GC Securities* Catastrophe Bond Market Update: First Quarter 2011; Expected Loss Characteristics, Industry Loss Warranties
Expected Loss Characteristics
The risk profile of new offerings increased relative to 2010, to a weighted average expected loss of 2.02 percent. While additional new issuance during the balance of the year could reduce the new offerings’ expected loss for 2011, we note that the weighted average expected loss from 1997 through the first quarter of 2011 is 1.58 percent and there has only been one year in the last six years where the weighted average expected loss of primary issuance in a calendar year has been less than this long-run mean. This increase in risk profile can be explained by an increasingly sophisticated and informed investor base, a reduction in the broad based availability of affordable leverage for catastrophe bonds and prevailing reinsurance market conditions. In relatively scarce capacity environments, such as 2006 and the first half of 2009, where minimum clearing spreads tend to increase, protection buyers are inclined to increase the expected loss of each transaction in order to improve price efficiency. In relatively plentiful capacity environments, such as the second half of 2009 and 2010, where minimum clearing spreads tend to decrease, protection sellers (with an improved ability to understand more “in the money” covers) are inclined to prefer riskier transactions in order to achieve target portfolio returns. The fact remains that, relative to the early 2000s, financial leverage for catastrophe bonds is less available, which tends to augment the tendency for higher risk catastrophe bond structures.
It is important to note that the increase in the expected loss of deals brought to the catastrophe bond market and the inclination of catastrophe bond investors to accept riskier transactions in declining premium environments does not imply an easing of the market’s analytical discipline. Nor does it imply a focus reduction on terms and conditions by catastrophe bond market participants. Rather, it signifies an improvement of the catastrophe bond market’s ability to evaluate, understand and, where modeling and disclosure are sufficient, competitively price a more diverse range of perils, risk profiles, structures and triggers. Going forward, this increased sophistication and measured expansion of investor appetite for risk should be a catalyst for productive and healthy long-term growth for the catastrophe bond market.
Industry Loss Warranties
The industry loss warranty (ILW) market hardened significantly during the final weeks of the first quarter. Catastrophes in New Zealand, Australia and Japan have increased demand for additional protections for the remainder of 2011, while the output from RMS RiskLink v11 appears more pronounced than anticipated in all the major hurricane zones of the United States. A period of intense trading immediately following the Tohoku earthquake saw pricing for U.S. wind risk increase by 20 percent (largely due to model concerns) and U.S earthquake risk increase by 15 percent (largely due to concerns about earthquakes creeping eastward from the Pacific Rim). More recently, however, the market is in a more reflective mood where new capacity is entering the space in an attempt to take advantage of rate increases. This new capacity and an abatement of protection buyer interest have moderated any further price increases and, in the short term, the ILW market pricing is showing signs of remaining stable at current levels.
* 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.