Catastrophe bond market emerges from crisis

The catastrophe bond market is emerging from the global financial crisis as investor demand revives and spreads tighten, promising a rise in issuance over coming months.
The cat bond sector, in which insurers manage their exposure to natural disasters by passing on potential losses to investors, was almost inactive from late 2008 through early 2009 after the collapse of Lehman Brothers - which played a counterparty role in several bonds - sparked fears over the security of collateral.
But a return of confidence in financial markets generally, and factors specific to the insurance-linked securities (ILS) sector, are now supporting a turnaround.
"Investor appetite has fundamentally changed. There is liquidity in the market and capital has become available for ILS transactions," said Rupert Flatscher, head of Munich Re's risk trading unit. The Swiss Re Catastrophe Bond Total Return Index, which tracks the total return for all outstanding dollar-denominated cat bonds and is based on Swiss Re pricing indications only, rose to 186.26 on October 9 from 185.21 a week earlier, posting its 18th straight week of gains.
The index is now well above its pre-Lehman peak of 172.27, hit in August 2008. Its low during the financial crisis was 165.23, reached in October 2008. Cat bond spreads over government debt have narrowed drastically. Fitch Ratings estimated early last month that spreads had shrunk around 15 percent so far this year. But Paul Schultz, President of Aon Benfield Securities in Chicago, said:
"The spread tightening has been more dramatic than the 15 percent suggested by others. Since the beginning of the US wind season (June 1), we have seen the multi-peril bonds tighten by 30 percent, while US wind and US quake have narrowed by about 25 percent. For non-US perils, the 15 percent sounds about right."
A general return in investors' appetite for risk globally has aided cat bonds. Spreads on BB-rated corporate debt in the United States have tumbled 45 percent since the start of this year, making cat bond returns look increasingly attractive. Flatscher said there was so much money seeking yield that funds were even investing in more exotic insurance-linked instruments, including industry loss warranties, which are derivatives triggered by the size of losses caused by an event to the entire insurance industry, and sidecars, which capture the risk of a sub-portfolio of an insurance or reinsurance company's business.
Chi Hum, Managing Director of GC Securities, part of reinsurance broker Guy Carpenter, said the cat bond market's expectations for returns had been artificially inflated during the financial crisis, because the main buyers of the bonds were taking advantage of distressed selling by hedge funds.
"Since then, and evident in the July deals that were priced, such as Guy Carpenter's Parkton and Hannover's Eurus II, the market started to show a significant reduction in return expectations. Pricing is back to where historically, multiples had been before 2008 for US wind and quake," Hum said.
The Parkton and Eurus II cat bonds, closed in late July, were both upsized from original indications - the Parkton deal to $200 million from $125 million, and the Eurus transaction to 150 million euros ($224 million) from 75 million euros. But the revival of the cat bond market may be supported by more than a simple reduction of risk aversion.
Guy Carpenter estimates that $300 million in cat bond risk capital matured in the third quarter of 2009, bringing the year-to-date total to $2.54 billion. Another $660 million is due to mature in the fourth quarter; much of that money is likely to be rolled into buying new cat bonds. Also, issuers have been experimenting since the Lehman disaster with new collateral provisions designed to reassure investors. Bonds using a counterparty this year have set strict rules for monitoring collateral; and Germany's Allianz sold a cat bond in April which did not employ a counterparty, instead investing the collateral in floating-rate notes issued especially by a triple-A rated state development bank.
Flatscher said bond structures since Lehman's bankruptcy had improved significantly, mainly on the collateral side, and the reform efforts were helping draw investors back to the market.
There are tentative signs that cat bonds and other forms of ILS may start to become mainstream investments. Global consultant Watson Wyatt, arguing that most investors lacked genuine diversity, advised its clients in August to consider including ILS in their portfolios. A total of 11 cat bonds totalling $1.79 billion were issued in the first three quarters of 2009, down from 13 bonds worth $2.69 billion a year earlier, according to Guy Carpenter. But the third quarter of this year was up 29 percent from a year earlier in monetary value.
The industry's consensus estimate for issuance in the whole of this year is $3-4 billion, implying a greatly accelerated fourth-quarter issuance rate of $1.2 billion to $2.2 billion.
Aon's Schultz predicts "a healthy level of activity between now and January. Next year, we have forecast issuance to be between $4 and 5 billion, which is a conservative estimation - I see levels returning to the level we were at before 2008.