Long an adjunct of the insurance and reinsurance sectors, the catastrophe bond market appears primed to become a more mainstream allocation alternative in 2012. This shift is prompted by issuers' growing capital needs and the incentive that the risk from natural disasters it mitigates is not correlated with the manmade financial variety. While 2011 new-issuance volume is anticipated to end up just short of last year's numbers, and outstanding cat bond issuance remains about the same, indications point to a strong 2012.
Cory Anger, managing director and global head of global linked securities (GLS) structuring at GC Securities, the investment banking arm of reinsurance broker Guy Carpenter, noted the firm's active pipeline, adding that overall she "wouldn't be surprised to see 15 deals in the first half" compared to eight completed last year during the same period. Twelve deals were completed in the second half of 2011.
John Seo, cofounder and managing principal of Fermat Capital Management, a fund specializing in cat bonds since 2001, said his firm calculated current volume at $13.8 billion. "We see the market at roughly $16 billion by the end of 2012," Seo said, with first-quarter issuance likely reaching $1.5 billion, compared to $1.1 billion last year."By most measures, we would expect that by early 2013, the market will have obtained new heights and size and will continue that [growth]."
Similar hopes for cat bonds becoming a more mainstream asset class and appealing to more investors have been dashed before over the market's more than 15 years of existence, and market participants have come and gone. Bond giant Pacific Investment Management Co., for example, was once a major player in the market and no longer is. Nevertheless, there are several factors today pointing to more issuance and market resiliency. Seo noted several outside the control of financial institutions that will likely drive them to seek upward of $200 billion in additional capital. And faced by low stock prices and the moribund mainstream bond market, cat bonds, which have performed strongly in the wake of the 2008 financial crisis, are an obvious part of the solution. "Cat bonds will be fundamental to meet regulatory capital requirements," Seo said.
The most straightforward reason is the rash of natural disasters worldwide in 2011 that have hit insurers with more than $50 billion in losses that must be replenished. Europe's Solvency II Directive, which harmonizes insurance regulations among European insurers, is expected to lump on insurers worldwide the need for a similar amount of additional capital. Perhaps more urgently, European sovereign debt-related losses are likely going to require financial institutions to raise still more capital. And to top it off, Risk Management Solutions (RMS), one of the top risk probability modelers, incorporated new science into its U.S. hurricane model that increased last March the "one in 100 year" U.S. hurricane industry loss - the biggest component of the cat bond market - to $180 billion from $120 billion. Leading rival AIR Worldwide has stated it has no intention to follow suit, but RMS's move has prompted insurers to reconsider their insurance capacity and capital needs.
"Virtually everybody has taken on board the new information and said, 'There's an expert that says risk has gone up a lot.' Many insurers have adjusted where their writing [policies], or their re-insurance, or the cat bonds in their portfolios," said Peter Nakada, managing director of risk management solutions at RMS.
Nakada said that another major reason prompting growth in the cat bond market is the asset class's strong performance during the financial crisis. Although the market's volume shrank along with the rest of the fixed-income market and is only now returning to pre-2008 levels, it was one of the few asset classes to provide a positive return throughout that period."Cat bonds are uncorrelated with the global economy, so they're fundamentally strong," Nakada said. "They were also immune from liquidity contagion because most investors in cat bonds are "real" money investors - pension funds and dedicated funds - that are not leveraged."
Stock markets around the world have seen double-digit drops and increases this year, and U.S. Treasury bonds - traditionally the most stable of investments - rallied 25% in October alone. Despite the volatile weather patterns in 2011, cat bonds continued to provide steady returns in the range of 8% to 9%. "The more there's global turmoil, the more investors gravitate to this asset class because it's very uncorrelated to other parts of the capital markets," said Judy Klugman, a managing director at Swiss Re Capital Markets. This is the brokerage arm of Swiss Re that underwrote $1.7 billion in cat bonds in 2011 compared to $2.1 billion the year before.
Pension funds invest in cat bonds mainly through funds such as Fermat and Nephila Capital that specialize in the asset class. Dedicated arms of several Swiss banks, such as Credit Suisse, and reinsurers, including Validus Group and Amlin, are also significant players. There are also a few pension funds, including Ontario Teachers Pension Plan and Australia's Challenger, that invest directly. In fact, the universe of funds investing directly in cat bonds has remained relatively small, although more investors are knocking at their doors. If Seo's market growth projects are realized, Fermat, which aims to capture routinely between 15% and 20% of the market, will see its assets under management grow to $3.2 billion on the high end.
Demand for the $150 million cat bond that raised capital to finance the California Earthquake Authority's (CEA) recent $150 million transformer reinsurance contract with Embarcadero Re was strong enough to oversubscribe it by three times. Tim Richison, the agency's chief financial officer who worked at USAA when it structured its first "act of God" bond in 1997, said the CEA plans to participate in similarly structured deals regularly.
Regular issuance is key, providing investors with a reliable and predictable alternatives for a portion of their portfolios, Richison said. Issuers such as Swiss Re, Munich Re and USAA have been regular issuers for years in a market that has otherwise comprised opportunistic and relatively infrequently issuers. A broader swathe of regular issuers should in turn attract a broader array of investors. "We've talked to investors to understand what they need, and they say it's product: The more diversified product they have, the more money they'll have to invest in the asset class," Richison added.
Michael Halsband, director in Deutsche Bank's capital markets and treasury solutions group, said that some 63% of cat bond deals between 2006 and 2010 provided funding for transactions that covered perils predominantly from U.S. hurricanes. In 2011, he said, those wind deals made up as much as 75% of the cat bond market. Transactions undertaken in 2011 for the CEA and another earthquake-related deal for California's State Compensation Insurance Fund - both first-time issuers - diversified that concentration of U.S. wind deals and made up approximately 9% of the year's total issuance.
"Investors are certainly pushing to find ways to diversify their portfolios," Halsband said, noting that this trend has provided opportunities for new sponsors whose transactions offer diversification by peril type, such as the offerings from the CEA and Argo Group. Investors are also looking for more diverse deal structures. "If your bond is not exposed to first-event loss, folks consider such structural diversification as offering balance in a portfolio and may reward you from a pricing perspective accordingly," Halsband added.
Issuing cat bonds can also pay off in the traditional insurance market. Although reinsurance is typically more economically attractive for issuers, Richison said the CEA was able to use the three-year cat bond deal, which priced at 6.6% over Treasury money markets last summer, as leverage when negotiating new reinsurance policies. "We got traditional reinsurance to price below the cat bond - a significant decrease for earthquake risk in California," Richison said. "We're going to go out again [with another cat bond] after the first of the year, and I'm hoping the pricing will be below my 2012 reinsurance pricing."
Richison said capital markets investors look for a much lower rate of return that's a third of the 18% to 24% return on capital that reinsurers typically seek. "So if we can provide a product that has a defined risk and they understand what it is, then the investor can price it appropriately," he stated. "And when they apply the rate of return they typically want for this type of product, it should come in cheaper than reinsurance."
Nakada said that if spreads - now at similar levels to the cost of reinsurance - tighten another percentage point or so, issuance volume is likely to ramp up. Not everyone agrees with that conclusion, however.
Seo said that if the demand were there, spreads would have already tightened, so if issuers were to artificially tighten spreads, it may be a while before there's sufficient demand to lap up all the bonds. Still, he agreed that there is plenty of demand for cat bonds, even if much of it remains latent and must be encouraged more gradually, using strategies such as the CEA's regular and more frequent issues. "To help grow this market, probably the best thing we can do is be consistent," Seo said.
More investment-grade deals and more pension funds, other institutional investors and dedicated specialist funds investing directly in cat bonds would also help grow volume, said William Dubinsky, head of insurance-linked securities at Willis Capital Markets & Advisory, a unit of major insurance and reinsurance broker Willis Group that structured the CEA deal. Sponsors typically reinvest investors' funds in very high-quality collateral, all but eliminating collateral risk - an issue of great concern for many investors following the financial crisis. He said that should draw more direct investors to the asset class. "And the second thing that could help at the margin to draw volume would be if there was more investment-grade or near investment-grade product to look at," he said. He added that the 'BB' and 'BB-' ratings the bonds typically carry tend to confine them to large institutional investors' smaller buckets dedicated to alternative investments, which those investors usually access through specialist managers rather than through the broader fixed-income buckets they typically manage in-house.
Dubinsky, whose firm anticipates new issuance - expected to reach upward of $4.6 billion in 2011, down from $5.2 billion the year before - to grow comfortably next year but not take off without tapping into that investment-grade investor base. The biggest bang to cat bond market volume could come if a market participant decides to become the provider, for example, of cheaper hurricane insurance capacity and start issuing $10 billion of Florida hurricane bonds annually.