Back to Previous High-Water Mark
This month the catastrophe bond market has quietly passed a rather significant milestone. The total outstanding non-life issuance is back over $14 billion for the first time since June 2008.
So does this mean the market will now resume the 2004 – 2007 pattern of strong growth in new issuance and total outstanding capacity year-on-year?
We expect to see a more gradual growth in both issuance and total outstanding risk capacity over time due to two factors.
- Firstly, demand for reinsurance of peak natural catastrophe exposures will likely increase.
- Secondly, we believe the share of this business assumed by capital markets investors will also increase over time.
It seems logical to disperse these very large peak catastrophe exposures into the broader capital markets where they provide an attractive uncorrelated risk rather than to try to retain these increasingly large exposures within the relatively small (in total capital terms) reinsurance industry.
However the rate of this growth will depend on timing of the reinsurance pricing cycle and the relative attractiveness of the catastrophe bond product at any given point in time.
Recent Pricing Trends
We have seen recently how the catastrophe bond market can sometimes operate in an apparently counter-intuitive manner. Anecdotal evidence abounds that the large catastrophe risk investment funds have seen significant net inflows of capital over the last two years resulting in increased assets under management. Yet the supply of new and outstanding bonds has been relatively stable (see chart above). This suggests we should have expected to see downwards pricing pressure on cat bond spreads despite the gradual pricing increases in traditional reinsurance pricing.
In fact, in the fourth quarter of 2011 and first quarter of 2012 we have seen a relatively sharp increase in risk spreads, particularly for U.S. hurricane exposed bonds. The year-on-year increase in cat bond risk spreads has been greater than price increases for traditional property catastrophe reinsurance. Furthermore, we believe these price levels have deterred several potential issuers from bringing new bonds to the markets. Why would investors, with capital to allocate, apparently set prices to discourage new cat bond issuance?
It’s Not Just About Cat Bonds
The simple reason is that some investors have become agnostic as to which product form they accept risk in. Catastrophe bonds represent just one sub-set of the risk transfer market available to capital markets investors and much of their capital is now allocated to private collateralized reinsurance trades.
While it is tempting to draw conclusions from a detailed analysis of catastrophe bond issuance and pricing, as this is where the most data is available, it can be misleading. Despite increasingly significant activity in other product forms, it is far more difficult to gather data to analyze as these trades are private and over-the-counter in nature. Market commentators have suggested that annual collateralized reinsurance volumes are approximately $15 billion and growing. In addition, capital markets investors are estimated to provide 75% of capacity to the Industry Loss Warranty (“ILW”) market, which could be worth another $5 billion in capacity to the ILW market in 2012.
We believe the medium term outlook for the catastrophe bond market remains encouraging. Investor inflows to the catastrophe risk asset class remain strong. Capital markets participants will likely want to support the catastrophe bond product alongside the other investment forms available to them such as private collateralized reinsurance contracts and index based products. Growth in peak insured exposures should continue creating more demand in the future for protection from natural catastrophes and these peak risks will likely drive further capital markets involvement in the market in coming years.
Guest blogger Adam Beatty is managing director of Willis Capital Markets & Advisory. He has been advising clients and executing transactions related to reinsurance capital markets and Insurance-Linked Securities (ILS) since 2006 and is based in New York. Adam joined Willis Re in 2004 as Chief Financial Officer. From 1998 to 2004, Adam worked within Willis’s in-house corporate finance and M&A team.
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