First Quarter Market Dynamics and Outlook for the Balance of 2011
First quarter market dynamics were altered by the Tohoku earthquake on March 11 particularly in combination with other first quarter losses emanating from flooding and Cyclone Yasi in Australia and the (second) Christchurch which occurred on February 21. Additionally, though to a lesser but still relevant degree, RMS’ release of its latest North American hurricane model, RiskLink v11, on February 28, also influenced market opinion on general valuation levels.
During January and February market conditions were generally in line with 2010 year-end expectations and, as mentioned, issuance was exceptionally strong, particularly on the heels of such a strong fourth quarter in 2010. The market’s focus very much remained on the size of the issuance pipeline and managing through the more than USD2.0 billion of scheduled maturities set to occur prior to June 30, 2011. From a secondary trading perspective, activity was light, with trading interest driven by some small to medium size accounts seeking to generate liquidity in order to participate/support new transactions from long-standing sponsors. The East Lane IV Ltd. transaction in particular, due to the market’s perception of pricing, regional risk profile and Chubb as a high quality sponsor for an indemnity triggered transaction, was particularly well received. Once expectations of the potential for upsize began to firm, some investors did look to exit existing positions in order to support larger East Lane IV orders. Deal specific trading aside, however, activity was light as catastrophe bond buyers continued to outstrip sellers, particularly for diversifying perils, non-U.S. Texas to Maine wind exposed catastrophe bonds and for the (relatively few) transactions carrying higher coupons.
In the aftermath of the Tohoku earthquake the market’s focus shifted to evaluating the probable impact of the event on existing catastrophe bonds and, to a lesser extent, on the implications for future issuance. Approximately USD1.43 billion of catastrophe bonds, consisting of fifteen individual classes from ten separate transactions associated with six sponsors, have exposure to Japan earthquake risk. In terms of risk capital, the USD1.43 billion of catastrophe bonds represented approximately a 12 percent share of the USD11.97 billion of natural peril exposed catastrophe bonds outstanding at March 31, 2011. Due to differing trigger designs and other structural features, the principal at risk in each of these bonds from the Tohoku earthquake differs significantly.
In the immediate aftermath of the Tohoku earthquake the secondary market was able to maintain good order as the loss implications and expectations were digested and priced into the most likely exposed bonds. Muteki Ltd., a USD300 million catastrophe bond (ultimately benefitting Zenkyoren) which utilizes a parametric trigger based on ground motion measurements via K-Net, quickly arose as investors’ primary bond of interest. During the days following the earthquake event until additional information concerning the stations’ readings became available (and confidence increased about the likelihood of a partial or total loss), the Muteki bond did continue to trade. Importantly, throughout the discovery process, there remained a consistent bid in the market, and while in many cases these bids were put forth at distressed levels by non-core cat bond investors; the continuous presence of liquidity throughout a period of significant uncertainty is further evidence of the maturation of the cat bond market.
Multi-peril bonds with exposure to Japan earthquake risk also traded down during March, reflecting mark to market losses on aggregate transactions and formerly second event bonds that are now “activated” and exposed to first event losses going forward. Marks on non-Japan earthquake exposed catastrophe bonds were affected as well due to concerns about reinsurance rates globally in light of the first quarter 2011 loss activity and impact of the RMS RiskLink v11 release. The loss activity of 2011 thus far, while not expected to be a “capital” event for the industry, has, in many cases, exhausted reinsurers’ annual catastrophe risk budgets - even prior to the onset of U.S. wind season. Renewals at June 1 and July 1 will demonstrate how reinsurers are reacting to the first quarter 2011 headwinds.
We note that while capacity sellers have sustained significant losses during the first quarter, Guy Carpenter estimates that going into 2011 the industry was carrying approximately USD19 billion of excess capital. However, the prospective rate environment is less certain than it was at January 1.
The range of opinions associated with the prospective rate environment in the traditional market is contributing to increased uncertainty with respect to catastrophe bond issuance for the second quarter and balance of 2011. While on the one hand, significant catastrophe activity should serve to increase the perceived value of multi-year collateralized protection in the eyes of protection buyers, concerns about cat bond market pricing and capacity still remain. Some sponsors have elected to take a wait and see approach (putting planned pre-U.S. wind season transactions on hold) while paying close attention to the pricing environment in the traditional market leading up to the June 1 renewals.
On balance, it is apparent that protection buyers do continue to recognize the value of the catastrophe bond market and the features of catastrophe bond protection. Features such as full collateralization and multi-year protection are recognized in an increasingly explicit sense during the transaction evaluation process. Relative “all-in” pricing is critical, as it reflects the additional benefits of catastrophe bond protection as well as transaction costs, when comparing the traditional and catastrophe bond markets. To the extent the catastrophe bond market, in this particular environment, can demonstrate coordination and a reasonable level of consistency with the traditional market, it would provide a measure of assurance to protection buyers currently contemplating new transactions. It is also worth nothing that while the returns on outstanding catastrophe bonds did have a negative month (due to mark-to-market effects reflecting potential losses, etc.) during March, the long-term cumulative return profile does still compare favorably to alternative asset classes.
With respect to activity in the third and fourth quarters, it seems reasonable to expect that Asia-Pacific issuers will have an increased need for protection and potentially could be more appreciative of the value of multi-year fixed spread protections. The Tohoku event has also provided an opportunity for market participants to identify structural improvements for future transactions that should improve transparency, reduce basis risk and improve post event loss determination processes going forward. With respect to other perils (particularly European windstorm), the prevailing rate environment, the continued expansion of the PERILS database and other trigger enhancements should still present value to both protection buyers and sellers and therefore additional issuance from these regions would not be surprising. Finally, while in recent years the catastrophe bond market has been predominantly utilized by primary companies, it is possible that rating agency and capital concerns, scarcity with respect to traditional retrocession covers and a desire to structure more certain multi-year capacity, could prompt reinsurers (as a group) to return to the market during the balance of the year.
At the beginning of 2011 consensus estimates pegged expected issuance for the year at between USD5 billion and USD7 billion. By and large those estimates were re-confirmed at the recent SIFMA Insurance-Linked Securities conference, which is widely attended by industry participants. With over USD1 billion of issuance already and positive underlying market fundamentals, the chances of reaching at least the low end of these issuance totals is still feasible. Relative pricing between traditional and capital markets will be important as will the occurrence or non-occurrence of additional catastrophe events.
Finally, it is important to highlight that the sympathies and thoughts of GC Securities and Guy Carpenter (and market participants, generally) are foremost with those personally affected by the Tohoku earthquake, Cyclone Yasi and the Christchurch earthquakes. We note that the catastrophe bond market, by providing consistent and effective protection for these types of events, has an important humanitarian and socially beneficial role in the reconstruction efforts.
* 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.