GC Securities, a division of MMC Securities Corp.*
The third quarter is traditionally quiet for the catastrophe bond market, and 2009 was no exception. Two transactions were closed, resulting in USD412 million in new risk capital.1 Nonetheless, risk capital issued was up by a third relative to the same quarter last year, as both catastrophe bonds issued were upsized considerably. The consensus estimate for the entire year remains USD3 billion to USD4 billion, implying a strong fourth quarter for primary issuance.
- Issuance Activity
- Catastrophe Bond Redemptions
- Risk Capital Outstanding
- Issuance Composition
- Industry Loss Warranties
- Outlook for the Fourth Quarter
New risk capital issued in the third quarter was up 28.8 percent from the third quarter of 2008. Last year, two transactions resulted in USD320 million in new risk capital issued, while this year, two deals, both of which closed in late July, resulted in risk capital of USD412 million.
Parkton Re Ltd., on which GC Securities acted as co-lead manager and joint bookrunner, was one of the few catastrophe bond issuances to be upsized this year — and the only deal so far this year to price below its initial price guidance. The initial target placement of USD125 million ultimately led to a USD200 million transaction as well as price tightening. Parkton Re was sponsored by the North Carolina Joint Underwriting Association and North Carolina Insurance Underwriting Association (collectively the NC JUA/IUA), a first-time sponsor to the catastrophe bond market, and covers North Carolina hurricane losses based on an indemnity trigger.
Eurus II Ltd, which closed a day later, was upsized to EUR150 million (from EUR75 million) and covers European windstorm risk (specifically, in Germany, United Kingdom, Netherlands, France, Belgium, Denmark and Ireland). The catastrophe bond replaced Eurus Ltd, a USD150 million bond that matured on April 8, 2009.
For the first three quarters of 2009, 11 catastrophe bonds were issued, for USD1.79 billion in risk capital. This trails the result posted for the first three quarters of 2008: 13 issuances, amounting to USD2.69 billion in catastrophe protection. Year-to-date issuance activity is down 33.5 percent from the same period in 2008.
Catastrophe Bond Redemptions
In the third quarter of 2009, USD300 million in catastrophe bond risk capital matured, bringing the year-to-date total to USD2.54 billion. Another USD660 million is scheduled to mature in the fourth quarter of this year.
Risk Capital Outstanding
Total risk capital outstanding grew from the second quarter of 2009 to the third quarter, reaching USD11.3 billion — up from USD11.19 billion. This represents a net increase of USD112 million (1 percent). This follows consecutive quarters of declines, though, as the first quarter posted a year-over-year decline of USD75 million, with the second quarter off USD779 million.
Risk capital outstanding peaked at the end of 2007, at USD14.02 billion. It then fell to USD12 billion by the end of 2008 before reaching USD11.3 billion at the end of July 2009. The current level is consistent with that of mid-year 2007.
Of the USD412 million issued in the third quarter of 2009, USD200 million had exposure exclusively to U.S. hurricane, and USD212 had exposure to European windstorm. The U.S. hurricane catastrophe bond was indemnity-triggered and sponsored by the NCJUA/IUA, an insurer. This was the first catastrophe bond sponsored by the NC JUA/IUA. The European windstorm catastrophe bond was sponsored by a reinsurer and used a parametric trigger.
Industry Loss Warranties
Consistent with catastrophe bond market, industry loss warranty (ILW) trading was light during the third quarter of 2009. Pricing for the most part remained flat throughout the quarter, with no major trades prompting significant pricing adjustments. Pricing remains down 15 percent to 20 percent relative to January 2009 and is now consistent with 2007 mid-wind season levels. In general, capacity sellers continue to outnumber capacity buyers.
Outlook for the Fourth Quarter
Last year, the fourth quarter was silent, primarily because the financial crisis reached its peak during this period. This was an anomaly in the history of the catastrophe bond market, since this is usually the second busiest quarter of the year. Based on the current pipeline, it looks as though the fourth quarter of 2009 will represent a return to the norm.
During the first half of this year, when global financial market conditions were more distressed, asset managers contended with greater uncertainty regarding redemptions and the valuations of their existing holdings. The prevailing perception was that insured losses generated by Ike, Gustav and other natural catastrophe events combined with asset write-downs and increased capital costs due to the 2008 credit crisis could contribute to traditional capacity shortfalls for peak catastrophe perils (particularly U.S. hurricane) at the June 1, 2009 and July 1, 2009 renewals. In this environment, the catastrophe bond market was driven by minimum return thresholds. This prompted the sponsors that did elect to issue bonds to increase the risk embedded in their transactions, improving the price efficiency of their protections.
As conditions have improved throughout the year, and insurance-linked securities (ILS) offerings have enhanced their collateral solutions (with increasing focus on U.S. Treasury money market funds), the stronger demand for ILS issuance and increasing capacity of investors has prompted a shift in the predominant driver in the ILS market relative to the beginning of the year. Whereas in the first and second quarters of 2009, many ILS investors were seeking to maintain minimum spread levels, in the currently prevailing environment there is greater focus on capital deployment and stimulating additional primary issuance, which is contributing to spread tightening across the market in general and most sharply for 2009 vintage transactions (which are benefiting from enhanced collateral solutions).
Historically, the fourth quarter has been the second most active quarter in terms of risk capital issued, accounting for 28 percent of total issuance since the market’s inception. Consensus estimate for 2009 total issuance remains from USD3 billion to USD4 billion, implying a fourth quarter issuance rate of USD1.2 billion to USD2.2 billion. If this level is attained, it would represent 40 percent to 55 percent of the issuance in 2009 and would make the fourth quarter the most active of 2009. A fourth quarter accounting for greater than 40 percent of any year’s total issuance has been reached only once (in 2004).
Though a USD1.2 to USD2.2 billion fourth quarter intuitively seems like a stretch, several factors suggest that it may be attainable. In the third quarter, both transactions were placed within (or, in the case of Parkton Re Ltd.,) below spread guidance and well inside the spread levels associated with transactions completed in the first half of the year. Both were also upsized significantly relative to initial placement targets.
The fundamentals of the ILS market also point to a strong fourth quarter for this year. The USD660 million scheduled to mature this quarter will be followed by another USD518 million in January 2010, and these redemptions should result in an increase in demand for new issuances. Further, consistent positive movements in existing bond prices in the secondary market should exert downward pressure on required clearing spreads on fourth quarter primary issuance. In particular, 2009 vintage transactions, which use “next generation” or clean collateral solutions are in high demand.
Improvements in general financial stability around the world and the positive perceptions of ILS as an important asset class for significant pools of traditional investment capital (e.g., pension funds, endowments and sovereign wealth funds) in the wake of the recent credit crisis may support higher demand for the direct investment in insurance risks, as well.
Spreads have tightened on similarly rated alternative investments. As an example, the yield on BB-corporate debt, which was near an all time high at the beginning of 2009, has declined by more than 45 percent during 2009 year to date.2 The general easing of prevailing yields across assets that are often compared to cat bonds should make it easier for ILS investors to accept lower spreads while still generating competitive returns.
A benign 2009 wind season thus far in terms of insured losses (though the season has been roughly average in terms of storm formation) is also making catastrophe bonds more attractive to both sponsors and investors. Only one Atlantic hurricane, Hurricane Bill, made landfall in North America. Some evidence suggests this is due to unusually favorable steering currents, which are pushing hurricanes that form from tropical African waves to the north (i.e., away from the eastern coast of the United States and the Gulf of Mexico). Though the outcome is not yet certain (September 10 marks the official middle of U.S. hurricane season), a season of light (or no) insured losses should contribute to further spread tightening in the catastrophe bond market.
The tightening of spreads is bringing the ILS market back from the unusually wide spread levels sustained in the first half of 2009. Elevated catastrophe bond spreads — especially when contemporaneous to adequate traditional reinsurance capacity that has not increased its pricing by the same magnitude as the capital markets from 2008 to 2009 have had a dampening effect on issuance activity, particularly from reinsurers. Sponsors that were not inclined to issue during the first two quarters of 2009 because of pricing concerns may renew interest in catastrophe bonds, as the other benefits of cat bond protection (e.g., multi-year fixed pricing, fully collateralized cover and a sourcing capacity from an alternative providers relative to traditional reinsurance and retrocession providers) not only remain but will now be attainable at more favorable price points.
- Chi Hum, Managing Director
- Cory Anger, Managing Director
- Hong Guo, Managing Director
- Ryan Clarke, Vice President
- Brad Livingston, Risk Analyst
- This includes the Eurus II Ltd. EUR150 million transaction converted to US Dollars at an exchange rate of USD1.41:EUR1. For Euro denominated issues, amounts are converted to US Dollars according to the prevailing exchange rate on the closing date of each transaction.
- BB-corporate yields measured by using the Merrill Lynch BB Index (1 — 10 year maturities). Bloomberg symbol: H5A1
* 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.