GC Securities, a division of MMC Securities Corp.*
A strong first quarter has demonstrated that catastrophe bonds are still important tools for risk managers, treasurers, and CFOs. After five months of silence since the last issuance in mid-August 2008, three bonds closed in the first quarter of 2009 bringing USD575 million in fresh capital and confirmation that these instruments are still attractive investments, despite the ongoing the global financial catastrophe. Investor marketing for a fourth catastrophe bond issuance began in the first quarter but is expected close in the early part of the second quarter. Issuance levels are consistent with the first quarter of 2008, a year that seemed likely to be the second-busiest in the history of the catastrophe bond market until the financial crisis accelerated in the fourth quarter of last year.
The prognosis for the remainder of 2009 is positive. A strong pipeline exists, and even just the replacement of maturing catastrophe bonds would make 2009’s issuance totals roughly consistent with those of 2008. With experienced sponsors using catastrophe bonds as part of a well-considered risk management plan, this is likely, as catastrophe bonds have become strategic tools for distributing peak risks into the capital markets directly.
1Q2009 Issuance Activity
Three catastrophe bonds were issued in the first quarter of 2009, representing USD575 million of risk capital. The number of transactions is equal to that of 2008’s first quarter, and the amount of risk capital is virtually unchanged (down 6.5 percent from USD615 million). While it is still too early to say that the catastrophe bond market will not be impacted further by the financial crisis, the resumption of issuance activity on a scale consistent with the beginning of 2008 is certainly a positive sign.
All three transactions this year were for U.S. perils only, specifically hurricane and earthquake, with one of the catastrophe bonds (USD150 million, 26 percent) exposed exclusively to Florida hurricane based on an indemnity trigger. The remaining two catastrophe bonds, representing USD425 million, use PCS-based triggers.
The coverage of U.S. perils only in the first quarter of 2009 represents a distinct change from the first quarter of 2008, in which USD400 million in risk capital had exposure to non-U.S. perils.
During the first quarter of 2009, six transactions matured and one was redeemed early, removing USD650 million from the catastrophe bond market. As a result, the net decrease in risk capital for the first quarter was USD75 million.
Pricing and Returns
The insurance-linked securities (ILS) space has held up remarkably well during the first quarter of this year. BB rated category catastrophe bonds posted a 1 percent gain while high yield bonds (rated in the BB category) returned 8 percent, and the S&P 500 dropped 12 percent during the same time period. Given the volatility of the broader capital markets, the small ILS return is welcome in exchange for the stability provided. Consequently, the ILS market remains a valuable alternative for investors, who appreciate the prevailing return profile and the non-correlation of the insurance risk characteristics relative to other asset classes.
Yet, for sponsors, catastrophe bond spreads have increased up to 50 percent year-over-year and remain elevated relative to historical pricing … and relative to the traditional reinsurance market at present. Several factors have contributed to this dynamic, including:
- The sale of catastrophe bond assets to meet redemption obligations or asset reallocations
- Distress in other asset classes leading to opportunistic investing away from catastrophe bonds
- Rate increases in traditional reinsurance markets, as well as broader concerns about capacity
The divestiture of catastrophe bond holdings by investors late in 2008 and early in 2009 — to meet redemption obligations or asset reallocations — pushed secondary market spreads wider. Essentially, the catastrophe bond market was a victim of its own success. Since these assets could be sold as compared with “no-bids” on their structured investments, they were divested, which in turn pushed spreads wider. Many multi-strategy hedge funds, in particular, faced the dual pressures of de-leveraging and investor redemptions, which led to the need for further divestiture and wider catastrophe bond spreads.
The relative strength of the catastrophe bond market amid broader financial market challenges has made the asset class less attractive to investors pursuing possible larger returns in distressed asset classes. Those with a thirst for yield (and are comfortable with the current economic environment) are more likely to allocate assets to categories such as distressed debt, where the potential for upside is considerably higher. For core investors in the catastrophe bond asset class, however, interest remains. In addition, new interest from fixed income investors (e.g., pension funds), often with less aggressive return targets relative to multi-strategy hedge funds, is increasing. Though pricing has been pushed higher by the withdrawal of some market participants, the space as a whole is still quite viable and expected to garner net positive cash inflows.
Activity in traditional reinsurance markets has had an impact on catastrophe bond pricing. Reinsurance rates increased at the January 1, 2009 and April 1, 2009 renewals. Some shortages of retrocession capacity and concerns about the demand for capacity in Florida have also led to wider catastrophe bond market spreads and an increase in the cost of this form of capital. Catastrophe bonds are not immune to the trends (i.e., demand for capacity) that affect the reinsurance market as a whole.
Price sensitivity has already manifested itself in the catastrophe bond market this year. Some transactions were postponed because of cost. Others were replaced with capital from other sources — such as traditional reinsurance, retrocession, or Industry Loss Warranties (ILWs).
Transparency and Mechanics
The global financial catastrophe has heightened investor interest in the transparency of securities’ risks (i.e., both insurance and collateral risks) and re-focused sponsors on the importance of collateralized protection. Recent experience supports the market’s shared thinking about improvements to the structure of catastrophe bonds. All closed transactions in the first quarter have used Treasury Liquidity Guarantee Program (TLGP) assets for the investments permitted within the catastrophe bond structure. Additionally, other transparency measures have been implemented, such as:
- Web-based access to transaction documentation
- The netting of obligations between the catastrophe bond issuer and collateral solution provider (in two deals)
- More frequent collateral account asset valuations (e.g. daily)
- “Top-up” requirements in the event that asset values fall below par (trend that began in 2008)
The efforts to further minimize any credit risk in ILS structures and improve transparency have been uniformly applauded by all market participants — including the rating agencies. While the development of these new approaches is further evidence of the ability of the ILS market to sustain and persevere through challenging market environments, the heavy reliance on TLGP assets – a program that currently expires on October 31, 2009, with issuance only guaranteed through 2012 — will not be a long-term solution. Further innovation and market testing of alternative collateral solutions is expected during the balance of 2009 and thereafter.
The Year Ahead
The recent divestiture of catastrophe bond holdings to generate liquidity quickly is expected to abate and as the financial markets and the general economy stabilizes, investors are expected to have a better sense of cash positions and ILS allocations. This is likely to lend some stability to catastrophe bond pricing, though it will not alleviate other sources of price pressure (e.g., any increases in reinsurance rates). Further, efforts to raise new capital are in progress, particularly with pension funds and other fixed income asset managers. This is expected to lead to net capital inflows through the rest of 2009.
Of course, available catastrophe bond capacity for the balance of the year will vary by peril. As the U.S. wind season approaches, capacity for this peril is expected to tighten. Sponsors considering catastrophe bond issuances should plan ahead, as it usually takes eight to 12 weeks to complete a transaction. Getting into the market early could result in lower coverage costs.
Overall, the consensus estimate for total issuance activity this year is USD3 billion, though the eventual amount will be determined by market conditions — particularly pricing. Reaching this level would result in an 11.1 percent year-over-year increase in catastrophe bond capital outstanding, as well as 2009 supplanting 2008 as the third busiest issuance year in the history of the catastrophe bond market. Of the USD2.4 billion that would have to be issued in the next nine months, more than USD2 billion could be funded through catastrophe bonds that are scheduled to mature this year.
A return to the pace of 2007 is unlikely, but 2009 is nonetheless expected to be a busy year for the catastrophe bond market. The drivers are strictly practical, with most issuances likely to come from experienced sponsors (particularly primary insurers) who have integrated cat bonds into their capacity purchase programs and have clear risk management objectives. Likewise, the investors purchasing catastrophe bonds will probably be anchored by specialists in this asset class, but with new money coming in as direct investors or as allocations to the dedicated funds.
- Chi Hum, Managing Director — Global Head of ILS Distribution
- Cory Anger, Managing Director — Global Head of ILS Structuring
- Hong Guo, Managing Director
- Ryan Clarke, Vice President
- Brad Livingston, Analyst
* 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.