Securitisation has left infancy and entered adolescence. Adrian Leonard examines changes in demand, appetite, and the nature of the cat bond buyer.

Observers should be excused for misunderstanding Munich Re's recent statement about the capital markets' limited appetite for catastrophe risk. Following the late-January completion of a $300m catastrophe note issue, Manfred Seitz, head of the Munich's Alternative Risk Transfer Division, stated: “We would have liked to place an even larger amount; however, the capacity available in the capital markets for catastrophe risks is limited.”

He probably meant to say that in December the capital markets' appetite for catastrophe risk securitisations – or indeed for any high-yield issues so close to year-end – was limited. The vast majority of high-yield investors had closed their books. But Munich Re definitely did want to place more: people close to the deal say that its initial conversations with potential investors revolved around a $250m note issue by each of three special purpose vehicles, PRIME Capital CalQuake Ltd, PRIME Capital EuroWind Ltd, and PRIME Capital Hurricane Ltd, but in the offer circular the figures had slipped to $200m each. When it came to the placement (in December), only half of that was achievable.

Usually a dead month by most measures, December 2000 was a particularly difficult time in the high yield bond market, amid US economic gloom (recession, the ‘R' word, was mentioned) and Presidential uncertainty. The Munich Re offering was probably a larger placement than was mustered that month by all the rest of the high yield market combined – indeed, during three weeks of the last month of 2000 there were no US high yield issues at all. The reinsurer's desire to close its placement ahead of the completion of the renewal season meant it was unable to find a home for as much risk as it had hoped to unload. Had the German giant been more patient, the result might have been different. More than $2bn flowed into the US high yield market in the first full week of January.

Hungry times
Despite Mr Seitz's assertion, most of the evidence points to plenty of capital market appetite for more catastrophe bonds. “I'm hoping we see more paper this year,” says Melanie Strüve, portfolio manager for the Risk Markets Group at Westdeutsche Landesbank (WestLB). Last year the German bank answered clients' hunger for exposure to non-correlating risk by establishing a E48m fund invested exclusively in securitised catastrophe instruments. “We established the portfolio according to the investors' demand,” she explains, adding that it was German insurers and reinsurers which asked WestLB to create the fund and issue notes against its performance. The same reinsurer clients set accumulation limits for the perils covered by the notes.

At the time of the deal WestLB said it planned an additional fund before year-end, but insufficient instruments were available either from the limited number of new issues or in the functionally illiquid secondary market for catastrophe bonds. “Nobody wants to sell. It is very difficult to get paper,” Ms Strüve says. In addition, the long-touted attraction to investors – non-correlation of risk – is proving an obstacle, at least for insurance sector buyers, since the major securitisations to date focus on the same old cat risks which the reinsurance industry has always had difficulty swallowing. “If you want to go into the market for diversification, you get only US hurricane, US and Japanese earthquake, and European windstorm, so no real diversification is possible.”

Ms Strüve cites Lehman Re's March 2000 securitisation of California earthquake and fire-following risk through Seismic Ltd, and Swiss Re's SR Earthquake Fund Ltd, which tackled the same risk through a bond issued in July 1997. “They were basically same, with the same triggers and the same risk, so it is not that interesting to buy both bonds. You can only look at the pricing. We're looking for other risks.” She mentions life insurance and satellite launches.

Such deals may be on the cards. Erwin Zimmermann, chief executive of Swiss Re New Markets, said that securitisations of non-nat-cat insurance risk may be on this year's agenda. However, to date such deals have been scant. More than 30 securitisations have dealt with the four perils Ms Strüve mentioned since the art was invented in 1996; the securitisation into tradable instruments of risk arising from other perils can be counted on one hand.

The problem of non-diversification is definitely real, but it may be a problem only for insurance-sector investors in insurance-linked securities (such as the investors buying WestLB's catastrophe notes). Reinsurers, particularly continental players, tend to have a penchant for pot-filling, and a pot of, say, Tokyo earthquake risk can be filled fairly quickly. But investors from other sectors should have no problem absorbing more catastrophe risk. Certainly the investment bankers believe there is both the will and the way, and thus non-insurance investors are – at last – playing a more important role in the non-traditional spreading of catastrophe risk.

Munich Re said its issue was placed “roughly equally amongst a broad range of investors from the insurance sector and other capital market investors,” highlighting the insurance-heavy profile of cat bond buyers (although people close to the deal say “roughly equal” is inaccurate and misleading, and that non-insurance capital was a notably heavier underwriter of the notes). That fits with the predictions of Dirk Lohmann, chief executive of Zurich Re, who said that reinsurers will probably underwrite fewer catastrophe bonds going forward. “Reinsurers had bought them because they were more attractive than the returns achievable through conventional reinsurance at soft-market prices. That has changed to an extent, and reinsurers' appetite will probably diminish.”

Sated?
As that universe of insurance-related high-yield instrument buyers grows – one investment banker puts the number at about 140 investors over the history of the asset class, up from 100 a year ago – the concern about diversification may ease. But a senior placing agent at a major insurance broker explains another reason for the shift of interest from insurance investors to other high-yield buyers. “The balance of investors is changing for several reasons. Initially, placing a part of an issue into the traditional insurance sector was a deliberate tactic on behalf of the brokers to give confidence to non-insurance investors that they weren't getting ripped-off,” the broker says.

The need for such ploys has diminished, he claims. Echoing Mr Lohmann, he explains that during the softening market, bonds were attractive to reinsurers because they were overpriced, but as catastrophe retrocession rates begin to increase they are becoming a less attractive vehicle for achieving high returns from catastrophe exposure: big players would simply rather write conventional retro, where the return is higher. The parametric triggers that are a feature of several recent securitisations (and which Munich Re states “ensure utmost objectivity” and will “become a standard feature” of catastrophe deals) have also made some reinsurers nervous, since they offer limited transparency, rely totally on modelling commissioned by the issuer, and are practically unverifiable.

Historic oversubscription is another factor, one which the broker says has led to “an element of resistance” among reinsurers to securitised catastrophe instruments. For example, demand for AGF's Mediterranean Re bonds, which last November provided exposure to Monaco earthquake risk, was far in excess of supply (because it moved away from the usual square of US earthquake, US wind, Japanese earthquake, European storm). “If transactions were oversubscribed, allocations to the insurance sector were always scaled back,” the broker reveals. Many insurance sector investors that had expended significant efforts to assess catastrophe bonds, but received small investment opportunities in return, are now less willing to look at cat bonds. WestLB's Ms Strüve complains of just such a phenomenon, although it has not been a feature of the latest issues.

Fortunately, other interests are stepping in to replace the reinsurers. “We are thinking about more insurance-linked notes for other investors,” Ms Strüve says. “French, Italian and German fund managers from outside the insurance sector have expressed interest in catastrophe bond exposure for diversification.” James Barder of Aon Capital Markets sees the same trend. “The volume of investors is definitely growing, and there is growing interest in Europe. It is the typical development,” he says. “America leads the way.”

A banking source says about half the risk capital raised in 2000 came from European sponsors. Continental industry players such as Swiss Re were a large part of the equation, catching up with their US counterparts, but non-industry capital is increasing both in terms of the number of participants and the proportion of the total securitised insurance risk they underwrite. “There's good interest from outside the insurance market. That's where the growth is coming from,” says the banker, adding that a “large number” of high yield investors are finding room for catastrophe insurance-linked instruments in their portfolio.

Cat fight
As for the cedants, they presumably are opening the capital markets channel of support because they believe it is important to their business. The urge to securitise for its own sake, simply to prove an organisation is capable of pulling it off, has long since waned. The drivers now are all about supply: cedants are turning to the capital markets either as a hedge against a supply squeeze in traditional retrocession markets (arising from their shrinkage or demise), or, more likely, as a hedge against the prices those markets may begin to demand.

Neither imperative has yet come to roost. Stupidly-priced naïve natural catastrophe retrocession may no longer be on offer (at least for now), but plenty of capacity is available. In stark contrast to some other lines – a marine retro slip, for example, will be difficult to finish – catastrophe retrocessionnaires are ready, willing and able, especially after the light loss year in 2000. Where demand is higher, they have shoehorned their cedants into structured retrocession programmes with collapsing limits and long lifespans that guarantee payback. The simple result is cat retro prices have not reached the dizzying heights some had hoped for, at least not yet. “The sophistication of the market has changed over the last decade, and a lot of retrocession is no longer placed on an annual basis. So the hardening will take maybe two or three years to wash through,” Mr Barder says. “The markets have known this hardening was coming for years, and so the reaction is not as severe as some people would like.”

If retrocession prices are ramped up over the next few years, investors could get the increase in the number of securitisations they are hoping for, as cedants seek the less expensive option. “The whole rationale is that [the capital markets] will be cheaper. Clearly there is not much point to an issuer structuring a transaction in the capital markets if you can do it in the reinsurance markets for less, and vice versa,” Mr Barder points out. “People are doing it because they see value there – and we are getting more interest.”

Increased deal flow leads to increased liquidity and increased investor appetite. That, in turn, will drive pricing down for the cedant, which should yield more and more interest in the capital markets as a source of retrocessional capacity. And while it is fair to say that the securitisation market has not developed as quickly as its proponents might have hoped, with the total number of issues falling in 2000 over 1999, a continued hardening of the traditional market may drive new issues this year, as has long been predicted by everyone, and as is now eagerly anticipated by ART proponents.

Overcapitalised retrocessionnaires will be faced with a choice: control supply-driven, knee-jerk price increases to ensure the capital markets are not a cheaper source of capacity; cut frictional costs to remain competitive (although the low cost, off-the-shelf securitisation remains a fiction... many more securitisations will have to be done before the transaction cost is lower than that of a conventional treaty); or stick to risk-based pricing, pull in the horns, and wait. If capital markets are a cheaper source of retrocessional capacity than traditional reinsurance markets, then provided greed is checked in the latter, the former, ultimately, will get burned.

“There is a fair amount of competition from within the industry, but even with that it is difficult to make a buck,” admits a leading international retrocessionaire. “For outsiders who hope to enter this business and turn a profit, it must be difficult.” There is no need for securitisation to exist, he says, because there is plenty of capacity around. But that won't stop it, he says. “I am sure some of it will be forced down investors' throats by the investment bankers.” Why? “One problem is that some cedants may not be willing to pay the price for the capacity they need,” the retrocessionaire says. Could bonds undercut retro markets? “If someone wants to sell dollar bills for 90 cents, let them.”