I have long been a fan of the idea of investing in catastrophe bonds as a portfolio diversifier. The biggest vehicle has been London listed fund CatCo, which has hoovered up a fair amount of money in recent years. I, like many, invested in its most recent C share issue.
Unfortunately, the news, as of late, hasn’t been great. In a note last week, Liberum Alternatives team reports that the recent catastrophic events around the globe are about to cut a swathe through the NAV. The fund has reported has reported a NAV decline in October 2018 of -2.9% for the ordinary shares and -7.0% for the C shares. Liberum calculates YTD NAV returns of -16.7% for the ordinary shares and +7.2% for the C shares, respectively. According to Liberum’s report “ the main reason for the NAV decline was loss reserves relating to Hurricane Michael in Florida and Typhoon Jebi in Japan. These events had a 3.7% impact on the ordinary share NAV and 9.8% impact on the C share NAV. These reserves have been based on early industry estimates and may change as more information comes through. The manager also believes there will be a material loss to the portfolio from the California wildfires in November. It may exceed the 2017 California wildfire events which reduced NAV by 17%. Furthermore, the ordinary shares may be exposed to more losses arising from 2017 loss events. The insurance market has continued to report further loss deterioration since the provision taken by the fund in April 2018. Industry loss estimates for these events have increased by at least 9% over the estimates at April 2018. The impact of this will be reflected in the November NAV.”.
Last week, Matt Hose at Jefferies also put out an excellent note, which I have pasted in below.
“ California wildfires? California’s current wildfires are the most destructive (and sadly deadliest) on record and, as such, are likely to come at a heavy cost in terms of insured losses. Although it is still too early to accurately project the losses, early indications suggest a multi-billion dollar impact from property damage alone. At this level some of the losses will likely flow through to the ILS market, begging the question of whether CAT’s 2018 portfolio will be impacted? As ever, it is difficult to tell. We can, however, see that the 2018 portfolio has a worst case single event net portfolio return of -1% for North American wildfire losses, making it one of the potentially more painful events for the fund (the maximum worst case single event net portfolio return is -8%). Moreover, we note the previous impact on returns from the Fort McMurray wildfire in 2016, the Tubbs/Atlas/Mendocino (Northern California) wildfires of October 2017, and the Thomas/Creek/Lilac (Southern California) wildfires of December 2017.
Wider portfolio losses? The wider issue presented is whether the wildfires and the recent confluence of industry loss activity will result in the establishment of loss reserves either within the October NAV, or at CAT’s year-end. In the past, losses have frequently been recognised at the point of the January (i.e. 1/1) renewals, albeit not all side pockets established have resulted in loss payments. To this end, we will need to be mindful of any potential impact from Hurricane Michael and Typhoon Jebi, where single digit losses are possible for each.
Are the losses already priced in? The even more difficult question posed is how much of the potential losses are already priced in to CAT’s two share classes. If we focus on the share price impact post Hurricane Michael as an identifiable line in the sand, CAT’s ordinary share class has fallen 12.1%, while the C shares have fallen 7.5%. As previously discussed regarding the potential impact from Hurricane Florence in September, this appears incongruous with the relative exposures of the two share classes to the 2018 portfolio. The C shares are fully exposed to this portfolio, while as at the end of September the ordinary share NAV was 39% exposed. If the C shares are therefore reflecting a 7.5% hit to the 2018 portfolio, assuming no recent adverse loss development on prior year reserving the ords are reflecting a 31% hit (i.e. 12.1% divided by 0.39). As before, it seems that for whatever reason the ords are overestimating the impact of 2018 losses, while the C shares could be doing the opposite.
2019 underwriting? At this stage it doesn’t appear that any of the recent individual industry loss events are ‘market moving’ in terms of their impact on reinsurance pricing at 1/1. That said, the overall extent of the loss activity may well be, possibly helping to improve on CAT’s expectations for flat pricing on the 2019 portfolio, as indicated in the Chairman’s statement within the interims. The statement also alluded to the early agreement of $1bn of orders to be written before the start of September, raising the issue of whether this capacity would be able to participate in any improved pricing terms.
What worries me here is that those of us who invested in the recent C issue may have fooled ourselves into thinking that some kind of normality might resume. In the case of wildfires in California, maybe the abnormal is about to become normal – as am Economist magazine headline suggested. And maybe the reinsurance market is so genuinely behind the curve – and the models so out of date – that premiums are utterly failing to keep up. In sum, the unthinkable has happened. Traditional catastrophe based reinsurance is a fundamentally uneconomic model. Ah, but the bulls might suggest that all needs to be done is for premiums to rapidly increase.
But what happens if no amount of premium increases can ever properly compensate for the huge, regular damage? And what happens when the people paying the hugely increased premiums simply cannot afford the cost. Cue government intervention and a socialisation of these growing external costs.