Despite Strong Growth in the Catastrophe Bonds Market, Something Seems to be Missing

Introduction

The catastrophe bonds (cat bonds) market, the vast majority of the insurance-linked securities (ILS), has experienced substantial growth in recent decades, driven by increased (re)insurer demand for alternative risk transfer solutions and investor appetite to diversify their investment portfolios. According to market statistics, cat bonds issuance increased more than sevenfold between 2003 and 2023. There is not just an increase in the number of cat bonds issued; coverage has also expanded from natural catastrophes to human-made disasters such as terrorism and cybersecurity events.

However, the regulatory landscape does not appear to be keeping pace with this significant market development. As catastrophe bonds have gained traction worldwide and their importance continues to grow, their potential impact on the financial system is undeniable. In this article, we will examine the current regulatory framework across different regions and shine a spotlight on any potential gaps in the current legislation.

Regulatory environments at a glance

Europe

In Europe, ILS-related activities (including cat bonds) are mainly regulated by supervising the operation of insurance Special Purpose Vehicle (SPV), an insurance entity that is created to issue those instruments. In the EU, related regulations lie in the existing Solvency II framework. In particular, Chapter 15, Title I of the Solvency II Regulation (Delegated Regulation (EU) 2015/35) specifies the operating requirements for SPV.

These include authorisation and solvency requirements, corporate governance standards, and some limited guidelines applicable to insurance risk transfer contracts. Chapter 5 (Section 10) of the same title provides some more guidance on risk mitigation techniques involving SPV. In the UK, a comparable SPV regulatory setting is provided by The Risk Transformation Regulations 2017, together with other supplementary supervisory guidelines such as SS8/17 - Authorisation and supervision of insurance special purpose vehicles.

Americas

While regulatory development in the region is still very limited , some major non-life insurance markets in the Americas do have designated regulations for ILS activities. The natural catastrophes in the US, which are considered the origin of cat bonds, are still the source of risks that the majority of such instruments nowadays are connected with.

In terms of regulatory setting, the country enacted the Special Purpose Reinsurance Vehicle Model Act and Protected Cell Company Model Act in the early 2000s to supervise SPV operation with the aim to facilitate cat bonds activities. Since then, there hasn’t been much evolvement to keep up with the market development. In Bermuda, one of the most active cat bonds players in the world, similar regulatory requirements are provided in the Guidance Note – Special Purpose Insurers of July 2020.

In Brazil, a more comprehensive ILS regulatory framework was established by the CNSP Resolution No 453/2022, which implemented the provisions of Law No 14,430/2022. Apart from the provisions that supervise the operation of SPV, such as Section III and Section IV of Chapter IV, the regulation also includes specific requirements applicable to ILS contracts (including cat bonds).

For example, Article 10 of Chapter II requires the maturity of those contracts to be a maximum of ten years; Article 12 (V) requires certain types of information to be included in the issuance documents (such as the value of the Maximum Risk Exposure and the description of the assets that will back the instrument); and Article 18 requires those contracts to establish a maximum period for reporting claims. These specifications also allow regulators to supervise ILS activities from contract supervision or investor protection perspectives, in addition to the traditional SPV operation angle.  

Asia Pacific and Africa

Although Asia Pacific is the home of some of the largest insurance markets in the world and is highly impacted by natural catastrophes, the pace of cat bonds-related regulatory development is relatively slow.

Hong Kong, one of the very few cat bonds players in the region, incorporated the SPV supervision framework into its Insurance Ordinance in 2021 to legally enable ILS issuance in the market. The work was subsequently endorsed by the Mainland China regulator through a circular to encourage cat bonds issuance in Hong Kong.

Other major markets in the region, such as Australia and Singapore, are still in the early stages of exploring the possibility of establishing their regulatory framework to support related activities. For Africa, cat bonds (or ILS in general) have not yet appeared to be a significant feature. Some markets, such as South Africa, indicated their interest in creating a framework for that, but nothing has been solidified so far.

Investor protection seems to be overlooked

Overall, while the pace varies across regions, the regulatory development for ILS or cat bonds activities worldwide is relatively limited compared with their long history and enormous transaction volume nowadays. For those territories that have specific regulations for ILS or cat bonds, the regulatory settings are mainly focused on the operations of SPV, which is considered a legal framework to facilitate or promote related activities. Prudential or safeguarding measures, particularly investor protection, do not appear to be a common feature in legislation.

Apart from the Brazilian regulation containing contract-specific supervision requirements, investor protection seems to be overlooked in the current regulatory environment. The only guideline available appears to emphasise that all ILS instruments should only be sold to “professional investors” and not to retail ones. In fact, investing in cat bonds implies indirectly providing a financial cushion to the underlying catastrophic risks.

This also means, to some extent, playing a similar role as a reinsurer. A job that not even “professional investors” would be competent enough to do. This “lack of expertise” puts investors in a disadvantaged position when dealing with such investments, especially when considering their limited information and knowledge (regarding the catastrophe risks concerned) compared with their contracting counterparts.

Today, a substantial number of cat bonds are issued and traded privately. The degree of investor protection provided in those contracts is unclear. Recalling the memory of the Global Financial Crisis 2007-2008, the failure of institutional investors produced a spillover effect which led to the collapse of the entire financial system.

As a lesson learnt, rules and regulations that supervise the securitisation activities of debt or loan, such as the EU Securitisation Regulation - Regulation (EU) 2017/2402, were developed to prevent similar disasters. Should there be something similar to monitor the securitisation of catastrophe risks before it is too late? Or at least a set of rules to ensure the fairness and transparency of those contracts? These are questions that the market needs to start thinking about urgently.