As the U.S. hurricane season approaches, catastrophe bond sponsors are taking advantage of a surge in investor enthusiasm to renew existing deals at much lower rates and expand or initiate insurance-linked securities (ILS) programs.
Although issuance in the first two months of 2013 was unusually light, the pace has since picked up markedly, and the more than $3.6 billion in cat bonds issued as of mid-May put the market on course to reach record annual issuance for the year as a whole.
The wildcard, said William Dubinsky, head of insurance-linked securities at Willis Capital Markets & Advisory, a unit of insurance and reinsurance broker Willis Group, is whether there will be investment grade deals. “Even without investment grade-deals, I think we’ll be ahead of last year’s [$6.3 billion] volume,” Dubinsky said. “And with one or two investment grade deals, we could easily be above the all-time record in 2007 of $7.2 billion.”
The same factor spurring demand in other riskier parts of the capital markets has drawn investors to cat bonds: historically low rates that have prompted them to search for return premiums.
Funds dedicated to investing in ILS, including Nephila Advisors, Leadenhall Capital Partners and Fermat Capital Management, have experienced significant growth over the last year. Just as important have been more “generalist” investors, such as pension and mutual funds that have either returned to the market or are making their first investments.
The increased demand has tightened spreads.
“Spreads have compressed significantly and are probably 25% below where they were last year,” said Markus Schmutz, head of ILS structuring and origination at Swiss Re. “That makes it more attractive for companies to access this market.”
Jonathan Herring, portfolio analyst at Nephila, said that in the past ILS was a “tough pitch” to potential sponsors because of higher rates and fees compared with traditional reinsurance. Now ILS rates are competitive with or lower than reinsurance, providing sponsors—mostly private insurance companies and some state entities—with an increasingly attractive way to diversify their insurance capacity.
“At times, sponsors have initiated the conversation and come to the ILS desks at broker-dealers armed with information and motivation, looking to strike before other [sponsors] snatch the opportunity,” he said.
Herring said spreads could change rapidly as a result of a natural catastrophe or an adverse financial event. And the depth of the market remains uncertain, given that this year’s issuance level, while significant in cat-bond terms, remains a tiny fraction of the $250 billion reinsurance market. In addition, the cat bond market has in past years halted abruptly because investors’ appetite for specific risks waned, or because they had to digest a flurry of transactions.
Luca Albertini, CEO of Leadenhall, said reinsurance rates have been either stable or are declining much less than cat bonds, showing that a simple prepackaged product—cat bonds—is “easier to execute [for] new investors than bespoke, private placements of collateralized reinsurance.”
Collateralized reinsurance is similar to reinsurance but aimed at investors that don’t meet the same security guidelines sponsors require from their reinsurance providers.
Those investors, often also cat bond investors, must put cash or Treasury bonds representing their portion of the bond’s principal into a trust that becomes available to sponsors when the deal is triggered.
Albertini said fund managers who invest in both types of ILS are likely to emphasize cat bonds less, due to their aggressive pricing, and that may “reinstate a pricing equilibrium” between the two.
For now, however, cat bonds are the rage. Dubinsky noted that cat bond issuance and renewals—the bonds generally have three-year maturities—have historically held some tie to the reinsurance renewal cycle. The primary reinsurance renewal dates are Jan. 1, June 1 and July 1, with the middle date being the most important one for U.S. hurricane risk. ILS deals have tended to cluster around that date.
“We’ve seen investors doing something new,” Dubinsky said, adding that instead of waiting to see where traditional reinsurance pricing ends up, “They’re stepping out on their own and saying, ‘This is the right price for us to take the risk, as investors.’”
Investors are not only willing to accept tighter spreads but apparently also greater risk. Dubinsky said pricing has hardly budged for reinsurance with an expected loss in the range of 20%, but reinsurers’ rates have become highly uncompetitive against ILS when the loss risk drops to 1%. Those dynamics may be changing.
