Room for some more

Growth in catastrophe bond market set to continue in 2014?

ILSgrowthgraphIn 2013, the catastrophe bond market saw $7.1 billion of new issuance taking the total amount of outstanding bonds to over $20bn for the first time. But a larger and more important change is the increasing breadth of the market. Last year saw 28 sponsors of 144A cat bonds. That was three more than the previous record in 2007 and almost 50% more than 2012. The question for 2014 is who else might be enticed to issue cat bonds and how much more room is there for this market to grow?

Despite the recent pace of innovation in reinsurance, insurance linked securities have maintained two distinct advantages over other structures – ease of access and liquidity. Anyone (at least anyone with $100m) can buy a $250,000 slice of a 144A security in the morning and sell it that afternoon. This flexibility has encouraged generalist funds to disintermediate the specialists and invest in bonds directly.

In a recent report produced by BNY Mellon, Dean Fletcher, head of EMEA Corporate Trust, said: “The initial investor base was dominated by hedge funds and private equity, but we are seeing more long-term investors such as pension funds buying cat bonds. Investors are attracted by the high yields in the current low interest rate environment. Cat bonds also offer investors a chance to diversify their portfolios because of the low correlation of risk between catastrophic events and broader financial markets.”

The ability of sponsors to issue deals at lower coupon rates and “increasingly favourable structures that suit individual company needs,” are also helping to drive market growth, according to Fitch Ratings.

In addition, industry expansion is being pushed forward by improving risk modelling, growing investor confidence as the asset class becomes more mainstream and moves to cover a wider set of risks (see: primary ILS issuance )

The need to continue to expand risk coverage in order to maintain such rapid growth was highlighted by Willis Capital Markets & Advisory in its ILS Market Update report last year, in which Bill Dubinsky, head of ILS at WCMA, said: “To continue the same pace of growth we have seen in the last few years the ILS market will need to accept a growing pool of perils. Some of these new perils are evolutionary, not revolutionary – such as earthquake risk in areas like Colombia, Chile, Israel and even China. Others may represent a more radical departure from market norms. For example, will investors accept standalone US terrorism risk if TRIPRA (the Terrorism Risk Insurance Program Reauthorization Act which is due to expire on
December 31, 2014) is not renewed? Will casualty risk finally become more at home in the capital markets?”

While insurance linked securities appear to be unstoppable, providing the industry moves with demand, there are voices against them. Some traditional reinsurers have criticized the asset class and suggested that investors will lose confidence in it if there are some major defaults in the coming years.

Munich Re board member Torsten Jeworrek reportedly cast doubt over the sustainability of the economic model that underpins alternative reinsurance and questioned whether alternative reinsurance buyers would stick with the asset class in the event of a major catastrophic loss or if there was a rebound in interest rates leading to an increase in returns from mainstream financial assets. Some financial advisers and investors also remain unconvinced by insurance linked securities. Don Martin, founder of independent financial adviser Mayflower Capital financial, in his blog warns investors against getting “clawed by cat bonds”.

“The temptation of the buyer of these instruments is to imagine that he will be the lucky one who never suffers a catastrophe. But that is very wrong because part of a risk analysis is to look at worst case scenarios…” he said.

And in its ILS report WCMA suggested that a trend towards increasingly flexible deal terms and conditions could set industry expansion back if some were poorly structured, resulting in structures that investors cannot easily understand.

The industry has suffered setbacks before, not least after the collapse of Lehman Brothers in 2008 led to several cat bonds, for which it acted as a total-return swap counterparty, defaulting. That resulted in a pause and decline in issuance that took several years to pull back.

What will issuance be like in 2014? Unless events conspire to reveal more unforeseen structural problems, it is difficult to envisage what would prevent more sponsors being drawn into the market and another record year.

Posted: Monday, January 6th, 2014