GC Securities, a division of MMC Securities Corp.*
The catastrophe bond market continues to advance, though issuances are down from 2008. The activity represents a positive rally from the hiatus during the second half of 2008. For the first half of 2009, nine bonds have been issued, with aggregate risk capital of USD1.38 billion. The continuing stabilization of financial markets and a decrease in catastrophe bond spreads, however, could result in more issuance activity in the second half of the year, particularly for sponsors which had considered issuances in the first and second quarters but deferred their plans because catastrophe bond spreads were considered to be too wide (i.e., catastrophe bond protection was considered to be too expensive).
- Issuances and Redemptions
- Total Risk Capital Outstanding
- Pricing and Capacity
- Second Quarter Issuance Composition
- Collateral Solutions and Alternatives
- Industry Loss Warranties
Issuances and Redemptions
Six catastrophe bond transactions were completed in the second quarter of 2009, with USD808 million in risk capital coming to market. The number of bonds issued is down 25 percent year-over-year (from eight), and risk principal issued is off 54 percent from the USD1.75 billion issued during the first quarter of 2008.
For the first half of the year, nine catastrophe bonds were issued, generating risk capital of USD1.38 billion. The first half of 2008 was more robust, with 11 transactions resulting in USD2.4 billion issued. From the first half last year to the first half this year, risk capital issued declined 42.5 percent, due in part to pricing conditions.Offsetting new issuances, USD1.59 billion in catastrophe bonds matured in the second quarter of 2009, bringing the year to date total of matured risk principal to just over USD2.24 billion. Another USD960 million is scheduled to mature in the second half of the year.
Total Risk Capital Outstanding
Net catastrophe bond risk capital outstanding fell USD779 million (6.5 percent) from the first quarter of 2009 to the second quarter of 2009 — from USD12.0 billion to USD11.2 billion, as maturities outpaced issuances. The second quarter of 2009 was the second consecutive quarter in which total risk capital outstanding declined.
Risk capital outstanding peaked at the end of 2007 at USD14 billion and fell to USD12 billion a year later. Two quarters into 2009, catastrophe bond risk capital outstanding is at mid-year 2007 levels.
Pricing and Capacity
Catastrophe bond spreads remained consistent from the first quarter of 2009 to the second — up 25 percent to 50 percent relative to 2008 levels. The market reacted positively in response to the relatively high yields, with three of the quarter’s six transactions upsizing relative to initial announced placement targets. Year-to-date and particularly during the second quarter, investors have shown consistent interest at this year’s relatively high spreads.For the rest of the year however, several factors may converge to make issuance conditions more favorable to catastrophe bond sponsors, assuming no major catastrophes:
- An improvement in broader capital markets conditions as the general economy stabilizes and the distance from last year’s financial crisis increases
- Increased risk capacity because some traditional reinsurance programs have been reduced or restructured, resulting in the purchase of less reinsurance
- Catastrophe bond maturities of more than USD960 million in the second half of 2009
If this year’s hurricane season generates significant insured damages or if an improvement in financial market conditions does not continue, catastrophe bond spreads are likely to remain high or even widen further relative to current levels. But absent these two factors and given prevailing supply and demand conditions, catastrophe bond spreads should exhibit a downward tendency during the second half of 2009.
Second Quarter Issuance Composition
Approximately 87 percent of second quarter issuances (USD704 million) had exposure to U.S. windstorm, U.S. earthquake, or both. Of this, USD576 million was exposed to both perils. USD150 million was exposed to U.S. windstorm only, with USD14 million exposed only to U.S. earthquake only. USD68 million (EUR50 million) in Euro-denominated issuances covered exposure to European windstorm and Turkish earthquake. In an environment in which investors are more sensitive to minimum return targets relative to diversification benefits, sponsors were inclined to access the catastrophe bond market for key peak perils.
Indemnity-triggered bonds accounted for USD250 million (31 percent) of issuances. Modeled Loss triggers were next at USD180 million (22 percent), with Weighted-PCS index triggers following at USD150 million (19 percent). Multiple Trigger transactions (Multi-peril transactions utilizing different triggers for each covered peril) reached USD127.6 million (16 percent), and USD100 million (12 percent) came from a Modified Industry Trigger Transaction- (MITT-) triggered bond.
Two transactions used a multiple trigger approach: Ianus Capital Ltd. and Successor II Ltd. Sucessor II Ltd. employed a modeled loss trigger for U.S. hurricane risk and a parametric trigger for California earthquake risk. Ianus Capital Ltd. employed a parametric trigger for European wind risk and a modeled loss trigger for Turkish earthquake risk.
- Indemnity: USD250 million (31 percent)
- Modeled-Loss: USD180 million (22 percent)
- Weighted PCS (Index): USD150 million (18.6 percent)
- Multiple Triggers: USD127.6 million (15.8 percent)
- MITT: USD100 million
The diversity of trigger types used so far this year indicates the depth of the catastrophe bond market and its ability to concurrently support several alternative trigger structures. The continued coexistence of trigger types allows sponsors and investors the flexibility needed to lay off and consume risk, respectively, depending on individual preferences and the characteristics of the underlying risk.
The bulk of second quarter catastrophe bonds were sponsored by insurers — USD680 million (84 percent). Reinsurer issuances comprised 16 percent, at USD 128 million. Potential reinsurer sponsors likely saw cat bond market spreads as too high and opted to postpone issuances.
The catastrophe bond market was dominated by experienced sponsors in the second quarter, continuing the year’s trend. Repeat sponsors issued USD658 million in catastrophe bonds in the second quarter of 2009, accounting for more than 80 percent of the quarter’s risk capital. There was only one first-time sponsor, with a USD150 million catastrophe bond. If catastrophe bond spreads come down in the second half of the year, however, activity from first-time sponsors may increase.
Sponsors are reacting to the market’s minimum return requirements by increasing the risk profiles of the transactions they place. This year, the median year-to-date expected loss is the highest in the market’s history, even exceeding 2006 (which was influenced by the active 2004 and 2005 hurricane years). With the availability of leverage down — and its cost up — investors are looking at transactions more carefully in order to meet their return targets. Investors, effectively, are willing to accept (and in some cases are actively seeking) transactions with embedded leverage (via multi-peril, multi-zone exposures) for peak risks to meet return hurdles. In an environment in which financial leverage is plentiful and cheap, investors (particularly the dedicated catastrophe funds) should be more inclined to build portfolios composed of diversified perils and more remote risk profiles — which carry lower coupons — as it is easier to borrow against a book that is stable (i.e., less total exposure to a single event or peril) and carries less risk.
Currently, two transactions are planned for the third quarter of 2009: one with European wind exposure and one with U.S. wind exposure. Traditionally the third quarter tends to be quiet, in part because of hurricane season and traditional cedent renewal dates. Historically, it accounts for only approximately 14 percent of risk capital issued (based on the period 1997 through 2008). If catastrophe bond market spreads decrease sufficiently, the door may open for sponsors that had considered issuing earlier this year to reconsider the market in the fourth quarter. The last quarter, historically, is the second busiest in terms of risk capital issued, accounting for 28 percent of issuances from 1997 through 2008.
Collateral Solutions and Alternatives
Collateral solutions continue to attract attention, and several alternative approaches have been developed. Current options include :
- Total return swap with FDIC-guaranteed bank debt
- Bank deposit
- Tri-party repurchase agreement
- Customized putable notes
- U.S. Treasury Money Market funds
The market is willing to support several alternatives to traditional collateral solutions, as long as they are perceived to be sufficiently transparent and insulated from credit risk. The existence of several choices enables sponsors to make decisions based on cost, protection and other considerations that affect how they manage risk and capital. Further, by using several solutions simultaneously, the market is less likely to become “overweight” on one single solution, maintaining an element of diversification across collateral solutions. The result is another layer of protection from shock events that could have a negative impact on a single type of collateral solution.
Industry Loss Warranties
The Industry Loss Warranty (“ILW”) market, though trading a distinct product relative to catastrophe bonds, occupies a similar position as an alternative and supplement to traditional capacity and is subject to similar supply and demand forces and (increasingly) market participants. Perhaps as a leading indicator, the ILW market is showing signs of softening with rates for bellwether contracts declining up to 15 percent (relative to January highs) in June in response to light volumes at higher price points and a relatively plentiful supply of risk transfer capacity.
- 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.