Last year, a financial catastrophe shook major market centers around the world. Several prominent, global banks have all but disappeared. Yet, insurers and reinsurers, in general, have persevered. We have been able to absorb the losses in capital triggered by both economic conditions and the second-busiest catastrophe year in at least four decades. But, these developments have changed our business, from perspective to transaction. This is particularly evident in the market for insurance-linked securities (ILS).*
Though only a small part of the overall risk transfer market, ILS (and catastrophe bonds, in particular) have become increasingly important to carriers seeking to remove stubborn perils from their portfolios, diversify sources of capital, or pursue carefully crafted risk management plans. The acceptance of these vehicles is evidenced by the growth of the catastrophe bond market from 1997 to 2007. Since 2005, record-setting years have become routine, and capital markets interest in the consumption of insurance risk grew noticeably.
With the past decade in mind, last year seemed quite challenging, particularly for catastrophe bonds, which comprise most of the ILS sector’s activity. The amount of risk capital issued fell 62 percent from the record levels set in 2007. By August, USD2.7 billion had come to market, and issuers remained silent for the rest of the year. The number of catastrophe bonds issued in 2008 also decreased from 2007: thirteen came to market, down 52 percent from the 27 issued the previous year.
A bit of perspective is necessary to understand what really happened last year.
As we passed the January 1, 2008 renewal, robust balance sheets and low rates on line (ROL) suggested that catastrophe bond issuances would not keep pace with 2007. Traditional capacity was inexpensive — with the Guy Carpenter World ROL Index down 9 percent year-over-year — and the market contemplated how to make “excess capital” productive. So, it is logical that catastrophe bond issuance roughly kept pace with 2006 levels.
The catastrophe bond market, therefore, proceeded relatively along expectations, as the third quarter is typically light in any calendar year. Following the dual catastrophes (asset-depleted balance sheets and natural catastrophes) that occurred in mid-September, the risk transfer market focused intently on the next renewal, and companies that had planned fourth quarter issuances pushed them to the first quarter of 2009. In 2007, seven catastrophe bonds had brought USD1.9 billion in fresh risk capital to market. A year later, nothing happened.
This was not a function of the catastrophe bond market. Rather, it was the result of the reinsurance market — where the bulk of risk transfer occurs — and the need for cedents to understand the trend for rates. With the renewal completed, issuance activity has resumed.
Nonetheless, there were tense moments in the fall of 2008, particularly for four catastrophe bonds that lost their total return swap (TRS) counterparty. This caused both investors and issuers to pause and wait for the implications to emerge. While some investors and issuers were initially concerned by the mark-down of these four bonds, they later learned that catastrophe bonds were not inherently flawed. Instead, these instruments simply showed room for improvement. As issuers continue to explore new catastrophe bond features, increased transparency and a tightening of collateral requirements are likely to be addressed.
Further innovation is also likely to improve the utility of catastrophe bonds for targeted risk and capital management. In the past, these vehicles were seen as sources of additional capacity when reinsurance markets were either expensive or unwilling to cover a particular risk. While this remains true to a certain extent, the transfer of risk to capital markets is being included in strategic risk management planning, especially for perils with low annual loss probabilities (usually from 1 percent to 3 percent).
New thinking will continue to advance the role of catastrophe bonds. A carrier’s decision to issue a catastrophe bond or purchase traditional reinsurance will be driven by its interest in the optimal deployment of capital - rather than the specific challenges involved in placing a particular program.
The second half of 2008 may have been quiet, but it was not because catastrophe bonds fell out of favor. Instead, investors and issuers followed the rhythms of the broader reinsurance market and based risk and capital management decisions on the many factors that impacted their portfolios. Market conditions during the fourth quarter of last year didn’t favor catastrophe bond issuances, so carriers waited. This simply makes sense.
Looking ahead, it is difficult to make predictions, aside from noting that capital markets will remain an important source of alternative capacity for insurers and reinsurers. The pace of innovation in the ILS space has been brisk, and new structures will help risk-bearers to manage their capital more effectively. The tools of risk transfer are changing, adapting to both the needs of issuers/investors and the availability of information.
Of course, the financial catastrophe is still unfolding, and it likely will influence issuer plans in the coming year. Traditional reinsurance capacity is likely to contract this year, and fourth quarter and full-year financial results have yet to be fully released. We will learn more about the current market over the next few weeks, and this undoubtedly will shape perspectives on risk transfer. Catastrophe bonds and other ILS will be among the many tools evaluated by carriers seeking to move risk from their portfolios efficiently.
The catastrophe bond market has resisted the pull of the broad financial market turmoil. There were some moments of anxiety, but in retrospect, these vehicles have demonstrated their usefulness — even in a difficult financial climate.
Originally published in CEO Risk Forum 2009
*Securities or investments, as applicable, are offered in the United States through GC Securities, 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. Securities or investments, as applicable, are offered in the European Union by GC Securities, a division of MMC Securities (Europe) Ltd., which is authorized and regulated by the Financial Services Authority. Reinsurance products are placed through qualified affiliates of Guy Carpenter & Company, LLC. MMC Securities Corp., 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.