Some cat bond return rates hit 18% but investors face risk of ‘losing it all’, exec says

Canadian insurance carriers will have a combined ratio exceeding 100 in 2013 and the industry will see “a lot more” disasters arising from transportation of hazardous materials, while money is flowing into the industry, indirectly, in the form of catastrophe bonds, an insurance company executive suggested Thursday.

“The hottest area of new investment into the business is not going directly into insurance companies,” said Philip Cook, chief executive officer of Omega Insurance Holdings Inc. “It’s going into insurance-linked securities and cat bonds in particular.”

He made his remarks at the CIP Society Industry Trends breakfast at the National Club in downtown Toronto. For the past several years, Cook has shared his predictions for upcoming years with industry professionals at the annual event, organized by the Insurance Institute of Ontario. One of his predictions for 2014 is that climate change will continue to affect the industry, with continued expansion of the cat bond market.

According to the latest study Cook has seen, there was $20.5 billion in capital invested in the cat bond market around the world, while $2.5 billion in new capital was invested into that market in 2013.

“Most of those cat bonds have been extremely profitable,” Cook noted, adding some of them had no losses. “As a result, the cat bond funds now are returning rates of return in the mid teens and I have seen them as high as 17% and 18%.”

Nonetheless, the cat bonds still pose some risk for investors, he suggested.

“It would only take one or two major exposures, I think, to reverse the whole popularity of the cat bonds but in the meantime it’s a very very strong investment,” he said. While investors include hedge funds, pension funds, endowments, trusts and the reinsurers, some celebrities are also investing.

“It’s kind of interesting to look through some of the lists of owners of cat bonds,” he said. “You will see film stars, TV stars, athletes. It’s going to be interesting because those are obviously not educated investors. I’m not sure that they fully understand that there’s a potential for losing, and losing it all.”

Catastrophe losses in 2013, meanwhile, were at a “long-time low,” and 40% lower than in 2012, Cook noted.

“The big non-event in 2013 was the U.S. Atlantic hurricane season,” he said. “It amazed everybody. I myself had predicted that we would likely see at least one landfall and three or four major hurricanes.”

But there were only two hurricanes in the Atlantic basin in 2013, while the predictions from 11 modelling organizations ranged from five to 11. As for major hurricanes, Cook said, the predictions from modelling organizations ranged from three to six, with two predicted to make landfall.

“That’s a scary scenario for the insurance industry,” he said. “A major hurricane is a more-than-Force-3 storm. The actual number? Zero. Not a particularly accurate prediction. In fact it was a record low frequency for hurricanes and none of them made landfall.”

Cook also revealed his forecast of some key financial performance ratios for Canadian insurers for 2013, using carriers’ actual results for the first three quarters of 2013 and then extrapolating from their fourth-quarter results from the previous five years.

He is anticipating that for domestic insurers in the full calendar year 2013, their loss ratio will be 70.5 and their expense ratio will be 31.3, with a  combined ratio of 101.8. Foreign carriers Canadian branches are predicted to have a higher loss ratio (72.5), a lower expense ratio (27.9) and a combined ratio of 100.4.

“That’s a minor deterioration from last year,” he said, adding he predicts the return on equity will be 4.9% for domestic carriers and 5.6% for Canadian branches of foreign firms.

“It’s not a particularly attractive industry from an investment point of view,” he said. “Investment losses are popping up on a lot of balance sheets.”

Meanwhile, storm surges, floods and train derailments were among the disasters affecting the insurance industry last year, Cook noted.

“It seems now that almost every news broadcast every week finds a train wreck somewhere in Canada,” he said. “Transportation of hazardous materials, whether it’s by road or rail or air is here to stay, and I think we are going to see a lot more of those disasters as we move forward.”