The World Bank’s parametric cat bonds have faced criticism this year for failing to respond to Hurricane Beryl, but analysis from Insurance Insider ILS tallies with cat bond sources who say that these deals tend to trigger relatively often compared to broader ILS benchmarks.
However, ILS market sources agreed that further refinement to parametric triggers could be beneficial, although it may come at a cost.
After the failure of a cat bond protecting Jamaica to trigger during Hurricane Beryl, the V20 group of countries called for the World Bank to “course correct” and re-assess the structure of such deals. Meanwhile, Bloomberg headlines called attention to “huge profits” cat bond investors were making, in contrast to the devastation on the island following the storm.
There is always a degree of basis risk with parametric deals, but Hurricane Beryl was particularly close to the trigger point. The storm crossed the pre-defined grids, but the minimum central pressure did not fall low enough to cause the bond to attach by a small margin.
World Bank bonds: The financial rundown
The Bloomberg coverage has raised eyebrows amongst the ILS community, which generally disagreed with the sentiment.
Market-wide ILS returns are not a good proxy for returns on the World Bank portfolio of cat bonds, which typically price based on their status as ESG-friendly diversifiers to ILS investors’ peak exposure of Florida wind risk.
Dirk Schmelzer, portfolio manager at Plenum, said: “These bonds have a tendency to trigger, as they often have an elevated risk profile.”
An ILS market source added that the World Bank IBRD bonds are more susceptible to attritional losses rather than market-moving catastrophic events, a consequence of which is a higher frequency of losses.
Overall, ILS market sources suggest that while the bonds offer a fair return to investors, they also provide reliable payouts under the agreed conditions, balancing sponsor needs with investor interests. The data supports this trend as well.
Since the first issuance in 2012, more than $4.3bn of World Bank-assisted bonds have been issued.
In that time, there has been around $507.5mn in payouts from a variety of hurricanes, earthquakes and pandemic events. This represents more than 10% of the total issued volume, according to data tracked by this publication – a relatively high threshold for a market that is often more geared to one-in-50-/100-year-type risks.
Investors have received roughly $845mn in total coupon payments from these deals, according to calculations made by this publication, taking into account the shorter duration of deals that paid out early.
This translates to a profit of $337.5mn, or roughly 7.7% of the total issued volume since 2012. However, since various bonds have been on risk for different timeframes during this period, a deal-by-deal level analysis provides an alternative way to assess returns.
In the table above, we calculated the premium earned while on-risk by World Bank cat bonds issued since 2012 – and then deducted any payouts on bonds which were triggered. With this net figure – premiums earned less payouts – and the initial collateral invested in each bond, we can estimate a rate of return for each transaction.
On a collateral-weighted basis, the average annualised return of this cohort of World Bank cat bonds to date has been negative, showing a loss of 1.4% p.a.
World Bank deal benefits
The World Bank IBRD bonds do offer diversification and ESG benefits that are less present in the broader cat bond market.
Schmelzer said: “We appreciate what the World Bank is doing by creating these bonds, as they help diversify our portfolio away from US risk.”
The bonds provide protection in nations prone to natural catastrophe activity but where the local insurance markets underserve the region.
This allows ILS managers to hedge returns in the event of a high-loss year in the US, although the overall diversifying volumes in the ILS market are still low.
Because the World Bank bonds protect regions underserved by the insurance markets, they also offer an ESG element and enable managers investing in these deals to better appeal to investors with ESG mandates and to differentiate their offering.
An ILS source said that “ESG is a materially important component of evaluating the cat bond market, and an important differentiator when talking to end investors”.
The bonds’ parametric trigger structure also offers benefits to investors as another diversifier to indemnity-geared portfolios. While their basis risk can be controversial, these triggers also serve to provide sponsor nations with fast payouts.
Michael Bennett, global head of market solutions and structured finance at the World Bank, said: “The parametric trigger works for our sponsors, which for the most part are national governments, as they value the fast payouts and a structure that provides the coverage they’re seeking.”
The World Bank is also aiming to increase its cat bond limit to $5bn over five years, implying the organization anticipates there will be both investor and sponsor demand to scale up.
Structural changes
Sources noted if sponsor nations wanted more frequent payouts, they would need to reconsider the “economic dynamics” of these bonds.
This includes decreasing the basis risk and paying higher premiums to attract investors willing to accept greater risk.
Florian Steiger, co-founder and CEO of Icosa Investments, said: “Investing in a cat bond is not a donation. If sponsors want something that is higher risk, then the risk profile changes, and it needs to pay a higher spread.”
Morton Lane of Lane Financial echoed that sentiment: “[Jamaica] could have purchased wider coverage, but it would have cost more. The dilemma is always cost vs coverage.”
However, ILS market sources agreed that some adjustments to the World Bank’s deals could improve the structure of the bonds.
Among these potential changes is a more granular payout model, which would introduce more variable payouts.
A granular payout system would move away from the fixed 25%/50%/75% structure currently triggered by reaching parametric thresholds.
Instead, sponsors could access lower-level payouts, such as a 10% or even 1%, more frequently, as the payout threshold would be reduced.
Lane said: “One other idea that could be explored is to have a smaller payout for wider area hits, even on an indemnity basis, but bigger payouts for the most concentrated loss area as defined in the current coverage.”
This would somewhat be a hybrid method, offering a more granular approach to payouts in wider-hit areas, and larger stepped payouts in more concentrated areas of loss.
While this approach could offer sponsors more consistent financial relief, it would also extend the time needed to finalize payouts.
Pricing and risk assessment remain key challenges under this revised structure.
Lowering the payout threshold inherently increases the bond’s risk profile, meaning investors would likely demand higher returns to offset the increased risk.
For investors, it would perhaps mean smaller payouts more frequently, which may translate to fewer large payouts overtime, ultimately resulting in a net positive for their returns.
Bennett notes that some refinements to the triggers have been made since the first World Bank bond.
“If you look at our cat bonds over time, we have made efforts to refine the triggers by making them granular or focusing more of the protection in the highest value areas,” Bennett added.
Ultimately, these proposed adjustments reflect the ongoing balancing act between enhancing sponsor appeal and maintaining investor interest in these complex financial products.
For under-insured countries, it may be difficult to weigh up whether to pay for insurance bonds or to invest in resilient infrastructure.
Individual deals may have resulted in perverse outcomes. But the perception that cat bond investors are raking in money from these cedants in the aggregate is belied by the data.