Recent total returns on U.S. catastrophe (cat) bonds are outperforming other fixed income assets as momentous reinsurance market growth is poised to continue in 2025 despite high issuance costs and potential principal losses.
Outstanding cat bond volume is nearly $48.5 billion as of Nov. 15, 2024, which is less than 10% of the total insurance-linked securities (ILS) market, which is composed largely of reinsurance contracts. The 80 cat bonds issued year-to-date in 2024 amount to $14.6 billion, according to Fitch Ratings, which expects the 2024 aggregate value to surpass the unprecedented 95 deals issued in 2023, totaling $16 billion.
It will be a race to yearend, said Jeff Mohrenweiser, a senior director of insurance at Fitch Ratings. Issuance in 2024 is on track to be the second-highest year of U.S. cat bond issuance, even if it does not pass 2023 production.
Issuance in 2024 is on track to be the second-highest year of U.S. cat bond issuance, even if it does not pass 2023 production.
Cat bond returns are uncorrelated with returns from other financial instruments.
Yields are in the mid-single digit range, outperforming comparable asset classes by a wide margin, Mohrenweiser said. For example, the total return rate on cat bonds surpassed 10% through August 31, 2024, according to the Swiss Re Global Cat Bond Total Return Index and continued to outperform as of mid-November.
ILS including cat bonds have received help from high investor demand and the rise in yields for short-term money market funds (MMFs), which are a critical part of the cat bond structure. Fitch data show in 2023 and 2024 MMF's yields stayed in the 4.5%-5.0% range, up from 0%-0.25% during the pandemic.
Unabated demand
As in the previous two years, Fitch does not see any abatement in issuance, Mohrenweiser said.
Compared to U.S. Treasury bills catastrophe bond indexes have emerged as "the holy grail" of investments, they have demonstrated annual positive returns in 21 of the past 22 years, noted financial markets expert Larry Swedroe in a recent Morningstar DBRS commentary.
The deals that do not come to market in 2024 will be in the queue for Q1 2025, while new issuance should be fast tracked for H1 2025, prior to the hurricane season.
Issuance will pick up in the 2025 renewal season as attractive risk spreads and strong demand continue to favor reinsurers, according to Fitch, yet "the 144A cat bond may face some competition from re-energized collateralized reinsurance structures."
Traditional reinsurers have relied on the ILS market to backfill unmet property risk needs increasingly, , according to "Investor Returns, Climate-Risk Mitigation Drive Cat Bond Issuance," a commentary authored by Mohrenweiser, Laura Kaster, a senior director, and Gerry Glombicki, senior director, North American Insurance at Fitch. Insurers also use the contracts to diversify counterparty exposure.
Investor gains reflect reinsurers' reduced capacity for coverage, ever-increasing invested premiums, and stricter underwriting. In 2023 this resulted in actual loss payouts for Hurricane Ian that were lower than estimated, which helped boost annual returns.
Costly business
Despite those advantages, the reinsurance industry grapples with inherently higher costs, as it manages its own particular risks. Fitch data show insured losses for 2024 have exceeded $100 billion. Reinsurers continue to endure meaningfully higher bond issue prices with underlying risk spreads in the 6%-8% range in 2024, Fitch data show. The average price range is highly volatile, Mohrenweiser says, insurance risk spreads have increased in 2023 and 2024 reflecting the hardening reinsurance market.
In 2023 and 2024, the average modeled expected loss decreased from 2.5% during the prior three years, to the 2.0%-2.25%.
Bond sponsors also continue to face higher administrative, legal and bookrunning expenses not directly linked to dealing with reinsurers. Investor demand is not yet strong enough to spur price competition and reduce risk spreads, according to Fitch.
In 2023 and 2024, the average modeled expected loss decreased from 2.5% during the prior three years, to the 2.0%-2.25% range supporting investor demand.
Cat bonds do not cover flood losses, while hurricane claims depend on landfall location. Milton, which narrowly missed the highly populated Tampa area earlier in 2024, is a recent example. Fitch estimates insured losses (or principal losses to cat bond investors) of $20 billion to $40 billion for Hurricane Milton, and $5 billion to $10 billion for Hurricane Helene.
These events will also incrementally increase losses to aggregate cat bonds still in the principal-at-risk period soon Fitch warns, in addition to new natural disasters occurring in 2024.
Despite risk and cost concerns, however, Fitch expects the record issuance of recent years will continue in 2025 as more investors embrace the cat bond alternative. Structured to eliminate counterparty risk
Cat bonds' appeal to issuers and investors is multifaceted, explains Andy Polacek, principal economist at the Federal Reserve Bank of Chicago, in Chicago Fed Letter No.405. They attract new alternative sources of capital, hedge funds, sovereign wealth funds, pension funds, and mutual funds, to compete with traditional reinsurers, Polacek says, which helps stabilize prices.
Cat bonds typically are 100% collateralized and structured to eliminate counterparty risk by using a special-purpose vehicle (SPV) as an intermediary between the issuer and participating investors. The SPV pools investor proceeds in a secured collateral account that invests in money market funds, typically U.S. Treasury, or other highly rated liquid debt. Bonds are floating-rate, one-to-five-year term $50 million to $2 billion notes with indemnity triggers that require actual loss verification.
