Average expected loss characteristics of catastrophe bonds on the rise?

Guy Carpenter have published their report looking back at Q1 catastrophe bond issuance, reviewing the market and looking ahead to the rest of the year. The report takes an interesting look at some of the trends emerging after the busiest Q1 of cat bond issuance ever. Of course no Q1 report would be complete without a look at the Tohoku earthquake which Guy Carpenter analyses as well.

We’ve covered Q1 and the disaster in Japan in great detail in recent weeks so we want to highlight one section of Guy Carpenters report that we think our readers will find of interest.

Guy Carpenter discusses the expected loss characteristics of the $1.02 billion of Q1 cat bond issuance. The risk profile of these new cat bonds has increased relative to transactions issued in 2010. The weighted average expected loss percentage for Q1 2011 issued deals is recorded as 2.02%. Guy Carpenter say that this average could decrease over the whole of 2011 but is significantly higher than the average expected loss from 1997 through Q1 2011 which comes out as 1.58%.

So does this mean that catastrophes are getting more prevalent and so the expected loss of a cat bond has risen? Or does it mean that issuers are desperate for cover for their peak perils and so issuing deals that are more risky? No, the reason for this increased risk profile in recent deals, Guy Carpenter say, can be explained by an increasingly sophisticated and informed investor base, a reduced availability of affordable leverage for cat bonds and the conditions in the reinsurance market.

Guy Carpenter say:

In relatively scarce capacity environments, such as 2006 and the first half of 2009, where minimum clearing spreads tend to increase, protection buyers are inclined to increase the expected loss of each transaction in order to improve price efficiency. In relatively plentiful capacity environments, such as the second half of 2009 and 2010, where minimum clearing spreads tend to decrease, protection sellers (with an improved ability to understand more “in the money” covers) are inclined to prefer riskier transactions in order to achieve target portfolio returns. The fact remains that, relative to the early 2000s, financial leverage for catastrophe bonds is less available, which tends to augment the tendency for higher risk catastrophe bond structures.

The graph below shows the weighted average expected loss of catastrophe bonds issued from 1997 through the recent quarter. You can clearly see the upward trend and the spikes in years where capacity in the reinsurance market was more scarce.

Weighted average expected loss of cat bonds 1997 through Q1 2011

Guy Carpenter note that the increase in the expected loss of cat bonds issued and the increasing willingness of investors to accept higher levels of risk in declining premium environments does not show an easing of analytical discipline in the market. Neither does it imply that market participants are making transaction terms lighter. Rather, it shows the improving ability of the cat bond market to “evaluate, understand and, where modeling and disclosure are sufficient, competitively price a more diverse range of perils, risk profiles, structures and triggers” say Guy Carpenter. That’s important, it shows a market which is becoming increasingly accepted by investors, increasingly sophisticated and diligent in its rigorous analysis methods.

So despite an evident trend for increasing expected loss characteristics the future looks bright, Guy Carpenter say, the increased sophistication and increased investor appetite for risk should help to stimulate productive and healthy long-term growth for the catastrophe bond market.

The rest of the report echoes much of what we have already written regarding Q1, the impact of the events in Japan and the outlook for the remainder of the year. Guy Carpenter acknowledge that cat bond sponsors have been holding off in the run up to the hurricane season as they assess pricing of traditional reinsurance. However they remain positive for the year as a whole and believe that the market could easily reach the lower end of the estimates for 2011 issuance (so somewhere around $5 billion).

Bill Kennedy, CEO of Global Analytics and Advisory, Guy Carpenter & Company, stated, “Aside from strong issuance, the story of the first quarter for the cat bond market was the Tohoku earthquake, with cat bond valuations declining for the second half of March. However, it is important to note that in the aftermath of one of the largest earthquakes in recorded history, the cat bond market continued to trade in an orderly and disciplined fashion. Additionally, investors report that their own capital providers are responding well to the potential for principal loss associated with the event. Capital providers are prospectively focused on the implications for future issuance and investment opportunities, rather than looking to reduce their exposure to the asset class.”

Chi Hum, Global Head of Distribution, GC Securities, added, “Overall, we see an improvement of the market’s ability to evaluate, understand and – where modeling and disclosure are sufficient – competitively price a more diverse range of perils, risk profiles, structures and triggers. This increased sophistication and measured expansion of investor appetite for risk should be a catalyst for healthy long-term growth. It is worth nothing that the long-term cumulative return profile for outstanding catastrophe bonds also compares favorably to alternative asset classes.”

You can read the press release here and download the full report.