The hype over cat bonds has been sustained by three years of dramatic growth. But can the good times last? Charles Thresh and Jonathon Lane consider the threat of the credit crunch to this burgeoning asset class.

Catastrophe bonds and other insurance-linked securities (ILS) have entered into the insurance lexicon over the last few years. These once experimental instruments are now an established additional access point for the capital markets to get exposure to insurance risk and returns. But as the capital markets tighten and investors struggle to raise capital, will these products continue to be in demand, especially as traditional reinsurance capacity remains high and rates soften?

Breaking records

Although cat bonds have been in existence in some form or other since the 1970s, the ILS market began in earnest in 1997, when the industry completed five transactions (Winterthur, SLF Re I, Residential Re, SR Earthquake Fund Ltd & Parametric Re) totalling some $633m of risk capital. Since then, the amount of capital issued in the form of cat bonds has increased year on year (with the exception of 2001 and 2004).

In total, 116 cat bond deals have been completed since 1997, representing total risk limits of $22.3bn, according to Guy Carpenter. Cat bond risk principals outstanding are now estimated to make up approximately 8% of property limits worldwide (and 12% of US limits).

The cat bond market has continued to grow. 2007 saw an increase of 49% in risk capital issued over 2006. 2006’s number was an incredible 251% increase over 2005. These are significant increases for a market still only just over ten years old. The desire of the capital markets to acquire risk within their portfolios that is non-correlated to their existing investment risk has created an unprecedented period of demand. The last three years have been extraordinary for the global ILS market. Cat bonds in particular have proved to be one of the structures of choice for external capital market players wishing to enter the insurance market.

The global insurance industry has made good use of this demand. A substantial majority of the world’s largest reinsurers now use cat bonds as part of their risk management programmes. A recent report by Aon Re Global stated that “alternative capacity” represented between 10% and 30% of programme capacity for insurers buying more than $500m of aggregate coverage.

The demand for ILS-related products has also driven substantial improvements in the communication and representation of information about underlying hazards and loss histories. As the capital markets and insurance industry requirements have become more convergent, structuring advisors have become better at presenting insurance risk in a way that can be modelled by the investment community.

Counterparties have gained a greater understanding of the underlying drivers of insurable risk. This in turn has promoted greater product transparency and market standardisation, easing the costs and time associated with structuring and issuing cat bonds. The emergence of international reinsurers and brokers as structuring and deal advisors, now makes it easier than ever for an insurer or reinsurer to access the cat bond market.

2007 not only saw the size and number of deals completed increase, but also the number and type of perils covered expand. Issuers continued to look at bonds covering Australian typhoon & earthquake, US tornado and hail and Mexican earthquake. Bond issuances not only encompassed more geographical variance on standard wind and earthquake perils but took on altogether new perils.

Is growth sustainable?

Despite the spectacular growth of the cat bond market, there are signs that it is entering a period of maturity. There are a number of drivers for this. ILS market size, until recently, was at a level that could provide a temporary solution to short-term capacity shortages. In the late 1990s, cat bonds were seen as “capacity of last resort” for the traditional markets, with early market trends showing an inverse relationship between cat reinsurance rates and activity on the cat bond markets.

More recently we have seen cat bond pricing trend away from traditional market rate cycles. Cat bonds are now seen as a complementary, but distinct, component of insurers’ and reinsurers’ risk management strategies.

Before 2005, the cat bond market fluctuated in deal size terms around a risk capital range of $1bn to $1.7bn. Whilst the trend has generally been upwards, the market did experience significant falls in 2001 and 2004 related to the excess capacity available in traditional markets at the time.

However, since 2005 the market has grown dramatically, reflecting the substantial shift in the relationship between traditional reinsurance and ILS markets. The 27 deals completed in 2007, accounting for $6.996bn of risk capital, represented a record for the industry. The cat bond market’s 2007 capacity would equate to the total risk capacity of a top five reinsurer, according to Benfield Global P&C list. This scale indicates that ILS has moved from the periphery to become a core component of the (re)insurance landscape. As such, the niche that cat bonds occupy is not unlimited in size.

The counterparties to cat bonds have experienced exceptional returns. Over the last two years, benign catastrophe loss experiences have meant that cat bonds covering US wind perils have generated significant returns for institutional counterparties. Cat bonds have appeared in the near term to be a “one-way” bet for investors, but the sustainability of these market conditions is uncertain.

Sidecars, although not a new concept, saw a resurgence in activity post Katrina Rita and Wilma in 2005, as they emerged as an alternative access point for investors wishing to enter the insurance and reinsurance markets. Like cat bonds, sidecars have developed as limited life vehicles and the “technology” for setting up, running and unwinding them is well-established. Although sidecars appear to have complemented, rather than competed with cat bonds, they do indicate that new structures can be developed over a relatively short period of time with the ebb and flow of demand and supply of capital.

The future of ILS

2008 will be an important year for the cat bond market. It will be the first real test of the sustainability of the ILS market at these high activity levels. In the context of the current financial liquidity pressures, supply of capital for cat bond deals is not assured. With traditional cat (re)insurance rates conservatively estimated to have fallen up to 20% in certain exposed regions, and the average drop in rates exceeding 10%, a drop in both number and size of issuances was to be expected.

However, over the first part of 2008 the cat bond market appears to be operating against prevailing wisdom. Publicly-disclosed transactions for the calendar year-to-date have already topped $2bn. If that trend continues, there should not be a major reduction in activity for the year as a whole.

This is illustrative of the confidence that the market has in ILS products. However, it is remarkable that very few cat bonds have actually been triggered. One of the few to have been subject to the loss determination provisions of an ILS is Kamp Re. The bond was triggered when claims from Hurricane Katrina exceeded its $1bn trigger amount. KPMG in the Cayman Islands was appointed as claims reviewer.

Whether investors could be put off if more cat bonds are triggered in 2008 remains to be seen. Ultimately though, it seems cat bonds are here to stay. They are playing a key role in the reinsurance markets, not only in terms of capacity but also in terms of linking the capital and insurance markets together. The ILS story has been one of innovation and spectacular growth and, while the traditional market continues to expand into new markets and technologies, this trend looks set to continue for cat bonds.

Charles Thresh is managing director and Jonathon Lane is manager of KPMG Advisory, Bermuda.