Last year was a slow but productive year in the cat bond market. Repeat issuers will continue to dominate, writes David Priebe.
The catastrophe bond market belonged to veteran issuers in 2008. An unusual year, shaped by financial and natural catastrophes, it favoured sponsors with experience transferring risk to capital markets – a trend that is extending into 2009. Last year, nearly 70% of issuance activity came from repeat sponsors (i.e. companies that had issued catastrophe bonds in the past). Even in the face of challenging financial market conditions, these carriers voted for catastrophe bonds with their capital – demonstrating the market behaviour that will define this space this year and beyond.
Expectations for the catastrophe bond market at the beginning of 2008 were reasonable. Most knew that a reprisal of the lofty records set in 2007 would be unlikely, and for the first half of the year, issuance activity kept pace with 2006 (rather than 2007).
By the middle of August, 13 bonds were issued, accounting for risk limits of $2.7 bn. While capacity from these vehicles was down 62% year-on-year, 2008 was still the third busiest in the history of this market.
Activity might have been higher last year if the market shocks of mid-September had not occurred. The banking sector struggled with the effects of a subprime mortgage crisis that eventually infected financial markets around the world. Hurricanes Gustav and Ike, though not market-changing, were large enough to give carriers pause. As a result, the usual flurry of fourth quarter catastrophe bond issuances was deferred to the first quarter of 2009.
While critics were quick to cast a suspicious eye on the use of capital markets as an alternative source of reinsurance capacity, experienced issuers realised that uncertainty regarding traditional reinsurance rates was the reason for the temporary halt in the catastrophe bond market. Insurers and reinsurers wanted to see where rates were headed before making risk and capital management decisions, particularly since there was no consensus (even in December) on where the renewal would land.
This perspective was confirmed early this year. Following the January 1, 2009 renewal, at which the Guy Carpenter World Rate on Line (ROL) Index climbed a modest 8%, sponsors resumed their catastrophe bond plans. Two have been issued already, and the pipeline continues to be robust.
A complicated marketplace not only caused the delay of several issuances, it put a premium on expertise. Insurers and reinsurers that had already used catastrophe bonds to transfer risk were thus more equipped to navigate treacherous market conditions. For potential first-time issuers, there was little reason to enter the market in the fourth quarter of 2008.
The majority of catastrophe bonds issued last year came from sponsors that had used them in the past. Only four of the 13 catastrophe bonds issued (31%) in 2008 came from first-time sponsors. This group brought only $764m in new capacity, making 2008 the smallest year for debut issuers since 2002.
First-time issuer risk capital fell a substantial 78% from 2007 to 2008.
Activity for repeat sponsors dropped as well, but not at the same rate. Seasoned issuers brought $1.9bn in new risk capital to market in 2008, though some of it involved replacing catastrophe bonds that had reached maturity. This was down 45% from 2007’s level of $3.5bn, but it was more favorable than the entire sector’s issuance drop of 62%.
In addition to completing more catastrophe bond transactions than first-time issuers, repeat issuers tended to prefer larger issuances. The average size of a first-time issuer’s transaction last year was $191m, slightly above the 12-year average of $188m but below 2008’s overall average of $207m. Repeat issuers, on the other hand, averaged $214m per issuance in 2008.
The stronger issuance activity for repeat sponsors reinforces the notion that catastrophe bonds remain useful tools for risk and capital management. These companies have already invested the time necessary to determine the specific advantages of catastrophe bonds for their portfolios. The ability to transfer stubborn perils off the books, lock in a cost of coverage for several years, or just being able to source additional capacity have become quite important to some carriers, as evidenced by the prevalence of issuances that replaced maturing bonds. Even with the increased cost of catastrophe bond capital stemming from the financial crisis, repeat sponsors are finding – and taking advantage of – the benefits of capital markets-based risk transfer.
The refocus of the market on repeat issuers (after a roughly even split in 2007) aligns with a rationalisation of the investor community. Catastrophe funds are continuing to invest in this asset class, though multi-strategy hedge funds began to divest their catastrophe bond holdings last year. Ironically, this exit was possible because of the viability of the catastrophe bond market. These vehicles withstood broader financial market pressures, resulting in a fairly liquid market.
“Wide” Is a Relative Term
Of course, catastrophe bonds were not immune to the effects of the global credit catastrophe. Spreads were pushed wider for this asset class, as well as corporate and government-issued bonds. However, catastrophe bonds did not sustain the same price changes that occurred in other corners of the credit market, largely because the drivers were different.
Catastrophe bonds have been touted as generally not being correlated with broader capital market risks since their inception. Unlike other credit instruments, catastrophe bonds are tied to physical events – such as earthquakes and hurricanes – as opposed to other factors, such as an issuer’s likelihood of default, interest rate risk, or currency risk. Nonetheless, broader economic conditions can affect catastrophe bond spreads, as we saw last year. The relationship, though, is indirect. The divestiture of catastrophe bond holdings by many hedge funds – because these assets could be sold in order to help them meet redemption obligations – ultimately influenced spreads.
There were tense moments along the way, however. Investors and issuers were concerned that the credit crisis had manifested itself in the catastrophe bond market when four bonds lost their total return swap (TRS) counterparty. When these bonds were marked down, some market participants thought it might suggest that catastrophe bonds could carry substantial credit risk and (worse) moral hazard. As the situation unfolded, though, it became clear that catastrophe bonds were not inherently flawed but could be improved through increased transparency and more rigorous collateral requirements.
This year, and for the foreseeable future, the watchword is “discipline.” Repeat sponsors will use their familiarity with the catastrophe bond market to deploy their capital judiciously and remove difficult perils from their portfolios. While this market will continue to serve as a supplemental source of capital when treaty ROLs increase, a core group of issuers will turn to catastrophe bonds primarily for strategic reasons. First-time issuers are likely to remain on the periphery—rather than shape the market.
Pessimistic concerns as to the stability and viability of the catastrophe bond market are thus premature. Despite the silent fourth quarter last year, activity has resumed, and a pipeline exists beyond the transactions that have been completed already. The market is smaller than it was in 2007, and it may stay that way for a while. But, experienced sponsors will continue to take advantage of these targeted risk management tools.
David Priebe is chairman of global client development for Guy Carpenter.