December 1st, 2011

GC Securities* Catastrophe Bond Market Update: Third Quarter 2011, Part II

Posted at 1:00 AM ET

Industry Loss Warranties (ILW)

Consistent with seasonal trading patterns, ILW activity tailed off in the third quarter relative to pre-U.S. wind season levels. Prices were driven down by increased available capacity (from sellers looking to take advantage of price increases available at the conclusion of the first quarter) and a demand reduction from protection buyers as the U.S. wind season proved less damaging than forecasts suggested.

LiveCat trading activity did pick up around Hurricane Irene, which threatened the East Coast, but trades were few in number as the industry suffered less than USD5 billion in insured losses.

With regard to expected activity for the remainder of 2011, the market is likely to remain quiet. Unsurprisingly, profit protection covers - which generally make up a significant portion of fourth quarter trading - are not a priority this year as the catastrophe losses for the 2011 calendar year have reduced or eliminated profits available for protection.

Some protection buyers have made early moves to renew January 1, 2012 covers and these discussions will continue throughout the coming weeks.

Looking into 2012, the ILW arena should remain a robust capacity resource. It is an active market capable of providing cost effective and rapidly implementable solutions to protection buyers and also attractive returns for protection sellers over an extended period of time.

Third Quarter Market Dynamics

The 2011 hurricane season has been active to date with 17 named storms, but has not yet caused any principal losses to the catastrophe bond market. The greatest threat for major damage and potential losses came from Hurricane Irene, which headed toward the eastern United States during the week of August 22. Projections leading up to the landfall of the storm in North Carolina on August 27 varied greatly. Some projections indicated losses of a magnitude large enough to impact the USD505 million of Johnston Re bonds, which have a large exposure to the Barrier Islands of North Carolina. As such, the Johnston Re bonds traded below 50 percent of par on the Friday afternoon before landfall. There were also more modest price declines in other bonds containing exposure to the U.S. wind exposed transactions, as credible modeling scenarios suggested Hurricane Irene had the potential to bring category 2 wind speeds into the northeast.

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However, the storm lost intensity and did not bring the type of wind speeds that were originally projected. It was clear after the weekend that none of the cat bonds were in danger of being attached by the event. Immediately, bond prices returned to pre-Irene levels and have continued to increase as more of the hurricane season passes without any loss-threatening storm systems developing.

The main drag on the ILS market in the third quarter was the mounting losses to the Mariah cat bonds. At the time of this writing, it is expected that the USD100 million 2010-2011 tranche has been triggered (which has been downgraded to CC by Standard & Poors) and that the USD100 million 2010-2012 tranche will sustain a total loss.

Outlook for Fourth Quarter 2011, First Quarter 2012

Looking ahead to the fourth quarter 2011 and into 2012, the catastrophe bond market appears poised for significant issuance activity. Issuance should be diverse with transactions containing exposure to peak perils of U.S. hurricane and earthquake on broad geographic bases, as well as regional transactions. Additional transactions with exposure to European wind and Japanese perils are also expected to come to market. Further variety by risk profile, trigger type and occurrence versus aggregate transactions should also be available. Given the losses of the 2011 calendar year, it is likely that severe convective storm will remain a peril of interest for both sponsors and investors despite the losses sustained by the Mariah tranches. Finally, as the investor base continues to evolve and demonstrate its ability to understand and price new perils, additional activity involving risks previously unsecuritized in the catastrophe bond market is also probable.

A sustained period of elevated and diverse issuance activity will no doubt be welcomed by a primed and ready investor community. Looking back at past periods of elevated issuance activity, such as the fourth quarter 2010 or the first three quarters 2007, significant issuance totals tend to be concentrated in one peril or a small peril group. In 2007, due to the impact of model revision and the losses from the Katrina/Rita/Wilma storms, issuance was dominated by U.S. hurricane risk. In 2010, driven by new issuers coming to market and favorable market conditions, issuance was dominated by U.S. wind and earthquake perils offered on a combined basis. In some instances, this created a crowded deal environment in which clearing spreads were pushed upwards due to concentration and capacity issues for a particular peril, even in the context of high and increasing cash levels for investors, generally. Ultimately, this temporal dislocation contributed to a deadweight loss for the market as sponsors did not issue as much as they would have in the context of higher prices, and investors did not get access to sufficient overall deal flow to match their cash deployment targets. With a more broad-based issuance forecast for the balance of 2011 and into 2012 coupled with sustained strong investor demand, there is reason to expect that the catastrophe bond market could be in for a banner year. It should continue to serve an important role as a complementary source of capacity to the traditional reinsurance market.

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Contributors

• Chi Hum, Managing Director

• Cory Anger, Managing Director

• Hong Guo, Managing Director

• Ryan Clarke, Vice President

• Brad Livingston, Assistant Vice President

ILW Market commentary provided by

• Barry Law, Managing Director (Guy Carpenter London)

• David Rothestein, Vice President (Guy Carpenter London)

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* 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.

Chi Hum, Cory Anger, Hong Guo, Ryan Clarke and Brad Livingston are registered representatives of MMC Securities Corp.

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