Lane Financial see rising catastrophe bond yields but more risk in the markets tail

The average yield of outstanding catastrophe bonds and insurance-linked securities (ILS) has risen significantly in the last year reflecting the rise in cat bond and ILS premiums according to the latest report from Lane Financial LLC, a consulting firm and broker-dealer focused on the ILS and associated sectors. The jump in average yield on an outstanding set of ILS and cat bonds at the end of February 2011, just prior to the Tohoku earthquake and tsunami, was 5.11% but at the end of March 2012 that number had jumped to 8.51%.

Lane Financial LLC have published their latest annual report on the catastrophe bond and insurance-linked securities market, which you can access after registration here. As usual, their report is full of detailed financial analysis on the market over the last year as well as the performance of their own index of outstanding cat bonds and ILS returns.

They note in the report that while the outstanding set of ILS and cat bonds have changed over the last year, the size of the shift in yields (from 5.11% to 8.51%) suggests that we are entering hard market territory within the sector. That analysis reflects many people’s opinions of where the wider reinsurance and indeed insurance markets are moving to as well.

Just because premiums are higher for cat bonds and ILS does not alone signify a hard market, says the Lane Financial report. To be able to determine this you need to look at the market in a risk adjusted manner and take into account the overall risk profile of the outstanding cat bond and ILS market.

Over the same period that average premiums have risen so sharply the average expected returns for the outstanding set of ILS and cat bonds has more than doubled from 3.17% to 6.42%. At the same time their calculations show that the remodelled expected loss of the market has risen slightly from 1.95% to 2.09% while the multiple has risen from 2.6 to 4.1. The report goes into great detail on how this displays an increase in tail risk in the outstanding set of cat bond and ILS and signifies a generally riskier marketplace.

Overall Lane Financial say that the hardening of this market shows that now is a good time to write insurance risk, the oversubscription of recent ILS and cat bond deals is testament to this fact. Part of the reason for the increase in premiums, which makes it a good time to be a writer of risk, is the increase in risk within the market portfolio, specifically in the tail.

Now, one of the things to note is that while the overall risk profile of the cat bond market has risen in the last year (a recent article of ours on this topic can be found here), this is no bad thing as it does signal that investors are becoming increasingly comfortable with putting capital into riskier tranches of cat bond and ILS notes. It’s believed that this is due to the market maturing and investors becoming more experienced with managing portfolios of catastrophe risk, along with improvements in portfolio management tools and a wider understanding of what this market is all about in the broader institutional investor community. Clearly if it gets too risky then investors may decide to pull back or at least stop committing funds to new deals, but at the moment investors clearly have an appetite to take on risks at the levels issued in recent cat bond deals.

We highly recommend you go and read the full report, it’s detailed and as comprehensive as any annual report on the sector that you are likely to see.