Another way that primary insurers cede the risk of large losses is by issuing catastrophe (cat) bonds. An example will illustrate the role of cat bonds. Imagine that a primary insurer based in Florida is concerned that if a large hurricane hits that densely populated state, then the total claims might drain so much capital from the firm that it is unable to continue writing insurance, or even to meet all the claims.
A primary insurer (with the help of consultants) estimates that in any one year there is a 1-in-50 chance (probability of 0.02) that a hurricane will cause it to have catastrophic claims of more than $2.5 billion. The primary insurer wants protection against the risk that claims will exceed $2.5 billion in any particular year. Specifically, it wants investors in its cat bonds to pay 80% of the primary insurer’s claims in the layer between $2.5 billion and $3.0 billion of total losses.
To achieve this protection the primary insurer issues cat bonds with a total principal of $400 million to pension funds, university endowments, and other institutional investors. The term of the bonds is 3 years and they yield the 90 day T-bill yield + 4.0% (risk premium).
If a severe hurricane hits Florida and the primary insurer’s losses exceed $2.5 billion then the principal of the cat bonds is written down by $0.80 for every $1 of the insurers losses, up to a maximum of $400 million (the total principal of the cat bonds). At the beginning of each year bondholders have an ‘expected’ loss of 2%, even though in most years they will lose nothing.
The commercial banking analogue of claims on insurers are loan losses. Just as insurers face the risk that claims will far exceed premiums if natural disaster occurs, banks face the risk that losses on loans will far exceed operating income if an economic disaster hits the economy.
In a normal year the bank’s operating income will cover any losses suffered in the non-payment of loans by a large margin. But if a deep economic recession coincides with plunging house prices, then provisions for loan losses will far exceed operating income and shareholder capital will be drained from the bank.
What is the analogy in banking of local insurers ceding risk to global reinsurers? There is none because, unlike natural catastrophes, economic crises are correlated around the world. Consequently, locally concentrated banking risks don’t diversify away at the global scale.
There is however a banking analogue of catastrophe bonds. Banks issue contingent convertible bonds (CoCos) to transfer risk of catastrophic losses on their loan books to institutional and personal investors. In Australia these bonds are called hybrid notes and are owned principally by wealthy households.
National Australia Bank (NAB) has just completed a $1.65 billion issue of hybrid notes (NAB Capital Notes 3, aka NABPF). These notes are complex and have many important terms, but for our purposes they can be condensed to the following:
1. The notes have a term of 9 years, NAB can redeem the notes after 7 years.
2. The yield is 90 bank bill rate (BBSW90) + 4.00%. The principal is $100.
3. If a banking crisis hits and NAB’s loss absorbing capital halves, then the notes will be converted into shares. The practical effect of the forced (mandatory) conversion is that the noteholders’ loss of capital depends on how much NAB’s share price has fallen since the time the hybrid notes were first issued (20 March 2019).
- NAB share price falls < 80%. No loss to noteholders.
- NAB share price falls (80 + X)%. Loss of noteholder capital is $5X.
For example, if NAB shares have fallen by 70% when forced conversion occurs, then noteholders will receive $100 worth of NAB shares, and suffer no capital loss. Alternatively, if the share price fall is 88%, then shareholders will receive $60 worth of shares, and suffer a capital loss of 40%.
The expected losses of NAB hybrid note holders is very low for three reasons. First, 80% is a very large fall in the share price relative to the volatility of bank shares – it is a fall of more than 4 times annual volatility. Second, Australian banks are highly profitable and can raise additional capital by issuing new shares and/or cutting dividends. Third, the four big banks in Australia are too big to fail. Expected losses are less than 0.5% on an annual basis (meaning that the probability of large losses in any one year is very low – less than 1-in-200).
Understanding the risk premium on Cat bonds and CoCos
In both our examples, the Cat bond and the Hybrid note, the spread over the yield on bank bills is 4%. Let’s say that 50 bps of the 4% spread is compensation for loss of liquidity: both payments liquidity (aka funding liquidity — the money is locked up for many years) and asset liquidity (aka market liquidity — buying and selling the notes is costly). That leaves 3.50% per annum as compensation to investors for bearing risk in both the cat bonds and the hybrid notes.
Now we have reached the crux of this article. Both types of notes are absorbing the risk of catastrophic losses – insurance claims from natural disasters and loan losses in a banking crisis. However, the 3.50% per annum compensation in each case is for very different types of risk. And, that difference tells us who are the natural owners of these notes.
Figure 1: Breaking down the credit risk spread on cat bonds and hybrids