Pension funds conservatively manage $30 trillion, and if 15% of those funds were allocated to alternative investments, and 15% of this alternative investment portfolio were allocated to catastrophe-related risk, that would cast $675 billion in search of some kind of cat risk exposure.
“That’s a lot of capital trying to get into the sector, and that’s not even including sovereign wealth funds, hedge funds and other types of funds,” said David Flandro, head of business intelligence at Guy Carpenter & Co.
On the other hand, Guy Carpenter puts global dedicated property catastrophe reinsurance capital at just over $320 billion. Traditional reinsurance, it says, makes up about $275 billion of that, and alternative forms of reinsurance from mostly capital markets sources, including catastrophe bonds, collateralized reinsurance, and sidecars, as well as capital-qualifying subordinated and convertible debt, comprise the remaining $45 million.
In other words, demand for cat bonds is potentially twice as large as the total catastrophe reinsurance market.
Supply of Capital Far Outweighs
Demand for Protection
Supply of capital to invest far outweighs demand for property/catastrophe protection, and there lies the instigator of what appear to be significant developments in the realm of catastrophe-risk investments, including ever lower rates, more generous terms for issuers, and frequently the option to increase transaction size in lieu of traditional reinsurance. In addition, it has opened the door for more issuance by smaller insurers as well as corporate entities, such as New York’s Metropolitan Transportation Authority (MTA).
The excess supply “is creating some dislocation in the property/catastrophe sector, but with that comes opportunity,” Flandro said.
Although reinsurance alternatives’ percentage of the total property catastrophe reinsurance limit has grown rapidly, to approximately 14% today from 8% in 2008, it still comes nowhere close to satisfying the supply of capital looking for cat exposure. As a result, and assuming no major catastrophe that triggers multiple payments and scares new investors away, that percentage is anticipated to increase in 2014 — the total volume of new deals is anticipated to surpass 2013’s record of more than $7.5 billion, which topped 2007’s $7.2 billion in the wake of Hurricane Katrina.
Renewals for U.S. wind reinsurance and alternative deals, typically executed through June, as well as other types of catastrophic risk worldwide are anticipated to proceed with few exceptions. The Willis Group anticipates roughly $4 billion in cat bonds to roll off throughout 2014 and much of it to be renewed.
The new, investor-driven capital coming into the marketplace is prompting reinsurers faced with limited capital to defend their market shares, in part by lowering their rates. Willis pegs the risk-adjusted rate reductions on property catastrophe renewals at 25% in the United States and 15% elsewhere at the start of the year. Munich Re estimates that yields on BB’-rated cat bonds dropped nearly 40%, to around 310 basis points from 500 basis points, pushing rates down.
“The influence of capital markets capacity is more pronounced on U.S. property catastrophe placements where a combination of traditional, collateralized and securitized capacity has been utilized throughout more program structures,” Willis says in its “1st View” report published on Jan. 1.
Influence Most Pronounced in U.S.
Florida’s Citizens Property Insurance Corp.’s first Everglades Re cat bond in 2012 was initially marketed at $250 million and when the bonds, rated B+’ by Standard & Poor’s, finally priced for a 17.75% coupon it had grown to $750 million, the largest single-tranche cat bond deal ever. The state insurer’s smaller, $250 million cat bond deal last year, rated a notch lower by the same ratings agency, priced for a spread of only 10%.
“That’s been the scenario playing out on a smaller scale across the country,” said Chi Hum, global head of distribution at GC Securities, an affiliate of Guy Carpenter.
Before its first deal, Citizens Property had requested its reinsurers to lower the 21.5% rate it was paying on the $575 million in two-year reinsurance it had accrued the year before, and they declined. So it proceeded to issue the cat bonds and then buy $500 million in reinsurance above the cat bond layer and $250 million in privately placed collateralized reinsurance alongside the cat bonds. Both pieces were two-years in length and respectively priced for 17.95% and 18.75%.
Market participants anticipate pressure on rates to continue in 2014, and the loosening of deal terms prevalent in 2013 is expected to continue this year. Lower rates provide the benefit of drawing less interest in the investments by hedge funds and other purveyors of fast and volatile money, while retaining longer-term investors that find risk exposures lack of correlation with interest-rate driven investments to be attractive.
Those investors, pension funds, endowments and foundations, typically do not invest in catastrophe risk products directly but instead through funds specializing in the asset class. One such fund, Fermat, now advertises managing $4 billion in capital, up from $3 billion in June 2012, while London-based Leadenhall saw its assets under management double to $1.6 billion in 2013.
“We had no trouble doing four years instead of the typical two or three,” said Steve Cottrell, chief financial officer of Louisiana Citizens Property Insurance Corp., referring to the state insurers $140 million cat bond deal in 2013.
Louisiana’s latest deal also contains a unique “drop-down” feature, so if part of its Pelican Re deal from 2012 is used, for example, the sponsor can request it be replaced by the more recent deal. And since the 2013 bonds rest higher up on the “reinsurance tower,” such a shift would result in its investors receiving a higher coupon.
Should Cat Bonds Yield Less Than High Yield Corporate Debt?
As recently as a year ago cat bonds carried a much more significant premium over comparably rated high-yield debt than they do today. Barney Schauble, managing partner at Nephila Advisors, which specializes in catastrophe risk and has seen its assets under management triple to $9 billion over five years, noted that “in theory cat bond returns should be lower” than high-yield debt, given the risk diversification they provide. Hence, he added, returns on cat bonds that are similar to or slightly better than those junk bonds are “still good for investors holding cat bonds in a diversified portfolio.”
Still, if returns continue to fall steadily, it is unclear how investors will react. Likewise, if terms continue to loosen and cat bonds become “covenant lite,” much like what happened in the credit markets during the last bubble, and a catastrophic event that results in investors incurring significant losses, they may end up casting blame on the market.
“The enthusiasm of investors new to the space could potentially get them out over their skis in a way that’s not good for the asset class,” Schauble said.
Another outcome of sponsors competing to attract investors is the recent prevalence of unrated deals, especially cat bond deals, that save costs. “Over the last six months, about half the deals were rated, and if you look back two or three years, it was close to 75% or 80%,” said Brian Schneider, co-head of reinsurance at Fitch Ratings.
Schneider said that as the asset class matures investors are becoming more comfortable with the risk, aided by more sophisticated models. In addition, brokers have developed “short forms,” in which deals that stay within certain parameters can avoid ratings and typically price lower. The trend has been a boon for mid-size insurers whose smaller bond offerings may find ratings fees burdensome.
Investors Growing Comfortable
with Unrated Deals
“For these smaller, first-time issuers, they look at that as added cost. Until there’s a big event, looking at ratings is not a necessity,” Schneider said.
In a similar vein, the MTA sought to take advantage in July of the growing capital markets demand when following Hurricane Sandy it was unable to build additional capacity from traditional reinsurers. Guy Carpenter and Goldman Sachs priced the MTA’s first-of-a-kind $200 million storm-surge deal, rated BB-’ by S&P, for a spread of 4.5%. Its parametric trigger results in payment if the tidal surge exceeds a range of 8.5 feet to 15 feet, depending on location. Hum said the deal attracted about $400 million in investor interest, and more corporate deals are likely to come.
“For folks like the MTA that have tried it once, they’ve integrated into their planning cycle. So instead of going to an insurance company, they’re saying let’s save something and get this from the cat bond market,” Hum said.
Reinsurance Sidecars Making Comeback
Another consequence of more competition from the capital markets has been an increase in sidecars, where investors traditionally pay a fee to put their capital to work alongside the reinsurance provider. Sidecars are typically offered by reinsurers who recognize they must address the issue of growing capital markets demand.
Tony Ursano, CEO of Willis Capital Markets & Advisory, said that his firm counted 15 sidecars done in 2013, a record number. “It’s attractive financially because it’s accretive to the reinsurers ROE, it is less volatile because the reinsurer is managing other people’s money, and it puts them in the middle of what’s going on instead of observing from the sidelines,” Ursano said.
He expects issuance of sidecars to continue apace in 2014, and potentially diversify into new perils such as workers compensation, terrorism, kidnap and ransom, and crop failure.
“There are a lot of conversations going on about how to structure sidecars with differentiated perils that attract more investors interested in diversifying their books, because they’re now all reasonably concentrated on peak property/catastrophe exposures,” Ursano said, adding, “I think we’ll see more financial engineering on sidecars as the year unfolds.”
Strong demand typically leads to riskier markets. Schauble said that beyond traditional sidecars, where investors pay a fee to put their capital to work alongside the reinsurance provider, some sidecars engage in retrocessional business. In that case, the reinsurer declines to share its own risk with the investor and instead uses the capital to sell protection to a competitor, collecting fees to do so.
That has a more destructive effect on the economics of the marketplace, according to Schauble, “Now the reinsurer buying the protection from the third party can compete more effectively in the market, drawing prices down more broadly.”
He wonders, “will you have this whole sort of parallel risk-taking system, much like what happened in the credit markets, where more and more credit was extended by loan funds and hedge funds, and not just the banking complex?
“Or does this all go away and do reinsurance companies recapture their hold on the market and put the genie back in the bottle?”