In the first quarter of 2010, two catastrophe bond transactions were completed, and USD300 million of risk capital was issued (1). In response to strong investor demand, both transactions closed within initial price guidance and were upsized relative to announced placement targets. While this activity furthers the integration of the capital markets into the risk management processes of protection buyers, on balance, issuance volumes for the quarter were perhaps a bit lighter than expected at the close of 2009.
As the insurance linked securities (ILS) asset class continues to increase in prominence (and additional asset allocations are made to the space) issuance conditions continue to improve. For sponsors, this makes more compelling the argument for locking significant amounts of multi-year fixed price capacity. This is particularly relevant in the context of the catastrophe activity of the first quarter which included a significant earthquake in Chile and European winter storm Xynthia. The issuance outlook for the second quarter of 2010 is positive, with between 5 and 10 new transactions expected (covering a wide variety of perils) and more activity anticipated later in the year.
First quarter issuance activity kicked off in January with Foundation Re III Ltd., a USD180 million transaction sponsored by longtime catastrophe bond market participant, The Hartford. This transaction provides The Hartford with PCS (Property Claims Services)-index-based protection for hurricanes that may cause insured losses along the U.S. Gulf and east coasts, stretching from Texas to Maine. Foundation Re III Ltd., on which GC Securities served as co-manager, was upsized from the announced target of USD100 million and priced at the tight end of its initial guidance.
Swiss Re’s USD120 million Successor X Ltd. was the second transaction of the first quarter. This transaction provides Swiss Re with multi-peril protection with different trigger types and different risk profiles depending on tranche. The Series 2010-1 Class II-CN3 and Class II-CL3 Notes provide USD45 million and USD35 million of protection for the perils of U.S. hurricane and European windstorm. The Class II-BY3 Notes provide USD30 million of protection for the perils of U.S. hurricane, European windstorm, Japanese earthquake and California earthquake. Though one class of the Successor X Notes included at the transaction announcement was ultimately not placed, the transaction did price at initial guidance (for each tranche) and was upsized from an initial announced target size of USD75 million.
Notably, the Successor X Ltd. transaction was the first catastrophe bond to utilize a PERILS-based trigger for its European windstorm exposure. PERILS AG was launched in January 2009 and fills a role functionally similar for European windstorm losses (and eventually other European perils) that Insurance Services Office Property Claims Service provides for U.S. (and more recently Canadian) perils. The unbiased aggregation and extrapolation of actual losses and reserves to an industry-level figure provides comfort to protection buyers and can also be easily referenced in reinsurance and capital markets transactions.
First Quarter 2010 versus First Quarter 2009
First quarter of 2010 issuance activity declined relative to first quarter of 2009, both in terms of transaction count (two versus three) and risk capital issued (USD300 million versus USD575 million). It is important to note however, that first quarter activity is hardly an indicator of what to expect for the balance of the year as the peak issuance periods within a calendar year for the catastrophe bond market are historically the second and fourth quarters. Notably, the highest annual new catastrophe bond issuance on record (USD6.99 billion) occurred in 2007 with first quarter issuance equal to first quarter of 2010.
Risk Capital Outstanding
Over the first quarter of 2010 total risk capital outstanding declined USD588 million to USD11.92 billion as USD300 million of new issuance was outstripped by USD888 million of maturities. This is the first quarter of declining total risk capital outstanding since the second quarter of 2009. An additional USD4.08 billion of risk capital is scheduled to mature prior to year-end 2010. Risk capital outstanding peaked at the end of 2007, at USD14.02 billion. It then fell to USD12 billion by the end of 2008 before reaching USD11.3 billion at the end of July 2009. The current level is consistent with that of year-end 2008.
Of the USD300 million issued in the first quarter of 2010, USD180 million had exposure exclusively to U.S. hurricane peril; USD80 million had exposure to U.S. hurricane and European windstorm perils; USD40 million had exposure to U.S. hurricane, European windstorm, California earthquake and Japanese earthquake perils.
Industry Loss Warranties
Discussion and negotiation surrounding 2010 industry loss warranty (ILW) placements began late in the calendar year. Buyers were drawn on the one hand, toward ILW alternatives, with upper normal limit retrocession capacity readily obtainable and cat bond issuance vibrant, but attracted to falling ILW rates on the other hand.
The combination of overcapacity in the market, a benign 2009 U.S. hurricane season and model change prompted year on year pricing down by 20 percent for U.S. hurricane only protection and in excess of 30 percent for U.S. earthquake specific coverage. Markets were mindful of current conditions and offered reductions to secure renewal orders. Moreover, a number of opportunistic cedents bound protection with terms proving always more appealing.
However, particularly in the second half of the first quarter of 2010, ILW rates stabilized. Cedents’ appetites for absorbing catastrophe losses have shrunk following the recent earthquake in Chile so they have begun exploring additional cover for peak territories. As the U.S. hurricane season approaches, ILW market activity is likely to increase further.
In the first quarter of 2010, all 2009 participating markets with the exception of IPC Re returned to the ILW space. However, with prices softening for much of the first quarter it remained the rated carriers (rather than unrated hedge funds, which typically must collateralize their obligations) that provided the majority of ILW limits.
Outlook for Second Quarter and Remainder of 2010
The relatively light level of catastrophe bond issuance in the first quarter does not temper GC Securities’ bullish outlook for the balance of the calendar year. In our updates throughout 2009, we frequently mentioned the need for catastrophe bond spreads, in the aftermath of the credit crisis, to come back into rough approximation with the traditional market to spur further issuance. A great deal of progress has been made on this front, as spreads have come in better than 40 percent relative to the first half of 2009.
Looking forward, while the rate of spread tightening may moderate, net cash inflows to sector, and more than USD4 billion of scheduled maturities (the majority of which are expected to return cash into the hands of dedicated ILS funds) should continue to exert downward pressure on spread levels. Sponsors have certainly taken note of this price tightening, particularly in the context of what will likely prove to be the most costly first quarter (measured by insured losses) on record. Importantly, while the losses of the earthquake in Chile, European storm Xynthia and other catastrophe loss activity have created earnings strain for reinsurers globally, neither event has put catastrophe bond layers in meaningful jeopardy. Potentially, this could contribute to an environment where traditional rates stabilize or decline more slowly, further enhancing relative pricing and capacity available in the catastrophe bond market. Additionally, the attractiveness of fully collateralized, multi-year fixed price capacity tends to increase in an environment where significant catastrophe activity is at the forefront of protection buyers’ minds. The second quarter of 2010 should prove significantly more active than the first. While transaction activity is always difficult to predict, estimates of between 5 and 10 second quarter transactions are not unreasonable in our view, with total issuance for the year ranging from USD3 billion to USD5 billion.
 The risk period of State Farm’s USD350 million Merna Re II catastrophe bond, which was marketed during the first quarter of 2010, incepts on April 1, 2010 and therefore is considered a second quarter transaction.
• Chi Hum, Managing Director**
• Cory Anger, Managing Director**
• Hong Guo, Managing Director**
• Ryan Clarke, Vice President**
• Brad Livingston, Analyst**
ILW market commentary provided by:
• Barry Law, Managing Director (Guy Carpenter London)
• Larry Rothstein, Vice President (Guy Carpenter London)
*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, Inc. 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.
**Registered Representatives of MMC Securities Corp.