

and investor share the risk above the trigger level proportionally. Addressing perils,

we find that if the number of insured peril regions or peril types increases, then the

premium increases due to the greater complexity of the deal. Furthermore, we find

that even if several other influencing factors are already present in the model, the

CAT bond premium increases if the rating declines. Thus, investors use ratings as an

additional source of information for their investment decisions. Finally, we cannot

find any empirical evidence for a liquidity premium measured by the maturity and

issue volume of the CAT bond.

In summary,this study makes the following contributions. First, we show that finan-

cial crises significantly affect CAT bond premiums by demonstrating a high correla-

tion between CAT bond premiums and corporate spreads. Second, we provide new

insights into the reaction of investors to natural catastrophes. Our results suggest that

investors react with distrust of the expected loss calculated by catastrophe modeling

companies. Third, our results improve our understanding of which factors influence

the secondary market premiums of CAT bonds.

The remainder of the article is structured as follows. The research hypotheses are

derived in the second section, where we consider CAT bond-specific hypotheses as

well as macroeconomic and event hypotheses. The third section describes the data set

used for the empirical analysis. We present and discuss the results of our empirical

analysis in the fourth section. Finally,the fifth section presents the conclusions of this

work.

Hypotheses

Multiple studies in the literature have addressed the factors that determine CATbond

premiums. Against this background the following subsection relates to CAT-bond-

specific factors that may affect CAT bond premiums. Subsequently, we discuss the

possible influence of macroeconomic factors and catastrophic events. Over the course

of this discussion, we derive several hypotheses on factors that determine premiums

and on the reactions of CAT bond premiums to catastrophic events.