Fears of an active Atlantic storm season have temporarily slowed cat bond activity. But the outlook for the year remains bullish, thanks to the market’s strong value proposition of diversification and competitive pricing
After a somewhat slow start in the first quarter of this year, $1bn of catastrophe bond capacity was placed in April and May, leading many experts to predict that 2010 will signal the recovery of the sector since activity plummeted in 2008. But, while early issuance was oversubscribed, more recent cat bonds have been less popular as investors have held back amid fears of an active hurricane season.
“Everything up to April was pretty successful, but May started to show a bit of fatigue,” says Luca Albertini, chief executive of Leadenhall Capital Partners, a firm that manages funds investing in insurance-linked securities (ILS). “One thing that started to scare the capital markets in the past few weeks was warnings that this year will be one of the worst hurricane seasons in history. I’ve been told by investors that they would rather invest later on in the year than now.”
The 2010 ILS calendar was kick-started with two cat bond transactions worth a combined $300m. Both issuances were upsized in response to upbeat investor interest. Sponsored by The Hartford, the $180m Foundation Re III Ltd covers US wind and has an industry loss trigger based on ISO’s Property Claim Services (PCS) index. A second bond, Swiss Re’s multi-peril $120m Successor X, was significant in that it was the first cat bond to use a Perils-based trigger for its European windstorm exposure.
After the positive start, activity trailed off until April and May, when $1bn of capacity entered the market. This includes the $305m Johnston Re transaction, covering US wind, on behalf of the North Carolina JUA/IUA, and the Munich Re-sponsored EOS Wind Ltd cat bond, worth $80m and covering US and European wind events. Allianz also launched its third offering in its $150m Blue Fin US hurricane and earthquake cat bond programme.
Total cat bond issuance reached $7.6bn in 2007 before the financial crisis caused activity to plummet to just $2.7bn in 2008. The picture improved slightly in 2009, with $3.4bn placed, but experts believe the outlook for 2010 is more positive still. Guy Carpenter predicts that total issuance for the year will be between $3bn and $5bn.
“With some of the cat bonds now being placed with pricing that is in line with traditional reinsurance, the value proposition is there not only in terms of diversification but also cost,” Albertini says.
Trends and innovations
While investors looking for diversification continue to show interest in non-US perils, they are also looking to replace the peak US perils covered by maturing cat bonds in 2010 (worth $4.08bn, according to Guy Carpenter).
The Successor X and EOS Wind cat bonds include European windstorm perils, but Japanese wind and quake so far remain under-represented. In Europe, the introduction of two industry loss indices has helped to fill a gap in the market. Previously, transactions on European perils had to be structured around parametric triggers (such as wind speed or ground shaking), leaving sponsors exposed to basis risk (when an insurer experiences a loss but its bond is not triggered) or indemnity triggers, which are less popular with investors.
The Successor X bond is an important milestone for the Perils index, explains Perils head of sales and products Eduard Held. “The first transaction is really helpful, and overall there has been $200m of capacity placed based on the Perils index, with a number of further transactions in the pipeline.”
Held believes there will be further European cat bonds in the second half of 2010, as the European windstorm season approaches and industry loss triggers become more tried and tested.
As ever, though, price remains a key factor. “The closer the prices get on the cat bond side to the traditional reinsurance, the more attractive it will be,” he explains. “As always, it will depend on events; a large event will change the equilibrium between demand and the price.”
Another notable trend is the continued convergence between traditional reinsurance and cat bonds. “Sponsors are starting to integrate the cat bond purchase into their capacity purchase programme,” GC Securities global head of distribution Chi Hum says. “It’s the broker that puts the entire programme together and who can therefore optimise that layer of cat bond capacity.”
When the ILS sector began to take off in 2006, following two active hurricane seasons in 2004 and 2005, some industry experts were concerned that capital market capacity could become a rival to the traditional reinsurance sector. Such concerns have proved to be unfounded, Hum says. “In order to get maximum value from using a cat bond, you really need to integrate it into the entire tower, because all the contracts interact with each other, ultimately to provide hedging for the client.”
If the forecasts for an active hurricane season this summer prove accurate, it could be the driver necessary to push cat bond activity back into the heady realms of 2007. “We’re now back within distance of where rates have been historically and seeing more sponsor discussion again,” Hum says. “But traditional rates are still very soft, so we’re kind of chasing it down a little bit. If the hurricane predictions are right, the traditional rates are probably the first to respond. So that will be an interesting opportunity, where it becomes advantageous to issue multi-year cat bonds to lock in current rates before traditional rates go up.” GR