As risk premiums fall in the catastrophe bond market, expected losses rise

It’s time for another look at two of the metrics which give an insight into catastrophe bond transactions that have come to market recently and where the cat bond and reinsurance investment market feels its risk appetite lies. With the constant flow of new capital into the space now affecting pricing it’s a good time to revisit the risk premium and expected loss of the outstanding cat bond market.

As we did before, we’re using data from the recent quarterly insurance-linked securities and catastrophe bond market report from Willis Capital Markets & Advisory (WCMA) which was published earlier this month. You can read WCMA’s comments on the ILS market at the end of Q1 2013, as well as our thoughts on the report, in our article New inflows and return of generalist investors aiding ILS market growth.

Expected loss as a metric in the catastrophe bond market describes the probability of a loss of a certain size occurring on a specific transaction. Examining how the expected loss characteristics of the outstanding cat bond market change over time gives an insight into two things. Firstly, on the issuers or sponsors side it can show us the level of risk that cedents feel the cat bond market is receptive to, while secondly, on the investor side the expected loss of cat bond deals give us an insight into investors risk appetites.

From the sponsors side this helps us to better understand what severity of risk sponsors want to offload to the capital markets, versus risk retained or reinsured in the traditional reinsurance markets. From the investors side it helps us to better understand the appetite for risk, motivations behind capital deployment and the level of return 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.

The first thing to note is that risk premiums of recent cat bond transactions have been dropping, in some cases quite dramatically, with a number of 2013 cat bond deals pricing about 40% cheaper than a near equivalent deal a year earlier. This trend, created by the growth of the ILS market and inflows of capital with lower costs into reinsurance vehicles and funds, looks set to continue so a trend of risk premium declines is to be expected.

So let’s look at the distribution of expected losses within the outstanding catastrophe bond market. The first two side-by-side charts show the distribution of expected losses, within ranges, of the cat bond market at the end of 2011 versus the end of 2012. These are taken from our article published in February and we include them here for additional comparison. The lower side-by-side charts are from the recent WCMA report and show the expected loss distribution of the cat bond market at the end of Q1 2012 versus the end of Q1 2013 (including some additional marketed but not yet settled cat bonds).

Catastrophe bond risk capital outstanding by expected loss - Source: WCMA transaction database

It’s clear from the four charts above that the clustering of expected loss within the catastrophe bond market between 0.76% to 4.50% continues, as we wrote in our update in February. This trend continued in the first quarter of 2013 and more deals have been launched in the 2.51% to 4.50% expected loss bracket. This gives us a good picture of where the appetite of the cat bond investment market lies. You can see from the lower two charts that by the end of Q1 2013 the expected loss average had again shifted a little further to the right and seems to be settling in the middle.

The next pair of charts (below) compare the weighted average quarterly risk premium and expected loss of the last twelve months newly issued U.S. hurricane exposed catastrophe bonds and non-U.S. wind exposed cat bonds. U.S. wind still accounts for around 70% of the market so it’s important to separate it out from the other diversifying perils to get a better picture of premium and expected loss trends in the market.

Quarterly Weighted Average Risk Premium and Expected Loss of U.S. Wind and Non-U.S. Wind Exposed Catastrophe Bonds - Source: WCMA transaction database

The top one of these two charts (above) shows the clear downward trend in the risk premiums of U.S. wind exposed catastrophe bond deals issued in the last quarter of 2012 and first quarter of 2013. The average risk premium dropped by 0.6% over the first quarter of the year and we suspect that the same chart at the end of Q2 will show another drop, judging by recent deal pricing. At the same time, the weighted average expected loss of U.S. wind exposed cat bonds has risen by 0.2% in the first quarter of 2013.

This shows that investors are growing increasingly comfortable with U.S. hurricane risks and are accepting higher levels of this risk for lower returns. We covered this trend in an article on Friday: Growing number of capital markets investors accepting hurricane risk.

So ILS and cat bond investors have been willing to take on more U.S. wind risk for less reward in the first few months of 2013. This perhaps shows a maturing in the ILS investor market as it finds its feet and becomes more confident deploying capital into recent deals at lower risk premiums, driving down the eventual pricing on transactions and helping sponsors to find more value in the capital markets as a source of risk transfer. Of course it’s also been assisted by the abundant capital looking for opportunities to deploy.

The lower of the two charts shows that weighted average risk premiums on non-U.S. wind exposed cat bonds dropped by 0.6% to the end of Q1 2013. In this case expected losses remained the same as at the end of 2012, but it still signifies that sponsors should be able to get more risk transfer for their money transacting a diversifying cat bond now rather than six months ago.

So the takeaway here is that, as a whole, the catastrophe bond market and its investors in 2013 are willing to accept a greater level of risk (higher expected loss) for a lower return (lower risk premium) than at the end of 2012. As the pricing environment begins to settle, which it clearly has to as premiums can only drop so far, it will be interesting to see if the average expected loss settles too. It will also be fascinating to see how the traditional reinsurance rate-on-line charts compare after the mid-year renewals are completed.

Read our other article on Willis Capital Markets & Advisory’s recent report: New inflows and return of generalist investors aiding ILS market growth.