Every few months we like to take a closer look at two key metrics which help to better demonstrate recent trends in the catastrophe bond primary issuance market. These two metrics help to demonstrate where insurance-linked securities investors risk appetite lies when it comes to cat bond and how pricing has moved recently.
With the catastrophe bond market reaching a new all-time high of $18 billion of risk capital outstanding and 2013 issuance well on the way to setting records in terms of deal volume issued, it’s a good time to revisit the risk premium and expected loss of the outstanding cat bond market.
Once again we’re using data from the most recent Willis Capital Markets & Advisory quarterly ILS and cat bond market report. You can read more of our commentary on WCMA’s recent report in our article from the 24th July, entitled: ILS and cat bond market has questions to answer to maintain growth: WCMA.
Given the recent influx of new capital into the ILS market, the heightened interest in investing in catastrophe bonds and other catastrophe reinsurance-linked investments and the resulting impact on pricing which has been well documented, it’s safe to assume that the data will show some reasonably large movements in these metrics in recent months.
Distribution of expected loss within the catastrophe bond market
First we’ll look at the expected loss distribution within the outstanding catastrophe bond market, as measured by WCMA. The expected loss distribution of the cat bond market can show us, on the issuers or sponsors side, the level of risk that cedents feel the cat bond market is receptive to, while secondly, on the investor side it gives us an insight into investors risk appetites.
This gives a view of the severity of risk sponsors want to offload to the capital markets, versus risk retained or reinsured in the traditional reinsurance markets. It also helps us understand the appetite for risk, motivations behind capital deployment and the level of return that ILS investors are willing to accept for assuming a certain level of risk. Comparing the expected loss to the risk premium makes this even more telling as you can clearly see where investor risk appetite lies across the broader ILS and cat bond market.
So, below you can see the distribution of expected losses within the outstanding catastrophe bond market at the 30th June 2013. It’s worth noting that WCMA’s market figures exclude a number of deals that other reports put as issued in Q2, but the trends remain the same. You can see from the graph that the market is $2 billion larger in 2013 than it was a year earlier and it looks like issuance has been focused on two expected loss brackets which have increased the most, the lower risk bracket of 0.76% to 1.5% expected loss and the mid-risk bracket of 2.51% to 4.5% expected loss.
From the above it does look like there has been a slight reduction in risk appetite from investors over the past year, but actually given the increased size of the market and the reductions in return that investors have been receiving, it actually shows that expected losses have not changed all that much across the whole market. There continues to be a clustering of deals within the 0.76% to 4.5% expected loss range. It would be interesting to see this broken down even further, perhaps by percentage point to show any clustering around specific expected loss points.
Perhaps a better comparison is with the same metric at the end of the first-quarter, which you can find here. The chart on that article clearly shows that there has been an influx of lower risk transactions in the last quarter, helping to bump up the 0.76% to 1.5% bracket from 29% of the market to now stand at 32% of the market. This perhaps shows that cedents have been taking advantage of cheaper pricing to offload their most remote risks into the catastrophe bond market.
Comparing risk premium and expected loss of the catastrophe bond market
The next pair of charts from WCMA compare the weighted average quarterly risk premium and expected loss of the last twelve months newly issued U.S. wind exposed catastrophe bonds and non-U.S. wind exposed cat bonds. It’s important to separate the two, U.S. wind and non-U.S. wind, to get a better picture of the trends in the marketplace. This is even more key at this point in time as price declines, both in traditional reinsurance and ILS, cat bonds and capital market alternatives to reinsurance, have been most pronounced in the U.S.
When we last looked at these charts at the end of Q1 2013, risk premiums had fallen slightly by the end of that quarter but expected losses had risen a little for U.S. wind and stayed static for non-U.S. wind cat bonds. This suggested that investors were willing to take on a little more risk in return for slightly lower coupon interest payments.
One quarter later and the impact of the declining prices and returns in the cat bond market have become much more apparent. As you can see from the charts above, U.S. wind weighted average quarterly risk premiums have plummeted by 30%, dropping from 11% at the end of Q1 to just 7.6% at the end of Q2. That’s a hefty decline and a very good way to visualise the impact of capital inflows and a maturing ILS investor base which is willing to take on risk at a lower return.
At the same time the weighted average quarterly expected loss of U.S. wind cat bonds has also declined, although not as far as risk premiums. From this chart we can work out a multiple, of risk premium to expected loss, which for U.S. wind at the end of Q2 was 3.45. A quarter earlier, when risk premiums were much higher, the multiple sat at approximately 4.4. This clearly shows that while pricing has dropped significantly, in terms of risk premium paid, investors risk appetite has risen and the multiple paid on U.S. wind exposed cat bonds has been dropping.
For non-U.S. wind exposed cat bonds risk premiums have also declined, from 4.8% to 4.2% over the last quarter, but when compared to the decline in U.S. wind cat bonds it’s clear that U.S. wind has felt the influx of investor capital the most in recent months. The multiple for non-U.S. wind cat bonds remains lower, however, showing that investors also have a heightened risk appetite for non-U.S. wind risk in catastrophe bond form.
So with risk premiums having declined faster than expected losses, and the multiple declining so much, on U.S. wind exposed cat bonds, it would suggest that the investors have been keen to deploy capital into the higher coupon U.S. wind risk in recent months. As well as showing a willingness to deploy capital for lower returns, returns which some might suggest have begun to be unrealistic compared to the risk on a number of deals, this also shows that there has been a need to deploy capital into the best opportunities available.
It has recently been suggested that ILS and cat bond pricing may have reached a floor and that it can decline no further. It will be interesting to watch where these metrics of risk premium and expected loss move to over the rest of 2013 and ahead into Q1 2014. Sponsors continue to take advantage of the attractive pricing and while it stays at these record low levels we expect issuance to remain strong. It’s unlikely that pricing could move any further south, however, without many established ILS investors having to consider their return targets which may help to establish a bottom for the market in terms of pricing.
Read our other article on WCMA’s recent report in our article from the 24th July, entitled: ILS and cat bond market has questions to answer to maintain growth: WCMA.
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