Only a few years have passed since cat bonds were commonly described as “an elegant solution in search of a problem”. They have since become a vital tool in the risk transfer armoury, but will they remain there? asks Mark Hvidsten.

The Florida storms in 2004 and Katrina in 2005 transformed the moribund cat bond market and generated a flurry of activity that continues to this day. Recalibrations of US windstorm models and the re-rating of the insurance and reinsurance sector by the rating agencies supported the drive for capital by companies whose surplus had been depleted by severe catastrophe losses. Regular announcements of new cat bond issuance competed with sidecar formation as the most topical news item of the day.

A new day had dawned, where post-event recapitalisation competed with capital efficiency as the more pressing issues facing companies with significant catastrophe exposures. Even the customary rash of private equity funded start-ups in Bermuda (and elsewhere) seemed to be but a mere part of the flood of capital rushing to replenish surplus and take advantage of superior pricing driven by market dislocation.

Challenging environment

Two and a half years later, the outlook may seem more uncertain. The underwriting cycle is, despite rumours to the contrary, decidedly not dead. Capital market investors, it transpires, seem to be influenced much more by softening pricing in the reinsurance market than by the relative value of an uncorrelated asset class. This is probably unsurprising given the relative sizes of the two markets.

While the year is still young, expectations for cat bond issuance are being talked down, and another year of record issuance looks doubtful. Sidecar closures of approximately $1bn have already been announced with shrinkages in ceded income in all the survivors. Some hedge fund investors (the fuel of much of the initial event-risk interest) have become pre-occupied with the credit-related problems and opportunities in the marketplace.

At the same time, cheap(er) and plentiful reinsurance has made the analysis of capital efficiency alternatives more complex and much less clear-cut. The prevailing refrain is one of too much capital chasing dwindling returns – not an auspicious time for products that seem to be predicated upon surplus relief or relative capital efficiency. Improvements in the efficiency and timeline of the process have taken place but many sponsors are still deterred

Back off the menu?

So, is the insurance-linked securities (ILS) market becoming less relevant (once again) to the insurance and reinsurance markets? This is emphatically not the case. A clear trend towards the inclusion of ILS alternatives into the analysis of capital structure for insurance companies is now standard. For instance, the reduction in sidecar capacity has been exactly what was expected and is indicative of intention being realised.

One recent material change is the recognition that the role of the cat bond placement will likely fluctuate with the reinsurance market – a useful and natural maturing of the products. As the market increasingly understands the distinct benefits and advantages of ILS products, a less cyclical outcome is probable.

Currently, this trend is slightly obscured by the soft reinsurance market in its various forms, but the underlying capital issues remain. If this is correct, then the supply of ILS instruments will ultimately be secure. What about demand? This may be a little less clear.

Historically, the ILS market benefitted from a relative cost of capital difference arising from the uncorrelated nature of ILS instruments to assets in the broader capital markets. This differential enabled the execution of a win-win trade: uncorrelated ILS assets enhance portfolio risk/return characteristics, while (re)insurer limits reinsurance credit exposure while financing risk at an accretive price.

Thinking like reinsurers

This assumption still underlies much of the ILS trading that takes place, but in many cases investors now seek to capture portfolio diversification effects for themselves, within their ILS book. They therefore think more like a regular reinsurer than someone looking for broad asset class diversification. This effect is particularly pronounced in specialist ILS funds that seek to deliver returns to investors entirely from the ILS exposures they assume – thereby explicitly abandoning the root attraction of the uncorrelated asset approach.

This has had some interesting side effects. Multiple territory coverage and multi-peril deals have less appeal for investors, many of whom prefer to diversify their own portfolios, rather than accepting “pre-diversified” risk. As a corollary, single territory/peril deals are more attractive and particularly in non-peak zones, are often subject to aggressive competition, not least by reinsurers.

The presence of the bank loan market – especially in the debt tranches of sidecars – was a fairly brief interlude. It promised much in terms of achieving a wider distribution of insurance risk to investors, but has suffered along with many other features of the credit crunch.

In the market’s embryonic stage, banks created products for the early investors, and these tended to be single peril, non-indemnity deals which were sold to pioneering sponsors. As the market has matured and the number of investors, including insurance-linked specialists, has increased, arrangers have included the capital markets arms of brokers and reinsurers. Arguably they are more focused on the broad objectives of the sponsor and seeking to match securitisations more closely to reinsurance structures.

This is to some extent what lies at the root of increasing numbers of indemnity deals as well as deals done on an aggregate loss basis. Despite this trend, the ILS market is unequivocally not just “another form of reinsurance”. It is indeed an elegant solution to the problem of peak zone catastrophe exposures, and will most likely evolve to be a solution for other issues as well.

Mark Hvidsten is chief executive officer of Willis Capital Markets.