2014 may be a pivotal year for catastrophe bonds and sidecars: Willis

The coming year of 2014 may prove to be a pivotal one for the catastrophe bond and sidecar market, as the shakeout between traditional and alternative reinsurance capital continues, according to Willis Capital Markets & Advisory.

WCMA, the capital markets unit of global insurance and reinsurance broker Willis Group, has published its latest insurance-linked securities (ILS) market update report today, taking a look at the fourth-quarter non-life ILS and cat bond issuance trends as well as a look ahead to 2014.

WCMA forecasts an important year for cat bonds, sidecars and other third-party reinsurance capital structures, as they get to grips with the increased competition from traditional reinsurance capital which has reacted aggressively to the influx of capital markets money.

2013 was, on the one hand, a banner year for cat bond issuance, sidecar structures and collateralized reinsurance, said WCMA, with $7.1 billion of cat bond issuance according to the broker (WCMA does not include private deals, Artemis recorded $7.64 billion of issuance in 2013) as well as considerable sidecar activity despite the softening market price environment.

WCMA’s $7.1 billion is just slightly below its record figure of $7.2 billion for 2007. However, the 2007 total does include some investment grade ILS and if those are excluded, to compare like for like, then 2013 was a record for non-life, non-investment grade catastrophe bond issuance, said the broker.

Investment grade vs non-investment grade catastrophe bond issuance, 2007 vs 2013

Outstanding cat bond capacity also grew and WCMA says that the outstanding market has grown at a compounded rate of around 18% since the year 2000. It puts the size of the market at $18.7 billion, again below Artemis’ figure of $20.5 billion, but WCMA’s numbers are non-life and exclude most private deals.

Non-life catastrophe bond capacity issued and outstanding by year

But on the other hand, the traditional reinsurers have come out fighting, offering aggressive price reductions themselves, broadening terms and conditions and increasing the flexibility of their offerings to compete more strongly with ILS and the capital markets. Reinsurers have been defending their market share, with some launching pre-emptive quotes on favoured reinsurance programs.

Bill Dubinsky, Head of ILS at WCMA, explained; “2014 may prove to be a pivotal year for the cat bond and sidecar markets. On the one hand, 2013 was a banner year for cat bonds, sidecars, and collateralized reinsurance with $7.1 billion in non-life cat bond issuance and considerable sidecar activity despite the softening market conditions. On the other hand, traditional reinsurers are reacting aggressively to maintain market share by launching preemptive quotes to defend previously unassailable positions on the programs of favored clients.”

ILS investors, seeing the reduction in available cat bond spreads, have been taking equally aggressive measures to secure business, with some seeking to negotiate sole-placed collateralized reinsurance contracts at what WCMA terms ‘off market’ prices. By ‘off market’ WCMA explains that some investors have been offering pricing and terms and conditions at generally less favorable terms for the ceding company (but more favorable for the investor) than would be available in a syndication, likely with the idea of locking the cedent down as quickly as possible to a price.

WCMA questions whether the more flexible traditional reinsurance offering will act as ‘sandbags or a levee’ in its attempts to resist the inflow of alternative capital into reinsurance. The question here is whether ILS investors can continue to pursue property catastrophe business at the current low pricing and whether ILS can broaden its outlook to new lines and continue to build its capital base within reinsurance.

WCMA estimates that the total amount of cat bond, ILS, ILW, sidecar and collateralized reinsurance capital in the market grew to $50 billion by the end of 2013.

Some reinsurer CEO’s believe that ILS capital will recede once meaningful catastrophe losses occur and other asset classes begin to look more attractive. They also believe, said WCMA, that traditional reinsurers relatively efficient capital structure, the simplicity of traditional reinsurance contracts and features which ILS cannot match, such as reinstatements, will stem the flow of capital from investors.

WCMA notes that investors will have to make their own fight back against the more aggressive traditional reinsurance market. Making transactions as efficient, as quick and as low-cost as possible is one way that this can happen, whether through private ILS deals or by making Rule 144A issues as low-cost as is possible, something that has been in evidence in 2013.

The key for investors is to offer a product which solves real problems for the ceding companies and if investors can achieve this, at the lowest possible frictional costs, then there is a high probability of the market expanding further, said WCMA.

The emergence of more reinsurers as managers of third-party capital, ILS funds and sidecars, brings more opportunity for investors, said WCMA. Institutional investors such as pension funds, endowments, life insurers and others, can piggyback on the risk expertise that reinsurers offer to diversify and expand their access to risks. This can be either as a complement to direct investments, as a complement to investing through an existing ILS investment manager, or even as a first allocation to the asset class.

WCMA notes that with the market in a state of flux, with competition coming from all sides and the looming spectre of ever softer rates while large loss making catastrophes remain scarce, it is particularly hard to make a forecast for cat bond and sidecar activity for 2014.

Falling rates should help to grow the overall pie of available reinsurance opportunities, which WCMA notes may help to narrow the economic to insured loss gap in some regions of the world. WCMA says it will reassess its outlook for the year at the end of Q1.

WCMA believes that cat bond and sidecar rates will at some point have to reach a floor, as even though investors are considered to be in the space for the long-term it does not mean they will pursue uneconomic returns. At some point new allocations have to begin to slow if rates do not reach a floor that the investor community believes is commensurate with the risk they are taking and their cost-of-capital. How such floors compare to the costs of traditional reinsurance remains to be seen, notes WCMA.

Regulation is set to play a role in 2014, with issues such as Citizens depopulation, NFIP rate freezes, potential changes to TRIPRA and clarity over Solvency II, all expected to play a role in reinsurance demand as a whole and with the potential to provide new opportunity to ILS. Dodd Frank continues to cast a shadow over ILS and reinsurance, notes WCMA, but this is gradually becoming clearer.

In terms of a forecast for 2014, WCMA believes we could see 2014 non-life non-investment grade cat bond issuance exceeding 2013’s total with issuance of between $7 billion and $8 billion. Further growth in collateralized reinsurance is also possible. Sidecars, as typically annual structures, should see the current capacity remain static, but overall WCMA expects reinsurer sponsored ILS fund and sidecar capital will continue to grow.

The one certainty for the year ahead is that cedents and insurers are set to benefit from increased choice, better terms, more innovation, better pricing and savings by seeking reinsurance capacity from a variety of sources. 2014 is the year of the ceding company, said WCMA.

Tony Ursano, CEO of WCMA, said; “The reinsurance industry is in the midst of a gradual transformation as the inflows of third party capital continue to increase. We expect that 2014 will be marked by innovation, seeing new sponsors, new perils and new structures come to market in an effort to meet investors demand for risk.”

As the dynamic between alternative and traditional reinsurance capital and structures continues to evolve we are likely in for a number of pivotal years. The equilibrium between traditional equity capital from reinsurers and third-party capital from investors may take some years to reach and in the mean time we are guaranteed to see some interesting and potentially pivotal moves by players in the market.

At the moment it is very hard to forecast how this period of potential structural change in reinsurance will play out. The industry that we look at in twenty or more years time may bear little resemblance to the one we see today, or it may look exactly the same but with capital increasingly coming from multiple sources. It’s very hard to predict but it will stimulate innovation, new business models and ongoing competition for market-share between all players (traditional and non-traditional).