A slow issuance year in 2008 masks a story of resilience and risk management flexibility. After a record-setting year in 2007, catastrophe bond issuances fell 62 percent by issuance volume and 52 percent by transaction count last year. During the first half of the year catastrophe bond issuance was tempered by ample capacity and favorable rates in the traditional reinsurance market, dampening sponsor demand for alternative capacity sources, with the fourth quarter quieter than expected. Overall, however, catastrophe bonds generally withstood the impact of onerous market forces and survived a substantial financial market test of their utility as risk and capital management instruments.
In terms of issuance volume, the first half of 2008 kept pace with the same period in 2006. Third quarter activity was light (in line with historical catastrophe bond market norms). Despite a fourth quarter that was expected to be robust, however, planned catastrophe bond issuances were postponed, due to the impact of the global financial crisis on secondary market spreads and concerns over the effectiveness of the collateral protection mechanics embedded in catastrophe bond structures.
2008 by the Numbers
Issuers secured USD2.7 billion in new and renewal capacity in the catastrophe bond market last year via 13 transactions. All but two came in the first half of the year.
As a whole, in terms of issuance volume, 2008 was the third busiest year since catastrophe bonds were introduced in 1997, accounting for 11 percent of all issuances. Risk capital issued was above the 11-year average of USD2.1 billion, and the USD2.7 billion issued last year came to market at a time when reinsurers had excess capital on their balance sheets. Even with continued buybacks and dividends — not to mention the Guy Carpenter World Rate on Line (ROL) Index’s drop of nine percent at the January 1, 2008 renewal – carriers perceived a benefit to transferring risk to capital markets. Rates continued to drop steadily through the July 1, 2008 renewal.
Light activity in the third quarter was in line with historical precedent. In 2008, however, the fourth quarter was silent in terms of primary issuance activity-compared to that of 2007, when seven bonds resulted in USD1.9 billion of capacity.
Ambiguity in the (re)insurance market as a whole - and distress in the global financial markets - is the primary reason for the sharp drop in catastrophe bond issuances in the fourth quarter of 2008. As the (re)insurance industry approached the January 1, 2009 renewal, few could gauge where rates were headed for specific regions and lines of business. Loss history ultimately mattered more than the other factors that influence pricing, but at the time, carriers decided to confirm the market’s direction before making specific and (in the case of catastrophe bonds) multi-year risk management decisions.
Questions about Capital Availability
The availability of capital remained a major concern through December 2008, as markets cited an increased cost of capital in efforts to increase rates for traditional reinsurance. While the disparity between the cost of capital and reinsurance rates did not define the January 1, 2009 renewal, it certainly shaped cedent and market thinking. Capital management factored into many reinsurance buys, as carriers moved to protect themselves from unfavorable market forces.
These same issues were at play in the broader capital markets space, as alternative investment vehicles coped with the same investment asset impairment and capital access challenges that (re)insurers faced. Alternative investment vehicles — such as hedge funds and private equity funds — lost access to leverage and experienced an increase in redemptions.
In several cases, multi-strategy hedge funds were forced to liquidate catastrophe bond holdings in order to meet liquidity needs created by severe value reductions in their other investments. Catastrophe bonds were sold because this asset class was among the few to maintain value during the first three quarters of 2008. Though this forced selling did prompt sufficient spread widening to forestall additional primary issuances, the fact that a significant amount of catastrophe bond positions was able to be liquidated quickly and in an orderly fashion — absent even more severe price reductions — is a testament to the increasing liquidity and depth of the catastrophe bond market.
As conditions deteriorated around the world, a situation accelerated by the interconnectedness of the global financial system, issuers opted to watch and wait. The loss of several international financial institutions — which coincided with Hurricane Ike’s contact with Galveston, TX — virtually guaranteed that catastrophe bond issuance activity for the year would be impacted.
Prior to the events of mid-September, several firms were planning catastrophe bond issuances for the fourth quarter. The number of bonds issued and risk capital represented would have been below that of the same period in 2007, but cautious insurers decided to defer the deals to the first quarter of 2009, in order to gauge the effects of an uncertain January 1, 2009 renewal.
Partly because of the decision to defer planned issuances to 2009, the total amount of risk capital outstanding fell 14.5 percent, from USD13.8 billion to USD11.8 billion. USD4.7 billion in risk capital disappeared during the year, as 24 catastrophe bonds were redeemed as a result of scheduled maturities or exercising of embedded early redemption call options.
Financial Catastrophe and Beyond
Since the inception of the catastrophe bond market, these instruments have been touted as largely non-correlated with broader capital market risks. A downturn in credit markets, many believed, would not cause catastrophe bonds to follow suit, as they are linked to physical events — such as earthquakes and hurricanes — as opposed to other factors, such as an issuer’s likelihood of default, interest rate risk, or currency risk. While catastrophe bond market secondary spreads did increase during the fourth quarter, they did not do so at the same rate as credit markets.
Both investors and issuers did pause when four catastrophe bonds seemed to have been infected by the global credit crisis, due to the loss of their total return swap (TRS) counterparty. The subsequent mark-down of these bonds initially unsettled some participants in the market, as they perceived it to be an indication that significant credit risk and (more alarmingly) moral hazard issues were embedded in the catastrophe bond market. But, as details emerged, it became evident that there was not a fundamental flaw in the catastrophe bond mechanism — just room for improvement in terms of transparency and tightened collateral requirements, both of which are expected to be incorporated into future issuances.
In contrast to other credit risk-related asset classes — such as auction rate securities and residential mortgage securities, which have effectively been slowed substantially by the ongoing credit crisis — catastrophe bond issuance activity will continue, and the asset class should actually emerge with improved utility for both sponsors and investors.
Global financial markets are still dealing with the effects of the financial catastrophe, and the future remains unclear. Traditional reinsurance capacity is expected to contract this year. Further, we have yet to see full-year financial results for publicly traded (re)insurers. The financial reporting revelations that will begin in the middle of March will define the severity of the crisis for the (re)insurance industry. Forecasts of an above-average catastrophe year could complicate the environment, as well.
To a certain extent, the industry’s agenda in 2009 will reflect that of the fourth quarter of 2008. Disciplined risk and capital management, as well as capital funding diversification, will be crucial. Financial market constraints are likely to continue, resulting in an important role for alternative sources of capital. The catastrophe bond market has remained resilient, a fact that is likely to come to mind as carriers manage their portfolios over the coming year.
* Securities or investments, as applicable, are offered in the United States through GC Securities, which is a division of MMC Securities Corp., a US registered broker-dealer and member FINRA/SIPC. Main Office: 1166 Avenue of the Americas, New York, NY 10036. Phone: (212) 345-5000. Advice on securities or investments, as applicable, are offered in the European Union is provided through GC Securities, a division of MMC Securities (Europe) Ltd., authorized and regulated in the UK by the Financial Services Authority. Reinsurance products are placed through qualified affiliates of Guy Carpenter & Company, LLC. MMC Securities Corp., GC Securities, MMC Securities (Europe) Ltd. and Guy Carpenter & Company, LLC are affiliates owned by Marsh & McLennan Companies. This communication is not intended as an offer to sell or a solicitation of any offer to buy any security, financial instrument, reinsurance or insurance product.